Acct2112-management-accounting-comprehe

86100
Management Accounting (University of Western Au
Week 1: Management Accounting Introduction
Financial Accounting vs Management Accounting
• 1. MA = different focus
o Management accountant = FINANCIAL and NON-FINANCIAL information that helps managers
make decisions that will help company achieve goals or implement strategy
o FORWARD LOOKING
• 2. MA = reports information that helps managers do their jobs better
o Not restricted by GENERALLY ACCEPTED ACCOUTING PRINCIPLES
• 3. FA =
o Historical focus; operations to external parties
o Adhere to GAAP
• 4. Cost Accounting & FA, do not operate independently
o CA; provide information for management accounting decision making needs & data to meet
financial accounting inventory-valuation needs
• 5. Cost management
o Approaches & activities of managers to use resources to increase the value to customers & to
achieve organizational goals (reduce cost, revenue & profit planning)

MANAGEMENT ACCOUNTING FINANCIAL ACCOUNTING

Purpose of Information Help managers make decisions Communicate an organisation’s
to fulfill organisation’s goals financial position to investors,
banks, regulators, externals
Primary Users Managers External users
Focus and emphasis Future-oriented (budget for Past oriented (reports on 2013
2014, prepared 2013) performance, prepared 2014)
Rules of Measurement and Internal Measures & reportings Financial Statements must be
Reporting do not follow GAAP but based prepared in accordance with
on cost-benefit analysis GAAP and certified by external
and independent auditors
TIME SPAN & Type of reports Varies from hourly information Annual and quarterly financial
to 15-20 years with financial reports on company as a whole
and non-financial reports on
products, departments,
territories and strategies
Behavioural Implications To influence the behavior of Reports economic events but
managers also influence behavior because
manager’s compensation is
often based on reported
financial results

Management Accountant and Affecting Strategic Decisions

• 1. STRATEGY
o Describes how an organisation will compete & the opportunities management should pursue
o Matching its capabilities with the opportunities in the market place to accomplish its objectives
o Focuses on LONG TERM; performed by UPPER MANAGEMENT
o Tactical decision making = SHORT TERM; lower & middle management
 • 2. TWO BROAD STRATEGIES
o Competing on basis of price
o Competing on basis of product differentiation
• 3. STRATEGIC COST MANAGEMENT
o Describes cost management specifically focused on strategic issues
o Seeks to answer:
§ Who are our important customers; how do we deliver value to them?
§ What substitute product exists in the market? How do they differ?
§ What is our most critical capability? What we do best?
§ Will adequate cash be available to fund the strategy?

Set of Business Functions in Value Chain + Dimensions of Performance That

Customers expect
• 1. VALUE CHAIN
o Sequence of business functions in which customers usefulness is added to products or services
• 2. R&D
o Generating & experimenting with new ideas (new products, services or processes)
• 3. Design function undertakes detailed planning and engineering of PSP
• 4. Production
o Acquiring, coordinating and assembling resources to PSP
• 5. Marketing
o Promoting & selling products/services to customers
• 6. Distribution
o Process of delivering products or services to customers
• 7. Customer Service
o After-sale support to customers
• 8. Management Accountants
o Keep track of costs in each category
o Help managers evaluate cost-benefit trade offs
• 9. SUPPLY CHAIN IS RELATED to VALUE CHAIN
o Value chain = internal
o SUPPLY CHAIN = flow of G/S from initial source of materials and services to delivery to consumers


• 10. VALUE CHAIN and SUPPLY CHIAN =
o Used by company to deliver improving levels of performance to customers
• Key factors to ensure the delivery include:
o COST EFFICIENCY
§ What consumers are willing to pay for a product or service and set a TARGET PRICE
§ By subtracting desired profit, company an work out = TARGET COST
o QUALITY
§ Total Quality Management = improve operations of company and exceed customer
expectations
o TIME
§ New product development time and customer response time = two elements
§ Customers want it NOW
o INNOVATION
§ Constant flow of new G/S
o SUSTAINABILITY
§ Applying all the factors above to promote sustainability

5 steps Decision Making Process

• Managers should go through a routine process to make effective decisions
• 1. Identify the problems and uncertainties
o What choices are being faced? Where do the uncertainties lie?
• 2. Obtain Information
o Gather information before making a decision = helps make informed decision
• 3. Make predictions about the future
o On the basis of information obtained, attempt to predict outcome of each course of action
• 4. Make decision by choosing among alternatives
o Information gathered + projection made = select an alternative
• 5. Implement the decision, evaluate performance & learn
• Once implemented, decision must be monitored = PERFORMANCE EVALUATION
• Can be done through comparing the budget with ACTUAL RESULTS
o Budgeting = control tool in addition to planning tool
o Accomplished by PERFORMANCE REPORT
• Budget = quantitative expression of a proposed plan of action
• LEARN:
o If results were not as planned, find out why
o Use this information to improve the decision making process for future decisions
• STEPS 1 – 4 = PLANNING
o Selection of organisation goals, predicting results under alternative ways of achieving these goals,
deciding how to attain these goals and communicating the goals to the entire organisation
• CONTROL
 o Action taken to implement the planning decisions represented by the budget

Management Accounting Fitting into an organisation’s Structure

• 1. Most organisation distinguish between LINE & STAFF relationships
o LINE MANAGEMENT
§ Responsible for attaining the goals of the organisaiton
§ Producing is a LINE FUNCTION
o STAFF MANAGEMENT
§ Supports line management with advice and assistance
§ Accounting + HR = staff management
• 2. CFO = responsible for overseeing the financial operations of an organisation. FUNCTIONS
o CONTROLLER
§ Financial information to managers + shareholders and oversees the overall operations of
the accounting system
o TREASURY
§ Banking, financing, investments & cash management
o RISK MANAGEMENT
§ Managing the financial risk of interest rate and exchange rate changes as well as
derivatives management
o TAXATION
§ Income taxes, sales taxes, and international tax planning
o INVESTOR RELATIONS
§ Respond to and interact with shareholders
o STRATEGIC PLANNIGN
§ Defining strategy and allocating resources to implement strategy
• INTERNAL AUDIT
o Increased importance in recent years
o Includes reviewing and analyzing financial and other records to attest to the integrity of the
organisation’s financial reports and adherence to policies and procedures


Week 2 : COST
Definition of Cost
• Cost is defined as resources sacrificed or forgone , usually measured in monetary terms, to achieve a
SPECIFIC COST OBJECT
• COST OBJECT
o An activity or thing for which we want to know the cost information
§ Products or service (eg computer, car, tax consulting fees)
§ Departments (eg production department, assembly department)
§ Customers
§ Project
§ Activity
• Example
o APPLE COMPUTER PRODUCT LINES
§ Mac mini
§ Macbook
§ Macbook air
§ Mac Pro
• COST OBJECT
o Costs information can be accumulated and/or measured
o COSTS = various components parts of manufacturing/producing a Mac Pro
• TYPES OF COSTS: Direct vs Indirect costs
o DIRECT COSTS
§ Workers
 § Readily traceable to the COST OBJECT; trance in an economically feasible (cost effective)
way (eg Direct Materials)
o INDIRECT COSTS
§ Not readily traceable – cannot be traced in an economically feasible (cost effective) way
to the COST OBJECT/PRODUCT
§ Part of the overheads
§ (eg Telephone Expenses)
• COST IS DIFFERENT FROM EXPENSES

Uses of Cost Information

• Information on cost associated with the cost object facilitates decisions
o What price should be charged for the product or service?
o Which department uses its resources most efficiently?

Cost Accumulation and Cost Assignment

• COST ACCUMULATION; collection of cost information in some organized way by means of an accounting
system
• Once we gather, we must assign it
• COST ASSIGNMENT;
o TRACIG accumulated costs to a cost object
o ALLOCATING accumulated costs to a cost object
o (Distributing the costs to the COST OBJECT)
• INDIRECT COST
o i.e TEXTBOOK; company has to pay insurance for building

Direct and Indirect

• Costs can be DIRECT in one situation and INDIRECT in another; depending upon the COST OBJECT
• (eg Departmental Supervisory Salary)
o Direct Cost; if object is the DEPARTMENT
o Indirect cost; if the cost object is the output of the DEPARTMENT

Example
• $10,000 Supervisory Salary/month; type of cost depends on COST OBJECT
o Direct
 o Indirect
• COST OBJECT
o Assembly Department ($); then the following direct costs
§ Insurance
§ Depreciation
§ Electricity to run machinery
§ Telephone
§ Supervisory Salary
o Macbook produced by the assembly department; DIERCT COSTS =
§ Direct labour
§ Direct Materials
§ Indirect;
• Insruance, depreciation, salary, telephone – cannot be easily traced to the
macbook

Indirect Manufacturing Costs and Other Overheads

• Indirect manufacturing costs (Factoring Manufacturing Overheads – FOH)
o Associated with factory or production unit (heating and lighting of factory)
• ADMINISTRATIVE COSTS
o Associated with the administration of the business (eg telephone expenses in administrative
office)
• SELLING AND DISTRIBUTING COSTS
o Association With acquiring orders and delivering finished goods to customers (i.e advertising,
warehousing)
• FINANCE COSTS
o Associated with getting funds into the business (eg interest expenses)

What is a Cost Driver?

• Cost Driver – any factor whose change causes a change in TOTAL COST of a related cost object

• As X1 increases to X2 -> DIRECT impact on TOTAL COST
• COST DRIVER = no. of hours worked by account clerk

Concept of Relevant Range

• Relevant Range
o The range of activity within which management expects the company to operate


Cost Behaviour Patterns

• FIXED COST
o A cost which does not change in total, despite changes in a cost driver
o (eg rent, taxes and insurance)

o
o Cost DRIVER can increase, but TOTAL FIXED COST will remain the same
• VARIABLE COST
o A cost which changes in direct proportion to a cost driver (eg DIRECT MATERIALS)

o
o (i.e hours worked by accountant)

Example
• VC = variable cost
• FC = fixed Cost
• VC + FC = Total Cost = Mixed Cost
• Relevant Range:
o X1 – X3 for example
o Management would like to operate due to resource constraint
 o

Total and Unit Costs Behaviour

TOTAL COST BEHAVIOUR UNIT COST BEHAVIOUR
VC Varies; total cost will change as Stays the same
your cost driver starts to change
FC Fixed; total fixed cost will CHANGE
remain fixed
Example: Total Cost Behaviour
• Assumptions:
o Variable Cost; raw material
§ Raw material = $2/unit
o Fixed Cost = Office salaries
§ =$5
• Cost Driver = the no. of units that will be produced
o If I produce nothing
§ Raw materials = $0
§ Fixed Cost will still be incurred = $5
o If I produce 1 unit
§ Variable Cost = $2 for raw materials
§ Fixed Cost = $5
§ TOTAL = $7
o If I produce 2 units
§ VC = $4
§ FC = $5
§ Total = $9
• As my cost driver increases, FIXED COST REMAINS FIXED
• Variable cost will increase

• VC + FC = TC
• Unit Cost = an AVERAGE
• EXAMPLE:
o Produce 1 unit:
§ Fixed Cost = $5
§ VC = $2
§ Unit Variable Cost = $2/1 = $2
§ UFC = $5/1 = $5
o Produce 2 units
§ FC = $5
§ VC = $4
§ Unit Variable Cost = $4/2 = $2 – remains the same
§ UFC = $5/2 = $2.50 (decreases)

• Horizontal line = unit variable cost
o Remains constant as cost driver increases
• FIXED COST = spread over more units as the cost driver increases (goes down)
o More unit produced = fixed cost is SPREAD
• UVC + UFC = Unit Total Cost
 •

Prime Costs and Conversion Costs

• PRIME COSTS
o Direct material costs (DM) and DML (Direct manufacturing labour cost)
o Traceable to cost object
• CONVERSION COST
o Direct manufacturing labour costs (DL) and indirect manufacturing costs or FACTORY OVERHEAD
(FOH)
o All manufacturing costs other than direct materials
o Converts raw materials into finished product
o Will not have material costs
o All production costs apart from material costs

Relationship Between Direct materials, Direct Labour & Factory Overheads

• PRIME COSTS:
o DM + DL
• Conversion Costs
o DL + FOH

Product Costs and Period Costs

• Product costs
o Costs of manufacturing a company’s products
o Report as either INVENTORY (ie before the units are sold) or COST OF GOODS SOLD (i.e after the
units are sold)
• PERIOD COSTS
 o Costs of selling and administration activities
o Recognise on the income statement during the FISCAL PERIOD in which they are incurred
o (i.e OPERATING COSTS; incurred periodically with a view to generate revenue – operating
expenses)

Inventoriable Costs
• Inventoriable costs:
o Product costs
o All costs of a product that regarded as an asset when they are incurred and come COGS when the
product is dolf

Manufacturing, Merchandising and Service Sector Companies

• Manufacturing sector companies
o Conversion of raw material into finished goods (pepsi)
o All manufacturing costs = inventoriable costs
• Merchandising sector companies
o Purchase products and sell without changing basic form (David Jones, Target)
o Costs of purchasing the goods – the invetoriable costs
• Service Sector Companies
o Services or intangible products (Arthur Anderson, Commonwealth bank)
o No inventoriable costs

Comparing Merchandising and Manufacturing

Relationships of Inventoriable & period costs (Manufacturing Company)

• Direct Manufacturing Inventory -> WIP Inventory -> finished Goods inventory – COGS (expense)
• WIP = work in progress
• DM = Direct Material inventory

Example: Manufacturing Sector

• Step 1: COST OF DIRECT MATERIAL USED:
o Beginning Inventory of DM 11,000
o + Purchases of DM 73,000
o – Ending Inventory of DM (8,000)
§ =Direct Materials Used 76,000
• Step 2: TOTAL MANUFACTURING COSTS INCURRED:
o (all direct manufacturing costs and manufacturing overhead costs for all goods worked during
the year)
o Direct materials Used 76,000
o Direct Manufacturing Labour 9,000
o Manufacturing Overhead Costs 20,000
§ =Total manufacturing costs Incurred 105,000
• Step 3: COST OF GOODS MANUFACTURED
o (cost of goods brought to completion, whether they were started before or during the current
accounting period)
o Beginning Work-in-Process Inventory 6,000
o +Total manufacturing Costs Incurred 105,000
§ =Total manufacturing costs to account for 111,000
§ -Ending Work-in-process inventory (7,000)
o =COGM 104,000
• Step 4: COGS
 o (Cost of the finished goods inventory sold to customers during current period)
o Beginning Inventory of Finished goods 22,000
o +Cost of goods manufactured 104,000
o –Ending inventory of finished goods (18,000)
§ =COGS 108,000

Relationship of Inventoriable & period Costs (Merchandising Company –

Retailer or Wholesaler)

Cost of Goods Manufactured

• = Beginning balance in WIP + Current Manufacturing costs – Ending Balance in WIP
o Direct Material
o Direct Labour
o Manufacturing overhead

Cost of Goods Sold

• =Beginning Balance in Finished Goods + Costs of Goods manufactured – Ending Balance in Finished Goods

Week 2 Lecture Examples

Example 1 Com
• Direct Labour
• Direct Material
• Selling and Distribution Costs
• Administration Costs
• Finance Costs
• Manufacturing overhead

COST CLASSIFICATIOn
Lubricant for sewing machines Manufacturing overhead
Interest on Bank overdraft Finance costs
Wages of security guards for factory Manufacturing overheads
Cost of advertising products on television Selling and distributing costs
Cost of raw materials Direct material
Wages of operatives in the Cutting Department Direct Labour
 Cost of painting advertising slogals on delivery Selling and distribution costs
vans
Wages of fork lift truck drivers who handle raw Manufacturing overhead
materials
Cost of fabric used in T SHIRT Direct material
Chief accountant salary Administration Costs
Example 2
XYZ Company manufactures leather belts. Relevant information as follows:
Raw material (Leather) $ 5.00 per unit
Rent 450.00

• When production = 1 unit:

o TOTAL COST BEHAVIOUR:
§ Leather (VC) = $5
§ Rent (FC) = $450
• TOTAL = $455
o UNIT COST BEHAVIOUR
§ Leather (UVC) = $5
§ Rent (UFC) = $450
• TOTAL = $455
• When production = 10 units
o TOTAL COST BEHAVIOUR
§ Leather (VC) = $50
§ Rent (FC) = $450
• TOTAL = $500
o UNIT COST BEHAVIOUR
§ UVC = 50/5 = $5
§ UFC = $450/10 = $45
• TOTAL = $50

Example 3
LECTURE ILLUSTRATION EXAMPLE 3
The following data are taken from the $
books of XYZ Company for the year 2015:
Cost incurred:
Purchases of raw materials 132,000
Direct labour 90,000
Advertising expense 100,000
Rent-factory building 80,000
Sales commission 35,000
Utilities-factory 9,000
Indirect labour 56,300
Maintenance-factory equipment 24,000
Supplies-factory 700
Depreciation-factory equipment 40,000
Depreciation-office equipment 8,000
July 1, 2014 June 30, 2015
$ $
Inventories:
Raw materials 8,000 10,000
Work-in-process 5,000 20,000
Finished goods 70,000 25,000

• A) COGM for year ended 30 June 2015

$ $
DIRECT MATERIALS
Raw Materials inventory – 1 July 2014 8,000
ADD: Purchases of raw materials 132,000
RAW MATERIALS AVAILABLE FOR USE 140,000
Less : Raw Materials Inventory : 30 June 2015 10,000
COST OF RAW MATERIALS CONSUMED 130,000
DIRECT LABOUR 90,000
PRIME COST =130,000 + 90,000
=220,000

MANUFACTURING OVERHEAD
Rent Factory Building 80,000
Indirect Labour 56,300
Utilities Factory 9,000
Maintenance Factory Equipment 24,000
Supplies Factory 700
Depreciation-factory Equipment 40,000

TOTAL OVERHEAD COSTS 210,000
MANUFACTURING COSTS INCURRED DURING =210,000 + 220,000
YEAR =430,000
ADD: WIP at 1 July 2014 5,000
Manufacturing Costs to be accounted for 435,000
Less : WIP at 30 June 15 20,000

COGM 415,000

• COST OF GOODS SOLD

Finished Goods Inventory, 1 July 2014 70,000

Add: COGM 415,000
GOODS AVAILABLE FOR SALE 485,000
Less: Finished Goods Inventory, 30 June 15 25,000
COGS 460,000

• Profit and Loss Statement for Year Ended 30 June 2015 (assume $1,000,000 sales revenue)

$ $
SALES REVENUE 1,000,000
Less:
COGS 460,000
 GROSS PROFIT 540,000
Less Operating Expense
Advertising Expense 100,000
Sales Commission 35,000
Depreciation –Office Equipment 8,000
(143,000)
NET PROFIT 397,000

Week 3: Cost Volume Profit Analysis

• A management planning technique which analyses the relationship between COST (Total Cost, Variable
and Fixed Cost) and VOLUME (the number of units output produced and sold, or the number of sales
dollars realized), and their combine impact on PROFIT

CVP Analysis
• Help to management in making decisions:
o What sales volume is required to break even ? (no profit or loss?)
o What sales volume is necessary to earn profit?
o How would changes in selling prices, variable costs, fixed costs and output, affect profits?
• Break-even analysis
o A process to determine the break-even sales where total cost equal total revenues
o TOTAL REVENUS = TOTAL COST
o TR = VC + FC
• BREAK EVEN POINT
o Where total revenues and total costs are equal
o Where the total revenues line and total costs line intersect
o Operating income = 0

• 25 units to breakeven => TR = TC
• 20 units => TR < TC so LOSS
• 40 units => TR > TC so PROFIT
• From management POV; avoid red area
Revenue Driver
• Cost DRIVER; to do with TOTAL COST
• Revenue driver = any factor whose change causes a change in total revenue of a related product/service
o Volume Sold
o Change in selling price
• EXAMPLE:
o Unit Selling Price = $10
o Volume = 100
o $10 x 100 = TR = $1000
• Use VOLUME as COST DRIVER
o $10 x 200 = $2000
o Increase revenue by $2000
o So VOLUME is a DRIVER

Basic CVP Assumptions

• Changes in the levels of revenues and costs are due to changes in the number of units sold
• No. of units sold = only COST and REVENUE DRIVER
• TOTAL COSTS, can be divided into VC and FC
• TR and TC are linear within the relevant range:
o (i.e between X1 and X2)

o
o X1 & X2 = where management wants to operate
• USP, Unit variable Cost and Fixed costs known and constant
• Single Product (or multiple product constant sales mix as total units sold change)
o SALES MIX = proportion of product you sell
o (i.e company sells 3 products)
§ A = 20%
§ B = 40%
§ C = 40%
o This proportion = CONSTANT

Break-Even Analysis
• Graph Method
• Equation Method
• Contribution Margin Method

Example 1
• Shirt:
 o Sale Price = $40
o VC:
§ Invoice Cost = $18
§ Sales Comission = $7
§ TOTAL UVC = $25
o Fixed Cost/yr
§ =$300,000
o Relevant Range
§ 0-45,000 shurts

Volume Revenue TVC FC TC Profit (loss)

0 0 0 300,000 300,000 (300,000)
10,000 400,000 250,000 300,000 550,000 (150,000)
15,000 600,000 375,000 300,000 675,000 (75,000)
20,000 800,000 500,000 300,000 800,000 0
• Breakeven Point = 20,000 volume

• 2. Assuming that in July, company had budget to sell 40,000 shirts, what is MARGIN OF SAFETY for that
month?
o MARGIN OF SAFETY
§ Measure of difference between the BUDGETED (or actual) level of sales and the break-
even sales
§ Amount by which sales revenue may drop before losses begin
 § Break-even = 20,000 units
o SAFETY MARGIN
§ Difference between budgeted and break-even
• =$1,600,000 - $800,000
• =$800,000 = SAFETY MARGIN
§ Expressed as a percentage:
• =800,000/1,600,000
• =50%

Contribution Margin Concepts

• Contribution Margin = excess of total revenues over TOTAL VARIABLE COSTS
o TOTAL REVENUES – TOTAL VARIABLE COSTS = Contribution Margin
o Contributes to recovering fixed costs; once fixed costs are fully recovered, it contributes to
operating income/profit
• Contribution Margin Per Unit (UCM)
o (Total Revenue = USP x Vol.)
o Total Variable Cost = UVC x Vol.
o Selling Price Per Unit (USP) – Variable Cost Per unit (UVC) = UCM
• Contribution Margin Ratio
o Calculated as a PERCENT OF SALES
o =UCM/USP

The Equation Method

• Total Revenue = TOTAL COST at breakeven
• TR > TC = TR – VC – FC = Income
• TC > TR = TC – TR = LOSS
• Revenues – VC – FC = Operating Income
• If we let (Q = Volume in units), the above relationship can be rewritten in terms of Q
o (USP x Q) – (UVC x Q) – FC = Operating Income
§ USP = unit selling price
§ UVC = unit variable costs

Contribution Margin Method

• At BREAKEVEN = (USP x Q) – (UVC x Q) – FC = 0
o (USP – UVC) x Q – FC = 0
• By Solving the above equation for Q, we have:
o
o Q = FC/ (USP – UVC)
o Q = FC / UCM
o Q = FC/CM Ratio
• Where:
o UCM = unit contribution margin
o Q = quantity in unit

Example 2
• $60/unit
 • Fixed Cost = $360,000
• Contribution Margin Ratio = 40%
• FIND:
o VARIABLE COST
§ CM Ratio = UCM/USP = 40%
§ UCM/60 = 40%
§ UCM = $24
§ Contribution Margin = USP – UVC
§ UVC = $60 - $24
§ UVC = $36
o BREAK EVEN POINT
§ 0 = Profit – VC – FC
§ Profit = VC + FC
§ 60X = 36X + 360,000
§ 24X = 360,000
§ X = 15,000 units (BREAK-EVEN POINT)
§ 15,000 x $60 = $900,000 (break-even point in sales dollars)
• (b) Calculate the sale level in units and in sales dollars required to earn an annual operating profit of
$90,000.
o 60X = 36X + 360,000 + 90,000
o 24X = 450,000
o X = 18,750 (Break-even point in units)
o 18,750 x $60 = $1,125,500 (Breakeven Point in sales dollars)
• (c) Assume MicroChips Company is able to reduce its variable costs by $3 per unit. Calculate the
company new break-even point in units and in sales dollars
o 60X = 33X + 360,000
o 27X = 360,000
o X = 13,333 (break-even point in units)
o 13,333 x $60 = $800,000 (break-even point in sales dollars)

Using the Contribution Margin

• (a)
o =360,000/(60-36) = 15,000 units
o 15,000 x $60 = $900,000
• (b)
o (360,000 + 90,000) / $60-$36 = 18,750 is BREAK-EVEN point in units
o 18,750 x $60 = $1,125,000 (Break-even point in sales dollars)
• ©
o $360,000 / ($60-$33) = 13,333
o 13,333 x $60 = $800,000

Operating Income and Target Net Income

• Income STATEMENT
o Revenue
o (Less: COGS)
§ Gross Income
 § (Less Operating Expenses)
§ Total = Operating Income
• Tax
o = TNI
• Operating Income
o Revenue earned from operations – Operating Costs (including COGS)
• Target Net Income (TNI)
o Operating Income + non-operating revenue – Non-operating costs – Income taxes
§ Assume in this unit
• Non-operating revenue and non-operating costs = 0
• (i.e bank interest)
• So TARGET NET INCOME = Operating Income – Income Taxes
• Say Operating Income = $1,000
o Tax = 40% = $400
o TNI = $1000 – 400 = $600

Impact of Income Tax

• By introducing income tax effects:
o TNI = OI – (OI x Tac Rate)
§ =$1000 – 1000 x 40%
§ =$600
o TNI = OI x (1- Tax Rate)
• Rearrange
o OI = TNI / (1 – Tax Rate)
• Using the equation method we have:
o Operating Income = Revenue – VC – FC
• By substitute
o OI = TNI / (1 – Tax Rate)
• We Have;
o Revenue – FC – VC = TNI / (1- Tax Rate)

Lecture Example 3
Smith Trading Company is the exclusive agent for a new product. The product is sold for $80 per unit. The
company's contribution margin ratio is 20 percent, and its annual fixed costs are $100,000. Assume the
income tax rate is 40 percent.
REQUIRED:
Calculate the number of units to be sold to earn a target net income of $150,000.

• Information:
o USP = $80
o FC = $100,000
o CM Ratio = 20%
o Tax Rate = 40%
o TNI = 150,000
• (USP x Q) – (UVC x Q) – FC = TNI / (1- Tax Rate)
• Operating Income = Revenue – VC – FC
o CM RATIO = UCM / USP
o 20% = UCM / 80
 o UCM = $16
• USP – UCM = UVC
• UVC = $80 - $16 = $64
• Let x = no. of units sold
o =80X – 64X – 100,000
o =150,000/ (1-0.4)
o 16X = [150,000/ (1- 0.4)] + 100,000
o 16X = 350,000
o X = 21,875 units
$ %
Sales Revenue (21,875 x $80 $1,750,000 100
VC ($64) (1,400,000) 80%
CM 350,000 20
FC (100,000)
Operating Income 250,000
Tax Rate (40%) 100,000 = 250,000 x 40%
NET PROFIT (TNI) $150,000

CVP Analysis With Multiple Products (1)

• Most firms have more than one product line
o (nokia 3210, 5670)
• The concept of SALES MIX – the relative proportion of each type of product sold
o Product A = 80%
o Product B = 20%
• Weighted average unit contribution margin
o The average of the products unit contribution margins, weighted by the relative sales proportion
of each product
• Break-even point (units)
o =FIXED COSTS/ Weighted Average Unit Contribution Margin
• Breakeven (TOTAL REVENUE)
o =Fixed Costs/ Weighted Average Unit Contribution Margin %

Example 4:
John’s Bicycle Shop sells bicycles. For purposes of a cost-volume-profit analysis, the shop owner has divided
sales into two categories, as follows:

• High Quality = 25%
• Medium = 75%

Three-quarters of the shop’s sales are medium-quality bikes. The shop’s annual fixed expenses are $65,000.
(In the following requirements, ignore income taxes).
REQUIRED:
1. Compute the unit contribution margin for each product type.

2. What is the shop’s sales mix?

3. Compute the weighted-average unit contribution margin, assuming a constant sales mix.

4. What is the shop’s break-even sales volume in dollars? Assuming a constant sales mix.

5. How many bicycles of each type must be sold to earn a target net income of $48,750? Assuming a constant
sales mix.

• 1) Contribution Margin

Bicycle Sales Price UVC UCM

High Quality $500 $300 = (275 + 25) =500 – 200 = $200
Medium Quality $300 (135 + 15) = $150 =300 – 150 = $150
• 2) Sales Mix

High Quality Bicycles (1/4) 25%

Medium Quality (3/4) 75%
• 3) Weighted Average UCM

Weighted Average UCM =(200 x 25%) + (150 x 75%)

=$162.5
• 4)Break even sales volume in dollars

Break-Even point in units =Fixed Expenses/ Weighted Average UCM

=65,000/162.5
=400 bicycles

Bicycle Type Break-Even Sales Sales Price Sales Revenue

Volume
High Quality 100 = ( 400 x 0.25) $500 $50,000
Medium Quality 300 = (400 x 0.75) $300 $90,000
TOTAL $140,000
• 5. FIXED COSTS to include a target net income of $48,750

Sales Volume required for TNI = $48,750 =(65,000 + 48,750) / 162.50

= 700 bycicles

Week 4: Job Costing

Concepts of Costing Systems
• COST OBJECT
 o Anything for which a measurement cost is desired
o (i.e product, service)
• DIRECT COSTS of a COST OBJECT
o Costs related to a particular cost object that can be traced to that cost object in an economically
feasible (cost-effective) way
o (purchase of parts for a computer)
• INDIRECT COST of a COST OBJECT
o Costs related to cost object that cannot be traced easily to the cost object in an economically
feasible way
o (cost of supervisors who oversee multiple products, rent)
• COST ASSIGNMENT
o Assigning costs; direct or indirect
• COST TRACING
o Assigning direct costs
• COST ALLOCATION
o Assigning indirect costs
• COST POOL
o Grouping of individual indirect cost items
o Range from broad such as all manufacturing-plant costs; to narrow such as costs of operating
metal-cutting machines
• COST-ALLOCATION BASE
o Systematic way to link an indirect cost or group of indirect costs to object cost
o EXAMPLE:
§ Indirect costs of operating metal cutting machines - $500,000; based on running 10,000
hours. Cost Allocation = 500,000/10,000 hours = $50/machine hour
§ Machine hour = allocation base
§ If 800 hours used = 800 x 50 = $40,000

Job Costing and Process Costing

• JOB COSTING SYSTEM
o In this system, COST OBJECT is a unit or multiple units of a distinct product or service called JOBS
o Provides for the accumulation of costs around an individual job or order
o Each job will differ in terms of amount, material, labour or overhead costs incurred
o (i.e each custom made furniture is different; chairs, tables)
o Job costing system accumulates differently to each product/service
• OPERATING COSTING
o Hybrid Costing System which:
§ 1) Assigns direct material costs to individual batches based on JOB COSTING approach
§ 2) Accumulated conversion costs by department which are allocated to all units passing
through the department relied a PROCESS COSTING approach
• PROCESS COSTING SYSTEM
o In this system, the cost object is masses of identical or similar units of a product or service
o (i.e Citibank provides the same service to all its customers when processing deposits. Intel
provides the same product to its customers)
o In each period, process-costing system divide the total costs of producing an identical product by
the total no. of units produced to obtain a PER-UNIT COST
 o The PER-UNIT COST = average unit cost that applies to each of the identical units produced in
that period
o Manufacturer produces large volumes of similar products in a continuous manner (MASS
PRODUCTION METHOD)

The Nature of Output and Costing Methods

OUTPUT HETEROGENOUS HOMOGENEOUS
INDUSTRY -Custom-built furniture -Produce chemicals
-Motor car mechanics -Microchip
-Ship buildings
COSTING METHODS -Job Costing (job-order costing) -Process Costing

Documentation Used in Job Costing: materials

• 1. Raw Materials are kept in the warehouse
• 2. As raw materials are needed for production, they are transferred from the warehouse to the
production department
• 3. Raw materials are drawn from the warehouse on the presentation of a MATERIAL REQUISITION FORM
(source document)
• 4. A copy of the material requisition form goes to the accounting department:
o Material requisition form is used as the basis for transferring the cost of material from the raw
materials inventory control account to WORK IN PROGRESS control account; and to enter the
COST OF DIRECT MATERIALS on the job cost card; or
o To enter COST OF INDIRECT MATERIALS on the manufacturing department overhead control
account
Material Requisition Record & Labour Time Ticket/Sheet

• PANEL A
o Information about the job
o Consists of brackets for 8 units
o Total Cost = $112 for this job; can trace to the job
o $112 = direct cost – will be reflected in the JOB COST CARD/RECORD
• PANEL B
o Rate = $18/hr
o Fort his specific job, has amount of hours worked
o Employee no.
o Direct Manufacturing Labour Cost for the JOB
o Employee also spends alternating days in maintenance
§ Not to do DIRECTLY with the JOB but INDIRECTLY
§ This is INDIRECT LABOUR OVERHEAD
o Labour time sheet = reflects direct and indirect labour
Job Cost Record/Card

• Direct Materials
o =$112 for this job
• Direct Manufacturing Labour
o For the specific job

Documentation Used in Job Costing: Labour

•
• When somebody comes to work in the factory = CLOCK IN
• When they leave = CLOCK OUT
• Time ticket = keeps track of your working hours for a specific job; DIRECT LABOUR COST
• Also keeps track of INDIRECT LABOUR; overhead
• The assignment of DIRECT LABOUR COST is based on TIME TICKETS
 o Source document
• The time ticket is the source document used in the accounting department as the basis for adding DIRECT
LABOUR COSTS to WIP Control Account to JOB COST CARD
• See Panel B

Allocation of Manufacturing Overheads

• Direct materials and direct labour can be traced directly to the physical units worked on through material
requisition forms and time tickets (source documents)
• MANUFACTURING OVERHEADS (indirect costs)
o Cannot be traced directly to the physical units
o (i.e heating & lighting, telephone expenses, depreciation on machinery)
• These costs bear NO obvious relationship to individual jobs or units of product, but they must be incurred
for production tot ake place
• Therefore, it is necessary to assign manufacturing overheads to jobs in order to have a complete picture
of product costs
• MANUFACTURING OVERHEADS
o Is allocated (absorbed by) product based on budgeted manufacturing overheads (indirect costs)
rate

Budgeted Manufacturing Overheads (Indirect Costs) Allocation Rate

• Has to allocate based on budgeted manufacturing overheads rates; estimated at the beginning of the
accounting period
• STEPS:
o 1. Select a COST ALLOCATION BASE (i.e direct labour, direct material)
o 2. Prepare a budgeted manufacturing overheads (MOH) amount if not given
o 3. Compute a budgeted MOH allocation rate
§ Budgeted MOH Allocation Rate = Budgeted Total MOH/ Cost Allocation Base
o 4. Obtain actual allocation base data (eg actual DLH)
o 5. Allocate MOH to job
§ =budgeted MOH allocation Rate x actual allocation base
Example 1
LECTURE ILLUSTRATION EXAMPLE 1
Job cost record for JOB #123 of XYZ Company has the following information:
Actual direct materials: $1,000
Actual direct labour: $2,000
Actual labour hours: 10
REQUIRED:
What is the total product costs of Job #123, if the XYZ Company budgeted total factory overheads is $800
and the budgeted direct labour hours is 8?

• TOTAL PRODUCT COSTS:

o Direct Material = $1,000
o Direct Lavour = $2,000
o MOH Allocated:
§ =$800/8
§ =$100/DLH
o Actual Allocation Base Data
§ =10 DLH
 o MOH To job #123
§ =10 x $100
§ =$1,000
• TOTAL:
o =1,000 + 2,000 + 1,000
o =$4,000

Actual Costing and Normal Costing

• Different types of product costing systems are distinguished by the TYPE OF COSTS that are entered in
the WIP account
• Actual costing means ACTUAL costs are used for ALL COSTS
• NORMAL COSTING
o Actual costs are used for PRIME COSTS
o Allocated costs = used for overheads
Actual Costing v Normal Costing
• Actual Costing
o Actual overhead rate
o More accurate, but untimely information
• Normal Costing
o Budgeted overhead rate
o Less accurate but timely information
• Use of actual or normal costing system
o Trade-off between timeliness and accuracy
o Costs and benefit
Example 2

• DM Actual Cost
o A = $600
o B = $800
• DL Actual Cost
o A = $200 + $400 = $600
o B = $800 + $600 = $1,400
Step 1: Apportionment of Heating & Lighting to production Departments
COST Basis of TOTAL PD1 PD2
Apportionment
Heating and Floor Size $9,000 1/3 = $3,000 2/3 = $6,000
Lighting


Step 2: Ascertain the TOTAL DEPARTMENT MANUFACTURING OVERHEAD
PD1 PD2
Indirect Materials 10,000 14,000
Indirect labour 12,000 16,000
 Heating & lighting 3,000 6,000
TOTAL 25,000 $36,000


Step 3: Workout FACTORY OVERHEAD ALLOCATION RATE to allocate costs in Step 2 (use DIRECT LABOUR HOURS)

PD1 PD2
=budgeted Department =25,000/25,000 DLH =36,000/18,000 DLH
Manufacturing
Overhead/Budgeted direct
labour hours
Rate =$1/DLH =$2/DLH

Step 4: Calculate the Factory Cost

JOB A B
Direct Materials $600 $800
Direct Labour:
PD1 $200 $800
PD2 $400 $600 $600 $1400
PRIME $1,200 $2,200
COST(DIRECT
COST)

MOH (Allocated)
PD1 20 x $1 $20 80 x $1 $80
PD2 40 x $2 $80 60 x $2 $120
TOTAL FACTORY $1300 $2400
COST

Problems with Using Budgeted MOH RATE

• The concept of under/over allocated MOH
• End-of year adjustments – disposition of under/over allocated MOH

Concept of Under/Over allocated MOH

• Budgeted (pre-determined) MOH rate is established before an accounting period begins and based
entirely on ESTIMATED INFORMATION
o There will be a difference between the amount of MOH that is allocated and MOH that is actually
incurred during a period
o Under/over allocated MOH
o Over-allocated MOH = Allocated MOH > Actual MOH
o Under Allocated MOH = Actual MOH > Allocated MOH

End-of year Adjustments – Disposition of Under/over allocated MOH

• Write-off to COGS approach
o Write it off to COGS (income statement)
o Make adjustments to your revenue and write it off by way of JOURNAL ENTRY
Example 3
LECTURE ILLUSTRATION EXAMPLE 3
The following information pertains to Johnson City Metal Works for 2014:
Budgeted direct labour cost: 75,000 hours at $14 per hour
Actual direct labour cost: 80,000 hours at $15 per hour
Budgeted manufacturing overhead: $997,500
Actual manufacturing $240,000
overhead: Depreciation
Property taxes 12,000
Indirect labour 82,000
Supervisory salaries 200,000
Utilities 59,000
Insurance 30,000
Rent 300,000
Indirect material (see data 79,000
below)
Indirect material:
Beginning inventory: 1 Jan $42,000
2012
Purchases during 2012 100,000
Ending inventory: 31 Dec 63,000
2012

REQUIRED
1. Compute the firm’s budgeted manufacturing overhead (MOH) rate, which is based on direct labour hours.
2. Calculate the overallocated or underallocated manufactured overhead for 2014.
3. Prepare a journal entry to close the manufacturing overhead account into cost of good sold.
• 1. Computation of Budgeted MOH
o =$997,500/75,000
o =$13.30/DLH
• 2. Calculation of ACTUAL MANUFACTURING OVERHEAD
Deprecation 240,000
Property Taxes 12,000
Indirect Labour 200,000
Utilities 59,000
Insurance 30,000
Rent 300,000
Indirect Material:
Beginning Inventory (1 Jan) 42,000
Purchases 100,00
(Ending Inventory) (63,000) 79,000
$1,002,000

ACTUAL MOH - Allocated MOH = Overallocation
$1,002,000 - (13.30 x 80,000) = $62,000
=$1,064,000
 • 3. Journal Entries
o Dr Manufacturing Overhead Allocated 1,064,000
§ Cr Manufacturing Overhead Control 1,002,000
§ Cr COGS 62,000
• COGS is on Dr Side = under allocation
• COGS is on Cr Side = over allocation

The Flow of Costs

The Flow of Costs and Accounting Records
• Need to know 6 accounts in this unit
o INVENTORY ACCOUNTS:
§ Material Control
§ WIP (Work-in-progress) Control
§ Finished Goods Control
o OVERHEADS T ACCOUNTS
§ MOH ‘Control’ (Actual cost)
§ MOH (Allocated)
§ Cost of Goods Sold
• When MATERIALS are purchased on credit/cash
o Dr. Materials Control

34 | P a g e

 § Cr Account Payable Control
• When MATERIALS are issued:
o If Direct Materials:
§ Dr WIP Control
• Cr Materials Control
o If Indirect Materials
§ Dr Manufacturing Overhead Control (reflects actual cost)
• Cr Materials Control
• When LABOUR is incurred/paid
o if DIRECT LABOUR:
§ Dr WIP Control
• Cr Wages Payable Control (Liability account)
o If INDIRECT labour
§ Dr Manufacturing Overhead Control
• Cr Wages Payable Control (some wages account; incurred but not
paid)
• When MOH allocated:
o Dr WIP Control
§ Cr Manufacturing Overhead Allocated
• When GOODS are manufactured (become finished goods)
o Dr Finished Goods Control (DM + DL + Allocated FOH)
§ Cr WIP Control
• When FINISHED goods are sold
o Dr Cost of Goods Sold Control
§ Cr Finished Goods Control

35 | P a g e

Example from Textbook

• 1. Purchase of Materials (direct and indirect) on credit, $89,000
o Materials Control 89,000
§ Accounts Payable Control 89,000
• 2. Usage of Direct materials, $81,000 and indirect, $4,000
o Work in Process Control 81,000
o Manufacturing Overhead Control 4,000
§ Materials Control 85,000
• 3. Manufacturing payroll for February : Direct Labour, $39,9000, and indirect, $15,000; paid in
cash
o Work in Process Control 39,000
o Manufacturing Overhead Control 15,000
§ Cash Control 54,000
• 4. Other manufacturing overhead costs incurred during February, $75,000, consisting of
supervision and engineering salaries ($44,000; paid in cash); plant utilities, insurance, $13,000
(cash) and plant depreciation $18,000
o Manufacturing Overhead Control 75,000
§ Cash Control 57,000
§ Plant Depreciation 18,000
• 5. Allocation of manufacturing overhead to jobs, $80,000
o Work-in-process control 80,000
§ Manufacturing Overhead Allocated 80,000

36 | P a g e

 o (MOH ALLOCATED = amount of manufacturing overhead costs allocated to individual
jobs based on the budgeted rate multiplied by actual quantity used of the allocation
base)
• 6. Completion and Transfer of individual jobs to finished goods, $188,000
o Finished Goods Control 188,800
§ Work-In-Process Control 188,000
• 7. COGS, $180,000
o COGS 180,000
§ Finished Goods Control 180,800
• 8. Marketing Costs; $45,000 and Customer Service Costs; $15,000; paid in CASH
o Marketing Expense 45,000
o Customer Service Expense 15,000
§ Cash Control 60,000
• 9. Sales revenues, all on credit, $270,000
o Accounts Receivable Control 270,000
§ Revenues 270,000

Example 4
• MOH Rate
o =420,000/20,000 = $21/DLH
• JOURNAL ENTRIES
o Dr Raw Materials Inventory Control 5,000
§ Cr Account Payable Control 5,000
o Dr Raw Materials Inventory Control 4,000
§ Cr Accounts Payable Control 4,000
o Dr WIP Control 11,250
§ Cr Raw Material Inventory Control 11,250
§ (=250x$5/sq + 1,000 x $10)
o Dr Manufacturing Overhead Control 100
§ Cr Manufacturing Supplies Inventory 100
§ (=10 x 10)
o Dr WIP Control (=800x20 + 900x20) 34,000
o Dr MOH Control (=100x90 + 500x8) 13,000
§ Cr Wages Payable 47,000
o Dr WIP Control 35,700
§ Cr Manufacturing Overhead Allocated 35,700
§ (=1700 hours x 21)
o Dr MOH Control 12,000
§ Cr Accumulated Depreciation 12,000
§ (Depreciation)
o Dr MOH Control 1,200
§ Cr Cash 1,200
§ (rent paid in cash)
o Dr MOH Control 2,100

37 | P a g e

 § Cr Account Payable 2,100
§ (Utility costs; invoices received but not yet paid)
o Dr MOH Control 2,400
§ Cr Cash 2,400
§ (Taxes Paid)
o Dr MOH Control 3,100
§ Cr Pre-Paid Insurance 3,100
§ (Pre-paid insurance)
o Dr Selling And Admin Expenses 8,000
§ Cr Cash 8,000
§ (non-manufacturing costs)
o Dr Selling and Admin Expenses 4,000
§ Cr Accumulated Depreciation 4,000
§ (depreciation of office equipment)
o Dr Selling and Admin Expenses 1,000
§ Cr Cash 1,000
o Dr Finished Goods Inventory 34,050
§ Cr WIP Control 34,050
§ (completion of Job T33)
§ (DM = 250 x 5 = 1,250)
§ (DL = 800 x 20 = 16,000)
§ (MOH = 800 x 21 = 16,800)
§ (Total = 34,050)
o Dr Accounts Receivable Control 26,600
§ Cr Sales Revenue 26,600
§ (38 units x 700)
o Dr COGS 17,025
§ Cr Finished Goods Inventory 17,025
§ (=34,050 + 2)
• Actual Overhead
o =100+ 13,000 + 12,000 + 1,200 + 2,400 + 3,100
o =$33,900
• OVER ALLOCATION
o =33,900 – 35,700 (=1,700 x 21)
o =$1,800
• Journal Entry:
o Dr MOH Allocated 35,700
§ Cr COGS Control 1,800
§ Cr MOH Control 33,900
• COG Manufactured

38 | P a g e

 Week 5 Actvity-Based Costing
Activity Based Costing
• Learning Objectives:
o Distinguish between tradition and the ABC approaches to design a costing system
o Cost products or services using activity-based costing
o Compare activity-based costing systems and traditional costing systems

Dealing With Factory Overhead – Overview

• Factory Overhead Allocation rates:
o Historically, mainly using DLH

Activity Based Costing

• The distinctive features of ABC is its focus on activities as the fundamental costs objects
• It uses the cost of these activities as the basis for assigning costs to other cost objects

•
o Activity = event, task or unit of work with a specified purpose; designing products,
operating machines, setting up machines, distributing products, etc.
• ABC:

39 | P a g e

 o Refines a costing system by identifying individual activities as the fundamental cost
objects

ABC Method – Overview

• Factory Overhead Costs:
o 1. Activities
§ Things/events which cause costs to be incurred (eg machine setups, purchase
orders)
o 2. Cost Driver
§ The ‘Things/events’ which cause a pool total costs to change
o 3. Cost Pools
§ Groups of costs associated with ACTIVITIES which have the same cost drivers
§ (i.e group into 1 cost pool; i.e cost pool A, B)
o 4. Pool Rate
§ =Cost Pool/Cost Driver
§ (used to allocate cost pool)

Traditional Costing Methods

Problems with Traditional Costing Method
• Pre-occupied with valuing inventory for inventory is valued purposes of company financial
reporting

40 | P a g e

 • There is no concern in distinguishing whether one particular product has been overvalued while
another had been undervalued
• By attaching DM, DL and FOH to particular products
• DM and DL = easily traced to products, but FOH can be problematic which could lead to
inaccuracy in costing of products

ABC Leads to:

• More accurate product costing
o To assign the costs of significant activities to the product that cause the cost to be
incurred
• Better cost management:
o By identifying the cost of activities, managers can attempt the reduction or elimination
of unnecessary costs
• SEE EXAMPLE

LECTURE ILLUSTRATION EXAMPLE 1

ABC Company is a company with manufacturing units throughout the country. At the moment it is
the company policy to charge factory overheads to products using a plant wide rate based upon direct
labour hours.
John Smith, the recently appointed financial controller of the company, is not satisfied with the
accuracy of factory costs. Over the past few years the company’s production methods and procedures
have changed considerably with the introduction of computers and robots.
John Smith believes an ABC approach to allocate factory overhead is more appropriate than the
method described above.
To illustrate a report which John Smith must give to the Board of Directors shortly, he has asked the
account clerk to produce some figures for him as follows:
Budgeted data for 1 2 3
2015 Product
Sales volume (units) 20,000 40,000 60,000
Direct labour hours 40,000 90,000 180,000
Maintenance hours 60,000 15,000 25,000
Number of material 500 700 800
requisition
Number of machine 125 225 400
setups
Prime costs $300,000 $1,200,000 $2,100,000

Overhead Costs: $
Maintenance 400,000
Storekeeping 200,000
Materials handling 100,000
Inspection (machines) 240,000
Machine setup 300,000
Total: 1,240,000

41 | P a g e

 REQUIRED:
Calculate the following figures:
1) the total factory cost of each product; and
2) the factory cost per unit of each product produced assuming the company were to use the ABC
approach
3) The figures calculated in requirements (1) and (2) above assuming the current method were
utilized.

1) And 2)
• Step One: ACTIVITIES & COST DRIVERS:
o Maintenance
§ CD = Maintenance Hours
o Storekeeping
§ CD = No. of material requisition
o Material Handling
§ CD = No. of material requisition
o Inspection
§ CD = No. of machine setup
o Machine Setup
§ CD = No. of machine set up
• Step 2: COST POOLS

COST POOL A (Maintenance) Cost Pool B (No. of Material Cost Pool C (No. of machine
Requisition) setup)
-Maintenance = $400,000 -Storekeeping -Inspection
-Material Handling -Machine Set up
=$200,000 + $100,000 =$240,000 + $300,000

=$300,000 =$540,000
• Step 3 : Cost Pool Rates

=$400,000 / (60,000 + 15,000 + =$300,000 / (500+700+800) =$540,000 / (125+225+400)

25,000)

=$4/maintenance hours =$150/material requisition =$720/machine set up
• Step 4 : APPLICATIONR ATES

PRODUCT 1 2 3
POOL A =(60,000 x 4) =(15,000 x 4) =(25,000 x 4)
=$240,000 =$60,000 =$100,000
POOL B =500 x 150 =700 x 150 =800 x 150
=$75,000 =$105,000 =$120,000
POOL C =125 x 720 =225 x 720 =400 x 720
=$90,000 =$162,000 =$288,000
TOTAL 405,000 327,000 508,000

42 | P a g e

 • Step 5 : TOTAL FACTORY COST and FACTORY COST PER UNIT

PRODUCT 1 2 3
Prime Cost $300,000 $1,200,000 $2,100,000
Factory Overhead 405,000 327,000 508,000
FACTORY COST TOTAL =$705,000 =$1,527,000 =$2,608,000

Production (Units) 20,000 40,000 60,000
FACTORY COST PER =705,000/20,000 =1,527,000 / 40,000 =$2,608,000/60,000
UNIT =$35.25 =$38.18 =$43.47

Part 3) Traditional Approach
• Step 1: FOH Rate
o =budgeted Factory Overhead/ Budgeted Direct Labour Hours
o =1,240,000 / (40,000 + 90,000 + 180,000)
o =$4/DLH
• Step 2: FOH Allocation Rate

PRODUCT 1 2 3
FOH =40,000 x $4 =90,000 x $4 =180,000 x $4
=$160,000 =$360,000 =$720,000
• Step 3: TOTAL FACTORY COST and FACTORY COST PER UNIT (production = sales)

PRODUCT 1 2 3
Prime Cost 300,000 1,200,000 2,100,000
FOH 160,000 360,000 720,000
FACTORY COST 460,000 1,560,000 2,820,000

Production (Units) 20,000 40,000 60,000
FACTORY COST PER =460,000/20,000 =1,560,000/40,000 =$2,820,000/60,000
UNIT =$23 =$39.00 =$47

Week 6: Chapter 10: Determining How Costs Behave

Determining How costs behave

• Learning Objectives:
o Explain the two basic assumptions frequently used in cot behavior estimation
o Describe linear cost functions and 3 common ways in which they behave
o Recognize various approaches to cost estimation

Basic Assumptions
• Variations in the level of a single activity explain variation in TOTAL COST of a COST OBJECT
• A LINEAR cost function adequately approximates cost behavior within the RELEVANT RANGE

43 | P a g e

 o Cost function; mathematical expression describing how costs change with changes in
the level of an activity
o Linear cost function
§ Y = a + bX
• Y = dependent variable
• X = independent variable
• a= constant (fixed cost; does not change)
• b= variable cost (slope coefficient)

Examples of Cost Functions

• Variable Cost:
o Y = bx (LINEAR LINE)
o When (b) is variable cost per unit and X is the number of units
• Fixed Cost
o Y = a (FLAT LINE)
o When (a) is the amount of fixed cost in total
• MIXED OR SEMI-VARIABLE COST
o Y = a + bX
o B slope coefficient = (Y2-Y1)/(X2-X1) = rise/run

Various approaches to cost estimation

• Industrial engineering method:
o A.k.a work measurement method
o Estimates cost functions by analyzing inputs and outputs in physical terms
o Relationship can be hard to specify for some items (i.e indirect manufacturing costs,
R&D costs)
• Conference Method
o Estimates cost functions on the basis of analysis and opinions about costs and their
gathered from various departments of a company (purchasing, engineering,
manufacturing, etc.)
o Encourages interdepartmental cooporation
o Does not require detailed analysis of data; cost functions/estimates can be quickly
developed
o Though accuracy depends on care and skill
• Account Analysis method
o Estimates cost function by classifying cost accounts as variable, fixed, or mixed with
respect to the indentified level of activity
o Managers use qualitative rather than quantitative analysis
o Used because:
§ Reasonably accurate
§ Cost-effective
§ Easy to use
o Supplementing this method with conference method improves accuracy
• Quantitative Analysis Method

44 | P a g e

 o High-Low Method
o Regression Analysis Method (least squares)

Steps in Estimating Cost Function Using quantitative Analysis

1. Choose the dependent variable
2. Identify the independent variable or COST DRIVER
3. Collect data on the dependent variable and the cost driver
4. Plot the data
5. Estimate the cost function

High Low Method

• Fixed costs remain constant despite changes of a cost driver (eg volume in sales), any difference
in the cost of any two periods must be due to the VARIABLE COSTS COMPONENT
• The selection of two periods is based on the HIGHEST AND LOWEST ACTIVITY, and not cost
• The rationale for selecting activity is:
o Activity is the independent variable while the cost is the DEPENDENT VARIABLE (Y = total
cost)
o To rely on the activity (the known variable) to determine/estimate cost (the unknown
variable)

Regression Analysis Method

• The linear regression method computes the regression line mathematically based on the
formulae that the gradient of a regression line is determined by:
• Formulae for LINEAR LINE:
o Y = a + bX
§ a= total fixed cost
§ b=gradient (variable cost)
§ X = independent variable (activity)
§ Y = dependent variable (cost $)
• FORMULAE DERIVE:

o
o Where:
§ N = number of observations

§
• Choosing among cost drivers
o 1. Economic plausibility
o 2. Goodness of Fit (R value)
o 3. Significance of independent variable

45 | P a g e

Lecture Examples
Lecture Example 1

• Step 1:
o High point Observed (February)
§ X-rays taken = 7,000
§ X-rays costs = $29,000
o Low point observed (June)
§ X-rays taken = 3,000
§ X-rays cost = $17,000
o Change observed
§ X-rays taken = 7,000 - 3,000 = 4,000
§ X-rays cost = 29,000 – 17,000 = $12,000
• Step 2 (Variable Cost Element)
o =Change in X-ray costs/ Change in X-ray taken
o =12,000/4,000
o =$3/x-ray taken
• Step 3 (Fixed Cost Element)
o X-ray cost at high point = 29,000
o Less: Variable Cost Element = (7,000 x $3 = $21,000)
o TOTAL FIXED COST = 29,000 – 21,000 = $8,000
• Step 4: Formula
o Y = 8,000 + 3X

46 | P a g e

 • Step 5: Application (X = 4,600)
o Y = 8,000 + 3(4,600)
o Y = $21,800

Lecture Example 2

• Step 1:
o Calculate Sum
§ Hour (X) = 1,260
§ Maintenance Cost (Y) =19,800
§ X^2 = 163,800
§ XY = 2,394,000
• Step 2 (equation 1 and equation 2):

o
o Equation 1:
§ 19,800 = 12a + 1260b…………..
o Equation 2
§ 2,394,000 = 1,260(a) + 163,800(b)……….
• Step 3 (get rid of ‘a’ number)

47 | P a g e

 o =1260/12 = 105, so multiply Equation 1 by this amount to get rid of ‘a’
o
o Equation 3 (= Equation 1 x 105)
§ 19,800 x 105 = 12 x 105 (a) + 1260 x 105 (b)
§ 2,079,000 = 1,260(a) + 132,300(b)
• Step 4 (combine both equations)
o Equation 4
§ 2,394,000 – 2,079,000 = 1,260 – 1,260 (a) + 163,800 – 132,300 (b)
§ 315,000 = 31,500 (b)
§ B = $10/ unit = VC
• Step 5 (FIXED COST)
o 19,800 = 12a + 1,260(10)
o A = $600 = FC
• Step 6 (FINAL EQUATION
o Y = 600 + 10X
• Step 7 : Application (X = 110)
o =600 + 10 (110)
o =$1,700

Week 8 Master Budget

• A comprehensive set of budgets covering all phases of an organisation’s operations for a specific
period of time
o Operating budgets
§ Budgeted income statements and its supporting budget schedules
o Financial budgets
§ A plan that shows how the organisation will acquire its financial resources,
include:
• Capital expenditure budget
• Cash budget (ONLY THIS IS RELEVANT IN THIS UNIT)
• Budgeted balance sheet
• Budgeted statement of cash flows

48 | P a g e

Overview of the Master budget

Start with revenue, then production (material, labour and overhead)

• Once you know your cost, then calculate COGS

49 | P a g e

Basic Operating Budget Steps
1. Prepare the REVENUES BUDGET (schedule 1; the starting point)
2. Prepare the production budget in units (schedule 2)
3. Prepare the DIRECT MATERIALS USAGE BUDGET (schedule 3A) and DIERCT MATERIALS
PURCHASES BUDGET (schedule 3B)
4. Prepare the DIRECT MANUFACTURING LABOUR BUDGET (schedule 4)
5. Prepare the MANUFACTURING OVERHEAD COSTS BUDGET (schedule 5)
6. Prepare the ENDING INVENTORIES BUDGET (in units schedule 6A; in dollars schedule 6B)
7. Prepare the COST OF GOODS SOLD BUDGET (schedule 7)
8. Prepare the OPERATING EXPENSE (period cost) budget (schedule 8)
9. Prepare the BUDGETED INCOME STATEMENT
a. (EXHIBIT 6-3)

Basic Financial budget Steps

• Based on the operating budgets:
o 1 prepare the capital expenditure budget
o 2. Prepare the CASH BUDGET (from appendix, p 246-250)
o 3. Prepare the budgeted balance sheet
o 4. Prepare the budgeted statement of cash flows

Budgeting and Responsibility Accounting

• Responsibility center
o A part, segment or subunit of an organisation whose manager is accountable for a
specified set of activities
• Responsibility accounting
o A system that measures the plans, budgets, actions and actual results of each
responsibility center

Types of Responsibility Centers

• 1. COST
o Accountable for costs only
• 2. Revenue
o Accountable for revenues only
• 3. Profit
o Accountable for revenues and costs
• 4. Investment
o Accountable for investments, revenues and costs
• (p237-240 of textbook)

Budget and Feedbacks

• Budgets offer FEEDBACKS in the form of VARIANCES; actual results deviate from budgeted
targets

50 | P a g e

 • VARIANCES; provide managers with:
o 1. Early warning of problems
o 2. A basis for performance evaluation
o 3. A basis for strategy evaluation

Responsibility & Controllability

• Controllability
o The degree of influence that a manager has over costs, revenues or related items for
which he or she is being held responsible
• Responsibility accounting
o Helps managers to first focus on whom they should ask to obtain information and not
on whom they should blame
o Focuses on gaining information and knowledge, not only on control
o Fundamental purpose of responsibility accounting is to enable future improvement

Human Aspects of Budgeting

• Behavioural effects of budgets
o 1. PARTICIPATIVE BUDGETING (self-imposed budget)
§ A budgeting approach in which managers prepare their own budget estimates
§ A budget that is prepared with the full cooperation and participation of
managers at all levels
§ Research
• Chong, Eggleton & Leong (2006)
• Libby (1999)
• Shields & Shields (1998)
o 2. BUDGETARY SLACK (padding the budget)
§ The practice of underestimating budgeted revenues or overestimating budgeted
costs to make budgeted targets easier to achieve
§ Based on AGENCY THEORY (humans = self-centred)
§ The difference between the revenues or cost projection that person provides
and a REALISTIC estimate of the revenue cost:
• (i.e plant manager believes the annual utilities cost will be $18,000 but
gives a budget of $20,000; the manager has built $2,000 of slack into
the budget)
§ Research
• Lau & Eggleton 92003
• Dunk (1993)
• Merchant (1985)

51 | P a g e

Lecture example
Lecture Example 1

52 | P a g e



• 1. Sales Budget

BOX C BOX P
Sales (units) 500,000 500,000
Sales price per unit 0.90 1.30
Sales Revenues $450,000 $650,000
• 2. Production Budget = COGS Backwards

BOX C BOX P
Sales (untis) 500,000 500,000
Add: Desired Ending Inventory 5,000 15,000
Total units needed 505,000 515,000

Less: beginning inventory 10,000 20,000
Production requirement 495,000 495,000

• 3. Direct Materials Budget: paperboard

53 | P a g e

 BOX C BOX P TOTAL
Production 495,000 495,000
requirements (no. of
boxes)

DM required per box 0.3 0.7
(pound)
DM required for 148,500 346,500 495,000 (pound)
production (pound)

Add: Desired ending 5,000
DM inventory
TOTAL DIRECT 500,000
MATERIALS NEEDED
Less: (beginning direct (15,000)
materials inventory)

Direct Materials to be =485,000
purchased (per pound
Price (per pound) 0.20
COST OF PURCHASES $97,000
• 4. Direct Materials Budget : Corrugating Medium

BOX C BOX P Total

Production 495,000 495,000
requirements (no of
boxes)

Direct materials 0.20 0.3
required per box
(poind)
Direct materials 99,000 148,500 =247.500
required for production
(pound)

Add: desired ending 10,000 (pound)
direct inventory
TOTAL DM NEEDED 257,000
Less: Beginning DM 5,000
Inventory

DM to be purchased 252,500
per pound
Price (per pound) $0.10
COST OF PURCHASES 25,250

54 | P a g e

 • TOTAL COST OF DM Purchases:
o =97,000 + 25,250
o =122,250
• 4. Direct Labour Budget

BOX C BOX P TOTAL

Production 495,000 495,000
requirement (no. of
boxes)

DL required per box 0.0025 0.005
(hours)
DL required for 1,237.5 2,457 3,712.5
production (horus)

DL rate $12
TOTAL DL Cost 44,500
• 5. MOH Budget

Indirect materials 10,000

Indirect labour 45,000
Utilities 30,000
Property taxes 15,000
Insurance 18,000
Depreciation 32,000
TOTAL MOH 150,000
• 6. Selling and Administrative Expenses Budget
o TOTAL = $210,000
§ Salaries and fringe benefit = 60,000
§ Advertising = 10,000
§ Management salaries = 100,000
§ Clerical wages = 35,000
§ Admin = 5,000
• 7. Budgeted Income Statement

Sales Revenue (sales budget – 1,100,000

requirement (1))
Less COGS
Box C = 500,000 x 0.21 105,000
Box P = 500,000 x 0.43 215,000 320,000
Gross Margin 780,000

Less: expenses 210,000
Income before taxes 570,000
Less: Income tax (40%) 228,000
NET INCOME 342,000

55 | P a g e

 • COGS
o (a) Computation of budgeted manufacturing overhead rate:
§ =150,000 / [(500,000 x 0.0025) + (500,000 x 0.005)]
§ =$40 per direct labour hour
§ Budgeted MOH rate = Budgeted MOH / DLH
o B) computation of manufacturing cost per unit

BOX C BOX P
DM:
Paper Board
(c) = 0.3 x 0.2 per lb 0.06
(p) = 0.7 x 0.2 per lb 0.14

Corrguating Medium
C = 0.2 x 0.1/lb 0.02
P = 0.3 x 0.1/lb 0.03

DL
=0.0025 x 12 0.03
=0.005 x 12 0.06

Allocated MOH
=0.0025 x 40 0.10
=0.005 x $40 per hour 0.2
TOTAL COST per unit 0.21 $0.43

56 | P a g e

Lecture Example 2

October November
Cash balance, beginning 10,000 8,000
Cash collection from customers 90,000 122,000
Collections of note receivable - 40,000
(a) $100,000 =$170,000
TOTAL CASH RECEIVABLE FOR
PERIOD

Cash Disbursements:
Inventory 102,000 121,000
Operating Expenses 30,000 30,000
(b) =132,000 =151,000
TOTAL DISBURSEMENTS
Minimum cash balance desired 7,500 7,500
(c) =139,500 =158,500
TOTAL CASH NEEDED
CASH EXCESS (deficiency) (39,500) 11,500
=(a – c)

Financial of cash deficiency
Borrowing at end of month 40,000*
Principal payments (at end of (10,000)**
month)
Interest expense (at 1.5% (600)
monthly)

57 | P a g e

 (d) $40,000 (10,600)
TOTAL EFFECTS OF FIANNCING
CASH BALANCE, ENDING 8,000 8,400
(= a – b + d) (=100,000 + 40,000 – 132,000)

Interest expense (Novemeber) 40,000 x 0.015 = $600

Tom John owes the bank in November $30,000

• * = need to borrow in multiple of $1,000. So 39,500 rounded to the nearest 1,000 is $40,000
• ** = November, had to pay $600 interest. Need to pay rapidly in multiple of $1,000 and due
to the bank requirement that min. cash balance is $7,500; can only repay $10,000

TRY 6.29 and 6.30 (exercises)

Management Accounitng : Chapter 7

Flexible Budgets, Direct Cost Variances and Management Control

• Learning Objectives:

◦ Understand static budgets and static-budget variances.

◦ Examine the concept of a flexible budget and learn how to

develop it.

◦ Calculate flexible-budget variances and sales-volume variances.

◦ Explain why standard costs are often used in variance

analysis.

◦ Compute price variances and efficiency variances for direct categories.

Static Budgets and Static Budget Variances

• STATIC BUDGET
o Or MASTER BUDGET, is based on planned level of output and is prepared at the START
of the budget period
• STATIC-BUDGET VARIANCES
o The difference between ACTUAL result and the corresponding amount in the static
budget

Basic concept
• VARIANCE:
o Difference between actual results and budgeted results

58 | P a g e

 • Management by exception:
o The practice of FOCUSING ATTENTION on areas not operating as expected (budgeted)
• Favourable Variance (F)
o In terms of revenue or cost
o Has the effect of increasing operating income relative to the budget
o (Actual > Budgeted = Income = Favourable)
o (Actual < Budgeted = Cost = Favourable)
• Unfavourable Variance (U)
o Has the effect of decreasing operating income relative to the budget amount
o (Actual < Budget = Income = unfavourable)
o (Actual > Budget = Cost = unfavourable)

Variances
• May start out at the top with a LEVEL 0 analysis
o The highest level of analysis, a super-macro view of operating results
o Is nothing more than the difference between ACTUAL and STATIC budget operating
income
• Further analysis decomposes (breaks down) the Level 0 analysis into progressively smaller and
smaller components:
o (How much were we off?)
• Level 1, 2 and 3 examine the Level 0 variance into progressively more-detailed levels of analysis
o (Where and why were we off?)

Level 1 Analysis Example

Actual Results Static-Budget Variances Static Budget
(1) (2) = (1) – (3) (3)
Unit Sold 10,000 2,000 = U 12,000
Revenues $1,250,000 190,000 = U 1,440,000
Variable
Costs
DM 621,600 98,400 = F 720,000
DML 198,000 6,000 = U 192,000
MOH 130,500 13,500 = F 144,000
TOTAL VC 950,100 105,900 = F 1,056,000

Contribution 299,900 84,100 = U 384,000
Margin
(Revenus –
Total VC)
Fixed Costs 285,000 9,000 = U 276,000
Operating =$14,900 93,100 = U 108,000
Income
• STATIC VARIANCE BUDGET
o =108,000 – 14,900 = $93,100 Unfavourable

59 | P a g e

 • Contribution Margin Percentage:
o 299,9000/ 1,250,000 = 24%
o 384,000/ 1,440,000 = 26.7%

Flexible Budget
• The budget that is ADJUSTED (flexed) to recognise the ACTUAL OUTPUT LEVEL
o Recalculate revenue and variable costs for the budget period (10,000 units)
o Represent a blending of actual activities and budgeted dollar amounts
o Will allow preparation for Level 2 & 3 variances

Static Budget vs Flexible Budget

• STATIC BUDGET
o Is based on PLANNED LEVEL of OUTPUT and prepared at the START of the budget period
• FLEXIBLE BUDGET
o Is ADJUSTED (flexed) to recognise the actual output level

Developing a Flexible Budget

• 3 Step Process:
o 1. Identify the ACTUAL OUTPUT QUANTITY
o 2. Calculate FLEXIBLE BUDGET REVENUES
§ (Budgeted Selling Price x Actual Quantity)
o 3. Calculate FLEXIBLE BUDGET COSTS
§ (Budgeted per-unit VC x Actual Quantity) + Budgeted FC

Sales volume variances and Flexible Budget Variances

• Sales Volume Variances
o Is the difference between the flexible budget (at actual output) and the corresponding
static budget amount
• Flexible-Budget variances
o Is the difference between actual revenues or costs and the corresponding flexible
budget amounts
o Flexible budget variance for revenues is called the selling-price variance
§ Difference between the ACTUAL selling price and the BUDGETED selling price

Level 2 Analysis Example

Actual Results Flexible Flexible Sales-Volume Static Budget
(1) Budget Budget Variances (5)
Variances (3) (4) = (3) – (5)
(2) = (1) – (3)
Units Sold 10,000 0 10,000 2000= U 12,000
Revenues 1,250,000 50,000 = F =10,000 x 240,000= U $1,440,000
$120
=$1,200,000
VC
DM ($60) 621,000 21,600 = U 600,000 120,000 = F 720,000

60 | P a g e

 DML 198,000 38,000 = U 160,000 32,000 = F 192,000
($16/jacket)
MOH 130,500 10,500 = U 120,000 24,000 = F 144,000
($12/jacket)
TOTAL VC 950,100 71,100 = U 880,000 176,000 = F 1,056,000

Contribution 299,900 20,100 = U 320,000 64,000 = U 384,000
Margin
Fixed 285,000 9,000 = U 276,000 0 276,000
Manufacturing
Costs
OPERATING 14,900 29,100 = U 44,000 64,000 = U 108,000
INCOME (FLEXIBLE (SALES
BUDGET VOLUME
VARIANCE) VARIANCE)
• Level 1
o Static Budget Variance = $93,100 = Unfavourable
• Level 2
o Flexible Budget Variance = $29,100 = Unfavourable
o Sales Volume Variance = $64,000 = unfavourable

Equation Method for Level 2

• SALES – VOLUME VARIANCES
o =Flexible Budget Amount – Static Budget Amount
o =44,000 – 108,000
o =64,000 Unfavourable
o Or,
o =(Budgeted Contribution Margin per unit) x (Actual Units sold – Static Budget Units Sold)
o =(120 – 88) x (10,000 -12,000)
o =64,000
• FLEXIBLE BUDGET VARIANCE
o =Actual Result – Flexible Budget Amount

Level 3 Variances: Price Variance and Efficiency Variance

• PRICE VARIANCE:
o Input-price Variance
o Is the differences between an ACTUAL INPUT PRICE and a BUDGETED INPUT PRICE
o For DL, it is sometimes referred as the RATE VARIANCE
• EFFICIENCY VARIANCE
o Reflects the difference between an ACTUAL INPUT QUANTITY and a BUDGETED INPUT
QUANTITY for ACTUAL OUTPUT
o For DM, it is sometimes referred to as the USAGE VARIANCE

Level 3 Variances: Price Variance and Efficiency Variance

• PRICE VARIANCE FORMULA

61 | P a g e

 o =(Actual Price of Input – Budgeted Price of Input) x Actual Quantity of Input
• EFFIENCY VARIANCE FORMULA
o =(Actual Quantity of Input Used – Budgeted Quantity of Input allowed for Actual Output) x
Budgeted Price of Output

Level 3 Example
Actual Costs Incurred Actual Input Quantity x Flexible Budget
(Actual Input Qty x Actual Budgeted Price (Budgeted Input Quantity
Price) (2) Allowed for Actual Output x
(1) Budgeted Price)

62 | P a g e

 (3)
DM (22,200 sq yds x $28/sq yd) (22,200 x $30) (10,000 x 2 sq yds/unit x
=$621,600 =$666,000 $30/sq yd)
=$600,000
LEVEL 3 Price Variance = 666,000 – Efficiency Variance
621,600 = $44,400 =600,000 – 666,000
FAVOURABLE =$66,000 Unfavourable
Level 2 Flexible Budget
Variance
=600,000 – 621,000
=21,000 Unfavourable

DL (9000 hrs x 22/hr) (9000 x 20) (10,000 x 0.8hr/unit x
=198,000 =180,000 $20/hr)
=160,000
Level 3 Price Variance Efficiency Variance
=180,000 – 198,000 =160,000 – 180,000
=$18,000 U =20,000 Unfavourable
Level2 Flexible Budget
Variance
=160,000 – 198,000
=38,000 U

Variance Summary

63 | P a g e

Standard
• Is a carefully determined PRICE, COST or QTY that is used as a benchmark for judging
performance.
o It is usually expressed on a per-unit basis
• Standard input
o Is quantity of input
o (eg 2 pounds of raw materials)
• Standard Price
o Is the price a company expects to pay for a unit of input
o (eg $10 per direct labour hour)
• Standard Cost
o Is the cost to the company of a unit of output
o (eg direct material cost of a completed unit)

Standard Costing
• Targets or standards are established for DM and DL
• The standard costs recorded in the accounting system
• Actual Price and Usage amounts are compared to the standard and variances are recorded

Variances and Journal Entries

• Each variance may be journalised
• Each variance has its own account
• FAVOURABLE VARIANCE
o Credits
• UNFAVOURABLE VARIANCE
o Debits
• Variance accounts are generally closed into COGS at the END OF THE PERIOD, if immaterial

64 | P a g e



Lecture Examples
Example 1

65 | P a g e

 1. Computation of STATIC BUDGET Operating Income

Revenue (13,000 x 155) $2,015,000

Less: Expenses
VC (13,000 x $115) 1,495,000
FC 286,000
STATIC BUDGET OI 234,000

2. Computation of ACTUAL Operating Income

Revenue (10,000 x 160) 1,600,000

Less: Expenses
VC( 10,000 x 120) 1,200,000
FC 300,000
ACTUAL OI 100,000

3. Computation Static Budget Variance Analysis (Level 1)

ACTUAL RESULTS STATIC BUDGET STATIC BUDGET

(1) VARIANCE (3)
(2) = (1) – (3)
Suit 10,000 3,000 = U 13,000
Revenue 1,600,000 415,000 = U 2,015,000
VC 1,200,000 295,000 = F 1,495,000
CM 400,000 120,000 = U 520,000
FC 300,000 14,000 = U 286,000
OI =100,000 134,000 = U 234,000

Developing Flexible Budget (Level 2)

• 1. Determine the actual QTY of output in the year
o 10,000 units were produced and sold
• 2. Determine the FLEXIBLE BUDGET REVENUES based on BUDGETED SELLING PRICE and Actual
QTY
o =155 x 10,000 units = $1,550,000
• 3. Determine budgeted selling price, variable cost per unit and budgeted fixed cost
o Budgeted Selling Price = 155
o VC per unit = 115
o Budgeted FC = 286,000
• 4. Computation of FLEXIBLE BUDGET VARIANCES & SALES-VOLUME VARIANCES

Actual Results Flexible- Flexible Sales-Volume Static Budget

(1) Budget Budget Variances (5)
Variances (3) (4) = (3) – (5)
(2) = (1) – (3)
Suit 10,000 0 10,000 3000 = U 13,000

66 | P a g e

 Revenue 1,600,000 50,000 = F 1,550,000 465,000 = U 2,015,000
VC 1,200,000 50,000 = U 1,150,000 345,000 = F 1,495,000
Contribution 400,000 0 400,000 120,000 = U 520,000
Margin
FC 300,000 14,000 = U 286,000 0 286,000
OI 100,000 14,000 =U 114,000 120,000 = U 234,000
=TOTAL =TOTAL SALES
FLEXIBLE VOLUME
BUDGET VARIANCE
VARIANCE
TOTAL
STATIC-
BUDGET
VARIANCE
=234,000 –
100,000
=134,000
Unfavourable

Example 2

• 1. Direct Material Price Variance
o Price Variance = (Actual price of input – Budgeted Price of Input) x Actual Qty of Input
o =(2.60 – 2.50) x 25,000
o DM Price Variance = 2,500 U
• 2. Direct Labour Price Variance

67 | P a g e

 o Price Variance = (Actual price of input – Budgeted Price of Input) x Actual Qty of Input
o =(14.60 – 15) x 40,100 hrs
o =16,040 F
• COMPUTATION OF EFFICIENCY VARIANCE
• 3. DM Efficiency Variance
o Efficiency Variance = (Actual Qty of Input – Budgeted Quantity of Input Allowed for
Actual Output) x Budgeted Price of Input)
o =(23,100 – (7,800 x 3 lbs per unit)) x 2.50
o =750 F
• 4. DL Efficiency Variance
o Efficiency Variance = (Actual Qty of Input – Budgeted Quantity of Input Allowed for
Actual Output) x Budgeted Price of Input)
o =(40,100 – (7,800 x 5 hours per unit)) x 15
o =16,500 U

Presentation

Example 3

DR CR
Material Control 62,500
Direct Material Price Variance (U) 2,500
Account Payable Control 65,000

68 | P a g e

 (To record DM purchased)

WIP Control 58,500
Direct Material Efficiency Variance (F) 750
Material Control 57,750
(to record DM used)

WIP Control 585,000
DL Efficiency Variance (U) 16,500
DL Price Variance (F) 16,040
Wages Payable Control 585,460
(To record liability for direct labour costs)

Week 10 : Flexible Budgets, Overhead Cost Variances and Management

Control
Learning Objectives:
– Explain the similarities and differences in planning variable
overhead costs and fixed overhead costs.
– Develop budgeted variable overhead cost rates and budgeted
fixed overhead cost rates
– Compute the variable overhead flexible-budget variance, the
variable overhead spending variance and the variable overhead
efficiency variance.
– Compute the fixed overhead flexible-budget variance, the fixed
overhead spending variance and the fixed overhead productionvolume
variance.
– Show how the 4-variance analysis approach reconciles the
actual overhead incurred

Developing Budgeted Variable Overhead Cost Rates

• 1. CHOOSE the period to be used for the budget
• 2. SELECT the cost-allocation bases to use in allocating variable overhead costs to output
produced
• 3. IDENTIFY the variable overhead costs associated with each cost-allocation base
• 4. COMPUTE the rate per unit of each cost-allocation base used to allocate variable overhead
costs to output produced

Standard Costing
• A costing system that:
o DIRECT COST; traces by = Standard Prices/Standard Rates x Standard Qty Allowed for
Actual Output

69 | P a g e

 o INDIRECT COST; allocates overhead cost on the basis of = Standard O/H rates x Std. qty
allocation bases allowed for the actual output

Flexible Budget
• Calculates budgeted revenues and budgeted costs based on ACTUAL LEVEL OF OUTPUT in the
budgeted period
• Is adjusted for changes in the activity level that differ from the master budget amount

Variable Overhead Flexible-Budget Variance

• Measures the DIFFERENCE between actual variable overhead costs incurred and flexible-budget
variable overhead amounts
• VARIABLE OVERHEAD FLEXIBLE-BUDGET VARIANCE=
o = Actual Costs Incurred – Flexible Budget Amount
• The Variance can further be broken down to:
o Variable Overhead Spending Variance
o Variable Overhead Efficiency Variance

Variable Overhead Spending Variance

• Is the difference between ACTUAL and BUDGETED variable overhead cost per unit of the cost-
allocation base, multiplied by the ACTUAL QUANTITY of variable overhead cost-allocation base
used
• VARIABLE OVERHEAD SPENDING VARIANCE =
o = (Actual variable overhead cost per unit of cost allocation base – Budgeted variable
overhead cost per unit of allocation base) x ACTUAL QUANTITY of VOH Cost-allocation
base used
o =(AR x BR) x Actual Qty.

Variable Overhead Efficiency Variance

• The difference between ACTUAL QUANTITY of the variable overhead cost allocation base used,
and the BUDGETED QTY of the variable overhead cost-allocation base allowed for the ACTUAL
OUTPUT x the BUDGETED variable overhead cost per unit of the cost-allocation base
• VARIABLE OVERHEAD EFFICIENCY VARIANCE =
o =(Actual Qty of variable overhead cost-allocation base used for actual output –
Budgeted Qty of variable overhead cost-allocation base used for actual output) x
Budgeted variable overhead cost per unit of cost-allocation base
o =(Actual Qty used – Budgeted Qty Allowed) x Budgeted Rate

70 | P a g e

Example:

• EFFICIENCY VARIANCE = hold constant BUDGETED RATE
• SPENDING VARIANCE = hold constant ACTUAL INPUT QUANTITY

Developing Budgeted Fixed Overhead Rates

• Fixed Overhead costs are
o A lump sum of costs that remain unchanged for a given period despite potentially wide
changes in activity within the relevant range
o These costs are FIXED in the sense that, unlike VARIABLE COSTS< fixed costs DO NOT
AUTOMATICALLY INCREASE or DECREASE, with the level of activity within the relevant
range

Developing Budgeted Fixed Overhead Cost Rates

• 1. CHOOSE the period to be used for the budget
• 2. SELECT the cost-allocation bases to use in allocating FIXED OVERHEAD COSTS to output
produced
• 3. IDENTIFY the fixed overhead costs associated with each cost-allocation base
• 4. COMPUTE the rate per unit of each cost-allocation base used to allocate variable overhead
costs to output produced

Fixed Overhead Flexible-Budget Variance & fixed overhead spending variance

• Fixed overhead flexible budget variance:
o The difference between ACTUAL FIXED overhead costs and fixed overhead costs in the
FLEXIBLE BUDGET
o The fixed overhead SPENDING variance is the same variance as the FIXED OVERHEAD
FLEXBILE BUDGET VARIANCE
• FMOH Flexible Budget Variance:
o =Actual Costs Incurred – Flexible Budget Amount
• No efficiency variance for fixed;
o Because TOTAL FIXED COSTS remain unchanged in relation to activities

71 | P a g e

Fixed OH Variances: Production-Volume variances
• PRODUCTION VOLUME VARIANCE:
o The difference between BUDGETED FIXED OH and FIXED OH ALLOCATED on the basis of
ACTUAL OUTPUT PRODUCED
o This variance is also known as the DENOMINATOR LEVEL VARIANCE
• Production Volume Variance
o =Budgeted Fixed Overhead – Fixed Overhead allocated for actual output units produced

Example 2:
ACTUAL COSTS INCURRED FLEXIBLE BUDGET: ALLOCATED:
(1) Same Budgeted Lump Sum (as Budgeted Input Qty Allowed
in Static Budget) Regardless of for Actual Output x Budgeted
Output Level Rate
(2) (3)
285,000 276,000 =(0.4 hr/unit x 10,000 units x
$57.50/hr)
=230,000
SPENDING VARIANCE PRODUCTION VOLUME
=276,000 – 285,000 VARIANCE
=9,000 Unfavourable =230,000 – 276,000
=46,000 Unfavourable
FLEXIBLE BUDGET VARIANCE
=9,000 Unfavourable

72 | P a g e

Integrated Variance Analysis

4 Variance Analysis
SPENDING VARIANCE EFFICIENCY VARIANCE PRODUCTION-
VOLUME VARIANCE
VARIABLE OVERHEAD Yes Yes Never a variance
FIXED OH Yes Never a Variance Yes

73 | P a g e



74 | P a g e

Lecture Examples
Example 1

• Variable Spending Variance = (AR – BR) x Actual Qty
• Variable Efficiency Variance = (Actual Qty – Budgeted Qty Allowed for Actual Output) x BR

ACTUAL COSTS ACTUAL INPUT x FLEXIBLE BUDGET: ALLOCATED:

INCURRED BUDGETED RATE Budgeted Input Budgeted Input
(AQ x AR) (AQ x BR) Allowed for Actual Allowed for Actual
(1) (2) Output x Budgeted Output x Budgeted
Rate Rate
(3) (4)
$52,164 (Given) =4,536 x 12 =4hr x 1080 x $12 =$51,840
=$54,432 =$51,840
Actual Rate =
52,164/4,536 = $11.5
SPENDING VARIANCE: EFFICIENCY (Never a Variance)
=54,432 – 52,164 VARIANCE:
=$2,268 FAVOURABLE =51,840 – 54,432
=2,592
UNFAVOURABLE
FLEXIBLE BUDGET
VARIANCE
=51,840 – 52,164
=324 UNFAVOURABLE

75 | P a g e


Example 2

• Budgeted Fixed Overhead Rate per unit of Allocation BASe
o =62,400/1,040 x 4
o =$15/hour

ACTUAL COSTS Same Budgeted Lump FLEXIBLE BUDGET: ALLOCATED:

INCURRED Sum (as in Static Same Budgeted Lump Budgeted Input
(1) Budget) Regardless of Sum (As in static Allowed for Actual
Output Level budget) regardless of Output x Budgeted
(2) output level Rate
(3) (4)
=63,916 62,400 62,400 =$15 x 1,080 x 4 hrs
(given) (given) (given) =64,800

76 | P a g e

 SPENDING VARIANCE PRODUCT-VOLUME
=62,400 – 63,916 VARIANCE:
=1,516 U =64,800 – 62,400
=2,400 F
FLEXIBLE BUDGET
=Spending Variance
=1,516 U
Journal Entries
VARIABLE MANUFACTURING OVERHEAD

• Dr Variable MOH 52,164

o Cr Various Accounts 52,164
o (To record actual variable manufactured overhead costs)

• Dr WIP Control 51,840
o Cr Variable MOH Allocated 51,840
o (to add variable MOH costs to WIP)

• Dr Variable MOH Allocated 51,840
• Dr Variable MOH Efficiency Variance 2,592
o Cr Variable MOH Spending Variance 2,268
o Cr Variable MOH 52,164
o (to record variances for the accounting period)

FIXED MOH

• Dr Fixed MOH 63,916

o Cr Various Accounts 63,916
o (to record actual fixed MOH costs)

• Dr WIP control 64,800
o Cr Fixed MOH Allocated 64,800
o (to add fixed MOH costs to WIP)

• Dr Fixed MOH Allocated 64,800
• Dr Fixed MOH Spending Variance 1,516
o Cr Production Volume Variance 2,400
o Cr Fixed MOH 63,916
o (To record variances for the accounting period)

77 | P a g e



Week 11: Inventory Costing and Capacity Analysis

INVENTORY COSTING DENOMINATOR LEVEL CAPACITY

The inventory costing system that is chosen The denominator-level capacity choice focuses
determines which manufacturing costs are on the cost allocation base used to set
treated as inventoriable costs. budgeted fixed manufacturing cost rates.

Inventory Costing Choices: Overview

• 1. ABSORPTION COSTING:
o ALL VARIABLE, and FIXED manufacturing costs are included as INVENTORIABLE COSTS
• 2. VARIABLE COSTING
o ALL VARIABLE manufacturing costs are included as INVENTORIABLE COSTS
• 3. THROUGHPUT COSTING
o Only direct materials are capitalised; all other costs expensed

78 | P a g e

 o (NON EXAMINABLE)

Absorption Costing vs Variable Costing

• ABSORPTION COSTING
o Treat ALL costs of production as products costs (inventoriable costs), regardless of
whether they are VARIABLE or FIXED in nature
§ Inventory “absorbs” all manufacturing costs
o Costs per unit of product consist of:
§ Direct materials
§ Direct labour
§ And both variable and fixed manufacturing overhead
• VARIABEL COSTING
o Only those costs of production that vary DIRECTLY with activity are treated as product
costs
o Cost per unit of product consists of
§ Direct materials
§ Direct labours
§ And ONLY VARIABLE portion of manufacturing overhead
o FIXED MOH = treated as PERIOD COST
o Also known as DIRECT COSTING

Fixed Factory Fixed Factory

Overhead Overhead Period

79 | P a g e



Inventory Costing: differences in Income

• Operating income will DIFFER between absorption and variable costing
• The amount of the difference represents the amount of FIXED MANUFACTURING COSTS
CAPITALISED as INVENTORY under absorption costing and EXPENSED as a PERIOD COST under
variable costing
• If inventory level changes, OPERATING INCOME will differ between the two methods because of
the difference in accounting for fixed manufacturing costs

80 | P a g e

Comparative Income Statement

• Panel A
o Contribution Margin format
o Fixed Manufacturing Overhead Costs = treated as EXPENSE
• Panel B
o Gross Margin Format
o Fixed MOH = treated as inventory

Comparative Income Effects: Variable Costing vs Absorption Costing

Production = Sales
• Absorption Costing Profit = Variable Costing Profit
o Absorption Costing – inventory level unchanged and all FIXED FMOH costs released
through COGS because all units produced are SOLD, hence the same profit
o VARIABLE COSTING – inventory level unchanged and ALL FIXED MOH costs EXPENSED
(i.e fixed FMOH costs are never inventoried) hence, same profit

Production (12,000 units) > Sales (10,000 units)

• ABSORPTION COSTING PROFIT ($79,000) > VARIABLE COSTING PROFIT ($61,000)
• Absorption Costing
o When production exceeds Sales, there is an increase in INVENTORY LEVEL:
§ Ending inventory exceeds (2000 units), exceeds the Opening Inventory (0)
§ Part of the FMOH costs incurred during the current period remains attached to
the UNSOLD UNITS IN THIS ENDING INVENTORY< and charging these fixed MOH
costs against revenue is DEFERRED until a future period
• =2,000 x 9 = $18,000
o When PRODUCTION > SALES, under ABSORPTION COSTING, Less FIXED MOH costs
appear on the profit and loss statement than under VARIABLE COSTING

81 | P a g e

Production (10,000 units) < Sales (12,000 units)
• Absorption Costing Profit ($83,000) < Variable Costing Profit ($101,000)
• Absorption Costing
o When production is less than sales, additional sales units must come from the OPENING
INVENTORY
o This means that more fixed factory overhead costs are released from the opening
inventory through the COGS and charged against current revenue
• When Production < Sales; under ABSORPTION COSTING, more Fixed MOH costs appear on the
profit and loss statement than under variable statement

Comparing Income statements for multiple years

• 2015:

82 | P a g e

 o Fixed cost = $135, based on budgeted capacity of 8,000 units (BUDGETED)
o Production = 5,000 units (ACTUAL)
§ Production Volume Variance = 3,000 x $135
§ =$405,000 of Production Volume Variance (Unfavourable; produced less than
intended)

Comparative Income Effects: Variable vs Absorption

Absorption Costing & performance measurement

• Absorption costing = the required inventory method for external financial report in most
countries
• Preferred because:
o Cost effective and less confusing
o Can help prevent managers from taking actions that make their performance measure
look good but that hurts the income they report to shareholders
o It measures the cost of all manufacturing resources (variable or fixed) necessary to
produce inventory
• One UNFAVOURABLE ATTRIBUTE of absorption costing is that it enables managers to increase
margins and therefore, OPERATING INCOME, by producing more ENDING INVENTORY
• Producing for inventory can be justified when rapid growth is forecasted, but should not be
undertaken simply to boost profits
• To reduce an undesirable buildup of inventory, companies can use variable costing for internal
reporting purposes including performance measurement

83 | P a g e

Production-Volume Variance
• The difference between budgeted fixed OH and FOH allocated, on the basis of actual output
produced
• Also known as DENOMINATOR LEVEL VARIANCE
• Budgeted Fixed OH vs Allocated Fixed OH:
o Budgeted fixed OH = Allocated Fixed OH*
§ No PVV
o Budgeted Fixed OH > Allocated Fixed OH*
§ Actual volume is less than expected volume
§ Fixed overhead is under-allocated
§ PVV (Unfavourable)
o Budgeted Fixed OH < Allocated Fixed OH*
§ Actual volume exceeds expected volume
§ Fixed OH is over-allocated
§ PVV (Favourable)
• (* Budget input allowed for actual output)

Example 3
Month Actual Volume Expected Variance
(production) Volume
March 12,000 > 11,000 (normal) PVV (Favourable)
April 10,000 < 11,000 (normal) PVV
(Unfavourable)

Week 12: Decision Making & relevant Costs

84 | P a g e

Information and the Decision process
Decision Model:
• Is a formal method of making a choice that often involves both quantitative and qualitative
analyses
• Managers use 5-Step decision-making process (presented in Chapter 1) to make decisions

5 Step decision Process

• Managers use the 5 step decision process presented above to make decisions
• Step 1:
o Identify problems and uncertainties
• Step 2:
o Gather all information (relevant or not) – information can be historical or futuristic
o Anything that will allow us to make a more effective decision
o (i.e routine decision, operating decision)
o Short term vs long term decisions (to do with investments)
o Chapter 11 = focus on short term (i.e make a product, buy a product, continue or
discontinue a department or division)
• Step 3:
o Make a prediction
• Step 4:
o Choose among alternatives
• Step 5:
o Implement the decision

The Concept of Relevance

• Relevant information must fulfill 2 conditions:

85 | P a g e

 o 1. DIFFER among alternative courses of action.
§ Question Ask:
• “What difference will a particular action make?”
o 2. OCCUR in the FUTURE
§ Cost and revenue must occur in the future
§ Both conditions must occur simultaneously or at the same time
§ Relevant cost = expected future cost
§ Relevant revenue = expected future revenue
§ Past, historical costs = irrelevant (sunk costs)

Quantitative & Qualitative information

Quantitative Factors
• Outcomes are measured in NUMERICAL TERMS
• Includes both FINANCIAL and NON-FINANCIAL TERMS
• Financial
o Direct Materials $
o Direct Labour $
• Non-Financial
o Reduction in new product development time
o Percentage of on time flight arrivals for airline
o Product lead-time

Qualitative Factors
• Outcomes that are DIFFICULT TO measure in numerical terms
• Employee:
o Job satisfaction
o Morale and prestige
o Reputation
• Some things to help:
o i.e employee turnover can be an indication of job satisfaction
• Customer Satisfaction
o On-time delivery
o No or minimal customer complaints

Relevant Costs vs Irrelevant Costs

• Relevant costs are those costs that can be changed as a result of making a particular decision
o (i.e, take one course of action instead of an alternative course of action)
o (eg in a MAKE OR BUY decision situation:
§ When buying a product, the costs of making that can be avoided.
§ These costs are known as:
• AVOIDABLE COSTS
• IRRELEVANT COSTS, are those costs which are not affected by a particular decision. These are:
o UNAVOIDABLE COSTS

86 | P a g e

Avoidable Costs vs Unavoidable Costs
• AVOIDABLE COSTS – cost that CAN BE ELIMINATED by choosing one alternative instead of
another
o Is differential cost
o RELEVANT for decision making purposes
• UNAVOIDABLE COSTS – cost which CANNOT be eliminated regardless of which course of action
is taken
o Unavoidable cost is IRRELEVANT for decision purposes

Relevant Cost Illustration

• Deciding whether or not to reorganize
• Shows a difference between $70,000 in operating income between Alternative 1 and Alternative
2
• When look at column 3 & 4; only the relevant values are presented = MANUFACTURING LABOUR
(reorganize vs do not organize)
o The rest (i.e revenues, costs), makes no difference
o Your manufacturing labour and your REORGANISATION COSTS
• Cost that is relevant
o $640,000 and $570,000
• Given a lot of information, but what you need to do is decide, WHAT WILL MAKE A DIFFERNCE?
o Those differences are the costs that we are interested in
• If it makes no difference = UNAVOIDABLE and IRRELEVANT
• RELEVANT:
o When they differ and avoidable

87 | P a g e

Terminology
• Incremental cost
o The additional total cost incurred for an activity
• Differential cost
o The difference in total cost between two alternatives
• Incremental Revenue
o The additional total revenue from an activity
• Differential Revenue
o The difference in total revenue between two alternatives
• Note that incremental cost and differential cost are sometimes used interchangeably in practice

Incremental Costs (Differential Costs) and Incremental Revenues

(Differential Revenues)
• Incremental costs (differentiable costs) are:
o Measured by the DIFFEERENCE in TOTAL COSTS between two alternative courses of
action
• INCREMETNAL REVENUES (differential revenues) are:
o Measured by the DIFFERENCE in TOTAL REVENUES between two alternative courses of
action

Two Potential problems in Relevant-cost analysis

• 1. Incorrect general assumptions
o All variable costs are relevant
§ (i.e from example, DM is a variable cost by is NOT RELEVANT; no difference)
o All fixed costs are irrelevant
§ (i.e from example, Reorgnisation costs = relevant and fixed)
• 2. Misleading unit-cost data
o Include irrelevant costs
o Use SAME UNIT costs at different output levels

Opportunity Costs
• Is a BENEFIT FORGONE as a result of putting a firm’s existing resources to one alternative use in
preference to the next most attractive alternative
o In a MAKE OR BUY decision, a firm may decide to use its existing idle facilities to “make”
rather than “buy” a component for its major product
o OPPORTUNITY to use these same facilities or any alternative purpose is SACRIFICED
• Not recorded in your FINANCIAL STATEMENTS
o Hidden costs that you need to consider when making choices

Sunk Costs & Out-of-Pocket Cots

• SUNK COSTS
o PAST COSTS which were incurred previously (cannot change the future), and

88 | P a g e

 o IRRELEVANT for decision making
• OUT OF POCKET COSTS
o Cots that require an OUTLAY OF CASH, either immediately or in the future, if a particular
decision is made
o Relevant to you; (i.e reorganization costs from example)

Decision Situations
• ACCEPT or REJECT a Special order
• MAKE or BUY decision
• ADD or DROP a;
o Service
o Product, or
o Department

Accept or Reject a Special Order

• In this situation, a manager is considering an order often:
o ONE TIME ONLY, at a SPECIAL RPICE
• Two key issues to consider:
o 1. COST BEHAVIOUR
§ There is the danger of thinking that acceptance of the order will raise all
production costs, when in fact, it will raise only VARIABLE COSTS (because fixed
costs is fixed within the relevant range)
§ Should accept the order as long as it is priced above the variable costs and idle
capacity exists
o 2. CAPACITY (idle or no excess capacity)
§ If there is INSUFFICIENT IDLE PRODUCTION CAPACITY to manufacture the
special order, then all or part of the order would have to be filled from REGULAR
PRODUCT SUPPLY
§ The opportunity costs of the LOST CONTRIBUTION MARGIN from the regular
higher priced sales would then have to be factored into the pricing of the special
order

Excess Idle Capacity Scenario

• Production =20,000 units
• Sales = 15,000 units
• Selling price per unit = $20
• FC per unit = $7
• VC per unit = $7
• Customer offer to buy 1,000 units at special price of $12?
o Knowing TC = $7 + $7 = $14
o Do you accept the special one-time only order?
o Does it generate additional operating income? If it generates = answer is YES
• RELEVANT COST:
o What is the relevant cost?

89 | P a g e

 o Consider only VARIABLE COST
• ANSWER: YES ACCEPT
o There is excess capacity of (20,000 units – 15,000 units) = 5,000 units of excess capacity
left
o Selling price of $12 per unit covers over and above the variable costs per unit of $7
o ACCEPT ONLY if this special one-time only order DOES NOT AFFECT THE NORMAL SALES
and you have a positive contribution margin
o $12 – 7 = $5 x 1,000 = additional operating income of $5,000
• What If the special once-off order is for 7,000 units?
o Excess capacity of only 5,000 units so:
o Additional 2,000 units will need to be at the NORMAL PRICE
§ If insufficient capacity for special order, then all/part is to be filled from
REGULAR ORDER, but why would you lose out for that?
§ Need to account for loss of contribution margin
o Need to account for the lost in contribution margin in NORMAL SALES
o NOTE:
§ Accept the special offer only if it will not affect the normal sale and need to
account for lost contribution margin of normal sale

Special order Decision

• Special Order = 5,000 units at $11/unit which is $9 less than normal selling price
• Decision Rule:
o Does this special order generate additional operating income?
§ Yes: Accept
§ No: reject
o Only account for the RELEVANT COSTS:

90 | P a g e

 § Manufacturing variable costs

Make or Buy Decision

• Make or buy decisions requires careful consideration of FIXED COSTS
• The per unit cost of a product includes a unitized portion of FIXED COSTS< FIXED COSTS that may
continue even if the product is purchased elsewhere at a lower price
• Instead of presenting PER-UNIT FIXED costs, the information should be presented to emphasise
that total FIXED COSTS will NOT CHANGE with number of units produced
• DECISION RULE
o Select the option that will provide firm with LOWEST COST, and therefore, the highest
profit
o Same as SPECIAL ORDER: choose the alternative that maximizes operating income

Insourcing v outsourcing and Make-or-buy Decision, EXAMPLE:

91 | P a g e

Make or Buy decision, Extended

Add or Drop a Service, Product or Department

• Requires careful consideration of FIXED COSTS
• Ascertain if costs are AVOIDABLE or UNAVOIDABLE
• Eg in considering to drop or continue a product line:
o Decision make should isolate costs which will disappear with that product line

Product Mix Decision with Capacity Constraints

• PRODUCT MIX DECISIONS
o Are decisions managers make about which products to sell and in what quantities
• DECISION RULE (with a constraint)
o Choose the product that produces the highest contribution margin per unit of the
constraining resource (not the highest contribution margin per unit of the product)

92 | P a g e

Example

• PRODUCT A:
o Contribution margin/ machine hour = $8 = 4/0.5 min)
• Product B
o Contribution Margin/ machine hour = 15/3 = $5
• CONCLUSION
o PRODUCE PRODUCT A to maximize profitability

Summary

93 | P a g e