COM 316 — Managerial Accounting

Chapter 1 — Managerial Accounting and the Business Environment

MANAGEMENTS JOB
- Planning = identifying alternatives, selecting the best one and develop budgets (formulating long
and short term plans)
- Controlling = ensuring that plans are being followed (measuring performance, and comparing
actual to planed performance)
- Directing and Motivating = managing day-to-day activities to keep the organization running
smoothly (problem solving, conflict resolution, effective communication)
- Decision Making = making intelligent, data driven decisions
• What should we be selling?

• Who should we be serving?

• How should we execute?

DIFFERENCE BETWEEN FINANCIAL AND MANAGERIAL ACCOUNTING

Financial Accounting Managerial Accounting

Users external persons managers (internal persons)

Time historical future

Verifiability vs.
objectivity and verfiability relevance
Relevance
Preciseness vs.
precision timeliness
Timeliness

Subject company wide reports segment reports

Rules must follow GAAP/ASPE/IFRS no rules to follow

Requirements mandatory (external reports) not mandatory

Chapter 2 — Cost Terms, Concepts, and Classifications

MANUFACTURING COSTS
Direct Materials
Raw Materials = materials that go into the final product
Direct Materials = materials that become an integral part of the product and can be physically and
easily traced
Indirect Materials = materials that either can’t be traced or the expense to trace them isn’t worth it
(materials like glue, cleaning supplies, screws, etc)

Direct Labour
Direct Labour = labour costs that can be physically and easily traced back to the individual units of a
product (labour involved in each unit)
- includes product specific overtime premiums
Indirect Labour = labour costs that cannot physically be traced to the creating of products (usually
labour involved in administration or selling, maintenance, security guards, etc)

Manufacturing Overhead
Manufacturing Overhead = all cost of manufacturing expect direct materials and labour
- includes overtime premiums for all factory workers (unless product specific)

NON-MANUFACTURING COSTS
Marketing or Selling Costs = costs that are necessary to get the order and deliver the product
Administrative Costs = all executive, organizational and clerical costs

COST CLASSIFICATIONS
Conversion Cost = direct labour costs plus manufacturing overhead cost
Prime Cost = direct material costs plus direct labour costs
Product Costs = all the costs involved in acquiring or making a product
- direct materials, direct labour, and manufacturing overhead
Period Costs = all the costs incurred by a business that do not directly relate to producing a product
- include all selling costs and administrative costs

BALANCE SHEET
- manufacturing companies have three types of inventory
• Raw (direct) Materials Inventory = the materials used to make a product that have not yet
been placed in production
 • Work in Progress Inventory = units of product that are partially complete and require

additional work before selling

• Finished Goods Inventory = complete units that are available for, but have not yet been sold

COSTS OF GOODS MANUFACTURED

Costs of Goods Manufactured = all manufacturing (product) costs associated with the goods that
were finished during that period
- direct materials, direct labour, and manufacturing overhead

Schedule of Costs of Goods Manufactured

Direct Materials:
Raw Materials Inventory, Beginning xxx
Add: Purchases of Raw Materials xxx
Raw Materials Available for Use xxx
Deduct: Raw Materials Inventory, End xxx
Raw Materials Used in Production xxx
Direct Labour xxx
Manufacturing Overhead:
Insurance, Factory xxx
Indirect Labour xxx
Indirect Materials xxx
Utilities, factory xxx
etc. xxx
Total Overhead Costs xxx
Total Manufacturing Costs xxx
Add: Work in Progress Inventory, Beginning xxx
xxx
Deduct: Work in Progress Inventory, End xxx
Cost of Goods Manufactured xxx

COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOUR

Cost Behaviour = how a cost reacts or responds to changes in the level of activity
Variable Costs = a cost that varies in direct proportion to changes in the level of activity
- Variable Costs per Unit = a constant cost, that doesn’t change as more units are added
Fixed Costs = cost that remains constant, regardless of changes in the level of activity
• Fixed Cost Per Unit = inversely changes with the changes in level of activity
Relevant Range = the range of activity within which the assumptions about variable and fixed costs
are valid (some costs change with more use — 0-1000 = $500, 0-2000 = $750)
Mixed Costs = costs that contain both variable and fixed cost elements (ie. salary and commission)

ASSIGNING COSTS TO COST OBJECTS

Cost Object = any unit of analysis for which cost data is desired (products, customers, jobs, etc)
Direct Cost = cost that can easily and conveniently be traced to a particular unit of a product
Indirect Costs = costs that cannot be easily and conveniently traces to a unit of a product
- Common Cost = a cost incurred to support a number of cost objects but cannot be directly traced
to any of them individually

COST CLASSIFICATIONS FOR DECISIONS MAKING

Differential Cost = a difference in costs between two alternatives
- Incremental Cost = a cost increase from one alternative to another
- Decremental Cost = a cost decrease from one alternative to another
Differential Revenue = a difference in revenues between two alternatives
Opportunity Cost = the potential benefit that is given up when one alternative is chosen over anther
Sunk Cost = a cost that has already been incurred and that cannot be changed by any decision
made now or in the future

Chapter 3 — Cost Behaviour: Analysis and Use

TYPES OF COST BEHAVIOUR PATTERNS
Variable Costs
Total Variable Cost = proportionate to the activity level within the relevant range
Variable Cost per Unit = remains the same over wide ranges of activity
Activity Base = a measure of whatever cause a cartable cost to be incurred
- ie. machine hours, direct labour-hours, units produced, units sold etc
True or Proportionately Variable Cost = the amount used during a period varies in direct
proportion to the level of production activity (ie. direct materials)
Step-Variable Cost = cost that is obtained only in large amount sand that increases and decreases in
response to large changes in the activity level
Fixed Costs
Total Fixed Cost = remains the same even when the activity level changes within the relevant range
Fixed Cost Per Unit = fixed cost per unit goes down as the activity level goes up (and vice-versa)
to avoid confusion only use total fixed costs NOT fixes cost per unit
Committed Fixed Costs = investments that cannot be significantly reduced without making
fundamental changes that might impair a firm’s ability to attain its long-term objectives
• depreciation on equipment, real estate taxes
- long term
- cannot be significantly reduced in the short term
Discretionary Fixed Costs (Managed FC) = the costs that arise from annual decisions by
management to spend in certain fixed cost areas
• advertising, research and development, management training programs
- may be altered in the short term
Relevant Range = total fixed cost doesn’t change for a wide activity range, the jumps to a new
higher cost for the next higher activity range (ie. renting a new office space)

Trend: Towards Fixed Costs

- tasks originally performed by hand are now done by machinery and equipment
- demand for knowledge workers has also increased (those who use their mind to work and not
their hands) — salaried, highly trained, difficult to replace (committed fixed costs)
- however: many start-ups want to be mostly variable (as the number of units they sell needs to be
lower to breakeven)

Relevant Range FC Pattern vs. Step-Variable Costs

1) SVC can be easily adjusted in the short term (laying off a worker or two) where RRFC are locked
down into a cost level for a certain amount of time (building lease for 10 years)
2) SVC has much narrower steps (hiring a new worker means +~40 hours) where RRFC has much
wider steps (a new machine means +~40,000 hours)

CONTRIBUTION MARGIN FORMAT (IS)

- separates variable and fixed costs
• useful for analyzing and making decisions
 Sales Revenue xxx
Less: Variable Costs xxx
Contribution Margin xxx
Less: Fixed Costs xxx
Net Operating Income xxx

MIXED COSTS
Mixed Cost = a cost that has both fixed and variable elements

Mixed Cost Line

Total Cost

Variable Cost

Fixed Cost Line

fixed monthly charge

Activity

Mixed Cost Formula

Y = a + bx
Y = the total mixed cost
a = the total fixed cost (vertical intercept of the line)
b = the variable cost per unit of activity (slope of the line)
x = the level of activity
Separating Mixed Costs

Scattergram Method
1) plot data points on a graph (total cost vs. activity)
2) draw a trend line though the data points
3) choose a point on the line and estimate the level of activity and the total cost at that level
4) calculate the estimated variable cost per unit and determine the cost equation

High-Low Method
1) Calculate the variable portion of the cost (use highest and lowest cost drivers)
!Change!in!Dollar!Value!
Variable!Cost!Per!Unit =
Change!in!Unit
2) Calculate the fixer portion of the cost
- pick either the highest or lowest level of activity and multiply the unit value by the variable
cost per unit to get total variable costs

Fixed!Cost = Total!Cost! − !Variable!Cost

3) Put into the cost equation

Ex. Use the high-low method to calculate the cost equation, separating mixed costs

Month Hours of Total Maintenance 1) High Level — 800 hours and $9,800
Maintenance Costs Low Level — 500 hours and $7,400

January 625 $7,950

△ in"dollar" 9,800" − "7,400"
VC = = = "8
February 500 7,400 △ in"hours" 800" − "300"
March 700 8,275
2) High Level = 800 hours × $8 per hour
April 550 7,625 = $6,400
May 775 9,100
FC = TC – VC → $9,800 – $6,400 = $3,400

June 800 9,800 3) Y = $3,400 + $8x

Least-Squares Regression Method

Least-Squares Regression Method = provides the most accurate method (should be used in real
business situations)
- scattergram and high-low are only rough estimates and provide differing estimates
Chapter 4 — Cost-Volume-Profit (CVP) Relationships
Cost-Volume-Profit (CVP) = shows the relationships between cost, volume and profit, focuses on
how profits are affected by prices of products, volume or the level of activity, the per unit variable
cost, total fixed costs, and the mix or products sold

CONTRIBUTION MARGIN
Contribution Margin (CM) = the amount remaining from sales revenue after variable expenses have
been deducted (are paid for)
- can be expressed on a per unit basis (each additional unit will generate $x to CM)
Contribution Margin Ratio = contribution margin expresses as a percentage of total sales
- can also be calculate with per unit costs
!Contribution!Margin! !CM!Per!Unit!
CM!Ratio = =
Sales !Sales!Per!Unit!

Contribution Margin Approach

- no income statement is needed
- the fixed and variable costs that are included in an IS are all accounted for in the CM approach

Total Per Unit CM Ratio

Sales Revenue xxx xx 100%
Less: Variable Costs xxx xx xx%
Contribution Margin xxx xx xx%
Less: Fixed Costs xxx xx
Net Operating Income xxx xx

APPLICATIONS OF COST-VOLUME-PROFIT
Variable Expense Ratio = the ratio of variable expenses to sales
- helps us to figure out the CM ratio (if we don’t have to CM)
!Variable!Expenses!
Variable!Expense!Ratio =
Sales

CM!Ratio = 1 − Variable!Expense!Ratio
BREAK-EVEN ANALYSIS
Break-Even Point = the level of sales where profit is zero, and the company has paid off all expenses
but is not yet making money (where total sales = total expenses)
- once the breakeven point is passed, each additional unit sold will increase profits by the CM

Break-Even Equation Method

- we know that profit is sales less variable expenses less fixed expenses:
Profit = Sales! − !Variable!Expenses! − !Fixed!Expenses
- to calculate breakeven, we set profits to 0, and rearrange the equation:
Fixed!Expenses = Sales! − !Variable!Expenses = Contribution!Margin

Fixed!Expenses = Price!Per!Unit!(Q) − !VE!Per!Unit!(Q) = CM!Per!Unit!(Q)

ex. What is breakeven if total fixed expenses are $80,000, variable expenses per unit are
$300 and sales price is $500.

Fixed Expenses = P(Q) – VC(Q)

$80,000 = $500Q – $300Q
$80,000 = $200Q
Q = 400 units

Break-Even Formula Method

!Fixed!Expenses!
BEP!Units!Sold =
CM!per!Unit

!Fixed!Expenses!
BEP!Sales!Dollars =
CM!Ratio

ex. What is breakeven if total fixed expenses are $80,000, variable expenses per unit are
$300 and sales price is $500.

!Fixed!Expenses! 80,000
BEP!Units!Sold = = = 400!units
CM!per!Unit !500! − !300!
 ex. What is breakeven if total fixed expenses are $80,000, variable expenses per unit are
$300 and sales price is $500.

!Fixed!Expenses! 80,000
BEP!Sales!Dollars = = = 200,000!dollars!
CM!Ratio 40!percent!

- If you want to achieve a target profit you can add target profit to fixed expenses
!Fixed!Expenses! + !Target!Profits!
BEP!Sales!Dollars =
CM!Ratio

MARGIN OF SAFETY
Margin of Safety = the excess of budgeting (or actual) sales over the break-even volume of sales

Margin!of!Safety = Total!Sales! − !Break-Even!Analysis

COST STRUCTURE
Cost Structure = the relative proportion of fixed and variable costs in an organization

High Fixed Costs

- income will be higher in good years because once they cover the fixed costs they get more profits
as variable costs are very low an the CM is high
- income will be lower in bad years, it takes a lot longer to cover FC and although the CM margin is
high, if they aren’t able to cover FC then they are at a loss

Low Fixed Costs

- companies generally have greater income stability over good and bad years

Operating Leverage
Operating Leverage = how sensitive net operation income is to percentage change in sales
- acts as a multiplier — if OL is high, a small percentage change in sales means a large percentage
change in income
Degree of Operating Leverage = a measure at a given level of sales how much of a change in sales
volume will affect the profits
Contribution!Margin!
Degree!of!Operating!Leverage =
!Net!Operating!Income!

Percent!Increase!in!Profits = Percent!Increase!in!Sales! × !Degree!of!OL

ex. if CM is $100,000 and Net Income is $20,000, if we increase sales by 15%, by how
much will profits increase?

Contribution!Margin! !100,000!
Degree!of!OL = = =5
!Net!Operating!Income! !20,000!

Percent!Increase!in!Profits = Percent!Increase!in!Sales! × !Degree!of!OL!

= 15 × !5! = 75!Percent!Increase

Indifference Analysis
Indifference Analysis = used to compare the profitability of alternative products or methods of
production (based on cost behaviour in relations to changes in activity level)
- OBJ: find the level of unit sales at which we are indifferent between the two options
1) determine the equation for each alternative → CM(Q) – FC
2) make the equation equal each other
3) solve for Q (the indifference point)
can also be found by dividing the difference if FC by the difference in CM

SALES MIX
Sales Mix = the relative proportions on which a company’s products are sold
• managers want the sales mix that will generate the most profits
- need to calculate the total CM IS Approach in order to get the CM% to calculate break-even

ASSUMPTIONS OF CVP ANALYSIS

Selling Price is Constant — the price doesn’t change throughout relevant range as volume changes
Costs are Linear — costs can be accurately divided into variable and fixed cost elements
Variable Costs Per Unit and Total Fixed Costs are Constant — in the relevant range
Sales Mix is Constant — in multi-product companies
Inventories Remain Unchanged — units produced = units sold (manufacturing companies)

Chapter 5 — Systems Design: Job-Order Costing

Absorption Costing = all manufacturing costs (fixed/variable), are assigned to units of production

PRODUCT COSTING VS. JOB ORDER COSTING

Process Costing = costing each unit by an average cost per unit
- one unit is indistinguishable from other units of product and only one product is produced
Total!Manufacturing!Cost!
Unit!Product!Cost =
!Total!Units!Produced!
Job-Order Costing = cost comes from tracing and allocating costs to each job within the process
- products are manufactured to order and many different products are produced each period

JOB ORDER COSTING

- essentially, you are spreading the direct material, direct about and manufacturing overhead costs
to all the jobs

Material Requisition
Bill of Materials = a record that lists the type and quantity of each item of the materials needed to
complete a unit of product
Production Order = issued when an agreement has been reached with the customer concerning the
quantities, prices, and shipment date
Material Requisition Form = controls the flow of materials into production and makes the entires
into to accounting records
1) Specifies the type and quantity of materials to be drawn from the storeroom
2) Identities the job to which the costs of the materials are to be charged
Job Cost Sheet = a form prepared for each separate job that records the materials, labour and
overhead costs charged to the job

Measuring Direct Labour

- direct labour consists of labour charges that are easily traced to a specific job
- only direct labour is posted on the Job Cost Sheet
Time Ticket = hour-by-hour summery of the employee’s activities throughout the day

COMPUTING PREDETERMINED OVERHEAD RATES

- Manufacturing Overhead must be included on the job cost sheet since its a product cost
• difficult to assign manufacturing overhead to product costs:
1. they are indirect costs
2. they consist of many different types of costs (glue to the production managers salary)
3. many costs are fixed even though output fluctuates
4. the payment of varying overhead costs happens at all different times
Allocation Base = a measure that is used to assign overhead costs to products or services
ie. direct labour-hours, or machine-hours
Predetermined Overhead Rate (POHR) = an estimated amount that will be applied to products to
cover overhead costs
Estimated!Total!Manufacturing!Overhead!Cost!
POHR =
!Estimated!Total!Units!in!the!Allocation!Base!
Overhead Application = the process of assigning overhead cost to jobs

Overhead!Applied = POHR! × !Actual!Amount!Charged!to!the!Job

ex. if total manufacturing overhead costs are $320,000 and a total of 40,000 direct labour
hours, calculate the predetermined overhead rate and how much in overhead costs will
get charged to a job that took 27 direct labour hours.

320,000!Dollars!
POHR = = 8!per!DHL
!40,000!DLH!

Overhead!Applied = 8!Dollars!per!DHL! × !27!Hours! = 216!Dollars

Why use Predetermined Overhead Rates?

- managers like to know the cost of a completed job before the end of the accounting period
- simplifies record keeping
- you can estimate total job cots faster
Choosing an Allocation Base
Cost Driver = a factor that causes overhead costs
ie. machine-hours, beds occupied, computer time, flight hours, etc
- the allocation base should drive the overhead cost
• if not: the results will be inaccurate and distort the overall product costs

ex. Total manufacturing overhead costs are $760,000 and a total of 20,000 direct labour
hours. We also use $200 in direct materials and 10 hours of direct labour was needed
at $15/hour. Calculate the cost of this job.

1) Calculate the overhead cost for this job:

$760,000/20,000 DLH = $38/Direct Labour Hour x 10 hours = $380
2) Calculate direct labour costs:
$15 x 10 hours = $150
3) Calculate direct materials cost:
Direct materials = $200
4) Calculate total cost: = $730

THE FLOW OF COSTS

Purchase and Issue of Raw Materials
Raw Materials Inventory = the asset account used to track all the materials used (not an expense)
Work In Process Inventory = items that are no longer raw materials and have been transformed into
partially completed products
Manufacturing Overhead = an asset account to hold all the indirect expenses, an asset because
Man. O/H eventually gets absorbed into the cost of goods

Purchasing Raw Materials

- debit raw materials inventory
- credit accounts payable or cash (or other if specified)

Issuing Direct and Indirect Materials

- debit work in process inventory (direct materials)
- debit manufacturing overhead (indirect materials)
- credit raw materials inventory
 ex. You purchase $75,000 of raw materials on account, in which $67,000 are direct
materials and $6,000 used indirectly.

Raw Materials Inventory $75,000

Accounts Payable $75,000

ACCOUNTS PAYABLE RAW MATERIAL INVENTORY

75,000 75,000

Work In Process Inventory $67,000

Manufacturing Overhead $ 6,000
Raw Material Inventory $73,000

RAW MATERIAL INVENTORY WIP INVENTORY MANUFACTURING OVERHEAD

73,000 67,000 6,000

Recording Labour Costs

Salaries and Wages Payable = the account used to track all the wages and salaries that have yet to
be paid
- debit work in process inventory (direct labour)
- debit manufacturing overhead (indirect labour)
- credit salaries and wages payable

ex. You pay $152,000 in wages and salaries, where $134,000 are direct, rest is indirect.

Work In Process Inventory $134,000

Manufacturing Overhead $ 18,000
Raw Material Inventory $152,000

SALARIES & WAGES PAY. WIP INVENTORY MANUFACTURING OVERHEAD

152,000 134,000 18,000

Recording Actual Manufacturing Overhead
- any other manufacturing overhead costs are charged to the Manufacturing Overhead account as
they are incurred
ie. property taxes of the factory, prepaid factory insurance, accumulated depreciation on
factory equipment
- debit manufacturing overhead
- credit relevant accounts (or cash or A/P)

ex. You pay $126,000 in other manufacturing overhead costs. $21,000 is attributable to
the depreciation of factory equipment. The rest is factory rent.

Manufacturing Overhead $126,000

Factory Rent Payable $ 21,000
Accumulated Depreciation, Factory Equipment $105,000
FACTORY RENT PAYABLE ACC. DEP. FACTORY EQUIP. MANUFACTURING OVERHEAD

21,000 105,000 126,000

Example Recap (Full T-Tables)

ex. MANUFACTURING OVERHEAD WIP INVENTORY

6,000 67,000
18,000 134,000
126,000

ACCOUNTS PAYABLE RAW MATERIAL INVENTORY SALARIES & WAGES PAY.

75,000 75,000 152,000

73,000

FACTORY RENT PAYABLE ACC. DEP. FACTORY EQUIP.

21,000 105,000
APPLYING MANUFACTURING OVERHEAD
• manufacturing costs need to be applied to work in process to become part of the product costs

• uses the predetermined overhead rate (POHR)

- debit work in process inventory (to move estimated applied amount into the cost of goods)
- credit manufacturing overhead (to account for the estimated amount)

ex. The estimated manufacturing overhead applied is $178,000.

Work In Process Inventory $178,000

Manufacturing Overhead $178,000

MANUFACTURING OVERHEAD WIP INVENTORY

6,000 67,000
18,000 134,000
126,000 178,000
178,000

Cost of Goods Manufactured

• when a job is completed, the product is no longer a work in process

• needs to get moved to finished goods inventory = COGM

- debit finished goods inventory
- credit work in process inventory

ex. All products were finished by the end of the year, leaving nothing in WIP.

Finished Goods Inventory $379,000

Work In Process Inventory $379,000

WIP INVENTORY FINISHED GOODS INV.

67,000 379,000
134,000
178,000
COGM = the total in Finished Goods before
379,000 moved to COGS
379,000
= $379,000
0 0
Cost of Goods Sold
- once the finished goods are sold they need to be recorded as no longer waiting to be sold
- two entries are requires:
1. record the sale
• debit accounts receivable or cash (to record the payments you receive)
• credit sales
2. record COGS
• debit cost of goods sold (to record that the items are gone)

• credit finished goods inventory

ex. $288,000 products that were finished were sold by the end of the year. Total sales
were $350,000.

Accounts Receivable $350,000

Sales $350,000

ACCOUNTS RECEIVABLE SALES

350,000 350,000

Cost of Goods Sold $290,000

Finished Goods Inventory $290,000

FINISHED GOODS INV. COST OF GOODS SOLD

379,000 288,000
288,000

91,000

COMPLICATIONS OF OVERHEAD APPLICATION

Underapplied and Overapplied Overhead
- the difference between the applied overhead costs (that moved to WIP Inventory) and the actual
cost of overhead for that period

Underapplied Overhead
Underapplied Overhead = the amount of overhead actually incurred is higher than the amount of
overhead applied to WIP
 • debit balance in manufacturing overhead account

• if underapplied, the remaining balance is automatically closed out to COGS

- debit cost of goods sold
- credit manufacturing overhead

ex. Overhead was underapplied by $15,000.

Cost of Goods Sold $15,000

Manufacturing Overhead $15,000

MANUFACTURING OVERHEAD COST OF GOODS SOLD

6,000 288,000
18,000 15,000
126,000
135,000

15,000
. 15,000

0 0

Overapplied Overhead
Overapplied Overhead = the amount of overhead actually incurred is lower than the amount of
overhead applied to WIP (credit balance)
• credit balance in manufacturing overhead account

• if overapplied, the remaining balance is allocated among WIP, finished goods, and COGS
• done in proportion to the overhead applied during the current period in the ending balance of
these accounts

Account Total
ex. Overhead was overapplied by $28,000.
Assume overhead applied in ending WIP, WIP Inventory $0
FG and COGS are as follows: Finished Goods Inventory $53,400

Cost of Goods Sold $124,600

Total $178,000
ex. continued.

Calculate the proportion of each and apply the overapplied based on the percentages:

Account Value Perentage Account Value Perentage

Work In Work In
$0 0% $0 0%
Process Process

Finished Finished
$53,400 30% $8,400 30%
Goods Goods

Cost of Cost of
$124,600 70% $19,600 70%
Goods Sold Goods Sold

Total $178,000 100% Total $28,000 100%

Record the allocation of overapplied:

MANUFACTURING OVERHEAD WIP INVENTORY

6,000 67,000
18,000 134,000
126,000 178,000
178,000 379,000
379,000
.. 28,000
28,000
0 0
0 0

FINISHED GOODS INV. COST OF GOODS SOLD

379,000 288,000
288,000 19,600

91,000 268,400
.. 8,400

82,600
Chapter 7 — Activity-Based Costing (ABC)
Activity-Based Costing = provides managers with additional cost informations and insights for
analysis and decision making
- does not assign all the manufacturing costs to the products
Activity = an event that causes overhead costs to be incurred
Activity Cost Pool = a “bucket” that collects all the costs relations to a particular activity measure
Activity Measure = an allocation base (cost drier) relating to the activity and its cost pool

Five Levels of Activity

Unit-Level Activities = performed each time one unit is produced (cost is proportional to the
number of units produced)
Batch-Level Activities = performed each time a batch is handled or processed (cost is incurred
once per batch)
Product-Level Activities = relating to specific activities (incurred regardless of the amount of units
or batches produced)
Customer-Level Activities = not related tony specific product, has to do with customer activities
Organizational-Level Activities = all other activities that don’t fall into the other categories

USING ACTIVITY BASED COSTING

Assign to Costs Assign to Cost

Identify and Define Calculate
Pools Objects

- activities assign the overhead track the activity cost assign the overhead
- activity cost pools costs to the activity cost measures and calculate costs to the cost objects
- activity measures pools the activity rates using the allocation rates

Step 1: Identify and Define

- in order to identify all the activities, one must interview the department heads
- there are usually many activities which is too difficult and too costly to track so they are combined
with other like activities
Step 2: Assign Costs to Pools
First Stage Allocation = the process of assigning functionally organized overhead costs derived
from a company’s general ledger to the activity cost pools
- allocating the costs into the cost pools means taking the different costs and putting them into the
cost pool category
• excludes the costs of direct materials, direct labour and shipping

• based off a percentage — how much of each expense is used for each cost pool

Step 3: Calculate Activity Rates

- Calculate the activity rate for each cost pool, taking the total cost of the activity pool divided by the
total number of times that activity occurs in the time period
!Total!Cost!
Activity!Rate =
!Total!Activity!

Step 4: Assign Costs to Cost Objects

- assigning overhead costs to cost objects using the activity rates and activity measures
- multiply the activity rate (calculated in step 3) by the number of actual orders in the period
ABC!Cost = !Activity!Rate! × !Activity

Step 5: Prepare Management Reports

Product Margin = the profit from a single product (a function of the product’s sales and the direct
and indirect costs it incurs)

Distribution of Resource Consumption

ie.
Activity Cost Pool
Customer Manual Electronic Line Item Other
$ Total
Deliveries Order Order Picking Org. Costs

Wages and Salaries 5% 25% 10% 40% 20% $1025,000

Packing Order Costs 67% 0% 0% 33% 0% 150,000

Delivery Vehicle
70% 0% 0% 0% 30% 350,000
Expenses

Other Activities 0% 10% 15% 10% 65% 475,000

Step 1 — done in question (defining cost pools, activities and measures)
Step 2 — assign costs to pools (calculate the % amounts in $ value)

Distribution of Resource Consumption

Activity Cost Pool
Customer Manual Electronic Line Item Other Org.
$ Total
Deliveries Order Order Picking Costs
Wages and Salaries $51,250 $256,250 $102,500 $410,000 $205,000 $1025,000

Packing Order Costs 100,000 0 0 50,000 0 150,000

Delivery Vehicle
245,000 0 0 0 105,000 350,000
Expenses
Other Activities 0 47,500 71,250 47,500 308,750 475,000
TOTAL $396,250 $303,750 $173,750 $507,500 $618,750 $2,000,000

Step 3 — Calculate Activity Rates (total cost/total activity)

Activity Cost Pool Activity Measure Total Cost Total Activity Activity Rate

Customer Deliveries # of Deliveries $396,250 5,000 Deliveries $79.25/delivery

Manual Order $75.94/manual

# of Manual Orders $303,750 4,000 orders
Processing order

Electronic Order $24.30/

# of Electronic Orders $303,750 12,500 orders
Processing electronic order

Line Item Picking # of line items picked $507,500 400,000 line items 1.27/line item

Other Organization
N/A $618,750 N/A N/A
Costs

Total Selling and

$2,000,000
Admin Costs

Step 4 — Assign Costs to Cost Object (activity cost x # of actual activity)

Activity Measure Activity in City Office Activity in County Office
# of Deliveries 50 40
# of Manual Orders 0 30

# of Electronic Orders 50 10

# of line items picked 500 650

 Step 4 cont. — assign costs to cost objects

City Office County Office

Activity Measure
# Activity Cost #Activity Cost
# of Deliveries 50 $3,962.50 40 $3,170.00
# of Manual Orders 0 $0 30 $2,279.20
# of Electronic Orders 50 $1,215.00 10 $243.00
# of line items picked 500 $635.00 350 $444.50
Total $5,812.50 $6,136.70

Step 5 — create management reports (sales for both are $6,000)

City Office County Office
Sales $6,000.00 $6,000.00
Indirect Costs:
Customer Deliveries 3,962.50 3,170.00
Manual Orders 0 2,279.20
Electronic Orders 1,215.00 243.00
Line Item Picked 635.00 444.50
Total Indirect Costs 5,812.50 6,136.70
Customer Margin $187.50 -$136.70

TRADITIONAL VS ABC PRODUCT COSTING

1) review the product margins reported by the traditional systems
2) look at the differences between the traditional and ABC product margins

Product Margins Computed Using the Traditional Costing System

1) the sales and direct materials and direct labour cost data are the same numbers used by the ABC
team to prepare
2) the traditional costing system uses a plant-wide overhead rate to assign manufacturing overhead
costs to products
Total!Estimated!Manufacturing!Overhead!
Plnt-Wide!Overhead!Rate =
!Total!Estimated!Units!in!the!Allocation!Base!
3) Calculate the manufacturing overhead cost

Overhead!Cost = !Total!Actual!Units! × !Plantwide!Overhead!Rate

The Differences between ABC and Traditional Product Costing

1) Traditional costing systems allocates ALL manufacturing costs to products regardless of whether
they consume those costs. ABC only allocates product specific costs, not customer relations or
other, as they are organization-sustaining.
2) Traditional costing systems allocates ALL manufacturing overhead costs using machine-hours
(may not properly reflect what is causing the costs). ABC uses unique activity measures (usually
not volume related) to allocate the cost of each activity pool.
- traditional costing → overcoats high volume products and undercoats low-volume products
• because batch level and product levels costs are assigned using volume related allocations
3) Traditional costing systems exclude non-manufacturing costs because they are period costs. SBC
includes these.

Targeting Process Improvements

- ABC can be readily used to identify area that would benefit from process improvements
Activity-Based Management (ABM) = the management approach that uses ABC to improve
processes and reduce costs
- mixed as the biggest benefit of ABC

ABC and External Reports

- not used for eternal reports
• external reports are less detailed than internal reports (individual costs are not reported, and
there are no breakdowns of COGS and inventory accounts)
• it is very difficult to make changes to an accounting system
• ABC does not conform to GAAP

• ABC is based on subjective data (interviewing employees) creating allocation assumptions that
auditors are necessarily comfortable with
LIMITATIONS OF ABC
- firms often will not use ABC because:
• substantial resources are needed (implement and maintain ABC)
• it is very difficult to make changes to the accounting system (cannot easily accommodate ABC)

• ABC does not conform to GAAP (firms need to use two costing systems(

Chapter 9 — Budgeting
THE BASIC FRAMEWORK OF BUDGETING
Budget = a detailed plan for acquiring and using financial and other resources in the future that is
typically expressed in quantitative terms
• two roles: planning and controlling
- planning — developing objectives using bateau budgets to achieve the objectives
- controlling — the steps taken by management to ensure that objectives are attained
- Budgeting = the act of preparing a budget
- Budgetary Control = the use of budgets to control firm activities
Master Budget = summarizes a company’s plans, setting specific targets for sales, production,
distribution, administrative, and financing activities
- usually made up of a cash budget, a budgeted income statement, and a budgeted balance sheet
- represents a comprehensive financial expression of managements plans for the future and how
theses plans will get accomplished

Advantages of Budgeting
1. Defining goals and objective that can serve as benchmarks for progress
2. Communicating plans throughout the organization resulting in a better understanding of the
goals and objectives
3. Requiring more thinking about and planning for the future, without, many managers spend
too much time on short term goals or issues
4. Providing a means of allocating resources to parts of the organization that can use them the
most effectively
5. Uncovering potential bottlenecks by identifying the demands placed on key activities and
processes
6. Coordinating activities of the entire organization by integrating the plans of various areas
RESPONSIBILITY ACCOUNTING
Responsibility Accounting = managers are held responsible only for the items that they can
actually control to a significant extent
- personalized accounting information by holding individuals responsible for revenues and costs
- central to any effective profit planning and control system
- managers aren’t necessarily penalized, but should take corrective action
Participative Budget
Participative Budget = a budget prepared with the cooperation and participation of managers at all
levels rather than having a budget imposed by top management

Top Management

Middle Middle
Management Management

Supervisor Supervisor Supervisor Supervisor

Advantages
1. Broader range of judgements because people at all levels of the organization are recognized
as part of the team and their views and judgements are valued by top management
2. Budget estimates prepared by front-line managers are generally more accurate and reliable
than those prepared by top management because they have first hand experience
3. Motivation is higher for individuals who are involved in setting their own goals
4. Managers aren’t able to say that the budget was unrealistic and therefore have to own up to
their mistakes
Behavioural Factors in Budgeting
1. Top management must be enthusiastic and committed to the budget process
2. Top management must not use the budget to pressure employees or blame them when
something goes wrong
3. Highly achievable budget targets are usually preferred when managers are rewarded based on
meeting budget targets
Stretch Budget = highly difficult to attain and often requires significant changes to the activities
Zero-Based Budgeting = managers are required to justify all their budgeted expenditures
- not just the changes in the budget from the prior year
- challenge: it required significant time and effort
- advantage: can be good to refocus management

THE MASTER BUDGET

Sales
Budget

Ending Production Selling and

Inventory Budget Administrative
Budget Expense Budget

Direct Direct Manufacturing

Materials Labour Overhead
Purchases Budget Budget
Budget

Cash
Budget

Budgeted Budgeted
Income Balance
Statement Sheet
Preparing the Master Budget
1. Sales Budget and Schedule of Expected Cash Collections
2. Production Budget
3. Direct Materials Purchases Budget and Schedule of Expected Cash Disbursements for
Raw Materials
4. Direct Labour Budget
5. Manufacturing Overhead Budget
6. Ending Finished Goods Inventory Budget
7. Selling and Administrative Expenses Budget
8. Cash Budget
9. Budgeted Income Statement
10. Budgeted Balance Sheet

Sales Budget
Sales Budget = a detailed schedule showing the expected sales for the period
- typically expressed in dollars and units
- an accurate sales budget is the key to the entire budgeting process
• all other parts of the master budget depend on the sales budget

Sales Forecasting
Sales Forecast = the basis for the sales budget
- managers analyze the unfilled orders, pricing plans, marketing strategies, industry trends and
overall economic conditions
- uses the previous years sales to predict the coming years sales

ie. Sales Budget Quarter

1 2 3 4 Year

Budgeted Sales (units) 20,000 60,000 80,000 40,000 200,000

Selling Price (per unit) $ 30 $ 30 $ 30 $ 30 $ 30

Total Budgeted Sales $ 600,000 $ 1,800,000 $ 2,400,000 $ 1,200,000 $6,000,000

Schedule of Expected Cash Collections
Schedule of Expected Cash Collections = shows how much of A/R a company expects to collect
each month or quarter
- cash collections consists of:
• collections in this budget period on sales made in the previous budget periods
- assume the same as accounts receivable from the previous year unless stated otherwise
• collections on sales made in the current budget period

ie. Sales Budget and the Schedule of Expected Cash Collections if 60% of sales are
collected in that quarter, and the rest the following quarter. Accounts Receivable
balance was $180,000 at the end of 2019.
Quarter

1 2 3 4 Year

Budgeted Sales (units) 20,000 60,000 80,000 40,000 200,000

Selling Price (per unit) $ 30 $ 30 $ 30 $ 30 $ 30

Total Budgeted Sales $ 600,000 $ 1,800,000 $ 2,400,000 $ 1,200,000 $6,000,000

Schedule of Expected Cash Collections

A/R Dec. 31, 2019 $ 180,000 $ 180,000

First Quarter Sales $ 360,000 $ 240,000 $ 600,000

Second Quarter Sales $ 1,080,000 $ 720,000 $1,800,000

Third Quarter Sales $ 1,440,000 $ 960,000 $2,400,000

Fourth Quarter Sales $ 720,000 $ 720,000

Total Cash Collections $ 540,000 $ 1,320,000 $ 2,160,000 $ 1,680,000 $5,700,000

The Production Budget

Production Budget = lists the number of units that must be produced during each budget period to
meet expected sales and to provide for the desired ending inventory
- ending inventory is usually based off a percentage of the following quarters budgeted sales
- budgeted sales in units is taken from the sales budget
 ie. Production Budget based on a 10% required ending inventory amount, assuming a ending
inventory of 2,000 in 2019, and an expected ending inventory of 3,000 for 2020.
Quarter

1 2 3 4 Year

Budgeted Sales (units) 20,000 60,000 80,000 40,000 200,000

Add Desired Ending Inv. 6,000 8,000 4,000 3,000 3,000

Total Needs 26,000 68,000 84,000 43,000 203,000

Less Beginning Inv. 2,000 6,000 8,000 4,000 2,000

Required Production . 24,000 . 62,000 . 76,000 . 39,000 . 201,000

Desired Ending Inventory for Q1 = (Q2 budgeted sales) (10%)

= (60,000) (10%)
= 6,000 units

Desired Ending Inventory for the Year = Desired Ending Inventory for Q4

Beginning Inventory for Q1 = Ending Inventory in 2019 = 2,000

Beginning Inventory for the Year = Beginning Inventory for Q1

Direct Materials Purchases Budget

Direct Materials Purchases Budget = shows the raw materials that must be purchased to meet the
production budget and to provide adequate inventories
- only includes direct materials, insignificant materials are included in variable manufacturing O/H
- ending inventory is usually based off a percentage of the following quarters production needs
- required production is taken from the production budget
 ie. Direct Materials Budget based on a 10% required ending inventory amount, assuming a
ending inventory of 2,400 in 2019, and an expected ending inventory of 3,000 for 2020.

Quarter

1 2 3 4 Year

Req. Production (units) 24,000 62,000 76,000 39,000 201,000

RM Needed/unit (metre) 1 1 1 1 1

Production Needs (m) 24,000 62,000 76,000 39,000 201,000

Add Desired Ending Inv. 6,200 7,600 3,900 3,000 3,000

Total Needs (m) 30,200 69,600 79,900 42,000 204,000

Less Beginning Inv. 2,400 6,200 7,600 3,900 2,400

Raw Mat. to Purchase 27,800 63,400 72,300 38,100 201,600

Cost per metre $ 4 $ 4 $ 4 $ 4 $ 4

Cost of Raw Mat. to be $ 111,200 $ 253,600 $ 289,200 $ 152,400 $ 806,400

Purchased

Schedule of Expected Cash Disbursements for Raw Materials

Schedule of Expected Cash Disbursements for Raw Materials = shows how much of A/P a
company expects to pay during the year

ie. Schedule of Expected Cash Disbursements for Raw Materials assuming A/P was
$26,688 at the end of 2019, and they pay 70% in the quarter purchased and the rest in
the following quarter Quarter

1 2 3 4 Year

A/P Dec. 31, 2019 $ 26,688 $ 26,688

1st Quarter Purchases $ 77,840 $ 33,360 $ 111,200

2nd Quarter Purchases $ 177,520 $ 76,080 $ 253,600

3rd Quarter Purchases $ 202,440 $ 86,760 $ 289,200

4th Quarter Purchases $ 106,680 $ 106,680

Total Cash Disbursment $ 104,528 $ 210,880 $ 278,520 $ 193,440 $ 787,368

- cash disbursements consists of:
• payments in this budget period on accounts from previous budget periods
- assume the same as accounts payable from the previous year unless stated otherwise
• payments made in the current budget period

Direct Labour Budget

Direct Labour Budget = a detailed plan showing labour requirements for the time period

ie. Direct Labour Budget assuming it takes 0.5 hours to product one unit and labour costs $20
per hour
Quarter

1 2 3 4 Year

Units to be Produced 24,000 62000 76000 39000 201,000

DL Time/Unit (hours) 0.5 0.5 0.5 0.5 0.5

Total DLH Needed 12,000 31,000 38,000 19,500 100,500

DL Cost per Hour $ 20 $ 20 $ 20 $ 20 $ 20

Total DL Cost $ 240,000 $ 620,000 $ 760,000 $ 106,680 $2,010,000

Manufacturing Overhead Budget

Manufacturing Overhead Budget = a schedule of all costs of production other than direct material
and direct labour
- fixed costs are usually the costs of supplying capacity to do things like make products, process
purchase orders, handle customer calls etc
- if the level of activity is greater than the level of capacity then fixed costs may increase
- if the level pf activity is decreases significantly then fixed costs might be able to decrease
• total budgeted manufacturing overhead costs must be adjusted to determine the cash
disbursements for manufacturing overhead
• you subtract the non-cash (depreciation) expenses to get cash disbursements
- but you need to add it back it to the total manufacturing overhead
- total direct labour hours comes from the total direct labour budget
 ie. Manufacturing Overhead Budget based on direct labour hours, with a variable overhead
rate of $2 and fixed manufacturing overhead of $251,250 and depreciation costs of $30,000
Quarter

1 2 3 4 Year

Budgeted DL Hours 12,000 31000 38000 19500 100,500

Variable OH Rate 2 2 2 2 2

Variable Man. O/H 24,000 62,000 76,000 39,000 201,000

Fixed Man. O/H $ 251,250 $ 251,250 $ 251,250 $ 251,250 $1,005,000

Total Man. O/H $ 275,250 $ 313,250 $ 327,250 $ 290,250 $1,206,000

Less Depreciation $ (30,000) $ (30,000) $ (30,000) $ (30,000) $(120,000)

Cash Disbursements $ 245,250 $ 283,250 $ 297,250 $ 260,250 $1,086,000

Total Man. O/H $1,206,000

Budgeted DL Hours $ 100,500

POHR for the Year $ 12

Ending Finished Goods Inventory Budget

Ending Finished Goods Inventory Budget = budget showing the dollar amount of cost expected
to appear on the balance sheet for unsold units at the end of the pyramid

ie. Ending Finished Goods Inventory Budget based assuming that the cost is $20 per item is
broken down into $4 for direct materials, $10 for direct labour, and $6 for manufacturing
overhead.
Item Quantity Cost Total

Production Cost Per Unit:

Direct Materials 1.0 metres $4 per metre $ 4.00

Direct Labour 0.5 hours $20 per hour $ 10.00

Manufacturing Overhead 0.5 hours $12 per hour $ 6.00

Unit Product Cost $ 20.00

Budgeted Finished Goods Inv.:

Ending Fin. Goods Inv. (units) $ 3,000

Unit Product Cost $ 20

Ending Fin. Goods Inv. ($) $ 60,000

Selling and Administrative Expense Budget
Selling and Administrative Expense Budget = lists the budgeted expenses for areas other than
manufacturing
• divided into variable and fixed expenses

• subtract non-cash expenses and add in cash expenses

- could consist of many individual department budgets in large organizations

ie. Selling and Administrative Expense Budget based on a $2 variable S&A expense, and
fixed expenses of $102,000.
Quarter

1 2 3 4 Year

Budgeted Sales (units) $ 20,000 $ 60,000 $ 80,000 $ 40,000 $ 200,000

Var. S&A expense/unit $ 2 $ 2 $ 2 $ 2 $ 2

Budgeted Var. Expense $ 40,000 $ 120,000 $ 160,000 $ 80,000 $ 400,000

Budgeted Fix. S&A Exp. $ 102,000 $ 102,000 $ 102,000 $ 102,000 $ 408,000

LOOK$AT$ANSWER$KEY$EXERCISE$9-6
Tot. Budgeted S&A Exp. $ 142,000 $ 222,000 $ 262,000 $ 182,000 $ 808,000
Less Depreciation Exp. $ (4,000) $ (4,000) $ (4,000) $ (4,000) $ (16,000)

Less Insurance Exp. $ (19,000) $ (19,000) $ (19,000) $ (19,000) $ (76,000)

Ins. Premium Payment $ 76,000 $ 76,000

Less Property Tax Exp. $ (9,000) $ (9,000) $ (9,000) $ (9,000) $ (36,000)

Add Property Tax Paid $ 36,000 $ 36,000

Cash Disbursements for $ 110,000 $ 190,000 $ 306,000 $ 186,000 $ 792,000

S&A Epenses

Cash Budget
Four major sections:
1. Receipts Section — list of all cash inflows expected during the budget period (sales)
2. Disbursements Section — all cash payments that are planned for the budget period
- raw materials (inventory) purchases, direct labour payments, manufacturing O/H costs, etc.
3. Cash Excess (Deficiency) Section — the total cash after receipts and disbursement sections
4. Financing Section — detailed account of borrowings and loan repayments including interest
payments that will take place during the budget period

ie. Cash Budget the beginning cash balance is $50,000, spent $20,000 each quarter on
equipment, paid $10,000 in cash dividends per quarter. Management wants a $50,000 cash
balance at the beginning of each quarter for contingencies. The company opened a line of credit
at 4% annual interest rate to a maximum total loan balance of $500,000.
Quarter
1 2 3 4 Year
Cash Balance, beg. $ 50,000 $ 50,000 $ 50,000 $ 55,514 $ 50,000
Add Collect. from Sales $ 540,000 $ 1,320,000 $ 2,160,000 $ 1,680,000 $5,700,000
Total Cash Available $ 590,000 $ 1,370,000 $ 2,210,000 $ 1,735,514 $5,750,000
Less Disbursements:
Direct Materials $ 104,528 $ 210,880 $ 278,520 $ 193,440 $ 787,368
Direct Labour $ 240,000 620,000 $ 760,000 $ 390,000 $2,010,000
Manufacturing O/H $ 245,250 $ 283,250 $ 297,250 $ 260,250 $1,086,000
Selling and Admin $ 110,000 $ 190,000 $ 306,000 $ 186,000 $ 792,000
Income Tax $ 89,400 $ 89,400 $ 89,400 $ 89,400 $ 357,600
Equipment Purchases $ 20,000 $ 20,000 $ 20,000 $ 20,000 $ 80,000
Dividends $ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 40,000
Tot. Disbursements $ 819,178 $ 1,423,530 $ 1,761,170 $ 1,149,090 $5,152,968

Excess (Def.) of Cash $ (229,178) $ (53,530) $ 448,830 $ 586,424 $ 597,032

Financing:

Borrowing (beg,) $ 281,998 $ 107,424 $ 0 $ 0 $ 389,422

Repayments (end) $ 0 $ 0 $ (389,422) $ 0 $(389,422)

Interest $ (2,820) $ (3,894) $ (3,894) $ 0 $ (10,608)

Total Financing $ 279,178 $ 103,530 $ (393,316) $ 0 $ (10,608)

Cash Balance, ending $ 50,000 $ 50,000 $ 55,514 $ 586,424 $ 586,424

Most numbers are from the other budgets

The ending cash balance is the banging cash balance for the next quarter
The beginning cash balance for the year = the beginning cash balance for Q1
The ending cash balance for the year = the ending cash balance for Q4

Excess (Def.) of Cash + Borrowing – Interest on Borrowing = Target Cash Balance

Borrowing Q1 = $(53,530) – $2,820 + X – (4%/4)X = $50,000 → $107,424
Borrowing Q2 = $(229,178) – $2,820 + X – (4%/4)X = $50,000 → $281,998
Budgeted Income Statement
Budgeted Income Statement = shows the company’s planned profit for the upcoming budget

ie. Budgeted Income Statement (income tax is 30%)

Schedule

Sales 1 $ 6,000,000

Less: Cost of Goods Sold 6 $ 4,000,000

Gross Margin $ 2,000,000

Less: Selling and Administrative Expenses 7 $ 808,000

Operating Income (before taxes and interest) $ 1,192,000

Income Taxes ($1,192,000 × 30%) $ 357,600

Interest Expense 10 $ 10,608

Net Income $ 823,792

period and its a benchmark against which the actual company performance can be measured
Budgeted Balance Sheet
- developed using the most recent fiscal period as the starting point and then adjusting the data
contained in the other budgets
- not all companies create a budgeted balance sheet
• but may be required by external stakeholders (lenders)

ie. Budgeted Balance Sheet

A/R = 40% of Q4 sales = $1,200,000 × 40% = $480,000 (schedule 1)

Ending Raw Mat. Inv. = 3,000m × $4/m (schedule 3) = $12,000
Buildings, Furniture & Equipment = $1,400,000 (balance 2019) + $80,000 (schedule 8)
Acc. Dep. = $584,000 (balance 2019) + $120,000 (schedule 5) + $16,000 (schedule 7)
A/P = 30% of Q4 Raw Mat. Purchases = $152,400 × 30% = 45,720 (schedule 3)
Retained Earnings = $628,912 (balance 2019) + $823,792 (net income, schedule 9)
— $40,000 (dividends schedule 8) = $1,412,704
 ie. Budgeted Balance Sheet
Schedule

ASSETS
Current Assets:

Cash 8 $ 586,424
Accounts Receivable 1 $ 480,000

Raw Materials Inventory 3 $ 12,000

Finished Goods Inventory 6 $ 60,000
Total Current Assets $ 1,138,424
Property, Plant & Equipment
Land $ 160,000

Buildings, Furniture & Equipment 8 $ 1,480,000

Accumulated Depreciation 5, 7 $ (720,000)

Property, Plant & Equipment, Net $ 920,000

Total Assets $ 2,058,424

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current Liabilities:

Accounts Payable 3 $ 45,720

Shareholders’ Equity:

Common Shares $ 600,000

Retained Earnings 9,8 $ 1,412,704

Total Shareholders’ Equity $ 2,012,704

Total Liabilities and Shareholders’ Equity $ 2,058,424

FLEXIBLE BUDGET
Static Budget = budgets that are prepared only for the planned or budgeted level of activity
- suitable for planning but adequate for control
• if the planned level of activity and the actual level of activity differ it can be difficult to compare
Flexible Budget = provides estimates of what revenues and cost should be for any level of activity
 ie. Flexible Budget Performance
Budgeted Actual Flexible Budget Flexible Budget
Amount/Unit (220,000) (220,000) Variance

Sales $30.00 6270000 6600000 $ 330,000.00 U

Less Variable Expenses:

Direct Materials $ 4.00 $ 869,000 $ 880,000 $ 11,000 F

Direct Labour $ 10.00 $ 2,244,000 $ 2,200,000 $ 44,000 U

Variable Man. O/H $ 1.00 $ 228,800 $ 220,000 $ 8,800 U

Selling and Administative $ 2.00 $ 426,800 $ 440,000 $ 13,200 F

Total Variable Expenses $ 17.00 $ 3,768,600 $ 3,740,000 $ 77,000 U

Contribution Margin $ 13.00 $ 2,501,400 $ 2,860,000 $ 358,600 U

Less Fixed Expenses:

Manufacturing O/H $ 1,012,000 $ 1,005,000 $ 7,000 U

Selling and Administrative $ 402,000 $ 408,000 $ 6,000 F

Total Fixed Expenses $ 1,414,000 $ 1,413,000 $ 13,000 U

Operating Income $ 1,087,400 $ 1,447,000 $ 345,600 U

All budgeted per unit amounts come from the static budget (which come from the
master budget and are then multiplied by the level of activity (220,000 units)

The Flexible Budget Fixed Expenses come directly from the static budget or master
budget and are what you thought you would have to pay

Using the Flexible Budget for Performance Reviews

- three parts to the flexible budget performance report:
• Actual Budget = shows the revenues and expenses incurred during the year
• Flexible Budget = shows what the costs and revenues should have been for the given actual
level of sales
• Flexible Budget Variance = the difference between the actual and flexible budgets
- Unfavourable (U) = when the actual budget expenses (revenues) are > (<) than flexible
- Favourable (F) = when the actual budget expenses (revenues) are < (>) than flexible
Static Budget Variance = the difference between actual results at an activity level and the static
budgeted amount at a different activity level
Sales Volume Variance = the difference between the flexible and static budget amounts for
revenues and expenses
- caused by the actual activity levels differing from the static budget activity levels

Chapter 10 — Standard Costs and Overhead Analysis

Management by Exception = standards are set for various operating activities that ar then
periodically compared to actual results and any difference that are deemed as significant
(exceptions) are brought to the attention of management
Variance Analysis Cycle = basic approach to identifying and solving problems

Take Corrective
Identify Questions Receive Explanations
Actions

Conduct Next Period’s

Analyze Variances
Operations

Begin
Prepare Standard Cost
Performance Report

STANDARD COSTS
Standard Cost Record = standard quantities and costs of the inputs required to produce a unit of a
specific product

Standard Cost = Standard Quantity of each output × price or rate of that input

Ideal Standards = those that can be attained only under the best circumstances
- don’t allow for machine breakdowns or other work interruptions
- call for a level of effort that can only be attained by the most skilled and efficient employees
 • variances from the standard have little meeting because its expected that the company isn’t

performing to its greatest capacity

• argued that these expectations had motivational value

Practical Standards = standards that are tight by attainable

- allow for normal machine downtime
- can be attained though highly efficient efforts by the average employee

Setting Direct Material Standards

Standard Price Per Unit = the price that should be paid for a single unit of material
- includes shipping, receiving and other costs, net of discounts

ex.
Purchase Price $3.60
Freight 0.44
Receiving and Handling 0.05
Less Purchase Discount (0.09)
Standard Price Per Kilogram $4.00

Standard Quantity Per Unit = the amount of material that should be required to complete a single
unit of product
- includes allowances for normal waste, spoilage and other inefficiencies

ex.
Materials Requirements, kg 2.7
Allowance for Waste and Spoilage, kg 0.2
Allowance for Rejects, kg 0.1
Standard Quantity in Kilograms 3.0

SC of Materials per Unit of Finished Product = SC per Unit × SQ per Unit

ex.
3 kilogram per unit × $4 per kilogram = $12 per unit
Setting Direct Labour Standards
Standard Rate Per Hour = the labour rate that should be incurred per hour of labour time
- including employment insurance, employee benefits and other labour costs

ex.
Basic Average Wage Rate Per Hour $15.00
Employment Taxes (10%) 1.50
Employee Benefits (30%) 4.50
Standard Rate Per Direct Labour-Hour $21.00

Standard Hours Per Unit = the amount of labour time that should be required to complete a single
unit of product
- includes allowances for breaks, machine downtime, cleanup, rejects and other inefficiencies

ex.
Basic Labour Time Per Unit (hrs) 1.9
Allowance for Breaks and Personal 0.1
Allowance for cleanup/breakdown 0.3
Allowance for rejects 0.2
Standard Labour-Hours per Unit 2.5

Standard Labour Cost per Unit of Product = SR per DLH × SLH per Unit

ex.
$21 per hour × 2.5 hours per unit = $52.50 per unit

Setting Variable Manufacturing Overhead Standards

Standard Rate Per Hour = variable portion of the predetermined overhead rate
- involves the unit cost of the variable overhead items used in production and the quantity required
for the planned level of production

Standard Variable Manufacturing Overhead Cost per Unit = SR per DLH × SLH per Unit

ex. if variable portion of the predetermined overhead rate is $3 per direct-labour hour
$3 per hour × 2.5 hours per unit = $7.50 per unit
Variance Analysis
Variances = differences between standard prices and actual prices, and standard quantities and
actual quantities
- Variance Analysis = the act of computing and interpreting variances
- Price Variance = the difference between actual and standard price
• Materials Price Variance for direct materials

• Labour Rate Variance for direct labour

• Overhead Spending Variance for variable manufacturing overhead
- Quantity Variance = differences between actual quantity and the standard quantity allows for
actual output
• Materials Quantity Variance for direct materials
• Labour Efficiency Variance for direct labour

• Variable Overhead Efficiency Variance for variable manufacturing overhead

General Model for Variance Analysis

Actual Quantity of Inputs Actual Quantity of Inputs Standard Quantity Allowed for
at Actual Price at Standard Price Actual Output at Standard Price

AQ × AP AQ × SP SQ × SP

Price Variance Quantity Variance

AQ (AP — SP) SP (AQ — SQ)

Total Flexible Budget Variance

AQ (AP — SP) — SP (AQ — SQ)

EXAMPLE

Given Information: The company should work 1,065 hours each month to produce 2,130
units. Total costs associated with this level of production are:
- direct materials = $35,385
- direct labour = $8,520
- var. man. O/H = $3,195

During August, the company only worked 1,050 hours and produced 2,700 units with the
following costs:
- direct materials (6,000 m) = $43,740
- direct labour = $11,340
- var. man. O/H = $5,670

At the standard, each unit requires 2.0 metres of material and all materials purchased
during the month were used in production.

Calculate Materials Price and Quantity Variances for August.

AQ = 6,000 m (what was actually used)

AP = $43,740 ÷ 6,000m = $7.29/m (what was actually paid per m)
SQ = 2,700 units × 2m/unit = 5,400m (how many m should have been used)
SP = $35,358 ÷ (2,130 units × 2m/unit) = $8.30/m (how much each m should have cost)

Materials Price Variance = AQ (AP−SP)

= 6,000m ($7.29/m − $8.30/m)
= — $6,060
➔ $6,060 Favourable

Materials Quantity Variance = SP (AQ−SQ)

= $8.30/m (6,000m − 5,400m)
= $4,980
➔ $4,980 Unfavourable

* (—) is unfavourable for costs and favourable for revenues

Calculate Labour Rate and Efficiency Variances for August.

AH = 1,050 hrs (amount of hours actually used)

AR = $11,340 ÷ 1,050h = $10.80/hr (what was actually paid per hour)
SH = 2,700 units × (1,065h ÷ 2,130 units) = 1,350 hrs (how many hours should have been used)
SR = $4/unit ÷ (1,065 h ÷ 2,130 units) = $8.00/hr (how much each hour should have cost)

Variable Overhead Rate Variance = AH (AR−SR)

= 1,050 hrs ($10.80/hr − $8.00/hr)
= $2,940
➔ $2,940 Unfavourable

Variable Overhead Efficiency Variance = SR (AH−SH)

= $8.00/hr (1,050hrs − 1,350hrs)
= —$2,400
➔ $2,400 Favourable

Calculate Variable Overhead Rate and Efficiency Variances for August.

AH = 1,050 hrs (amount of hours actually used)

AR = $5,670 ÷ 1,050h = $5.40/hr (what was actually paid per hour)
SH = 2,700 units × (1,065h ÷2,130 units) = 1,350 hrs (how many hours should have been used)
SR = $3,195 ÷ 1,065 = $3.00/hr (how much each hour should have cost)

Variable Overhead Rate Variance = AH (AR−SR)

= 1,050 hrs ($5.40/hr − $3.00/hr)
= $2,520
➔ $2,520 Unfavourable

Variable Overhead Efficiency Variance = SR (AH−SH)

= $3.00/hr (1,050hrs − 1,350hrs)
= —$900
➔ $900 Favourable
Denominator Activity = the activity figure used to compute the predetermined overhead rate
= estimate total units in the base (machine hours, direct labour hours, etc.)

Overhead from the flexible budget at the denominator level of activity

Predetermined
=
Overhead Rate
Denominator level of activity

OVERHEAD APPLICATION IN A STANDARD COSTING SYSTEM

- overhead is applied to WIP on the basis of the standard hours allowed for the actual output of the
period instead of on the basis of the actual number of hours worked
Fixed Overhead Variances

Given Information:
Denominator Activity in DLH = 50,000 hrs
Budgeted Annual Fixed O/H Costs = $300,000
Fixed Portion of the POHR = $300,000 ÷ 50,000 hrs = $6.00/hr

During August:
Actual Direct Labour Hours = 5,400 hrs
Standard Direct Labour Hours Allowed = 5,000 hrs
Total Actual Fixed Costs = $27,500

Actual Fixed Overhead Costs = $27,500

Flexible Budget Overhead Costs = $300,000 ÷ 12 months) = $25,000
Fixed O/H Cost Applied to Work in Process = 5,000 standard hours × $6.00/hr = $30,000

Budget Variance = Actual Fixed O/H Costs — Flexible Budget O/H Costs
= $27,500 — $25,000
= $2,500
➔ $2,500 Unfavourable

Volume Variance = Flexible Budget O/H Costs — Fixed O/H Cost Applied to WIP
= $25,000 — $30,000
= —$5,000
➔ $5,000 Favourable

* difference between budget and volume variances is the

under- or overapplied of FIXED overhead
 Graphic Analysis

denominator standard
hours hours
$36,000

$30,000
Volume Variance
$27,500 ($5,000 F)
Fixed Overhead Cost

Budget Variance ($2,500 U)

$24,000

$18,000

$12,000

$6,000

$0
0 1 2 3 4 5 6
Direct Labour Hours (Thousands)

Overhead Variances and Under- or Overapplied Overhead Costs

Variable Overhead Spending Variance xxx
Variable Overhead Efficiency Variance xxx
Fixed Overhead Budget Variance xxx
Fixed Overhead Volume Variance xxx
Total Overhead Variance (over- or under applied) xxx

VARIANCE INVESTIGATION DECISIONS

- is it worth it to investigate?
• dollar amount — $5 probably isn’t worth it but maybe $5,000 is

• size of variance — 0.1% of spending isn’t worth it but 10% would be

• using a statistical control chart — investigate all variances that are more than X st. dev. from zero
CAPACITY ANALYSIS
Theoretical Capacity = volume of activity if all available production time was used and no waste was
occurred (24/7/365)
Practical Capacity = what would be produced if unavoidable downtime was removed from
theoretical capacity

STANDARD COSTING
Uses
- Cost Control and Performance Evaluation
- Product Costing
- Budgeting and Forecasting

Advantages
1. Key Element in Management by Exception — as long as costs remain within the standards,
managers can focus their effort elsewhere or tackle problems when they arise
2. Reasonable Standards Promote Efficiency — employees can use standards as a benchmark
3. Simplify Bookkeeping — instead of recording actual costs for each job, the standard costs for
materials, labour and overhead can be charged to jobs instead
4. Fit with Responsibility Accounting — standards establish what the costs should be, who
should be responsible for them and whether or not they’re under control

Potential Problems
1. May not be timely
2. Assumptions are made about labour — production process is labour-paced and labour is a
variable cost
3. Favourable variance may be misinterpreted — too small of a quantity variance might actually be
bad because they are using less than they publicize
4. emphasizing standards sometimes results in deemphasizing the importance of other important
objectives (increasing quality, on-time delivery, customer satisfaction)
5. Continuous improvement may be more important that just meeting standards
Chapter 11 — Reporting for Control
DECENTRALIZED ORGANIZATIONS
Decentralized Organization = decision making is spread throughout the organization rather than
confined to a few top executives
Advantages
1. Delegating day-to-day problem solving to lower-level managers allows top management to
focus on larger issues and overall strategies
2. Allowing lower-level managers to make decisions puts the decision-making authority with
those who have more detailed and up-to-date informations about day-to-day operations
3. By eliminating decision making approval layers allows organizations to more quickly respond to
customers and changes in the operating environment
4. Granting decision making authority helps to train lower-level managers for higher-level
positions
5. Empowering lower-level managers to make decisions increased motivation and job satisfaction
Disadvantages
1. Inability to see big picture — decisions are made without a full understanding of the
company’s overall strategy
2. Lack of coordination throughout company — each employee makes their own decisions
3. Differing objective — lower-level managers may make decisions to improve their
department but do not take the rest of the organization into account
4. Inability to spread ideas — difficult to share ideas that would benefit other departments

SEGMENT REPORTING
Segment Reporting = reports are made for the different segments in the organization as well as
companywide — permits analysis and evaluation of the decisions made by the segment managers
Segment = a part or activity of an organization about which managers would like costs, revenue or
profit data, can be a geographical region, an individual store, by type or merchandise etc

Levels of Segmented Statements

- often companies are divided into divisions, such as business products and consumer products
• the contribution format income statement (CFIS) has three columns: total company, business
product division and consumer product division
- then each division could be divided into product, ie. consumer product division is divided into
computer animation and computer game product lines
• the CFIS again has three columns: consumer product division (should be the same as in the

previous statement), computer animation and computer games

- a company can keep segmenting until they believe it is suffice

Assigning Costs to Segments

1. according to cost behaviour patterns
2. according to whether the costs are directly traceable to the segments involved

Fixed Costs
Traceable Fixed Costs = fixed costs that can be identified with a particular segment and arise
because that segment exists
- if the segment didn’t exist, the company would not have to pay that cost
- charged to particular segments
ie. salary of a product segment manager
Common Fixed Costs = fixed costs that supports the operations of more than one segment and isn’t
traceable in whole or in part to any one segment
- even if a company eliminated a segment, there would be no change in a true common fixed costs
- not allocated to segments, but deducted from the segment margin
ie. salary of the CEO

Identifying Traceable Fixed Costs

Traceable Costs = only those costs that would disappear over time if the segment itself disappeared
- costs will always fall between the traceable and common categories — needs good judgement
• resist the temptation to allocate costs that are clearly common
• allocating a common cost to a segment reduced the value of that segment margin (a guide to
segment profitability and performance)
- you can use ABC costing to breakdown traceable foxed costs
• Discretionary Fixed Costs = costs under the immediate control of the manager
• Committed Fixed Costs = investments that cannot be reduced and are company-wide
- traceable costs in one segment may become common costs in another segment
• because there are limits to how finely segments are defined
 • the manager salaries for a division would be traceable when segmented by division, but once

segmented by product the division manager salary becomes a common cost because you can’t
split it up between the two (+) product segments

Segment Margin
Segment Margin = the net income per segment
- represents the margin available after a segment has covered all of its own costs
Segment Margin = Segment CM — Segment Traceable FC

- best gauge of long-run profitability of a segment because it only includes costs that are caused by
the segment
- SM ≤ 0 = segment should be dropped (unless essential to other segments)

Issues with Proper Cost Assignment

1. Omission of Costs — many companies just use their absorption costing, which omits part or all
of the upstream costs (R&D and product design) and downstream costs (marketing,
distribution, and customer service) which are just as important in determining product
profitability
2. Inappropriate Methods of Assigning Traceable Costs — either by not tracing fixed expenses
to segments when feasible, or by using inappropriate allocation bases
3. Failure to Trace Costs Directly — by to tracing costs directly to a specific segment results in the
costs being placed in a companywide overhead pool
4. Arbitrarily Dividing Common Costs among Segments — doesn’t ensure that the full common
costs will be covered
- if a segment is dropped the divided common cost is still there
- common fixed costs are not manageable by the manager and therefore doesn’t produce an
accurate segment margin

RESPONSIBILITY CENTRES
Responsibility Centre = any part of an organization whose manager has control over and is
accountable for cost, profit, or investments
- Cost Centre = business segment whose manager has control over costs but not over revenue or
investment finds (accounting, finance, S&A, legal and personnel)
- Profit Centre = business segment whose manager has control over both cost and revenue, but
not investment funds
- Investment Centre = any segment of an organization whose manager has control over cost,
revenue, and investments in operating assets

Headquarters
Investment Centres President and CEO

Operations Finance Legal Personnel

Vice-President CFO General Counsel Vice-President

Profit Centres Product Product Product

Manager Manager Manager

Warehouse Distribution
Plant Manager
Cost Centres Manager Manager

RETURN ON INVESTMENT
Return on Investment (ROI) = a way to evaluate performance
- the higher to ROI of a business segment, the greater the profit generated per dollar invested in
the segment’s operating assets

Operating Income
ROI =
Average Operating Assets
Operating Income = income before interest and taxes (sometime EBIT)
Operating Assets = cash, A/R, inventory, plant and equipment and all other assets help for
productive use in the organization and/or the investment centre
- doesn’t include: land held for future use, investments in other companies, or factory buildings
rented to someone else
- usually the average of the operating assets between the beginning and end of the year

Issue with Operating Assets

Use net book value or the entire gross costs for PP&E?
- Net Book Value = purchase costs less any depreciation
• NBV is consistent with how PP&E are reported on the balance sheet

• NBV is consistent with the computation of operating income (includes depreciation as an exp.)
- Gross Cost = purchase cost of PP&E
• eliminates the age of equipment and the method of depreciation as factors in ROI
- with NBV, ROI tends to increase over time as NBV declines with depreciation
• does not discourage replacement of old, worn-out equipment
- with NBV, replacing fully depreciated equipment can have a dramatic adverse effect on ROI
- most companies use NBV (so we will) but the most important part is consistency

ROI = Margin × Turnover

Understanding ROI

Operating Income
Margin =
Sales

Sales
Turnover =
Average Operating Assets

Operating Income Sales

ROI = ×
Sales Average Operating Assets

Margin = measure of management’s ability to control operating expenses in relation to sales

Turnover = measure of the sales generated for each dollar invested in operating assets
Ways to Increase ROI
1. increase sales
2. reduce operating expenses (increases operating income)
3. reduce operating assets

Sales
Cost of Goods
Sold Operating
Income

Operating
Selling Expense
Expenses Margin

Administrative
Sales
Expense

Return on
Investment
Cash
Sales

Accounts Current
Receivable Assets
Turnover

Inventories
Average
Operating
Assets
Plant and
Equipment
Non-Current
Assets

Other Assets

Criticisms of ROI
1. management may not know how to control ROI — telling them to increase it might result in
negative results, an increase that is inconsistent with company’s overall strategy, or they may
increase ROI in the ST but affect the company in the LT
2. managers often inherit committed costs that they have no control over — these committed
costs may be relevant in assessing the performance of the business segment but provides
difficulty in assessing the performance relative to other segments
3. managers evaluated on ROI may reject profitable investment opportunities — investing
would decrease overall ROI
RESIDUAL INCOME
Residual Income = operating income that an investment earns above the minimum required return
on its operating assets

Residual
= Operating Income — (Ave. Operating Assets × Min. Required Rate of Return)
Income

Disadvantage
- cannot be used to compare the performance of divisions of different sizes
• problem can be reduced to some degree by focusing on the percentage change in residual
income from year to year

Criticisms
1. based on historical accounting data — the accounting values used for capital assets can suffer
fro being out of date when costs are rising = inflated amounts for residual income
2. does not indicate what earning should be — a mens of comparison is needed, which could
involve using external benchmarks
3. does not incorporate important leading non-financial indicators of success — like employee
motivation and customer satisfaction

BALANCED SCORECARD
Balanced Scorecard = an integrated set of performance measures that is derived from and supports
the company’s strategy
- top management translates its strategy into performance measures that employees can
understand and act upon
Strategy = theory about how to achieve the organization’s goals
- Cost Leadership = maintaining low cost though efficiency relative to competitors
- Differentiation = products that are perceived as unique
- Focus or Niche = targeting narrower target markets

Characteristics of a Balanced Scorecard

- performance measures in the balance scorecard fall into four groups:
• financial — looking at financial performance and comparing that to the goals
 • customer — looking at whether customers recognize the value we deliver and assessing

whether we are reaching our target market

• internal business processes — looking at our internal processes and if they can be improved to

deliver more customer value

• learning and growth — looking at whether we continue to learn, improve and change

Compensation
- bonuses for employees should be tied to balanced scorecard performance measures
• only after the organization has successfully used to balanced scorecard

Appendix 11A — Additional Control Topics

TRANSFER PRICING
Transfer Price = price charged when one segment sells goods or services to another segment of the
same company
- goal is to motivate managers to act in the best interests of the overall company

Setting Transfer Prices

1. allow managers involved in the transfers to negotiate their own prices
2. set transfer prices at cost (using either variable cost or full absorption cost)
3. set transfer prices at the market price

Negotiated Transfer Prices

Negotiated Transfer Price = a transfer price that is agreed on between the selling and purchasing
segments or divisions
- the selling division will agree to the transfer as ling as the profits of the selling division will increase
as a result of the transfer
- the purchasing division will agree to the transfer only if the profits of the purchasing division also
increase as a result of the transfer

Advantages
1. preserves the autonomy of the divisions and is consistent with decentralization
2. managers are more likely to have better information about the potential costs and
benefits of the transfer than others in the company
Range of Acceptable Transfer Prices = the range of transfer prices within which the profits of both
divisions participating in a transfer would increase
- Lower Limit = determined by the situation of the selling division
- Upper Limit = determined by the situation of the purchasing division

LOOK AT PREZI FOR TRANSFER PRICE EXAMPLE: https://prezi.com/zbxzbfwbiki_/untitled-prezi/

Transfers at Cost
- setting transfer prices at the variable cost or full absorption cost incurred by the selling division

Disadvantages
1. the use of cost (full cost) as a transfer price can lead to sub-optimization
2. the selling division will never show a profit on any internal transfers
3. cost-based prices do not provide any incentive to control costs — there is no incentive to reduce
costs as they are just passed to another segment

Transfers at Market Price

Market Price = the price charged for an item on the open market
- often regarded as the best approach to establishing transfer prices

Advantage
- works well when the product or service is sold in its present form to outside customers and the
selling division has no idle capacity

Disadvantage
- does not work well when the selling division has idle capacity

Divisional Autonomy
- decentralization suggests that companies should grant managers autonomy to set transfer prices
and decide whether to sell internally or externally

International Aspects of Transfer Pricing

- objectives for international transfer pricing differ from domestic objectives, moving away from
greater divisional autonomy and motivation, and better performance evaluation
 • Minimizing taxes, duties and tariffs

• Reducing foreign exchange risks

• Increasing the competitive position

• Strengthening government relationships

Chapter 12 — Relevant Costs for Decision Making

Relevant Cost = a cost that differs among the alternatives under consideration and that will be
incurred in the future
Irrelevant Costs = costs that are the same regardless of the alternatives
- Sunk Costs = a cost that was previously incurred and cannot be avoided
- Future Costs (that don’t differ between alternatives) = payments that will need to be paid in the
future regardless of the alternatives chosen
Avoidable Costs = costs that can be eliminated in whole or in part by choosing one alternative
- also known as differential cost or incremental costs
Unavoidable Costs = costs that are present with all alternatives

- costs are relevant and avoidable OR irrelevant and unavoidable

RELEVANT (DIFFERENTIAL) COST APPROACH

1. Eliminate costs and benefits that do not differ between alternatives
2. Use the remaining costs and benefits that do differ between alternatives to make the decision
* costs that are relevant in one decision aren’t necessarily relevant in other decisions

ex. You’re driving to visit a friend

Relevant Costs: cost of gasoline for the trip
maintenance an repairs (proportional to the amount driven)
tire replacement costs (the more km driven the sooner replaced)
the cost of taking the train instead of the car
any benefits to taking either option
- ability to studying on the train
- ability to have a car when visiting a friend
cost of parking when visiting friend
Irrelevant Costs: original cost of the car (sunk)
auto insurance and licensing
cost of parking at university
rent and other costs that are being paid regardless
 ex. You’re driving to visit a friend (numbers given)
Add up all relevant costs and compare:
cost of gasoline for the trip $63.60
maintenance an repairs 26.50
tire replacement costs 6.36
cost of parking 50.00
Total $146.46

cost of train $85.00

NEED TO TAKE INTO ACCOUNT NON-MONETARY RELEVANT INFO:

is the extra cost of taking the car worth it because she get to have
her car with her?

TOTAL APPROACH
1. Identify all costs for the current situation and the new situation
2. Compare the difference

ex. Company ABC is buying a new labour-saving machine

Current New Machine Differential Costs

and Benefits
Sales $200,000 $200,000 $0
Less VC:
DM 70,000 70,000 0
DL 40,000 25,000 15,000
VOH 10,000 10,000 0
Total VC 120,000 95,000
CM 80,000 105,000
Less FC:
Other 62,000 62,000 0
Rent, equip. 0 3,000 (3,000)
Total FC 62,000 65,000
OI $18,000 $30,000 $12,000

Disadvantages
1. rarely enough info to prepare a detailed income statement
2. combining relevant and irrelevant costs can cause confusion
VARIOUS DECISION SITUATIONS

** I was too lazy to put in any examples but they’re pretty

straightforward and the textbook has some great one sorry!!!

Adding and Dropping a Segment

What costs cane avoided by dropping a product line?
- remove all irrelevant and unavoidable costs
- add up all avoidable and relevant costs
- subtract those fixed costs from the contribution margin
• avoided fixed costs > lost contribution margin = better off eliminating the segment

• avoided fixed costs < lost contribution margin = keep the segment

Allocated Fixed Costs

Allocated Fixed Costs = costs that are unavoidable but spread across the different segments
- makes segments look less profitable than they actually are
- unless the allocated fixed costs of that segment can be covered by the other product lines then
the segment should not be dropped

Make or Buy Decision

Vertical Integration = the involvement by a single company in more than one of the steps of the
value chain
Value Chain:
1. Obtaining Raw Materials — through mining, drilling, growing, raising animals etc
2. Processed Raw Materials — to remove impurities and extract the desirable and usuable parts
3. Conversion of Useable Materials — so they can be used in final products (ie cotton to thread)
4. Manufacturing — the finished product is created
5. Distribution — of the product to consumers
Make or Buy Decision = a decision as to whether an item should be produced internally or
purchased form an outside supplier

Advantages of Integration
1. smoother flow of parts and materials — due to being less dependant on its suppliers
2. better quality control — they follow their own standards and don’t have to rely on the supplier
Advantages of Suppliers
1. Economies of Scales — by pooling demand from a number of firms
- higher quality and lower unit costs

Relevant Costs
- incremental costs of making the product (variable and fixed)
- opportunity cost of utilizing space to make the product
- outside purchase price
Relevant Costs = Incremental Costs + Opportunity Costs

Irrelevant Costs
- allocated common costs
- sunk costs

Decision Rule
- total relevant costs > outside purchasing price = buy
- total relevant costs < outside purchasing price = make

SPECIAL ORDERS
Special Orders = one-time order that is not considered part of the company’s normal business

Relevant Costs
- incremental costs and benefits
- opportunity cost of filling the order
- incremental revenues from the order
- fixed manufacturing overhead costs are not relevant because they aren’t affected by the order
Relevant Costs = Incremental Costs + Opportunity Costs

Decision Rule
- total relevant costs > incremental revenues = reject
- total relevant costs < incremental revenues = accept

JOINT PRODUCT COST

Joint Products = two or more items that are produced from a common input
Joint Product Costs = used to describe the manufacturing costs that are incurred in producing
going products up to the split-off point
Split-Off Point (SOP) = the point in the manufacturing process at which the joint products can be
recognized as separate products

Pitfalls of Allocations
- joint product costs are often allocated to end products on the basis of relative sales value
- allocated joint product product costs are sunk costs and therefore shouldn’t be used when making
decisions about what to do beyond the split-off point

Sell or Process Further Decisions

Sell or Process Further Decision = deciding what to do with a product after the split-off point

Irrelevant Costs
- Joint Costs because they have already been incurred by the SOP and are sunk costs
• relevant when considering the overall profitability of the entire operation

Relevant Costs
- incremental costs of further processing
- incremental revenues from further processing

Decision Rule
- incremental revenues > incremental costs of further processing = process further
- incremental revenues < incremental costs of further processing = sell at split-off point

UTILIZATION OF A CONSTRAINED RESOURCE

Constraint = when a limited resource of some type restricts a company’s ability to fully satisfy
demand for its product or services
ie. shelf space, machine-hour restrictions, labour-hours, raw materials available, etc.
Theory of Constraints (TOC) = effectively managing a constraint is important to the financial
success of an organization

Contribution Margin
- maximizing contribution margin:
• not necessarily promote those products that have the highest unit contribution margin
 • total CM will be maximized by promoting those products or accepting those orders that provide

the highest unit contribution margin in relation to the constrained resource

Profitability Index = the contribution margin per unit of the constrained resource

Contribution Margin Per Unit

Profitability
=
Index
Quantity of Constrained Resource Required Per Unit

- the product with the higher profitability index should be emphasized

Managing Constraints
- can increase profits by managing organization constraints
• if bottleneck = select the product mix that maximizes the total contribution margin and take
active control in managing the constraint itself
- focus effort in increasing the efficiency of the constraint and on increasing its capacity
Relaxing (Elevating) the Constraint = increasing the capacity of a bottleneck or constraint
- working overtime on the bottleneck
- subcontracting some of the processing work done at the bottleneck
- shifting workers form processes that aren’t bottlenecks to the bottleneck
- focusing business process improvement efforts (ie. total quality management or re-engineering the
bottleneck process)
- reducing defective units

Chapter 8 — Variable Costing: A Tool For Management

Absorption Costing (Full Costing) = treats all manufacturing costs as product costs, regardless if
they’re variable costs or fixed costs (includes DM, DL and MOH — variable and fixed)
- allocates a portion of fixed manufacturing overhead cost to each into of product
Variable Costing (Direct Costing or Marginal Costing) = only manufacturing costs that vary with
output are considered product costs (DM, DL, and VMOH)
Income Comparison

Compare the Variable and Absorption Costing Methods:

- Number of units produced each year = 6,000
- Direct Materials Per Unit = $2.00
- Direct Labour Per Unit = $4.00
- Variable Manufacturing Overhead Per Unit = $1.00
- Variable Selling and Admin Expenses Per Unit = $3.00
- Fixed Manufacturing Overhead = $30,000
- Fixed Selling and Admin Expenses = $10,000
Absorption Costing Variable Costing

Direct Materials $ 2.00 $ 2.00

Direct Labour $ 4.00 $ 4.00

Variable Man. O/H $ 1.00 $ 1.00

Total Variable Production Cost $ 7.00 $ 7.00

Fixed Manufacturing O/H $ 5.00 —

$ 12.00 $ 7.00

Fixed Manufacturing Overhead = $30,000 ÷ 6,000 Units = $5.00/Unit

Fixed Manufacturing Overhead Cost Deferred in Inventory = the portion of the fixed
manufacturing overhead cost of a period that goes into inventory under the absorption costing
method as a result of production exceeding sales
Fixed Manufacturing Overhead Cost Released from Inventory = the portion of the fixed
manufacturing overhead cost of a prior period that becomes an expense of the current period
under the absorption costing method as a result of sales exceeding production

Comparative Income Effects

- Production > Sales → no change in inventory → AC OI > VC OI
• because FMOH is deferred in inventory under absorption costing ad inventories increase
- Production = Sales → inventory increases → AC OI = VC OI
- Production < Sales → inventory decreases → AC OI < VC OI
• because FMO is released from inventory under absorption costing ad inventories decrease
RECONCILING VARIABLE COSTING AND ABSORPTION COSTING
- adding FMOH costs deferred in inventory under absorption costing
- deducting FMOH costs released in inventory under absorption costing

Appendix 12A — Pricing Products and Services

Cost-Plus Pricing = pricing method where a predetermined markup is applied to a cost base to
determine the target selling price
Markup = the difference between the selling price and cost of a product

Selling Price = Cost + (Cost × Markup Percentage)

Issues
1. What costs are relevant to the pricing decision?
2. How should the markup be determined?

Setting a Target Selling Price using Absorption Costing

1. Compute the Unit Product Cost — use absorption (include DM, DL, VMOH and FMOH)
2. Add Markup Cost — taking a percentage of the product cost

Determining the Markup Percentage

- could be result of industry norms or company tradition (if it works well)

Compare the Income Statements under the Variable and Absorption Costing Methods:
- Units in beginning inventory = 0
- Number of units produced each year = 6,000
- Units sold = 5,000
- Units left over at end of year = 1,000
- Selling price per unit = $20.00
- plus all the previous information

**continued on next page**

 Compare the Income Statements under the Variable and Absorption Costing Methods:

Absorption Costing Variable Costing

Sales $ 100,000 Sales $ 100,000

Less COGS: Less VE:

Beg. Inventory $ 0 Var. COGS Beg. Inv. $ 0

Add: COGM $ 72,000 Add: Var. COGM $ 42,000

COGAS $ 72,000 Var. COGAS $ 42,000

Ded: End Inv. $ 12,000 $ 60,000 Ded: Var. End Inv. $ 7,000 $ 35,000

Gross Margin $ 40,000 Var. S&A $ 15,000

Less S&A: Contribution Margin $ 50,000

Variable S&A $ 15,000 Less: Fixed Man. O/H $ 30,000

Fixed S&A $ 10,000 $ 25,000 Less: Fixed S&A $ 10,000 $ 40,000

Operating Income $ 15,000 Operating Income $ 10,000

Based on Absorption Costing

- markup must be large enough to cover selling and administrative expenses and provide adequate
return on investment

(Required ROI × Investment) + Selling and Admin Expenses

Markup on Absorption =
Unit Sales × Unit Product Cost

ie. must invest $200,000 to produce and market 10,000 units each year. The selling price is
$40/unit and selling and admin costs are $4/unit plus $120,000 (fixed). If the required ROI
20%, what is the markup?
(20% × $200,000) + ($4/unit × 10,000 units + $120,000)
50% =
10,000 Units × $20/unit
- if > 10,000 units are sold → ROI will increase (ie. greater than 20% in example)
- if < 10,000 units are sold → ROI will decrease (ie. less than 20% in example)
- required ROI will only be attained if the forecast unit sales volume is attained or exceeded at the
expected unit price (or higher)

Problem
Relies on a forecast of unit sales — assumes that customers need the forecasted unit sales and will
pay whatever price the company decides to charge
- absorption costing is only a safe approach to pricing if customers choose to buy at least as many
units as managers forecasted they would buy

Based on Variable Costing

(Required ROI × Investment) + Total Fixed Expenses

Markup on Total
=
Variable Cost
Unit Sales × Unit Total Variable Costs

Advantages
1. consistent with the cost-volume-profit analysis — allows managers determine the profit edicts of
changes in price and volume
2. avoids the need to arbitrarily allocate common fixed costs to specific products

Based on Time and Materials Pricing

Time and Materials Pricing = variation of cost-plus pricing where two pricing rates are established,
one based on direct-labour time and the other based on the cost of direct materials used
- rates are determined by supply and demand and by competitive conditions in the industry
• some companies set the rates using rates that include allowances for S&A expenses, other direct
and indirect costs and for desired profit

Time
- usually expressed as a rate per hour of labour
Rate is a combination of:
1. direct cost of the employees (including salary and benefits)
2. pro rata allowance for S&A expenses
3. allowance for a desired profit per hour of employee time
Materials
Materials Loading Charge = markup applied to the cost of materials that is designed to cover the
costs of ordering, handling, and carrying materials in inventory and to provide some profit

TARGET COSTING
Target Costing = process of determining the maximum allowable cost for a new product and then
developing a prototype that can be profitably made for that maximum target cost figure
- product development team is given the responsibility of designing the product so that it can be
made for no more than the target cost

Target Cost = Anticipated Selling Price — Desired Profit

Advantages
1. Most companies have less control over price than they want — supply and demand really
determined the price
- the anticipated market price is taken as a given in target costing
2. most of the cost of a product is determined in the design stage — once in production it is
difficult to significantly reduce costs
- target costing has to happen before the product development process

ie. Company XYZ wants to roll out a new product, they believe it can sell for $150 and they can
sell 80,000 units. This new product will require an investment of $8,000,000 and XYZ’s ROI
is 30%. What is the target cost per unit?

Projected Sales = 80,000 units × $150/unit = $12,000,000

Desired Profit = 30% × $8,000,000 = $2,400,000

Target Cost for 80,000 units = $12,000,000 — $2,400,000 = $9,600,000

Target Cost Per Unit = $9,600,000 ÷80,000 units = $120/unit