ACCOUNTING FOR

MANAGERS

UNIT III:
COST AND MANAGEMENT ACCOUNTING
 TOPICS TO BE COVERED: UNIT III
• Cost and Management Accounting: Meaning, Functions, Utility and
Limitations
• Financial Accounting vs Cost Accounting
• Financial Accounting vs Management Accounting
• Tools of Management Accounting
• Methods of Costing, Techniques of Costing
• Basic Cost Concepts
• Classification of Costs
• Absorption Vs Marginal Costing.
• Unit Costing: Preparation of Cost Sheet and computation of profits.
• Cost Volume Profit Analysis, Break-even Analysis, Margin of Safety.
• Managerial Decisions involving Alternate Choices: fixing the selling price,
exploring neW markets, make or buy decision, product/ sales mix
decision (with and without key factor), shut down or continue.
THIS UNIT WILL BE COVERED IN
SIX PARTS:
• PART I: COST & COST CLASSIFICATIONS

• PART II: COST REDUCTION, COST CONTROL AND COST

MANAGEMENT

• PART III: COST SHEET (NUMERICAL QUESTIONS AS WELL)

• PART IV: ABSORPTION COSTING AND VARIABLE COSTING (NO

NUMERICAL QUESTIONS)

• PART V: CVP ANALYSIS (NUMERICAL QUESTIONS AS WELL

• PART VI: DECISION MAKING (NUMERICAL QUESTIONS AS WELL

 UNIT III: PART I

COST & COST CLASSIFICATIONS

 What is a Cost?

• Cost refers to sacrifice of resources.

 Cost versus Expenses
Cost

Outlay Cost Opportunity Costs

Past, present, Forgone benefit from
or future cash the best alternative
outflow course of action

Expense
Cost charged against
revenue in an
accounting period
 Presentation of Costs
in Financial Statements
Explain how costs are presented in financial statements.
Income Statements
Service company
Revenues Cost of
– Cost of services sold billable
= Gross margin hours
– Marketing and
administrative costs
= Operating profit

The excess of operating revenue over costs

necessary to generate those revenues
2-7
 Presentation of Costs
in Financial Statements
Income Statements
Merchandising company
Revenues Expense assigned
– Cost of goods sold to products sold
= Gross margin during a period
– Marketing and
administrative costs
= Operating profit

The excess of operating revenue over costs

necessary to generate those revenues
2-8
 COST TERMINOLOGY:

Ø COST: Cost means the amount of expenditure incurred on a particular thing.

Ø COSTING: Costing means the process of ascertainment of costs.

Ø COST ACCOUNTING: The application of cost control methods and the ascertainment of the
profitability of activities carried out or planned

Ø COST CONTROL: Cost control means the control of costs by management

Ø JOB COSTING: It helps in finding out the cost of production of every order and thus helps in
ascertaining profit or loss made out on its execution. The management can judge the profitability of each job
and decide its future courses of action.

Ø BATCH COSTING: Batch costing production is done in batches and each batch consists of a number of
units, the determination of optimum quantity to constitute an economical batch is all the more important.
 COST ACCOUNTING - INTRODUCTION
Accounting for determination and control of costs.

• COST ACCOUNTING: The Institute of Cost and Management Accountant,

England (ICMA) has defined Cost Accounting as – the process of
accounting for the costs from the point at which expenditure incurred, to
the establishment of its ultimate relationship with cost centers and cost
units. In its widest sense, it embraces the preparation of statistical data, the
application of cost control methods and the ascertainment of the
profitability of activities carried out or planned .

Cost Accounting = Costing + Cost Reporting + Cost Control.

OBJECTIVES OF COST ACCOUNTING

Ø Ascertainment of costs

Ø Estimation of costs

Ø Cost control

Ø Cost reduction

Ø Determining selling price

Ø Facilitating preparation of financial and other statement

Ø Providing basis for operating policy

 The Need for Cost Accounting
• Cost accounting provides the detailed cost data
that management needs to control current
operations and plan for the future.

• Companies must control costs in order to keep

prices competitive.

• In today s global environment, cost information

is more crucial than ever in remaining
competitive.
 Financial Accounting Versus
Management Accounting

ü Financial accounting is devoted to providing

information for external users; these users
include investors, government agencies, and
banks.

ü Cost management identifies, collects,

measures, classifies, and reports information
that is useful to managers in costing
(determining what something costs), planning,
controlling, and decision making.
 Cost Accounting Versus
Management Accounting

ü Cost accounting attempts to satisfy costing

objectives for both financial and management
accounting

ü Management accounting is concerned

specifically with how cost information and other
financial and non-financial information should be
used for planning, controlling and decision
making
Financial Accounting Vs. Managerial Accounting
Characteristics Financial Accounting Managerial Accounting
Users: •External Parties
•Managers Managers
Focus: Entire business Segments of the business
Uses of Cost Information: Product costs for •Budgeting
calculating cost of goods •Special decisions such as
sold and finished goods, make or buy a
work in process, and raw component, keep or
materials inventory using replace a facility, and sell a
historical costs and GAAP. product at a special price.
•Nonfinancial information
such as defect rates, % of
returned products, and
on-time deliveries
 Elements of Manufacturing Costs
• Direct materials
– Materials that become part of the finished good and can
be readily identified.

• Direct labor
– Labor of employees who work directly on the product
manufactured.

• Factory overhead
– Includes all costs related to production other than direct
materials and direct labor.
 Prime Cost and Conversion Cost

Direct Materials
Elements of Prime Cost
Cost Direct Labor
Conversion
Factory Overhead Cost
 Flow of Manufacturing Costs

Direct Materials
Work in Process Finished Goods Cost of Goods Sold
Direct Labor
(Assets) (Assets) (Expenses)
Factory Overhead
 Direct and Indirect
Manufacturing Costs
Direct costs:
Costs that, for a reasonable cost, can
be directly traced to the product.

Direct materials: Direct labor:

Materials directly Work directly traceable to
traceable to the product transforming materials
into the finished product

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 Direct and Indirect
Manufacturing Costs
Indirect costs:
Costs that cannot reasonably
be directly traced to the product.

Manufacturing overhead:
All production costs except
direct materials and direct labor.

Indirect materials Indirect labor Other indirect costs

2 - 20
 Prime Costs and
Conversion Costs
Direct
Prime costs: materials
The primary costs
of the product Direct
labor

Conversion costs: Direct

Costs necessary to labor
convert materials Manufacturing
into a product overhead

2 - 21
 Managerial Accounting

• Managerial Accounting provides

information to the internal decision makers
of a business.
• Managerial accounting provides both
financial and non-financial information.
Managerial Accounting Topics
Some of the topics of managerial accounting
follow:

n Determining the costs of products and services

n Product Pricing
n Cost Analysis
n Budgeting
n Break-even analysis
n Profit Planning
 Classifying Costs
• Recall that one of the purposes of managerial
accounting is to provide management with
information about the costs of products or services.

• Companies incur different types of costs that can be

classified based on certain characteristics.

• Each cost classification provides management with a

different type of information to be applied in analyzing
different business situations.
 Cost Classifications
Costs can be classified on the basis of following aspects:

n Behavior
n Traceability
n Controllability
n Relevance
n Function

Any cost may be categorized using any one or a

combination of the five different classifications.
Costs can be

Classification by Behavior

n Fixed – a cost which does not change as the

volume of activity (production) changes

n Variable – a cost which changes with changes in

the volume of activity

n Mixed – a cost which has both fixed and variable

components
 Classification by Traceability

n Direct – a cost which is incurred for the

benefit of one specific product (cost object)

n Indirect – a cost which is incurred for the

benefit of more than one cost object or
which cannot be easily or efficiently traced
to a specific cost object
Classification by Controllability

nControllable – a cost which can be affected

(controlled) at the hierarchical level which is
being measured

nUncontrollable – a cost which cannot be

affected (controlled) at the hierarchical level
which is being measured
 Classification by Relevance

n Sunk – a cost which has already been incurred and

cannot be avoided or changed regardless of future
actions
n Out-of-pocket – a cost which requires future cash
outlays
n Opportunity – a cost measured as the loss of
potential benefits by choosing one course of
action over another
 Classification by Function

n Product – a cost which is necessary to

produce a finished product

n Period – a cost which is necessary to run the

business during a specified fiscal period
 Costs are classified into
(a) product costs
(b) period costs,

from the point of view of whether

they are charges against revenue
or by whether they are
inventoriable
 PRODUCT VS. PERIOD COST

Product Costs or Inventoriable Costs – costs assigned

to products that were either purchased for resale
(merchandising firm or retailer) or manufactured for sale
(manufacturing firm)
• When products are sold, product costs are recognized as
an expense (cost of goods sold or COGS). The costs of
unsold products remain in inventory and are not
expensed (i.e. not deducted from revenue in calculating
net income)

Period Costs – costs that are not product costs and that
are associated with the period in which they are incurred
• Period costs such as selling and administrative costs are
expensed (i.e. deducted from revenue in calculating net
income) in the period they are incurred
Product Costs Versus Period Costs

Product costs include Period costs are not

direct materials, direct included in product
labor, and costs. They are
manufacturing expensed on the
overhead. income statement.
Cost of
Inventory Goods Sold
Expense

Sale

Balance Income Income

Sheet Statement Statement
 QUICK CHECK ü
Which of the following costs would be
considered a period rather than a
product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate
headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.`
 Product Costs
• Product costs are inventoriable costs, identified as part of inventory on hand.
• Product costs are those costs which are identified with the product and included in stock valuation

• All manufacturing costs are product costs

• In a manufacturing concern, it is composed of four elements:

(i) direct materials
(ii) direct labour
(iii) direct expenses and
(iv) manufacturing overhead.

• That is, product cost is a full factory cost.

• Prior to sale, product costs are deferred as inventories and until the goods are sold, are
shown on the balance sheet as assets.

• As finished inventory goods are sold, product costs are transferred from the inventory
accounts to the cost of goods sold account, thus becoming part of the period costs at
the time revenue is realised.

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 Period Costs
• Period costs are those costs which are not included in stock-valuation and are treated as expenses
during the period in which they are incurred.

• They are not carried forward as a part of value of stock to the next accounting period.

• In a manufacturing organization, period costs include many selling and administrative costs needed to
keep the business operating.

• These costs are necessary to generate revenues but they cannot be directly associated with units of
product.

• Rather they can be assigned with periods of times in which they are consumed (expired).

• They are treated as expenses in the same period in which the costs are incurred.

• Product costs may be direct cost as well as indirect costs (direct costs with regard to direct material and
direct labour, and indirect costs with regard to factory overhead).

• Similarly, period costs i.e. selling and distribution and administrative overheads may be direct and
indirect costs.

http://www.yourarticlelibrary.com/accounting/product-costing/product-costs-and-period-costs-with-diagram/52517
http://www.yourarticlelibrary.com/accounting/product-costing/product-costs-and-period-costs-with-diagram/52517
 Reasons for such treatment of
product and period costs
• It is difficult to select equitable bases to apportion period costs to products. On the other hand,
product costs can be assigned to specific products through objective and direct measurement and
some by allocation.

• The majority of these expenses are fixed regardless of the change in production or activity.

• It is difficult, if not impossible, to determine the relationship between the incurrence of these costs and
the production of individual units of output.

• It is difficult to get evidence as to any future benefits that would be obtained from these expenses at
the end of the accounting period.
– Such is the case with clerical salaries, used postage, office supplies, rent and the like.

• Even if it is argued that there will be future benefits, it is difficult to make accurate measurements of
such benefits. Therefore objectivity and conservatism demand that such costs be treated as period
costs and expensed.
– For example, costs like advertising, sales promotion, consulting fees may be expected to provide future benefits,
but they are usually expensed when incurred.

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Effect of Product Costs and Period
Costs:
• The net income of a business enterprise is influenced by
the amount of product cost and period costs.

• Therefore, the manner in which some costs are divided

as product or period will surely have a bearing on
reported net income of a business firm.

• Product costs because of their association with the actual

production process are added to the cost of product and
period costs are treated only as expenses in the period in
which they have occurred.

http://www.yourarticlelibrary.com/accounting/product-costing/product-costs-and-period-costs-with-diagram/52517
Effect of Product Costs and Period
Costs:
• Product costs in the first instance, influence the value of
inventory as such costs by nature should be included in the
cost of product.

– Product costs affect net income in the period in which products

representing the product costs have been sold.
– This may be a subsequent accounting period and not necessarily
the period in which the product has been manufactured and
product costs have been incurred.
`
• However, period costs appear directly on the income
statement in the month or the period in which they expire.

http://www.yourarticlelibrary.com/accounting/product-costing/product-costs-and-period-costs-with-diagram/52517
 Presentation of Costs
in Financial Statements
Cost incurred to manufacture Income Statements
the product sold
Manufacturing company

Product costs recorded as

inventory when cost is incurred

Sales revenue
Expensed
– Cost of goods sold when sold
= Gross margin
Period costs recorded as – Marketing and
an expense in the period
the cost is incurred administrative costs
= Operating profit

2 - 41
 Primary Classifications

The three cost classifications we will

focus on in our computations are
§ Variable vs. Fixed
§ Direct vs. Indirect
§ Product vs. Period
Check Your Comprehension

Minchoy Company manufactures kitchen

cabinets. Check your comprehension of the
ways in which costs can be classified by
identifying the appropriate classification for
the cost items listed on the following slides
for Minchoy Company.
 Check Your Comprehension -
Classification by Behavior (1)

Variable vs. Fixed

§ Variable costs change with volume; fixed costs
stay constant within a relevant range of activity
Wood used in producing cabinets
Variable Fixed
The amount of wood used in
producing cabinets would vary with
the number of cabinets produced.
The amount of wood used in
producing cabinets would vary with
the number of cabinets produced;
therefore, this would be classified as a
variable cost.
 Check Your Comprehension -
Classification by Behavior (2)

Variable vs. Fixed

§ Variable costs change with volume; fixed costs
stay constant within a relevant range of activity

Cabinet pulls
Variable Fixed
 Variable

The number of cabinet pulls used

would vary with the number of
cabinets produced.
The number of cabinet pulls used
would vary with the number of
cabinets produced, therefore, cabinet
pulls used is a variable cost. Study
this concept some more.
 Check Your Comprehension -
Classification by Traceability (3)
Direct vs. Indirect
§ Direct costs can be traced to a specific cost
object; indirect costs benefit more than one cost
object.
Paint used on cabinets
Direct Indirect
Since it would be difficult to trace the
exact amount of paint used on any
given cabinet, this cost would be
classified as indirect.
 The amount of paint used on any
given cabinet would be difficult to
trace, therefore, paint would
be considered an indirect cost.
 Check Your Comprehension -
Classification by Traceability (4)
Direct vs. Indirect
§ Direct costs can be traced to a specific cost
object; indirect costs benefit more than one cost
object.

Cabinet pulls
Direct Indirect
Since a specific cabinet pull can be
traced to a specific cabinet, this would
be classified as a direct cost.
 Check Your Comprehension -
Classification by Function (5)
Product vs. Period
§ Product costs are incurred in producing a
product or providing a service; period costs are
costs incurred in operating a business.

Rent expense on administrative offices

Product Period
Any administrative expense is
considered a period cost. This cost
cannot be traced to a product.
 Check Your Comprehension -
Classification by Function (6)

Product vs. Period

§ Product costs are incurred in producing a
product or providing a service; period costs are
costs incurred in operating a business.

Cabinet pulls
Product Period
Because cabinet pulls are used in a
finished product, they are considered a
product cost.
 Combinations of Cost Classifications

Remember that costs can be

categorized based on any combination
of the classifications discussed above.
Classification Exercise
Classify the following cost items
¢ Depreciation on factory building
¢ Depreciation on office equipment
¢ Property tax on finished goods warehouse
¢ Wages paid to forklift operator in finished
goods warehouse
¢ Wages paid to forklift operator in factory
¢ Wages paid to welders when welding
equipment is not working
¢ Paper used in textbook production
¢ Paper used in central office computer
¢ Wages paid to assembly line workers
¢ Maintenance cost for machines
 Cost Allocation

• It is the process of assigning indirect costs

to products, services, business units, etc.

2 - 61
 Understand how material, labor, and overhead costs are
added to a product at each stage of the production process.

Details of Manufacturing
Cost Flows
• Product costs are recorded in inventory when costs are incurred.
• A manufacturing company has three inventory accounts:
1. Raw Materials Inventory:
Materials purchased to make a product
2. Work-in-Process Inventory:
Products currently in the production process,
but not yet completed
3. Finished Goods Inventory:
Completed products that have not yet been sold
2 - 62
 Inventory Accounts
– The Balance Sheet
Direct Materials Work-in-Process Finished Goods
Inventory Inventory Inventory
Beg. RM inventory Beg. WIP inventory Beg. FG inventory
+ Purchases + Direct materials + Cost of goods
transferred from completed and
= Raw materials
raw materials transferred from WIP
available for
production + Direct labor = Goods available
for sale
– Ending RM inventory + Manufacturing overhead
= Total manufacturing costs - Ending FG inventory
= Raw materials
transferred to WIP = Cost of goods sold
- Ending WIP inventory
= Costs of goods completed
and transferred to
finished goods (or cost of To the Income
goods manufactured Statement

2 - 63
Define basic cost behaviors, including fixed,
variable, semivariable, and step costs.

Cost Behavior

Cost behavior:
How costs respond to a change in
activity level within the relevant range

Relevant range:
Activity levels within which a given total fixed
cost or unit variable cost will be unchanged

2 - 64
 Components of Product Costs
Direct materials = $8

Variable
Full absorption Direct labor = $7 manufacturing
cost per unit cost = $23
= $29
Variable manufacturing
Full cost overhead = $8 Unit
per unit variable
= $40 Fixed manufacturing cost = $27
overhead = $6
Variable
Variable marketing and marketing and
administrative costs = $4 administrative
costs = $4
Fixed marketing and
administrative costs = $7

2 - 65
Identify the components of a product s costs.

Components of Product Costs

Full cost:
The sum of all costs of manufacturing
and selling a unit of the product

Full absorption cost:

The sum of all variable and fixed costs
of manufacturing a unit of the product

Variable cost:
The sum of all variable costs of manufacturing
and selling a unit of the product
2 - 66
 UNIT III: PART II

Cost Reduction, Cost Control

and Cost Management
 COST REDUCTION

• Cost reduction refers to the real and

permanent reduction in the unit cost
of the goods manufactured or
services rendered.
 WAYS OF COST REDUCTION

1. By reduction in unit cost of

production:
• By elimination of wasteful and non-
essential elements in the design of
products and from techniques and
practices carried out.
 WAYS OF COST REDUCTION

2. By increasing productivity:
This refers to increase in the volume
of output with the expenditure
remaining the same.
But this should not be achieved at
the cost of the characteristics and
quality of the product
 AREAS OF COST REDUCTION

1. Design
2. Factory organisation and method
3. Product planning
4. Factory layout and equipment
5. Utility services
6. Marketing
7. Finance
 COST CONTROL

• Cost control is concerned with keeping

the expenditure within acceptable
limits.
• Its major assumption is that costs are
in control unless costs exceed budget
or standard by an excessive amount.
COST CONTROL VS. COST REDUCTION
 COST CONTROL IS EFFECTED THROUGH
BUDGETING &
STANDARD COSTING
Budgeting:
A budget may be defined as a comprehensive and
coordinated plan of action, expressed in monetary terms. It is
prepared and approved prior to the budget period and may show
income, expenditure and capital to be employed to attain the
objective.
Standard costing:
In this, standards are set and actuals are compared with
the standard. Corrective measures are undertaken for any
discrepancy found between the standard and actuals.
74
 Cost efficiency
• Cost efficiency does not mean merely
cutting costs... Cost cutting is normally
done as a fire fighting measure when things
go terribly wrong.
• If cost efficiency is in built into the
management system of an organization
Then….
• The need for drastic cost cutting measures
might not be necessary at all.
 Cost management……(1)
• Managing the cost of the resources consumed and the
value of the output delivered

• Management of cost by collecting, analyzing, evaluating

and reporting cost information

• For budgeting, estimating, forecasting and monitoring

costs.
 Cost management…….(2)

• Measuring performance ,
• Comparing against expectations,
• Finding reasons for divergence
• Optimizing performance
• Prediction of final outcomes
 Cost management…….(3)

— Providing strategic recommendations

— Why ,what it means and what can be
done about it
— Measure of accountability for business
leadership
UNIT III: PART III

COST SHEET
 COST SHEET

• According to CIMA London Cost Sheet is ‘A

statement which provides for the assembly of
the detailed cost of a centre or a cost unit’.

• It is also a periodical statement.

• ‘The expenditure which has been incurred upon

product for a period is extracted from the
financial books and the store records and set out
in a memorandum statement.
 COST SHEET

DIRECT MATERIAL
DIRECT LABOUR
DIRECT EXPENSES

PRIME COST
FACTORY OVERHEADS

FACTORY COST
OFFICE OVERHEADS

COST OF PRODUCTION
SELL & DIST OVERHEADS

COST OF SALES
PROFIT

SALES
COST SHEET - ADVANCED

OPENING STOCK OF RAW MATERIALS

+PURCHASES
+CARRIAGE INWARDS
-CLOSING STOCK OF RAW MATERIALS

VALUE OF MATERIALS CONSUMED

+DIRECT WAGES
+DIRECT EXPENSES

PRIME COST
+FACTORY OVERHEADS

GROSS FACTORY COST

+OPENING STOCK OF WIP

-CLOSING STOCK OF WIP

NET FACTORY COST

(CONT.)
 NET FACTORY COST

+ADMINISTRATIVE OVERHEADS

COST OF PRODUCTION
+OPENING STOCK OF FINISHED GOODS
-CLOSING STOCK OF FINISHED GOODS

COST OF GOODS SOLD

+SELL. & DIST. OVERHEADS

COST OF SALES
+PROFIT

SALES
Direct Materials
Opening stock of materials
Add Purchases of materials
Less Closing stock of materials
(a) Materials consumed
Direct Wages
Direct Expenses ------ ------
PRIME COST
Add Factory Overheads
Factory rent, rates, taxes Fuel-power and water Lighting and Heating Indirect wages Depreciation, Repairs
Salaries of Works Manager etc. Indirect Materials
Drawing office and works office expenses Depreciation on factory land and building Less Scrap value
Defective work
Add Work in progress (opening)
Less Work in progress (closing) ------
WORKS COST
Add Office/Administration overheads
Office rent, insurance, lighting, cleaning
Office salaries, telephone, law and audit expenses

General Manager’s salary

Printing and stationery
Maintenance, repairs, upkeep of office bldg
Bank charges and miscellaneous expenses ------
COST OF PRODUCTION
Add Opening stock of finished goods
Less Closing stock of finished goods ------
COST OF GOODS SOLD
Add Selling and Distribution Overheads
Showroom expenses, salesmen’s salaries
& commission, bad debts, discounts, warehouse rent, carriage outwards, advertising, delivery expenses, samples and free gifts etc.
COST OF SALES
Add Net Profit or deduct net loss: ------ SALES ------
COST SHEET: ILLUSTRATION 1
COST SHEET: ILLUSTRATION 1- SOLUTION
COST SHEET: ILLUSTRATION 2
COST SHEET: ILLUSTRATION 2- SOLUTION
COST SHEET: ILLUSTRATION 3
ILLUSTRATION 3: SOLUTION
ILLUSTRATION 3: SOLUTION…CONTD
COST SHEET: ILLUSTRATION 4
ILLUSTRATION 4: SOLUTION
COST SHEET: ILLUSTRATION 5
COST SHEET: ILLUSTRATION 5- SOLUTION
 UNIT III: PART IV

ABSORPTION COSTING &

MARGINAL COSTING
 Variable and Absorption Income
Statements
• Many companies consist of separate business units
called profit centers.

• It is important for these companies to determine both the

overall performance of the business and the
performance of the individual profit centers.
 Variable and Absorption Income
Statements (cont.)
• Therefore, it is important to develop a
segmented income statement for each
profit center.

• Two methods of computing income have

been developed:
– one based on variable costing and
– the other based on full or absorption
costing.
 Absorption Costing
• Absorption costing assigns all manufacturing costs to
the product.
• Direct materials, direct labor, direct expenses (if any) variable
factory overhead and fixed factory overhead define the cost of a
product.

• Under this method, fixed overhead is assigned to the

product through the use of a predetermined fixed
overhead rate and is not expensed until the product is
sold.
• Fixed overhead is an inventoriable cost.
 Variable Costing

• Variable costing stresses the difference between fixed

and variable manufacturing costs.

• Variable costing assigns only variable manufacturing

costs to the product; these costs include direct materials,
direct labor, direct expenses if any and variable factory
overheads
 Variable Costing (cont.)

• Fixed factory overhead is treated as a

period expense and is excluded from the
product cost.

• Under variable costing, fixed factory

overhead of a period is seen as expiring
that period and is charged in total cost
against the revenues of the period.
 Comparison of Variable and
Absorption Costing Methods
• Generally accepted accounting principles (GAAP)
require absorption costing for external reporting.

• The Financial Accounting Standards Board (FASB),

the Internal Revenue Service (IRS), and other
regulatory bodies do not accept variable costing as a
product-costing method for external reporting.
 Comparison of Variable and
Absorption Costing Methods (cont.)
• The only difference between the two approaches is
the treatment of fixed factory overhead.

• The unit product cost under absorption costing is

always greater than the unit product cost under
variable costing.
Comparison of Variable and
Absorption Costing Methods
 Production, Sales, and Income
Relationships

• The relationship between variable-costing

income and absorption-costing income changes
as the relationship between production and
sales changes.
Production, Sales, and Income
Relationships (cont.)
Full (Absorption) Costing

1. Full (Absorption) Costing includes:

a. Direct material
b. Direct labor
c. Manufacturing overhead (both
variable and fixed)

2. Decision making and what-if decisions are

difficult because of the commingling of fixed
and variable overhead.
3. Required for GAAP.
 Variable Costing

1. Variable Costing includes:

a. Direct material
b. Direct labor
c. Variable Manufacturing overhead

2. Variable Costing lends itself well to

decision making and what-if
analyses.
3. Not allowed for GAAP.
 Differences Between Full
(Absorption) and Variable Costing

1. Fixed manufacturing overhead (included in

Full Costing).

2. Fixed manufacturing costs, like

depreciation, are a period expense on the
income statement under variable costing.

3. Fixed manufacturing costs, like

depreciation, are inventoried until sold
under full costing.
Variable Costing Income
Statement

1. The format uses a contribution

margin approach.

2. All costs, manufacturing, selling

and administrative, are classified
as either fixed or variable.
Variable Costing Income
Statement Example

Sales $100,000
Less Variable:
Variable COGS $20,000
Variable Selling 10,000
Variable Admin. 5,000 35,000
Contribution Margin 65,000
Less Fixed:
Fixed Mfg. 10,000
Fixed Selling 8,000
Fixed Admin 7,000 25,000
Net Income 40,000
 Full (Absorption) Costing
Income Statement Example

Sales $100,000
Less COGS 30,000
Gross Margin 70,000
Less Selling and Admin:
Selling 18,000
Admin 12,000 30,000
Net Income 40,000
 EXAMPLE:
Effects of Production on Income for Full
Versus Variable Costing: Clausen Tube

Facts:
§ 5,000 units produced and sold
§ Selling Price: $2,000 per unit
§ Variable Manufacturing:
§ Direct Materials: $600 per unit
§ Direct Labor: $225 per unit
§ Variable MFG: $75 per unit
§ Fixed Manufacturing: $1,200,000 per year
§ Selling Expense: $40 per unit variable plus
$100,000 fixed.
§ Administrative: $500,000 per year (fixed)
 Clausen Tube
Income Statement: Full Costing

Sales $10,000,000
Less COGS 5,700,000
Gross Margin 4,300,000
Less Selling and Admin:
Selling $300,000
Admin 500,000 800,000
Net Income $3,500,000
 Clausen Tube
Income Statement: Variable Costing

Sales $10,000,000
Less Variable:
Variable COGS $4,500,000
Variable Selling
and Admin 200,000
Contribution Margin 5,300,000
Less Fixed:
Fixed Mfg. 1,200,000
Fixed Selling 100,000
Fixed Admin 500,000 1,800,000
Net Income $3,500,000
 Variable Costing Income
Statement: Considerations
1. When sales volume and production
volume are exactly equal, net income
is the same under either full or variable
costing.

2. Contribution margin is easily calculated

under variable costing: 2,000 – 940 =
1,060.

3. Contribution margin ratio is: 1,060 /

2,000 = 53%
 Overview of Variable and
Absorption Costing
Variable Absorption
Costing Costing
Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs
Fixed Manufacturing Overhead
Period
Variable Selling and Administrative Expenses Period
Costs
Fixed Selling and Administrative Expenses Costs
 Unit Cost Computations

Harvey Company produces a single product

with the following information available:
 Unit Cost Computations
Unit product cost is determined as follows:

Under absorption costing, all production costs, variable

and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
Varable and Absorption Costing
Income Statements

Let s assume the following additional information

for Harvey Company.
§ 20,000 units were sold during the year at a price
of $30 each.
§ There is no beginning inventory.

Now, let s compute net operating

income using both absorption
and variable costing.
Variable Costing Contribution
Format Income Statement All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Variable cost of goods sold (20,000 × $10) $ 200,000
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Total variable expenses
Contribution margin 340,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
Absorption Costing Income
Statement
Unit product
cost.

Fixed manufacturing overhead deferred in inventory is

5,000 units $6 = $30,000.
Extended Comparisons of Income
Data Harvey Company – Year Two
Variable Costing Contribution
Format Income Statement
All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.
Variable Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Variable cost of goods sold (30,000 × $10) $ 300,000
Variable selling & administrative
expenses (30,000 × $3) 90,000 390,000
Total variable expenses
Contribution margin 510,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 260,000
Absorption Costing Income
Statement
Unit product
cost.

Fixed manufacturing overhead released from

inventory is 5,000 units $6 = $30,000.
Summary of Key Insights
 Understand the distinction between financial
and contribution margin income statements.

Making Cost Information Useful

Full absorption costing: Variable costing:
• Required by GAAP • Used for:
• Used for: – Managerial purposes
– Financial purposes – Internal decision
– External reporting making

Sales revenue Sales revenue

– Cost of goods sold – Variable costs
= Gross margin = Contribution margin

2 - 127
Part V: Cost-Volume-
Profit Analysis
or
CVP Analysis
COST-VOLUME-PROFIT (CVP) ANALYSIS
CVP analysis examines the interaction of a firm s sales
volume, selling price, cost structure and profitability.

It is a powerful tool in making managerial decisions including

marketing, production, investment and financing decisions.

• How many units of its products must a firm sell to break even?

• How many units of its products must a firm sell to earn a certain
amount of profit?

• Should a firm invest in highly automated machinery and reduce its labor
force?

• Should a firm advertise more to improve its sales?

 CVP Model – Assumptions
Key assumptions of CVP model

• Selling price is constant

• Costs are linear and can be divided into variable and

fixed elements.

• In multi-product companies, sales mix is constant

• In manufacturing companies, inventories do not change.

 CVP ANALYSIS
Advantages
• Assists in establishing prices of products.

• Assists in analyzing the impact that volume has

on short-term profits.

• Assists in focusing on the impact that changes in

costs (variable and fixed) have on profits.

• Assists in analyzing how the mix of products

affects profits.
 LIMITATIONS OF CVP ANALYSIS

• Requires accurate knowledge of revenue and

cost amounts and behavior patterns
• Identification of fixed and variable components

• Linear revenue and cost functions

• Integration of concept of relevant range

• No change in inventories

• Constant sales mix

CVP - 132
Learning
Objective
1
 The Break-Even Point
The break-even point is the point in the volume of
activity where the organization s revenues and
expenses are equal.

Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 100,000
Net income $ -

7-134
 Equation Approach
Sales revenue – Variable expenses – Fixed expenses = Profit

Unit Sales Unit Sales

sales × volume variable × volume
price in units expense in units

($500 × X) – ($300 × X) – $80,000 = $0

($200X) – $80,000 = $0

7-135
X = 400 surf boards
Learning
Objective
2
 Contribution-Margin Approach
Consider the following information developed
by the accountant at Curl, Inc.:
For each additional surf board sold, Curl
generates $200 in contribution margin.

Total Per Unit Percent

Sales (500 surf boards) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

7-137
 Contribution-Margin Approach

Fixed expenses Break-even point

=
Unit contribution margin (in units)

Total Per Unit Percent

Sales (500 surf boards) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

$80,000
= 400 surf boards
7-138
$200
 Contribution-Margin Approach

Here is the proof!

Total Per Unit Percent

Sales (400 surf boards) $200,000 $ 500 100%
Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ -

400 × $500 = $200,000 400 × $300 = $120,000

7-139
 Contribution Margin Ratio

Calculate the break-even point in sales dollars rather

than units by using the contribution margin ratio.

Contribution margin
= CM Ratio
Sales

Fixed expense Break-even point

=
CM Ratio (in sales dollars)
7-140
 Contribution Margin Ratio

Total Per Unit Percent

Sales (400 surf boards) $200,000 $ 500 100%
Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ -

$80,000
= $200,000 sales
7-141
40%
Learning
Objective
3
 Graphing Cost-Volume-Profit Relationships

Viewing CVP relationships in a graph gives managers a

perspective that can be obtained in no other way.
Consider the following information for Curl, Inc.:

300 units 400 units 500 units

Sales $ 150,000 $ 200,000 $ 250,000
Less: variable expenses 90,000 120,000 150,000
Contribution margin $ 60,000 $ 80,000 $ 100,000
Less: fixed expenses 80,000 80,000 80,000
Net income (loss) $ (20,000) $ - $ 20,000
7-143
 Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

200,000

150,000
Fixed expenses
100,000

50,000

100 200 300 400 500 600 700 800

Units

7-144
 Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

200,000
n se s
exp e
l
150,000 Tota
Fixed expenses
100,000

50,000

100 200 300 400 500 600 700 800

Units

7-145
 Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

200,000
n se s
exp e
l
150,000 Tota
Fixed expenses
100,000

50,000

100 200 300 400 500 600 700 800

Units

7-146
 Cost-Volume-Profit Graph
450,000

400,000
le s
350,000 l s a
a
Tot
300,000

250,000
Dollars

200,000
n se s
exp e
l
150,000 Tota
Fixed expenses
100,000

50,000

100 200 300 400 500 600 700 800

Units

7-147
 Cost-Volume-Profit Graph
450,000

400,000
le s
s a
350,000
a l rea
Break-even Tot of it a
300,000
point Pr
250,000
Dollars

200,000
n se s
exp e
l
150,000 Tota
Fixed expenses
100,000
re a
s a
50,000
Los

100 200 300 400 500 600 700 800

Units

7-148
 Profit-Volume Graph

100,000

80,000

60,000
Break-even
point re a
ta
40,000

rofi
20,000 P
Profit

0 `

(20,000) 100 200 300 400 500 600 700

re a Units
(40,000)
s a
Los
(60,000)

7-149
Learning
Objective
4
 Target Net Profit

We can determine the number of surfboards that

Curl must sell to earn a profit of $100,000 using the
contribution margin approach.

Fixed expenses + Target profit Units sold to earn

=
Unit contribution margin the target profit

$80,000 + $100,000
= 900 surf boards
$200

7-151
 Equation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X) – ($300 × X) – $80,000 = $100,000

($200X) = $180,000

X = 900 surf boards

7-152
 Applying CVP Analysis
Safety Margin
• The difference between budgeted sales revenue
and break-even sales revenue.
• The amount by which sales can drop before
losses begin to be incurred.

7-153
 Safety Margin
Curl, Inc. has a break-even point of $200,000. If
actual sales are $250,000, the safety margin is $50,000 or
100 surf boards.

Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net income $ - $ 20,000
7-154
 Changes in Fixed Costs

• Curl is currently selling 500 surfboards per year.

• The owner believes that an increase of $10,000 in
the annual advertising budget, would increase
sales to 540 units.

Should the company increase the advertising

budget?

7-155
 Changes in Fixed Costs

Current Proposed
Sales Sales
(500 Boards) (540 Boards)
Sales $ 250,000 $ 270,000
Less: variable expenses 150,000 162,000
Contribution margin $ 100,000 $ 108,000
Less: fixed expenses 80,000 90,000
Net income $ 20,000 $ 18,000

540 units × $500 per unit = $270,000

7-156
$80,000 + $10,000 advertising = $90,000
 Changes in Fixed Costs
Current Proposed
Sales will increase by
Sales Sales
$20,000, but net income (500 Boards) (540 Boards)
decreased by $2,000.
Sales $ 250,000 $ 270,000
Less: variable expenses 150,000 162,000
Contribution margin $ 100,000 $ 108,000
Less: fixed expenses 80,000 90,000
Net income $ 20,000 $ 18,000

7-157
 Changes in Unit
Contribution Margin

Because of increases in cost of raw materials, Curl s

variable cost per unit has increased from $300 to $310
per surfboard. With no change in selling price per
unit, what will be the new break-even point?

($500 × X) – ($310 × X) – $80,000 = $0

X = 422 units (rounded)

7-158
 Changes in Unit
Contribution Margin

Suppose Curl, Inc. increases the price of each

surfboard to $550. With no change in variable
cost per unit, what will be the new break-even
point?

($550 × X) – ($300 × X) – $80,000 = $0

X = 320 units
7-159
 Predicting Profit Given Expected Volume

Fixed expenses
Given: Unit contribution margin Find: {req d sales volume}
Target net profit

Fixed expenses
Given: Unit contribution margin Find: {expected profit}
Expected sales volume

7-160
 Predicting Profit Given
Expected Volume
In the coming year, Curl s owner expects to sell 525
surfboards. The unit contribution margin is
expected to be $190, and fixed costs are expected
to increase to $90,000.

Total contribution - Fixed cost = Profit

($190 × 525) – $90,000 = X

X = $99,750 – $90,000

7-161
X = $9,750 profit
Learning
Objective
5
CVP Analysis with Multiple Products
For a company with more than one product, sales mix
is the relative combination in which a company s
products are sold.
Different products have different selling prices, cost
structures, and contribution margins.

Let s assume Curl sells surfboards and sail boards

and see how we deal with break-even analysis.

7-163
CVP Analysis with Multiple Products

Curl provides us with the following information:

Unit Unit Number
Selling Variable Contribution of
Description Price Cost Margin Boards
Surfboards $ 500 $ 300 $ 200 500
Sailboards 1,000 450 550 300
Total sold 800

Number % of
Description of Boards Total
Surfboards 500 62.5% (500 ÷ 800)
Sailboards 300 37.5% (300 ÷ 800)
Total sold 800 100.0%
7-164
CVP Analysis with Multiple Products

Weighted-average unit contribution margin

Contribution Weighted
Description Margin % of Total Contribution
Surfboards $ 200 62.5% $ 125.00
Sailboards 550 37.5% 206.25
Weighted-average contribution margin $ 331.25

$200 × 62.5%

$550 × 37.5%
7-165
CVP Analysis with Multiple Products

Break-even point
Break-even Fixed expenses
=
point Weighted-average unit contribution margin

Break-even $170,000
=
point $331.25

Break-even 514 combined unit sales

=
point

7-166
CVP Analysis with Multiple Products

Break-even point
Break-even 514 combined unit sales
=
point

Breakeven % of Individual
Description Sales Total Sales
Surfboards 514 62.5% 321
Sailboards 514 37.5% 193
Total units 514

7-167
Learning
Objective
6
 Assumptions Underlying
CVP Analysis
1. Selling price is constant throughout the
entire relevant range.
2. Costs are linear over the relevant range.
3. In multi-product companies, the sales
mix is constant.
4. In manufacturing firms, inventories do
not change (units produced = units
sold).

7-169
Learning
Objective
7
 CVP Relationships and the
Income Statement

A. Traditional Format
ACCUTIME COMPANY
Income Statement
For the Year Ended December 31, 20x1

Sales $500,000
Less: 380,000
Gross margin $120,000
Less: Operating expenses:
Selling expenses $35,000
Administrative expenses 35,000 70,000
Net income $50,000

7-171
 CVP Relationships and the
Income Statement
B. Contribution Format
ACCUTIME COMPANY
Income Statement
For the Year Ended December 31, 20x1

Sales $500,000
Less: Variable expenses:
Variable manufacturing $280,000
Variable selling 15,000
Variable administrative 5,000 300,000
Contribution margin $200,000
Less: Fixed expenses:
Fixed manufacturing $100,000
Fixed selling 20,000
Fixed administrative 30,000 150,000
Net income $50,000
7-172
 CVP Definitions
• Contribution margin
Revenue – Variable costs

• Contribution margin ratio

Contribution margin
Revenue

*These items may be computed either in total or

per unit

CVP - 173
 A CVP Example
Assume the following:
Total Per unit %of Sales

Sales (400 Microwaves) $200,000 $500 100%

Less: Variable Expenses 120,000 300 60
Contribution Margin $ 80,000 $200 40%

Less Fixed Expenses 70,000

Net Income $10,000

1. What is the break-even point?

2. How much sales-revenue must be generated to earn
a before-tax profit $30,000?
3. How much sales-revenue must be generated to earn an after-tax profit
of $30,000 and a 40% marginal tax rate?

CVP - 174
The Operating Income Approach
for Breakeven Point
Sales - Variable costs - Fixed Costs = Net Income
Sales-Revenue Method:
100%(Sales)- 60%(Sales) - $70,000 =0 (at BEP)
.4 (Sales) = $70,000
Sales = $175,000

Units-Sold Method:
Let x = Number of microwaves at the break-even
point

$500(x) - $300(x) - $70,000 = 0 (at BEP)

$200 (x) = $70,000
x = 350 microwaves

CVP - 175
The Contribution Approach for
Breakeven Point
Sales-Revenue Method:

BEP (Revenue $) = (Fixed Costs + Net Income)/Contribution Ratio

= $70,000 + 0/.40
= $175,000

Units-Sold Method:

BEP (Revenue Units) = (Fixed Costs + Net Income)/Contribution

per microwave
= $70,000 + 0/$200 per microwave
= 350 units

CVP - 176
 COST-VOLUME-PROFIT
Traditional Format

Total
Revenue

Total $
Total Costs
Breakeven
Point

Total Variable
Costs

Total Fixed
Costs

Level of Activity
CVP - 177
 COST-PROFIT-VOLUME
Contribution Margin Format

Total
Revenue
Total Costs

Total $

Breakeven
Point

Total Fixed
Costs

Total Variable
Costs
Contribution
Margin

Level of Activity

CVP - 178
 One Product Cost-Volume-Profit Model

Net Income (NI) = Total Revenue – Total Cost

Total Revenue = Selling Price Per Unit (P) * Number of Units

Sold (X)

Total Cost = Total Variable Cost + Total Fixed Cost (F)

Total Variable Cost = Variable Cost Per Unit (V) * Number of

Units Sold (X)

NI = P X – V X – F
NI = X (P – V) – F
 One Product Cost-Volume-Profit Model
Net Income (NI) = Total Revenue – Total Cost

Total Revenue = Selling Price Per Unit (P) * Number of Units

Sold (X)

Total Cost = Total Variable Cost + Total Fixed Cost (F)

This is an Income Statement
Total Variable Cost = Variable Cost PerSales
UnitRevenue
(V) * Number
(P X)
of
Units Sold (X)
- Variable Costs (V X)

NI = P X – V X – F Contribution Margin
NI = X (P – V) – F - Fixed Costs (F)
Net Income (NI)
 Contribution Margin Ratio
Or, in terms of units, the contribution margin ratio is:

Unit CM
CM Ratio =
Unit selling price
For Racing Bicycle Company the ratio is:

$4 = 25%
$16
PRACTICE QUESTIONS ON CVP
ANALYSIS FROM BOOK
 Part II: BUDGETARY
CONTROL
• Concept and types.
• Preparation of master budget, fixed & flexible budgets.
• Concept of Zero Base Budgeting
 BUDGETARY CONTROL
• Budgets are the quantitative expressions of plans that
identify an organization’s objectives and the actions
needed to achieve them
– They form the basis for operations

• Control is the process of setting standards, receiving

feedback on actual performance and taking corrective
action

• Budgets can be used to compare actual outcomes with

planned outcomes
 BUDGETARY CONTROL
Study Objective 1

Ø A major function of management is to control

operations
Ø Takes place by means of budget reports which compare
actual results with planned objectives
Ø Provides management with feedback on operations
 BUDGETARY CONTROL
Ø Works best when a company has a formalized
reporting system which:
§ Identifies the name of the budget report (such as the
sales budget or the manufacturing overhead budget)
§ States the frequency of the report (weekly or monthly)
§ Specifies the purpose of the report
§ Indicates recipient of the report
 BUDGETARY CONTROL
Ø Schedule below illustrates a partial budgetary control
system for a manufacturing company.
Ø Note the frequency of reports and their emphasis on
control
 Use of Budgets in Planning and
Control

1. The entire planning and control process of

many companies is built around budgets
 Planning

1. Budgets are useful because they enhance:

a. Communication
b. Coordination

2. The process of developing a budget forces

managers to consider:
a. Goals
b. Objectives
c. Specify means of achieving them
 Control

1. Budgets are useful because they provide a

basis for evaluating performance

2. Performance evaluation is carried out by

comparing actual performance with planned
or budgeted performance

3. Significant deviations from planned

performance are associated with three
potential causes
Control: Significant Deviations From
Planned Performance Are
Associated With

1. Poorly conceived budgets

2. Business conditions may have

changed

3. Managers that have done a

particularly good or bad job
managing operations
 ADVANTAGES OF BUDGETING
• Forces management to plan for the future—to develop an overall
direction for the organization, foresee problems and develop future
policies.

• Helps convey significant information about the resource

capabilities of an organization, making better decisions possible.
Example: A cash budget points out potential shortfalls

• Helps set standards that can control the use of a company’s

resources and control and motivate employees.

• Improves the communication of the plans of the organization to

each employee.
– Budgets also encourage coordination because the various areas and
activities of the organization must all work together to achieve the stated
objectives.
 Zero Base Budgeting

1. Zero Base Budgeting (ZBB) is a method of

budget preparation which begins each
period with a clean state.

2. Managers must start from zero and justify

budgets every period.

3. Used in government budgeting.

4. Not commonly used in business.

 The Master Budget

Master Budget (comprehensive) Includes:

1. Sales budget.
2. Production budget.
3. Direct materials budget.
4. Direct labor budget.
5. Manufacturing overhead budget.
6. Selling and administrative budget.
 The Master Budget

Master Budget Includes:

7. Capital acquisitions budget.
8. Cash receipts and disbursements
budget.
9. Budgeted income statement.
10. Budgeted balance sheet.
The Master Budget: Graphic
 Sales Budget

1. Sales budget is the first step in the

budget process.
2. It comes first because other budgets
cannot be prepared without an estimate
of sales.
3. Example: production estimates are
based on forecast sales.
 Sales Budget (Continued)

4. Companies use a variety of methods to

estimate sales:
a. Econometric models.
b. Previous sales trends.
c. Trade journals and magazines.
d. Sales force estimates.
 Production Budget

Production forecasts are based on the

following relationships:
Finished units to be produced
=
expected sales in units
+
desired ending inventory of finished units
–
beginning inventory of finished units
 Direct Material Purchase Budget

1. Direct materials budgets depend on:

a. The amount needed for production
b. The amount need for ending
inventory.
 Direct Material Purchase Budget
(Continued)

2. Calculated as follows:
Required purchases of direct materials
=
amount required for production
+
desired ending inventory of direct materials
–
beginning inventory of direct materials
 Direct Labor Budget

Direct labor budget calculated by

multiplying:
Number of units to be produced
x
Labor hours per unit
x
rate per hour
 Manufacturing Overhead Budget

1. Cost per unit of production of each variable

cost item is multiplied by the quantity of units
produced.

2. Fixed costs remain relatively constant.

 Selling and Administrative
Expense Budget

Selling and administrative expense budgets

include:

1. Salaries.
2. Advertising.
3. Office expenses.
4. Other general expenses.
 Budgeted Income Statement

1. Sales figures come from the sales budget.

2. Cost of goods sold is based on unit cost of

production (and the direct materials
budget).

3. Labor cost information comes from the

direct labor budget.

4. Overhead cost information is provided by

the manufacturing overhead budget
provides.
 Capital Acquisitions Budget

1. Acquisitions of capital assets such as:

a. Property.
b. Plant
c. Equipment.
2. Must be carefully planned because they
consume substantial cash reserves.
Cash Receipts and Disbursements
Budget

1. Managers plan for the

a. Amount of cash flows and the
b. Timing of cash flows.

2. VERY important budget because...

3. The timing of cash inflows and outflows

may diverge substantially from the
income statement.
 Budgetary Control

1. In addition to:
a. Planning
b. Communicating goals
c. Coordinating activities

2. Budgets also facilitate control of

operations.
 Budgets as A Standard For
Evaluation

1. Budgets facilitate control by providing a

standard for evaluation.

2. The standard is the budgeted amount

against which actual results are compared.

3. Differences between budgeted and actual

amounts are called budget variances.

4. Material differences between actual and

budgeted should investigated.
 Static and Flexible Budgets

1. Make sure that the level of activity used in

the budget is equal to the actual level of
activity.

2. Production budgets are a function of

planned sales.

3. If sales suddenly, production must increase

to meet demand , thus total variable
production costs will rise.
 Static and Flexible Budgets

4. A static budget is not adjusted for the

actual level of production and is not
suited for performance measurement.

5. A flexible budget is a set of budget

relationships that can be adjusted to
various activity levels. It is suited for
performance measurement.
STATIC BUDGET REPORTS
Study Objective 2

Ø Projection of budget data at

one level of activity
Ø Ignores data for different
levels of activity
Ø Always compares actual
results with the budget data
at the activity level used in Static budgets are
best for fixed costs
the master budget and expenses
 STATIC BUDGET REPORTS
Example – Hayes Company

Ø Budget/actual sales data for Kitchen-mate for the first

and second quarters of 2005
Ø Data for Hayes Company
 STATIC BUDGET REPORTS
Example – Hayes Company

Ø Shows that sales are $1,000 under budget – an

unfavorable result.
Ø Difference is less that 1% of budgeted sales - assume
immaterial (not significant) to top management with no
specific action taken
 STATIC BUDGET REPORTS
Example – Hayes Company

Ø Shows that sales were $10,500, or 5%, below budget

Ø Material difference between budgeted and actual sales
Ø Merits investigation - begin by asking the sales
manager the cause(s) – consider corrective action
 STATIC BUDGET REPORTS
Uses and Limitations

Ø Appropriate for evaluating a manager s

effectiveness in controlling costs when:
§ Actual level of activity closely approximates the master
budget activity level
§ Behavior of the costs is fixed in response to changes in
activity
Ø Appropriate for fixed costs
Ø Not appropriate for variable costs
 FLEXIBLE BUDGETS
Study Objective 3

Ø Projects budget data for various

levels of activity
Ø Essentially, a series of static
budgets at different activity
levels
Ø Budgetary process more useful
if it is adaptable to changes in
operating conditions Flexible budgets
are static budgets
Ø Can be prepared for each type at different
of budget in the master budget activity levels
 FLEXIBLE BUDGET
Example – Barton Steel
Static budget for the Forging Department at a 10,000 unit level:
 FLEXIBLE BUDGET
Example – Barton Steel
Demand increases – produce 12,000 units rather than 10,000
 FLEXIBLE BUDGET
Example – Barton Steel
Ø Very large variances in budget report due to increased
demand for steel ingots
§ Total unfavorable difference of $132,000 – 12% over
budget
Ø Comparison based on budget data for 10,000 units -
the original activity level which is not relevant
§ Meaningless to compare actual variable costs for 12,000
units with budgeted variable costs for 10,000 units
§ Variable cost increase with production
Budgeted amounts should increase
proportionately with production
 FLEXIBLE BUDGET
Example – Barton Steel
Ø Budget data for variable costs at 10,000 units:

Ø Calculate variable costs at the 12,000 unit level:

 FLEXIBLE BUDGET
Example – Barton Steel
New budget report (no change in fixed costs)
 DEVELOPING
THE FLEXIBLE BUDGET
Steps
ΠIdentify the activity index and the relevant range
of activity
 Identify the variable costs and determine the
budgeted variable cost per unit of activity for
each cost
Ž Identify the fixed costs and determine the
budgeted amount for each cost
 Prepare the budget for selected increments of
activity within the relevant range
 FLEXIBLE BUDGET – A CASE STUDY
Example – Fox Manufacturing Co.
Ø Monthly comparisons of actual and budgeted
manufacturing overhead costs for Finishing Department
Ø 2005 master budget
§ Expected operating capacity of 120,000 direct labor hours
§ Overhead costs:
 FLEXIBLE BUDGET – A CASE STUDY
Example – Fox Manufacturing Co.

ΠIdentify the activity index and the relevant range

§ activity index: direct labor hours
§ relevant range: 8,000 – 12,000 direct labor hours per month
 Identify the variable costs, and determine the budgeted
variable cost per unit of activity for each cost
FLEXIBLE BUDGET – A CASE STUDY
Example – Fox Manufacturing Co.

Ž Identify the fixed costs and determine the

budgeted amount for each cost
§ Three fixed costs per month:
depreciation $15,000
property taxes $5,000
supervision $10,000
 Prepare the budget for selected increments of
activity within the relevant range
§ Prepared in increments of 1,000 direct labor hours
FLEXIBLE BUDGET – A CASE STUDY
Example – Fox Manufacturing Co.

Ø Formula to determine total budgeted costs from the budget

at any level of activity:

* Total variable cost per unit X activity level

Ø Determine total budgeted costs for Fox Manufacturing

Company with fixed costs of $30,000 and total variable cost
$4 per unit
§ At 9,000 direct labor hours : $30,000 + ($4 X 9,000) = $66,000
§ At 8,622 direct labor hours: $30,000 + ($4 X 8,622) = $64,488
FLEXIBLE BUDGET – A CASE STUDY
Example – Fox Manufacturing Co.
Graphic flexible budget data highlighting 10,000 and 12,000 activity levels
 FLEXIBLE BUDGET REPORTS
Ø A type of internal report
Ø Consists of two sections:
§ Production data for a selected activity index, such
as direct labor hours
§ Cost data for variable and fixed costs
Ø Widely used in production and service departments
to evaluate a manager s performance in production
control and cost control
Ø A budget report for the Finishing Department for the
month of January follows
Part III: DECISION
MAKING
 Learning
Objective 1 The Concept of Relevance

Relevant information depends

on the decision being made.

Decision making is choosing

among several courses of action.

Relevant information is the predicted future costs

and revenues that differ among the alternatives.
The Concept of Relevance

Accountants should use two

criteria to determine whether
information is relevant:

1. Information must be an
expected revenue or cost and...

2. it must have an element of

difference among the alternatives.
 Decision Model

A decision model is any

method used for making a
choice, sometimes requiring
elaborate quantitative
procedures. A decision model
may also be simple.

You will be able to focus on

relevant information—the
predicted future differences
between alternatives—in any
decision.
 Learning Decision Process and Role of
Objective 2
Information

(1) Historical Other

(A) (B)
information information

(2) Predictions as inputs

Prediction method
to decision model

(3) Decisions by managers with

Decision model the aid of the decision model

(4) Implementation
and evaluation

Feedback
 Accuracy and Relevance

In the best of all possible worlds,

information used for decision making
would be perfectly relevant and accurate.

The degree to which information is relevant or precise often

depends on the degree to which it is:

Qualitative Quantitative
(Subjective) (Financial)
 Information and the
Decision Process

A decision model is a formal method

for making a choice, often involving
quantitative and qualitative analysis.
 Five-Step Decision Process

Historical Costs
Step 1. Gather Information
Other Information

Step 2. Make Predictions Specific Predictions

Feedback

Step 3. Choose an Alternative

Step 4. Implement the Decision

Step 5. Evaluate Performance

 The Meaning of Relevance

Relevant costs and relevant revenues are

expected future costs and revenues that
differ among alternative courses of action.

Historical costs Sunk costs

Differential income Differential costs
Quantitative and Qualitative
Relevant Information

Quantitative factors

Financial Nonfinancial

Qualitative factors
 The Decision-Making Model
• A decision model, a specific set of procedures that produces a
decision, can be used to structure the decision maker s thinking
and to organize the information to make a good decision.
• The following is an outline of one decision-making model:
– Step 1. Recognize and define the problem.
– Step 2. Identify alternatives as possible solutions to the problem. Eliminate
alternatives that clearly are not feasible.
– Step 3. Identify the costs and benefits associated with each feasible
alternative. Classify costs and benefits as relevant or irrelevant, and eliminate
irrelevant ones from consideration.
– Step 4. Estimate the relevant costs and benefits for each feasible alternative.
– Step 5. Assess qualitative factors.
– Step 6. Make the decision by selecting the alternative with the greatest overall
net benefit.

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1 Relevant Costs Defined
• The decision-making approach just described emphasized the
importance of identifying and using relevant costs.
• Relevant costs possess two characteristics:
1. they are future costs AND
2. they differ across alternatives.
• All pending decisions relate to the future.
• Accordingly, only future costs can be relevant to decisions.

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1 Opportunity Costs
• Opportunity cost is the benefit sacrificed or foregone when
one alternative is chosen over another.
• An opportunity cost is relevant because it is both a future cost
and one that differs across alternatives.
• While an opportunity cost is never an accounting cost,
because accountants do not record the cost of what might
happen in the future (i.e., they do not appear in financial
statements), it is an important consideration in relevant
decision making.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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1 Sunk Costs
• A sunk cost is a cost that cannot be affected by any future
action.
• It is important to note the psychology behind managers
treatment of sunk costs.
• Although managers should ignore sunk costs for relevant
decisions, it unfortunately is human nature to allow sunk costs
to affect these decisions.
– For example, depreciation, a sunk cost, is sometimes allocated to
future periods though the original cost is unavoidable. In choosing
between the two alternatives, the original cost of an asset and its
associated depreciation are not relevant factors.

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1 Cost Behavior and Relevant Costs
• Most short-run decisions require extensive consideration of
cost behavior.
• It is easy to fall into the trap of believing that variable costs
are relevant and fixed costs are not.
• But this assumption is not true.
• The key point is that changes in supply and demand for
resources must be considered when assessing relevance.
• If changes in demand and supply for resources across
alternatives bring about changes in spending, then the
changes in resource spending are the relevant costs that
should be used in assessing the relative desirability of the two
alternatives.
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2 Some Common
Relevant Cost Applications
• Relevant costing is of value in solving many different
types of problems. Traditionally, these applications
include decisions:
– to make or buy a component.
– to keep or drop a segment or product line.
– to accept a special order at less than the usual price.
– to further process joint products or sell them at the split-off
point.
• Though by no means an exhaustive list, many of the same
decision-making principles apply to a variety of problems.

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2 Make-or-Buy Decisions
• Managers often face the decision of whether to make a particular
product (or provide a service) or to purchase it from an outside
supplier.
• Make-or-buy decisions are those decisions involving a choice
between internal and external production.
• One type of relevant cost that is becoming increasingly large due to
globalization and the green environmental movement concerns the
disposal costs associated with electronic waste (or e-waste).

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Cornerstone 13-1
2 Structuring a Make-or-Buy Problem

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Cornerstone 13-1
2 Structuring a Make-or-Buy Problem (continued)

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2 Special Order Decisions
• From time to time, a company may consider offering a product or
service at a price different from the usual price.
• Firms often have the opportunity to consider special orders from
potential customers in markets not ordinarily served.
– Special-order decisions focus on whether a specially priced order
should be accepted or rejected.
– These orders often can be attractive, especially when the firm is
operating below its maximum productive capacity.

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Cornerstone 13-2
2 Structuring a Special Order Problem

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Cornerstone 13-2
2 Structuring a Special Order Problem (continued)

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2 Keep-or-Drop Decisions
• Often, a manager needs to determine whether a segment,
such as a product line, should be kept or dropped.
• Segmented reports prepared on a variable-costing basis
provide valuable information for these keep-or-drop
decisions.
• Both the segment s contribution margin and its segment
margin are useful in evaluating the performance of segments.
• However, while segmented reports provide useful
information for keep-or-drop decisions, relevant costing
describes how the information should be used to arrive at a
decision.

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Cornerstone 13-3
2 Structuring a Keep-or-Drop
Product Line Problem (continued)

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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 PRACTICE QUESTIONS ON
DECISION MAKING FROM BOOK
 Sources:
• Chapter 2; Cost Concepts and Behavior; McGraw-
Hill/Irwin
• Managerial Accounting and Cost Classification; Laurie
L. Swanson; Nashville State Community College
• Principles of Cost Accounting 14E; Edward J.
VanDerbeck’ Chapter-1
• Cost Management:ACCOUNTING AND CONTROL; Hansen & Mowen
•
Variable Costing and Segment Reporting: Tools for
Management: CHAPTER 5: THE MC GRAW-HILL COMPANIES. INC.
• Chapter 8: Absorption and Variable Costing, and
Inventory Management; Cornerstones of Managerial
Accounting, 5E, CENGAGE LEARNING, 2014
• Cost Accounting, Dr. Sajid Ali, College of Business
Administration, Al-kharj, Kingdom of Saudi Arabia