MANAGEMENT ACCOUNTING

MANAGEMENT ACCOUNTING
DLBMAE01
MASTHEAD
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2
TABLE OF CONTENTS
Introduction
Signposts Throughout the Course Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Basic Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Unit 1
Introduction to Management Accounting 11
1.1 Definition of Management Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

1.2 Definition of Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.3 Cost Behavior: Fixed and Variable Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.4 External Factors Influencing Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Unit 2
Cost-Volume-Profit Analysis 23
2.1 Break-Even Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2.2 CVP-Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.3 Cost Structure and Operating Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.4 Cost Structure and Variabilization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Unit 3
Simplistic Methods of Cost Allocation 33
3.1 Cost Behavior: Direct and Indirect Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

3.2 The Need for Cost Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.3 Overhead Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Unit 4
Activity-Based Costing 43
4.1 Basics of Activity-Based Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

4.2 Implementing Activity-Based Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Unit 5
Overhead Analysis Sheet 53
5.1 Departmental Cost Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

5.2 Reciprocal Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
5.3 Step Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
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Unit 6
Relevant Cost Concepts 63
6.1 Foundational Cost Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

6.2 Cost Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Unit 7
Budgets 73
7.1 The Budgeting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

7.2 Different Types of Operating Budgets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
7.3 Financial Budgets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Appendix
List of References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
List of Tables and Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
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INTRODUCTION
WELCOME
SIGNPOSTS THROUGHOUT THE COURSE BOOK
This course book contains the core content for this course. Additional learning materials
can be found on the learning platform, but this course book should form the basis for your
learning.
The content of this course book is divided into units, which are divided further into sec-
tions. Each section contains only one new key concept to allow you to quickly and effi-
ciently add new learning material to your existing knowledge.
At the end of each section of the digital course book, you will find self-check questions.
These questions are designed to help you check whether you have understood the con-
cepts in each section.
For all modules with a final exam, you must complete the knowledge tests on the learning
platform. You will pass the knowledge test for each unit when you answer at least 80% of
the questions correctly.
When you have passed the knowledge tests for all the units, the course is considered fin-
ished and you will be able to register for the final assessment. Please ensure that you com-
plete the evaluation prior to registering for the assessment.
Good luck!
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BASIC READING
Atkinson, A. A., Kaplan, R., Matsumura, E. M., & Young, S. M. (2012). Management account-
ing: Information for decision-making and strategy execution (6th ed.). Pearson.
Drury, C. (2019). Management accounting for business (7th ed.). Cengage.
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FURTHER READING
UNIT 1
Dobbs, R., Koller, T., & Ramaswamy, S. (2015). The future and how to survive it. Harvard
Business Review, 93(10), 48—62.
Van der Linden, B., & Freeman, R. E. (2017). Profit and other values: Thick evaluation in
decision making. Business Ethics Quarterly, 27(3), 353—379.
UNIT 2
Barbu, I.-M. (2015). Cost behavior analysis. Review of General Management, 21(1), 185—
197.
Machuga, S. (2012). A case method approach to teaching cost-volume-profit analysis. Jour-

nal of Accounting and Finance, 12(5), 104—109.
UNIT 3
Boon, J., & Wynen, J. (2017). On the bureaucracy of bureaucracies: Analyzing the size and
organization of overhead in public organizations. Public Administration, 95(1), 214—
231.
Norfleet, N. A. (2007). The theory of indirect costs. AACE International Transactions, 12.1—
12.6.
UNIT 4
Cokins, G., & Capusneanu, S. (2010). Cost drivers: Evolution and benefits. Theoretical &
Applied Economics, 17(8), 7–16.
Fito, M. A., Llobet, J., & Cuguero, N. (2018). The activity-based costing model trajectory: A
path of lights and shadows. Intangible Capital, 14(1), 146–161.
UNIT 5
Atik, M., Köse, Y., & Yilmaz, B. (2014). Allocation of the general production costs to the cost
centers by linear programming method. MVU, 7(1), 53—65.
Togo, D. (2013). Reciprocal cost allocations for many support departments usingbspread-
sheet matrix functions. Journal of Accounting and Finance, 13(4), 55—59.
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UNIT 6
Churchill, N. C. (1984). Budget choice: Planning vs. control. Harvard Business Review, 62(4),
150—164.
Howell, R. A. (2004). Turn your budgeting process upside down. Harvard Business Review,
82(7/8), 21—22.
UNIT 7
Churchill, N. C. (1984). Budget choice: Planning vs. control. Harvard Business Review, 62(4),
150—164.
Howell, R. A. (2004). Turn your budgeting process upside down. Harvard Business Review,
82(7/8), 21—22.
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LEARNING OBJECTIVES
Decision-making is an essential managerial task and activity in businesses and other
organizations. A major source of information guiding decisions of far-reaching importance
are accounting data. Management Accounting provides and processes such data in order
to provide a sound basis for managerial decisions.
In this course book, you will discover different perspectives on cost and related account-
ing data. You will become familiar with proven concepts of cost analysis in support of
managerial decision-making. Furthermore, you will gain insight into various techniques
that help management make decisions.
You will also consider major aspects of the contemporary business environment as con-
textual background. After examining real-life occurrences presented as short introductory
stories at the beginning of each unit, you will learn to apply basic managerial accounting
methods.
Moreover, you will acknowledge the complexity of the field. You will come to understand
managerial accounting as a task full of ambiguities despite some clear-cut approaches to
deriving figures. You will acknowledge the need to interpret data and the requirement of
understanding contextual factors and specifics along with the need to adapt the basic
tools to each respective business or situation.
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UNIT 1
INTRODUCTION TO MANAGEMENT
ACCOUNTING
STUDY GOALS
On completion of this unit, you will have learned …
– the purpose of management accounting.

– the definition of cost.
– the difference between fixed and variable costs.
– the concepts of step cost and mixed cost.
– to calculate and distinguish between total and per-unit cost methodologies.
1. INTRODUCTION TO MANAGEMENT
ACCOUNTING
Introduction
Management or managerial accounting, often referred to as cost accounting, is a task
most managers or responsible experts within businesses and other organizations must
conduct to facilitate, support, and contrast decisions and decision alternatives based on
financial data. There are many potential forms and sources within their business that
managers can use to derive financial data. Organizational decision-makers receive infor-
mation from data generated in financial accounting databases and reports as well as infor-
mation derived from enterprise resource software, which measures operational processes.
Managers retrieve and interpret information relevant to making decisions. Data tell stories
through numbers with obvious and sometimes more obscure meanings, so understanding
the data sometimes requires interpretation. It is important to be aware that there is no
such thing as the truth in finance or accounting data. There is just plentiful information
compiled following certain rules or logic that requires interpretation to derive responsible
decisions that will affect the future of the organization. This course book explores basic
concepts and typical cost analysis techniques of business processes to provide not only a
toolset but also a way of thinking.
1.1 Definition of Management Accounting

The information provided by accounting is important for internal users within a company
as well as for external stakeholders (i.e., shareholders and creditors). Thus, there are two
different types of accounting, each providing different types of information. Whereas man-
agement accounting provides information for people within an organization to help them
to make better decisions and to improve the effectiveness and efficiency of a company's
operation, financial accounting has the task of providing information (e.g., an annual
report) primarily to external stakeholders (Drury, 2018).
Therefore, Atkinson et al. (2012) define management accounting as follows: “Management

accounting is the process of supplying the managers and employees in an organization
with relevant information, both financial and nonfinancial, for making decisions, allocat-
ing resources, and monitoring, evaluating, and rewarding performance” (p. 26). Typical
financial information provided in management accounting are costs and revenues. Typical
nonfinancial information provided in management accounting includes measures that are
related to customer satisfaction and customer loyalty, employee motivation, and process
and product quality.
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As illustrated in the following table, financial accounting and management accounting are
mainly distinguished according to their users, the provided information, the time dimen-
sion, and the existence of formal requirements.
Table 1: Overview of Major Differences between Management and Financial Accounting
Management accounting Financial accounting
Audience Internal (e.g., managers and External (e.g., tax authorities,

other decision-makers) investors)
Emphasis of information Relevance for the purpose of Precision, conformity/compli-

decision-making ance, and reliability of financial
data
Time horizon • Future orientation • Coverage of the past

• Flexible time horizons • Defined periods (e.g., a busi-
ness year)
Formal requirements • Not mandatory • Mandatory

• No formal rules • Defined by law and rulesets
(e.g., US GAAP or IFRS)
Source: Hastenteufel, 2020 based on Drury, 2019.
When looking at financial data it is important to keep in mind that it is not objective and is
mostly a matter of interpretation. On the one hand, the data provided in financial account-
ing are collected according to different accounting laws and rulesets that, at least partly,
reflect cultural traditions and political interests. Moreover, the balance sheet policy of a
company is reflected in these data. On the other hand, the internally produced informa-
tion in management accounting reflects mainly the values and attitudes of company man-
agers. Therefore, to be able to understand financial data – regardless of whether it is con-
ducted for internal or external purposes – they always need to be put into a context and
interpreted.
1.2 Definition of Cost

At the outset, it is important to have a closer look at costs. Generally speaking, cost is “the
amount or equivalent paid or charged for something” (Merriam-Webster, n.d.). There are
two ways that cost is incurred in organizations. Firstly, cost is incurred when an organiza-
tion consumes an asset. The consumption of an asset occurs through its use, for example, Asset
printing paper used in the copy machine and sent out as letters, or raw material trans- An asset is a resource
with an economic value
formed into a finished product when used in a manufacturing company’s production line. that is controlled by a
The consumption of an asset also occurs through depreciation, which is the allocation of business expecting that it
the purchase price of a fixed asset (such as a car, machine, or building) over its useful life- will provide a future ben-
efit.
time. This allocation procedure must be performed following the accounting ruleset valid
in the respective country.
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Depreciation The second way of incurring cost is the use of a paid service. Companies use various serv-
This is an accounting ices while conducting business. Examples include utilities (e.g., electricity, water, and gas),
method to allocate the
costs of tangible or physi- work performed by employees who receive salaries or by external service providers (e.g.,
cal assets over their use- repair or maintenance work), financial services for which the respective institution typi-
ful life and represents cally charges fees or interest (e.g., insurance or bank loans), and consulting (e.g., IT or
how much of an asset’s
value has been used. business consulting).
Services
Services are typically It is worth noting that cost incurred does not mean the same as money being paid out.
intangible products or
activities such as account-
There is a difference between costs or expenses and cash payments. For example, organi-
ing, banking, consulting, zations may purchase some goods or services against an invoice, which means that while
insurance, or banking. they incur a cost at the point of purchase, they do not have to make a cash payment at
that time. In addition, some costs are non-cash items. This is the case with depreciation,
where a cost is incurred on the financial statement of an organization without any cash
transaction taking place.
• direct and indirect costs,

• period and product costs,
• fixed and variable costs, and
• relevant and irrelevant costs (Drury, 2018).
Some of these cost types are considered in this course book.
1.3 Cost Behavior: Fixed and Variable

Costs
As mentioned before, there is no obligation for the internal analysis of costs. Managers
and consultants brought in to provide organizations with advice will have to develop their
own systems and rationality to make sense of cost-related data. There are, however,
widely used basic categorizations of cost and cost behavior helpful for in-depth analysis.
To be able to make essential decisions managers must understand how costs and reve-
nues will vary with different activity levels (different units of production or sales). One
such method of categorization is the distinction between fixed and variable costs. This
information is required to answer questions, such as
• How will costs and revenues change if volume is increased/decreased by X percent?

• What is the impact on profits if the selling price is reduced by X percent?
• How many product units must be sold to break even?
In this context, fixed and variable costs can be differentiated (Drury, 2018).
Definition of Fixed and Variable Costs
Costs that remain constant in their total amount regardless of the level of organizational
activity within a certain period are called fixed costs (FC). For example, if a company has
committed to paying a monthly rent of $3,500 for an office building, this cost is not affec-
14
ted by how many customers are served by the sales representatives working at that office. Fixed costs
Even if the company does not conduct any business in the office, the rent still must be These costs remain con-
stant regardless of the
paid, but, in the long run, there are no fixed costs because any contract forcing the com- level of output within a
pany to pay rent, salaries, license fees, etc., can be terminated or can expire according to certain time period.
its terms and conditions. Insofar as payment obligations are part of the contracts in ques-
tion, any new contract signed, contract alteration, or termination will change an organiza-
tion’s total amount of fixed costs. Management accounts can express the total fixed costs
on a monthly, quarterly, or annual basis or define a different time horizon that is meaning-
ful for their analysis (Atkinson et al., 2012).
When looking at fixed costs, there is a special feature to consider. Costs that remain fixed
within a certain range and then increase in increments are referred to as step costs (Drury,
2018). For example, a gate at the airport with fixed costs of $6,000 can process up to 2,000
passengers per day. If an airline wants to operate additional flights and handle more pas-
sengers at this airport, they must add another gate. Increasing the capacity in this manner
will lead to a doubling of fixed costs (2 · $6,000 = $12,000) but will allow the airline to proc-
ess a maximum of 4,000 passengers per day.
Figure 1: Step Costs
Source: Hastenteufel, 2020.
Operating at capacity is most attractive from a management perspective in step cost sce-
narios. Management will typically be reluctant to add capacity even if there is more
demand potential unless it is likely that the increased capacity can be fully utilized within
the foreseeable future. In the airport example, assuming fixed cost is also shown daily, the
actual handling of 2,000 passengers per day results in the following:
Total FC $6,000
FC per unit = output
= 2, 000
= $3 per passenger
If an airport wants to fully capitalize on, for example, a 2,500-passenger demand potential,
the required additional gate doubles fixed cost to $12,000. The extra passengers, there-
fore, amount to per-unit fixed cost of $12,000/2,500=$4.80per passenger. That means to
increase the passenger capacity by 25 percent (2,000⋅1.25 = 2,500 ), the fixed costs rise by
15
60 percent ($4.80 compared to $3.00). Hence, managers will often stretch the existing
capacity as far as possible to squeeze the higher demand into the existing infrastructure
before they will commit to enlarging their capacities.
Variable costs Costs that vary in direct proportion to the level of activity are called variable costs (VC).
These costs vary in direct For example, if a restaurant incurs $5.50 of food costs for each meal served, the total food
proportion to the level of
output. cost will equal $5.50 multiplied by the number of guests who ordered meals. Variable
costs are also valid for specific time horizons that become input in the production or serv-
ice provision process at the negotiated price. A change in that price resulting from a new
or adapted contract will translate into an altered variable cost level (Atkinson et al., 2012).
The following figure shows the graphic representation of fixed costs (FC) and variable
costs (VC). Fixed costs are shown on the left side of the graph as a straight line parallel to
the x-axis. That axis shows the output or activity level. At the y-axis, the fixed cost line
shows that the total fixed cost amount does not change; it remains $3,500 regardless of
the number of guests served because the rent will not change until the contract is altered.
Variable costs are shown on the right side of the graph as a line with a linearly increasing
slope. With each additional output, the company incurs additional variable costs.
Figure 2: Fixed and Variable Costs
Source: Drury, 2018.
Please note that the linear function of variable cost is a simplification of reality. In many
real-life business settings, the rate of change in costs with increasing activity or output is
typically curvilinear. The following figure illustrates the standard relationship between
production and variable costs. The following graph on the left side shows decreasing vari-
able cost as would be the case with volume discounts where additional units can be pur-
chased at lower unit prices if specified thresholds are reached. The following graph on the
right shows increasing variable costs that could apply when increasing wages/bonuses are
paid for higher production output. For reasons of simplification, however, a linear cost
trend is assumed throughout this course book.
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Figure 3: Curvilinear Variable Costs
Total Costs
Total costs (TC), also referred to as mixed costs, include both fixed costs and variable costs.
Note that the total cost line in the graph starts with the fixed costs at output level zero at
the y-axis because even with no output, fixed costs are incurred (Atkinson et al., 2012).
Total costs are calculated with the following formula:
Total costs = total fixed costs + variable costs per unit·output
TC = FC + vc · x
The following example shows the development of the total costs with a rising output.
Table 2: Total Costs Example
Number of guests Fixed costs Variable costs Total costs
100 $1,000.00 $5.00 $1,500.00
150 $1,000.00 $5.00 $1,750.00
200 $1,000.00 $5.00 $2,000.00
250 $1,000.00 $5.00 $2,250.00
300 $1,000.00 $5.00 $2,500.00
350 $1,000.00 $5.00 $2,750.00
400 $1,000.00 $5.00 $3,000.00
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Figure 4: Mixed Costs
Source: Atkinson et al., 2012.
The fixed cost portion of mixed cost or total cost remains constant regardless of the activ-
ity level. The variable cost portion of mixed cost or total cost increases linearly so that the
cost increase of mixed cost or total cost with an increased number of units corresponds
exactly with the change in total variable cost.
Per Unit Costs
The cost characteristics of fixed and variable costs in terms of their relationship to the
level of organizational activity invert when we consider the per-unit costs instead of the
total costs.
In the previous example, we looked at the relationship between fixed and variable costs
and total output. When total output costs are calculated, fixed costs remain static while
variable costs are proportional to the number of units produced. However, the relation-
ship between fixed and variable costs changes when costs per unit produced are deter-
mined. In this calculation, fixed costs become proportional to the number of units pro-
duced, while variable costs remain the same (Drury, 2018). In other words, fixed costs per
unit change depending on the output while variable costs do not change.
This perspective is often important for cost analysis. Pricing decisions rely upon accurate
cost information. A product’s price per unit is the first step in setting a profitable sale price.
In fact, the cost per unit strongly influences sale price feasibility. For example, a total rent
of $3,500 per month divided by 100 customers equals $35 rent per customer. If the busi-
ness has 200 customers, this turns into $17.50 per customer. The formula to calculate FC
per unit is as follows:
total FC
FC per unit = output
However, variable costs per unit do not change with increasing activity levels. The follow-
ing illustration provides an overview of fixed cost per unit versus variable cost per unit cost
behavior:
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Figure 5: Fixed and Variable Costs per Unit
To evaluate whether a company can afford a certain amount of fixed costs, this kind of
analysis is essential. If the fixed costs are due monthly, the output should also be conver-
ted to monthly figures to provide meaningful comparability. Unlike fixed costs that change
per unit according to the activity level, variable costs remain constant. However, some-
times there are exceptions. Consider a contract with a supplier that factors in volume dis-
counts; if the company purchases at least 2,000 goods per month, the purchase price
offered by the supplier may fall from $100 to $95 per unit.
1.4 External Factors Influencing Costs

In the constantly changing contemporary business environment, there is a strong empha-
sis on costs. In the past, companies mainly focused on producing as many units as possi-
ble or gaining/increasing market share. Nowadays controlling and cutting costs has
become the major driving force behind management activity in many corporate cultures.
The reasons for such a paradigm shift include, but are not limited to (1) global competition
and supply chains, (2) shortening product life cycles, and (3) technology.
Global Competition and Supply Chains
In the past, competition in certain market segments was limited to local or regional com-
petitors. Nowadays businesses must compete with providers from all over the world. And
there is always someone offering a cheaper product. Supply chains have also become glo-
balized. Thus, products and product components are shipped around the world at mini-
mal per-unit costs in large container vessels granting global availability (Drury, 2018).
Nowadays, due to globalization, sourcing the cheapest input units has become common
practice for many organizations. Every cent saved per unit produced can contribute to a
competitive advantage or a substantially higher profit generated on aggregate. Many com-
panies buy their products or product components abroad to make sure they get the
cheapest price.
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Shortening Product Life Cycles
In many industries, new generations of products are rolled out faster each year. Previously,
new designs and upgrades often went to market a few years apart; this development
period has now been shortened drastically. Occasionally, it will be enough to update a few
design features to keep up with the competition and maintain customer loyalty (e.g., fea-
ture improvements such as more power or improved energy efficiency). The development
of new features or even entirely new products or product generations is costly. Expenses
associated with product development typically include the salaries of personnel responsi-
ble for product innovation such as engineers or software programmers, specialized facili-
ties like laboratories or office buildings, and materials consumed in the process of experi-
mentation. This trial-and-error process is required to prepare a product for mass
production and distribution. Cost control and an understanding of the cost-benefit rela-
tionship of each product version over its expected lifetime is therefore vital for an organi-
zation to remain competitive and avoid loss-making projects (Drury, 2018).
Technology
Enterprise resource and workflow software with integrated counting and measuring appli-
cations have especially enabled managers to obtain precise and almost endless streams
of data. That allows for a more sophisticated cost pattern analysis of even the most com-
plex manufacturing or service delivery processes. Smart and mobile tools with massive
storage capacity and online communication capabilities, referred to by Friedman (2006) as
the steroids of a globalized business world, transmit all relevant data to managers in near
real-time, whether they are sitting in their office, waiting for their connecting flight at the
airport, or networking at the golf course. Furthermore, the results of digitization and
increased connectivity have yet to be fully realized. Due to the massive surge in data crea-
tion and availability, online processes hold the potential for more targeted managerial
analysis (Drury, 2018).
SUMMARY
Management accounting or cost accounting is an important function
that supports the decision-making process within organizations. It relies
on internal financial data as well as published financial reports. Unlike
financial accounting, which is governed by national laws and even inter-
national rulesets to protect various external stakeholders, there are no
formal guidelines for management accounting.
However, there are some proven basic concepts and ways of thinking
about costs. Fixed costs do not change in in response to activity level,
whereas variable costs do change proportionally with the level of activ-
ity.
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It is important to acknowledge that data selected for decision-making
require interpretation. Furthermore, thorough understanding of internal
processes is essential to finding meaningful answers to urgent business
questions.
Management accounting has elevated in importance over recent years.

The strong focus on costs in most businesses nowadays is owed to a
business' environment. It is characterized by technological advances
and by competition putting pressure on companies to be cost-efficient.
21
UNIT 2
COST-VOLUME-PROFIT ANALYSIS
STUDY GOALS
– what the break-even point is.

– how to apply a break-even analysis.
– the concept of contribution.
– to perform basic cost-volume-profit analysis calculations.
– how to distinguish the cost structures of organizations.
– what operating leverage is.
– why many businesses try to transform fixed costs into variable costs.
2. COST-VOLUME-PROFIT ANALYSIS
Introduction
about whether a world economy driven by oil is viable considering that crude oil, like all
natural resources extracted from Earth, is a finite resource and that its consumption dam-
ages the environment (e.g., Schneider-Mayerson, 2015). On the one hand, visionary and/or
environmentally concerned people try to outline a future without oil amid our still oil-
dependent era; on the other hand, economic thinkers point out that there may still be
much more oil than we envisioned but that its extraction is not profitable because of the
high costs associated with extracting it from difficult terrains. Recently, global oil prices
have recovered after a decline for several years. Costly shale oil extraction projects
become viable at around $70 per barrel (The Economist Daily Chart, 2018), and the pros-
pect of achieving that price sparked new production highs. This context illustrates the core
of cost-volume-profit (CVP) analysis that will be examined in this unit.
In this unit, break-even analysis and cost structure, with a special focus on operation lev-
erage and variabilization, are discussed in detail.
2.1 Break-Even Analysis

This type of analysis works with both fixed costs and variable costs. Break-even analysis is
useful in understanding the relationship between sales revenues, costs, and profits in sce-
narios of changing activity or output levels. Based on the assumption that the manage-
ment of a company can decide the activity level (i.e., how many units to produce or to
sell), calculations can be made to understand how changes in volume will yield profit or
loss.
Break-Even Point (BEP)
The activity level resulting in zero profit or loss – which means that the amounts of both
Break-even total revenues and total costs are equal – is referred to as break-even. In a graphical dis-
This means that total rev- play, the BEP is located at the point where the volume or quantity (Q) shown on the x-axis
enue equals total cost, so
that neither a profit nor a and the cost/revenue shown on the y-axis results in neither a profit nor a loss. Total costs
loss shows at the bottom and revenues are equal; hence the BEP represents the intersection of the total costs (TC)
line. and total revenue (TR) lines (Drury, 2018).
The total cost line corresponds to the mixed cost line shown before. It intersects with the
y-axis at the amount of the fixed costs (FC), as even at zero output fixed cost is still incur-
red. The total revenue line (TR) starts at zero/zero because zero sales will result in zero
revenues. Each additional unit sold will add to the revenue by the corresponding sales
price per unit. For a matter of simplification, it is assumed that the total cost and the total
revenue line are both linear functions.
24
Figure 6: Break-Even Point
Contribution Margin
Another essential concept in management accounting is called contribution margin. It is

the amount remaining from revenue after variable costs (VC) are deducted. It is called con-
tribution because this amount contributes to covering the fixed costs (FC) of the organiza-
tion (Drury, 2018).
To distinguish the per-unit variable cost from the total amount of variable costs (VC), the
lowercase acronym of (vc) is introduced. The following example illustrates the idea of the
contribution margin: A company sells a product for $250 per unit, and vc amounts to $175.
The contribution margin per unit is $250–$175=$75. Hence, with each unit the company
sells it contributes $75 toward covering the fixed costs.
2.2 CVP-Calculations
The following sections will show major calculations that can be made in CVP analysis by
using the appropriate formulas. However, it is important to note the calculations rest on
several assumptions simplifying the complexity of real-world business situations to aid in
understanding and interpreting costs. The following assumptions apply (Atkinson et al.,
2012):
• Total costs and revenues are linear functions of volume.

• All costs can be accurately distinguished as either fixed or variable costs.
• The analysis applies to a relevant range (determined by, e.g., capacity).
If these simplifications are applied, CVP analysis can be used to understand the costs and
revenues of a business. An example is used to illustrate the following calculations and
approaches. For a specified period, a business has total fixed costs (FC) of $135,000. It sells
products at $12 per unit. The selling price is shown as (P) in CVP formulas and calcula-
tions. Furthermore, each unit sold incurs variable costs (vc) of $7.50.
25
Break-Even Point in Units
This calculation determines how many units a company must sell to break even (Drury,
2018, p. 176):
FC
BEP in units = P − vc
For the example, the calculation of BEP in units is as follows:
$ 135, 000
BEP in units = $ 12 − $ 7 . 50
BEP in units = 30, 000
In this example, the company would need to produce 30,000 units to break even.
Break-Even Point in Revenue
To calculate the break-even point in revenue (i.e., currency value resulting from sales
instead of volume or quantity), the formula is as follows:
FC
BEP in revenue = profit − volume − ratio PVR
P − vc
with PVR = P
FC · P
BEP in revenue = P − vc
For our example, the calculation of BEP in revenue is as follows:
$ 135, 000 · $ 12
BEP in revenue = $ 12 − $7.50
BEP in revenue = $ 360, 000
Total cost for this example is calculated as follows:
TC = FC + VC
TC = $ 135, 000 + 30, 000$7.50
TC = $ 360, 000 neither profit nor loss
In this example, the company would need to earn revenue of $360,000 to break even.
26
Units Required for Targeted Profit
To determine how many units a company must sell to achieve a specific profit figure, add
the targeted profit to the fixed cost amount. The logic behind this is that companies do not
just need to cover all costs through sales, but they also must earn a profit (Atkinson et al.,
2012, p. 92):
FC + target profit
Units sold for target profit = P‐vc
In the example, the management of our business examines the possibility of generating a
profit of $45,000. The calculation then looks like this:
$ 135, 000 + $ 45, 000

Units sold for target profit = $ 12 − $ 7.50
Units sold for target profit = 40, 000
To reach its target profit, the company would have to sell 40,000 units.
Profit from the Sale of Predetermined Volume
This calculation makes sense if the management of a company relies on market analysis
data indicating how large the demand is, i.e., how many units the company will be able to
sell at the current price.
Profit = P · x − FC + vc · x = P − vc · x − FC
In the example, market research leads to the optimistic outlook of selling 50,000 units. To
determine how much profit would yield, the calculation would be:
Profit = 50, 000 · $ 12 − $ 7 . 50 − $ 135, 000

Profit = $ 90, 000
With a predetermined sales volume of 50,000 units, the company would be able to make a
profit of $90,000.
Price to Charge for Predetermined Profit and Volume
Provided that management relies on market research indicating how many units can be
sold in the market and that a certain profit level is targeted, this approach determines the
selling price per unit required.
Formulas:
revenue required
P= x
with revenue required = FC + vc · x + target profit
27
Regarding the previous example, 50,000 units can be sold to add a target profit of
$100,000. The calculation of the selling price per-unit is as follows:
$ 135, 000 + $ 7 . 50 · 50, 000 + $ 100, 000

P= 50, 000
= $ 12 . 20
If profit and volume are predefined, the company needs to sell its products for $12.20 per
unit.
Margin of Safety
The margin of safety is a valuable consideration for business managers in volatile markets
or ones prone to periods of economic downturn where a drop in demand is always possi-
ble. It shows how much sales may decrease before a loss occurs by connecting the expec-
ted revenue figure to the one required to break even (Drury, 2018, p. 179).
expected sales−break‐even sales

Margin of safety = expected sales
⋅ 100
Taking up our previous example, the expected sales volume is 40,000 units, which then
amounts to a revenue of $480,000 (40,000 units · $12).
Since the BEP is reached at 30,000 units (see above), the revenue needed to break even
will be $360,000 (equals 30,000 units · $12).
$ 480, 000 − $ 360, 000

Margin of safety = $ 480, 000
⋅ 100
Margin of safety = 0 . 25 25 %
The amount by which the expected sales exceed the break-even sales is expressed as a
percentage; in this case, it is 25 percent. In general, higher margins of safety are associated
with lower risk of business activity.
Graphical Representation
To show a complete graphical representation of a typical CVP analysis, the previous busi-
ness example is again refered to:
• FC = $135,000 (for a specified period)

• P = $12
• vc = $7.50
BEP is reached at a volume of x = 30,000 units. The total costs and the total revenue are
both $360,000.
Total revenue = P · x = $ 12 · 30, 000 = $ 360, 000
Totalcosts = FC + vc · x = $ 135, 000 + $ 7 . 50 · 30, 000 = $ 360,

000
28
Figure 7: CVP Analysis
The graph illustrates that with a quantity above 30,000 units a profit is generated, whereas
a quantity below 30,000 will result in a loss. However, the maximum quantity depends on
the capacity of the business. Assuming the maximum quantity is 60,000, the profit at that
point would be $135,000:
Total revenue = P · x = $ 12 · 60, 000 = $ 720, 000
Total costs = $ 135, 000 + $ 7.50 · 60, 000 = $ 585, 000
Profit = total revenue − total costs = $ 720, 000 − $ 585, 000 =

$ 135, 000
2.3 Cost Structure and Operating

Leverage
For analytical purposes, it is helpful to not just look at the total cost of an organization but
to distinguish how much of the total cost are fixed costs and variable costs. That differen-
tiation is a simple step in looking at a company’s cost structure. An organization with total
costs of $750,000 in any given year, $500,000 of which are fixed costs and $250,000 of
which are variable costs, operates with two-thirds fixed costs and one-third variable costs.
Whether two-thirds is a high fixed cost proportion and if that is a favorable position cannot
be answered easily. As mentioned in the introduction, accounting data are a matter of per-
spective, subject to interpretation, which also depends on context-specific aspects.
The nature of companies and industries determines to some degree typical cost struc-
tures. A company that needs office or retail buildings or manufacturing machinery to oper-
ate tends to have higher fixed costs because of rent, depreciation, maintenance/ repair
costs, and fixed salaries than, for example, a business providing software that program-
29
mers could design from home. However, in almost every industry there are cases of higher
and lower fixed cost proportions reflecting managerial decision- making and strategic
choices rather than being part of a certain industry.
Operating leverage Operating leverage, for example, helps measure how sensitively the bottom line result
a measure of profits’ sen- responds to changes in revenues (Drury, 2018). The sensitivity is higher in cases of a high
sitivity to changes in
sales/revenues fixed cost, as the following example illustrates. A massage parlor employs a masseur who
can treat a maximum of five patients per shift. The following data are known:
• FC (per shift; consisting of rent, insurance premium, salary, etc.): $120

• vc (per patient, consisting of massage oil and towel laundry): $5
• Price per massage: $49
Experience shows that, on average, four patients book a massage per masseur per shift.
Hence, the corresponding data are considered a standard scenario for calculations. To
understand the implications of differing demand levels, the management of the parlor
compares three scenarios: the standard of four clients per masseur and the variations of
three or five clients for one masseur per shift are inserted into the following table to com-
pare the different outcomes.
Table 3: Operating Leverage
Scenario Scenario Scenario

Data per mas- (minimum) % change (average) % change (maximum)
seur/shift 3 patients ← 4 patients → 5 patients
Revenue $ 147 -25 % 196 +25 % 245

(Q · P)
P = $49
FC per shift 120 120 120

$120
VC (Q · vc) 15 20 25
vc = $5
Profit $ 12 -78.6 % 56 +78.6 % 100

(Rev. – FC –
VC)
We notice that the percentage change in revenue (25% either up or down from the stand-
ard/average perspective of four clients) is much smaller than the resulting percentage
change in profit (approximately 78% in both directions). Hence, small changes in demand
have a dramatic effect on the bottom line. Mathematically, we can explain that quite sim-
ply: the base figure for the application of the respective percentages is much smaller in the
case of profit compared to revenue ($196 for the standard scenario equals 100% of reve-
nue, but only $56 equals 100% of profit). The absolute change, however, is almost the
same ($49 revenue per client and $44 profit). That phenomenon is typical in organizations
30
with a high proportion of fixed costs leveraging profits up or down. In the case of the mas-
sage parlor – assuming the standard scenario of four patients – the following cost struc-
ture is shown:
Total costs = FC + vc · x = $ 120 + $ 5 · 4 = $ 140
$ 120
FC share = $ 140
· 100 = 85 . 71 % high FC proportion
$ 20
VC share = $ 140
· 100 = 14 . 29 %
2.4 Cost Structure and Variabilization

The previous section on the operating leverage effect illustrated how a change in revenue
results in a much more substantial change in profit or loss. This effect is true both ways,
i.e., for revenue increases as well as decreases, and it is stronger the higher the fixed cost
proportion of a company. If managers are convinced that their business operates in a per-
manently growing market with ever-increasing revenues it would be a wise decision to
build a cost structure with a high fixed cost proportion to benefit from the positive operat-
ing leverage effect. On the other hand, if managers are convinced that their business is
operating in declining markets with revenue decreases, a cost structure characterized by a
high variable cost proportion would be more favorable to reduce the negative operating
leverage effect (although the overall situation in a declining market is, of course, unfavora-
ble).
Obviously, neither managers nor other stakeholders can realistically foresee the future,
despite thorough market analyses and economy outlook reports published by various
experts. The reality of the business world is that unforeseen developments occur and
there is fluctuation in demand behavior. In many markets, there is a considerable degree
of volatility, which means that the demand for goods and services is subject to frequent
and/or unpredictable changes. Furthermore, prices may frequently change due to com-
petitive pressures so that a decrease in revenue is not only triggered by fewer customers
willing or able to buy goods and services but also by selling the same quantity as before at
lower unit prices.
To reduce the risk resulting from revenue fluctuations, especially from downturns or even
short-term decreases many companies nowadays try to convert fixed costs into variable
costs – a process called variabilization. Unlike fixed costs, variable costs are usually cov- Variabilization
ered directly by revenues, as they are incurred only when there is output to be sold. Partic- This is the attempt to
transform fixed costs into
ularly, businesses facing seasonal (e.g., European beach resorts with booming business variable costs.
during summer holidays and weak demand during the winter months) or other typically
recurring fluctuations in their industry due to the nature of their product or service prac-
tice variabilization. One way of achieving it is outsourcing. This means services or prod-
ucts previously provided in-house, i.e., by departments and employees belonging to the
organization, are now purchased from third-party suppliers. Instead of internal depart-
ments, the suppliers are external business partners supplying what is purchased based on
business contracts. Own employees typically mean fixed costs due to fixed salaries, social
31
Outsourcing security duties, etc. In addition, buildings and machinery owned in-house result in fixed
This is the process of con- costs, such as rent, depreciation, and maintenance. Purchasing from outside suppliers
tracting out activities so
that goods are purchased makes costs variable.
from external suppliers
instead of being produced
inhouse.
OUTSOURCING BY VARIABILIZATION
The hotel sector provides a good example of this trend – many hotels have con-
tracted out housekeeping to specialized service firms. The hotel orders the
cleaning service only for rooms actually sold and pays per room cleaned. That
makes the personnel cost of housekeeping variable, as only rooms sold cause
housekeeping cost – and that cost is covered by the revenue generated through
guests. Employing their own staff would mean fixed costs that become problem-
atic whenever not enough rooms are sold to cover their salaries.
SUMMARY
Cost-volume-profit analysis draws on the differentiation of fixed and var-
iable costs. It is useful to understand the relationship between sales rev-
enue, costs, and profit in scenarios of changing activity levels. Based on
the assumption that the management of a company can decide the
activity level, i.e., how many units to produce or sell, calculations can be
made to understand how changes in volume will result in changes in
profit or loss.
A key concept to that end is the break-even analysis in which the total
revenue and total cost amounts are equal so that neither profit nor loss
is incurred. Calculations within the break-even analysis determine how
many units must be sold to break even or to achieve a predetermined
profit or to calculate a price for which price units have to be sold for a
certain profit, etc.
Many businesses are concerned about their cost structure (i.e., the pro-
portion of fixed and variable costs). There is a trend toward converting
fixed costs into variable costs wherever possible. Fixed costs are consid-
ered a higher risk in times of volatile demand and potential disruptions
in the market because fixed costs are not matched by revenues and
thereby put pressure on the financial bottom line in times of decreasing
sales.
32
UNIT 3
SIMPLISTIC METHODS OF COST
ALLOCATION
STUDY GOALS
– to distinguish direct from indirect costs.

– to distinguish product from period costs.
– which costs need to be allocated and why.
– the meaning of cost objects.
– how to allocate costs based on simple approaches.
3. SIMPLISTIC METHODS OF COST
ALLOCATION
Introduction
This unit examines the problem of dividing total costs fairly and appropriately so that all
cost is accounted for and no unit (a product, a department, etc.) bears too much or too
little cost in the end. Such a result could lead to deflected management decisions with a
high likelihood of negative consequences. It is a bit like splitting a virtual pie so that each
person gets their share, whereas the intuitive practice for real pies – cutting the pie into
equal slices – may not be the best solution. On the contrary, in management practice, this
approach would almost always represent the worst solution.
To understand this problem, we resort to another challenge known from everyday life: dis-
tributing utility costs among the tenants of an apartment building. Besides the vested
interests of landlords and leasers, there are complex legal regulations. In Germany, there
is, for example, a law requiring the regular testing of central-heating/water tanks or boil-
ers for Legionella. Who bears the cost of this? It can be distributed among the tenants as
ancillary expenses (e.g., real estate tax, waste collection fees), but what if the hot water
consumption pattern varies widely across the tenants? Some families use the washing
machine more often, some people take a hot bath every day, and others are hardly at
home because they often go on business trips. Investors buying apartment buildings just
as a safe, easy-care investment are likely to hit a “moment of truth” when the first clearing
is due (e.g., Schütrumpf, 2012).
3.1 Cost Behavior: Direct and Indirect

Costs
Besides the categorization of costs as fixed and variable, there is another widely used
approach that is helpful for certain types of cost analyses: the distinction between direct
and indirect costs.
Direct Costs
Costs that can be clearly traced to a specific output of a company are referred to as direct
Direct costs costs. In a further step of categorization, direct costs are often divided into direct labor
These can be traced back (DL) and direct material (DM) costs. The former includes all costs incurred due to labor
to a specific output.
activity performed directly on output, for example, the salary of a worker at the assembly
line of a manufacturer or the salary of a service person directly working with customers.
The latter includes the costs of all materials arising from the output, for example, the steel
that becomes part of a car (Drury, 2018).
34
Indirect Costs
Indirect costs cannot be traced to a specific output of an organization. Once more there is Indirect costs
the subcategorization of indirect labor and indirect materials. The former encompasses These costs cannot be
clearly traced back to a
costs of labor activity that go beyond working on a specific output, such as the salaries of specific output.
supervisors in charge of several production lines. The latter refers to materials that do not
directly become part of the output, such as lubricants used for machines that in turn are
deployed to produce different output types in a factory (such as different car models or
different pieces of furniture). In addition, there is manufacturing overhead. This sub-type
of indirect costs denotes costs incurred in operations that are not adequately captured as
either labor or material. These include, for example, rent or insurance costs for production
buildings or costs for utilities such as electricity. If electricity is used at a manufacturer to
operate machines that produce different types of output or at a bakery for an oven baking
different types of bread and cakes, the costs cannot be associated with a specific output.
All the aforementioned costs are related to the production of goods or services and can
therefore be summarized as product costs. Furthermore, some costs are not even related
to production such as selling and administrative expenses. These costs include, for exam-
ple, salaries of salespeople, rent and depreciation for office buildings, or human resource
management department costs. All these costs are unrelated to the core activity of a busi-
ness and are often referred to as period costs to differentiate them from costs incurred in
operations (Drury, 2018). The following table provides an overview of these direct, indi-
rect, and period costs.
Figure 8: Product Costs
35
Figure 9: Period Costs
If a company only provided exactly one specific product or one service without variations
– a rather hypothetical case – all costs could be considered direct costs because they all
are fully caused by that one product/service. The need to differentiate direct, indirect, and
period costs arises through the variety in goods and services offered.
3.2 The Need for Cost Allocation

Most cost analysis and cost accounting activities within organizations deal with the chal-
lenge of allocating indirect (and period) costs to specific (units of) products or services.
Knowing the costs of one unit of a certain output as precisely as possible enables manage-
ment to make better decisions. One example would be pricing since managers usually
want to know at which minimum price the products offered will be profitable. Whereas
direct costs can be associated with a specific output, indirect costs cannot. Therefore, cost
allocation is required. That means these costs are allocated to cost objects such as prod-
ucts in some systematic way.
The factual starting point of cost analysis is usually the figure of total costs. These are
exact and known, e.g., from the invoices the organization has to pay or from the cash
already paid for expenses. Total costs are also featured in income statements produced in
the domain of financial accounting as required by law or by international rulesets depend-
ing on the size, legal form, and financial market context of the organization. What is not
known is how much of the total costs belong to specific products or departments. As soon
as there are several cost objects in an organization, there is no unified natural logic for
determining how much of the total indirect and period cost belongs to each one. No cost
allocation approach is 100 percent accurate; there is always a notion of arbitrary interven-
tion. The terminology featured in the table below is essential for subsequent cost analysis.
36
Table 4: Important Cost Terminology
Cost Expenses incurred through the consumption of an asset or the use of a service
Cost object The target of which managers want to know the price incurred to build/have/operate it.
For example, products manufactured in the company, departments of the organization,
or customers of company services
Cost allocation The process of allocating costs that cannot be traced to cost objects
Cost driver An object, activity, or phenomenon that causes a change in the costs incurred
3.3 Overhead Rates

Predetermined Overhead Rate
To allocate indirect or period costs systematically, there must be a basis of cost allocation,
a so-called cost driver. This term points to the underlying assumption that the use of a
cost driver will also increase costs. The most simplistic way of allocating costs to cost
objects is to use the same cost driver across an organization. Such cost drivers are often
volume-based, as they refer to an amount produced or provided in operations. For exam-
ple, the number of units produced can be a volume-based cost driver, as can the number
of direct labor hours worked. There are four steps involved in establishing a predeter-
mined overhead rate (Accountingformanagement, 2020). These are as follows:
1. Estimate the total amount of overhead for the operating period.

2. Select the cost driver.
3. Estimate the total volume of the cost driver for the operating period.
4. Divide the estimated overhead figure by the estimated cost driver volume.
To allocate overhead based on this rate, multiply the rate by the number of cost driver
units applied in production.
Consider the following example: a company estimates a total overhead of $700,000 and a
total of 87,500 direct labor hours (DLH) for the next operating year. The predetermined
overhead rate then is $ 700, 000 ÷ 87, 500 = $ 8 per DLH. The company produces three
different products: A, B, and C. The following table shows the respective DLH for all three
products and the company-wide overhead rate, which is sometimes also referred to as the
blanket rate.
Table 5: Predetermined Overhead Rate Example Dataset
Total A B C
Overhead costs $ 700,000
Direct labor hours 87,500 22,250 33,050 32,200
37
Total A B C
Overhead rate ($ per DLH) 8
With the following calculation, we can allocate the total overhead to the three products
based on the predetermined rate of $8 per DLH:
A: 22,250 DLH · $8 = $178,000
B: 33,050 DLH · $8 = $264,400
C: 32,200 DLH · $8 = $257,600
→ total overhead allocated = $178,000 + $264,400 + $257,600 = $700,000
Departmental Overhead Rate
Continuing with the previous example, the company now wants to achieve a more precise
cost allocation with a little more information available. The number of direct labor hours
in the different departments is known for each product, as shown in the table below.
Table 6: Departmental Overhead Rate Example Dataset 1
A B C Total
DLH in department I 2,500 1,800 8,200 12,500
DLH in department II 4,750 7,250 13,000 25,000
DLH in department III 15,000 24,000 11,000 50,000
Total DLH 22,250 33,050 32,200 87,500
Moreover, the following overview of department overhead and DLH, which leads to a sep-
arate overhead rate per department, is known.
Table 7: Departmental Overhead Rate Example Dataset 2
Dept. I Dept. II Dept. III Total
Overhead costs $ 150,000 450,000 100,000 700,000
Overhead rate ($ per DLH) 12 18 2 8
38
This leads to a new calculation of overhead allocation to products. Differentiating the DLH
each product requires in each of the departments, respectively:
The total amount allocated remains the same. But there is a shift between the products.
Product C absorbs much more of the total cost as it did with the blanket rate because it
requires the most hours in department II, which has the highest rate. Products A and B
each absorb much fewer of the total costs as with the predetermined overhead rate.
Table 8: Comparison of Predetermined Overhead Rate and Departmental Overhead

Rate
Predetermined Departmental over-

All amounts in $ overhead rate head rate Difference
A 178,000 145,500 – 32,500
B 264,400 200,100 – 64,300
C 257,600 354,400 + 96,800
Total allocated 700,000 700,000 0
Over- and Under-Application of Overhead
Companies often rely on budgeted overhead rates for the upcoming operating year rather
than waiting until the actual figures are available at the end of the period. This delay
would be a major disadvantage, for example, by hindering management from making
accurate pricing decisions. At the latest, a selling price needs to be calculated when sales
start. It can still be adjusted later if necessary.
Example: A business estimates its overhead and activity for the following period as
• activity of 400,000 DLH

• total overhead of $8 million
The predetermined overhead rate is $ 8, 000, 000 ÷ 400, 000 = $ 20 per DLH.
As production goes along, the company’s accountant will apply this rate and allocate $20
of overhead whenever one DLH is worked on a product. Assuming that the actual data at
the end of the period are
• activity of 425,000 DLH (more than planned) and

• overhead incurred: $8 million (as planned).
then the overhead applied is 425, 000 · $ 20 = $ 8, 500, 000.
In this case, there is an over-application of overhead, which means that more costs were
allocated to products than were incurred.
39
If the actual data at the end of the period are assumed to be as follows:
• activity of 375,000 DLH (less than planned) and

• overhead incurred: $8 million (as planned).
The overhead applied is 375,000 DLH · $20 = $7,500,000.
In this case, there is an under-application of overhead, which means that not all costs
incurred were allocated to the products.
The following table provides an overview of various scenarios to illustrate how either over-
or under-application of overhead can occur. Even though an exact application is possible,
it is rather unlikely.
Table 9: Overhead Over-/Under-Application Scenarios
Predetermined Overhead Actual over-

Actual DLH rate $ per DLH applied $ head $ Consequence
250,000 20 5,000,000 7,750,000 Under-application of

$2,750,000 m
350,000 20 7,000,000 8,500,000 Under-application of

$1,500,000 m
450,000 20 9,000,000 9,000,000 Exact application
500,000 20 10,000,000 7,250,000 Over-application of

$2,750,000 m
Any misapplied overhead will have to be adjusted. That can either be done by using the
so-called costs of goods sold (COGS) account, which is used in financial accounting, or by
using production-related accounts such as work-in-process (WIP) or finished goods inven-
tory. It is important that all costs incurred are absorbed by appropriate accounts. Usually,
such adjustments will be made only at the end of the year as seasonal fluctuations during
the year are likely to lead to over- and under-applications offsetting each other.
Adjustments in this domain show a strong link between financial and managerial account-
ing: the total cost figures are factual and therefore appear in both systems. For accurate
reporting as required by financial accounting rules, however, it does not matter how you
internally allocate the factual cost figures to your cost objects, such as departments, prod-
ucts, or units of a product.
40
SUMMARY
Another differentiation of costs separates direct from indirect costs. The
former can be traced directly to a specific output such as one product
out of the product range of a factory, whereas the latter cannot be traced
to a specific output as it is caused indirectly by the entire product range
or the manufacturing facility itself. Whenever a business produces more
than one product or provides more than one service, there is no natural
way of knowing how much of the known total cost incurred is caused by
each single one. Therefore, there is a need for cost allocation.
Cost allocation is defined as the process of assigning costs to cost

objects, especially to products produced or services provided. There are
simplistic cost allocation methods like the predetermined overhead rate
however, this approach tends to deliver imprecise results that are inap-
propriate for decision-making. The more differentiated cost and proc-
ess-related information is available, the more precise allocation proce-
dures can be.
The goal of each cost allocation procedure is to gain a precise under-

standing of how much it costs a business to produce and sell its prod-
ucts or services. This foundational concept is important to understand-
ing how to make appropriate pricing decisions. The more accurate the
results, the more likely a business is to make meaningful decisions.
41
UNIT 4
ACTIVITY-BASED COSTING
STUDY GOALS
– how to split business processes into activities.

– the assumption underlying the implementation of activity-based costing.
– how to implement activity-based costing.
– to understand different outcomes in terms of profit or figures resulting from different
approaches to cost allocation.
– why activity-based costing tends to be more accurate than simplistic cost allocation
methods.
4. ACTIVITY-BASED COSTING
Introduction
Low-cost airlines offer hundreds of routes from and to Germany throughout the summer.
Most routes connect Germany to Spain, Italy, and the UK. For an airline, every route is a
product and is under scrutiny for its profitability. Low-cost airlines face very intense cost
pressure and tough competition. They cannot afford to hold on to loss-making routes so
they frequently change their routes and timetables.
Every business that has several product lines needs an overview of how profitable each of
these product lines is. With many products, or even product types, on offer and with com-
plex manufacturing or service delivery operations it is not easy to determine the contribu-
tion of each product to the overall bottom line. Simplistic cost analysis, such as the prede-
termined overhead rate approach, often generates a distorted cost picture and may
provide data that lead the management to misguided decisions. Activity-based costing is
more complex to perform than simplistic overhead allocation methods, but it also prom-
ises a much more accurate and more reliable result so it is preferred by most companies
with complex operations and a variety of different products or product lines.
4.1 Basics of Activity-Based Costing

Activity-based costing is a cost analysis approach that promises a much more precise and
accurate allocation of overhead to cost objects. It is widely considered state-of- the-art in
terms of cost allocation methods in today’s business world. The idea of this approach is to
break down production/service provision processes analytically into all the activities
involved in it. This allows the analyst to apply a separate cost driver to each of these activi-
ties. The simplistic overhead allocation methods are based on just one cost driver, which
does not allow for a differentiated picture and tends to generate potentially distorted cost
allocations (Drury, 2018).
Of course, there are multiple activities involved in business operations, and the exact
activities involved will be unique to each business. An understanding of these activities is
crucial to working with activity-based costing. While each organization requires individual
analysis, there are some typical activities you will find in certain industries or among cer-
tain types of business. The following table provides a few examples.
44
Table 10: Activities of Businesses
Manufacturing companies Service companies
• Ordering supplies • Ordering supplies

• Handling materials • Scheduling
• Setting up machines • Greeting/meeting clients
• Assembly • Customer registration
• Inspection • Providing core service
• Transport • Billing customers
For cost analysis of processes, it is useful to classify activity levels at which costs are incur-
red. In this context, four levels are usually distinguished (Drury, 2018). These are as fol-
lows:
1. Facility-level activities. The costs of these are incurred to sustain the entire organiza- Facility-level activities
tion, which means that they are incurred independent of separate products produced. The facility-level activities
are necessary for sustain-
These costs are mostly fixed costs, such as factory building depreciation, manage- ing the whole business.
ment salaries, accounting department salaries, or insurance premiums.
2. Batch-level activities. The costs related to these are incurred in the production of Batch-level activities
product batches rather than individual units, which means that a certain number of These activities are costs
incurred every time a
units is produced together in a certain step or sequence of steps, for instance, 30 group of units is pro-
loaves of bread baked as a group in the oven. Examples of typical costs related to duced.
batches include machine setup costs, machine running costs, and packing shipments
of goods.
3. Product-level activities. These activities relate to specific products. Costs incurred at Product-level activities
this level are, for example, product design costs or product-testing costs. The product-level activi-
ties are those activities
4. Unit-level activities. These activities relate to individual units of a product. Costs that support a specific
incurred in this category are mostly direct labor or material (which are direct costs product or an entire prod-
and therefore irrelevant for cost analysis aimed at overhead allocation). uct line.
Unit-level activities
These activities relate to a
single unit of a product or
a service.
WINERY EXAMPLE
At a winery, the different activity levels apply as follows: each barrel or each bot-
tle to sell can be seen as a unit. Barrels of the same production age together
before the wine is ready to be bottled form a batch. Each red or white wine the
winery produces is a separate product.
4.2 Implementing Activity-Based Costing

To implement activity-based costing, a thorough understanding of the organization’s pro-
cesses is required. A detailed, often consultant-aided, internal process analysis must pre-
cede the design of activity-based costing. As a result of a preliminary analysis, inefficient,
45
non-value-adding or redundant activities or steps in the production/manufacturing or
service delivery process are discovered so that the process can be economized. That
should result in an overall cost-saving effect. The implementation of activity-based costing
requires a lot of effort and is only feasible if the company has sophisticated data analysis
tools at hand, such as enterprise resource software tracing the flow of materials, power
consumption, machine hours, etc., even in complex and/or fast-paced settings (Drury,
2018).
To illustrate how activity-based costing can provide a much more accurate picture than
simplistic overhead allocation methods, a furniture manufacturer can be used as an exam-
ple. This small-town company currently manufactures two lines of seating furniture: a
large sofa bed that has become very popular among students and is produced in large
quantities, and a classy, calfskin office swivel chair that has found its niche market among
young, dynamic managers and is only produced in small quantities. The following data
from last year are available.
Table 11: Initial Data
Sofa bed Office chair Total
Units produced 1,200 240
DLH 5,000 1,500 6,500
Overhead $ 520,000
Direct labor $ 75,000 25,500 100,500
Direct material $ 180,000 264,000 444,000
So far, the company has used a predetermined overhead rate based on DLH to allocate the
overhead. Last year, the overhead rate was $ 520,000 ÷ 6,500DLH = $ 80 per DLH. After
adding the respective revenue data, the profitability analysis featuring the two products is
below.
Table 12: Predetermined Overhead Rate
Sofa bed Office chair
Price per unit $ 499 2,499
Units sold 1,200 240
Revenue $ 598,800 599,760
DLH 5,000 1,500
Overhead rate 80 80
Overhead allocated $ 400,000 120,000
46
Direct labor $ 75,000 25,500
Direct material $ 180,000 264,000
Profit $ –56,200 190,260
The overall profit generated last year was $ 190, 260 – $ 56, 200 = $ 134, 060. According
to this analysis, the only profit generator was the office chair, whereas the sofa bed accu-
mulated a loss. The manufacturer does not want to drop the sofa bed and thinks that
increasing its selling price would turn many customers away. The company would cer-
tainly regret losing this customer base either way. Thus, the business brings in an expert
who suggests implementing activity-based costing to get a more precise picture of prod-
uct profitability and then reconsider its options.
Activity-based costing is done in six steps (Drury, 2018, p. 263):
1. Identify all separate activities involved in the production process.

2. Determine how much of the total overhead belongs to each activity.
3. Define a cost driver for each activity and establish its total volume.
4. Calculate a separate overhead application rate for each activity.
5. Determine the cost driver volume each cost object consumes for each activity.
6. Apply all activity rates to the cost objects.
In the case of this furniture manufacturer, the analysis of steps one to four is provided as
follows.
Table 13: Activity Analysis
Activity Overhead Cost driver Volume Rate in $
Materials handling 57,720 DM worth 444,000 0.13
Machine setup 203,392 Set-up hours 10,119 20.10
Assembly 179,400 DLH 6,500 27.60
Quality inspection 34,992 Units produced 1,440 24.30
Shipment 44,496 Units produced 1,440 30.90
520,000
The activity cost driver volume consumption of both cost objects (sofa bed and office
chair) is determined (step five) and provided in the following table.
47
Table 14: Activity Analysis with Cost Driver Volumes
Activity Cost driver Cost driver volumes
Materials handling DM worth 180,000 264,000
Machine setup Set-up hours 2,100 8,019
Assembly DLH 5,000 1,500
Quality inspection Units produced 1,200 240
Shipment Units produced 1,200 240
In the final sixth step, the respective activity rates are applied to the cost objects to allo-
cate the overhead accordingly. To retrieve the total cost figures, the direct costs must not
be forgotten – they feature in the last lines of the following overview.
Table 15: Cost Driver Rate Application (Sofa Bed)
Cost driver
Cost position Rate Volume Cost
Handling materials $0.13 180,000 $23,400.00
Machine setup $20.10 2,100 $42,210.00
Assembly $27.60 5,000 $138,000.00
Quality inspection $24.30 1,200 $29,160.00
Shipment $30.90 1,200 $37,080.00
Total overhead $269,850.00
Direct materials $180,000.00
Direct labor $75,000.00
Total $524,850.00
Table 16: Cost Driver Rate Application (Office Chair)
Cost driver
Handling materials $0.13 264,000 $34,320.00
48
Cost driver
Machine setup $20.10 8,019 $161,182.00
Assembly $27.60 1,500 $41,400.00
Quality inspection $24.30 240 $5,832.00
Shipment $30.90 240 $7,416.00
Total overhead $250,150.00
Direct materials $264,000.00
Direct labor $25,500.00
Total $539,650.00
Based on this activity-based costing implementation, a new profitability table can be con-
structed. The following table shows the calculated profit of the two products according to
the predetermined overhead rate and the activity-based costing.
Table 17: Predetermined Overhead Rate versus Activity-Based Costing
Predetermined overhead rate Activity-based costing
Sofa bed Office chair Sofa bed Office chair
Price per unit $ $499.00 $2,499.00 $499.00 $2,499.00
Units sold 1,200 240 1,200 240
Revenue $ $598,800.00 $599,760.00 $598,800.00 $599,760.00
Overhead alloca- $400,000.00 $120,000.00 $269,850.00 $250,150.00

ted $
Direct labor $ $75,000.00 $25,500.00 $75,000.00 $25,500.00
Direct materials $ $180,000.00 $264,000.00 $180,000.00 $264,000.00
Profit per prod- $—56,200.00 $190, 260.00 $73,950.00 $60,110.00

uct $
Total profit $134,060.00 $134,060.00
According to activity-based costing, both products are profitable, and the sofa bed con-
tributes even more to the total bottom line profit than the office chair. The manufacturer
will decide to continue both products. Note that the factual total figures, such as the total
revenue ($ 598, 800 + $ 599, 760 = $ 1, 198, 560 ), the total allocated overhead
49
($520,000), and the total costs ($1,064,500), as well as the overall profit
(revenue – cost = $ 134, 060) have not changed. They are independent of how overhead
is allocated to the cost objects within the company.
In this example, the dramatic differences in the overhead allocated mainly come from the
setup costs. That is a typical result: costly setup procedures preparing machines for pro-
duction runs are unfavorable if only a small number of units are produced. Under DLH-
based simplistic allocation methods, high-volume products often look unprofitable and
low-volume products, with few DLH required, look profitable, but that can be misleading
as it provides only part of the whole picture.
But one must keep in mind that there is no fully accurate cost allocation method. Some
arbitrariness remains in all methods, even in activity-based costing, due to the need to
determine cost drivers. However, activity-based costing is much more precise than sim-
plistic cost allocation methods and therefore delivers more reliable results for manage-
ment decisions, such as pricing or keeping/abandoning product lines.
SUMMARY
Activity-based costing is a state-of-the-art cost analysis approach that
enables more precise and accurate allocation of overhead to cost
objects. The essence is to break down production or service provision
processes into the individual activities involved. This allows us to apply
a separate cost driver to each of these activities, unlike simplistic over-
head allocation methods that rely on only one cost driver for the entire
process.
The implementation of activity-based costing requires a thorough analy-

sis of the internal production or service provision processes. In this con-
text, there is the potential for streamlining and optimizing various activi-
ties by identifying and getting rid of redundancies. In complex
production settings, however, activity-based costing is not trivial, and
quite likely a substantial investment into IT and software will be neces-
sary in order to gather the sufficiently differentiated and real-time infor-
mation required for analysis.
As a tendency, activity-based costing tends to show high-volume, i.e.,

mass-produced goods, in a more favorable light than simplistic, old-
fashioned cost allocation methods. It reveals that low-volume jobs tend
to be more expensive per unit because certain fixed costs, like machine
setup in preparation of production runs, can only be split between a few
50
units of output. Activity-based costing therefore helps to evaluate the
profitability of individual products more accurately than simplistic
approaches.
51
UNIT 5
OVERHEAD ANALYSIS SHEET
STUDY GOALS
– the meaning of company-wide cost allocation to cost objects.

– the rationale of profit centers in organizations.
– the three phases of the overhead analysis sheet procedure.
– two different approaches to the overhead analysis sheet.
5. OVERHEAD ANALYSIS SHEET
Introduction
It is a widespread phenomenon in the corporate world to scrutinize the contribution of
every branch or segment to the organization’s bottom line. Some corporations are known
for quickly dropping unprofitable business lines or closing/outsourcing internal service
departments that are considered to be too costly. General Electric and Siemens are two
often-quoted examples of global players that frequently reassess their corporate struc-
tures. Business fields and departments are rapidly opened or closed in efforts to optimize
efficiency and profitability. Such an approach contributes to streamlining organizations
and puts pressure on managers. It can also reduce bureaucracy. However, it can also be
unproductive. If, eventually, every department is declared to be a profit center, coming
under pressure to prove its positive contribution to the overall bottom line of the business,
the overall strategy and common goal of the organization are easily lost. In the worst case,
internal and reciprocal invoicing and questioning of tasks hinder efficient processes
(Stocker, 2006). Eventually, a cost-/profit-center obsession can ruin the corporate culture
of a business with everyone focused on justifying their existence within the organization
and/or on denying other departments’ justification of existence.
5.1 Departmental Cost Allocation

Many departments, functions, or activities are not directly related to operations and yet
are required to sustain the organization, such as human resource management, legal
departments, and accounting. Large companies with multi-branch operations often con-
centrate such administrative or supporting functions at centralized places, servicing all
branches or outlets. This is predominantly a cost-saving effort, as maintaining these serv-
ices at every location of operation would be costlier but does not add any value, unlike
operational activities that generate revenues. These internal support services are often
referred to as shared services since several branches or outlets share the service provided
by the centralized departments (Drury, 2018).
Over the past few decades, management paradigms like the focus on core competencies,
competitive pressures, and the focus on profit maximization, have led to the outsourcing
of assorted support functions. In some cases, however, support functions have even
become separate legal entities providing their services as spin-offs to not only the parent
company but also any interested player in the market and possibly even the parent com-
pany’s competitors. Lufthansa, for example, has entities such as Lufthansa Technik, which
provides aircraft maintenance services both for Lufthansa and for many airlines that do
not have the competency or have decided that maintaining it in-house would not be
efficient. Even LSG SkyChefs, another Lufthansa spin-off, provides catering services for
many airlines in need of meals for their passengers.
54
Wherever administrative or support services are still provided in-house, the challenge of
allocating their costs along with the product costs to the final output of the business ari-
ses. This entails a process usually consisting of three phases.
Figure 10: Different Phases of Overhead Analysis
5.2 Reciprocal Method

This method allows for integrating the costs of service departments that not only provide
their support activities for production departments but also for other service departments
considering their reciprocal proportions (Drury, 2018). The following example will illus-
trate the application of this method. The initial data of the business is shown below.
Table 18: Reciprocal Method: Initial Data
Serv 1 Serv 2 Prod 1 Prod 2 Total
Labor hours 2,400.00 3,500.00 1,400.00 6,200.00 13,500.00
Machine hours 0.00 0.00 8,600.00 2,800.00 11,400.00
Direct labor costs $ $40,000.00 $180,000.00 $220,000.00
Direct material costs $ $50,000.00 $20,000.00 $70,000.00
Indirect labor costs $ $90,000.00
Indirect material costs $ $45,000.00
55
Serv 1 Serv 2 Prod 1 Prod 2 Total
Total costs $ $425,000.00
The first phase of this analysis requires the allocation of all costs to all departments. The
company allocates indirect labor costs based on labor hours and indirect material costs
based on machine hours to all departments.
Table 19: Phase One Overhead Analysis Sheet
Phase 1 Serv 1 Serv 2 Prod 1 Prod 2 Total
Labor hours 2,400.00 3,500.00 1,400.00 6,200.00 13,500.00
Proportion of total 17.78% 25.93% 10.37% 45.93%
Machine hours 0.00 0.00 8,600.00 2,800.00 11,400.00
Proportion of total 0.00% 0.00 % 75.44% 24.56%
Direct costs traced & indirect costs allocated based on labor/machine hours proportion
Direct labor costs $ $- $- $40,000.00 $180,000.00 $220,000.00
Direct material $- $- $50,000.00 $20,000.00 $70,000.00

costs $
Allocated indirect $16,000.00 $23,333.33 $9,333.33 $41,333.33 $90,000.00

labor $
Allocated indirect $- $- $33,947.37 $11,052.63 $45,000.00

material $
Total costs $ $16,000.00 $23,333.33 $133,280.70 $252,385.96 $425,000.00
Source: Hastenteufel, 2020
The second phase requires the allocation of the service department costs to the produc-
tion departments while considering a reciprocal service department provision. The recip-
rocal cost absorption of Serv 1 and 2 is performed first before moving on to allocate the
derived figures to Prod 1 and 2. In this context, the business has analyzed the work pattern
of Serv 1 and 2, deriving the proportions in the following table.
Table 20: Phase Two Additional Information
Serv 1 Serv 2 Prod 1 Prod 2
Serv 1 works for … n/a 20 % 30 % 50 %
Serv 2 works for … 30 % n/a 40 % 30 %
56
Therefore, Service 1 department accounting for 17.78% of labor hours gets allocated
17.78% of the indirect labor cost of $90,000, which amounts to $16,000 and so on. Keep
verifying that the total cost figure of the company of $425,000 never changes because that
is factual and not impacted by allocations. That leads to the following two cost allocation
equations:
• Serv 1 = $16,000 (allocation from phase 1) +30 % of Serv 2

• Serv 2 = $23,333.33 (allocation from phase 1) +20 % of Serv 1
We now have two simultaneous equations, i.e., two equations with the same two varia-
bles. One approved way of solving this mathematical problem is to substitute one into the
other:
Now insert x as Serv 1 into the second equation:
The cost figures of Serv 1 and 2 plus the already known cost figures from phase one are
accumulated to derive the costs allocated to Prod 1 and 2. For example, Prod 1 gets alloca-
ted 30% of Serv 1 because Serv 1 works 30% for it. 30% of $24,468.09 equals $7,340.43.
Table 21: Phase Two Overhead Analysis Sheet
Phase 2 Prod Prod 2
Cost from Phase 1 $ $133,280.70 $252,385.96
Allocated from Serv 1 $ 30 % $24,468.09 $7,340.43
50 % $12,234.05
Allocated from Serv 2 $ 40 % $28,226.95 $11,290.78
30 % $8,468.09
Total costs $ $151,911.91 $273,088.09 $425,000.00
The third phase requires the allocation of the production costs of the departments to cost
objects. The business produces Gadget A and Gadget B. The costs of Prod 1 are allocated
based on machine hours; the costs of Prod 2 are allocated based on labor hours. The table
below contains all the necessary information.
Table 22: Phase Three Overhead Analysis Sheet
Phase 3 Gadget A Gadget B Total
Labor hours 7,020.00 6,480.00 13,500.00
Proportion of total 52.00% 48.00%
Machine hours 3,876.00 7,524.00 11,400.00
57
Phase 3 Gadget A Gadget B Total
Proportion of total 34.00% 66.00%
Cost of Prod 1 $ $51,650.05 $100,261.86 $151,911.91
Cost of Prod 2 $ $142,005.81 $131,082.29 $273,088.09
Total costs $ $193,655.86 $231,344.15 $425,000.00
For example, Gadget A causes 34% of all machine hours, and Prod 1 department costs of
$151,911.91 (derived in the previous phase) are allocated to the products based on
machine hours so that Gadget A gets 34% of $151,911.91, amounting to $51,650.05.
Please note that the complexity of the reciprocal method increases considerably the more
departments or functional areas an organization has. The accurate capture of all recipro-
cal uses of services the departments provide requires reliable and measurable data that
tend to come in large volumes and still need fine differentiation. To that end, IT systems
with the capacity to trace various processes in real-time are necessary.
5.3 Step Method

This method is mostly applied, as it forms the basis of performing the three phases of cost
allocation. Costs are allocated step by step until the cost objects absorb all costs incurred
within the business. Even the reciprocal method exercised in the previous section per-
forms essentially the same steps of cost allocation through the phases. The major differ-
ence is that the step method does not consider the reciprocal work relationships of service
departments in the second phase. The step method will be illustrated with another exam-
ple focusing on the typical complexity of various overhead cost positions that need to be
allocated and also through the availability of various potential cost drivers (Drury, 2018).
A manufacturer runs two production departments, a machine hall where largely automa-
ted production steps are performed, and a finishing department performing mostly man-
ual labor in the finalization of assembly and inspection of finished goods. There are also
two service departments, material storage in charge of handling materials, and technical
support providing help for staff in the production departments. The following cost over-
view is available:
Table 23: Cost Overview
Machine Materials Tech

Total $ hall Finishing storage support
Direct labor 3,850,000 250,000 3,600,000 0 0
Direct materi- 3,700,000 2,400,000 1,300,000 0 0

als
58
Machine Materials Tech
Total $ hall Finishing storage support
Indirect labor 2,100,000 350,000 250,000 400,000 1,100,000
Indirect mate- 4,370,000 360,000 230,000 3,000,000 780,000

rials
Depreciation 1,010,000 920,000 77,000 7,000 6,000
Building 250,000
insurance
Machine 520,000
insurance
Rent for 1,800,000

buildings
Heating, light- 2,400,000

ing, cooling
Total cost 20,000,000
There are no direct costs shown for the service departments, as these costs are by
definition incurred in operations and traceable there. When looking at the three phases of
cost allocation, the total cost of $20,000,000 will never change. To allocate the last four
cost positions of the table above, the following information is provided.
Table 24: Overview of Potential Cost Drivers
Materials Tech sup-

Total Machine hall Finishing storage port
DLH 192,000 12,000 180,000 0 0
Area (sqm) 3,350 1,800 800 500 250
Machine hours 6,500 6,000 500 0 0
Book value of 3,400,000 2,750,000 620,000 12,000 18,000

mach. $
Power con- 100 % 62 % 23 % 6% 9%

sumption
This second table provides a list of potential cost drivers. To allocate the remaining costs
to all departments in phase one of the allocation process, the cause-and-effect relation-
ship must be considered. For each cost position, we need to determine which of the five
available parameters is most closely causally linked to the respective cost position to allo-
cate to all departments. Although there is no perfect cost driver to use, consider the fol-
lowing assignment of cost drivers:
59
• Building insurance is allocated based on the area occupied by each department, which
isbased on the assumption that each sqm is insured at the same premium.
• Machine insurance is allocated based on the book value of the machinery.
• Rent for buildings is allocated based on the area in sqm.
• Heating, lighting, and cooling are allocated based on the power consumption.
Once the cost drivers are selected, the costs can now be allocated. Each department
absorbs each cost position in question in the same proportion as it uses the cost driver.
The calculation applied in the table below, therefore, inserts direct proportion. For exam-
ple, to allocate the appropriate building insurance amount to the machine hall depart-
ment, the calculation is
total costs·sqm occupied by the machine hall

total sqm
$ 250, 000 · 1, 800sqm

= 3, 350sqm
Finally, the following cost allocation is the result of phase one:
Table 25: Phase One Cost Allocation for Overhead Analysis Sheet
Phase 1 Machine Materials Technical

(in $) hall Finishing storage support Total
Direct labor 250,000.00 3,600,000.00 $- $- 3,850,000
Direct 2,400,000.00 1,300,000.00 $- $- 3,700,000

materials
Indirect 350,000.00 250,000.00 400,000.00 1,100,000.00 2,100,000

labor
Indirect 360,000.00 230,000.00 3,000,000.00 780,000.00 4,370,000

materials
Deprecia- 920,000.00 77,000.00 7,000.00 6,000.00 1,010,000

tion
Building 134,328.36 59,701.49 37,313.43 18,656.72 250,000

insurance
Machine 420,588.24 94,823.53 1,835.29 2,752.94 520,000

insurance
Rent for 967,164.18 429,850.75 268,656.72 134,328.36 1,800,000

buildings
Heat, light, 1,488,000.00 552,000.00 144,000.00 216,000.00 2,400,000

cooling
Total costs 7,290,080.77 6,593,375.77 3,858,805.44 2,257,738.02 20,000,000
60
In phase 2, the service department costs are allocated to production departments. Mate-
rial storage costs are reallocated based on direct material values, and technical support
costs are reallocated based on machine hours. Again, the costs to distribute are allocated
in the same proportion as the cost driver used by the production departments. For exam-
ple, to calculate the cost the machine hall absorbs from materials storage, we would use
total costs of materials storage·costs for direct materials machine hall

total costs for direct materials
$ 3,858,805.44 · $ 2, 400, 000

= $ 3, 700, 000
Table 26: Phase Two Cost Allocation for Overhead Analysis Sheet
Phase 2 Machine Materials Technical

(in $) hall Finishing storage support Total
Total costs 7,290,081.77 6,593,375.77 3,858,805.44 2,257,738.02 20,000,000.00

phase 1
From materi- 2,503,008.94 1,355,796.51 -3,858,805.44 $-

als storage
From sup- 2,084,065.86 173,672.16 -2,257,738.02 $-

port
Total Costs 11,877,155.57 8,122,844.43 $- 20,000,000.00
The sum of the costs from phase 1 and the costs allocated from the service departments is
still $20,000,000.
In phase 3, the costs will finally be allocated to cost objects. Instead of products, in this
case the manufacturer wants to know the total costs per DLH or machine hour. The costs
of the machine hall are allocated to machine hours, as automated production is strongly
machine-based and features only a few DLH in comparison, whereas the costs of finishing
are allocated to DLH.
Table 27: Phase Three Cost Allocation for Overhead Analysis Sheet
Phase 1 (in $) Machine Hall Finishing Total
Total costs phase 2 11,877,155.57 8,122,844.43 $20,000,000.00
Machine hours 6,000.00
DLH 180,000.00
Costs per hour 1,979.53 45.13
The total costs per hour are $1,979.53 for the machine hall and $45 for the finishing.
61
SUMMARY
An overhead analysis sheet allows the inclusion of all costs of a (large)
company into the cost analyses of individual products or product
ranges. Even cost positions that are completely unrelated to operations,
such as the rent paid for administrative offices are considered and thus
can become part of the analysis. In a three-stage process all costs are re-
allocated to the cost objects in consideration.
Firstly, all costs incurred and registered by financial accountants are

allocated to all departments of the organization. In the second step, sup-
port or service department costs are re-allocated to operating or pro-
duction departments. In the final step, costs are allocated to specific
cost objects, usually products produced by the company.
In the process of this analysis, department or functional unit costs for

the company become transparent. However, there is still the potential
problem that the cost allocation methods applied are not fully without
error or are at least debatable due to some unavoidable arbitrariness in
cost driver selection. As many organizational cultures spark internal
competition, department heads may find themselves under attack for
lack of cost efficiency in an internal competition. Conflicts of interest
may arise particularly where departments are treated unfairly through
inappropriate cost allocation approaches.
62
UNIT 6
RELEVANT COST CONCEPTS
STUDY GOALS
– the definitions of relevant and irrelevant revenue and cost data.

– the major criteria to consider in outsourcing decisions.
– the most important quantitative and qualitative criteria in make-or-buy decisions.
– to differentiate when the acceptance of special orders is viable.
– to evaluate whether dropping a product line improves the bottom line.
6. RELEVANT COST CONCEPTS
Introduction
In past decades, following the rise of China to the “workbench of the world,” many compa-
nies all over the world outsourced and offshore production to Chinese factories. They
were attracted by low wages, huge availability of labor, and tremendous production
capacities of suppliers willing to provide the desired quantity and specification of any
goods. During recent years, however, an increasing number of European manufacturers’
production has returned to their home countries as cost advantages diminish. Labor costs
in China are still lower than in Western European countries but are sharply rising – and
other costs such as logistics, transportation, and direct material (to be purchased at the
same price worldwide) diminish labor cost advantages.
A German case in point is the plush toys company of Steiff, known as a premium brand. In
2009, the company halted some of its overall production in China because the Chinese
supplier often missed delivery deadlines and had a high staff turnover, leading to quality
problems detrimental to a high-quality and tradition-rich brand (Erling et al., 2008). With
labor costs in China increasing by 20% per year, and many miscalculated offshoring ven-
tures, fears that manufacturing would disappear from Germany altogether were prema-
ture (Schlandt, 2012). China still is an option for offshore production despite diminishing
cost advantages, but it is much more interesting as a sales market – especially for export-
driven nations such as Germany.
6.1 Foundational Cost Concepts

There are many decisions managers face in their daily business. Some decisions have a
bigger impact than others, and some have long-term consequences. Closing factories, out-
sourcing departments, expanding production, and investing in new business segments are
examples of larger decisions with consequences. Cost data are a major source of informa-
tion when making such decisions. In an extension of that idea, both cost and revenues are
important to consider because the relationship between revenues and costs determines
the bottom-line outcome of profit or loss. For a reasonable picture of likely outcomes of
decisions, current data and projections of future benefits are often required.
Relevant costs The concept of relevant costs refers to the consideration only of data that are relevant for
These costs differ the specific decision in question and ignoring all irrelevant data. In terms of costs, only the
between decision alterna-
tives. costs that differ between decision alternatives are relevant. All other costs are considered
to be irrelevant (Drury, 2018).
A typical case of irrelevant costs are sunk costs. These are costs incurred or committed in
the past that cannot be changed. Such costs would include for example license fees
already paid for a product that cannot be recovered regardless of the use of the license to
produce this product (Drury, 2018).
64
6.2 Cost Decisions Sunk costs
These are costs that can-
not be recovered with a
decision alternative and
Replacement of Equipment are therefore considered
irrelevant.
One classic type of decision relying on relevant cost data is the replacement of equipment,
which may entail a significant investment. Major criteria to consider in such decision sce-
narios include
• calculating and deciding on the purchase price and financing options (incorporating
opportunity costs and the time value of money). Opportunity costs
• power/fuel consumption (new machines tend to be more efficient). These costs represent the
benefits a business
• the difference in other operating costs (new equipment tends to promise efficiency misses out on when
gains but may require additional staff training). choosing one alternative
• modification requirements at existing factory buildings. over another.
Time value of money
• the projected lifetime of old versus new equipment.
This assumes that the
• the projected development of the market, demand, and economic environment. same amount of money is
more valuable today than
it is in the future.
There is no optimum time to replace equipment, or it would at least be almost impossible
to know it if there was one. Replacing equipment too early means that the remaining life-
time of the old machines is given up along with the profit potential of fully depreciated
assets. A major financial/investing burden would also be incurred. Replacing equipment
too late means that frequent or costly repairs of old equipment are incurred, probable
downtime or disruption in production can happen, and efficiency gains of new genera-
tions of machines are likely missed (Drury, 2018).
The following example illustrates the application of relevant costs in the case of replace-
ment decisions. A business has encountered a machine breakdown. The equipment in
question can be repaired rather quickly, but the management is now also considering
replacing the old machine to prevent another breakdown. Thus, the data the machine
manufacturer provide for the new machine and the internal data for the old machine must
be compared to make a decision.
Table 28: Replacement of Equipment (Full Cost Analysis)
Repairing the old Buying the new

(in $) machine machine
Revenue 18,000,000.00 18,000,000.00

(15,000 units sold at 1,200)
Operating costs Staff costs 332,500.00 -

(9,500 hours at $35
each)
Staff costs 0 175,000.00

(5,000 hours at $35
each)
Power costs 84,000.00 75,000.00
65
Repairing the old Buying the new
(in $) machine machine
Staff training costs - 24,000.00
Repair costs 8,000.00 ---
Deduction of the machine 11,500.00 11, 500.00
Current disposal value of old - -4,500.00
Price of new machine - 125,000.00
Total costs 436,000.00 406,000.00
Operating income 1,364,000.00 1,394,000.00
This table includes some irrelevant information, which will not change according to the
chosen decision. The table yields the same bottom line when only considering the rele-
vant cost positions.
Table 29: Replacement of Equipment (Relevant Cost Analysis)
Repairing the old

(in $) machine Buying the new machine
Operating costs (summarized) 416,500.00 250,000.00
Staff training costs - 24,000.00
Repair costs 8,000.00 -
Current disposal value of old - -4,500.00
Price of new machine - 125,000.00
Total costs 424,500.00 394,500.00
The decision whether to keep and repair the old machine results in $30,000 higher cost (or
less operating income) than the replacement decision. We achieve the same overall differ-
ence by considering only the relevant positions. The revenue is irrelevant, as it does not
change with either decision. The book value of the old machine is irrelevant because it can
be considered sunk costs (either it is depreciated as a lump sum when replaced now or
periodically if repairing and keeping it). Relevant costs include the different operating
costs, repair versus staff training costs, the current disposal value of the old machine
(which will be a benefit realized in case of replacement), and the price of the new
machine. Note that for reasons of simplification and a focus on relevant information, we
ignore the time value of money in this example and that the actual useful lifetime for both
machines from the time of decision is assumed the same for both decision alternatives.
66
Make-or-Buy
Another type of decision relying on relevant cost data is the make-or-buy scenario. Com-
panies with the capacity and expertise to manufacture products or components neverthe-
less often consider contracting out production to suppliers and purchasing the goods/
parts needed if this move has cost-saving effects. Beyond mere cost-saving, sometimes
additional aspects, such as freed-up capacity and resources, can be beneficial. Various
strategic considerations may also drive outsourcing decisions. One important basis of Outsourcing
make-or-buy decisions is relevant cost information (Atkinson et al., 2012). Consider the This is the process of pay-
ing to have a part of a
following example: McMullen Ltd. of Galway, Ireland requires 5,000 units of an electronic company's work done by
component for their manufacturing process. Currently, these components are produced another company.
in-house. The management considers an outsourcing move, and a first offer from a sup-
plier is received to buy the components at $30 each . The cost data of the currently prac-
ticed in-house production are as follows:
Table 30: Make-or-Buy: Initial Data
(in $) Total costs Costs per unit
Fixed costs Rent $25,000.00 $5.00
Depreciation $12,500.00 $2.50
Variable costs Direct materials $20,000.00 $4.00
Direct labor $100,000.00 $20.00
Total $157,500.00 $31.50
When looking at the initial data, the external offer of $30 per unit looks more attractive, as
it seems to save $1.50 per unit produced. However, a closer look at only the relevant costs
of the outsourcing option changes the picture.
Table 31: Make-or-Buy: Cost Comparison
Costs (in $) Make Buy
Variable costs $24.00 30
Neither fixed cost positions are relevant for this decision because, in the short run, these
costs cannot be avoided even if outsourcing and stopping in-house production is chosen.
The contract for the rent is still running and depreciation continues, assuming the
machines in use so far for production cannot be sold immediately. Thus, only the variable
cost of production could be avoided, assuming that the workforce so far performing direct
labor can be released (or deployed otherwise in the company). A total cost comparison
would therefore add the fixed costs per unit of $7.50 to the offer of $30, making it $37.50
versus $31.50 for continued in-house production. The relevant cost analysis is sufficient to
67
get the same bottom line: a difference of $6 per unit in favor of continuing the production.
Based on this information, the company could, of course, renegotiate with the supplier to
possibly get an offer below $24 per unit, which would turn the picture around.
But a business needs to be aware that cost should not be the only criterion in favor of out-
sourcing. As mentioned before, such a short-sighted or limited view can and most likely
will backfire. Problems can arise in areas such as
• quality. Foreign suppliers may not meet a company's quality standards. Especially at
the beginning of a new supply relationship, much time and many trial production runs
may be required before the defined parameters are met.
• reliability. It cannot always be taken for granted that suppliers will be punctual in deliv-
ery and/or capable of delivering the promised goods or services.
• logistics. The coordination of international supply chains is complex, especially in the
case of just-in-time patterns. In addition, there may be costly disruptions to interna-
tional transportation due to regional material shortages, volcano ashes hindering air
cargo, piracy threatening ships, local workforce strikes, etc.
• image. Many customers of high-priced goods wonder why they should pay so much for
goods “made overseas” (i.e., in low-cost countries) and may refrain from consuming
that brand or at least react critically.
Special Order
The third type of decision relying on relevant cost data is related to whether exceptional
offers should be made in response to special requests. The typical challenge is to decide
whether a one-time batch is sold at a lower price than normally calculated and offered
(Atkinson et al., 2012). Consider the following case: a manufacturer produces, as part of
their standard product range, a high-quality table that is sold via exclusive furniture retail-
ers at $2,500. The company has the capacity to manufacture 1,000 units of this table per
year and currently operates at 75% of its capacity (750 units per year). The following costs
apply.
Table 32: Special Order: Initial Data
Variable costs Direct materials ($600 each) $450,000.00
Direct labor (1,000 each) $750,000.00
Fixed costs $375,000.00
Total costs $1,575,000.00
It is assumed that a furniture retailer, looking for a one-time special product to sell at their
150th company anniversary, approaches the manufacturer and wants to buy 150 units of
the table at $1,800. To analyze whether accepting this request is viable, the following anal-
ysis is conducted, comparing the difference in the bottom line resulting from the varying
cost and revenue figures for the two options.
68
Table 33: Special Order Cost Analysis (Scenario 1)
Without special With special

(in $) order order
Revenue Regular 1,875,000.00 1,875,000.00
Special order — 270,000.00
Costs Variable costs 1,200,000.00 1,440,000.00
Fixed costs 375,000.00 375,000.00
Gross profit 300,000.00 330,000.00
In this case, it is only relevant to regard the difference in gross profit as with the special
order the revenue increases by $270,000, and the total costs increase by $240,000. Thus,
the special order generates an additional profit of $30,000 and is therefore attractive and
should be realized. As long as an extra order’s revenues exceed its variable costs, the result
will always be an increased income.
Be aware that the result would look different if a special order resulted in production
exceeding capacity. In this case, the regular production would have to be cut to fulfill the
extra batch, reducing regular revenue. Consider the following alteration of the example:
the regular sales now are 1,000 units, meaning that the company already operates at full
capacity utilization. Accepting the special order would result in regular production being
reduced from 1,000 units to 850 to fit the 150 units for the special order into the produc-
tion schedule. Hence, regular unit revenue is cut.
Table 34: Special Order: Cost Analysis (Scenario 2)
Without spe- With special

(in $) cial order order
Revenue Regular 2,500,000.00 2,125,000.00
Special order — 270,000.00
Costs Variable costs 1,600,000.00 1,600,000.00
Fixed costs 375,000.00 375,000.00
Gross profit 525,000.00 420,000.00
In this scenario, the schedule with the special order only leads to diminished overall reve-
nue. Fixed and variable costs are identical under either schedule because the number of
units produced would be the same. In this scenario, the company should not accept the
additional order. That is a very typical outcome of these types of analysis. Whenever
capacity constraints require a special order to give up at least some portion of a compa-
69
ny's regular production and sales, the lower contribution of the special offer units com-
pared to their regular counterparts’ contribution bites into the profit. If a company runs at
100 percent capacity utilization with regular products, accepting a special offer will never
be more profitable if the sales price for the special order is lower than the regular sales
price. However, if there is some capacity left, while the special offer still requires a cut in
regular production, only the analysis will show whether accepting the offer yields a better
bottom line.
Drop Product Line
A similar logic applies in the case of the fourth type of decision relying on relevant cost
data, which is whether to drop or hold on to product lines (Drury, 2018). Consider the fol-
lowing example: the management of a manufacturing company is looking at the current
product profitability analysis table.
Table 35: Drop Product Line: Initial Data
Product 1: Product 2: Product 3:

Holiday Business Hiking
(in $) sandal loafer boot Total
Units sold 16,000 10,000 14,000 40,000
Selling price per unit 29.50 89.50 99.50
Revenues 472,000.00 895,000.00 1,393,000.00 2,760,000.00
Variable Direct materials 176,000.00 176,000.00

costs ($11 each)
Direct materials 330,000.00 330,000.00

($33 each)
Direct materials 616,000.00 616,000.00

($44 each)
Direct labor ($8 128,000.00 128,000.00

each)
Direct labor ($55 550,000.00 550,000.00

each)
Direct labor ($42 588,000.00 588,000.00

each)
Fixed costs 120,000.00 75,000.00 105,000.00 300,000.00
Operating income 48,000.00 –60,000.00 84,000.00 72,000.00
Being unhappy with the loss-making business loafer, the management considers dropping
this product. That would leave the company with the holiday sandals and the hiking boots
as their remaining products. The resulting scenario analysis (with all other data remaining
the same) would be as follows:
70
Table 36: Drop Product Line: Analysis
Product 1: Product 3:
Holiday Hiking
(in $) sandal boot Total
Units sold 16,000 14,000 30,000
Selling price per unit 29.50 99.50
Revenues 472,000.00 1,393,000.00 1,865,000.00
Variable costs Direct materials 176,000 616,000.00 716,000.00

($11 each)
Direct materials 616,000.00

($44 each)
Direct labor ($8 128,000 128,000.00

each)
Direct labor ($42 588,000.00 588,000.00

each)
Fixed costs 160,000.00 140,000.00 300,000.00
Operating income 8,000.00 49,000.00 57,000.00
Now the two remaining products are both profitable – but the overall operating income
will decrease from $72,000 to $57,000. This is because dropping product 2 means that
both its revenue and its variable costs are eliminated. The revenue given up is $895,000,
while the variable costs saved amount to $880,000. As revenue minus variable cost is the
contribution, one can say that product 2 contributes $15,000. That is exactly the difference
between the two operating income figures.
Note that fixed costs in total remain the same but are now distributed over just two
instead of three products. Therefore, the fixed costs per unit went up from $7.50 to $10.
Thus, keeping the loafer in the production program is advisable. But in the long run, drop-
ping the product could change fixed cost.
SUMMARY
The concept of relevant costs represents a specific view of costs in deci-
sion-making situations. It assumes that only those costs that differ
across available alternatives are relevant for consideration when trying
to make an appropriate decision. Any costs that don't differ are consid-
ered irrelevant. This perspective is not limited to costs, but also applies
for revenues. Thus, revenue figures that differ across alternatives should
be considered.
71
In most cases, fixed costs are irrelevant, at least in the short run. For that
reason, any decision taken now will not change them. For example, the
rent a business has committed to pay for a year cannot be altered even if
the management decides right now not to use the rented building any
longer. But there are no fixed costs and no irrelevant costs in the long
run because at some point each contract ends or can be terminated.
Typical decision scenarios where relevant cost concepts are applied

include the replacement of old equipment, the (non-)acceptance of spe-
cial orders at discount selling prices, make-or-buy decisions, and drop-
ping or continuing product lines. Potential alternative uses of freed-up
resources, finance principles such as the time value of money, and long-
term qualitative consequences make such decisions more complex than
the basic relevant cost analysis suggests.
72
UNIT 7
BUDGETS
STUDY GOALS
– the major characteristics of a budget.

– the components of a master budget.
– the interdependence of budgets within the master budget.
– how to assemble operating budgets.
– the importance of liquidity.
– the components of a cash budget.
– how to derive budgeted cash collections and payments resulting from operating budg-
ets.
7. BUDGETS
Introduction
For some time now, budgeting has been one of the central instruments of success-orien-
ted corporate management in many companies. This management tool was developed to
keep increasingly complex and diversified companies controllable. Therefore, the intro-
duction of budgets was a reaction to the growing complexity of companies and makes it
possible to handle the planning process by systematically comparing the various knowl-
edge bases (centralized: overall company view, decentralized: detailed production and
market knowledge).
A budget can be defined as follows: “budgets in organizations reflect in quantitative terms

how to allocate financial resources to each part of an organization […] based on planned
activities and short-run objectives of that part of the organization” (Atkinson et al. 2012, p.
420). Based on this, budgets fulfill different functions including:
• coordinating,
• initiating,
• motivating,
• planning,
• allocating resources,
• indicating, and
• controlling.
7.1 The Budgeting Process

Budget Budgeting is a crucial activity in businesses. A budget is the quantified formulation of a
A budget is a plan to show plan of an organization’s activities for the following business period(s). Hence, budgets
how much money a busi-
ness will earn and how largely consist of figures of units, revenues, and costs into which the planned activity is
much it will be able to translated. Budgeting is crucial insofar as it directs the activity of the following month,
spend. quarter, or year (sometimes even several years), which will have consequences, such as
costs incurred, staff hired or fired, and capacity build-up or reduction. Major aspects to
consider in the budgeting process include (Drury, 2018):
• vision and mission of the organization,

• long-term and short-term strategic objectives, and
• external environment.
The budgeting process is quite complex. A large amount of interdependent data, much of
which consists of projections of an insecure future, is evaluated and generated. Even the
organizational culture is considered in this process. In some companies, a top-down
approach is practiced. Only a secluded circle of executives devises the targets everyone
else must live with for the period covered. The opposite approach, bottom-up, considers
74
input from the shop-floor (i.e., front-line employee) level. In reality, most organizations
practice an in-between approach with an emphasis on goals defined and devised from the
top floor but integrating input from operational departments to some degree. The budget
is like an overarching stage direction guiding the activity of ultimately every section,
branch, department, and employee of a company. To be meaningful and effective, budg-
ets should be:
• ambitious (setting targets too high triggers frustration and setting them too low results
in little motivation to go the extra mile),
• realistic (setting targets beyond reach leads to capacity build-up and causes significant
costs that cannot be covered as sales lag behind),
• crafted with the input of operating departments (omitting the know-how of operational
staff will result in less realistic data),
• well-communicated (to avoid rumors, frustration, and lack of orientation and to enable
department heads to organize resources).
The way of deriving, building, interacting with, and communicating budgets and related
information reveals a lot about organizational cultures. Highly hierarchical companies will
more or less “dictate” targets top-down. Lower levels must comply with the rules and
deliver what higher levels (or just the top floor) want to be delivered. Start-ups will fre-
quently adjust budgeting data, especially in dynamic growth phases, and possibly play
more by ear than by accurate analysis. Corporations listed in stock markets usually have a
short-term orientation, and investors want to read optimistic if not enthusiastic sales and
particularly profitable forecasts. Even warnings if there are indications that budgeted
profits will most likely not be achieved in the current market situation have to be pro-
claimed timely according to stock market rules and regulations. In contrast, family-owned
traditional businesses tend to look at longer terms since they try to protect the family
business and therefore plan more cautiously (Atkinson et al., 2012).
The budgeting process requires the alignment of interdependent data to prepare for the
next business period. The package of interrelated budgets covering separate business
functions or activities is often referred to as the master budget. Within it, we can distin-
guish between operating budgets (schedules of activities) and financial budgets (financial
data, in particular, vital projections of cash flows). The overview of a simplified master
budget can look as follows.
75
Figure 11: Operating Budgets
Source: Atkinson et al., 2012.
The master budget consists of operating and financial budgets. The operating budgets
usually include
• the sales budget,

• the production budgets, and
• the administrative expense budget.
The cash budget, the budgeted balance sheet, and the budgeted cash flow statement are
part of financial budgeting. The budget income statement lies in between (Atkinson et al.,
2012).
7.2 Different Types of Operating Budgets

Sales Budget
The first budget to draft is the sales budget. It drives all other budgets, since, generally, all
activities and expenditures depend on how many units a company intends to sell in the
next period. The sales budget contains quantities of output and the resulting revenue
76
(which means the sales price also needs to be decided or projected at that point) (Drury,
2018). In the following example, the budget is designed for the next year, and the data are
shown per quarter.
Table 37: Sales Budget Example
Q1 Q2 Q3 Q4
Units 5,000 6,000 5,000 4,000
Price per unit $ 350 350 350 350
Revenue $ 1,750,000 2,100,000 1,750,000 1,400,000
As the starting point of the budgeting process and the initial component of the master
budget, meaningful content is crucial for the sales budget. There is much leeway for the
key decision-makers of the company to set the sales goals and translate them into their
respective budget figures. There is considerable responsibility in setting targeted sales
figures, as the characteristics of meaningful budgets mentioned before need to be consid-
ered thoroughly.
Besides the decision-makers’ leeway, much of the data are derived from previous periods
through forward-projection of past data, which helps the process remain realistic. How-
ever, in new markets no such data are available. In any case, market research may feed
data into the budgeting process. Furthermore, knowledge of the market context and
(anticipated) behavior of competitors such as their pricing moves, market share ambi-
tions, or planned capacity changes are relevant.
Production Budgets
Knowing intended sales, the company must now determine how many units need to be
produced. Consider a company that wants to sell 5,000 units of its product in the first
quarter of next year. In principle, that is the number of units they need to produce. How-
ever, there may be another variable: inventory reserve. It is a typical policy to have some
inventory of finished units in reserve in case there is a disruption of production/logistics or
to prevent lost sales opportunities in case the demand is higher than anticipated. Let’s
assume the policy is to have 10% of the following period’s budgeted units as a reserve
inventory on hand at all times. The units budget would look like this:
77
Figure 12: Production Units Budget
Once the number of units to produce is known, the direct material budget (DM budget)
can be extrapolated. The information required is the volume of raw material needed to
produce each unit expressed in gallons, tons, kilograms, or whatever is applicable (Drury,
2018). In this example, three kilograms of raw material are needed per product unit. Again,
there is a policy of stocking 10% of the following quarter’s need as ending inventory each
quarter. Furthermore, the cost of the material is considered (if no contracts have been
negotiated yet with suppliers, this figure is also a projection or an estimate). Each kilo-
gram of the raw material is expected to be procured at $8. The bottom line of the budget
shows the cost incurred for the purchase of the raw material corresponding to the inten-
ded sales and production:
Figure 13: Direct Materials Budget
78
In the next step, the direct labor budget (DL budget) is conducted. Effectively, a company
could build this one parallel to the DM budget because it likewise draws its essential infor-
mation from the units budget. Once a company knows how many units to produce, the
corresponding labor force can be planned (Drury, 2018). The following information is
available for this case: each unit to be produced requires five direct labor hours at $20 of
semi-skilled labor and two direct labor hours at $25 of skilled labor. The bottom line of the
DL budget will show the projected total cost of direct labor for each quarter.
Table 38: Direct Labor Budget
Q1 Q2 Q3 Q4
Units in production 5,100 5,900 4,900 3,950
Semi-skilled Number of 25,500 29,500 24,500 19,750

hours hours
Costs ($20 per 510,000.00 590,000.00 490,000.00 395,000.00

hour)
Skilled hours Number of 10,200 11,800 9,800 7,900

hours
Costs ($25 per 255,000.00 295,000.00 245,000.00 197,500.00

hour)
Total direct labor hours 35,700.00 41,300 34,300 27,650
Total costs in $ 765,000.00 885,000.00 735,000.00 592,500.00
The last production budget is the (factory) overhead budget. The company assumes from
experience that, per direct labor hour, $3.25 of variable overhead is incurred (consisting of
indirect materials). The budgeted number of direct labor hours is taken from the direct
labor budget. Fixed overhead costs are also projected. These include depreciation, which
is deducted to get the disbursement amounts for each quarter. Remember that deprecia-
tion is a non-cash expense and therefore relevant for income projections but not for cash
flow planning (Drury, 2018). The factory overhead budget would look as follows.
Table 39: Overhead Budget
(in $) Q1 Q2 Q3 Q4
Variable overhead 116,025.00 134,225.00 111,475.00 89,862.50
Fixed overhead 150,000.00 150,000.00 170,000.00 170,000.00
Total overhead 266,025.00 284,225.00 281,475.00 259,862.50
Less depreciation 35,000.00 35,000.00 55,000.00 55,000.00
79
(in $) Q1 Q2 Q3 Q4
Total disbursement 231,025.00 249,225.00 226,475.00 204,862.50
Administrative Expense Budget
The next budget is the administrative expense budget. It includes all administration-rela-
ted, selling, and marketing expenses; it is essentially grouping all expenses that are not
production-related. Besides variable selling expense, cost data are not derived from any
other operating budget but are projected as a separate activity for the respective depart-
ments. Variable selling expense may contain several items, but it primarily refers to sales
commissions or bonus payments granted to employees, retailers, or other sales force part-
ners in direct relation to how much they sell during the defined time. Therefore, such posi-
tioning of the administrative expense budget depends on sales budget figures, although it
cannot be directly retrieved. The total budgeted sales figure does not yet differentiate who
sells how much of it, and some bonus/commission schemes would require more detailed
input in this regard to determine the total variable selling expense (Drury, 2018).
Once again, there is a position of non-cash expenses, consisting of depreciation plus bad
Bad debt expense debt expense. For this example, it is assumed that there is $2.50 of variable selling
This is a provision for expense per unit sold (e.g., for packaging). The total expense figures will be relevant for
uncollectable receivables,
e.g., due to insolvent cus- the budgeted incomes statement, whereas the disbursement figures will be needed for
tomers who cannot pay the cash budget.
their invoices anymore.
Table 40: Administrative Expense Budget
(in $) Q1 Q2 Q3 Q4
Variable selling
expenses 12,500 15,000 12,500 10,000
Fixed selling expen- 89,500 89,500 89,500 89,500

ses
Total expense 102,000 104,500 102,000 99,500
less non-cash 14,000 15,200 13,000 12,450
Total disbursement 88,000 89,300 89,000 87,050
Budgeted Income Statement
Having finished all the operating budgets, companies can use their respective bottom
lines to compile a summary of the projected revenues and expenses to be generated or
incurred during the budgeted period. Compiling all revenue and cost-related information,
80
i.e., all sales and expense data, they receive the expected profit or loss for the budgeted
period. Hence, the document is referred to as a budgeted income statement. It corre-
sponds with a normal income statement with the exception that the latter is assembled Income statement
at the end of the business period being reported and therefore contains actual instead of The income statement is
a financial statement fea-
projected data. turing all revenues and
costs of an organization
The budgeted income statement shows in a summarized format the bottom line, i.e., for a specified period.
profit or loss, to expect if business is conducted according to budgets. If the result is not
satisfying, the budgeting process will have to be started anew. Remember to keep in mind
that realistic data are key to meaningful budgeting. However, there are adjustable ele-
ments, such as negotiable purchase prices of input or stacking up capacities for any plan-
ned expansion, that can play a role in achieving more desirable results in the budgeted
income statement (Drury, 2018).
In this example, the following result is achieved by incorporating all operating budgets as
a budgeted income statement. The costs of goods sold comprise direct material, direct
labor, and overhead, i.e., the typical three components of product costs. In the example
below, a 30% income tax rate is assumed.
Table 41: Budgeted Income Statement
(in $) Q1 Q2 Q3 Q4
Sales revenue 1,750,000.00 2,100,000.00 1,750,000 1,400,000
Cost of goods sold 1,130,808.82 1,333,042.37 1,157,219.39 959,151.90
Admin expenses 102,000.00 104,500.00 102,000.00 99,500.00
Income before tax 517,191.18 662,457.63 490,780.61 341,348.10
Income tax (30%) 155,157.35 198,737.29 147,234.18 102,404.43
Net income 362,033.82 463,720.34 343,546.43 238,943.67
7.3 Financial Budgets

“Cash is king” is a famous motto in the business world. It holds a truth: without liquidity,
companies cannot meet their obligations, such as paying bills, taxes, and salaries. Liquid-
ity is even more important than profitability, at least in the short run. Especially for start-
ups with little to no experience in a market they enter, it is difficult to come up with mean-
ingful projections. Monthly planning is advisable, and frequent updates of budgets upon
reality checks are helpful. Successful budgeting depends on accuracy and on the ability to
enact it. Many businesses get into trouble due to budgeted cash from customer collections
that do not materialize and ultimately fail to be paid.
81
Cash Budget
The cash budget projects the availability, generation, and use of cash throughout the
budgeted period. It is a crucial source of information because it helps identify whether
(and if so, when) cash shortages threaten the viability of a business. Early knowledge
about expected cash gaps helps companies to arrange financial options well ahead of
trouble. If the projected cash situation is unviable at any time covered by the budget, the
entire planning process might either have to restart or adjustments may be required to
steer the company toward a more viable path (Drury, 2018). The figures generated in the
cash budget result directly from the previous example.
The cash budget summarizes all receipts and disbursements. In the basic scenario, col-
lections are only generated from sales, so the data are transferred from there. All other
operating budgets provide information on how much cash will be spent for various purpo-
ses, such as production or administration.
Cash collections build the first part of the cash budget.
Revenue (from the sales budget) is expected to be collected. However, depending on col-
lection policies and terms of payment extended to customers, it is not granted that the
revenue figure and the collections in the same quarter are identical. In this context, the
following information is available:
• Eighty percent of sales are made on account, and 20 percent are made against cash.
• Of the sales on account, 75 percent of the collections happen in the same quarter as the
sales are made, 23 percent happen in the next quarter, and the remaining 2 percent are
likely to be bad debt.
• The revenues in the fourth quarter of the previous year were $1,300,000.
This information can be displayed as follows.
82
Figure 14: Cash Collection Scheme
The resulting cash collections part of the cash budget is assembled as follows.
Table 42: Cash Collections
(in $) Q1 Q2 Q3 Q4
From same
quarter 1,400,000 1,680,000 1,400,000 1,120,000
From previous 239,200 322,000 386,400 322,000

quarter
Total 1,639,200 2,002,000 1,786,400 1,442,000
In addition to the cash collection, the cash disbursements must be calculated. The data
needed for the overview of cash payments come from the direct materials (purchase)
budget, the direct labor budget, the overhead budget, and the administrative expense
budget.
In the case of DM purchases, the total cash disbursement for the quarter does not equal
the actual value of purchases. That is once again owed to the payment pattern as follows:
• Seventy percent of the purchases are made on account, and 30 percent are made
against cash.
• Of the purchases on account, 75 percent of payments happen in the same quarter as the
purchase is made; the other 25 percent in the next quarter.
• The DM purchase value in the fourth quarter of the previous year was $125,000.
83
The cash disbursement scheme for DM purchases is displayed as follows.
Figure 15: Cash Disbursement Scheme
The resulting cash disbursement section of the cash budget looks as follows.
Table 43: Direct Materials Cash Disbursement
(in $) Q1 Q2 Q3 Q4
For the same quar-

ter 102,564 114,840 95,139 77,319
For the last quarter 21,875 21,756 24,360 20,181
Total 124,439 136,596 119,499 97,500
It is assumed that all further disbursements are made in the same quarter as the related
cost is incurred. Additional disbursements are summarized as follows.
Table 44: Further Cash Disbursement
(in $) Q1 Q2 Q3 Q4
Direct labor budget 765,000.00 885,000.00 735,000.00 592,500.00
Overhead budget 231,025.00 249,225.00 226,475.00 204,862.50
Admin expense 88,000.00 89,300.00 89,000.00 87,050.00

budget
84
(in $) Q1 Q2 Q3 Q4
Direct labor budget 765,000.00 885,000.00 735,000.00 592,500.00
Total 1,084,025.00 1,223,525.00 1,050,475.00 884,412.50
To assemble the overall cash budget, the following additional information is provided:
• The cash balance at the beginning of the first quarter is $250,000.

• At the beginning of the third quarter, a new machine is purchased for $200,000 and paid
for in cash.
With this information, the cash budget is completed through the assembly of all relevant
portions.
Table 45: Completed Cash Budget
(in $) Q1 Q2 Q3 Q4
Cash balance
(beginning) 250,000.00 680,736.00 1,322,615.00 1,739,041.00
Collections 1,639,200.00 2,002,000.00 1,786,400.00 1,442,000.00
Direct materials 124,439.00 136,596.00 119,499.00 97,500.00

budget
Direct labor 765,000.00 885,000.00 735,000.00 592,500.00

budget
Overhead budget 231,025.00 249,225.00 226,475.00 204,862.50
Admin expense 88,000.00 89,300.00 89,000.00 87,050.00

budget
Machine purchase - - 200,000.00 -
Total 680,736.00 1,322,615.00 1,739,041.00 2,199,128.50
The budgeted cash-flow statement will correspond with the cash budget. Please note that
conducting the budgeted balance sheet here is not part of this course.
SUMMARY
A budget is the quantified formulation of a plan of an organization’s
activities for the following business period(s). Budgeting is crucial for
business insofar as it directs the activity of the budgeted period, which
85
will have consequences such as costs incurred, staff hired or fired, and
capacity build-up or reduction. Major aspects to consider in the budget-
ing process include the vision and mission of the organization, long-
term and short-term strategic objectives, and the external environment.
The budgeting process is quite complex, as a lot of data are generated

and evaluated. The organizational culture is important in the process as
it determines how important hierarchy is within a company. To achieve
realistic projections, which in turn are vital for allocating appropriate
resources, the incorporation of operating staff input is also advisable.
The budgeting cycle starts with the setup of the sales budget determin-
ing how much the business intends to sell during the budgeted period.
Production-related budgets follow in logical sequence, and then the
administrative expense budget is provided. These operating budgets
lead to the assembly of a pro-forma income statement showing how
much profit or loss is expected resulting from the projected business
activity.
“Cash is king” – without liquidity, companies cannot meet their obliga-

tions such as paying bills, taxes, and salaries. At least in the short run,
liquidity is even more important than profitability. Therefore, the cash
budget is highly important. It projects the cash inflows and outflows of
the budgeted period. Thus, it also helps detect potential cash shortages,
which can then be prevented by arranging short-term loans or through
collection or payment policy changes.
The cash budget comprises both cash collections and disbursements.

The former result from projected sales, the latter from projected produc-
tion, procurement, and administration activity, which all lead to expen-
ses that will have to be paid. It is important to be ambitious, yet realistic;
if the projected sales figures are too high, the projected cash collections
may not materialize.
86
BACKMATTER
LIST OF REFERENCES
Accountingformanagement.org (2020, May 25). Predetermined overhead rate. https://ww
w.accountingformanagement.org/predetermined-overhead-rate/
Atkinson, A. A., Kaplan, R., Matsumura, E. M., & Young, S. M. (2012). Management account-
ing: Information for decision-making and strategy execution (6th ed.). Pearson.
Drury, C. (2018). Management and cost accounting (10th ed.). Cengage.
Drury, C. (2019). Management accounting for business (7th ed.). Cengage.
The Economist Daily Chart. (2018, February 7). Rising oil prices are making more extrac-
tion methods viable. The Economist.https://www.economist.com/blogs/graphicdetail/
2018/02/daily-chart-3
Erling, J., Grabitz, I., & Hartmann, J. (2008, July 7). Was deutsche Unternehmen an China
stört [What German companies dislike about China]. Die Welt. http://www.welt.de/wirt
schaft/article2187955/Was-deutsche-Unternehmen-an-China-stoert.html
Friedman, T. L. (2006). The world is flat: The globalized world in the twenty-first century.
Penguin.
Griffin, J. M., & Teece, D. J. (2018). OPEC behavior and world oil prices. Routledge.
Merriam-Webster (n.d.). Cost. In Merriam-Webster.com dictionary. Retrieved May 27, 2020,

from https://www.merriam-webster.com/dictionary/cost
Schlandt, J. (2012, March 16). China adé—Firmen kehren nach Deutschland zurück [China
ade: Companies return to Germany] [Video]. Frankfurter Rundschau. https://www.fr.d
e/wirtschaft/china-firmen-kehren-nach-deutschland-zurueck-11311898.html
Schneider-Mayerson, M. (2015). Peak oil: Apocalyptic environmentalism and libertarian

political culture. University of Chicago Press.
Schütrumpf, K. (2012, January 22). Wie Vermieter Nebenkosten abrechnen [How landlords
settle service charges]. Handelsblatt. Retrieved from http://www.handelsblatt.com/fin
anzen/immobilien/ratgeber-hintergrund/immobilien-wie-vermieter-nebenkosten-abr
echnen/6092396-all.html#
Stocker, G. (2006). Avoiding the corporate death spiral. ASQ Quality Press.
88
LIST OF TABLES AND
FIGURES
Table 1: Overview of Major Differences between Management and Financial Accounting 13
Figure 1: Step Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Figure 2: Fixed and Variable Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Figure 3: Curvilinear Variable Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Table 2: Total Costs Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Figure 4: Mixed Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Figure 5: Fixed and Variable Costs per Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Figure 6: Break-Even Point . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Figure 7: CVP Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Table 3: Operating Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Figure 8: Product Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Figure 9: Period Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Table 4: Important Cost Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Table 5: Predetermined Overhead Rate Example Dataset . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Table 6: Departmental Overhead Rate Example Dataset 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Table 7: Departmental Overhead Rate Example Dataset 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Table 8: Comparison of Predetermined Overhead Rate and Departmental Overhead Rate

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Table 9: Overhead Over-/Under-Application Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Table 10: Activities of Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
89
Table 11: Initial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Table 12: Predetermined Overhead Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Table 13: Activity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Table 14: Activity Analysis with Cost Driver Volumes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Table 15: Cost Driver Rate Application (Sofa Bed) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Table 16: Cost Driver Rate Application (Office Chair) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Table 17: Predetermined Overhead Rate versus Activity-Based Costing . . . . . . . . . . . . . . . 49
Figure 10: Different Phases of Overhead Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Table 18: Reciprocal Method: Initial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Table 19: Phase One Overhead Analysis Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Table 20: Phase Two Additional Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Table 21: Phase Two Overhead Analysis Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Table 22: Phase Three Overhead Analysis Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Table 23: Cost Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Table 24: Overview of Potential Cost Drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Table 25: Phase One Cost Allocation for Overhead Analysis Sheet . . . . . . . . . . . . . . . . . . . . . 60
Table 26: Phase Two Cost Allocation for Overhead Analysis Sheet . . . . . . . . . . . . . . . . . . . . 61
Table 27: Phase Three Cost Allocation for Overhead Analysis Sheet . . . . . . . . . . . . . . . . . . . 61
Table 28: Replacement of Equipment (Full Cost Analysis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Table 29: Replacement of Equipment (Relevant Cost Analysis) . . . . . . . . . . . . . . . . . . . . . . . 66
Table 30: Make-or-Buy: Initial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Table 31: Make-or-Buy: Cost Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Table 32: Special Order: Initial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
90
Table 33: Special Order Cost Analysis (Scenario 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Table 34: Special Order: Cost Analysis (Scenario 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Table 35: Drop Product Line: Initial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Table 36: Drop Product Line: Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Figure 11: Operating Budgets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Table 37: Sales Budget Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Figure 12: Production Units Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Figure 13: Direct Materials Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Table 38: Direct Labor Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Table 39: Overhead Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Table 40: Administrative Expense Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Table 41: Budgeted Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Figure 14: Cash Collection Scheme . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Table 42: Cash Collections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Figure 15: Cash Disbursement Scheme . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Table 43: Direct Materials Cash Disbursement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Table 44: Further Cash Disbursement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Table 45: Completed Cash Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
91
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1.1 Definition of Management Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

2.1 Break-Even Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

3.1 Cost Behavior: Direct and Indirect Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

4.1 Basics of Activity-Based Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

5.1 Departmental Cost Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

6.1 Foundational Cost Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

7.1 The Budgeting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

Drury, C. (2019). Management accounting for business (7th ed.). Cengage.

Machuga, S. (2012). A case method approach to teaching cost-volume-profit analysis. Jour-

On completion of this unit, you will have learned …

– the purpose of management accounting.

1.1 Definition of Management Accounting

Therefore, Atkinson et al. (2012) deﬁne management accounting as follows: “Management

Table 1: Overview of Major Differences between Management and Financial Accounting

Management accounting Financial accounting

Audience Internal (e.g., managers and External (e.g., tax authorities,

Emphasis of information Relevance for the purpose of Precision, conformity/compli-

Time horizon • Future orientation • Coverage of the past

Formal requirements • Not mandatory • Mandatory

Source: Hastenteufel, 2020 based on Drury, 2019.

1.2 Definition of Cost

• direct and indirect costs,

Some of these cost types are considered in this course book.

1.3 Cost Behavior: Fixed and Variable

• How will costs and revenues change if volume is increased/decreased by X percent?

Definition of Fixed and Variable Costs

Figure 1: Step Costs

Source: Hastenteufel, 2020.

Figure 2: Fixed and Variable Costs

Source: Drury, 2018.

Source: Hastenteufel, 2020.

Total costs = total fixed costs + variable costs per unit·output

Table 2: Total Costs Example

Number of guests Fixed costs Variable costs Total costs

100 $1,000.00 $5.00 $1,500.00

150 $1,000.00 $5.00 $1,750.00

200 $1,000.00 $5.00 $2,000.00

250 $1,000.00 $5.00 $2,250.00

300 $1,000.00 $5.00 $2,500.00

350 $1,000.00 $5.00 $2,750.00

400 $1,000.00 $5.00 $3,000.00

Source: Hastenteufel, 2020.

Source: Atkinson et al., 2012.

Per Unit Costs

Source: Drury, 2018.

1.4 External Factors Influencing Costs

Global Competition and Supply Chains

Management accounting has elevated in importance over recent years.

On completion of this unit, you will have learned …

– what the break-even point is.

2.1 Break-Even Analysis

Break-Even Point (BEP)

Source: Drury, 2018.

Another essential concept in management accounting is called contribution margin. It is

• Total costs and revenues are linear functions of volume.

For the example, the calculation of BEP in units is as follows:

BEP in units = 30, 000