ARBAMINCH UNIVERSITY

COLLAGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

COST AND MANAGEMENT

ACCOUNTING II (ACFN3032)

Lecture Note for Exit Exam

Prepared By: Accounting & Finance Department

March, 2023

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Contents

CHAPTER 1 COST-VOLUME-PROFIT ANALYSIS, ABSORPTION COSTING, AND VARIABLE COSTING ...................3

CHAPTER 2 RELEVANT INFORMATION AND DECISION MAKING .................................................................... 19

Chapter 3 Information for budgeting, planning, and control purposes ......................................................... 44
CHAPTER 4 Standard Costing, Flexible Budgeting and Variance Analysis ...................................................... 71
CHAPTER 5 .................................................................................................................................................... 104
The pricing of goods and services ................................................................................................................. 104
Chapter 6....................................................................................................................................................... 113
Responsibility Accounting ............................................................................................................................. 113

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 CHAPTER 1
COST-VOLUME-PROFIT ANALYSIS, ABSORPTION COSTING, AND
VARIABLE COSTING
AN OVERVIEW OF ABSORPTION AND VARIABLE COSTING
Absorption costing is the traditional approach to product costing. Absorption costing treats the costs of all
manufacturing components (direct material direct labor, variable overhead and fixed overhead) as inventoriable
or product costs in accordance with generally accepted accounting principles (GAAP). Absorption costing is
also known as full costing.
Under absorption costing, costs incurred in the non-manufacturing areas of the organization are considered
period costs and expensed in a manner that properly matches with revenue.
Absorption costing presents expenses on an income statement according to their functional classifications. A
functional classification is a group of costs that were all incurred for the same principal purpose. Functional
classifications include categories such as cost of goods sold, selling expense, and administrative expense.
Under FASB Statement 34, certain interest costs may be capitalized during a period of asset construction. If a
company is capitalizing or has capitalized interest costs, these costs will not be shown on the income statement
but will become a part of the fixed asset cost. The fixed asset cost is then depreciated as part of fixed overhead.
Thus, although interest is typically considered period cost, it may be included as fixed overhead and affect the
overhead application rate.
Exhibit 1.1: Absorption Costing Model

Variable costing- facilitates the use of models for analyzing break-even point, cost-volume-profit relationships,
the margin of safety. Variable costing is a cost accumulation method that includes only variable production costs
(direct material, direct labor, and variable overhead) as product or inventoriable costs. Under this method, fixed
manufacturing overhead is treated as a period cost.

Like absorption costing, variable costing treats costs incurred in the organization’s selling and administrative
areas as period costs. Variable costing income statements typically present expenses according to cost behavior
(variable and fixed), although they may also present expenses by functional classifications within the behavioral

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categories. Variable costing has also been known as direct costing. Exhibit 1.2 presents the variable costing
model.
Exhibit 1.2: Variable costing Model

Two basic differences can be seen between absorption and variable costing. The first difference is the way fixed
overhead (FOH) is treated for product costing purposes.
Under absorption costing, FOH is considered as product cost; under variable costing, it is considered as period
cost. Absorption costing advocates contend that products cannot be made without the capacity provided by fixed
manufacturing costs and so these costs are product costs.
Variable costing advocates contend that the fixed manufacturing costs would be incurred whether or not
production occurs and, therefore, cannot be product costs because they are not caused by the production.
The second difference is in the presentation of costs on the income statement. Absorption costing classifies
expenses by function; whereas variable costing categorizes expenses first by behavior and then may further
classify them by function.
Variable costing allows costs to be separated by cost behavior on the income statement or internal management
reports. The cost of goods sold, under variable costing, is more appropriately called variable cost of goods sold
(VCGS) because it is composed only of variable production costs.
Sales (S) minus the variable cost of goods sold is called product contribution margin (PCM) and indicates how
much revenue is available to cover all period expenses and potentially provide net income.
Variable non-manufacturing period expenses (VNME), are deducted from the product contribution margin to
determine the amount of total contribution margin (TCM).
The total contribution margin is the difference between total revenues and total variable expenses. This amount
indicates the dollar figure available to “contribute” to the coverage of all fixed expenses, both manufacturing and
nonmanufacturing. After fixed expenses are covered, any remaining contribution margin provides income to the
company. A variable costing income statement is also referred to as a contribution income statement.
A formula representation of a variable costing income statement

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Major authoritative bodies of the accounting profession, such as the Financial Accounting Standards Board and
Securities and Exchange Commission, believe that absorption costing provides external parties with a more
informative picture of earnings than variable costing. By specifying that absorption costing must be used to
prepare external financial statements, the accounting profession has, in effect, disallowed the use of variable
costing as a generally accepted inventory method for external reporting purposes. Additionally, the IRS requires
absorption costing for tax purposes.

The Tax Reform Act of 1986 requires all manufacturers and many wholesalers and retailers to include many
previously expensed indirect costs in inventory. This method is referred to as “super-full absorption” or uniform
capitalization. The uniform capitalization rules require manufacturers to assign to inventory all costs that directly
benefit or are incurred because of production including some administrative and other costs. Wholesalers and
retailers, who previously did not need to include any indirect costs in inventory, now must inventory costs for
items such as off-site warehousing, purchasing agents’ salaries, and repackaging.
Cost behavior (relative to changes in activity) cannot be observed from the absorption costing income statement
or management report. However, cost behavior is extremely important for a variety of managerial activities
including cost-volume-profit analysis, relevant costing, and budgeting.

Absorption and Variable Costing Illustrations

Comfort Valve Company makes a single product, the climate control valve. Comfort Valve Company is a 3-year-
old firm operating out of the owner’s home. Data for this product are used to compare absorption and variable
costing procedures and presentations. The company employs standard costs for material, labor, and overhead.
Exhibit 1.3 gives the standard production costs per unit, the annual budgeted nonmanufacturing costs, and other
basic operating data for Comfort Valve Company. All standard and budgeted costs are assumed to remain
constant over the three years 2000 through 2002 and, for simplicity, the company is assumed to have no Work
in Process Inventory at the end of a period.4 Also, all actual costs are assumed to equal the budgeted and
standard costs for the years presented. The bottom section of Exhibit 11–3 compares actual unit production
with actual unit sales to determine the change in inventory for each of the three years.
The company determines its standard fixed manufacturing overhead application rate by dividing estimated
annual FOH by expected annual capacity. The total estimated annual fixed manufacturing overhead for Comfort
Valve is $16,020 and the expected annual production is 30,000 units. These figures provide a standard FOH
rate of $0.534 per unit. Fixed manufacturing overhead is typically under or over applied at year-end when a
standard, the predetermined fixed overhead rate is used rather than actual FOH cost.
Under- or over application is caused by two factors that can work independently or simultaneously. These two
factors are cost differences and utilization differences. If the actual FOH cost differs from the expected FOH
cost, a fixed manufacturing overhead spending variance is created. If actual capacity utilization differs from
expected utilization, a volume variance arises.
Actual costs can also be used under either absorption or variable costing. Standard costing was chosen for these
illustrations because it makes the differences between the two methods more obvious. If actual costs had been
used, production costs would vary each year and such variations would obscure the distinct differences caused
by the use of one method, rather than the other, over a period of time. Standard costs are also treated as constant
over time to more clearly demonstrate the difference between absorption and variable costing. The independent
effects of these differences are as follows:

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 Actual FOH Cost > Expected FOH Cost = Under applied FOH
Actual FOH Cost < Expected FOH Cost = Over applied FOH
Actual Utilization > Expected Utilization = Over applied FOH
Actual Utilization < Expected Utilization = Under applied FOH

Basic Data for 2000, 2001, and 2002 Exhibit 1.3

Sales price per unit------------------------------------------------------------------------------$ 6.00
Standard variable cost per unit
Direct material -----------------------------------------------------------------------------------$ 2.040
Direct labor-----------------------------------------------------------------------------------------1.500
Variable manufacturing overhead-------------------------------------------------------0.180
Total variable manufacturing cost per unit-----------------------------------------$ 3.720
Standard fixed factory overhead rate = Budgeted annual fixed factory overhead
Budgeted annual capacity in units

FOH rate = $16, 020/30,000 = $ 0.534

Total absorption cost per unit:
Standard variable manufacturing cost--------------------------------------------$3.720
Standard fixed manufacturing overhead (SFOH)----------------------------0.534
Total absorption cost per unit--------------------------------------------------------$4.254
Budgeted non-manufacturing expense:
Variable selling expense per unit-----------------------------------------------------$0.24
Fixed selling and administrative expenses --------------------------------------2, 340
Total budgeted non-manufacturing expense= (0.24 per unit + 2,340)

2000 2001 2002 Total

Actual units made 30, 000 29,000 31,000 90,0000
Actual unit sales 30,000 27,000 33,000 90,000
Change in FG inventory 0 +2,000 -2,000 0

In most cases, however, both costs and utilization differ from estimates. When this occurs, no
generalizations can be made as to whether FOH will be under or over-applied. Assume that Comfort
Valve Company began operations in 2000. Production and sales information for the years 2000 through
2002 are shown in Exhibit 1.3.
Because the company began operations in 2000, that year has a zero balance for beginning the Finished
Goods Inventory. The next year, 2001, also has a zero-beginning inventory because all units produced
in 2000 were also sold in 2000. In 2001 and 2002, production and sales quantities differ, which is a
common situation because production frequently “leads” sales so that inventory can be stock-piled for a
later period.
The illustration purposefully has no beginning inventory and equal cumulative units of production and
sales for the 3 years to demonstrate that, regardless of whether absorption or variable costing is used, the
cumulative income before taxes will be the same ($128,520 in Exhibit 1.4) under these conditions. Also,
for any particular year in which there is no change in inventory levels from the beginning of the year to
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 the end of the year, both methods will result in the same net income. An example of this occurs in 2000
as is demonstrated in Exhibit 1.4.
Because all actual production and operating costs are assumed to be equal to the standard and budgeted
costs for the years 2000 through 2002, the only variances presented are the volume variances for 2001
and 2002. These volume variances are immaterial and are reflected as adjustments to the gross margins
for 2001 and 2002 in Exhibit 1.4.

Volume variances under absorption costing are calculated as standard fixed overhead (SFOH) of $0.534
multiplied by the difference between expected capacity (30,000 valves) and actual production. For 2000,
there is no volume variance because expected and actual production is equal. For 2001, the volume
variance is $534 unfavorable, calculated as [$0.534 *(29,000 - 30,000)]. For 2002, it is $534 favorable,
calculated as [$0.534 * (31,000 - 30,000)].

Variable costing does not have a volume variance because fixed manufacturing overhead is not applied to
units produced but is written off in its entirety as a period expense.

Absorption and Variable Costing Income Statements for 2000, 2001, and 2002
Exhibit 1.4

Absorption Costing Presentation

2000 2001 2002 Total
Sales ($6 per unit) $180,000 $162,000 $198,000 $540,000
CGS ($4.254 per unit) (127,620) (114,858) (140,382) (382,860)
Standard Gross Margin $ 52,380 $ 47,142 $ 57,618 $157,140
Volume Variance (U) 0 (534) 534 0
Adjusted Gross Margin $ 52,380 $ 46,608 $ 58,152 $157,140
Operating Expenses
Selling and administrative (9,540) (8,820) (10,260) (28,620)
Income before Tax $ 42,840 $ 37,788 $ 47,892 $128,520

Variable Costing Presentation

2000 2001 2002 Total
Sales ($6 per unit) $180,000 $162,000 $198,000 $540,000
Variable CGS ($3.72 per unit) (111,600) (100,440) (122,760) (334,800)
Product Contribution Margin $68,400 $ 61,560 $ 75,240 $205,200
Variable Selling Expenses
($0.24 3 *units sold) (7,200) (6,480) (7,920) (21,600)
Total Contribution Margin $ 61,200 $ 55,080 $ 67,320 $183,600
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Fixed Expenses
Manufacturing $ 16,020 $ 16,020 $ 16,020 $ 48,060
Selling and administrative 2,340 2,340 2,340 7,020
Total fixed expenses $ (18,360) $ (18,360) $ (18,360) $ (55,080)
Income before Tax $ 42,840 $ 36,720 $ 48,960 $128,520
Differences in Income before Tax $0 $1,068 $ (1,068) $0

In Exhibit 1.4, income before tax for 2001 for absorption costing exceeds that of variable costing by $1,068. This
difference is caused by the positive change in inventory (2,000 shown in Exhibit 1.3) to which the absorption
SFOH of $0.534 per unit has been assigned (2,000 *$0.534 = $1,068). This $1,068 is the fixed manufacturing
overhead added to absorption costing inventory and therefore not expensed in 2001. Critics of absorption
costing refer to this phenomenon as one that creates illusionary or phantom profits. Phantom profits are
temporary absorption-costing profits caused by producing more inventory than is sold. When sales increase to
eliminate the previously produced inventory, the phantom profits disappear. In contrast, all fixed manufacturing
overhead, including the $1,068, is expensed in its entirety in variable costing.
Exhibit 1.3 shows that in 2002 inventory decreased by 2,000 valves. This decrease multiplied by the SFOH
($0.534), explains the $1,068 by which 2002 absorption costing income falls short of variable costing income in
Exhibit 1.4. This is because the fixed manufacturing overhead is written off in absorption costing through the
cost of goods sold at $0.534 per valve for all units sold in excess of production (33,000 - 31,000 = 2,000) results
in the $1,068 by which absorption costing income is lower than variable costing income in 2002.
Variable costing income statements are more useful internally for short-term planning, controlling, and decision-
making than absorption costing statements. To carry out their functions, managers need to understand and be
able to project how different costs will change in reaction to changes in activity levels. Variable costing through
its emphasis on cost behavior provides that necessary information.
The income statements in Exhibit 1.4 show that absorption and variable costing tend to provide different
income figures in some years. Comparing the two sets of statements illustrates that the difference in income
arises solely from which production component costs are included in or excluded from product cost for each
method.
If no beginning or ending inventories exist, cumulative total income under both methods will be identical. For
the Comfort Valve Company over the three-year period, 90,000 valves are produced and 90,000 valves are
sold. Thus, all the costs incurred (whether variable or fixed) are expensed in one year or another under either
method. The income difference in each year is caused solely by the timing of the expensing of fixed
manufacturing overhead.

Comparison of the two approaches

Whether absorption costing income is greater or less than variable costing income depends on the
relationship of production to sales. In all cases, to determine the effects on income, it must be assumed that

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 variances from the standard are immaterial and that unit product costs are constant over time. Exhibit 1.5
shows the possible relationships between production and sales levels and the effects of these relationships on
income. These relationships are as follows
If production is equal to sales, absorption costing income will equal variable costing income.
If production is greater than sales, absorption costing income is greater than variable costing income. This
result occurs because some fixed manufacturing overhead cost is deferred as part of inventory cost on the
balance sheet under absorption costing, whereas the total amount of fixed manufacturing overhead cost is
expensed as a period cost under variable costing.
If production is less than sales, income under absorption costing is less than income under variable costing.
In this case, absorption costing expenses all of the current period fixed manufacturing overhead cost and
releases some fixed manufacturing overhead cost from the beginning inventory where it had been deferred
from a prior period.
This process of deferring and releasing fixed overhead costs in and from inventory makes income
manipulation possible under absorption costing, by adjusting the production of inventory relative to sales.
For this reason, some people believe that variable costing might be more useful for external purposes than
absorption costing. For internal reporting, variable costing information provides managers with information
about the behavior of the various product and period costs. This information can be used when computing
the break-even point and analyzing a variety of cost-volume-profit relationships.
Production/Sales Relationships and Effects on Income Measurement and Inventory Assignments
Exhibit 1.5

Absorption Vs. Variable Absorption Vs. Variable

Income statements Balance sheet
Income before tax Ending inventory
P=S AC = VC No additional difference
No difference from the beginning inventory FOHEI = FOHBI
FOHEI = FOHBI = 0
P<S AC>VC Ending inventory increased
(Stockpiling By the amount of fixed OH in ending (by fixed OH in additional
inventory) inventory minus FOH in the beginning units because P > S)
inventory FOHEI > FOHBI
FOHEI – FOHBI = + amount
P<S AC<VC Ending inventory difference
(Selling of By the amount of FOH released from the reduced (by FOH from
beginning balance sheet beginning inventory BI charged to cost of goods
inventory) FOHEI – FOHBI = – amount sold)
FOHEI < FOHBI
The effects of the relationships presented here are based on two qualifying assumptions:
1. That unit costs are constant over time; and
2. That any fixed cost variances from standard are written off when incurred rather than being
rotated to inventory balances.
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 where P= Production FOHEI = fixed overhead ending inventory
S = Sales FOHBI = fixed overhead beginning inventory
AC = Absorption Costing
VC = Variable Costing

COST-VOLUME-PROFIT (CVP) ANALYSIS: UNDERSTANDING THE CONCEPTS OF

BREAK-EVEN-ANALYSIS AND MARGIN OF SAFETY
Cost-volume-profit (CVP) analysis is one of the most powerful tools that helps managers as they make decisions
by facilitating quick estimation of net income at different levels of activity. In other words, it helps them to
understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions
between the following five elements: prices of products, volume or level of activity, per unit variable costs, total
fixed costs, and mix of products sold.
CVP analysis helps managers to understand the interrelationship between cost, volume, and profit. So it is
a vital tool in many business decisions. These decisions include, for example, what products to manufacture
or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities
to acquire.

VARIABLE AND FIXED COST BEHAVIOR AND PATTERNS

Cost behavior is the manner in which a cost changes as a related activity changes. The behavior of cost is
useful to managers for a variety of reasons. For example, to predict profit as sales and production volume
change, to estimate cost which affects a variety of decisions. Understanding the behavior of a cost depends on
cost drivers and their relevant range.
Variable costs are costs that vary in proportion to changes in activity base. When the activity base is unit-
produced direct materials and direct labor is classified as a variable cost.
Fixed costs are costs that remain the same in total dollar amount as the activity base changes. When the
activity base is units produced many factory overhead costs such as straight-line depreciation is classified as a
fixed cost.
A. Contribution Margin versus Gross Margin
The form of income statement used in CVP analysis is shown in Exhibit 1.6 i.e., the projected income statement
of Sample Merchandising Company for the month ended January 31, 2006. This income statement is called
the contribution approach to the income statement. The contribution income statement emphasizes the
behavior of the costs and therefore is extremely helpful to managers in judging the impact of changes in selling
price, cost, or volume on profits.
Exhibit 1.6
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31, 2006
Total Unit
Sales (10, 000 units) Br. 150, 000 Br.15.00
Variable Expenses 120, 000 12.00
Contribution Margin Br. 30, 000 Br.3.00
Fixed Expenses 24, 000
Net Income Br. 6, 0000

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In the income statement here above, sales, variable expenses, and contribution margin are expressed on a
per-unit basis as well as in total. This is commonly done on income statements prepared for management’s
own use since it facilitates profitability analysis.
The contribution margin represents the amount remaining from sales revenue after variable expenses have
been deducted. Thus, it is the amount available to cover fixed expenses and then to provide profit for the
period.
The per unit contribution margin indicates by how much Birr the contribution margin is increased for each
unit sold. Sample Merchandising Company’s contribution margin of Br.3.00 per unit indicates that each unit
sold contributes Br.3.00 to covering fixed expenses and providing for a profit. If the firm had sold 5, 000
units, this would cover only Br.15, 000 of their fixed expenses (5, 000 units x Br.3.00 per unit). Therefore,
the firm would have a net loss of Br.9, 000(15,000- 24,000). If enough units can be sold to generate Br.24,
000 in contribution margin, then all of the fixed costs will be covered and the company will have managed to
show neither profit nor loss but just cover all of its costs. To reach this point (called the break-even point),
the company will have to sell 8, 000 units in a month, since each unit sold yields Br. 3.00 in contribution
margin.
Total Per Unit
Sales (8, 000 units) Br.120, 000 Br.15.00
Variable expenses 96, 000 12.00
Contribution margin Br. 24, 000 Br.3.00
Fixed expenses 24,000
Net income Br. 0

Too often people confuse the terms contribution margin and gross margin. Gross margin (which is also called
gross profit) is the excess of sales over the cost of goods sold (that is, the cost of the merchandise that is
acquired or manufactured and then sold). It is a widely used concept, particularly in the retailing industry.
Contribution Margin Ratio (Cm-Ratio)
In addition to being expressed on a per unit basis, revenue, variable expenses, and contribution margin for
Sample Merchandising Company can also be expressed on a percentage basis:
Total Per Unit Percentage
Sales (10, 000 units) Br.150, 000 Br.15.00 100%
Variable expenses 120, 000 12.00 80%
Contribution margin Br.30, 000 Br.3.00 20%
Fixed expenses 24,000
Net income Br. 6, 000

The percentage of the contribution margin to total sales is referred to as the contribution margin ratio (CM-ratio).
This ratio is computed as follows:

CM-ratio= Contribution Margin or

Sales
Contribution margin ratio = 1 – variable cost ratio.

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The variable-cost ratio or variable-cost percentage is defined as all variable costs divided by sales. Thus, a contribution
margin of 20% means that the variable-cost ratio is 80%.
The contribution margin percent or contribution margin ratio, also called profit/volume ratio (p/v ratio) is 20%. This
means that for each birr increase in sales, the total contribution margin will increase by 20 cents (Br.1 sales x CM
ratio of 40%). Net income will also increase by 20 cents, assuming that there are no changes in fixed costs.

BREAK-EVEN ANALYSIS USES AND TECHNIQUES

The study of cost-volume-profit analysis is usually referred to as a break-even analysis. This term is misleading
because finding the break-even point is often just the first step in planning a decision. CVP analysis can be used to
examine how various alternatives that a decision maker is considering affect operating income. The break-even point
is frequently one point of interest in this analysis.
The Break-even point can be defined as the point where total sales revenue equals total expenses, i.e., total variable
cost plus total fixed costs. It is a point where the total contribution margin equals to total fixed expenses. Stated
differently, it is a point where the operating income is zero. There are three alternative approaches to determining
the break-even point:
 Equation technique,
 Contribution margin technique and
 Graphical method.

EQUATION TECHNIQUE:
It is the most general form of break-even analysis that may be adapted to any conceivable cost-volume-profit situation.
This approach is based on the profit equation. Income (or profit) is equal to sales revenue minus expenses. If
expenses are separated into variable and fixed expenses, the essence of the income statement is captured by the
following equation.
Profit= Sales revenue-Variable expenses-Fixed expenses
Profit (net income) is the operating income plus non-operating revenues (such as interest revenue) minus non-
operating costs (such as interest cost) minus income taxes. For simplicity, throughout this unit non-operating revenues
and non-operating cost are assumed to be zero. Thus, the above formula can be restated as follows:
(P XQ)-(VxQ)-F=Profit (Net income)
Where P=sales price Q=break-even unit sales V= variable expenses per unit F=fixed expenses per period, NI=
net income
At the break-even point, net income=0 because total revenue equals total expenses.
That is, NI=PQ-VQ-F
0= PQ-VQ-F……………………………………equation (1)

CONTRIBUTION-MARGIN TECHNIQUE
The contribution margin technique is merely a short version of the equation technique. The approach centers on
the idea that each unit sold provides a certain amount of fixed costs. When enough units have been sold to generate
a total contribution margin equal to the total fixed expenses, the break-even point (BEP) will be reached. Thus, one
must divide the total fixed costs by the contribution margin being generated by each unit sold to find units sold to
break even.
BEP= Fixed expenses
Unit contribution margin
Given the equation for net income, you can arrive at the above shortcut formula for computing break-even sales in
units as follows:
NI=PQ-VQ-F
0=Q (P-V)-F because at BEP net income equals zero.
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 Q (P-V)=F…divide both sides by (p-v)
Q = F ………………….…. equation (2)
P-V
There is a variation of this method that uses the CM ratio of the unit contribution margin. The
result is the break-even point in total sales birrs rather than in total units sold.
BEP (in sales birrs) =Fixed expenses= F
CM ratio P-V
P
This approach to break-even analysis is particularly useful in those situations where a company has multiple product
lines and wishes to compute a single break-even point for the company as a whole. More is said on this point in a
later section titled Sales Mix and CVP Analysis.
The contribution- margin and equation approaches are two equivalent techniques for finding the break-even point.
Both methods reach the same conclusion, and so personal preference dictates which approach should be used.

GRAPHICAL METHOD
In the graphical method we plot the total costs and revenue lines to obtain their point of intersection, which is the
breakeven point.
Total costs line is the sum of the fixed costs and the variable costs. Total Revenue Line is line representing total sales
birrs at the activity you have selected. The break-even point is where the total revenues line and the total costs line
intersect. This is where total revenues just equal total costs.

Example (1) Zoom Company manufactures and sells a telephone answering machine. The company’s income
statement for the most recent year is given below:
Total Per Unit Percent
Sales (20,000 units) Br. 1,200,000 Br. 60 100
Variable expenses Br. 900,000 Br. 45 ?
Contribution Margin Br. 300,000 Br. 15 ?
Fixed Expenses Br. 240,000
Net Income Br. 60,000
Based on the above data, answer the following questions.
A. Compute the company’s CM ratio and variable expense ratio.
B. Compute the company’s break-even point in both units and sales birrs. Use the above three approaches to
compute the break-even point.
C. Assume that sales increase by Br. 400,000 next year. If cost behavior patterns remain unchanged, by how much
will the company’s net income increase?

APPLYING CVP ANALYSIS

Sensitivity “What If” Analysis
Sensitivity analysis is a “what if” technique that examines how a result will change if the original predicted data are
not achieved or if an underlying assumption changes. In the context of CVP, sensitivity analysis answers such
questions as, what will operating income be if the output level decreases by a given percentage from the original
reduction? And what will be the operating income if variable costs per unit increase? The sensitivity analysis to
various possible outcomes broadens managers’ perspectives as to what might actually occur despite their well-laid
plans.

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Example (2) Zena Concepts, Inc., was founded by Zemenu Adugna, a graduate student in engineering, to market a
radical new speaker he had designed for an automobile’s sound system. The company’s income statement for the
most recent month is given below:
Total Per Unit
Sales (400 speakers) Br.100, 000 Br.250 Variable
expenses 60, 000 150
Contribution margin 40, 000 Br.100
Fixed expenses 35, 000
Net income Br.5, 000
Yohannes Tilahun, the senior accountant at Zena Concepts, wants to demonstrate to the company’s president how
the concepts developed on the preceding pages can be used in planning and decision-making. To this end, Yohannes
will use the above data to show the effects of changes in variable costs, fixed costs, sales, and sales volume on the
company’s profitability.
Changes in Fixed Costs and Sales Volume: Zena Concepts is currently selling 400 speakers per month (monthly
sales of Br.100, 000). The sales manager feels that a Br.10, 000 increase in the monthly advertising budget would
increase monthly sales by Br.30, 000. Should the advertising budget will be increased or not increased?
Changes in Variable Costs and Sales Volume: Refer to the original data. Management is contemplating the use of
high- quality components, which would increase variable costs by Br.10 per speaker. However, the sales manager
predicts that the higher overall quality would increase sales to 480 speakers per month. Should the higher quality
component be used?
Change in Fixed Cost, Sales Price, and Sales Volume: Refer to the original data and recall that the company is
currently selling 400 speakers per month. To increase sales, the sales manager would like to cut the selling price by
Br 20 per speaker and increase the advertising budget by Br 15, 000 per month. The sales manager argues that if
these two steps are taken, unit sales will increase by 50%. Should the change be made?
Changes in Variable Cost, Fixed Cost, and Sales Volume: Refer to the original data. The sales manager would like
to replace the sales staff on a commission basis of Br 15 per speaker sold, rather than on flat salaries that now total
Br 6, 000 per month. The sales manager is confident that the change will increase monthly sales by 15%. Should the
change be made?
Changes in Regular Sales Price: Refer the original data. The company has an opportunity to make a bulk sale of 150
speakers to wholesalers if an acceptable price can be worked out. This sale would not disturb the company’s regular
sales. What price per speaker should be quoted to the wholesaler if Zena Concepts wants to increase its monthly
profits by Br 3, 000?

TARGET NET PROFIT ANALYSIS

Managers can also use CVP analysis to determine the total sales in units and birrs needed to reach a target profit.
The method used for computing desired or targeted sales volume in units to meet the desired or targeted net income
is the same as was used in our earlier breakeven computation.

Example (3) Tantu Company manufactures and sales a single product. During the year just ended the company
produced and sold 60,000 units at an average price of Br.20 per unit. Variable manufacturing costs were Br 8 per
unit, and variable marketing costs were Br 4 per unit sold. Fixed costs amounted to Br. 180,000 for manufacturing
and Br.72, 000 for marketing. There was no year-end work-in-progress inventory. Ignore income taxes.
Required:
A. Compute Tantu’s breakeven point (BEP) in sales birrs for the year.
B. Compute the number of sales units required to earn a net income of Br 180,000 during the year

14
THE MARGIN OF SAFETY
The margin of safety is the excess of budgeted (or actual) sales over the breakeven volume of sales. It states the
amount by which sales can drop before losses begin to be incurred. In other words, it is the amount of sales revenue
that could be lost before the company’s profit would be reduced to zero. The formula for its calculations follows:
Total sales - Break even Sales = Margin of safety
The margin of safety can also be expressed in percentage form. This percentage is obtained by dividing the margin
of safety in birr terms by total sales:
Margin of safety in birrs = Margin of safety Ratio
Total sales
Example (4): Consider the cost structure for ABC Company and XYZ in Exhibit 1-7
ABC Co. and XYZ Co.
Comparative Cost Structures
ABC Co. XYZ Co.
Amount Percent Amount Percent
Sales Br. 500,000 100 Br. 500,000 100
Variable costs 100,000 20 300,000 60
Contribution Margin 400,000 80 200,000 40
Fixed costs 300,000 100,000
Net income Br. 100,000 Br. 100,000
Required: compute BEP, the margin of safety, and the margin of safety ratio for each company.

IMPACT OF INCOME TAXES ON CVP ANALYSIS

Thus far we have ignored income taxes. However, profit-seeking enterprises must pay income taxes on their profits.
A firm’s net income after tax, the amount of income remaining after subtracting the firm’s income-tax expense, is
less than its before-tax income. This fact is expressed in the following formula:
NIAT = NIBT (1 – tax rate) Where NIAT = net income after taxes NIBT=net income before taxes
The requirement that companies pay income taxes affects their CVP relationships.
To earn a particular after-tax net income will require greater before-tax income than if there were no tax.
Example (5) Hydro System Engineering Associates, Inc. provides consulting services to city water authorities. The
consulting firm’s contribution margin ratio is 20%, and its annual fixed expenses are Br. 120, 000. The firm’s income-
tax rate is 40%.
Required:
A. Calculate the firm’s break-even volume of service revenue.
B. How much before-tax income must the firm earn to make an after-tax net income of Br. 48, 000?
C. What level of revenue for consulting services must the firm generate to earn an after-tax income of Br.48, 000?
D. Suppose the firm’s income-tax rate rises to 45 percent. What will happen to the break-even level of consulting
service revenue?

CVP ANALYSIS WITH MULTIPLE PRODUCTS

Definition of Sales Mix
The term sales mix (also called revenue mix) is defined as the relative proportions or combinations of quantities of
products that comprise total sales. If the proportions of the mix change, the CVP relationships also change. Thus,
managers try to achieve the combination, or mix, that will yield the greatest amount of profit.

15
A shift in sales mix from high-margin items to low-margin items can cause total profits to decrease even though total
sales may increase. Conversely, a shift in the sales mix from low-margin items to high-margin items can cause the
reverse effect-total profit may increase even though total sales decrease.

SALES MIX AND CVP ANALYSIS

To this point the discussion on CVP analysis focused on a firm that sells a single product; such a firm is generally
unrealistic, existing only in the minds of textbook writers. This section of the unit examines the usefulness of the
CVP technique for firms that deal in several products. In the general case the CVP equation could be presented as:
P1Q1 + P2Q2+...+PnQn – V1Q1 – V2Q2-...VnQn-FC = NI
where Pi = Selling price per unit of product i
Qi = Number units of i produced and sold
Vi = Unit variable cost of product i
FC = Fixed Cost Per Period
NC = Net Income
In a multi-product firm, break-even analysis is somewhat more complex. The reason is that different products will
have different selling prices, different costs, and different contribution margins.
Using the contribution margin approach, the computation of the break-even point (BEP) in a multi-product firm
follows:
BEP (in units) =Total fixed expenses
Weighted average CM
BEP (in birrs) = Total Fixed Expenses
CM – ratio
Weighted average unit contribution margin is the average of the several products’ unit contribution margins, weighted
by the relative sales proportion of each product.
For a company manufacturing and selling three products (X, Y and Z), with sales of mix of n1,n2 and n3, respectively,
the break-even point may be given by the following short cut formula:
BEP (in units) = Total fixed costs
cm1n1 + cm2n2 + cm3n3
n1 + n2 + n3
Where cmi = Unit contribution margin for product i.
n= sales proportion of each product
To prove the above formula, let us begin with general CVP equation for a company producing three products.
NI = P1Q1 + P2Q2 + P3Q3- V1Q1 – V2Q2 – V3Q3 – FC
Where, NI = net income
Pi = Unit sales price for product i
Qi = Sales volume for product
Vi = Unit variable cost for product i
FC = Fixed cost per period
The difference between total sales and total variable costs for each product, i.e. PiQi – ViQi, equals their total
contribution margin (TCM). The above general formula can be restated as follows:
NI = TCM1 + TCM2 + TCM3 – FC
0 = TCM1 + TCM2+ TCM3 – FC (NI equals zero at BEP)
0 = CM1Q1 + CM2Q2 + CM3Q3 – FC
Where CMi=contribution margin per unit for product i
Qi = sales volume for product i to break even
Given the sales mix X: Y: Z = n1: n2 : n3, and assuming that the company break-even at “Q” units, then
0 = CM1 n1Q + CM2n2Q + CM3n3 Q – FC
16
 n1 + n2 + n3
0= Q (Cm1n1 + Cm2n2 + Cm3n3) – FC
n1 + n2 + n3
FC= Q (Cm1n1 + Cm2n2 + Cm3n3)
n1 + n2 + n3
Q (Cm1n1 + Cm2n2 + Cm3n3) = FC (n1 + n2 + n3)
Q= FC (n1 + n2 + n3)
Cm1n1 + Cm2n2 + Cm3n3
Q= FC …………….. equation (1)
Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3
Here in equation (1), the denominator, Cm1n1 + Cm2n2 + Cm3n3 , is weighted average contribution margin.
n1 + n2 + n3
Similarly, the company’s break-even sales in birrs would be calculated as
BEP (in birrs) = Fixed expenses
CM – ratio
= Fixed expenses
Average CM
Average Sales Price
= Fixed expenses
Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3
P1n1 + P2n2 + P3n3
n1 + n2 + n3

BEP (in birrs) = Fixed expenses …………….. equation (2)

Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3
Here in equation (2), the denominator represents the contribution margin ratio.
Example (8) Addis Marine Products Inc. plans to manufacture and sell accessories for recreational fishing craft and
pleasure boats. Three of the principal product lines are manufactured at the Awassa plant. Operating data for the coming
year is estimated as follows:
Product Lines
Ethio-01 Ethio-02 Ethio-03
Sales price Br.150 Br.80 Br.40
Variable costs 100 60 10
Units sales 3, 200 units 1, 600 units 4, 800 units
The total annual fixed cost on the three-product lines amount to Br. 840,000
Required:
A. Assuming the above sales mix, determine the BEP (break-even point) for Addis Company during the coming year.
Also determine the number of units of each product that should be sold to break even in units and in birrs.
B. What volume of sales in birrs for each product must Addis Marine Products Inc. achieve to earn a net income of Br.
73,500 after taxes in the coming year? Assume the company is subject to a 30% income tax rate.
C. Calculate the total sales volume in units and in birrs for each product so that Addis Company achieves 8.4% return
on sales.
D. Suggest any other alternative sales mix that can lower the Company’s BEP in units holding the unit selling price, the
unit variable cost and the total annual fixed costs constant.

17
Exercise1. Topper Sports, Inc., produces high-quality sports equipment. The company’s Racket Division
Manufactures three tennis rackets: - the Standard, the Deluxe, and the Pro- that are widely used in amateur play.
Selected information on the rackets are given below:
Standard Deluxe Pro
Selling price per racket Br. 40.00 Br. 60.00 Br. 75.00
Variable expenses per racket:
Production 22.00 27.00 40
Selling (5% of selling price) 2.00 3.00 4
All sales are made through the company’s own retail outlets. The Racket Division has the following fixed costs:
Per Month
Fixed production costs………………………….Br. 120, 000
Advertising expenses…………………………… 100, 000
Administrative salaries…………………………. 50, 000
Total Br.270, 000
Sales, in units, for the month of May have been as follows:
Standard Deluxe Pro Total
Sales in units………… 2, 000 1, 000 5, 000 8, 000
Required:
A. Compute weighted- average unit contribution margin, assuming above sales mix is maintained.
B. Compute the Racket Division’s break-even point in birrs for May.
C. How many units of each product should the company sale in order to earn a Br.162, 000 income? Ignore
income taxes.

UNDERLYING ASSUMPTIONS IN CVP ANALYSIS

For any CVP analysis to be valid, the following important assumptions must be reasonably satisfied within the relevant
range.
1. Costs are linear (straight-line) through the entire relevant range, and they can be accurately divided into two
variable and fixed elements. This implies the following more specific assumptions.
B. Total fixed expenses remain constant as activity changes, and the unit variable expense remains unchanged
as activity varies.
C. The efficiency and productivity of the production process and workers remain constant.
2. The behavior of total revenue is linear (straight-line). This implies that the price of the product or service will not
change as sales volume varies within the relevant range.
3. In multiproduct companies, the sales mix remains constant over the relevant range.
4. In manufacturing firms, inventories do not change, i.e., the inventory levels at the beginning and end of the period
are the same. This implies that the number units produced during the period equals the number of units sold.
5. The value of a birr received today is the same as the value of a birr received in any future year.

18
 CHAPTER 2
RELEVANT INFORMATION AND DECISION MAKING
After studying this chapter, you should be able to:
 Understand the role of accountants in special decisions

 Differentiate relevant costs and revenues from irrelevant costs and revenues in any decision
situation

 Distinguish between quantitative factors and qualitative factors in decisions

 Recognize how to make special order decision

 Know analysis of make or buy decisions

 Describe the key concept in choosing which among multiple products to produce when there
are capacity constraints

 Discuss the key factor managers must consider when adding or dropping product lines and
segments

 Explain why the book value of equipment is irrelevant in equipment replacement decisions

1.1. Introduction

During the last decade, increasing competition has forced many companies to refocus their resources
and to defend their core businesses against aggressors. In developing strategies to fight this war,
managers have generally reached a consensus on two strategic criteria. First, to win a battle, the focus
of organizations must be on delivering products and services in the manner most consistent with the
desires of customers. Second, no company can do all things well. The strategies managers devise in
this intensive struggle evolve from internal evaluations in which the managers identify the functions
they must do well to survive. These functions are regarded as core competencies and maintaining
leadership in these areas is regarded as vital. All other functions, although important to the
organization, are regarded as noncore functions. By intensely focusing on core functions, managers
try to maintain a competitive advantage. However, an undesirable consequence of focusing on only
the core competencies is that the quality and capabilities of the noncore functions can deteriorate. This
deterioration, in turn, can reduce a firm’s ability to attract customers to its products and services.
Outsourcing the noncore functions to firms that have core competencies in those functions frequently
solves the dilemma of maintaining a focus on core competencies while also maintaining excellence
in noncore functions. Managers are charged with the responsibility of managing organizational
resources effectively and efficiently relative to the organization’s goals and objectives. Making
19
decisions about the use of organizational resources is a key process in which managers fulfill this
responsibility. Accounting and finance professionals contribute to the decision-making process by
providing expertise and information.

Accounting information can improve, but not perfect, management understands of the
consequences of decision alternatives. To the extent that accounting information can reduce
management’s uncertainty about economic facts, outcomes, and relationships involved in various
courses of action, such information is valuable for decision-making purposes.

Many decisions can be made using relevant costing, which focuses managerial attention on a
decision’s relevant (or pertinent) facts. Relevant costing techniques are applied in virtually all
business decisions in both short-term and long-term contexts. This chapter examines their
application to several common types of business decisions: replacing an asset, outsourcing a product or
part, allocating scarce resources, determining the appropriate sales/production mix, and accepting
specially priced orders. In general these decisions require a consideration of costs and benefits that
are mismatched in time; that is, the cost is incurred currently but the benefit is derived in future periods.
In making a choice among the alternatives available, managers must consider all relevant costs and
revenues associated with each alternative

1.2. Information and the Decision Process

Decision making is the process of choosing the best course of action from alternatives available.
Decision model is a method used by managers for deciding among courses of action. Accounting
information (revenue and cost information) are basic inputs in to decision model. However, other
quantitative as well as qualitative information can also be used. In general information is divided in
to relevant and irrelevant information. Relevant information is information which is useful for
decision making where as irrelevant information is not useful for decision making since such
information is common for all alternatives. The management accountant’s role in the decision making
process is to produce relevant information to the managers who make the decisions. Thus, the primary
role of cost accountant in decision process is to: decide what information is relevant to each decision
problem, and provide accurate and timely information (data).
Decision making process involves basically the following activities.
i. Identify and Define the Problem. The most important phase of decision making process
because all other activities in the process depend on this phase. Incorrectly defined problems waste
time and resources. That is why it is usually said that defining a problem is solving half of the problem.
ii. Specify the Criterion. The phase in which the purpose of decision is to be made. Is the
objective to maximize profit, increase market share, minimize cost, or improve public service? For
20
example, cost minimization, increase the quality of product, maximize profit, etc.
iii. Identify Possible Alternatives: Determining the possible alternatives is a critical step in
the decision process.

21
 iv. Gathering Relevant Information. Information could be subjective or objective, internal or
external to the organization, historical (past) data, or future (expected) ones.
v. Making the Decision: Select the best alternative (course of action).

1.3. The Concept of Relevance

For information to be relevant, it must possess three characteristics: (1) be associated with the decision
under consideration, (2) be important to the decision maker, and (3) have a connection to or bearing on
some future endeavor.

Association with Decision

Costs or revenues are relevant when they are logically related to a decision and vary from one decision
alternative to another. Cost accountants can assist managers in determining which costs and revenues are
relevant to decisions at hand. To be relevant, a cost or revenue item must be differential or incremental.
An incremental revenue is the amount of revenue that differs across decision choices and incremental
cost (differential cost) is the amount of cost that varies across the decision choices.

To the extent possible and practical, relevant costing compares the incremental revenues and incremental
costs of alternative choices. Although incremental costs can be variable or fixed, a general guideline
is that most variable costs are relevant and most fixed costs are not. The logic of this guideline is
that as sales or production volume changes, within the relevant range, variable costs change, but
fixed costs do not change. As with most generalizations, some exceptions can occur in the decision-
making process.

The difference between the incremental revenue and the incremental cost of a particular alternative is the
positive or negative incremental benefit (incremental profit) of that course of action. Management can
compare the incremental benefits of alternatives to decide on the most profitable (or least costly)
alternative or set of alternatives.

Some relevant factors, such as sales commissions or prime costs of production, are easily identified and
quantified because they are integral parts of the accounting system. Other factors may be relevant and
quantifiable, but are not part of the accounting system. Such factors cannot be overlooked simply because
they may be more difficult to obtain or may require the use of estimates. For instance, opportunity costs
represent the benefits foregone because one course of action is chosen over another. These costs are
extremely important in decision making, but are not included in the accounting records.

22
Importance to Decision Maker
The need for specific information depends on how important that information is relative to the objectives
that a manager wants to achieve. Moreover, if all other factors are equal, more precise information is given
greater weight in the decision making process. However, if the information is extremely important, but
less precise, the manager must weigh importance against precision.

Bearing on the Future

Information can be based on past or present data, but is relevant only if it pertains to a future decision
choice. All managerial decisions are made to affect future events, so the information on which decisions
are based should reflect future conditions. The future may be the short run (two hours from now or next
month) or the long run (three years from now). Future costs are the only costs that can be avoided, and a
longer time horizon equates to more costs that are controllable, avoidable, and relevant. Only information
that has a bearing on future events is relevant in decision making.
Costs incurred in the past for the acquisition of an asset or resources are called sunk costs. They
cannot be changed, no matter what future course of action is taken because past expenditures are
not recoverable, regardless of current circumstances. Thus, the historical cost is not relevant to the
decision.

Example: Marina Company, a manufacturer of a line of ashtrays, is thinking of using aluminum instead
of copper in the manufacture of its product. Historical direct material cost was Br. 0.50 per unit. The
company expected future costs for aluminum is Br. 0.40 and it is unchanged for copper. Direct labor cost
were Br.0.80 per unit and will not be affected by the switch in materials.
The analysis in a nutshell is as follows:
Copper Aluminum Difference
Direct material Br. 0.50 Br. 0.40 Br. 0.10
Direct labor 0.80 0.80 -
In the foregoing analysis, the material cost (the expected future cost of copper compared with expected
future cost of aluminum) is the only relevant cost. The material cost met both criteria for relevant
information. That is, bearing on the future and an element of difference between the alternatives. However,
the direct labor cost will continue to be Br 0.80 per unit regardless of the material used. It is irrelevant
because the second criterion – an element of difference between the alternatives – is not met.

1.4. Relevant Information for Specific Decisions

Managers routinely choose a course of action from alternatives that have been identified as feasible
solutions to problems. In so doing, managers weight the costs and benefits of these alternatives and
determine which course of action is best. Incremental revenues, costs, and benefits of all courses of action

23
are measured against a baseline alternative. In making decisions, managers must provide for the inclusion
of any inherently non quantifiable considerations. Inclusion can be made by attempting to quantify those
items or by simply making instinctive value judgments about nonmonetary benefits and costs.
In evaluating courses of action, managers should select the alternative that provides the highest
incremental benefit to the company. Rational decision-making behavior includes a comprehensive
evaluation of the monetary effects of all alternative courses of action. The chosen course of action should
be one that will make the business better off. Decision choices can be evaluated using relevant costing
techniques.

1.4.1. Special Order Decisions

One type of decision that affects output level is accepting or rejecting a special order. A special order is
a one-time order that is not considered part of the company’s normal ongoing business. In general, a
special order is profitable as long as the incremental revenue from the special order exceeds the
incremental costs of the order. Thus, conditions to consider in a special order decisions are: (i) Customers
must be from markets not ordinarily served by the company, and (ii) the company must operate below it
maximum productive capacity
Example: Consider the following details of the income statement, on absorption costing basis (that is,
both variable and fixed manufacturing costs are included in inventoriable costs and cost of goods sold),
of Samson Company for the year just ended December 31, 2014

Total per unit Sales (1,000,000 units) Br 20,000,000 Br 20

Cost of Goods Sold 15,000,000 15
Gross Margin Br 5,000,000 Br. 5
Selling and Administrative Expenses 4,000,000 4
Operating Income Br. 1,000,000 Br. 1
Samson’s fixed manufacturing costs were Br 3 million and fixed selling and administrative expenses were
Br 2.9 million. Near the end of the year, Ethio Company offered Samson Br 13 per unit for 100,000 unit
special order. The special order would not affect Samson‘s regular business in any way. Furthermore, the
special sales order would not affect total fixed costs and would not require any additional variable selling
and administrative expenses.
Required:

a) Should Samson accept or reject the special order?

b) Could the special order affect Samson’s regular business?

Solution:

24
a). The correct analysis to the above problem employs the contribution approach to income statement, not
the absorption or financial approach- that treats fixed costs, i.e., fixed manufacturing costs as if it were
variable.
• Variable manufacturing cost per unit═ 15,000,000 -3,000,000 ═ 12per unit
1,000,000
• Total Variable manufacturing cost ═ Br. 12 x 1,000,000 ═ Br.12,000,000
• Variable selling and administrative cost per unit═4,000,000 -2,900,000═1.1per unit
1, 000, 0000
• Total Variable selling and administrative cost ═ Br. 1.1 x 1, 000, 0000 ═ Br.1,100,000( the special
order does not affect this cost)
The analysis would be as follows on comparative contribution income statement.
Without special order With special order Difference:
1,000,000 units to be 1,100,000 units to relevant amount
sold be sold for the 100,000
units of special
order
Sales Br. 20,000,000 Br. 21,300,00 Br. 1,300,000
Variable Expenses:
Manufacturing Br. 12,000,000 Br.13,200,000 Br.1,200,000
Selling and Adm. 1,100,000 1,100,000
Total Variable Exp. Br. 13,100,000 Br. 14,300,000 1,200,000
Contribution Margin Br. 6,900,000 Br. 7,000,000 Br. 100,000
Fixed Expenses:
Manufacturing Br. 3,000,000 Br. 3,000,000
Selling and Adm. 2,900,000 2,900,000
Total Fixed Expenses Br.5,900,000 Br. 5,900,000
Operating Income Br.1,000,000 Br.1,100,000 Br. 100,000

The above comparative income statements for Samson illustrates two key complete to analyzing relevant
revenues for decision: (1) distinguish relevant costs and revenues from irrelevant ones and (2) use the
contribution income statement to focus on whether each variable cost and each fixed cost is affected by
the alternatives(i.e. reject or accept) under consideration.
In this case, the relevant revenues and costs are the expected future revenues and costs that differ as a
result of accepting the special offer sales of Br 1,300,000(Br 13 per unit X 100,000 units) and variable
manufacturing costs of Br. 1,200,000 (Br 12 per units X 100,000 units). The fixed manufacturing costs
and selling and Administration costs (including variable costs) are irrelevant. That is because these costs
will not change in total whether the special order is accepted or rejected. Based on the relevant data

25
analyzed above, Samson would gain an additional Br100, 000(relevant revenues, Br 1,300,000 less
relevant costs Br 1,200,000) in operating income by accepting the special order. In this example,
comparing total amounts for 1,000,000 units versus 1,100,000 units or focusing only on the relevant
amounts in the difference column in comparative income statement avoids misleading implication --- the
implication that would result from comparing the Br 13 per unit selling price against the manufacturing
cost per unit of Br 15 (from Samson’s income statement on absorption costing basis) which includes both
Variable and fixed manufacturing costs.

Thus, based on the relevant data analyzed above, Samson Company should accept the special order
because it brings an additional income of Br. 100,000 for the company as:
Income with special order Br. 1,100,000
Income without special order 1,000,000
Additional income if the order had been accepted Br. 100,000

a) Yes. Unless Samson Company has effectively segments its market so that the special order to the
Ethio Company does not affect the regular business.

1.4.2. Product Line Decisions

This is a decision relating to whether old product lines or other segments of a company should be dropped
and new ones added are among the most difficult decision that a manager has to make. Operating results
of multiproduct environments are often presented in a disaggregated format that shows results for separate
product lines within the organization or division. In reviewing these disaggregated statements, managers
must distinguish relevant from irrelevant information regarding individual product lines. If all costs
(variable and fixed) are allocated to product lines, a product line or segment may be perceived to be
operating at a loss when actually it is not. The commingling of relevant and irrelevant information on the
statements may cause such perceptions.
In classifying product line costs, managers should be aware that some costs may appear to be avoidable
but are actually not. For example, the salary of a supervisor working directly with a product line appears
to be an avoidable fixed cost if the product line is eliminated. However, if this individual has significant
experience, the supervisor is often retained and transferred to other areas of the company even if product
lines are cut. Determinations such as these needs to be made before costs can be appropriately classified
in product line elimination decisions.

For instance, mostly on add or delete decisions, fixed costs are divided into two categories, avoidable and
unavoidable. Avoidable costs are costs that will not continue if an ongoing operation is changed, deleted
or eliminated. These costs are relevant costs in decision making. Unavoidable costs are costs that continue
even if a subunit or an activity is eliminated and are not relevant for decision.

26
Example: Eyoha Department store has three major departments: groceries, general merchandise, and
drugs. Management is considering dropping groceries, which have consistently shown a net loss, as shown
below on statement of departments’ profitability
analysis of Eyoha.

Departments
Groceries General merchandise Drugs Total
Sales Br. 100,000 Br. 8,0000 Br. 10,000 Br.190,000

Variable CGS & Expenses

80,000 56000 6,000 142,000
Contribution margin Br. 20,000 Br. 24000 Br. 4,000 Br. 48,000
Fixed_Expenses:
Avoidable Br. 15,000 Br. 10,000 Br. 1,500 Br. 26,500
Unavoidable 6,000 10,000 2,000 18,000

Total fixed expenses Br.21,000 Br. 20,000 Br.3,500 Br. 44,500

Operating income (loss) Br. (1,000) Br.4,000 Br. 500 Br. 3,500

Required:
a) Which alternative would be recommended if the only alternatives to be considered are
dropping or continuing the grocery department? Assume that the total assets would be unaffected
by the decision and the space made available by dropping groceries would remain idle.
b) Refer the income statement presented above. Assume that the space made available by
dropping groceries could be used to expand the general merchandise department. The space would
be occupied by merchandise that increase sales by Br. 50,000, generate a 30% contribution margin
percentage and have additional avoidable fixed costs of Br.7, 000. Should Eyoha discontinue
grocery and expand merchandise department?
Solutions
(a). Analysis for dropping grocery department and leaving the space idle
(A) Total (B) Effect of (A – B) Total
Before change dropping grocery after change
Sales Br. 190.000 Br 100.000 Br 90.000
Variable COGS and Expenses 142.000 80.000 62.000
Contribution margin Br 48.000 Br 20.000 Br 28.000

27
 Fixed expenses
In this Avoidable Br 26.500 Br 15,000 Br 11,500
Unavoidable 18.000 - 18,000
Total fixed expenses Br 44,500 Br 15,000 Br 29,500
Operating income (loss) Br 3,500 Br 5,000 Br (1,500)
analysis, column 2, presents the relevant –revenues and relevant-cost analysis using data from the grocery
column in department profitability analysis of Eyoha. Eyoha’s operating income will be Br.5, 000 (income
with grocery department, Br.3500 less loss assuming grocery is dropped, Br.1500 or it implies that the
cost savings from dropping the grocery department, Br.95, 000 (Br.80, 000+ Br.15, 000), will not be
enough to offset the loss of Br.100, 000 in revenues. So, under this condition Eyoha’s managers should
decide to keep the grocery department rather dropping.
Notice that all of the grocery’s variable expenses are avoidable and relevant for decision making. If the
grocery department is discontinued, the Br 6,000 of the fixed expenses will continue, which is irrelevant.
And also note that there is no opportunity costs of using spaces for grocery because without grocery, the
space and equipment will remain idle.
(b) Analysis for dropping the grocery department and expanding general merchandise.

(A) Total (B) Effect (C) Effect of (A – B) + C Total

before of Expanding after change
change Dropping General
Groceries Merchandise

Sales Br190,000 Br 100,000 Br 50,000 Br 140,000

Variable CGS and 142,000 80,000 35,000 97,000
expense
Contribution margin Br 48,000 Br 20,000 Br 15,000 Br 43,000
Fixed expenses
Avoidable Br 26,500 Br 15,000 Br 7,000 Br 18,500
Unavoidable 18,000 - 18,000
Total fixed expenses Br 44,500 Br 15,000 Br 7,000 Br 36,500
Operating income (loss) Br 3,500 Br 5,000 Br 8,000 Br 6,500

Effect of expanding general merchandise:

Incremental revenue = Br 50,000
Incremental cost
Variable cost = (1-0.30) x 500,000 = (35,000)
Fixed cost = (7,000)

28
 Incremental income = Br 8,000
Recommendation: As the above analysis shows, dropping grocery and using the vacated space to expand
general merchandise will be a good decision.

1.4.3. Optimal Use of Scarce Resources Decisions (Product Mix Decisions)

Managers are frequently confronted with the short-run problem of making the best use of scarce resources
that are essential to production activity, but are available only in limited quantity. Scarce resources create
constraints on producing goods or providing services and can include machine hours, skilled labor hours,
raw materials, and production capacity and other inputs. Management may, in the long run, obtain a greater
quantity of a scarce resource. For instance, additional machines could be purchased to increase availability
of machine hours. However, in the short run, management must make the most efficient use of the scarce
resources it has currently.

Determining the best use of a scarce resource requires managerial recognition of company objectives. If
the objective is to maximize company profits, a scarce resource is best used to produce and sell the product
having the highest contribution margin per unit of the scarce resource. This strategy assumes that the
company is faced with only one scarce resource. A scarce resource or a limiting factor refers to any factor
that restrict or constraint the production or sale of a product or service.

Example: Jimma Computers manufactured two products, desktop computer and notebook computer. The
Company’s scarce resource is a data chip that it purchases from a supplier. Each desktop computer requires
one chip and each notebook computer requires three chips. Currently, the firm has access to only 5,100
chips per month to make either desktop or notebook computers or some combination of both. Demand is
above 5,100 units per month for both products and there is no variable selling or administrative costs
related to either product. The desktop’s Br. 650 selling price less its Br. 545 variable cost provides a
contribution margin of Br. 105 per unit. The notebook’s contribution margin per unit is Br.180 (Br.900
selling price minus Br.720 variable cost). Fixed annual overhead related to these two product lines totals
Br. 6,570,000 and is allocated to products for purposes of inventory valuation. Fixed overhead, however,
does not change with production levels within the relevant range

Instructions: on the bases of the above information which product is more profitable and on which
products should the firm spend its resources?

Solution:

29
Present information on two products being manufactured by Jimma Computers and total contribution
margin per unit and per chip would be:
Descriptions Desktop Notebook
Selling price per unit (a) Br 650 Br 900

Variable production cost per unit:

Direct material Br.345 115 Br. 480
Direct labor 85 Br. 545 125
Variable overhead 115
Total variable cost (b) Br. 20

Unit contribution margin [(c) = (a) _ (b)] Br 105 Br.180

Chips required per unit (d) 1 3

Contribution margin per chip of per unit [(c) /(d)] Br.105 Br.60

In the above analysis, because fixed overhead per unit is not relevant in the short run, unit contribution
margin rather than unit gross margin is the appropriate measure of profitability of the two products. Unit
contribution margin is divided by the input quantity of the scarce resource (in this case, data chips) to
obtain the contribution margin per unit of scarce resource. The last line in the above analysis table shows
the Br. 105 contribution margin per chip for the desktop compared to Br. 60 for the notebook. Thus, it is
more profitable for Jimma Computers to produce desktop computers than notebooks.

At first glance, it would appear that the notebook would be, by a substantial margin, the more profitable
of the two products because its contribution margin per unit (Br. 180) is significantly higher than that of
the desktop (Br. 105). However, because the notebook requires three times as many chips as the desktop,
a greater amount of contribution margin per chip is generated by the production of the desktops. If these
were the only two products made by Jimma Computers and the company wanted to achieve the highest
possible profit, it would dedicate all available data chips to the production of desktops. Such a strategy
would provide a total contribution margin of Br. 535,500 per month (5,100 units * Br. 105), if all units
produced were sold.

In addition to considering the monetary effects related to scarce resource decisions, managers must
remember that all factors cannot be readily quantified and the qualitative aspects of the situation must be
evaluated in addition to the quantitative ones. For example, before choosing to produce only desktops,

30
Jimma Computers’ managers would need to assess the potential damage to the firm’s reputation and
markets if the company limited its product line to a single item. Such a choice severely restricts its
customer base and is especially important if the currently manufactured products are competitively related

1.4.4. Make or Buy (In source or out sourcing) decision

A concern with subcontracting or outsourcing has dominated business in recent years as the cost of
providing goods and services in-house is increasingly compared to the cost of purchasing goods on the
open market. Thus, a daily question faced by managers is whether the right components and services will
be available at the right time to ensure that production can occur. Additionally, the inputs must be of the
appropriate quality and obtainable at a reasonable price. Traditionally, companies ensured themselves of
service and part availability and quality by controlling all functions internally. However, there is a growing
trend toward “outsourcing” (buying) a greater percentage of required materials, components, and services.

This outsourcing decision (make-or-buy decision) is made only after an analysis that compares internal
production and opportunity costs with purchase cost and assesses the best uses of available facilities.
Consideration of an in source (make) option implies that the company has available capacity for that
purpose or has considered the cost of obtaining the necessary capacity. The make versus buy decision
should be based on which alternative is less costly on a relevant cost basis; that is, taking into account
only future, incremental cash flows. In other words, in a make or buy situation with no limiting factors,
the relevant costs for the decision are the differential costs between the two options.

For example, the costs of in-house production of a computer processing service that averages 10,000
transactions per month are calculated as Br. 25,000 per month. This comprises Br.0.50 per transaction for
stationery and Br. 2 per transaction for labor. In addition, there is a Br. 10,000 charge from head office as
the share of the depreciation charge for equipment. An independent computer bureau has tendered a fixed
price of Br. 20,000 per month.

Based on this information, stationery and labor costs are variable costs that are both avoidable if
processing is outsourced. The depreciation charge is likely to be a fixed cost to the business irrespective
of the outsourcing decision. It is therefore unavoidable. The fixed outsourcing cost will only be incurred
if outsourcing takes place.

The relevant costs for each alternative can be compared as shown in Table 6.1 below. The Br. 10,000
share of depreciation costs is not relevant as it is unavoidable. The relevant costs for this decision are
therefore those shown in Table 6.2

31
Based on relevant costs, there would be a Br. 5,000 per month saving by outsourcing the computer
processing service.

Table 1 Relevant costs – make versus buy

Cost to make Cost to buy

Stationery 10,000 @ Br. 0.50 Br. 5,000

Labour 10,000 @ Br. 2 20,000
Share of depreciation costs 10,000 10,000
Outsourcing cost 20,000
Total relevant cost Br. 35,000 Br. 30,000

Table 2Relevant costs – make versus buy, simplified

Relevant cost to makeRelevant cost to buy
Stationery 10,000 @ Br. 0.50 Br. 5,000
Labour 10,000 @ Br. 2 20,000
Outsourcing cost 20,000
Total relevant cost Br. 25,000 Br. 20,000

Note that relevant information for make or buy decision includes both quantitative and qualitative factors.
Such as:
Quantitative Factors
Buy Make
• the amount paid to supplier • variable costs incurred to produce the
component
• transportation costs • special equipment to produce the
product
• costs incurred to process the • hire additional supervisory personnel to
part upon receipt assist with making the product

Qualitative Factors

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 • Advantage of long term • The quality of the product is decided
relationship with suppliers to be controlled
• Possibility of shortage of • If the purchase price is likely to rise
material or labor for making due to increased demand in the
the component market, it becomes uneconomical to
Buy
• Uninterrupted supply of • Where the technical know-how is to
requisite quality from reliable be kept secret and not to be passed on
supplies to the suppliers

1.4.5. Keep or Replace Equipment Decisions

The usefulness of plant assets may be impaired long before they are considered to be worn out. Equipment
may be no longer being efficient for the purpose for which it is used. On the other hand, the equipment
may not have reached the point of complete inadequacy. Decisions to replace usable plants assets should
be based on studies of relevant costs. The relevant costs are the future costs of continuing to use the
equipment versus replacement. The book values of the plant assets being replaced are sunk costs and are
irrelevant.

As for example, assume that a business is considered disposing of several identical machines having a
total book value of Birr 1,000,000 and an estimated remaining life of five years. The old machines can be
sold for Birr 25,000. They can be replaced by a single high-speed machine at a cost of Birr 250,000. The
new machine has an estimated useful life of five years and no residual value. Analyses indicate an
estimated annual reduction in variable manufacturing costs from Birr 225,000, with the old machine
to Birr 150,000 with the new machine. No other changes in the manufacturing costs or the operating
expenses are expected. The relevant costs are summarized in the differential report are as follows:
Proposal for Replacement Equipment (Differential Analysis Report – Replacement Equipment):
Annual variable costs of present equipment (a) Birr 225,000
Annual variable costs - new equipment (b) 150,000
Annual differential decrease in cost(c= a-b) Birr 75,000
Number of years applicable (d) 5
Total differential decrease in cost (e=cxd) Birr 375,000
Proceed from sales of present equipment (f) 25,000
total (g =e+f) Birr 4, 00,000
Cost of new equipment (h) 2, 50,000

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 Net differential decrease in cost, 5 year total (i =g+h) Birr 1, 50,000
So, annual net differential decrease in cost – new equipment (i÷d) Birr 30,000

Additional factors are often involved in equipment replacement decisions. For example, differences
between the remaining useful life of the old equipment and the estimated life of the new equipment could
exist. In addition, the new equipment might improve the overall quality of the product, resulting in an
increase in sales volume. Other factors that could be significant include the time value of money and other
uses for the cash needed to purchase the new equipment.

In general, in deciding whether to replace or keep existing equipment, four commonly encountered items
considered in relevance:
i. Book value of old equipment: irrelevant, because it is a past (historical) cost. Therefore, depreciation
on old equipment irrelevant.
ii. Disposal value of old equipment: relevant, because it is an expected future inflow that usually differs
among alternatives.
iii. Gain or loss on disposal: this is the algebraic difference between book value and disposal value. It is
therefore, a meaningless combination of irrelevant and relevant items. Consequently, it is best to think
of each separately.
iv. Cost of new equipment: relevant, because it is an expected future outflow that will differ among
alternatives. Therefore, depreciation on new equipment is relevant.

1.5. Pricing Decisions

Companies are constantly making product and service pricing decision. These are strategic decision that
affects the quantity produced and sold, and therefore cost and revenues. To make these decisions,
managers need to understand cost behavior pattern and cost drivers. They can then evaluate demand at
different prices and manage costs across the value chain and over a products life cycle to achieve
profitability.
Major influences on pricing decision
How companies prices a product or a service ultimately depends on the demand and supply of it. Three
influences on demand and supply are:-
i. Customers: - customer influences price through their effect on the demand for a product or
services, based on factors such as the features of a product and its quality.
ii. Competitors: when there are competitors, knowledge of rivals’ technology, plant capacity, and
operating policies enables a company to estimate its competitors’ costs-valuable information
in setting its own prices.

34
 iii. Costs – costs influence prices because they affect supply. As companies supply more product
the cost of producing each additional unit initially declines but then eventually increase
managers who understand the cost of producing their companies product set polices that make
the products attractive to customers. In computing the relevant costs for a pricing decision, the
manager must consider relevant costs in all business functions of the value chain.

Costing and pricing for the short run

Short-run pricing decisions typically have a time horizon of less than a year and include decision such as
(a) pricing one time only special order with no long run implications and (b) adjusting product mix and
output volume in a competitive market.
Company’s short run pricing decisions need identify a sufficiently low price at which company would still
make a profit and assumed that (a) company has access to extra capacity and (b) a competitor with an
efficient plant and idle capacity was likely to make a low bid. However, short run pricing does not always
work this way. Companies may experience strong demand for their products in the short-run, but they may
have limited capacity. In these cases, companies strategically increase prices in the short run to as much
as the market will bear.
In general, short run pricing decisions are responses to short-run demand and supply condition, and the
relevant costs are only those costs that will change in the short run.

Costing and pricing for the long run

Long run pricing decisions have a time horizon of a year or longer and include pricing a product in a major
market in which there is some see way in setting price. Two key differences affect pricing for the long run
versus the short run:-
1. Costs that are often irrelevant for short run pricing decisions, such as fixed costs that cannot be
changed, are generally relevant in the long run because cost can be altered in the long run.
2. Profit margins in the long run pricing decision are often set to earn a reasonable return on
investment. Short run is opportunistic, prices are decreased when demand is weak and increased
when demand is strong.
Long run pricing is a strategic decision desired to build long run relationship with customers based on
stable and predictable prices. But to change a stable price and earn the target long run return, a company
must, over the long run, know and manage its costs of supplying product to customers. Thus, relevant
costs for long run pricing decision include all future fixed and variable costs.

35
Long run pricing approaches
Two different approaches for pricing decision using product cost information are:-
1. Market based approach
2. Cost based/cost plus approach

1. Market based pricing

Market based pricing approach starts by management asking, given that our customers want and how our
competitors will react to what we do, what price should we charge?
Companies operating in a very competitive market, for example, commodities such as steel, oil, and
natural gas, use the market based pricing. An important form of market based pricing is target pricing.
Target price is the estimated price for a product or service that potential customers will be willing to pay.
This estimate is based on an understanding of customer’s perceived value for a product or service and how
competitors will price competing product or service.
Hence, target operating income is the operating income that a company wants to earn on each unit of a
product or service sold and target price leads to a target cost, target cost per unit is the estimated long run
cost per unit of a product or service that, when sold at the target price, enables the company to achieve the
target operating income.
Thus, Target price - Target operating income = Target cost

Implementing target pricing and target costing

In developing target prices and target cost companies may require to follow the following five steps:
• Develop a product that satisfy the needs of potential customers
• Choose a target price based on customer’s perceived value for the product and the price
competitors charge, and target operating income per unit.
• Drive a target cost per unit by subtracting the target operating income per unit from the target price
• Perform cost analysis to analyze which aspects of a product or service to target for cost reduction.
• Perform value engineering to achieve target cost. Value engineering is a systematic evaluation of
all aspect of the value chain business function with the objective of reducing cost while satisfying
customers’ needs. Value engineering can result in improvement in product design, change in
material specification, and modification in process method. In this case, Costs can be value adding
or non value adding. Value adding costs are costs that costumers perceive as adding utility or value
while non value adding cost that do not add value to the product and to customers.

36
Example:Astel Company is a manufacturer of personal computer .Astel expects its competitors to lower
prices of PC. Astels management believes that it must respond by reducing price by 20% from Br. 1000
per unit to Br.800 per unit. At this low price, Astels marketing manager forecast an increase in annual
sales from 150,000 to 200,000 units. Astel management wants a 10% target operating income on sales
revenue. The total production cost at the moment for 150,000 units is Br. 135 million.
Required compute
a) The total target revenue
b) Total target operating income
c) Target operating income per unit
d) Current target cost per unit
Solution
a) Total target revenue ═ target price per unit x target annual unit sold
═ Br.800 per unit x 200,000 units ═ Br.160, 000,000
b) Total target operating income═ target rate x Total target revenue
═ 10% x Br.160, 000,000═ Br.16, 000,000
c) Target operating income per unit═ Total target operating income/ annual unit sold
═ Br.16, 000,000/200,000 units ═ Br.80
d) Current cost per unit═ target price per unit less target operating income per unit
═ Br.800 per unit - Br.80 ═ Br.720

2. Cost-plus pricing
Accounting information may be used in pricing decisions, particularly where the firm is a market leader
or price-maker. In these cases, firms may adopt cost-plus pricing, in which a margin is added to the total
product/service cost in order to determine the selling price. In many organizations, however, prices are set
by market leaders and competition requires that prices follow the market (i.e. the firms are price-takers).
Nevertheless, even in those cases an understanding of cost helps in making management decisions about
what product/services to produce, how many units to make and whether the price that exists in the market
warrants the business risk involved in any decision to sell in that market. An understanding of the firm’s
marketing strategy is therefore, essential in using cost information for pricing decisions.

In the long term, the prices that businesses charge must cover all of its costs. If it is unable to do so, it will
make losses and may not survive. For every product/service, the full cost must be calculated, to which the

37
desired profit margin is added. Full cost includes an allocation to each product/service of all the costs of
the business, including producing and delivering a good or service, and all its marketing, selling, finance
and administration costs.
The general formula for setting a cost based price adds a markup component to the cost base to determine
the prospective selling price. One way to determine the markup percentage is to choose a markup to earn a
target rate of return on investment.
The target rate of return on investment is the target annul operating income that an organization aims to
achieve divided by invested capital (asset)
i.e. TRR = T a r g e t operating income
Invested capital
Therefore, Target operating income=TRR*Invested capital

Let illustrate a cost – plus pricing formula on top company. Assume top’s engineers have redesigned
product CD into 2CD and that top uses a 12% markup on the full unit cost of the product in developing
the prospective selling price. The target product 2CD profitability for 2000 is as follows:

Estimated total amounts Estimated total amount

for 200,000 units (1) per unit (2) = (1)  200,000
Revenues Bir 160,000,000 Bir 800
Cost of goods sold 108,000,000 540
Operating costs 36,000,000 180
Total cost of product Bir 144,000,000 720
Operating income 16,000,000 Bir 80

Suppose that top’s target rate of return on investment is 18% and 2CD’s capital investment is Bir 96
million. The target annual operating income for 2CD is:
Invested capital ……………………………….. Bir 96,000,000
Target rate of return on investment……………. 18%
Target Annual Operating income [0.18 Bir 96mln]…Bir17,280,000
Target operating income per unit of 2A
[Bir17,280,000  200,000 units] ....................Bir 86.40
This calculation indicates that top needs to earn a target operating income of Bir86.40 on each unit of 2A.
The mark up of Bir 86.40 expressed as a percentage of the full production cost per unit of Bir720 equals
12% (Bir 86.40 Bir 720]

38
Thus the prospective selling price of product 2A is Bir806.40 (Full unit cost of 2A, Bir 720 plus the
markup component of 12% (0.12 Bir 720=Bir 86.40).

1.6. Summary

The following points are linked to the chapter‘s learning objectives

1. The five-step decision process is (a) obtain information, (b) make predictions, (c) choose
alternative courses of action, (d) implement decisions, and (c) evaluate performance.

2. To be relevant to a particular decision, a revenue or cost must meet two criteria: (a) It must
be an expected future revenue or cost, and (b) it must differ among alternative courses of action.

3. The consequences of alternative actions can be quantitative and qualitative.

Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors
can be easily expressed in financial terms, others cannot. Qualitative factors, such as employee
morale, cannot be measured in numerical terms. Due consideration must be given to both
quantitative and qualitative factors in making decisions.

4. Two potential problems that should be avoided in relevant-cost analysis are (a)
making incorrect general assumptions such as all variable costs are relevant and all fixed costs are
irrelevant, and (b) losing sight of grand totals and focusing instead on unit costs.

5 . In choosing among multiple products when resource capacity is constrained, managers should
emphasize the product that yields the highest contribution margin per unit of the constraining
or limiting resource (factor).
6. Managers should ignore allocated overhead costs when making decisions about dropping and
adding customers and segments. They should focus instead on how total costs differ across
alternatives.

7. The book value of existing equipment in equipment-replacement decisions represents past

(historical) cost and therefore is irrelevant.

1.7. Review Questions

WORKOUT QUESTIONS

39
 1) Belt and Braces Ltd makes a single product which sells for Br 20. It has a full cost of Br 15 which
is made up as follows:

Direct Material Br 4
Direct Labor 6
Variable Overhead 2
General Fixed Overhead 3
Br. 15
The labor force is currently working at 90% of capacity and so there is a spare capacity for 2,000 units. A
customer has approached the company with a request for the manufacture of a special order of 2,000 units
for which he is willing to pay Br. 25,000. Assess whether the contract should be accepted or not.

2) Buster Ltd makes four components, W, X, Y and Z, for which costs in the forthcoming year are
expected to be as follows.

W X Y Z
Production (units) 1,000 2,000 4,000 3,000
Unit variable costs
Direct materials Br. 4 Br 5 Br 2 Br 4
Direct labor 8 9 4 6
Variable production overheads 2 3 1 2
Br 14 Br 17 Br 7 Br 12

attributable fixed cost per annum and other fixed costs are as follows:
Incurred as a direct consequence of making W Br 1,000
Incurred as a direct consequence of making X 5,000
Incurred as a direct consequence of making Y 6,000
Incurred as a direct consequence of making Z 8,000
Other fixed costs (committed) 30,000
Total fixed costs Br 50,000
A subcontractor has offered to supply units of W, X, Y and Z for Br 12, Br 21, Br 10, and Br 14
respectively.
Required: Decide whether Buster Ltd should make or buy the components and mention some qualitative
factors to be considered by Buster Ltd in decision making

40
 3) Great Company manufacturers 60,000 units of part XL – 40:

Total costs Cost per

60,000 units unit
Direct material Br 480,000 Br 8
Direct labor 360,000 6
Variable factory overhead (FOH) 180,000 3
Fixed FOH 360,000 6
Total manufacturing costs Br 1,380,000 Br 23
Another manufacturer has offered to sell the same part to Great for Br 21 each. The fixed overhead consists
of depreciation, property taxes, insurance, and supervisory salaries. The entire fixed overhead would
continue if the Great Company bought the component except that the cost of Br 120,000 pertaining to
some supervisory and custodial personnel could be avoided.
Required:
a. Should the parts be made or bought? Assume that the capacity now used to make parts internally will
become idle if the pats are purchased?
b. Assume that the capacity now used to make parts will be either (i) be rented to nearby manufacturer
for Br 60,000 for the year or (ii) be used to make another product that will yield a profit contribution
of Br 250,000 per year. Should the company purchase them from the outside supplier?

SOLUTIONS FOR WORKOUT QUESIONS

Q1
Br. Br.
Value of order 25,000
Cost of order
Direct materials (Br. 4 x 2,000) 8,000
Direct labor (Br. 6 x 2,000) 12,000
Variable overhead (Br 2 x 2,000) 4,000
Relevant cost of order (24,000)
Profit form order acceptance 1,000
Fixed costs will be incurred regardless of whether the special order is accepted and so are not relevant to
the decision. The contract should be accepted since it increases contribution to profit by Br 1, 000.
Other factors to be consider in the special-order decision.

41
 a) The acceptance of the special order at a lower price may lead other customers to demand lower
prices as well.
b) There may be more profitable ways of using the spare capacity.
c) Accepting the special order may lock up capacity that could be used for future full-price business.
d) Fixed costs may exist, in fact, if the contract is accepted.

Q2
a. The relevant cots are the differential costs between making and buying, and they consist of difference
in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in some
fixed cost savings.
W X Y Z
Unit variable cost of making Br. 14 Br 17 Br 7 Br 12
Unit variable cost of buying 12 21 10 14
Br (2) Br 4 Br 3 Br 2
W X Y Z
Annual requirements (units) 1,000 2,000 4,000 3,000
Extra variable cost of buying (per annum) Br. (2,000) Br. 8,000 Br.12, 000 Br. 6,000
Fixed costs saved by buying (1,000) (5,000) (6,000) (8,000)
Extra total cost of buying (3,000) 3,000 6,000 (2,000)
b. The company would save Br 3,000 by subcontracting component W (where the purchase cost would be
less than the variable cost per unit to make internally) and would save Br 2,000 by subcontracting
component Z (because of the savings in fixed costs of Br 8,000).
c. In this question, relevant costs are the variable cots in-house manufacture the variable costs of
subcontracted units, and the saving in fixed costs.

Q3
To approach the decision form a financial point of view, the manager must focus on the relevant or
different costs. The differential cost can be obtained by eliminating from the cost data those costs that are
not avoidable – that is, by eliminating the sunk costs and the future costs will continue regardless of
whether the parts XL – 40 are produced internally or purchased from outside. Thus, the relevant cost
computation follows:

42
 Cost To Make Cost To Buy
Per unit Total Per unit Total
Purchase Cost -0- -0- 21.00 1,260,000
Direct materials Br 8.00 Br 480,000
Direct labor 6.00 360,000
Variable FOH 3.00 180,000
Fixed FOH, avoidable 2.00 120,000
Total cost Br 19.00 Br 1,140,000 Br 21.00 Br 1,260,000
Recommendation: Great Company should reject the outside supplier’s offer because it costs Br 2 less per
unit to continue to make the part – XL – 40.

Relevant costs Per unit

Cost to buy Br 21.00
Cost to make 19.00
Advantage of making the part internally Br 2.00
Total advantage = Br 2.00 x 60,000units = Br 120,000
a. Assuming the space now being used to produce part XL – 40 would be
i. Rented to a nearby manufacture of Br 60,000 per annum or
ii. Used to produce other product that contributes a profit of Br 250,000 per year, the relevant cost
computation follows:
Make Buy and Buy and Buy and
Leave Rent out Produce
Facility Idle Other
Product
Cost to obtain parts Br1,140,000 Br1,260,000 Br1,260,000 Br 1,260,000
Contribution from other - - - (250,000)
products
Rent revenue - - (60,000)
Net relevant costs Br1,140,000 Br1,260,000 B1 ,200,000 Br 1,010,000
Great Company would be better off through accepting the supplier’s offer and to using the available
facility to produce the new product line. This move has the least net relevant cost of Br 1,010,000.

43
 Chapter 3
Information for budgeting, planning, and control purposes

3.1 Objectives and concepts of budgetary systems

Like many accounting terms, budgeting is used commonly in our everyday language. The news
media discuss budgets of federal and state governments, and many people describe a variety of
resource allocation decisions, ranging from vacation planning to the purchase of food and clothing,
as budgeting. The purpose of this chapter is to introduce the framework for the budgeting process,
define budgeting terms, enumerate the principal advantages of budgeting, explain the concepts of
responsibility accounting and participatory budgeting and provide a clear understanding of the
concepts of budgeting. Although the primary emphasis in this chapter is on business budgeting,
most of the concepts are also applicable to non-business activities.
THE FUNDAMENTALS OF BUDGETING
A budget is a comprehensive formal management plans expressed in quantitative terms,
describing the expected operations of an organization over some future time period. A budget
deals with a specific entity, covers a specific future time period and is expressed in quantitative
terms.
Budget entity .The entity concept, so important in financial accounting, is essential to budgeting
also. A specific budget must apply to a clearly defined accounting entity. For budgeting purpose
the entity may consist of a small part of a business, a single activity, or a specific project. The
concept of a budget entity applies to individuals as well. For example, a student interested in
budgeting the cost of a first year’s college education should not include in the budget the cost of
three weeks vacation or the purchase of a Br. 5800 guitar. Although these two expenditures may
be cost of the period, they are not college education expenses. A budget entity can be as a specific
as a single project such as Addisalem’s Langano trip or it can be a broad activity, such as the budget
for an entire manufacturing firm, or for the Ethiopian government.
Future time period .Many financial figures are meaningless unless they are couched in some time
references. For example, income statements are annual, quarterly, or monthly. A job offer of Br.
40,000 is of little value without knowing if the figure represents pay for a month, a year, a lifetime,

44
or some other time period. We might assume the Br. 40,000 is annual salary. In accounting,
however, time reference should be clearly stated.
Budgets should express the expected financial consequences of programs and activities planned
for a specific period of time. Annual budget are widespread. In addition to annual budgets,
budgets for many other time periods are prepared. The planning horizon for budgeting may vary
from one day to many years. For example, master budget usually cover 1 month to 1year where
as long-range plan are prepared for 2 to 10 years. In planning for profits, managers must consider
two time horizons: the short term and the long term.
Short-term planning is the process of deciding what objectives to pursue during a short, near-
future period, usually one year, and what to do to achieve those objectives. The typical short-term
budget covers one year and is broken down into monthly or quarterly units. Another method
frequently used to prepare a short-term budget is the continuous budget. This kind of budget starts
with an annual budget broken down into 12 monthly units. As each month arrives, it is dropped
from the plan and replaced by a new month so that at any given time, the next 12 months are
always shown. Thus, in a budgetary period covering January through December 20X4, when
January 20x4 arrives, it would be dropped from the plan and replaced by January 20x5, thus
creating a new budgetary period covering February 20x4 through January 20x5. Using this
technique, a firm always has guidance for the full following year. When a continuous budget is
not used, a firm will have guidance for only a month or two as it approaches the end of its
budgetary period.
Long-term planning, also known as strategic planning, is the process of setting long-term goals
and determining the means to attain them. Short-term planning is concerned with operating
details for the next accounting period, but long-term planning addresses broad issues, such as new
product development, plant and equipment replacement, and other matters that require years of
advance planning. For example, short-term planning in the automotive industry would be
concerned with which and how many of the current year’s models to manufacture, while long-
range planning would focus on new model development and major changes, as well as equipment
replacements and modifications. The time frame for long-range planning may extend as far as 20
years in the future, but its usual range is from 2 to 10 years. An important part of long-term
planning is the preparation of the capital budget, which details plans for the acquisition and
replacement of major portions of property, plant, and equipment.
45
Quantitative plan: Often budgets contain materials describing the various programs and activities
planned by the company. This chapter focuses primarily in the way that cost and revenue
estimates of the activities are expressed by the budget. All planned projects or activities for the
organization are reduced to the common denominator of money and other quantitative measures,
such as units of input or output.
Principal Advantages of Budgeting
As noted earlier, a budget is a detailed plan expressed in quantitative terms that specifies how
resources will be acquired and used during a specific period of time. The act of preparing a budget
is known as budgeting. The use of budgets to control a firm’s activities is called budgetary control.
Companies realize many benefits from a budgeting program. Among these benefits are the
following:
• Requires periodic planning.
• Fosters coordination, cooperation, and communication.
• Provides a framework for performance evaluation.
• Means of allocating resources.
• Satisfies legal and contractual requirements.
• Created an awareness of business costs.
Periodic Planning (Formalization of Planning): The most obvious purpose of a budget is to quantify a plan
of action. The development of a quarterly budget for a Sheraton Hotel, for example, forces the hotel manager,
the reservation manager, and the food and beverage manager to plan for the staffing and supplies needed to
meet anticipated demand for the hotel’s services. To sum up, budgets forces managers to think a head
to anticipate and prepare for the changing conditions. The budgeting process makes planning an
explicit management responsibility.
Coordination, Cooperation and Communication: Planning by individual managers does not ensure an
optimum plan for the entire organization. Therefore, any organization to be effective, each manager
throughout the organization must be aware of the plans made by other managers. In order to plan reservations
and ticket sales effectively, the reservation manager for Ethiopian Air Lines must know the flight schedules
developed by the airline’s route manager. The budget process pulls together the plans of each manager in an
organization. In a nutshell, a good budget process communicates both from the top down and from the bottom
up. Top management makes clear the goals and objectives of the organization in its budgetary directives to

46
middle and lower level managers, and also to all employees. Employees and lower level managers inform
top-level managers how they can plan to achieve the objectives.
Performance Evaluation or Framework for Judging Performance: Budgets are estimates of future
events, and as such they serve as estimates of acceptable performance. Comparing actual result
against budgeted results helps managers to evaluate the performance of individuals, departments,
or entire companies.
Budgets are generally a better basis for judging actual results than is past performance. The major drawback
of using historical results for judging current performance is that inefficiencies may be concealed in the past
performance.
Means of Allocating Resources: Because we live in a world of limited resources, virtually all
individuals and organizations must ration their resources. The rationing process is easier for some
than for other. Each person and each organization must compare the costs and benefits of each
potential project or activity and choose those that result in the most appropriate resource allocation
decision.
Generally, organizations resources are limited, and budgets provide one means of allocating
resources among competing uses. The city of Addis Ababa, for example, must allocate its revenue
among basic life services (such as police and fire protection), maintenance of property and
equipment (such as city streets, parks and vehicles) and other community services (such as
programs to prevent alcohol and drug abuse).
Legal and Contractual Requirements: Some organizations are required to budget because of legal
requirements. Others commit themselves to budgeting requirement when signing loan
agreements or other operating agreements. For example, a bank may require a firm to submit an
annual operating budget and monthly cash budget throughout the life of a bank loan. Local police
department, for example, would be out of funds if the department decided not to submit a budget
this year.
Cost Awareness. Accountants and financial managers are concerned daily about the cost
implications of decisions and activities, but many other managers are not. Production managers
focus on input, marketing manager’s focuses on sales, and so forth. It is easy for people to overlook
costs and cost-benefit relationships. At budgeting time, however, all managers with budget
responsibility must convert their plans for projects and activities to costs and benefits. This cost

47
awareness provides a common ground for communication among the various functional areas of
the organization.
Components of Master Budget
The master budget is the total budget package for an organization; it is the end product that
consists of all the individual budgets for each part of the organization aggregated into one overall
budget for the entire organization.
The two major components of master budget are the operating budget and the financial budget.
Operating budget: It focuses on income statement and its supporting schedules. It is also called
profit plan. However, such budget may show a budgeted loss, or can be used to budget expenses
in an organization or agency with no sales revenues.
Financial budget: It focuses on the effects that the operating budget and other plans will have on cash. The
usual master budget for a non-manufacturing company has the following components.
1. Operating budget includes: 2. Financial budget include:
a. Sales budget a. Capital budget
b. Purchases budget b. Cash budget
c. Cost of goods sold budget c. Budgeted balance sheets
d. Operating expense budget d. Budgeted statement of cash flows
In addition to the master budget there are countless forms of special budgets and related reports.
For example, a report might detail goals and objectives for improvements in quality or customer
satisfaction during the budget period.

48
Figure 3-1 Preparation of Master Budget (Non manufacturing Company)

Sales
Budget

Ending –inventory Purchase

Budget Budget

Operating Cost of Goods

Budget Sold Budget

Operating
Expenses Budget

Budgeted Statement of
Income

Financial
Budget

Capital Cash Budgeted Balance

Budget Budget Sheet

Exhibit 3-1 above show graphically the follow of process in development of the master budget
for a non-manufacturing firm. The master budget example that follows should clarify the steps
required to prepare the budget package. After studying the entire example, return to Exhibit 1-1
and follow the example through the flow diagram.
Operating Budget
The operating budget is composed of the income statement elements. A manufacturing business
budgets both manufacturing and non-manufacturing activities. Below the various elements of the
operating budget of a manufacturing firm have been discussed.

49
Sales Budget: The sales budget is the first budget to be prepared. It is usually the most important
budget because so many other budgets are directly related to sales and are therefore largely derived
from the sales budget. Inventory budgets, purchases budgets, personnel budgets, marketing budgets,
administrative budgets, and other budget areas are all affected significantly by the amount of revenue
that is expected from sales.
Sales budgets are influenced by a wide variety of factors, including general economic conditions,
pricing decisions, competitor actions, industry conditions, and marketing programs. In an effort to
develop an accurate sales budget, firms employ many experts to assist in sales forecasting. The sales
budget is usually based on a sales forecast. A sales forecast is a prediction of sales under a given
conditions. The objective in forecasting sales is to estimate the volume of sales for the period based
on all the factors, both internal and external to the business that could potentially affect the level of
sales. The projected level of sales is then combined with estimated of selling prices to form the sales
budget. Sales forecasts are usually prepared under the direction of the top sales executive. Important
factors considered by sales forecasters include:
a) Past patterns of sales: Past experience combined with detailed past sales by product line,
geographical region, and type of customer can help predict future sales.
b) Estimates made by the sales force: A company’s sales force is often the best source of information
about the desires and plans of customers.
c) General economic conditions: Predictions for many economic indicators, such as gross domestic
product and industrial production indexes (local and foreign), are published regularly. Knowledge
of how sales relate to these indicators can aid sales forecasting.
d) Competitive actions: Sales depend on the strength and actions of competitors. To forecast sales,
a company should consider the likely strategies and reactions of competitors, such as changes in
their prices, products, or services.
f) Changes in the firm’s prices: Sales can be increased by decreasing prices and vice versa. Planned
changes in prices should consider effects on customer demand.
f) Changes in product mix: Changing the mix of products often can affect not only sales levels but
also overall contribution margin. Identifying the most profitable products and devising methods
to increases sales is a key part of successful management.

50
g) Market research studies: Some companies hire market experts to gather information about market
conditions and customer preferences. Such information is useful to managers making sales forecasts
and product mix decisions.
h) Advertising and sales promotion plans: Advertising and other promotional costs affect sales levels.
A sales forecast should be based on anticipated effects of promotional activities.
Purchases Budget: After sales are budgeted, prepare the purchases budget. The total merchandise
needed will be the sum of the desired ending inventory plus the amount needed to fulfill budgeted
sales demand. The total need will be partially met by the beginning inventory; the remainder must
come from planned purchases.
These purchases are computed as follows:
Budgeted Desired Cost of
Beginning

Purchases = Ending inventory + Goods Sold - Inventory

Budgeted cost of goods sold: For a manufacturing firm cost of goods sold is the production cost of
products that are sold. Consequently, the cost of goods sold budget follows directly from the
production budget. However, a merchandising firm has no production budget. The cost of goods sold
budget comes directly from merchandise inventory and the merchandise purchases budget.
Operating Expense Budget: The budgeting of operating expenses depends on various factors.
Month – to – month fluctuation in sales volume and other cost-drivers activities directly influence
many operating expenses. Examples of expenses driven by sales volume include sales
commissions and many delivery expenses. Other expenses are not influenced by sales or other
cost-driver activity (such as rent, insurance, depreciation, and salaries) within appropriate relevant
ranges and are regarded as fixed.
Budgeted Income Statement: The budgeted income statement is the combination of all of the
preceding budgets. This budget shows the expected revenues and expenses from operations
during the budget period.
A firm may have budgeted non-operating items such as interest on investments or gain or loss on
the sale of fixed assets. Usually they are relatively small, although in large firms the birr amounts
can be sizable. If non-operating items are expected, they should be included in the firm’s budgeted
income statement. Income taxes are levied on actual, not budgeted, net income, but the budget

51
plan should include expected taxes; therefore, the last figure in the budgeted income statement is
budgeted after tax net income.

Financial Budget
The second major part of the master budget is the financial budget, which consists of the capital
budget, cash budget, ending balance sheet and the statement of changes in financial position.
Although there are some differences in operating budgets of manufacturing, merchandising and
service firms, very little difference exists among financial budgets of these entities.
Capital expenditure budget: Capital budgeting is the planning of investments in major resources
like plant and equipment, and other types of long-term projects, such as employee education
programs. The capital expenditure budget or capital budget describes the capital investment plans
for an organization for the budget period. It contains some of the most critical budgeting decisions
of the organizations.
Cash budget: The cash budget is a statement of planned cash receipts and disbursements. The cash
budget is composed of four major sections:
i. The receipts section: It consists of a listing of all of the cash inflows, except for
financing, expected during the budget period. Generally, the major source of receipts
will be from sales.
ii. The disbursement section: It consists of all cash payments that are planned for the
budget period. These payments will include inventory purchases, wages and salary
payments and so on. In addition, other cash disbursements such as equipment
purchases, dividends, and other cash withdrawals by owners are listed.
iii. The cash excess or deficiency section: The cash excess or deficiency section
is computed as follows:
Cash balance, beginning xxx
Add receipts xxx
Total cash available before financing xxx
Less disbursements xxx
52
Excess (deficiency) of cash available over disbursements xxx
If there is a cash deficiency during any budget period, the company will need to borrow funds. If
there is cash excess during any budget period, funds borrowed in previous periods can be repaid
or the idle funds can be placed in short-term or other investments.
iv. The financing section: This section provides a detail account of the
borrowing and repayments projected to take place during the budget
period. It also includes a detail of interest payments that will be due on
money borrowed.
Budgeted Balance Sheet: The budgeted balance sheet, sometimes called the budgeted statement of
financial position, is derived from the budgeted balance sheet at the beginning of the budget
period and the expected changes in the account balance reflected in the operating budget, capital
budget, and cash budget.
Budgeted Statement of Changes in Financial Position: The final element of the master budget
package is the statement of changes in financial position. It has emerged as a useful tool for
managers in the financial planning process. This statement is usually prepared from data in the
budgeted income statement and changes between the estimated balance sheet at the beginning of
the budget period and the budgeted balance sheet at the end of the budget period.
Preparing the Master Budget
The master budget is a network consisting of many separate but interdependent budgets. This
network is illustrated in Exhibit 1-1. The master budget can be a large document even for a small
organization. The simple example that follows on the next page for Blue Nile Company’s give
some indication of the potential size and complexity of the master budget of a business. The
example illustrates a fixed or static budget prepared for a single expected level of activity. Flexible
budgeting that involves various activity levels will be discussed later in the next unit.
Preparation of Master Budget (Manufacturing Company)
Example (2) Great Company manufactures and sells a product whose peak sales occur in the third
quarter. Management is now preparing detailed budgets for 20x4- the coming year and has
assembled the following information to assist in the budget preparation:
1) The company’s product selling price is Br. 20 per unit. The marketing department has
estimated sales as follows for the next six quarters.

53
 20x4 Quarters 20x5 Quarters

1 2 3 4 1
2
Budgeted sales in units 10, 000 30,000 40, 000 20, 000 15, 000 15, 000
2) Sales are collected in the following pattern: 70% of sales are collected in the quarter in
which the sales are made and the remaining 30% are collected in the following quarter.
On January1, 20x4, the company’s balance sheet showed Br.90, 000 in account receivable,
all of which will be collected in the first quarter of the year. Bad debts are negligible and
can be ignored.
3) The company maintains an ending inventory of finished units equal to 20% of the next
quarter’s sales. The requirement was met on December 31, 20x3, in that the company
had 2, 000 units on hand to start the New Year.
4) Fifteen pounds of raw materials are needed to complete one unit of product. The
company requires an ending inventory of raw materials on hand at the end of each
quarter equal to 10% of the following quarter’s production needs of raw materials. This
requirement was met on December 31, 20x3 in that the company had 21, 000 pounds of
raw materials to start the New Year.
5) The raw material costs Br.0.20 per pound. Raw material purchases are paid for in the
following pattern: 50% paid in the quarter the purchases are made, and the remainder
is paid in the following quarter. On January 1,20x4, the company’s balance sheet showed
Br.25, 800 in accounts payable for raw material purchases, all of which be paid for in the
first quarter of the year.
6) Each unit of Great’s product requires 0.8 hour of labor time. Estimated direct labor cost
per hour is Br.7.50.
7) Variable overhead is allocated to production using labor hours as the allocation base as
follows:
Indirect materials Br.0.40
Indirect labor 0.75
Fringe benefits 0.25
Payroll taxes 0.10
54
Utilities 0.15
Maintenance 0.35
Fixed overhead for each quarter was budgeted at Br. 60, 600. Of the fixed overhead amount,
Br. 15, 000 each quarter is depreciation. Overhead expenses are paid as incurred.
8) The company’s quarterly budgeted fixed selling and administrative expenses are as follows:
20X4 Quarters
1 2 3 4
Advertising Br.20, 000 Br.20, 000 Br.20, 000 Br.20, 000

Executive salaries 55, 000 55, 000 55, 000 55, 000
Insurance - 1, 900 37,750 -
Property taxes - - - 18, 150
Depreciation 10, 000 10, 000 10, 000 10, 000

The only variable selling and administrative expense, sales commission, is budgeted at Br.1.80 per
unit of the budgeted sales. All selling and administrative expenses are paid during the quarter, in
cash, with exception of depreciation. New equipment purchases will be made during each quarter
of the budget year for Br. 50, 000, Br. 40, 000, & Br.20, 000 each for the last two quarter in cash,
respectively. The company declares and pays dividends of Br.8, 000 cash each quarter. The
company’s balance sheet at December 31, 20x3 is presented below:

55
 ASSETS
Current assets:
Cash Br. 42, 500
Accounts Receivable 90, 000
Raw Materials Inventory (21, 000 pounds) 4, 200
Finished Goods Inventory (2, 000 units) 26, 000
Total current assets Br.162, 7 00
Plant and Equipment:
Land Br.80, 000
Building and Equipment 700, 000
Accumulated Depreciation (292, 000)
Plant and Equipment, net 488, 000
Total assets Br.650, 700
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable (raw materials) Br.25, 800
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 449, 900
Total stockholders’ equity 624, 900
Total liabilities and stockholders’ equity Br.650, 700
The company can borrow money from its bank at 10% annual interest. All borrowing must be
done at the beginning of a quarter, and repayments must be made at the end of a quarter. All
borrowings and all repayments are in multiples of Br. 1,000.

56
The company requires a minimum cash balance of Br.40, 000 at the end of each quarter. Interest is
computed and paid on the principal being repaid only at the time of repayment of principal. The
company whishes to use any excess cash to pay loans off as rapidly as possible.
Instructions: Prepare a master budget for the four-quarter period ending December 31. Include
the following detailed budget and schedules:
1. a) A sales budget, by quarter and in total
b) A schedule of budgeted cash collections, by quarter and in total
c) A production budget
d) A direct materials purchase budget
e) A schedule of budgeted cash payments for purchases by quarter and in total
f) A direct labor budget
g) A manufacturing overhead budget
h) Ending finished goods inventory budget
i) A selling and administrative budget
2. A cash budget, by quarter and in total
3. A budgeted income statement for the four- quarter ending December 31, 20x4
4. A budgeted balance sheet as of December 31, 20x4.
Preparation of Master Budget (Merchandising Company)
Example 1: Blue Nile Company’s newly hired accountant has persuaded management to prepare
a master budget to aid financial and operating decisions. The planning horizon is only three
months, January to March. Sales in December (20x3) were Br. 40, 000. Monthly sales for the first
four months of the next year (20x4) are forecasted as follows:
January Br. 50, 000
February 80, 000
March 60, 000
April 50, 000
Normally 60% of sales are on cash and the remainders are credit sales. All credit sales are collected
in the month following the sales. Uncollectible accounts are negligible and are to be ignored.
Because deliveries from suppliers and customer demand are uncertain, at the end of any month
Blue Nile wants to have a basic inventory of Br. 20, 000 plus 80% of the expected cost of goods to
be sold in the following month. The cost of merchandise sold averages 70%of sales. The purchase
terms available to the company are net 30 days. Each month’s purchase are paid as follows:
57
 50% during the month of purchase and,
50% during the month following the purchases
Monthly expenses are:
Wages and commissions……………………………Br. 2, 500 + 15%of sales, paid as incurred.
Rent expense………………………………………..Br. 2, 000 paid as incurred.
Insurance expense…………………………………..Br.200 expiration per month
Depreciation including truck……………………….Br.500 per month
Miscellaneous expense…………………………….5% of sales, paid as incurred.
In January, a used truck will be purchased for Br. 3, 000 cash. The company wants a minimum cash
balance of Br. 10, 000 at the end of each month. Blue Nile can borrow cash or repay loans in
multiples of Br. 1, 000. Management plans to borrow cash more than necessary and to repay as
promptly as possible. Assume that the borrowing takes place at the beginning, and repayment at
the end of the months in question. Interest is paid when the related loan is repaid. The interest rate
is 18% per annum. The closing balance sheet for the fiscal year just ended at December 31, 20x3,is:
Blue Nile Company
Balance Sheet
December 31, 20x3
ASSETS
Current assets:
Cash Br. 10, 000
Account receivable 16,000
Merchandise inventory 48, 000
Unexpired insurance 1, 800
Br.75, 800
Plant assets:
Equipment, fixture and other Br.37, 000
Accumulated depreciation 12, 800 Br.24, 200
Total assets Br.100,000
LIABILITIES AND OWNERS’ EQUITY
Liabilities:
Accounts payable Br.16, 800
Accrued wages and commissions payable 4, 250
Br.21, 050
Capital:
Owners’ equity 78, 950
Total liabilities and owners’ equity Br.100, 000

58
Instructions:
1) Using the data given above, prepare the following detailed schedules for the first quarter of
the year:
b) Sales budget
c) Cash collection budget
d) Purchase budget
e) Disbursement for purchases
f) Operating expenses budget
g) Disbursement for operating expenses
2) Using the budget data given above and the schedules you have prepared, construct the
following pro forma financial statements
a. Income statement for the first quarter of the year.
b. Cash budget including receipts, payments, and effect of financing
c. Balance sheet at March 31, 20x3.

Solution-Preparation of Master Budget (Merchandising Company)

STEPS IN PREPARATION OF MASTER BUDGET
59
 1. A) Sales budget

December* January February March Jan.-Mar.

Total
Cash sales (40%) Br.24, 000 Br.30, 000 Br.48, 000 Br.36, 000 Br.114, 000
Credit sales (60%) 16, 000 20, 000 32, 000 24,000 76, 000
Totals Br.40, 000 Br.50, 000 Br.80, 000 Br.60, 000 Br.190, 000

*December sales are included in the schedule (a) because they affect cash collected in January.

b) Cash collection budget

January February March
Cash sales of the Br.30, 000 Br.48, 000 Br.36, 000
month
Credit sales of last 16, 000 20, 000 32, 000
month
Total cash collected Br.46, 000 Br.68, 000 Br.68, 000

c) Purchase budget

January February March Jan.-Mar

Required ending Br.64, 800 Br.53, 600 Br.48, 000
inventory
Cost of gods sold 35, 000 56, 000 42, 000 Br.133, 000
Total needed Br.99, 800 Br.109, 600 Br.90, 000
Beginning inventory 48, 000 64, 800 53, 600
Purchases budget Br.51, 800 Br.44, 800 Br.36,
400

d) Disbursement for purchases

January February March

50% of last month’s purchase Br.16, 800 Br.25, 900 Br.22, 400
50% of current month’s 25, 900 22, 400 18, 200
purchase
Total disbursement for Br.42, 700 Br.48, 300 Br.40, 600
purchase

e) Operating expense budget

January February March Jan.-Mar.

Wages and commissions Br.10, 000 Br.14, 500 Br.11, 500 Br.36, 000
Rent expense 2, 000 2, 000 2, 000 6, 000
60
 Insurance expense 200 200 200 600
Depreciation expense 500 500 500 1, 500
Miscellaneous expense 2, 500 4, 000 3, 000 9, 500
Total Br.15, 200 Br.21, 200 Br.17, 200 Br.53, 600

f) Disbursement for operating expenses budget

January February March

Wages and commissions Br.14, 250 Br.14, 500 Br.11, 500
Rent expense 2, 000 2, 000 2, 000
Miscellaneous expense 2, 500 4, 000 3, 000
Total Br.18, 750 Br.20, 500 Br.16, 500

2. A) Budget income statement

Blue Nile Company

Budget Income Statement
For the Quarter Ended, March 31, 20x4

Sales (schedule 1(a)) Br.190, 000

Cost of goods sold (schedule 133, 000
1(c))
Gross profit 57, 000
Operating expenses
Wages and commissions Br.36, 000
Rent expense 6, 000
Insurance expense 1, 500
Depreciation expense 600
Miscellaneous expense 9, 500 53, 600
Operating income 3, 400
Interest expense* 885
Net income Br. 2, 515

*Interest expense computation

Paid interest = 11, 0000.183/12= 495
Accrued amount:
On the first batch borrowing:
8, 0000.183/12= 360
On the second batch borrowing:
1, 0000.182/12= 30
Total interest expense incurred Br.885
61
b) Cash budget including receipts, payments and effects of financing

January February March

Beginning balance Br.10, 000 Br.10, 550 Br.10, 750
Collections (Schedule1 (b)) 46, 000 68, 000 68, 000
Cash available for the use (x) Br.56, 000 Br.78, 550 Br.78, 750
Cash disbursements for:
Purchases (Schedule 1(d)) 42, 700 48, 300 40, 600
Operating expenses (Schedule1 (f)) 18, 750 20, 500 16, 500
Truck purchases 3, 000 - -
Total disbursement (y) Br.64, 450 Br.68, 800 Br.57, 100
Minimum cash balance required 10, 000 10, 000 10, 000
Total cash needed Br.74, 450 Br.78, 800 Br.67, 100
Cash excess (deficiency) Br.(18, 450) Br.( 250) Br.11, 650
Effects of financing
Borrowing 19, 000 1, 000 -
Payment of the principal - - (11, 000)
Payment of interest - - (495)
Net effect of financing (z) Br.19, 000 Br.1, 000 Br.(11, 495)
End cash balance (x+z-y) Br.10, 550 Br.10, 750 Br.10, 155

c) Budgeted balance sheet

Blue Nile Company

Budgeted Balance Sheet
March 31, 20x4
ASSETS
Current assets
Cash Br. 10, 155
Accounts receivable 24, 000
Merchandise inventory 48, 000
62
 Unexpired insurance 1, 200
Br. 83, 355
Plant assets
Equipment, Fixture and others 40, 000
Accumulated depreciation 14, 300 25, 700
Total assets Br. 109, 055

LIABILITIES AND OWNER’S EQUITY

Liabilities
Accounts payable Br.18, 200
Loan payable 9, 000
Interest payable 390
Total liabilities Br.27, 590
Capital
Beginning owners’ equity Br.78, 950
Net income 2, 515
Ending capital balance 81, 465
Total equities Br.109, 055

Solution-Preparation of Master Budget (Manufacturing Company)

1. a) Sales Budget
Quarter
1 2 3 4
Expected sales in 10, 000 30, 000 40, 000 20, 000
units
Selling price per unit x Br. 20 x Br. 20 x Br.20 x Br.20
Total sales Br.200, 000 Br.600, 000 Br.800, 000 Br.400, 000

b) Schedule of Expected Cash Collections

Quarter
1 2 3 4 Total
30% of the previous Br. 90, 000 Br.60, 000 Br.180, 000 Br.240, 000 Br.570, 000
quarter sales
70% of the current 140, 000 420, 000 560, 000 280, 000 1, 400, 000
quarter sales
Total collections Br.230, 000 Br.480, 000 Br.740, 000 Br. 520, 000 Br.1, 970, 000
c) Production Budget
63
After the sales budget has been prepared, the production requirements for the forth-coming
budget period can be determined and organized in the form of a production budget. Sufficient
goods will have to be available to meet sales and provide for the desired ending inventory. A
portion of these goods will already exist in the form of a beginning inventory. The remainder will
have to be produced. Therefore, production needs can be determined as follows:
Budgeted sales in units ………………………………………… xxxx
Add desired ending inventory……………….…………………. xxxx
Total needs……………………………………………………… xxxx
Less beginning inventory……………………………………….. xxxx
Required production……………………………………………. .xxxx
The schedule given below shows the production budget for Great Company. Note that the desired
level of the ending inventory influences production requirements for a quarter. Inventories should
be carefully planned. Excessive inventories tie up funds and create storage problems. Insufficient
inventories can lead to lost sales or crash production efforts in the following period
Quarter Total
Expected sales(units) 10, 000 30, 000 40, 000 20, 000 100, 000
Add: Desired Ending 6, 000 8, 000 4, 000 3, 000 3, 000
Inventory
Total needs 16, 000 38, 000 44, 000 23, 000 103, 000
Lees: Beginning 2, 000 6, 000 8, 000 4, 000 2, 000
Inventory
Units to be produced 14, 000 32,000 36, 000 19, 000 101, 000
1 2 3 4
d) Direct Materials Budget
Returning to Great Company’s budget data, after the production requirements have been
computed, a direct materials budget can be prepared. The direct materials budget details the raw
materials that must be purchased to fulfill the production budget and to provide for adequate
inventories. The required purchases of raw materials are computed as follows:
Raw materials needed to meet the production schedule…………………………….xxxx
Add desired ending inventory of raw materials……………….……………………..xxxx

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 Total raw materials needs…………………………………………………… .xxxx
Less beginning inventory of raw materials………………………….………… xxxx
Raw materials to be purchased………………………………………………………. .xxxx
Quarter Total
1 2 3 4
Production needs(pounds) 210, 000 480, 000 540, 000 285, 000 1, 515, 000
Add: Desired ending 48, 000 54, 000 28, 500 22, 500 22, 500
inventory
Total needs 258, 000 534, 000 568, 500 307, 500 1, 537, 500
Less: Beginning inventory 21, 000 48, 000 54, 000 28, 500 21, 000
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516,500
purchased(pounds)
Raw Materials to be purchased (in birrs)
1 2 3 4 Total
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516, 500
purchased
Raw materials cost per x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20
pound
Total Br.47, 400 Br.97, 200 Br.102, 900 Br.55, 800 Br.303, 300

e) Schedule of Expected Cash Disbursements (for Materials Purchase)

Quarter Total
1 2 3 4
50% of the previous quarter Br. 25, 800 Br.23, 700 Br.48, 600 Br.51, 450 Br.149, 550
50% of the current quarter 23, 700 48, 600 51, 450 27, 900 151, 650
Total cash disbursement Br.49, 500 Br.72, 300 Br.101, 050 Br.79, 350 Br.301, 200

f) Direct Labor Budget

The direct labor budget is also developed from the production budget. Direct labor requirements
must be computed so that the company will know whether sufficient labor time is available to

65
meet production needs. By knowing in advance just what will be needed in the way of labor time
throughout the budget year, the company can develop plans to adjust the labor force as the
situation may require. Firms that neglect to budget run the risk of facing labor shortage or having
to hire and lay off at awkward times. Erratic labor policies lead to insecurity and inefficiencies on
the part of employees. To compute direct labor requirements, the number of units of finished
product to be produced each produced each period (month, quarter, and so on) is multiplied by
the number of direct labor-hours required to produced a single unit. Many different types of labor
may be involved. If so, then the computation should be by type of labor needed. The labor
requirements can then be translated into expected direct labor costs. How this is done will depend
on the labor policy of the firm. In schedule given below, the management of Great Company has
assumed that the direct labor force will be adjusted as the work requirement change from quarter
to quarter (for example as units produced changes from l4, 000 units in quarter 1 to 32, 000 units
in quarter 2 for Great Company, the direct labor work force will be fully adjusted to the workload,
i.e., total hours of direct labor time needed) . In that case, the total direct labor cost is computed by
simply multiplying the direct labor-hour required by the direct labor rate hour as was done in the
schedule here under.
Quarter Total
1 2 3 4
Direct labor time 11, 200 25, 600 28, 800 15, 200 80, 800
needed
Direct labor cost per x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50
hour
Total direct labor Br.84, 000 Br.192, 000 Br.216, 000 Br.114, 000 Br.606, 000
cost
g) Manufacturing Overhead (MOH) Budget
The manufacturing overhead budget provides a schedule of all costs of production other than
direct materials and direct labor. These costs should be broken down by cost behavior for
budgeting purposes and a predetermined overhead rate developed. This rate will be used to
apply manufacturing overhead to units of product throughout the budget period.

66
A computation showing budgeted cash disbursement for manufacturing overhead should be
made for use in developing the cash budget. Since some of the overhead costs do not represent
cash outflows, the total budgeted manufacturing overhead costs must be adjusted to determine
the cash disbursement for manufacturing overhead. At Great Company, the only significant
noncash manufacturing overhead cost is depreciation. Any depreciation charges included in
manufacturing overhead must be deducted from the total in computing expected cash payments,
since depreciation is a noncash charge.
Quarter Total
1 2 3 4
Variable overhead Br.22, 400 Br.51, 200 Br.57, 600 Br.30, 400 Br.161,600
Fixed overhead 60, 600 60, 600 60, 600 60, 600 242,400
Total MOH Br.83, 000 Br.111, 800 Br.118, 200 Br.91, 000 Br.404,000
Less: Depreciation 15, 000 15, 000 15, 000 15, 000 60, 000
Cash disbursements Br.68, 000 Br.96, 800 Br.103, 200 Br.76, 000 Br.344, 000
for MOH
h) Ending Finished Goods Inventory Budget
After completing schedules (a) to (g), the company had all of the data needed to compute unit
product costs. This computation was needed for two reasons: first, to know how much to charge
as cost of goods sold on the budgeted income statement; and second, to know what amount to put
on the balance sheet inventory account for unsold units. The carrying cost of the unsold units is
computed on the ending finished goods inventory budget
Budgeted Finished Goods Inventory 3, 000
Unit product cost Br.13
Ending Finished Goods Inventory in birrs Br.39, 000
Production cost per unit
Quantity (unit) Cost Total
Direct materials 15 pounds Br.0.20 per pound Br.3
Direct labor 0.8 hours 7.50 per hour 6
Manufacturing overhead 0.8 hours 5.00 per hour 4
Unit product cost Br.13

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 MOH rate= Total MOH = 404, 000 = Br.5.00
Direct labor hours 80, 800
i) Selling and Administrative Expenses Budget
Quarter Total
1 2 3 4
Variable selling Br.18, 000 Br.54, 000 Br.72, 000 Br.36, 000 Br.180, 000
expenses
Fixed selling &
administrative
expenses
Advertising 20, 000 20, 000 20, 000 20, 000 80, 000
Executive salaries 55, 000 55, 000 55, 000 55, 000 220, 000
Insurance - 1, 900 37, 750 - 39, 650
Property taxes - - - 18,150 18,150
Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total budgeted selling Br.103, 000 Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
& administrative
expenses

Disbursement for Selling & Administrative Expenses

Quarter Total
1 2 3 4
Budgeted Selling & Br.103, Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
Administrative 000
Less: Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total Cash Disbursements Br.93, 000 Br.130, 900 Br.184, 750 Br.129, 150 Br.537, 800

2. a) Cash Budget
Quarter Total
1 2 3 4
Cash balance, beginning Br.42, 500 Br.40, 000 Br.40, 000 Br.40, 500 Br.42, 500
Add : Collection from 230, 000 480, 000 740, 000 520, 000 1, 970, 000
customers
Total cash available before 272, 500 520, 000 780, 000 560, 500 2, 012, 500
financing
Less: Disbursements for
Direct materials 49, 500 72, 300 100,050 79, 350 301,200
Direct labor 84, 000 192, 000 216,000 114, 000 606,000
Manufacturing overhead 68, 000 96, 800 103,200 76, 000 344,000
Selling & Administrative 93, 000 130, 900 184,750 129, 150 537,800
Equipment purchases 50, 000 40, 000 20,000 20,000 130,000
Dividend 8, 000 8, 000 8, 000 8, 000 32,000
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 Total disbursements 352, 500 540,000 632,000 426,500 1,951,000
Minimum cash balance 40, 000 40, 000 40, 000 40, 000 40, 000
Total need 392, 500 580, 000 672, 000 466, 500 1, 991,000
Excess (deficiency) of cash (120, 000) (60, 000) 108, 000 94, 000 21, 500
available over total need
Financing:
Borrowing(at beginning) 120,000 60, 000 - - 180, 000
Repayments( at ending) - - (100, 000) (80,000) (180,000)
Interest(at 10% per annum) - - (7,500) (6,500) (14,000)
Total financing 120, 000 60, 000 (107,500) (86,500) (14,000)
Cash balance, ending Br.40,000 Br.40, 000 Br.40, 500 Br.47, 500 Br.47, 500

b) Budgeted Income Statement

Great Company
Budgeted Income Statement
For the Year Ended December31, 20x4

Sales [100, 000units at Br.20 Schedule 1(a)] Br.2, 000, 000

Cost of Goods Sold [100, 000 units at Br.13 Schedule1 (h)] 1, 300, 000
Gross Margin 700, 000
Selling & Administrative Expenses [Schedule 1 (i)] 577, 800
Net Operating Income 122, 200
Interest Expense [Schedule 2(a)] 14, 000
Net Income Br. 108, 200
c) Budgeted Balance Sheet
Great Company
Budgeted Balance Sheet
December31, 20x4
ASSETS
Current assets:
Cash [Schedule 2(a)] Br. 47, 500
Accounts Receivable 120, 000

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 Raw Materials Inventory 4, 500
Finished Goods Inventory 39, 000
Total current assets Br.211, 000
Plant and Equipment:
Land Br.80, 000
Building and Equipment 830, 000
Accumulated Depreciation (392, 000)
Plant and Equipment, net 518, 000
Total assets Br.729, 000
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable (raw materials) Br.27, 900
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 526, 100
Total stockholders’ equity 701, 100
Total liabilities and stockholders’ equity Br.729, 000

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 CHAPTER 4
Standard Costing, Flexible Budgeting and Variance Analysis
Standard Costing System

Standard cost systems is accounting system that value products according to standard costs only. A standard
cost is a carefully determined cost per unit that should be attained. A standard cost is a predetermined
measure of what a cost should be under stated conditions. A standard is more than just an estimate; it is a
goal. Achieving this goal represents a reasonable level of performance predetermined costs; they are target
costs that should be incurred under efficient operating conditions. Standard cost is planned, generally
established well before production begins, and provides management with goals to attain (planning) & a
basis for comparison with actual results (control).
Standard costs are not the same as budgeted costs. A budget relates to an entire activity or operation; a
standard presents the same information on a per unit basis. A standard therefore provides cost expectations
per unit of activity and a budget provides the cost expectation for the total activity. If the budget output for
a product is for 10 000 units and the standard cost is Br 3 per unit, budgeted cost will be Br 30,000. We shall
see that establishing standard costs for each unit produced enables a detailed analysis to be made of the
difference between the budgeted cost and the actual cost so that costs can be controlled more effectively.
Standard costs are also known as planned costs, predicted costs and scheduled costs. The purpose of standard
costing is to assist the management of an organization to plan and control their operations

Types of Standards
Standards can be classified by their degree of rigor and, thus, their motivational value from easy to difficult,
which parallels the lax, expected, practical, and ideal levels of capacity.
Ideal standard represents perfect operating conditions and therefore can be hard to achieve. It assumes no
material wastage, the worker always measures perfectly, and the machines never get out of adjustment. Ideal
standards have no slack – that is, no allowance for waste, breaks, or stress reduction. The use of ideal
standards creates unfavorable variances, which can have a negative impact on employee morale. Even when
71
attained, ideal standards can cause a high level of tension in the organization. It is for this reason that many
researchers argue that some slack in standards is functional. An ideal standard is sometimes called theoretical
standard.
A practical standard deliberately builds slack into the standard. It represents estimated cost under tight, but
achievable conditions. Practical standards make allowances for normal breakdowns in machinery and for
rest periods for workers. Ideal standards, however, assume that operations are 100% efficient throughout the
entire production process. Practical standards are considered to be more realistic than ideal standards.
Practical standards can be reached with reasonable effort under existing operating conditions. It may be
useful for firms to use both ideal and practical standards for cost management. The former focuses and
challenges the organization to continually move the actual results closer to the ideal. The latter ensures that
standards do not create unnecessary tension or lower employee morale. Practical standard is sometimes
called attainable standard.
Expected Standard: are standards that reflect what is actually expected to occur in a future period
Lax standard: refers to standard that can be achieved with little effort.
Most companies presently use attainable standards but a new manufacturing environment, like just in time
(JIT), is developing that emphasizes ideal standards.

Standard Costing Steps

There are five major steps in standard costing. Careful application of these steps helps maximize the value
of the SCS as a cost management tool and supports its supplemental objectives of inventory valuation and
simplifying bookkeeping. The five steps are:
Step 1: Develop standards
Step 2: Accumulate actual information
Step 3: Compute variances
Step 4: Investigate variances
Step 5: Take corrective action
STEP 1: DEVELOP STANDARDS
A standard cost represents the predetermined amount of resources necessary to produce a unit of output of a
product or service. Therefore, standard costing begins with a good understanding of the input-output
relationships in a process. To set standards, we must also decide how difficult they must be, what data to use
as a basis for setting standards and who participates in setting standards.
a. Understanding Input-Output Relationships

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An analysis of the work activities in the production process is the first step in setting standards. Knowledge
of the production process can be translated into the quantity of material, labor, and other resources required
for producing a product. When this information is combined with knowledge of market prices, accountants
can set standard product costs for the materials, labor and other short-term consumable resources.
b. Data Used for Setting Standards
Setting standards requires data. This data may come from engineering studies, external benchmarks, or past
historical experience. Engineering studies done by production engineers may help to determine the input-
output relationships in a process. This data may be used to define ideal and attainable standards. External
benchmarking of firms in the same industry or firms in a different industry but with a similar process can
also provide data for standards. Such external comparisons have the added advantage of keeping a firm aware
of what their competition is doing and help the firm stay competitive. Past historical data can be used for
standard setting. There are two dangers in using past data. We can institutionalize past inefficiency in the
standards, and the past may not be a good guide to the future because of design changes in the product and/or
the process.
c. Who Participates In Setting Standards
Standards may be imposed from the top-management or they may be set through a participative process of
consultation with employees who are affected by the standard.
An imposed standard, which is set with little or no input from those responsible for meeting the standard,
is used when it is desirable to ensure that all actions lead to a uniform strategic target. However, imposed
standards do not create a sense of ownership of the part of employees. Motivating employees to achieve
these standards, therefore, may be more difficult.
Participative standards use inputs from employee either affected by a standard or who have the best
understanding of the process. Participation does not mean those responsible for meeting the standard get to
set the standard. It does mean that employees have input in the standard setting process. Normally standards
are developed by a group composed of representatives from the following areas: management accounting,
product design, industrial engineering, personnel, data processing, purchasing, and production management
Key Point: To set standards we must understand the input-output relationships in a process decide how
much slack to allow in standards, select the data to use as a basis for setting standards and determine who
should participate in setting standards.
d. Development of Standards
Standards are conventionally established for each component (materials, labor, and overhead) of product
cost. A standard cost is an estimated cost to manufacture a single unit of product or perform a single service.
The development of a standard cost involves judgment and practicality in identifying the types of material
73
and labor to be used and their related quantities and prices. The development of standards for overhead
requires that costs are appropriately classified by cost behavior, valid allocation bases have been chosen, and
a reasonable level of activity has been specified.
i. MATERIAL STANDARDS
The first step in developing material standards is to identify and list the specific direct material components
used to manufacture the product or to perform the service. Three things must be known about the materials:
a. what inputs are needed,
b. what the quality of those inputs must be, and
c. What quantities of inputs of the specified quality are needed?
Physical quantity estimates can be made in terms of weight, size, volume, or other measures – given the level
of quality chosen for each essential component. The estimates should be based on the results of engineering
tests, opinions of people using the materials, or historical data. A bill of materials is a document that contains
information about product material components, their specifications (including quality), and the quantities
needed for production.
The main information sources of standard setting for the amount of material could be:
• Product specifications (the ‘recipe’ for the product being made)
• Technical data from the material supplier (e.g. recommended usage)
• Historical data on quantities used in the past
• Observation of manufacture
• Estimates of wastage
• Quality of material
• Production equipment & machinery available, and its performance
The main information sources of standard setting for the cost of material could be:
• Data from suppliers
• Records of previous prices paid
• anticipated cost inflation (measured by general or specific price indices)
• anticipated demand for scarce supplies
• Production schedules and bulk buying policy (in conjunction with availability of bulk discounts)
• Seasonality of prices
• anticipated currency exchange rates
ii. LABOR STANDARDS
The development of labor standards requires procedures that are similar to those used for materials. An
analysis of labor tasks is completed, then an operations flow document can be prepared which lists all tasks
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necessary to make a unit of product or perform a service and the corresponding time allowed for each
operation. The main information sources of standard setting for the amount of labor time could be:
• Data on previous output and efficiency levels
• Results of formal observations (work study or ‘time & motion’ study)
• Anticipated changes in working practices or productivity levels
• The level of training of employees to be used
The main information sources of standard setting for the cost of labor could be:
• Current pay rates
• Anticipated pay rises
• The expected effects of bonus schemes
• Equivalent pay rates of other employers in the locality
• Changes in legislation (e.g. minimum wage rates)
• Grade of labor (or sub contractors) to be used
iii. OVERHEAD STANDARDS
FOH cost pool includes IM, IL, factory rent, factory depreciation, factory insurance, etc. To prepare the
standard usually involves input from many department & managers. The development of standards for
overhead requires that costs are appropriately classified by cost behavior, valid allocation bases have been
chosen, and a reasonable level of activity has been specified. Budgets are commonly used in controlling
factory overhead costs. Fixed budgets show anticipated costs at one level of activity. Flexible budgets show
anticipated costs at different levels of activities. A standard cost card is a document that summarizes the
direct material and direct labor standard quantities and the prices needed to complete one unit of product as
well as the overhead allocation bases and rates.
e. Considerations in Establishing Standards
Appropriateness and attainability need to be considered when standards are established.
▪ Appropriateness, in relation to a standard, refers to the basis on which the standards are developed and
how long they are expected to last. Standards are developed from past and current information, and
they should reflect technical and environmental factors expected for the period in which the standards
are to be applied. Factors such as materials quality, normal ordering quantities, employee wage rates,
degree of plant automation, facility layout, and mix of employee skills should be considered. Standards
must evolve over the organization’s life to reflect its changing methods and processes.
Attainability refers to management’s belief about the degree of difficulty or rigor that should be incurred in
achieving the standard. Standards can be classified by their degree of rigor and, thus, their motivational value
from easy to difficult, which parallels the lax, expected, practical, and ideal levels of capacity. Lax standard
75
refers to standard that can be achieved with little effort. Expected standards are standards that reflect what
is actually expected to occur in a future period. Practical standards are a standard that allows for normal,
unavoidable time problems or delays, such as machine downtime and worker breaks; can be reached or
slightly exceeded approximately sixty to seventy percent of the time with reasonable effort by workers. Ideal
standard is a standard that allows for no inefficiency of any type and, therefore, is sometimes also called
perfection or an ideal standard.

STEP 2: ACCUMULATE ACTUAL INFORMATION

Standard cost systems compare actual and standard costs to make sure costs are under control. This means
that actual cost information must be collected and reported using the same categories as those used for setting
standards. Managers use standards to manage costs by taking corrective actions when the process is out of
control. For standard costing to be an effective cost management tool, the data on actual cost performance
must be captured and reported in a timely fashion.
The frequency of reporting depends upon how fast corrective action should and can be taken. If reporting is
too late and the time for corrective action is over, standard cost and variance reports are not useful for cost
management. Critical information that operating personnel need to actively manage operations is often
captured and reporting using other tools. This allows problems to be identified and solved before the standard
cost variances are even reported. For example, observation, a control chart, or an hourly quality report may
show that more products than normal are flawed. This information leads to immediate corrective action.
Key Point: Actual information for computing and analyzing variances must be collected and reported in the
same categories as the standards and the information should be reported in a timely manner for corrective
action to be taken quickly. When this is not possible, we must supplement standard costing with other real
time tools such as hourly display boards or control charts.
STEP 3: COMPUTE VARIANCES
A. VARIANCE ANALYSIS
A variance is a deviation from a predetermined standard cost. Since the cost of any item is the sum of the
unit price multiplied by the total quantity purchased, mathematically a variance is the result of a deviation
in the price paid, the quantity purchased, or both. In a typical organization, the responsibility for purchasing
inputs and using those inputs is usually separate. For example, the procurement department negotiates and
orders materials while the plant supervisors usually control usage of that material. In a responsibility
accounting system, therefore, variances are used to assign responsibility to appropriate people who have
control over that element of the cost and to draw their attention to the need for corrective action.
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Based on this mathematical and organizational logic, most standard cost systems compute and report three
major variances. They are material variance, labor variance, and overhead variances.
A. Material Variances
The standard material cost for any product consists of a standard price of materials times the standard
quantity for those materials. Total actual costs may differ from standard because of either a difference in the
price paid for those materials and/or the amount of materials used. Hence, we can isolate two variances for
materials: materials price variance and materials usage variance. There are two good reasons for breaking
the materials variance into these two components: (1) different individuals or departments may be
responsible for each component (purchasing manager for price and production manager for quantity), and
(2) materials may be purchased in one period and used in another. It would probably be of little use for
management to learn that an unfavorable price variance exists some time after the purchase was made.
A) The materials price variance: It measures how much is paid for material consumed and how much
should have been paid. If actual price is higher than standard, an unfavorable variance exists. If the reverse
were true, a favorable variance would exist. MPV is computed using the following formula:
MPV = (AP-SP) X AQ, where AP= Actual Price per Unit
SP= Standard Price per Unit
AQ= Actual Material Consumption
B) The materials quantity (or usage) variance: It measures how much material is consumed and how
much should have been consumed. An unfavorable variance results when the actual quantity used exceeds
the standard quantity allowed. A favorable variance results when the reverse is true.
MQV is computed as follows:
MQV = (AQ - SQ) X SP, where AQ= Actual Total Material Used
SQ= Standard Total Material Used
SP= Standard Price per Unit
Total Material Variance= MPV+ MQV
B. Labor Variance
The standard labor cost of a product consists of the standard hours allowed to produce the product times the
standard rate. It follows that total labor costs may differ from standard for two reasons: a deviation from
standard pay rates and/or from standard hours. We can therefore isolate two variances for labor: the labor
rate variance and the labor efficiency variance. The labor rate variance indicates what portion of the total
difference between actual and standard labor cost is due to a variation in pay rates. The labor efficiency
variance shows what portion of the total difference between actual and standard labor cost is due to a
deviation in the number of hours worked. It is similar to the usage variance computed for materials.
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A) The labor rate variance: It measures how much is paid and hoe much should have been paid. If the
actual rate is higher than the standard rate, an unfavorable variance exists. If the actual rate is less than the
standard rate, a favorable variance exists. LRV is computed as follows:
LRV = (AR - SR) X AH, where AR= Actual Labor Rate per Hour
SR= Standard Labor Rate per Hour
AH= Actual Total Labor Hour Worked
b) The labor efficiency variance: It measures how much time is used and how much should have been
used. If more hours are used to produce a given number of products than are allowed under standard, an
unfavorable variance exists. If actual hours are less than standard, a favorable variance exists. LEV is
computed as follows:
LEV = (AH - SH) x SR, where SR= Standard Labor Rate per Hour
SH= Standard Total Labor Hour Allowed
AH= Actual Total Labor Hour Worked
Exercise:
Budget Standards per unit Actual
Production 50 units 30 units
DM usage 4 lbs. @ Br 0.50 per lb. 140 lbs @ Br 1 per lb.
DL usage 2 hrs. @ Br1 per hour 72 hours @ Br 0.75 per hr.
Compute: a) Material Price Variance
b) Material Quantity Variance
c) Total Material Variance
d) Labor Rate Variance
e) Labor Efficiency Variance
h) Total Labor Variance
C. Factory Overhead variances
In a standard cost system, overhead is assigned to production via a predetermined overhead rate just as is
done in normal cost system. This predetermined rate is often based on a flexible overhead budget. The
flexible overhead budget shows the amount of overhead that is expected to be incurred at various levels of
activity. Overhead will differ (and therefore overhead rates will differ) at various levels due to the variable
nature of some overhead costs and the fixed nature of others. Total fixed overhead is the same at various
levels of output, which will result in a different rate per unit for the different levels of output. On the other
hand, total variable overhead varies according to the activity level chosen since it is a constant amount per
unit.
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Once an expected volume has been chosen (the standard volume of output), the predetermined overhead rate
can be set on estimated overhead for that level. The standard volume of output may be expressed as percent
of capacity, number of units or direct labor hours. Overhead is then applied to production based on this
predetermined rate. The amount of over- and under-applied overhead resulting from using this rate can be
investigated using the two-variance approach, which results in the computation of the overhead budget
variance and the overhead volume variance. The overhead budget variance shows the efficiency of
operations and may be considered a combination of the price and usage variance for total overhead. The
overhead volume variance results from two factors: (1) the fixed nature of some overhead costs, and (2)
operating at a level of output different from that expected. In effect, this variance shows whether the level
chosen was appropriate.
Budgeted variable and fixed overhead rates are developed following the following steps:
Developing variable overhead rate
1. Identify the costs to include in the variable overhead cost pool and fixed overhead cost pool
2. Select the cost allocation base for variable FOH and fixed FOH. The cost allocation base may
be output, direct labor hour, machine hour, etc.
3. Estimate the budgeted quantity of the selected allocation base(s)
4. Compute the budgeted variable FOH and fixed FOH rate, which are computed by dividing
the budgeted overhead cost by estimated allocation base
The overhead variance is computed as the difference between total actual overhead costs and budgeted total
overhead for the actual output attained. If the budgeted overhead costs exceed the actual overhead, a
favorable variance exists. Conversely, if actual overhead costs exceed budgeted overhead, an unfavorable
variance exists. At the end of the period, actual overhead costs are compared against amounts shown in the
flexible budget. The difference, or variance, is subdivided into two components for variable overhead and
two for fixed overhead.
Remember: For the sake of simplicity in the variance formula “budgeted overhead rate” refers to
‘budgeted overhead rate per unit of selected cost allocation base” and “Actual overhead rate” refers to
‘Actual overhead rate per unit of selected cost allocation base”.
Variable Overhead Variance (VFOH)
Variable-overhead variances are conceptually similar to variances for direct material and direct labor. The
variances may be divided into spending and efficiency variance.
1. The VFOH spending variance
It is the result of comparing the amount that was spent on variable overhead items at the actual level of
activity with the amount that should have been spent at that level. The variance may be expressed
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algebraically as follows:
VFOH Actual quantity of VFOH Actual Budgeted
spending = allocation base for actual X VFOH rate - VFOH rate
variance output
The spending variance can arise from paying higher/lower prices than expected and consuming
larger/smaller quantities than expected (e.g., energy, supplies), so it is not a “pure” price/rate variance.
2. The VFOH efficiency variance
It is not a direct measure of how efficiently the quantity of overhead was used but instead is a measure of
efficiency with the application base (e.g., machine hours, process hours, and so on). The variance may be
expressed algebraically as follows:
VFOH Budgeted Actual quantity of Budgeted quantity of
Efficiency = VFOH X VFOH allocation base - VFOH allocation base
variance rate for actual output Allowed for actual output
Fixed Overhead Variances (FFOH)
Fixed overhead variances are divided into spending and volume variances.
1. FFOH spending variance, also called budget variance
It is the result of comparing total actual fixed-overhead expenditures with lump-sum, budgeted fixed
overhead costs. It is calculated as follows:
FFOH Spending variance = Actual fixed overhead - Budgeted fixed overhead
If the budgeted FFOH costs exceed the actual overhead, a favorable variance exists. Conversely, if actual
overhead costs exceed budgeted overhead, an unfavorable variance exists. Although it is often difficult to
change certain fixed cost expenditures (such as property taxes) in the short run, unfavorable fixed overhead
items should be carefully monitored and the information used when making future budgets.
2. Production-Volume variance
The volume variance occurs whenever the actual production differs from the budgeted level used to calculate
the budgeted FFOH rate. The production –volume variance is the difference between budgeted FFOH and
the FFOH allocated. The FFOH is allocated based on the budgeted FFOH rate times the budgeted quantity
of the FFOH allocation base for the actual output units achieved. Production-volume variance sometimes
termed as output-level overhead variance and denominator-level variance. It is calculated as follows:
Production-volume variance = Budgeted FFOH - Applied FFOH
Applied FFOH= Standard quantity of FFOH allocation base for Actual Output X Budgeted FFOH Rate

If the applied overhead exceeds the budgeted overhead, a favorable variance exists because a level of
production higher than expected was achieved. Conversely, if budgeted overhead exceeds applied overhead,
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an unfavorable variance exists. The overhead volume variance can also be calculated by subtracting the
budgeted hours from the standard hours allowed for actual production and multiplying this figure by the
fixed overhead rate.
A common interpretation of a positive volume variance is that a company has underutilized its facility.
However, this interpretation is faulty when a reduction in activity levels is in response to an unexpected
decrease in demand. In such a situation, the volume variance is a demand prediction error and not the fault
of the production manager.
Note
Total FOH Spending Variance = VFOH Spending Variance + FFOH Spending Variance
Total FOH Flexible-Budget Variance = Total FOH Spending Variance + Production-volume Variance
Example
Addis Manufacturing uses a standard costing system and its fiscal year ends on Hamle 30. Variable overhead
for Hamle 1997 was budgeted at Br 4 per machine hour. Budgeted fixed overhead in Hamle 1997 was Br
240,000. Addis has budgeted 200,000 units of output for Hamle 1997. Machine hour is the allocation base
for variable and fixed overhead costs. Machine hour is budgeted to be 0.50 hours per unit of output. The
actual number of units produced for the month is 192,000 with a total machine hours of 57,600. The actual
variable and fixed overhead costs for the month are Br 120,000 and Br 256,800, respectively.
Required: Compute
1. VFOH Efficiency Variance
2. VFOH Spending Variance
3. FFOH Spending Variance
4. Production-Volume Variance

B. VARIANCE REPORTS
All of the variances computed are to be typically summarized in a variance report to management and first
level supervisors. The report may provide comparisons at any level of detail. For example, a firm might
compare actual or expected labor costs on an overall basis, for each facility, for each department, for each
work classification, and for each product. The SCS should provide variance reports customized to the level
of detail needed to maintain control of costs.
Top management typically receives summary financial information on major variances by product, process,
or cost factors in a quarterly report. Plant, product, or division managers receive monthly variance reports
that summarize significant financial variances in major categories such as labor or material use or price.
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Operating managers and supervisors receive detailed analysis of price and quantity variances for each
material, labor, or variable overhead item that has a standard. These reports typically cover a week’s activity.
While birr variances are useful to gauge the financial impact of deviating from plans, they may be too late
to take corrective actions. Critical variables, such as quantity produced, are often monitored and reported
daily, by shift, hourly, or even continually. Activities that are monitored more frequently are measured in
operational and not financial terms.

STEP 4: INVESTIGATE VARIANCES

The primary purpose of investigating reported variances is to manage costs. This requires identifying the
root causes of variances and assigning responsibility for variances so corrective action may be taken.
However, it takes employee time and other costs to investigate variances. The benefits of investigating a
variance, therefore, should be greater than the cost of doing the analysis. Only those variances deemed
significant should be investigated.
a. Deciding Which Variances to Investigate
Given that investigation is costly, most firms use a management by exception system that focuses on
variances that are large in size or show a negative trend. Management by exception is a technique in which
managers set upper and lower limits of tolerance for deviations and investigate only deviations that fall
outside those tolerance ranges. Variances large enough to fall outside the ranges of acceptability are usually
indicative of trouble, and the variances themselves do not reveal the cause of the trouble or the person or
group responsible. Mangers must investigate problems through observation, inspection, and inquiry to
determine the causes of variances.
In addition, it may be useful to randomly select a small percentage of variances to investigate to ensure that
cost controls remain adequate. It is also important to investigate both favorable and unfavorable variances.
A favorable variance for a particular item may be unfavorable to the firm overall. For example, using less
material than required creates a favorable quantity variance, but might make the product unsafe and lead to
legal problems.
Size: The absolute or relative size of a variance is an important factor in the investigation decision. Often
absolute size or percentage difference criteria are set and all variances that exceed these criteria are
investigated.
Trend: If a variance shows a trend, that is, it is getting larger period by period or is always negative or
positive, further investigation may be warranted. Even though the size of the variance remains below preset

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size criteria, the trend may be a warning that a particular part of a process may be deteriorating and may fail
if corrective action is not taken.
Key Point: It is important to investigate both favorable and unfavorable variances if they are large, exceed
a certain percent of budget or seem to have trend.
b. Identifying Root Causes of Variances
Once accountants identify that a variance needs investigation, operating personnel must apply a systematic
process to find out what causes these variances. Many firms use a tool called root cause analysis. Root cause
analysis is a method of linking a variance to the underlying cause of the variance. This technique requires
that investigators ask “why” until they find the underlying cause of the variance.
Root Cause Analysis Using the 5-Why Method
Most firms find it takes four or five levels of analysis to identify root causes. For one company, root cause
analysis simply may take the form of asking “five whys”- that is, they recommend asking "why" at least five
times to determine the root cause of a problem or a variance.
Assume that Girum Company has a persistent problem with an unfavorable labor quantity variance. The
following five levels of analysis provide a possible root cause analysis for why the company has this
unfavorable variance.
Labor Quantity Variance
Why?
More hours used than allowed in the standard
Why?
Less experienced labor used in the labor pool
Why?
Not enough experienced workers available
Why?
Experienced workers hired by competitors
Why?
No career opportunity for growth
Note that at the first level the answer is more labor hours than budget were used. This is not only obvious; it
is also not very helpful. The second question asks why we used more hours. The answer, there were lots of
inexperienced labor in the pool, is a little more helpful. The next why asks why inexperienced labor was
used? The answer is that experienced labor was unavailable. The fourth why tells us that the reason little
experienced labor was unavailable was because competitors are hiring this labor away. The fifth and last
why tells us that the reason experienced workers leave is that they do not have career growth opportunities.
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Note that root cause analysis shows that labor quantity variance, a problem normally associated with
manufacturing, is actually the result of the human resource policies of the firm. It reveals the process linkages
that show how decisions in one area can adversely affect other areas. By understanding the root cause, we
can attack the real source of the problem rather than simply putting pressure on the production supervisor-
the normal outcome without root cause analysis.
Key Point: Root cause analysis, which requires asking why several times, allows managers to understand
and address the source of variances rather than their symptoms.
STEP 5: TAKE CORRECTIVE ACTION
The final step in the standard costing process is to use the information derived from the root cause
investigation to take corrective action. However, to select the appropriate corrective action, we must array
the root causes by source – that is, where in the organization a root cause originates. A root cause can
originate within a unit, from another unit, or from the external environment.
Assume that Girum Company has done a complete root cause analysis of all variances and that this analysis
shows the following six root causes for the variances:
▪ Poor safety training for workers
▪ Improper storage of molds
▪ New hires poorly trained and inexperienced
▪ Incentives to accept the lowest bidder for materials
▪ Early retirement package to layoff workers
▪ Demand fluctuations making prediction difficult
The following analysis places these causes in the three different cells depending on where these causes
originate -- within unit, inter-unit or external environment.
Classifying Root Causes by Source and Frequency
Source Root Cause of Variances
Poor safety training for workers
Within Unit
Improper storage of materials
New hires poorly trained and inexperienced
Inter-unit Incentives to accept the lowest bidder for materials
Early retirement package to layoff workers
External environment Demand fluctuations making prediction difficult

Within unit causes are properly addressed by unit managers and first line supervisors. They have the primary
responsibility for analyzing, investigating, and taking corrective action on such causes. If improper storage
of molds is causing warping in products, this is something that should be addressed by the molding
department supervisor.
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When variances result from actions that originate from other units, a cross functional team is better suited to
take care of this problem. This is because corrective action requires cooperation and coordination among
these mangers. If procurement is causing variances from poor purchasing policies, they need to be part of
the production team to understand the consequences of their actions.
Finally, top management is best suited to handle causes that originate outside an organization from its
environment. For example, fluctuations in demand cause production schedules to go off. Stabilizing demand
is not something the production managers can do even if the variances are in production costs.
Key Point: The source of a root cause determines whether the unit manager, a cross-functional team or upper
management can best handle it.
Dealing with Variances
Variances assist managers in their planning and control decisions. Management by exception is the practice
of concentrating on areas not operating as expected (such as a shortfall in sales of a product) and giving less
attention to areas operating as expected. Managers use information from variances in deciding how to
allocate their energies. Areas with sizable variances receive more of their attention than do areas with
minimal variances. Variances also are used in performance evaluation. For example, production-line
managers may have quarterly efficiency incentives linked to achieving a budgeted amount of operating costs.
Managers consider many possible causes for price variances and efficiency variances. Here are some
examples.
▪ A favorable materials-price variance occurs if the purchasing manager bought in larger lot sizes
than budgeted, thereby obtaining quantity discounts.
▪ An unfavourable labor-price variance occurs because wage rates for highly skilled workers
unexpectedly increase.
▪ An unfavourable materials-efficiency variance results from inadequate training of the labour force.
▪ A favorable labour-efficiency variance occurs because budgeted time standards for highly skilled
workers are not set tight enough.
The most important task in variance analysis is to identify the causes of variances and use this knowledge to
promote continuous improvement. Often the causes of variances are interrelated. For example, an
unfavourable materials efficiency variance is likely to be related to a favorable materials price variance when
the purchasing manager buys lower-priced, lower-quality materials. It is always best to consider possible
interdependencies among variances rather than to interpret them in isolation of each other. In some cases,
the causes of variances are in different parts of the company's value chain or in other companies in the supply
chain. For example, an unfavourable labour-efficiency variance could be caused by the marketing manager
obtaining a large number of rush orders that disrupts the normal flow of production. If rush orders caused
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the variance, top management could establish a policy limiting the number of rush orders or could increase
the selling price for these orders.
Managers use variance analysis in performance evaluation. Effectiveness and efficiency are two common
attributes of performance. Effectiveness is the degree to which a predetermined objective or target is met.
Efficiency is the relative amount of inputs used to achieve a given output level Performance can be both
effective and efficient, but either condition can exist without the other. For example, assume a company's
static budget calls for production and sales of 12,000 units. If the company produces and sells 15,000 units,
performance is effective. Given the 25% increase in output, performance would be inefficient, however, if
the usage of direct materials and direct manufacturing labour inputs exceeds the static-budget amounts by
more than25%. Favorable and unfavorable are not synonymous with good and bad results. Variances must
be investigated before an accurate assessment can be made. Although variances are isolated, they may not
be independent.
Managers must decide when to investigate variances. They often use rules of thumb such as "investigate all
variances exceeding Br 5,000 or 5% of budgeted cost, whichever is lower." This approach recognizes that
the budget represents a range of possible acceptable outcomes rather than a single acceptable outcome.
Variances within this range are due to random chance and hence do not require investigation.
A continuous improvement budgeted cost is progressively reduced over succeeding periods. For example,
budgeted direct material costs of a product could be reduced by 1% per month. Continuous improvement
budgeted costs signal to managers and employees the importance of constantly seeking ways to reduce total
costs. Products in the initial months of their production often have higher budgeted improvement rates than
those that have been manufactured for longer periods.

Behavioral & Cultural Aspects of SCS

A good standard costing system (SCS) provides management and operating personnel with information they
need to take corrective action in a timely manner. Without an SCS, it is difficult for an organization to
provide a quality product at an affordable cost. The results of variance investigations, when arrayed properly,
also help in understanding linkages between units and those that originate from the external environment.
However, in order to use SCS effectively, managers must understand the behavioral and cultural properties
of these systems.
a. Behavioral Impact of SCS
A SCS, if used properly, can help to motivate employees. This is because SCS can be used to affect aspiration
levels and create a sense of empowerment. However, if used carelessly, standard costing can encourage
negative or dysfunctional behaviors.

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i. Affect aspiration levels. Standards are targets. They can be challenging or they can be easy. Research
shows that the level of goal difficulty has an impact on employee aspiration level and performance. Higher
aspiration levels lead to higher performance.
However, aspiration levels are revised upward or downward based on past success or failure in achieving a
goal. When a person sets a high aspiration and fails in reaching that goal, he or she tends to lower their
aspiration in the next period. Conversely, if they succeed in meeting a goal easily, they tend to revise their
expectation upward.
If standards are too difficult, they will result in variances. Employees may see variances as failure to achieve
goals. This will lead to revising aspiration levels downward and, therefore, decrease the chance of meeting
standards in the future. If the standards are too easy, employees may not be challenged to achieve them
either. Setting standards at just the right level of difficulty is important to use standard costing effectively.
ii. Sense of empowerment: Standards that are imposed by top management or functional experts make
individuals less likely to accept the legitimacy of the targets and fail to motivate employees to perform.
When standard setting allows employees to participate, it can create a sense of empowerment. Research
shows that participation can increase employee “buy in” and lead to less frustration, higher satisfaction and
better performance. When individuals are involved in the process, they are more likely to take ownership of
the standards, work to meet targets, and accept evaluations based on differences between standard and actual
results. On the downside, participation takes additional time and must be real and not “pseudo”. Pseudo
participation can create a credibility gap and cause frustration if employees feel that management is simply
going through the motions but is not interested in their input.
iii. Encouraging dysfunctional employee behaviors: Standard costing systems are often used to evaluate
the performance of employees. When used carelessly, they often lead to dysfunctional behaviors in an
organization. Here are a few examples of how this might happen.
Since SCS operates on a management by exception basis, that is, intervene only when things are going
wrong, they accentuate the focus on negative performance. Too much focus on negative variances and not
enough reinforcement of positive accomplishments can cause frustration and lower employee satisfaction
levels. Employees may start gaming to reduce variances rather than increase efforts to attain them. Focus on
assigning responsibility for variances may cause individuals to take short-term actions to avoid negative
consequences. For example, material price variance may lead to substituting low cost material that may be
below quality. This will result in shifting variances from procurement to production that may have to deal
with the consequences of low cost material. You will recall that we recommended against computing fixed
overhead volume variance. This is because this variance can lead to unnecessary build up in inventory.
Pressure to meet quantity standards can lead to dysfunctional behaviors as well.
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A department has been known to continue production to meet preset targets, even when the department
receiving their output has broken equipment and has no need for the output. This leads to build up in work
in process inventory.
Finally, pressure to meet standards can remove the incentive to share improvement ideas. Individuals will
focus on meeting existing standards even if they are inefficient or easy rather than share process improvement
ideas that will change or increase standards.
b. Cultural Attributes
A SCS can reflect and reinforce important cultural values. One important value is fairness. The process of
setting standards and using variances to evaluate performance affects how operating personnel and managers
view the system. A well-designed standard costing system is perceived as fair and can create a value system
where quickly adjusting to variations from expectations becomes a way of life. If the standards are perceived
as unfair, a negative culture grows and inhibits the organization’s ability to meet its strategic objectives.
Developing and using standards is a signal that planning matters and that managing the actual results is
important. Standards represent the type of rational calculated action that Western culture values over impulse
and instinct. The creation and use of standards provide organizations with a vehicle for demonstrating that
it considers actions logically and rationally. The calculation and reporting of variances on a regular schedule
celebrates rationality and the organization’s commitment to rationality.
Changes in the Use of Standards
Many accountants now believe that incorrect measurements are sometimes used in utilizing variances for
performance evaluation. The Japanese philosophy is a notable exception to the disbelief in the use of
theoretical standards for performance evaluation.
The just-in-time (JIT) production systems and total quality management (TQM) concepts developed by
the Japanese were started from the premises of (1) zero defects, (2) zero inefficiency, and (3) zero downtime.
Theoretical standards become expected standards under such a system, and allow for no level of acceptable
deviation from those standards. Management must be committed to execute a four-step process if theoretical
standards are to be implemented.
a. Teams are established to determine where current problems lie and identify the causes of the problem.
b. Management must be prepared to invest in plant and equipment items, equipment rearrangements, or
worker training so that the standards are amenable to the operations if the causes relate to equipment,
facility, or workers.
c. Workers must be granted the authority to react to problems if they have been assigned responsibility
for quality.

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 d. Management must furnish rewards for achievement if people are required to work at their maximum
potential.
Company management needs to assess the effects of rapid changes in the environment on company
production standards during a year in which significant changes occur. Management can either (1) ignore
the changes, or (2) reflect the changes in the standard. Management may consider combining the two choices
in the accounting system: plans prepared by use of original and new standards can be compared, and any
variances will reflect changes in the business environment.
SUMMARY
The Budgeting Cycle
1. establish attainable and reasonable goals and objectives
2. create a plan to reach those goals and objectives
3. compare the actual results to the budgeted results
4. identify problems areas and analyze the variances
5. take action to correct unfavorable variances
6. always seek new techniques and procedures that will improve the effectiveness of the budgeting
process (this creates a dynamic process)
Limitations to Budget Forecasting Techniques
1. the results are only as good as the forecasted data used
2. mathematical approaches cannot substitute for individual judgment and experience
3. mathematical approaches may not consider certain variables controllable by management
4. the longer the time horizon budgeted the greater is the chance for forecasting error
5. historical data may not be a good predictor of future activity levels
Advantages and Disadvantages of Budgeting
• Advantages
1. encourages participation and enhances communication among management, employees, and
customers
2. encourages the development of potential courses of action for evaluation and consideration
3. allows comparison between the standards developed and actual results
4. may provide a variety of different operating scenarios
5. forces the organization to look into the future
6. requires those involved to be aware of the internal and external factors affecting the
organization
• Disadvantages
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 1. the time and resulting costs in preparing the budget may be considerable
2. based largely on "unknown" information - our best "guesstimates"
3. may require the use of confidential information
4. There could be a tendency to "spend to the budget"

The Advantages and Disadvantages of Using Standard Costs

If set properly, standard costs may result in a number of benefits:
1. Cost Control. A standard cost system aids in controlling costs because it highlights exceptions. A variance
exists anytime actual costs differ from standard. Variances represent the profit impact of differences
between actual costs (or revenues) and budgeted costs (or revenues). These variances can be isolated, thereby
providing a starting point for judging the effectiveness of managers. In general it aids management in:
▪ Production of a unit of usable product at the lowest possible cost at predetermined quality standards;
▪ Making periodic comparisons of actual costs with standard costs to measure performance & correct
inefficiencies.
2. Information for Decision Making. An effective standard cost system will result in more accurate
estimates of what costs should be in the future because actual costs should be fairly close to standard. As a
result, more accurate bids and better decisions can be made.
3. Cost Savings. Because all inventory accounts contain standard costs only, the details necessary in an
actual cost system are avoided. Cost savings may also result as employees become more cost conscious
because of the standards.
4. Inventory Costing. Inventories costed at standard must be adjusted if necessary to approximate actual
cost on external financial statements.
5. Product Pricing. Selling price of a unit & the cost per unit are closely related and may affect each other.
Mgt attempts to achieve the best combination of price & volume to maximize profits.
▪ When selling price increases, if sales decrease, then unit cost increases.
▪ When selling price decreases, if sales increase, then unit cost decreases.
When standard costs are used, they may result in some unplanned disadvantages as follows:
1. Materiality. The materiality of variances may be hard to measure. Since materiality is a judgment call,
many problems or conflicts may arise in setting materiality limits of the variances.
2. Unreported Variances. All variances may not be reported. Since workers are evaluated through the
use of budgets and since management only investigates unusual variances, workers may not report
negative exceptions to the budget or may try to minimize these exceptions in an effort to keep
themselves out of management's eye of scrutiny.
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 3. Poor Morale. Morale of good workers may fail. Management's main objective in the use of budgets is
to find where variances exist and try to correct or minimize them. Thus, workers who deviate from the
constraints of the budget may not be recognized for their good work, and consequently, their morale
may suffer.

Fixed and Flexible Budgets

A flexible budget is a budget which is designed to change as volume of output changes. It is a vital
management planning and control tool. Flexible budget is a detailed plan for controlling overhead and other
costs. Most important, the flexible budget is prepared for different levels of activity within a firm’s relevant
range.
In contrast, a static budget (such as the master budget) sets forth a plan for only one level of activity. The
flexible budget results in improved performance evaluations. Actual results at one activity level are
compared against what should have happened (i.e., budgeted costs) at the same level of output. With static
budgets, actual results are compared against anticipated results at what might be two different volume levels.
Example
Omega Company uses a standard costing system. The standard production cost data are as follows
Direct Material..................Br 4 per Unit
Direct Labor......................Br 10 per Unit
Variable FOH....................Br 5 per Unit
Fixed FOH....................... Br 20,000 per month
The Company budgeted to produce 50,000 units in June. In this month the Company actually produced
40,000 units. The actual costs are as follows: -
Direct Material..................Br 170,000
Direct Labor......................Br 440,000
Variable FOH....................Br 205,000
Fixed FOH....................... Br 20,000
Required: Prepare Fixed and flexible budget and compute the variance

Fixed budget
Budget Actual Result Variance

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 Units 50,000 40,000 10,000 U
Direct Material 200,000 170,000 30,000F
Direct Labor 500,000 440,000 60,000F
Variable FOH 250,000 205,000 45,000 F
Fixed FOH 20,000 20,000 -0-

Flexible Budget
Budget based Actual Result Variance
on Actual Unit
Units 40,000 40,000 -0-
Direct Material 160,000 170,000 10,000U
Direct Labor 400,000 440,000 40,000U
Variable FOH 200,000 205,000 5,000 U
Fixed FOH 20,000 20,000 -0-
Difference between flexible and fixed budget
• A fixed budget is rigid and does not change with the volume of activity achieved, whereas a flexible
budget can be changed to suit the level of activity to be achieved. Flexible budget is not rigid.
• A fixed budget is prepared for a particular level of activity and for a particular set of conditions. It is
prepared under the premise that there will be no change in the outside conditions. Flexible budget is
prepared for various levels of activities.
• All the costs like variable and fixed are related only to a particular level of activity in the case of
fixed budgets, whereas for a flexible budget, variance analysis each cost and its behavior.
• Fixed budget does not enable price fixation etc, where budgeted and actual figures vary, but a flexible
budget enables cost and sales price fixation and enables tender quotations.
• Where there is a difference in two activity levels, comparison of actual and budgeted performance is
of no significance, in the case of fixed budgets. While in the case of flexible budgets, the comparison
of actual and budgeted performance is, meaningful.
Flexible budgets are prepared under the following circumstances:
• In industries where there are seasonal fluctuations in the production of goods and their sales.
• In industries where the business depends on the orders received.
• Industries where sales depend on the current trends like the fashion business.
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 • Business which keeps diversifying and keeps introducing change.
• Industries that are related to the general changes in sales.

Mix and Yield Variances

There are a variety of possible extensions to the basic variance analysis presented in previous chapter.
Although it is not practical to include all possible variations of variance analysis, one or two additional types
of analysis will provide you with a feel for the variations of variance analysis found in practice. Material
mix and yield variances provide a variance analysis extension that some firms have found useful.
Most products are a combination of different materials and several types of labor. For such products,
particularly those that require precise recipes the mix of materials and labor should not vary. Bottling plant
managers at MOHA are not allowed to tamper with the formula used to make Pepsi. Dairies mix precise
amounts of chocolate and milk to produce chocolate flavored milk. Some production environments,
however, offer some flexibility. Different types of materials or classes of labor may be substituted in a
product. For example, orange juice manufacturers can mix Jimma and Harar oranges in slightly different
proportions. A fried chicken franchise may mix experienced higher paid cooks with low paid helpers in their
breading operation.
When materials or labor varies from their predetermined proportion, a mix variance results. A mix variance
is the cost that results from the difference between an actual mix and a standard mix. Often mix changes can
also impact the total output that is produced from a given amount of input. For example, substituting cooks
for helpers may result in higher quantity of breaded chicken pieces because the cooks are faster and more
experienced. A yield variance is the extra cost from the loss in quantity that results when there is a change
in the mix material or labor.
Material Mix and Yield Variance
When different types of materials may be used as substitutes for each other, a standard mix is usually
determined to insure a quality product at the lowest possible cost. If the actual material mix varies from the
standard mix, both quality and cost may be affected. The effect on cost can be determined by separating the
material quantity variance into two variances referred to as material mix and material yield variances. In
addition to the substitutability requirement, the unit of measure for the various materials needs to be the
same. Materials may be measured in gallons or pounds or board feet, or some other measure, but the unit of
measure must be the same for each ingredient. If these two prerequisites are satisfied, material mix and yield
variances can be calculated.

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As said earlier, mix and yield variances for materials may be used when the materials are substitutable for
each other. When inputs are substitutable, direct materials efficiency improvement relative to budgeted costs
can come from two sources:
(1) Using less input to achieve a given output, and
(2) Using a cheaper mix to produce a given output.
The total material variance is the sum of material price variance and material quantity variance. The material
quantity variance is the difference between a flexible budget based on the actual quantity used and a flexible
budget based on the standard quantity allowed. The material quantity variance is further separated into mix
and yield variances. Material mix and yield variances are computed as follows.
Direct Material Actual DM Budgeted Actual Qty Budgeted
Mix Variance = Mix - DM mix x of All DM x Price of
Percentage Percentage used DM input

Direct Actual Qty Budgeted Qty of Budgeted Budgeted

Material = of All DM - All DM Allowed x DM mix x Price of
Yield Used for Actual Output Percentage DM input
Variance

Total Material
Variance

Material Price Material Quantity

Variance Variance

Material Mix Material Yield

Variance Variance

EXAMPLE

Assume Bole Burger combines three ingredients in the production of the firm's popular hamburger. The
standard quantities and input prices of these materials are provided below for a normal production batch of
2,000 pounds of hamburger.
Material Standard Mix Standard Inputs Standard Price
per pound
A 10% 200 Br1.00
C 50% 1,000 2.00
B 40% 800 3.00
2,000 lbs
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The following data are provided for a recent production period in which 20,500 pounds of materials were
used to produce 20,000 pounds of hamburger.
Material Actual Quantities Used
A 2,460
C 9,225
B 8,815
20,500
The requirements are simply to calculate the materials quantity, mix and yield variances for this situation.
The standard quantities of inputs allowed for actual output are:
A = (200/2,000) x 20,000 = 2,000
B = (1,000/2,000) x 20,000 = 10,000
C = (800/2,000) x 20,000 = 8,000
The variances are calculated in the following manner:
Material Quantity Variance = (AQ - SQ)(SP)
A = (2,460 - 2,000) (1.00) = Br 460 U
B = (10,000 – 9,225) (2.00) = 1,550 F
C = (8,000 - 8,815) (3.00) = 2,445 U
Br 1,355U
Material Mix Variance = (AM- SM) (ATM)(SP)
A (0.12-0.10) x 20,500x 1.00 = Br 410 U
B (0.45– 0.50) x20,500 x 2.00 = 2,050 F
C (0.43 -0.40) x 20,500 x 3.00 = 1,845U
Br 205U
Material Yield Variance = (ATM - STM) (SM)(SP)
A (20,500-20,000)x 0.10x 1.00 = Br 50 U
B (20,500-20,000)x 0.50x 2.00 = 500 U
C (20,500-20,000)x 0.40x 3.00 = 600 U
Br 1150 U

The sum of the mix and yield variances must be equal to the material quantity variance. The status of the
material quantity variance is determined in the usual way, i.e., it is unfavorable if the actual quantity used
exceeds the standard quantity allowed. The mix variance is unfavorable if Actual Mix > Standard Mix, i.e.,
the actual quantity exceeds the quantity called for by the standard mix. This is unfavorable because it
increases the cost of the product. The material yield variances represent a measure of what the material
quantity variances would have been if the actual mix proportions were equal to the standard mix proportions.
The yield variances are unfavorable when Actual Total Material Used >Standard Total Materials allowed
for Actual Output.
Labor Mix and Yield Variances
The idea of labor mix and yield variance is the same as material mix and yield variance. To illustrate mix
and yield variances, consider Birhanu Electric Works – an electrical contractor who does new construction
wiring. The typical crew consists of one experienced electrician and two apprentice electricians. An
experienced electrician can wire 10 fixtures per hour while an apprentice can wire only 5 fixtures per hour.
The standard and actual data is summarized as follows.
Birhanu Electric: Standard Cost Sheet for Ginbot
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 Labor Standard Standard Standard Standard Standard
Rate per Crew Mix Hours Labor Cost Output in
Hour Fixtures
Apprentice Br 15 2 (67%) 320 Br 4,800 1,600
Electricians
Master Br 40 1 (33%) 160 6,400 1,600
Electricians
Total 480 Br 11,200 3,200

During Ginbot, Birhanu Electric wired 3,600 fixtures at a total labor cost of Br 15,000. The detailed
breakdown of the actual hours is shown as follows:

Labor Standard Rate Actual Actual Output in

per Hour Hours Fixtures
Apprentice Electricians Br 15 240 1,440
Master Electricians Br 40 240 2,160
Total 480 3,600

Labor Quantity Variance

To understand labor mix and yield variances, we will begin by computing the quantity variance for the two
types of labor, apprentice and master. The first table shows the standard wage rates and the budgeted hours
(480) for a budgeted output of 3,200 fixtures. Since the actual output is 3,600 fixtures (see the second table),
the standard total hours for the actual output is 540 hours [(3,600/3,200) x 480)]. Ignoring the mix, we can
compute a quantity variance as simply the difference between actual hours and the flexible budget for the
standard hours earned on the basis of the output of 3,600 fixtures. The labor quantity variance for Ginbot is:
LQV (Apprentices) = (AQ – SQ) x SP
= (240 – 360) x Br 15
= Br 1,800 F
LQV (Master) = (AQ – SQ) x SP
= (240 – 180) x Br 40
= Br 2,400 U
LQV (Combined) = Br 1,800 F + Br 2,400 U
= Br 600 U

Labor Mix Variance

Let us now consider the impact of a crew mix. For Ginbot, there is a mix variance because the actual labor
mix used differed from the standard labor mix. The third column of the second table above shows that the
actual apprentice labor was 50 percent rather than the expected 67 percent and that the master electrician
was 50 percent rather than 33 percent. The mix variance measures the monetary effect of using a different
mix. In our example, it is the higher than expected percentage of master electrician hours. The mix variance
uses the actual hours, but assumes that they are distributed in the budgeted mix. This is because we want to
isolate the effect of a change in mix without adding the effect of a change in output as well. The formula for
computing the mix variance is as follows:

Direct Labor Actual DL Budgeted DL Actual Qty Standard

Mix Variance = Mix - Mix x of All DL x Rate per
Percentage Percentage Hours Used Hour
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The electrician crew mix variance for Ginbot is computed as follows:
DLMV (Apprentice) = (.50 – .67) x 480 x Br15 = Br 1,200 F
DLMV (Master) = (.50 – .33) x 480x Br 40 = Br 3,200 U
Total Labor Mix Variance Br 2,000 U
The decrease in the percentage of apprentice labor used results in a favorable variance while the increase in
the use of master labor results in an unfavorable mix variance. The net effect of the mix change is an
unfavorable crew mix variance of Br 2,000. Because the total mix must equal 100 percent, there is always
at least one favorable and one unfavorable mix variance if there is any change in mix.

Labor Yield Variance

The change in mix required more of the expensive master electricians. While this increased the total wages
paid, master electricians work faster and the yield from the same 480 labor hours has gone up. Instead of the
budgeted 3,200 fixtures we have 3,600 fixtures. In effect, the 480 hours at the new mix has yielded 540 labor
hours worth of output. This impact can be captured in the yield variance, which shows us the productivity
impact of the new mix. Again, to isolate the effect of a change in the yield, we will hold the mix constant
and assume that the earned hours and the actual hours were both at the standard mix. The formula for
computing the mix variance is as follows:
Direct Labor Actual Budgeted Total Budgeted Standard
Yield = Total - Labor Hours x DL mix x Rate per
Variance Labor Allowed for Percentage Hour
Hours Used Actual Output

The crew yield variance for Ginbot is computed as follows:

DLYV (Apprentice) = (480 – 540) x 0.67 x Br 15 = Br 600 F
DLYV (Master) = (480 – 540) x 0.33 x Br 40 = Br 800 F
Total Labor Yield Variance = Br 1,400 F
Note that the mix and yield variances together give additional information about the causes of a quantity
variance. When mix and yield variances are combined, they equal the quantity variance. In our example, the
mix and yield equal the combined quantity variance of Br 600 Unfavorable.
Total mix variance = Br 2,000 U
Total yield variance = Br1,400 F
Total Quantity variance = Br 600 U
We can see that despite the increased productivity of the master electricians, the decision to substitute the
higher paid labor has resulted in an overall unfavorable variance of Br 600. This was because unfavorable
mix variance was larger than the favorable yield variance. Birhanu is better off sticking to its standard crew
mix and avoiding the type of tradeoff between using cheaper labor it did in Ginbot.
SALES VARIANCES
The idea of variance analysis can be extended to areas other than production. For example, an analysis can
be made on why actual revenue differed from budgeted revenue. If, for example, a company budgeted to sell
10,000 units at Br 50 each but because of market forces had to reduce the price to Br 48 and even so they
were only able to sell 9,000 at this price, a variance occurs. Then:
Actual Sales Revenue = 9,000 x Br 48 = Br 432,000
Budgeted Sales Revenue = 10,000 x Br 50 = Br 500,000
Sales Variance = Br 432,000 – Br 500,000 = -Br 68,000 = Br 68,000 U

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This variance is negative which means that less revenue was obtained than expected and is therefore
unfavorable and marked with U. This variance is made up of two elements: the reduction in volume of 1,000
units and the reduction in selling price of Br 2 per unit. From the above example it can be seen that two items
will contribute to sales variance: the sales-price variance (SPV) and the sales-volume variance (SVV).
The sales-price variance arises because a company increased or decreased its sales price when compared
with the budgeted sales price. The sales-volume variance arises from an increase or decrease in units sold.
Generally speaking, sales variances can be analyzed by splitting the total variance into six variance as shown
below.

Static-Budget
Variance

Flexible-Budget Sales-Volume
Variance Variance

Sales-Mix Sales-Quantity
Variance Variance

Market-Size Market-Share
Variance Variance

Example
Agere ltd sales three products in the Dembel City centre. The Company Budgeted to sell 10,000 units. The
budgeted 10,000 units represent 50% market share. The details for the budgeted and actual data for the year
1996 fiscal year are as follows:

Budgeted Data Actual Data

Produc Selling Quantity Sales Total Selling Unit Sales Total
t Price per Mix Revenu Price Volume Mix Reven
Unit e per Unit ue
A 12 1,000 10% 12,000 10 1,800 15%
18,000
B 20 3,000 30 60,000 25 4,800 40 120,00
0
C 15 6,000 60 90,000 15 5,400 45
81,000
10,000 162,000 12,000 219,00
0

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Static-budget variance: is the difference between an actual result and a budgeted amount in the static
budget.

Static-Budget Variance= Actual Result- budgeted Amount

The Static-budget variance for Agere Ltd is computed as follows:
A= 18,000-12,000 = 6,000F
B= 120,000-60,000 =60,000F
C= 81,000-90,000 = 9,000U
Total SBV =57,000F
A. Static-Budget variance can be further split into Flexible-Budget and Sales-Volume variance.
1. Flexible-budget variance: Is the difference between the actual revenues and the flexible-budget amount
for the actual unit volume of sales. It is computed as: -
FBV=Actual Result- Flexible-budget Amount
The Static-budget variance for Agere Ltd is computed as follows:
FBV A=18,000- (12x 1,800) = 3,600U
B=120,000-(20x 4,800) =24,000F
C=81,000-(15 x 5,400) = 0 Total..............................20,400F
2. Sales-volume variance: shows the effect of the difference between the actual and budgeted quantity of
variable used to flex the flexible budget. The sales-volume variance, which arises from an increase or
decrease in units sold, is calculated as:
SVV = (Actual Sales Quantity - Budgeted Sales Quantity) x Budgeted Selling Price per Unit
The Sales-volume variance for Agere Ltd is computed as follows:
SVV-A= (1,800-1,000) x 12= $9,600F
B= (4,800-3,000) x 20=$36,000F
C= (5,400-6,000) x 15= $9,000U
Total SVV=$36,600F
B. Subdivisions of sales-volume variance
1. Sales-mix variance: difference between (1) budgeted amount for the actual sales mix, and (2) the
budgeted amount if the budgeted sales mix had been changed. The formula for computing the sales-
mix variance in terms of revenue and the amount for Agere Ltd is:-

Actual Budgeted Actual Units Budgeted

SMV = Sales Mix - Sales Mix x Of All Products x Selling Price
Percentage percentage Sold Per Unit
SMV-A= (0.15-0.10) x 12,000 x 12=$7,200F
B= (0.40-0.30) x 12,000 x 20=$2,400F
C= (0.45-0.60) x 12,000 x 15=$27,000U
TSMV= $17,400U
2. Sales-quantity variance: is the difference between two amounts: (1) the budgeted amount based on
actual quantities sold of all products and the budgeted mix, and (2) the amount in the static budget
(which is based on the budgeted quantities to be sold of all products and the budgeted mix). The
formula for computing the sales-quantity variance in terms of revenue and the amount for Agere Ltd
is:-
Actual Units Budgeted Budgeted Sales Budgeted
SQV = Of All - Units Of All x Mix percentage x Selling Price
Products Sold Products Sold Per Unit

SQV-A = (12,000 -10,000) x 0.10x 12=

B = (12,000 -10,000) x 0.30x 20=
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 C = (12,000 -10,000) x 0.60x 15=
Market Share and Market Size Variance
Sales depend on overall market demand as well as the firm’s ability to maintain its share of the market.
The following table summarizes the budgeted and actual sales units for the industry.
Budgeted Industry Actual Industry
Quantity Quantity
Product A 1,800 2,200
Product B 6,200 8,000
Product C 12,000 14,800
Total 20,000 25,000

Agere Ltd can use the industry information to get further insight into the sales quantity variance by dividing
this variance into a market-size and market-share variance.
Market- size variance is the difference between two amounts (1) the budgeted amount based on the actual
market size in units and the budgeted market share, and (2) the static budget amount based on the budgeted
market-size in units and the budgeted market share. The formula and the amount for Agere Ltd are: -
MSV= (Actual MSZ - Budgeted MSZ) x Budgeted MSR x Budgeted ASP
Where, MSV= Market Share Variance MSR= Market Share in Units
MSZ= Market Size in Units ASP= Average Selling Price per Unit
MSV for Agere Ltd is computed as follows:-
MSV= (25,000-20,000) x 0.50x 16.20
= Br 40,500F
Market –share variance is the difference between two amounts: (1) the budgeted amount at budgeted mix
based on actual market size in units and the actual market share, and (2) the budgeted amount at budgeted
mix based on actual market size in units and the budgeted market share. The formula and the amount for
Agere Ltd are: -
Mkt-share Variance= (Actual MSR- Budgeted MSR)x Actual MSZ x Budgeted ASP
MSV for Agere Ltd is computed as follows:-
Mkt-share Variance= (0.48- 0.50) x 25,000x 16.20
=Br 8,100 U

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Assignment
The Gedion Electronics sells Konka and Gold Star brand TV sets. The Company operates in a defined
geographical location that has been enjoying tremendous growth in new home building and sales. At the
beginning of the year, Gedion had budgeted sales of 75,000 TV sets. Konka TVs were budgeted for 80%
and Gold Star for 20% of this total sales amount. Gedion budgeted to sell the Konka brand for Br 2,600 each
and the Gold Star for Br 2,000 each. Recent market information had led Gedion to believe that it could expect
75% of the market for TVs in that area.
At year end, actual sales of TVs by Gedion Electronics were 84,000 TVs. Of this 58,800 represent Konka
and the remaining is Gold Star. Actual selling prices were Br 2,800 for the Konka and Br 1,500 for the Gold
Star. The market information published immediately after the end of the year showed sales of 120,000 Konka
and Gold Star sold in the geographical area in which Gedion Electronics operates.
Required: Compute
1. market-size variance________________
2. The market-share variance___________
3. Total sales-mix variance_____________
4. Total sales-quantity variance__________
5. Selling-price variance_______________
Productivity Measures
Productivity measures the relationship between actual inputs and actual outputs over two or more periods.
The lower the input for a given set of outputs or the higher the output for a given set of inputs, the higher the
level of productivity. Productivity measures examine two aspects of the relationship between inputs and
outputs. They evaluate
1. Whether more inputs than necessary have been used to produce a given level of output, and
2. Whether the best mix of inputs has been used to produce that output

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Efficiency, mix and yield variances discussed earlier are some approaches used to getting the above two
points. However, productivity measure has two important features that distinguish it from variance analysis.
These features are: -
1. Unlike variance analysis productivity measures do not use information from budgets or standards. They
compare the relation between actual inputs and actual outputs across similar organizations or over different
time periods.
2. Mix and yield variance calculations only apply when substitutions occur within a given category of inputs
(that is within direct material or within direct labor).
However, often substitution can occur between direct material and direct labor, or between direct labor and
capital. As a result, productivity measures incorporate general substitutions between different types of input
(materials and labor).
To understand productivity measures use the following data for Awash Manufacturing
1996 1995
Output 850,000 1,020,000
Direct materials used in Kilo gram (1) 68,000 74,800
Cost of direct material per Kilogram (2) 28 30
Total cost of Direct materials used (3= [1x2]) 1,904,000 2,244,000
Direct labor hours used (4) 340,000 439,000
Direct labor cost per hour (5) 4.10 4.00
Total cost of direct labor used (6=[4x5]) 1,394,000 1,756,000
Total Cost of DM and DL (7=[3+5]) 3,298,000 4,000,000
Types of Productivity Measures
1. Partial Productivity Measures
A. Partial productivity compares the quantity of output produced with the quantity of a single input
consumed. It is called partial because it takes one input and ignores the other. The higher the PP ratio, the
higher the productivity. PP is expressed as follows:
PP= Quantity of Output Produced
Quantity of Input Used
For Awash Mfg, The PP for material and labor for the year 1996 are as follows
DM Partial Productivity= 850,000/68,000=12.50
DL Partial Productivity = 850,000/340,000=2.50
The partial productivity for Awash Mfg. is summarized as follows:

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 1996 1995
Direct Material 850,000 =12.50 1,020,000=13.64
68,000 74,800
Direct Labor 850,000=2.50 1,020,000=2.32
340,000 439,000

Question: What do you understand from the above table?

Comparing changes in partial productivity and efficiency variances is important. The partial productivity
measures look at changes over time of actual output to actual input, while the efficiency variance is
comparing actual output to budgeted input for the current period.
A major usefulness of the partial productivity measures is that they focus on a single input; hence they are
simple to calculate and easy to understand at operational level. Managers and operators can easily examine
these numbers to understand the reason underlying productivity changes from one period to the next. For
example, decrease in the PP for labor may be caused by poor training of labor, higher absenteeism, high
labor turnover, poor incentive, etc.
The major drawback of partial productivity measure is that it focuses only on one input at a time rather than
all inputs simultaneously and hence does not allow managers to evaluate the trade-offs among various inputs
and the effect on overall productivity. The total factor productivity or total productivity is a technique for
measuring productivity that considers all inputs simultaneously.
2. Total Factor Productivity (TFP)
Total factor productivity is the ratio of the quantity of output produced to the quantity of all inputs used,
where the inputs are combined on the basis of current period prices.
TFP= Quantity of Output Produced
Cost of all input Used
As the above formula indicates, TFP considers all inputs simultaneously and also considers the trade-offs
across inputs based on current input prices. TFP has a financial objective.
The TFP for Awash Mfg. for the year 1996 is computed as follows:
TFP for 1996 = 850,000 = 0.258 per one birr
3,298,000

It is obvious that by itself the TFP of 0.25 unit of output per one birr is not helpful. It must be compared
against something. One comparison method is to compare TFP over time. Thus for Awash Mfg. we can
compare the TFP of 1996 with TFP of 1995. The TFP of 1995 is computed using the output of 1995 and the
inputs of 1995 at the inputs prices of 1996.

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 Cost of inputs used in 1995 Based on 1996 price = (74,800 x 28) + (439,000 x4.10)
= Br 3,894,300
TFP for 1995 using = 1,020,000 = 0. 262 units of output per one birr
the price of 1996 3,894,300
Assignment
Ethio Limited manufactures a special floor tile which measures ½ m x ¼ m x 0.01 m. The tiles are
manufactured in a process which requires the following standard mix:

Material Quantity Price (Br) Labor Hours Rate (Br)

A 40 1.5 X 6.00 20
B 30 1.2 Y 4.00 15
C 10 1.4 10.00
80
Each mix should produce 100 square metres of floor tiles of 0.01 m thickness. During Hamle, 60 mixes were
processed and the actual output was 4,600 tiles from an input of:

Material Quantity Price (Br) Labor Hours Rate (Br)

A 2,200 1.6 X 189 18
B 1,400 1.1 Y 231 16
C 400 1.5 420
For the month of Hamle, you are required to calculate total:
A. Material Price Variance__________ E. Labor Rate Variance_______________
B. Material Usage Variance________ F. Labor Efficiency Variance___________
C. Material Mix Variance__________ G. Labor Mix Variance________________
D. Material Yield Variance_________ H. Labor Yield Variance_______________

CHAPTER 5
The pricing of goods and services
104
A pricing decision is a troublesome area for many organizations; determining the 'right' price for a good or
service is important and can be very difficult. A company that sets its prices too high does not generate sales,
resulting in total profitability below target. On the other hand, prices set too low might lead to an increase in
sales activity, but the revenues might fail to cover costs. Both results miss the target profits.

Accounting information is often an important input to pricing decisions. Most firms needs to make decision
about setting or accepting selling prices for their products or services. In some firms selling prices are derived
directly from cost information by estimating future products cost & adding a suitable profit margin. In others
an established market price is accepted. Fundamentally, in pricing decision the management must first decide
on its pricing goal and then set the base price for goods or services. After this the firm may design its pricing
strategies.

In this chapter, we are going to discuss major influences on pricing decisions, costing and pricing for the
short run and long run, and cost plus target rate of return on investment.

Major Influences On Pricing Decisions

Generally speaking, organizations consider several factors when determining prices: markets, customers,
competitors, costs, life cycles, timing, and a variety of legal, political, and image-related issues. Of these,
three influences are ultimately depended on demand and supply relationship. These are customers,
competitors and costs.
Customers
An organization should consider pricing decisions for new products from the perspective of its customers.
Customers influence price through their effect on the demand for a product or service, based on factors such
as the features of a product and its quality.
• Prices that are to high will not generate the sales levels necessary to recover costs and target profits
because customers will seek a less expensive or substitute product or service. They might wait for a
competitor's offerings.
• Conversely, setting prices too low could underestimate customers' willingness to pay for what might
be a valuable innovation. Understanding customers' willingness to pay for the attributes and functions
of a product or service is key to setting prices successfully.

Competitors
105
No business operates in a vacuum. Companies must always be aware of the actions of their competitors. At
one extreme, alternative or substitute products of competitors hurt demand and force a company to lower
prices. At the other extreme, a company without a competitor is free to set higher prices. When there are
competitors, companies try to learn about competitors’ technologies, plant capacities, and operating
strategies to estimate competitors’ costs—valuable information when setting prices. Because competition
spans international borders, fluctuations in exchange rates between different countries’ currencies affect
costs and pricing decisions. For example, if the yen weakens against the U.S. dollar, Japanese products
become cheaper for American consumers and, consequently, more competitive in U.S. markets.

Costs

Costs influence prices because they affect supply. The lower the cost of producing a product, the greater the
quantity of product the company is willing to supply. Generally, as companies increase supply, the cost of
producing an additional unit initially declines but eventually increases. Companies supply products as long
as the revenue from selling additional units exceeds the cost of producing them. Managers who understand
the cost of producing products set prices that make the products attractive to customers while maximizing
operating income.

Costing and Pricing for the Short Run and Long Run
Costing and Pricing for the Short run
Short-run pricing decisions typically have a time horizon of less than a year and include decisions such as
a) pricing a one-time-only special order with no long-run implications and
b) Adjusting product mix and output volume in a competitive market.
Long-run pricing decisions have a time horizon of a year or longer and include pricing a product in a market
where there is some leeway in setting price.
Relevant Costs for Short-Run Pricing Decisions: One-time-only special order
Astel Computer manufactures two brands of personal computers (PCs)—Desk point, Astel’s top-of-the-line
product, and Provalue, a less-powerful Pentium chip-based machine. Data tech Corporation has asked Astel
to bid on supplying 5,000 Provalue computers over the last three months of 2010. After this three-month
period, Data tech is unlikely to place any future sales orders with Astel. Data tech will sell Provalue
computers under its own brand name in regions and markets where Astel does not sell Provalue. Whether
Astel accepts or rejects this order will not affect Astel’s revenues—neither the units sold nor the selling
price—from existing sales channels.
Before Astel can bid on Data tech’s offer, Astel’s managers must estimate how much it will cost to supply
the 5,000 computers. The relevant costs Astel’s managers must focus on include all direct and indirect costs
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throughout the value chain that will change in total by accepting the one-time-only special order from Data
tech. Astel’s managers outline the relevant costs as follows:
Direct materials ($460 per computer x 5,000 computers) $2,300,000
Direct manufacturing labor ($64 per computer x 5,000 computers) 320,000
Fixed costs of additional capacity to manufacture Provalue 250,000
Total costs $2,870,000*
*No additional costs will be required for R&D, design, marketing, distribution, or customer service
The relevant cost per computer is $574 ($2,870,000 ÷ 5,000). Therefore, any selling price above $574 will
improve Astel’s profitability in the short run. What price should Astel’s managers bid for the 5,000-computer
order?
Strategic and Other Factors in Short-Run Pricing
Based on its market intelligence, Astel believes that competing bids will be between $596 and $610 per
computer, so Astel makes a bid of $595 per computer. If it wins this bid, operating income will increase by
$105,000 (relevant revenues, $5,955,000 = $2,975,000 minus relevant costs, $2,870,000). In light of the
extra capacity and strong competition, management’s strategy is to bid as high above $574 as possible while
remaining lower than competitors’ bids.
What if Astel were the only supplier and Data tech could undercut Astel’s selling price in Astel’s current
markets? The relevant cost of the bidding decision would then include the contribution margin lost on sales
to existing customers. What if there were many parties eager to bid and win the Data tech contract? In this
case, the contribution margin lost on sales to existing customers would be irrelevant to the decision because
the existing business would be undercut by Data tech regardless of whether Astel wins the contract. In
contrast to the Astel case, in some short-run situations, a company may experience strong demand for its
products or have limited capacity. In these circumstances, a company will strategically increase prices in the
short run to as much as the market will bear. We observe high short-run prices in the case of new products
or new models of older products, such as microprocessors, computer chips, cellular telephones, and software.
Effect of Time Horizon on Short-Run Pricing Decisions
Two key factors affect short-run pricing.
1. Many costs are irrelevant in short-run pricing decisions. In the Astel example, most of Astel’s costs
in R&D, design, manufacturing, marketing, distribution, and customer service are irrelevant for the
short-run pricing decision, because these costs will not change whether Astel wins or does not win the
Datatech business. These costs will change in the long run and therefore will be relevant.
2. Short-run pricing is opportunistic. Prices are decreased when demand is weak and competition is
strong and increased when demand is strong and competition is weak. As we will see, long-run prices
need to be set to earn a reasonable return on investment.
Costing and Pricing for the Long run
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Long-run pricing is a strategic decision designed to build long-run relationships with customers based on
stable and predictable prices. A stable price reduces the need for continuous monitoring of prices, improves
planning, and builds long-run buyer–seller relationships. But to charge a stable price and earn the target
long-run return, a company must, over the long run, know and manage its costs of supplying products to
customers. As we will see, relevant costs for long-run pricing decisions include all future fixed and variable
costs.

Manufacturing Cost Information to Produce 150,000 Units of Provalue

Cost Category Cost Details of Cost Quantities Total Quantity Cost per
Driver Drivers of Cost Drivers Unit of
Cost
Driver
(1) (2) (3) (4) (5) = (3) x (4) (6)
Direct Manufacturing Costs
Direct Materials No. of kits 1 kit per unit 150,000 units 150,000 $460
Direct Mfg labor (DML) DML Hrs 3.2 DML hrs per unit 150,000 units 480,000 $20
Direct machining (fixed) M.hrs 300,000 $38
Manufacturing Overhead Costs
Ordering & receiving No. of 50 Orders per 450 comp. 22,500 $80
orders component
Testing & inspection T.hrs 30 testing-hrs per unit 150,000 units 4,500,000 $2
Rework 8% defect rate
Rework-hrs 2.5 12,000a 30,000 $40
Rework-hrs per defective units
defective unit
a
8% defect rate x 150,000 units = 12,000 defective units
Calculating Product Costs for Long-Run Pricing Decisions

Astel has no beginning or ending inventory of Provalue and manufactures and sells 150,000 units during the
year. Astel uses activity-based costing (ABC) to calculate the manufacturing cost of Provalue. Astel has
three direct manufacturing costs, direct materials, direct manufacturing labor, and direct machining costs,
and three manufacturing overhead cost pools, ordering and receiving components, testing and inspection of
final products, and rework (correcting and fixing errors and defects), in its accounting system. Astel treats
machining costs as a direct cost of Provalue because Provalue is manufactured on machines that only make
Provalue. The following table summarizes manufacturing cost information to produce 150,000 units of
Provalue in 2011.
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Manufacturing is just one business function in the value chain. To set long-run prices, Astel’s managers must
calculate the full cost of producing and selling Provalue. For each nonmanufacturing business function,
Astel’s managers trace direct costs to products and allocate indirect costs using cost pools and cost drivers
that measure cause and-effect relationships.
Manufacturing Costs of Provalue for 2011 Using Activity-Based Costing
Total Manufacturing
Costs for Manufacturing
150,000 units Cost per Unit
(1) (2) = (1) ÷ 150,000
Direct manufacturing costs
Direct material costs
(150,000 kits x $460 per kit) $69,000,000 $460
Direct manufacturing labor costs
(480,000 DML-hours x $20 per hour) 9,600,000 64
Direct machining costs
(300,000 machine-hrs x $38 per machine-hour) 11,400,000 76
Direct manufacturing costs 90,000,000 600
Manufacturing overhead costs
Ordering and receiving costs
(22,500 orders x $80 per order) 1,800,000 12
Testing and inspection costs
(4,500,000 testing-hours x $2 per hour) 9,000,000 60
Rework costs
(30,000 rework-hours x $40 per hour) 1,200,000 8
Manufacturing overhead cost 12,000,000 80
Total manufacturing costs $102,000,000 $680
Product Profitability of Provalue for 2011 Using Value-Chain Activity-Based Costing
Total Amounts
For 150,000 units Per Units
(1) (2)=(1)÷150,000
Revenues $150,000,000 $1,000
Costs of goods solda (from the above table) 102,000,000 680
Operating costsb
R&D costs 5,400,000 36
Design cost of product& process 6,000,000 40
Marketing costs 15,000,000 100
Distribution costs 3,600,000 24
Customer-service costs 3,000,000 20
Operating costs 33,000,000 220
Full cost of the product 135,000,000 900
Operating income $15,000,000 $100
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a
Cost of goods sold = Total manufacturing costs because there is no beginning or ending inventory of
Provalue in 2011
b
Numbers for operating cost line-items are assumed without supporting calculations

Cost-Plus Pricing
The general formula for setting a cost-based price adds a markup component to the cost base to determine a
prospective selling price. Because a markup is added, cost-based pricing is often called cost-plus pricing,
with the plus referring to the markup component. Managers use the cost-plus pricing formula as a starting
point. The markup component is rarely a rigid number. Instead, it is flexible, depending on the behavior of
customers and competitors. The markup component is ultimately determined by the market.
Cost-Plus Target Rate of Return on Investment
This approach involves establishing a cost base and adding to this cost base a markup to determine a target
selling price. This is the selling price that will provide the desired profit when the seller has the ability to
determine the product’s price. The size of the markup (the “plus”) depends on the desired return on
investment (ROI = Net income ÷ Invested assets) for the product line, product, or service. In determining
the proper markup, the company must also consider competitive and market conditions, political and legal
issues, and other relevant risk factors.
The cost-plus pricing formula is expressed as follows.
Cost + (Mark up percentage x Cost) = Target Selling Price

Markup percentage is determined based on target rate of return on investment. The target rate of return on
investment is the target annual operating income divided by invested capital. Invested capital can be defined
in many ways. In this chapter, it is defined as total assets—that is, long-term assets plus current assets.

Example: Air Corporation produces air purifiers. The following per unit variable cost information is
available: direct materials $16, direct labor $18, variable manufacturing overhead $11, and variable selling
and administrative expenses $6. In addition, Air Corporation has the following fixed cost per unit at a
budgeted sales volume of 10,000 units.

Total Costs ÷ Budgeted Volume = Cost per unit

Fixed manufacturing overhead $100,000 ÷ 10,000 units = $10

Fixed selling and administrative expenses 100,000 ÷ 10,000 units = 10

Fixed cost per unit $ 20

Air Corporation decided to price its new air purifier to earn a 31.95% return on its $1,000,000 investment
(ROI). Therefore, the company expects to receive income of $319,500 (31.95% x $1,000,000) on its
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investment. On a per unit basis, the desired ROI is $31.95 ($319,500 ÷ 10,000 units). Compute the target
selling price.

Solution:

Direct materials........................................................................ $16

Direct labor............................................................................... 18

Variable MOH........................................................................... 11

Variable selling & admn. expenses............................................ 6

Fixed MOH................................................................................ 10

Fixed selling & admn. expenses................................................ 10

Total unit cost........................................................................... $71

Method I:

Target Selling price per unit = Total unit cost + Desired ROI

= 71 + 31.95 = $102.95

Method II:

Desired ROI per Unit ÷ Total Unit Cost = Markup Percentage

$31.95 ÷ $71 = 45%

Cost + (Markup percentage x Cost) = Target Selling Price

$71 + (45% x $71) = 71 + (0.45 x 71) =

71 + 31.95 = $102.95 = Target selling price

:- Air Corporation should set the price for its air purifiers at $102.95 per unit.

Limitations of Cost-Plus Pricing

The cost-plus pricing approach has a major advantage: It is simple to compute. However, the cost model
does not give consideration to the demand side. That is, will customers pay the price Air Corp. computed for
its air purifiers? In addition, sales volume plays a large role in determining per unit costs. The lower the sales
volume, for example, the higher the price Air Corp. must charge to meet its desired ROI.

To illustrate, if the budgeted sales volume was 8,000 instead of 10,000, Air Corp’s variable cost per unit
would remain the same. However, the fixed cost per unit would change as follows.
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Total Costs ÷ Budgeted Volume = Cost per unit

Fixed manufacturing overhead $100,000 ÷ 8,000 units = $12.5

Fixed selling and administrative expenses 100,000 ÷ 8,000 units = 12.5

Fixed cost per unit $ 25

Air Corp’s desired 31.95% ROI now results in a $39.94 ROI per unit [(31.95% x $1,000,000) ÷ 8,000]. Air
Corporation computes the selling price at 8,000 units as follows.

Target selling price per unit = Total unit cost + Desired ROI per unit

= (VC per unit + FC per unit) + Desired ROI per unit

= ($51 + $25) + $39.94 = $115.94

Important Points:

 As shown, the lower the budgeted volume, the higher the per unit price. The reason: Fixed costs and
ROI are spread over fewer units, and therefore the fixed cost and ROI per unit increase.
 In this case, at 8,000 units, Air Corporation would have to mark up its total unit costs 52.55% to earn
a desired ROI of $39.94 per unit, as shown below.
Desired ROI per Unit ÷ Total Unit Cost = Markup Percentage
$39.94 ÷ $76 = 52.55%
 The target selling price would then be $115.94, as indicated earlier:
Cost + (Markup percentage x Cost) = Target Selling Price
$76 + (52.55% x $76) = $115.94
The opposite effect will occur if budgeted volume is higher because fixed costs and ROI can be spread over
more units. As a result, the cost-plus model of pricing will achieve its desired ROI only when the company
sells the quantity it budgeted. If actual volume is much less than budgeted volume, Air Corporation may
sustain losses unless it can raise its prices.

Additional Considerations For Pricing Decisions

In some cases, cost is not a major factor in setting prices. It is explored some of the ways that market
structures and laws and regulations influence price setting outside of cost.
Price Discrimination

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Price discrimination is the practice of charging different customers different prices for the same product or
service. It occurs most of the time in service industries, such as Airlines.
Importantly, the Robinson-Patman Act does allow price discrimination under certain specified conditions:
(1) if the competitive situation demands it and (2) if costs (including costs of manufacture, sale, or delivery)
can justify the lower price. Clearly, this second condition is important for the accountant, as a lower price
offered to one customer must be justified by identifiable cost savings. Additionally, the amount of the
discount must be at least equaled by the amount of cost saved.
Peak-Load Pricing
In addition to price discrimination, other non cost factors such as capacity constraints affect pricing
decisions. Peak-load pricing is the practice of charging a higher price for the same product or service when
the demand for the product or service approaches the physical limit of the capacity to produce that product
or service. When demand is high and production capacity is limited, customers are willing to pay more to
get the product or service. In contrast, slack or excess capacity leads companies to lower prices in order to
stimulate demand and utilize capacity. Peak-load pricing occurs in the telephone, telecommunications, hotel,
car rental, and electric-utility industries.
Predatory Pricing
Predatory pricing is the practice of setting prices below cost for the purpose of injuring competitors and
eliminating competition. It is important to note that pricing below cost is not necessarily predatory pricing.
A company engages in predatory pricing when it deliberately prices below its costs in an effort to drive
competitors out of the market and restrict supply, and then raises prices rather than enlarge demand.
Predatory pricing on the international market is called Dumping, which occurs when companies sell below
cost in other countries, and domestic industry is injured. For years, U.S. steel manufacturers have accused
Japanese, Russian, and Brazilian companies of dumping.

Chapter 6
Responsibility Accounting

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I. Responsibility Accounting
The responsibility accounting system has been developed to support the decentralized organizational
structure with many responsibility centers where:
A responsibility center is a segment of the business whose manager is accountable for only the
activities of that center.
Responsibility accounting is a system that measures the results of each responsibility center and
compares those results with some measure of expected or budgeted outcome.
A. Types of responsibility centers include:
1. Cost centers—managers are responsible only for costs.
Example: Production departments within the factory
2. Revenue centers—managers are responsible only for sales.
Example: A company’s marketing department
3. Profit centers—managers are responsible for both revenues and costs.
Example: A plant within a firm
4. Investment centers—managers are responsible for revenues, costs, and investments.
Example: A division within a firm
Note that in a decentralized organization, some interdependencies usually exist. Thus, decisions
made by the manager, such as transfer pricing, can affect other responsibility centers.
B. The Role of Information and Accountability
Managers should be held accountable for outcomes in the areas in which they have the most
knowledge and information available to them.
II. Decentralization
A. Decentralization is the practice of delegating decision-making authority to the lower levels.
1. In centralized decision making:
Decisions are made at the very top level of the organization.
Lower-level managers are charged with implementation.
2. In decentralized decision making:
Managers at lower levels make and implement key decisions.
B. Reasons for Decentralization
1. Have better access to local information
Lower-level managers may have better quality information because they are “closer to the
action.”
2. Avoid cognitive limitations
No one person has all of the expertise and training needed to process and use the information.
Individuals with specialized skills will be needed.
3. Allow more timely response
Avoid delays caused by transmitting information to central management and waiting for the
responses, and decrease the potential for miscommunication.
Decentralization allows the local managers to both make and implement the decision.
4. Better focusing of central management
Top management is free to focus on strategic planning and decision making.
5. Facilitate training and evaluation
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 Lower-level managers are given the opportunity to make decisions as well as implement them.
6. Provide motivation
Greater responsibility can produce more job satisfaction and motivate the local manager.
7. Enhance competition
Each decentralized division’s contribution to profit can be more easily measured.
Each division is exposed more directly to market forces.
C. The Units of Decentralization
1. Decentralization is usually achieved by segmenting the company into divisions. Divisions may
be differentiated by:
a. Types of goods or services provided
b. Types of customers served
c. Geographic regions
2. Decentralization creates the opportunity for control of the divisions through the use of
responsibility accounting.
III. Measuring the Performance of Investment Centers
A. Return on Investment
1. Return on investment (ROI) measures profits earned per dollar of investment.
a. It is the most common measure of performance for an investment center.
Operatingincome
ROI =
Averageoperatingassets
Operatingincome Sales
ROI = ×
Sales Averageoperatingassets
ROI = Operating income margin × Operating asset turnover
b. Operating income is earnings before interest and taxes.
c. Operating assets are all assets acquired to generate operating income.
Includes cash, receivables, inventories, land, buildings, and equipment.
Beginningnet book value + Ending net book value
Average operating assets =
2
2. Margin is the ratio of operating income to sales.
3. Turnover shows how productively assets are being used to generate sales.
4. Advantages of using ROI include:
a. It encourages managers to pay careful attention to the relationships among sales, expenses,
and investments.
b. It encourages cost efficiency by focusing on reducing non value-added activities and/or
improving productivity.
c. It discourages excessive investment in operating assets and, thus, encourages efficient
investment.
5. Disadvantages of the ROI measure include:
a. It discourages managers from investing in projects that would increase the profitability of
the company as a whole but would decrease the divisional ROI measure.
Managers would reject projects with an ROI less than a division’s current ROI but higher
than the firm’s cost of capital.
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 b. It can encourage myopic behavior, in that managers may over emphasize short-run
results at the expense of the long-term profitability.
B. Residual Income
1. Residual income (RI) is the difference between operating income and the minimum dollar
return required on a company’s operating assets.
RI = Operating income – (Minimum rate of return × Operating assets)
2. Advantage of residual income:
A manager will accept any project that earns above the minimum rate of return because they
will increase the company-wide profitability.
3. Disadvantages of residual income:
a. RI an absolute measure of return that makes it difficult to compare divisions of different
sizes.
Solution: Compute a residual return on investment.
RI
Residual return on investment =
Averageoperatingassets
b. May encourage myopic behavior.
Same disadvantage as for ROI.
C. Economic Value Added
1. Economic value added (EVA) is after-tax operating profit minus the total annual cost of
capital.
EVA = After-tax operating income –
(Weighted average cost of capital × Total capital employed)
a. EVA is a dollar figure rather than a percentage rate of return.
b. EVA emphasizes after-tax operating profits and actual cost of capital.
c. EVA uses the weighted average cost of capital, which is measured on an
after-tax basis.
Computation of the cost of capital employed involves the following steps:
(1) Determine the weighted average cost of capital as a percentage.
(a) Identify all sources of invested funds.
(b) Multiply the proportion of capital from each source of financing by its after-tax
cost.
Interest expenses of debt financing are tax deductible. Thus,
After-tax cost of capital for debt = Cost × (1 – Tax rate)
There are no tax adjustments for equity.
Over time, stockholders receive an average return that is 6% higher than the
return on long-term government bonds.
(2) Determine the total dollar amount of capital employed, including:
Buildings, land, and machinery.
Other investments meant to have a long-term payoff, such as research and
development, employee training, and so on.
d. Positive EVA means that the firm creates wealth (value) by earning operating profit over
and above the cost of capital used.

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 EVA has a higher correlation with stock prices than other accounting measures of return
because it relates profit to the amount of resources needed to achieve it.
2. Behavioral Aspects of EVA
a. EVA encourages managers to maintain a balanced emphasis on operating income and
capital employed. It helps lower-level management understand that capital employed is
not free.
b. EVA can be improved by reducing capital usage.
D. Multiple Measures of Performance
Modern managers use multiple measures of performance and include non financial measures as
well as financial measures.
ROI, residual income and EVA are financial performance measures.
Non financial performance measures linked to long-run success factors include market share,
customer complaints, personnel turnover rates, and personnel development.
IV. Measuring and Rewarding the Performance of Managers

Managers should be evaluated on the basis of factors under their control.

A. Incentive Pay for Managers—Encouraging Goal Congruence
A well-structured incentive compensation plan encourages goal congruence between managers
and owners, and between lower-level managers and top management. It should encourage
managers to take risk, work hard, and not to abuse perquisites.
Goal congruence is the alignment of low-level managers’ goals with those of top management,
so that managers will act in the best interest of the firm.
Perquisites are a type of fringe benefit received over and above salary.
B. Managerial Rewards
Managerial rewards often include incentives tied to performance as follows:
1. Cash Compensation
a. Many companies use a combination of salary and bonuses to reward performance.
(1) Salaries can be kept fairly level.
(2) Bonuses can fluctuate with reported income, giving companies more flexibility.
b. Income-based compensation can encourage dysfunctional behavior, such as
manipulating the timing of revenues and expenses.
c. Profit-sharing plans pay employees a share of profits over and above their flat-rate wages
to provide an incentive for employees to work harder and smarter.
Profit-sharing plans make employees partial owners in the sense that they receive a share
of the profits.
2. Stock-Based Compensation
a. Issue stock to managers to make them part owners of the company.
Objective: To encourage goal congruence.
b. Offer stock options to managers.
A stock option is the right to buy a certain number of shares of the company’s stock at a
particular price and after a set length of time.

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 Objective: To encourage managers to focus on long-term performance improvement. If
the stock price rises in the future, managers may exercise the option, thus purchasing
stock at a below-market price and realizing gains.
A disadvantage of stock options is that the price of stock is influenced by many factors
out of a manager’s control.
3. Issues to Consider in Structuring Income-Based Compensation
a. Cash bonuses and stock options can encourage short-term orientation and gaming
behavior.
Gaming behavior occurs when managers increase short-term profit at the expense of long-
term profitability.
b. Owners and managers are affected differently by risk.
Managers may prefer to take less risk than owners because they have so much of their
financial and human capital invested in the company.
Owners may prefer a more risk-taking attitude because of their ability to diversify away
some of the risk.
4. Non cash Compensation
a. Gives employees autonomy in the conduct of their daily business activities.
b. Provides employees perquisites such as improvements in title, office location and
trappings, use of expense accounts, and so on.

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Text Book:
• Horngren, Foster, &Datar. Cost Accounting: A Managerial Emphasis. 9th Ed. 1997
• Horngren, Sunden& Stratton. Introduction to Management Accounting. 11th Ed. 1999
Reference Books
• C.T Homgren, Introduction to Management Accounting 4th to 8 th editions, 1999 USA
• C.T. Homgren, Cost Accounting: A Managerial Emphasis 5th to 8th ecitionsprentice Hall Inc. 1982 to 1994
• Homgren, foster, &Datar, Cost Accounting A Managerial Emphasis. 10 thEcition
• L.E. Heitger Managerial Accounting 1th and 2 nd editions, McGraw Hill , 1998, India
• GetuJemaneh, Management Accounting 1996.
• Ray H.Garrison, Managerial Accounting. 6th edition
• Caluinengler, Managerial Accounting 2nd edition

• L. Gayle Rayburn Principles of cost Accounting using a cost Management Approach 4th edition Richard DIR
WIN Inc. 1989. Robert X. Kaplan Advanced Management Accounting 1st and 2nd edition prentice Haill,
Inc, 1982 and 1989 (Chapters 2, 11,12, and 13 only

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