Cost Management

2022: MBA
Session – 1 : Introduction
Prof. Arpita Ghosh
 Planning and Control Cycle

Formulating plans Begin

(Planning - Budgeting)

Comparing actual Implementing

to planned Decision plans
performance
Making (Directing and
(Controlling) Motivating)

Measuring
performance
(Controlling)
 Need for Cost Management
Create Value: through Cost minimization and /or Revenue maximization

• Ananya needs to decide as a Manager of ABC Automobiles whether to buy a tool from
outsider or make it in‐house.
• Akansha decides to open a boutique. She needs to know how to price her products.
• Mr Goenka, the sales manager of a Furniture company needs to decide whether the company
should drop a product line (say sofa‐cum‐bed) which is reporting losses.
• Shivam needs to decide for JND Stainless Ltd whether they should expand their
manufacturing unit to Japan.
• Tushar Ltd has received a big, new project. It needs to identify the most efficient division for
taking up the project.

Earlier Use : Inventory valuation and Profit determination (external reporting)

Cost Accounting system provides cost, revenue & other information to managers to
support them in decision making within an organization towards achieving
organizational goals

Decisions which : Improve products/services, Improve allocation of resources within

a company, Reduce and Control costs, Support strategies adopted
 Course Overview

• Overview and Introduction – Basic Cost concepts, cost classifications

• Product costing methods based on Absorption costing :

– Job costing

– Process costing

• Activity Based Costing (ABC)

• Cost‐Volume‐Profit Analysis

• Relevant costs for short‐term decision making

• Budgeting & Standard costing

• Responsibility Accounting
 Learning Goals

• Need for Cost Management

• Course Overview
• Cost Accounting and Financial Accounting
• Basic Cost Terms : Cost, Cost Object, Cost Centre, Cost Unit, Cost Drivers
• Flow of Manufacturing Costs
• Cost Classifications
– Manufacturing, Administrative, and Selling costs;
– Direct and indirect costs;
– Product and period costs;
– Material, Labor, and Overheads;
– Variable and fixed costs; step & mixed costs
– Controllable and uncontrollable costs;
– Differential, average, and marginal costs
– Opportunity, Sunk and Out of pocket costs
• Determine Cost of goods manufactured (COGM) and Cost of goods sold(COGS)
 Cost Accounting & Financial Accounting
Similarities :
– Information for decision making
– Based on common documents or records

Differences :

Areas of difference Financial Accounting Cost Accounting

Users External Internal
Time Focus Past Future
Data Emphasis Verifiability Relevance
Precise Timely
Subject Organisation Segments
GAAP Must follow Need not
Preparing Reports Mandatory Not mandatory
 Basic Cost Terms

• Cost : Amount of resources consumed to achieve an objective; sacrifice made to

achieve a particular purpose
– Actual Cost (Cost Incurred in the past‐ Historical) and Budgeted Cost (Planned for
Future ‐ Forecasted)
• Cost Object
 Anything for which separate measurement of costs is desired. Can be:
 Product, Process, Service, Customers, Departments, Jobs
• Cost Centre
• Segment of the enterprise for which costs are accumulated
‐ Production centre, Service centre
• Cost Unit
– Form of measurement of volume of production or service

• Cost Driver:
– Activities that cause costs to be incurred (labor hours in manual assembly work)
 Cost Classification
• Based on Element:
– Material, Labour and Overheads
• Based on Function:
– Manufacturing and Non‐manufacturing costs
• For Preparing external Financial Statements (Relationship with accounting
period):
– Product and Period Costs
• For Assigning costs to cost objects (Traceability)
– Direct and Indirect Costs
• For Predicting cost behavior i.e., changes in cost due to changes in activity
– Fixed and Variable Costs
• For Controllability : Controllable, & Non‐controllable
• For Decision making & planning
– Differential, Opportunity, Sunk
– Average, Marginal, Differential
 Cost Classification : By Element and Function

Costs

Manufacturing Costs Non-Manufacturing Costs

Direct Material Direct Labour Manufacturing/Factory

Overhead

Administrative
Indirect Material
costs

Prime Cost Indirect Labour

Selling Costs
Indirect Expenses
 Flow of Manufacturing Costs

Raw Material : Total Manufacturing Costs

Opening RM Direct Material
+ RM Purchases Prime
Cost + Opening WIP
(+ Freight in, if any) + Direct Labour
‐ Closing WIP
‐ Closing RM
= Raw Material + Manufacturing OH
= Cost of goods
Consumed in
manufactured
production
= Total Manufacturing Costs + Opening FG

= Cost of goods
available for sale
Direct Material
‐ Closing FG
Conversion Costs
= Cost of Goods Sold
(COGS)
 Flow of Costs
Opening Costs incurred Balance Sheet
RM (10) During the period
Closing Raw
Material (5)
Direct Material
purchases (35)
Work in
Direct Labor (50)
Process
Opening WIP (10) Inventory
(10+100)
Manufacturing Completed
Income Statement
Overhead (10) Closing WIP(20) (COGM) (90)

Finished Cost of
Sold (95)
Goods Goods
Opening FG (15)
Inventory Sold
(15+90)

Closing FG (10)
Selling, General &
Non-Manufacturing Administrative
Costs expenses, R&D etc
 Calculation of Cost of goods sold (COGS) - For Merchandising Company
Purchases net of Purchase Returns and Discounts 300000
Add: Freight inwards, Transit Insurance , Others like handling 4000
Charges (related to Purchases)
= Cost of goods Purchased 304000
Add: Opening Inventory 10000
= Cost of goods available for sale 314000
Less: Closing Inventory 4000
= Cost of goods sold 310000
Opening Raw Material 10000
Add: Raw Material Purchased net of Returns, Discounts 200000
Add: Freight in etc. 4000
COGS - For Manufacturing Company

Less: Closing Stock of Raw Material 7000

= Raw Material Consumed 207000

Add : Direct Labour cost or Direct wages 50000

Conversion Cost
Add: Manufacturing Expenses 35000
= Total Manufacturing Costs 292000
Adjustment for WIP :
Add: Opening WIP 20000
Less: Closing WIP 30000
Adjustment for FG :
= Cost of goods manufactured 282000
Add: Opening Finished Goods 8000
= Cost of goods available for sale 290000
Less: Closing Finished Goods 10000
= Cost of goods sold 280000
H-12e Problem 2-43
 San Fernando Fashions Company
H-12e Problem 2-43 Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 20x2
Direct material:
Schedule of cost of goods manufactured

Raw‐material inventory, January 1 $ 40,000

Add: Purchases of raw material 180,000
Raw material available for use $220,000
Deduct: Raw‐material inventory, December 31 25,000
Raw material used $195,000
Direct labor 200,000
Manufacturing overhead:
Indirect material $ 10,000
Indirect labor 15,000
Utilities: plant 40,000
Depreciation: plant and equipment 60,000
Other Manufacturing Overhead 80,000
Total manufacturing overhead 205,000
Total manufacturing costs $600,000
Add: Work‐in‐process inventory, January 1 40,000
$640,000
Deduct: Work‐in‐process inventory, December 31 30,000
Cost of goods manufactured $610,000
 San Fernando Fashions Company
SCHEDULE OF COST OF GOODS SOLD
FOR THE YEAR ENDED DECEMBER 31, 20X2
Finished goods inventory, January 1 $ 20,000
Add: Cost of goods manufactured 610,000
Cost of goods available for sale $630,000
Problem 2-43 continued

Deduct: Finished‐goods inventory, December 31 50,000

Cost of goods sold $580,000

San Fernando Fashions Company

INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 20X2
Sales revenue $950,000
Less: Cost of goods sold 580,000
Gross margin $370,000
Selling and administrative expenses 150,000
Income before taxes $220,000
Income tax expense 90,000
Net income $130,000
Problem 2–41 (H12) Case A Case B Case C
Beginning inventory, raw material ? 60,000 20,000 15,000
Ending inventory, raw material 90,000 10,000 30,000
Purchases of raw material 1,00,000 85,000 70,000
Direct material used 70,000 95,000 55,000
Direct labor ? 2,00,000 1,00,000 1,25,000
Manufacturing overhead 2,50,000 1,50,000 1,60,000
Total manufacturing costs 5,20,000 3,45,000 3,40,000
Beginning inventory, work in process 35,000 20,000 15,000
Ending inventory, work in process 30,000 35,000 5,000
Cost of goods manufactured ? 5,25,000 3,30,000 3,50,000
Beginning inventory, finished goods 50,000 40,000 20,000
Cost of goods available for sale ? 5,75,000 3,70,000 3,70,000
Ending inventory, finished goods ? 30,000 40,000 25,000
Cost of goods sold 5,45,000 3,30,000 3,45,000
Sales ?8,00,000 5,00,000 4,80,000
Gross margin 2,55,000 1,70,000 1,35,000
Selling and administrative expenses ?1,05,000 75,000 45,000
Income before taxes 1,50,000 95,000 90,000
Income tax expense 40,000 45,000 35,000
Net income ?1,10,000 50,000 55,000
Problem 2–41 (H12) Case A Case B Case C
Beginning inventory, raw material 60,000 20,000 15,000
Ending inventory, raw material 90,000 10,000 30,000
Purchases of raw material 1,00,000 85,000 70,000
Direct material used 70,000 95,000 55,000
Direct labor 2,00,000 1,00,000 1,25,000
Manufacturing overhead 2,50,000 1,50,000 1,60,000
Total manufacturing costs 5,20,000 3,45,000 3,40,000
Beginning inventory, work in process 35,000 20,000 15,000
Ending inventory, work in process 30,000 35,000 5,000
Cost of goods manufactured 5,25,000 3,30,000 3,50,000
Beginning inventory, finished goods 50,000 40,000 20,000
Cost of goods available for sale 5,75,000 3,70,000 3,70,000
Ending inventory, finished goods 30,000 40,000 25,000
Cost of goods sold 5,45,000 3,30,000 3,45,000
Sales 8,00,000 5,00,000 4,80,000
Gross margin 2,55,000 1,70,000 1,35,000
Selling and administrative expenses 1,05,000 75,000 45,000
Income before taxes 1,50,000 95,000 90,000
Income tax expense 40,000 45,000 35,000
Net income 1,10,000 50,000 55,000
 Cost Classification – Whether Inventoriable
Reported as Expense or Asset

• Product (inventoriable) Costs

• Costs of goods manufactured, or cost of goods purchased for resale
• Includes : Direct materials, direct labour, manufacturing overhead
• Expensed to Income Statement on sale – as Cost of goods sold
• Capitalized or Inventoried, appears on Balance Sheet till sold – as Inventory
– For Manufacturing Company :
» Raw Materials, Work in process, Finished Goods
– For Merchandising Company : Merchandise Inventory
• Period Costs
– General (non‐product) costs of being in the business
– Not inventoried, not involved in making a product and can’t be traced to any revenue
transaction during the period
– Expensed to Income Statement in the period in which incurred
– Includes: Selling, General and Administrative Expenses

Period cost or Product cost for a manufacturing company?

Manufacturing equipment depreciation, Property taxes on corporate headquarters, Direct materials
costs
 (H-12) Problem 2-50

Indicate for each of the following costs whether it is a product cost or a period
cost.
Cost Item Costs Product Cost or
Number Period Cost
1 Wages of aircraft mechanics employed by an airline period*
2 Wages of drill-press operators in a manufacturing plant product
3 Cost of food in a microwavable dinner product
4 Cost incurred by a department store chain to transport product
merchandise to its stores
5 Cost of Grapes purchased by a winery product
6 Depreciation on pizza ovens in a pizza restaurant period*
7 Cost of plant manager’s salary in a computer production facility product
8 Wages of security personnel in a department store period
9 Cost of utilities in a manufacturing facility product

*Service industry firms typically treat all costs as operating expenses which are period expenses. Such firms do not
inventory costs.
 (H-12) Problem 2-50

Indicate for each of the following costs whether it is a product cost or a period
cost.
Cost Item Costs Product Cost or
Number Period Cost
1 Wages of aircraft mechanics employed by an airline period*
2 Wages of drill-press operators in a manufacturing plant product
3 Cost of food in a microwavable dinner product
4 Cost incurred by a department store chain to transport product
merchandise to its stores
5 Cost of Grapes purchased by a winery product
6 Depreciation on pizza ovens in a pizza restaurant period*
7 Cost of plant manager’s salary in a computer production facility product
8 Wages of security personnel in a department store period
9 Cost of utilities in a manufacturing facility product

*Service industry firms typically treat all costs as operating expenses which are period expenses. Such firms do not
inventory costs.
 Cost Classification based on Assignment

– Direct Costs
• Easily, conveniently and economically traceable to cost object (say, to a unit
of product)
• Example: Direct Material like raw cotton in textile manufacturing plant
– Indirect Costs
• Not easily, conveniently and economically traceable to cost object
• Must be allocated to a product or department
• Example:
– Manufacturing Overhead like lubricants for the machines used for
production
– Factory managers salary in a company producing products A and B,
when the cost object is A: common costs for A & B
– A cost may be direct or indirect cost depending on whether the cost is caused
by the cost object under consideration
– Factory manager’s salary when the cost object is manufacturing
division – Direct Cost
 Direct Costs or Indirect Costs ?

Direct Indirect
Cost Cost object Cost Cost

1 The wages of pediatric nurses The pediatric department X

2 Prescription drugs A particular patient X

3 Heating the hospital The pediatric department X

4 The salary of the head of pediatrics The pediatric department X

5 The salary of the head of pediatrics A particular pediatric patient X

6 Hospital Superintendent’s salary A particular patient X

7 Lab tests by outside contractor A particular patient X

8 Lab tests by outside contractor A particular department X

 Direct Costs or Indirect Costs ?

Direct Indirect
Cost Cost object Cost Cost

1 The wages of pediatric nurses The pediatric department X

2 Prescription drugs A particular patient X

3 Heating the hospital The pediatric department X

4 The salary of the head of pediatrics The pediatric department X

5 The salary of the head of pediatrics A particular pediatric patient X

6 Hospital Superintendent’s salary A particular patient X

7 Lab tests by outside contractor A particular patient X

8 Lab tests by outside contractor A particular department X

 Cost Classification ‐ Behaviour
• Based on Behavior: Variable Costs
300
– Variable Costs (V): move in direct Total Variable Costs
250
proportion to a change in activity Variable cost per unit
200
– Fixed Costs (F): remain constant in

C o sts
150
total as the level of activity changes
100
• Relevant Range & Relevant Period 50
• Variable cost in an ice cream shop? 0
– Wages of shop manager 1 2 3 Units 4 5

– Lighting costs
– Cost of ice cream Fixed Costs

1200
• Manufacturing Overhead: F or V ? 1000
• Period Costs: F or V? 800
• Is Direct Labour always variable ? Total Fixed Costs
Costs

600
Fixed cost per unit
400
Costs Behaviour w ith increase in level of activity
200
Costs Total Per Unit
0
Fixed Costs Constant Decreases
1 2 3 4 5
Variable Costs Increases Constant
Units
 Other cost behaviours
• Step costs
– Fixed within a wide range of activity but will change outside that range.
– Increase in small steps Y
– Supervisory Salary

Costs
X
Units
• Mixed costs (Semi‐Variable Costs)
– Cost of electric power
– Compensation to a sales personnel Y
• Fixed salary Variable
• Commission based on units sold
Costs Fixed
X
Units
 Cost Classification : Decisions
• Average Cost: Total cost divided by quantity produced.
• Marginal Cost: The extra cost incurred to produce one additional unit.
• Differential Costs: Net Difference in cost between any two alternatives
Present1000 units Expansion1200 units Differential
Sales 20000 24000 4000
Less : Variable Expenses 5,000 6,000 1000
Less : Fixed Expense 6000 7000 1000
Net Income 9000 11000 2000
(Rs)
Incremental Revenue (Increase in sales) 4000
Less: Differential costs (increase in costs) Variable 1000
Fixed 1000 2000
Decision to go for expansion 2000

• Controllable cost: costs over which a manager has influence (direct materials)
• Uncontrollable costs: costs over which a manager has no influence (CEO's Salary
from production manager viewpoint)
• Opportunity cost: Potential benefit forgone by choosing an alternative course of
action (over another), no cash outlay
• Out of Pocket cost: cost that requires a cash outlay, directly attributable to an
activity
• Sunk cost: cost incurred in the past, cannot be changed by current/future decisions
Self Study Assignments: S‐1

H-12 : P 2-40 ; P 2-45 ; 2-60

 PROBLEM H‐12e, 2‐40 : COST BEHAVIOUR
1. Determine the cost of the Dec 31st finished-goods inventory
Fixed manufacturing overhead per unit: $600,000  24,000 units produced = $25
Direct material……………………….. $ 20
Direct labor…………………………… 37 2. Compute Net Income for the current year ended Dec 31st
Variable manufacturing overhead.. 48
Sales revenue (20,000 units x $185)………… $3,700,000
Fixed manufacturing overhead…… 25
Cost of goods sold (20,000 units x $130)….. 2,600,000
Average unit cost……………….. $130
Gross margin……………………………………. $1,100,000
Production……………………………. 24,000 units Selling and administrative expenses……….. 860,000
Income before taxes…………………………… $ 240,000
Sales…………………………………… 20,000 units
Income tax expense ($480,000 x 40%)……… 72,000
Ending finished‐goods inventory 4,000 units Net income………………………………………. $ 168,000
Cost of December 31 finished-goods inventory: 4,000 units x $130 = $520,000

3. If next year’s production decreases to 23,000 units and general cost behaviour patterns do not change, what
is the likely effect on
a) Direct labour cost of $37 per unit ? Why ?
No change. Direct labor is a variable cost, and the cost per unit will remain constant.
b) Fixed manufacturing overhead cost of $600,000 ? Why ?
No change. Despite the decrease in the number of units produced, this is a fixed cost, which remains the
same in total
c) Fixed Selling and administrative cost of $860,000 ? Why ?
No change. Selling and administrative costs move more closely with changes in sales than with units produced.
Additionally, this is a fixed cost.
d) Average unit cost of production ? Why ?
Increase. The average unit cost of production will change because of the per-unit fixed manufacturing overhead.
A reduced production volume will be divided into the fixed dollar amount, which increases the cost per unit.
Problem 2–45 (H12e):
Cape Cod Shirt Shop manufactures T-shirts and decorates them with custom designs for retail sale on the premises.
Several costs incurred by the company are listed below. For each cost, indicate which of the following classifications
best describe the cost. More than one classification may apply to the same cost item.

Cost Items Var Fixed Period Product Admin Selling Mfg R&D DM DL MOH

a b c d e f g h i j k

1 Cost of fabric used in    

T‐shirts

2 Wages of shirtmakers    

3 Cost of new sign in    The sign will be depreciated as a

front of retail T‐shirt period cost
shop
4 Wages of the    
employee who
repairs the firm’s
sewing machines
5 Cost of electricity    
used in the sewing
department
6 Wages of T‐shirt    
designers and
painters
7 Wages of sales   
personnel
8 Depreciation on    
sewing machines
 Cost Items Var Fixed Period Product Admin Selling Mfg R&D DM DL MOH

a b c d e f g h i j k
9 Rent on the building.       
Part of the building’s
first floor is used to
make and paint T‐
The building is used for several purposes
shirts. Part of it is used
for the retail sales
shop. The second
floor is used for admin
offices and storage of
raw material and
finished goods
10 Cost of daily   
advertisements in
local media
11 Wages of designers   
who experiment with
new fabrics, paints,
and T‐shirt designs
12 Cost of hiring a pilot   
to fly along the beach
pulling a banner
advertising the shop
13 Salary of the owner’s   
secretary

14 Cost of repairing the       

gas furnace

The building heated by the furnace is used for several purposes.

15 Cost of insurance for    

the production
employees
 H‐12e : Case 2‐60 : Understanding Cost Concepts
1 a. FastQ Company would be indifferent to acquiring either the small‐volume copier, 1024S, or the medium‐volume copier,
1024M, at the point where the costs for 1024S and 1024M are equal. This point may be calculated using the following
formula, where X equals the number of copies:

(Variable costS * XS) + fixed costS = (variable costM * XM) + fixed costM
1024S 1024M
$.14X + $8,000 = $.09X + $11,000
$.05X = $3,000
X= 60,000 copies

The conclusion is that the company would be indifferent to acquiring either the 1024S or 1024M
machine at an annual volume of 60,000 copies.
1 b. A decision rule for selecting the most profitable copier, when the volume can be estimated, would
establish the points where management is indifferent to each machine. The volume where the costs are
equal between alternatives can be calculated using the following formula, where X equals the number of
copies: (Variable cost * X) + fixed cost = (variable cost * X) + fixed cost
S S M M
For the 1024M machine compared to the 1024G machine:
1024M 1024G
$.09X + $11,000 = $.05X + $20,000
$.04X = $9,000
X = 225,000 copies

The decision rule is to select the alternative as shown in the following chart.
Anticipated Annual Volume Optimal Model Choice
060,000 1024S
60,000225,000 1024M
225,000 and higher 1024G
 H‐12e : Case 2‐60 : Understanding Cost Concepts
2. a. The previous purchase price of the endor on hand, $5.00 per gallon, and the average cost of the
endor inventory, $4.75 per gallon, are sunk costs. These costs were incurred in the past and will have no
impact on future costs. They cannot be changed by any future action and are irrelevant to any future
decision.
Although the current price of endor is $5.5 per gallon, no endor will be purchased at this price. Thus,
it too is irrelevant to the current special order.
If the order is accepted, the required 800 gallons of endor will be replaced at a cost of 5.75 per
gallon. Therefore, the real cost of endor for the special order is $4,600 (800  $5.75).

b. The $20,000 paid by Alderon for its stock of tatooine is a sunk cost. It was incurred in the
past and is irrelevant to any future decision.
The current market price of $11 per kilogram is irrelevant, since no more tatooine will be
purchased.
If the special order is accepted, Alderon will use 1,500 kilograms of its tatooine stock, thereby
losing the opportunity to sell its entire 2000‐kilogram stock for $14,000. Thus, the $14,000 is
an opportunity cost of using the tatooine in production instead of selling it to Solo Industries.
Moreover, if Alderon uses 1,500 kilograms of tatooine in production, it will have to pay
$1,000 for its remaining 500 kilograms to be disposed of at a hazardous waste facility. This
$1,000 disposal cost is an out‐of‐pocket cost.
The real cost of using the tatooine in the special order is $15,000 ($14,000 opportunity cost +
$1,000 out‐of‐pocket cost).
 H‐12e : Case 2‐60 : Understanding Cost Concepts

3. The projected donations from the wildlife show amount to $100,000 (10 percent of the TV
audience at $10,000 per 1 percent of the viewership). The projected donations from the
robotic manufacturing series amount to $75,000 (15 percent of the TV audience at $5,000 per 1
percent of the viewership). Therefore, the differential revenue is $25,000, with the advantage
going to the wildlife show.
However, if the robotic manufacturing show is aired, the station will be able to sell the wildlife
show to network TV. Therefore, airing the wildlife show will result in the incurrence of a $25,000
opportunity cost.
The conclusion, then, is that the station's management should be indifferent between the two
shows, since each would generate revenue of $100,000.

Wildlife show (10  $10,000) $100,000 donation

Robotic Manufacturing show (15  $5,000) $75,000 donation

Robotic Manufacturing show (sell wildlife show) 25,000 sales proceeds
$100,000 total revenue
Thank You 
 Extra Exercise - Product Cost, Period Cost

Product Costs or Period Costs ? Product

Cost
Period
Cost

Depreciation on salespersons’ cars X

Rent on equipment used in the factory X

Lubricants used for maintenance of machines X

Salaries of finished goods warehouse personnel X

Soap and paper towels used by factory workers at the end of a shift X

Factory supervisors’ salaries X

Heat, water, and power consumed in the factory X

Advertising costs X

Workers’ compensation insurance on factory employees X

Depreciation on chairs and tables in the factory lunchroom X

The wages of the receptionist in the administrative offices X

Lease cost of the corporate jet used by the company's executives X

Rent on rooms at a Florida resort for holding the annual sales conference X
 Manufacturing
Variable Non-manufacturing Cost
Extra Exercise on COST Classification or Fixed Cost
(V or F) Selling Administrative Direct Indirect
1. Depreciation, executive jet. F x
2. Costs of shipping finished goods to
customers. V x

3. Wood used in manufacturing furniture. V x

4. Sales manager’s salary F x
5. Electricity used in manufacturing
furniture. V x
6. Salary of the secretary to the company
president. F x
7. Aerosol attachment placed on a spray can
produced by the company. V x
8. Billing costs. V x
9. Packing supplies for shipping products
overseas. V x
10. Sand used in manufacturing concrete. V x
11. Supervisor’s salary, factory. F x
12. Executive life insurance. F x
13. Sales commissions. V x
14. Fringe benefits, assembly-line workers. V x
15. Advertising costs. F x
16. Property taxes on finished goods
warehouses. F x

17. Lubricants for production equipment. V x

Cost Management

MBA- 2022
Session 2
Product Cost: Job Costing
 Learning Goals

 Explain the flow of manufacturing costs in job costing

system.

 Compute pre‐determined overhead rate and allocate

overheads.

 Learn the disposition of under‐applied and over‐applied

overheads.

 Allocation of service department costs to production

departments
 Costing Systems based on - Absorption costing
Job Costing:
– Different products as per Customer specification– Non-repetitive
• Not for mass market, produced in low volumes or one at a time
– Each job order is unique
• Can be continuously identified at each stage of production
– Jobs are separately identifiable
– Example : Houses made as per customer requirements

Process Costing
– Homogeneous products in continuous flow processing lines - Mass Scale
– Many units of a product - units are undistinguishable from each other
– Soft drink producer, Oil Refinery, Chemical processing plant, Cement

Comparison Job costing Process Costing

Number of Jobs Worked Many Same Product

Cost Accumulation Job Department

Average Unit Cost computed by Job Department
 The Flow Of Documents In a Job-order Costing System

FEATURES
• Costs accumulated as per job
Sales Order
• Every job is identified by a unique
A sales order is prepared
number, has a job card or job cost as a basis for issuing a ...
sheet
• Job cost sheet is used to track
costs
Production Order
- Direct material, direct labor and A production order initiates
work on a job, whereby costs
manufacturing cost is accumulated for are charged through ...
each job

Materials Predetermined
Requisition Labour Time Ticket Ovhd. Rates

The various costs of production are

accumulated on a form, prepared by the
accounting department, known as a ...

Job Cost
Sheet
The job cost sheet forms the basis for valuing
ending inventories and Cost of Goods Sold.
 Measuring Direct Material & Labour Costs,
Applying Manufacturing Overheads

Materials Requisition Form Employee Time Ticket

Application of Manufacturing Overhead:

Predetermined OH Rate (POHR) = $6.4 lac/80,000 DLH = $ 8 per DLH
OH Applied: Actual DLH used * POHR = 27 hrs * $ 8 = $216
Also look at Exhibit 3.3-page 121/88 of the Textbook
 Application of Manufacturing Overhead

• Overhead Absorption - Charging of OHs to units produced

• Actual OH Absorption rate: Delay, Seasonality
• OH is applied to jobs using a predetermined overhead rate (POHR)
based on estimates made at the beginning of the accounting period

Budgeted manufacturing overhead cost

POHR =
Budgeted amount of cost driver (or activity base)

Overhead applied = POHR × Actual activity

Based on estimates, and Actual amount of the allocation base,

determined before the such as direct labor hours, incurred
period begins during the period
Flows of Cost in Job Costing

If actual and applied manufacturing

overhead are not equal, a year-end
adjustment is required

Traced

Applied

Income Statement
 Over-applied and Under-applied
Manufacturing Overhead - Summary

Alternative 1 Alternative 2
If Manufacturing Close to Cost
Overhead is . . . Allocation of Goods Sold

UNDERAPPLIED INCREASE INCREASE

Work in Process Cost of Goods Sold
(Applied OH is less Finished Goods
than actual OH) Cost of Goods Sold

OVERAPPLIED DECREASE DECREASE

Work in Process Cost of Goods Sold
(Applied OH is greater Finished Goods
than actual OH) Cost of Goods Sold

More accurate but more complex to compute (check page 102 of text 12e)
 Over-applied and Under-applied
Manufacturing Overhead - Summary

Alternative 1 Alternative 2
If Manufacturing Close to Cost
Overhead is . . . Allocation of Goods Sold

UNDERAPPLIED INCREASE INCREASE

Work in Process Cost of Goods Sold
(Applied OH is less Finished Goods
than actual OH) Cost of Goods Sold

OVERAPPLIED DECREASE DECREASE

Work in Process Cost of Goods Sold
(Applied OH is greater Finished Goods
than actual OH) Cost of Goods Sold

More accurate but more complex to compute (check page 102 of text 12e)
Problem 3–42 (H12e), Schedule of COGM, COGS, Income Statement

11
 1. TWISTO PRETZEL COMPANY
SCHEDULE OF COST OF GOODS MANUFACTURED
FOR THE YEAR ENDED DECEMBER 31, 20X1
Direct material:
Raw-material inventory, 12/31/x0 $10,100
Add: Purchases of raw material 39,000
Raw material available for use $49,100
Deduct: Raw-material inventory, 12/31/x1 11,000
(H12e)

Raw material used $38,100

Direct labor 79,000
Manufacturing overhead:
Indirect material $ 4,900
Indirect labor 29,000
Problem 3–42

Depreciation on factory building 3,800

Depreciation on factory equipment 2,100
Utilities - factory 6,000
Property taxes - factory 2,400
Insurance on factory and equipment 3,600
Rental of warehouse space 3,100
Total actual manufacturing overhead $54,900
Add: Overapplied overhead* 3,100
Overhead applied to work in process 58,000
Total manufacturing costs $175,100
Add: Work-in-process inventory, 12/31/x0 8,100
Subtotal $183,200
Deduct: Work-in-process inventory, 12/31/x1 8,300
Cost of goods manufactured $174,900
 1. TWISTO PRETZEL COMPANY
SCHEDULE OF COST OF GOODS MANUFACTURED
FOR THE YEAR ENDED DECEMBER 31, 20X1
Direct material:
Raw-material inventory, 12/31/x0 $10,100
Add: Purchases of raw material 39,000
Raw material available for use $49,100
Deduct: Raw-material inventory, 12/31/x1 11,000
(H12e)

Raw material used $38,100

Direct labor 79,000
Manufacturing overhead:
Indirect material $ 4,900
Indirect labor 29,000
Problem 3–42

Depreciation on factory building 3,800

Depreciation on factory equipment 2,100
Utilities - factory 6,000
Property taxes - factory 2,400
Insurance on factory and equipment 3,600
Rental of warehouse space 3,100
Total actual manufacturing overhead $54,900
Add: Overapplied overhead* 3,100
Overhead applied to work in process 58,000
Total manufacturing costs $175,100
Add: Work-in-process inventory, 12/31/x0 8,100
Subtotal $183,200
Deduct: Work-in-process inventory, 12/31/x1 8,300
Cost of goods manufactured $174,900
 2. TWISTO PRETZEL COMPANY
SCHEDULE OF COST OF GOODS SOLD
FOR THE YEAR ENDED DECEMBER 31, 20X4

Finished-goods inventory, 12/31/x0 $ 14,000

Add: Cost of goods manufactured* 174,900
Cost of goods available for sale $188,900
Deduct: Finished-goods inventory, 12/31/x4
continued

15,400
Cost of goods sold $173,500
Deduct: Over-applied overhead† 3,100
Cost of goods sold (adjusted for over-applied overhead) $170,400

3. TWISTO PRETZEL COMPANY

Problem 3-42 (12 e)

INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 20X4

Sales revenue $205,800

Less: Cost of goods sold 170,400
Gross margin $ 35,400
Selling and administrative expenses:
Salaries $13,800
Utilities 2,500
Depreciation 1,200
Rental of office space 1,700
Other expenses 4,000
Total 23,200
Income before taxes $12,200
Income tax expense 5,100
Net income $ 7,100
 2. TWISTO PRETZEL COMPANY
SCHEDULE OF COST OF GOODS SOLD
FOR THE YEAR ENDED DECEMBER 31, 20X4

Finished-goods inventory, 12/31/x0 $ 14,000

Add: Cost of goods manufactured* 174,900
Cost of goods available for sale $188,900
Deduct: Finished-goods inventory, 12/31/x4
continued

15,400
Cost of goods sold $173,500
Deduct: Over-applied overhead† 3,100
Cost of goods sold (adjusted for over-applied overhead) $170,400

3. TWISTO PRETZEL COMPANY

Problem 3-42 (12 e)

INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 20X4

Sales revenue $205,800

Less: Cost of goods sold 170,400
Gross margin $ 35,400
Selling and administrative expenses:
Salaries $13,800
Utilities 2,500
Depreciation 1,200
Rental of office space 1,700
Other expenses 4,000
Total 23,200
Income before taxes $12,200
Income tax expense 5,100
Net income $ 7,100
 Schedule of Cost of Goods Manufactured Schedule of Cost of Goods Sold

Schedule of Cost of Goods Manufactured Schedule of Cost of Goods Sold

Direct material: Finished goods inventory, beginning $xxx

Raw material inventory, beginning $xxx Add: Cost of goods manufactured* xxx
Add: Raw material purchases xxx Cost of goods available for sale $xxx
Raw material available for use $xxx Deduct: Finished goods inventory, ending xxx
Deduct: Raw material, ending xxx Cost of goods sold $xxx
Raw material used $xxx Add: Underapplied overhead
or Deduct: Overapplied overhead xxx
Direct labor xxx Cost of goods sold (adjusted) $xxx

Manufacturing overhead * From Cost of Goods Manufactured Schedule

Indirect material $xxx
Indirect labor xxx
Other actual overhead charges xxx
Total actual manufacturing overhead $xxx
Add: Overapplied overhead
or Deduct: Underapplied overhead xxx
Overhead applied to work-in-process xxx

Total manufacturing costs $xxx

Add: Work-in-process inventory, beginning xxx
Subtotal $xxx
Deduct: Work-in-process inventory, ending xxx
Cost of goods manufactured $xxx
 Actual and Normal Costing

Actual direct material Actual direct material

and direct labor and direct labor
combined with combined with
actual overhead predetermined overhead

• Using a predetermined rate makes it possible to estimate total job costs sooner.
• Actual overhead for the period is not known until the end of the period.
• Choosing an appropriate cost driver (past production processes were labour intensive)
• Single vs. multiple overhead rates
• A single overhead rate is commonly known as a plantwide rate;
• multiple rates are often known as departmental rates.

3-35 ( pg119) , Various cost Drivers and POHR

3-35 (H12e) ( pg119) , Various cost Drivers and POHR
 3-35 (H12e) ( pg119), Various cost Drivers and POHR

1. Predetermined overhead rate = budgetedmanufacturing overhead

budgeted levelof cost driver
$364,000
(a) = $36.40 per machine hour
10,000 machine hours

(b) $364,000 = $18.20 per direct-labor hour

20,000 direct labor hours

(c) $364,000 = $1.30 per direct-labor dollar or 130% of direct-labor cost

$280,000∗
*Budgeted direct-labor cost = 20,000 * $14

2. Actual Applied
manufacturing – manufacturing = Over-applied or Under-applied Overhead
overhead overhead

(a) $340,000 – (11,000)($36.40) = $60,400 overapplied overhead

(b) $340,000 – (18,000)($18.20) = $12,400 underapplied overhead

(c) $340,000 – ($270,000†)(130%) = $11,000 over-applied overhead

†Actual direct-labor cost = 18,000 * $15
 Departmental Overhead Rates

Indirect Indirect Other

Labor Materials Overhead
Stage One:
Costs assigned to pools

Department Department Department

Cost pools
1 2 3
Direct Machine Raw
Stage Two:
Costs applied to products
Labor Hours Materials
Hours Cost

Products
Departmental Allocation Bases
PROBLEM 3‐48 (H12e)

21
 PROBLEM 3‐48 (H12e) (CONTINUED)

1. Machining Dept. overhead rate = budgeted overhead ÷ budgeted machine hours

= $4,000,000 ÷ 400,000 = $10 per machine hour
Assembly Dept. overhead rate = budgeted overhead ÷ budgeted direct‐labor cost
= $3080,000 ÷ $5600,000 = 55% of direct‐labor cost

2. The ending work‐in‐process inventory is carried at a cost of $153,530, computed as follows:

Machining Department:
Direct material…………………………………… $24,500
Direct labor………………………………………. 27,900
Manufacturing overhead (360 x $10)………… 3,600 $ 56,000
Assembly Department:
Direct material…………………………………… $ 6,700
Direct labor………………………………………. 58,600
Manufacturing overhead ($58,600 x 55%)….. 32,230 97,530
Total cost……………………………………………... $153,530
 PROBLEM 3‐48 (H12e) (CONTINUED)

3. Actual overhead in the Machining Department amounted to $42,60,000, whereas applied

overhead totaled $42,50,000 (425,000 hours x $10).Thus, overhead was under‐applied by
$10,000 during the year.

4. Actual overhead in the Assembly Department amounted to $30,50,000, whereas applied

overhead totaled $31,79,000 ($57,80,000 x 55%). Thus, overhead was over‐applied by
$129,000.

5. The company’s manufacturing overhead was overapplied by $119,000 ($129,000 ‐ $10,000). As

a result, excessive overhead flowed from Work‐in‐Process Inventory, to Finished‐Goods
Inventory, to Cost of Goods Sold, meaning that the Cost of Goods Sold account must be
decreased at year‐end.

6. The Work‐in‐Process account is charged with applied overhead, or $74,29,000 ($42,50,000 +

$31,79,000).

7. The firm’s selection of cost drivers (or application bases) seems appropriate.
• There should be a strong correlation between the cost driver and the amount of overhead
incurred.
• In the Machining Department, much of the overhead is probably related to the operation of
machines.
• Similarly, in the Assembly Department, a considerable portion of the overhead incurred is
related to manual assembly (i.e., labor) operations.
 Manufacturing overheads : Two stage allocation process

SERVICE DEPARTMENTS
1. Inspection
2. Repair and maintenance
Methods:

Distribution
Secondary
STAGE 1: 1. Direct
2. Step Down
Mfg OH costs assigned Manufacturing Overhead 3. Reciprocal‐Services
Method
To Production Departments Distribution (Simultaneous

B)
equation method)

PRODUCTION DEPARTMENTS
1. Machine Shop
2. Assembly Shop
3. Finishing Department

Overhead application/
STAGE 2: Absorption (based on
respective cost drivers)
Mfg OH costs assigned
Cost Objects like Products or
To Production JOBS Production Jobs (which pass through
24
production departments)
 Stage 1 – Step A: Primary Distribution
:
Distribution of all Manufacturing Overheads (OHs)
1: Allocation of directly identifiable OHs to departments/cost centers
(production and service departments) in entirety. Examples:
• Indirect Material (based on material requisition slips – material
analysis)
• Indirect Labour (based on payroll records – wage analysis book)
2: Apportionment of common costs to departments/cost centres (production
and service departments) using
• An equitable basis – proportionate benefits criteria
• Choice of the basis ‐ Judgment
Bases of Apportionment or Allocation Bases
Related to Overhead Basis of Distribution
Space Rent, Rates, Depreciation of Building, Light and Heat Floor Area Occupied
Value Depreciation, Insurance of Plant and Equipment Asset Value
Activity Power Horse Power * Hours, KWH
Labour Cafeteria, Safety, Labour welfare cost Number of Employees
Material Material Handling Store Keeping Material Consumed/handled
 Primary Distribution

Production Departments Service

Departments

Expenses Basis of Total Machine Assembly Finishing Inspect Repairs

Allocation / (Rs.) Shop Shop Dept ion &
Apportionme Maint.
nt
Indirect Material Allocation 15,400 5,200 6,000 2,000 600 1,600
Indirect Labour Allocation 22,800 7,900 5,100 6,100 2,200 1,500
Rent & Rates Area 10,000 3,000 2,000 2,500 1,000 1,500
30:20:25:10:15
Insurance Asset Value 2,000 800 900 200 50 50
40:45:10:2.5:2.5
Depreciation Asset Value 30,000 12,000 13,500 3,000 750 750
Power H.P x Hours 9,000 5,400 3,600 - - -
Light & Heat Area 4,000 1,200 800 1,000 400 600

Total 93,200 35,500 31,900 14,800 5,000 6,000

Assets Value 400,000 450,000 100,000 25,000 25,000

 Stage 1- Step B : Secondary Distribution and
Stage 2: OH Absorption
3. Re‐apportionment of OH collected under service departments or cost
centres to production departments/cost centres using an equitable basis
 Three methods (Direct, Step Down, Reciprocal Services)

Typical Allocation Bases for Re- apportionment

Service Cost Centre Basis
Repairs and Maintenance Maintenance hours
Stores and Internal Transport, Receiving Value of material used or requisitioned, Units Handled
Personnel, Cafeteria Number of Employees
Inspection Inspection Hours
Power House Power Consumed (KWH)
Custodial/ Security Square Footage
Accounting Staff Hours

4. Compute Separate POHR for each production department/ cost centre

5. Absorption of overheads :
 Charging of Overheads from Production departments/ cost centers to
products or services or production jobs (chosen cost objects) by means
respective POHR
 Allocation of Service Department Cost to Production departments

First Stage Allocations (step 2)

Service department costs are allocated to
Service production departments
Department
(Cafeteria) Production
Department
Service (Machining)
The
Department
Product
(Accounting) Production
Department
Service (Assembly)
Department
Second Stage Allocations
(Personnel) Production department overhead costs, plus allocated
service department costs, are applied to products using
departmental predetermined overhead rates.
 Service Cost Centre : Re-apportionment Methods

Direct Method
• Direct allocation of service department costs to production
departments only ‐ one by one – based on benefits received
• Reciprocal services ignored ‐ simple, inaccurate

Secondary Direct Method Production Departments Service Departments

Distribution

Expenses Basis of allocation / Total Machine Assembly Finishing Inspecti Repairs &
apportionment (Rs.) Shop Shop Dept on Maint.

Primary dist. ( earlier Table) 93,200 35,500 31,900 14,800 5,000 6,000

Inspection Inspn hrs (9 :6 :5) 2,250 1,500 1,250 - 5,000

Repairs & Maint Maint hrs 2,000 3,000 1,000 - 6,000

( 2: 3: 1)

93,200 39, 750 36.400 17,050 0 0

Allocation Base 5,000 * 5/ (9+6+5) =1,250

Case 3-61 (H12 e) (p134)
 Case 3-61 (H12 e) (p134)
1. A job‐order costing system is appropriate in any environment where costs can be readily
identified with specific products, batches, contracts, or projects.
This situation typically occurs in a manufacturing setting when relatively small numbers of
heterogeneous products are produced.

2. The only job remaining in CompuFurn’s work‐in‐process inventory on December 31 is job

PS812. The cost of job PS812 can be calculated as follows:

Job PS812 balance, 11/30 $250,000

December additions:
Direct material $124,000
Purchased parts 87,000
Direct labor 200,500
Manufacturing overhead (19,500 machine hrs × $5.00*) 97,500 509,000
Work‐in‐process inventory, 12/31 $759,000

Closing RM ?
$4,500,000 (668+638-631.8)K
∗Manufacturing overhead rate
900,000 hours =674,200
$5.00 per hour
 3. The cost of chairs remaining in CompuFurn’s finished‐goods inventory on December 31 is
$455,600, calculated as follows: Units of chairs in finished‐goods inventory on December 31:
Chair Units
Finished‐goods inventory, 11/30 19,400
Add: Units completed in December 15,000
Units available 34,400
Deduct: Units shipped in December 21,000
Finished‐goods inventory, 12/31 13,400

Since CompuFurn uses the first‐in, first‐out (FIFO) inventory method, all units remaining in finished‐
Case 3-61 (H12 e (Continued)

goods inventory were completed in December. Unit cost of Chairs completed in December:

Work in process inventory, 11/30 $431,000

December additions:
Direct material $ 3,000
Purchased parts 10,800
Direct labor 43,200
Manufacturing overhead (4,400 machine hrs  $5.0) 22,000 79,000
Total cost $510,000
total cost $510,000 = $34 per unit COGS for Chairs ?
Unit cost =
=
units completed 15,000 (679+ 510- 455.6)K
=7,33,400
Cost of finished‐goods inventory = unit cost  quantity
= $34  13,400
= $455,600
 4. Overapplied overhead is $7,500, calculated as follows:
Machine hours used:
January through November 8,30,000
Case 3-61 (H12 e (Continued)

December 49,900
Total 8,79,900

Applied manufacturing overhead = 879,900 machine hours  $5 = $4,399,500

Actual manufacturing overhead:

January through November $4,140,000
December 2,52,000
Total $4,392,000

Overapplied overhead = applied overhead - actual overhead

= $4,399,500 - $4,392,000
= $7,500
Comprehensive Problem
Revision – Similar to Review Problem at Chapter End
Predetermined overhead rate
= budgeted overhead ÷ budgeted machine hours
= $1,680,000 ÷ 32,000 = $52.50 per machine hour
 Learning Goals Achieved

1. Explain the flow of costs through manufacturing accounts in job

costing system
2. Compute pre‐determined overhead rate and allocate overheads in
two stages
3. Learn disposition of under‐applied or over‐applied overhead
4. Explain how service department costs are allocated to production
departments.
Thanks 
 Cost Management

Session‐ 3: MBA‐ 2022

Product Costing Systems: Process Costing
Learning Goals:
• Explain the flow of costs in process costing system
• Compute Equivalent Units of Production, Cost per equivalent unit using
Weighted average method
 Process Costing ‐ Features
• Ascertaining Costs for
– Repetitive Production environment, Homogeneous products large number
of identical products are produced simultaneously on mass scale
– Involves sequence of continuous processes – for long duration, without
interruption
– Example : Paint Manufacturer, Paper Mill, Chemicals, Oil refinery

• Costs accumulated by departments

• For each department,

– Costs to be accounted for consists of
• Costs of opening WIP, Costs added during the year
– Equivalent units are determined for each cost category
– Cost per equivalent unit is calculated
– Cost are accounted for by assigning them to goods transferred to next
department and closing WIP

2
 Cost Flows in Job Costing

Total Direct Traced

Job 1 (job sheet)
Material cost

WIP Inventory
Total Direct
Labour cost
Cost of goods
Job 2 (job sheet) manufactured

Manufacturing
Overheads Finished Goods

COGS

3
 Cost Flows in Process Costing

Total Direct Traced

WIP : Department A
Material cost
Transferred from
Department A
Total Direct (Transferred‐In Costs)
Labour cost Cost of goods
manufactured
WIP: Department B

Manufacturing Finished Goods

Overheads
Transferred-In Costs COGS
WIP – B A/C….. Debit
WIP – A A/C ……….Credit

4
 Two Sequential Production Departments
Work-in-Process Inventory Work-in-Process Inventory
Production Department A Production Department B
Direct material Cost of goods completed in
Direct labor department A Cost of goods completed
Applied manufacturing transferred to and transferred to
overhead department B finished goods

Direct material
Direct labor
Applied manufacturing
overhead

Finished Goods Inventory Cost of Goods Sold

Cost of goods sold
during current period

5
 Equivalent production units

• Continuous manufacturing process

– Average Cost per unit of Output = Total cost accumulated during a
period ÷ Number of units processed

• Departments tend to have partially completed units in opening and

closing inventory

• Equivalent Units
= Number of partially completed units × Percentage Completion
– Example : 1000 units which are 50% complete are equivalent to 500
complete units

+ = l

6
 Direct materials and conversion costs per equivalent unit
Materials cost per equivalent unit
= Materials cost for the period
Materials equivalent units for the period

When direct labor is a relatively

small amount compared to material
and overhead, it is often combined
Conversion cost per equivalent unit with overhead.
= Conversion cost for the period
Conversion equivalent units for the period
Departmental Production Report
 Analysis of
physical flow
of units.
 Calculation
of equivalent
units.
 Computation
of unit costs.
 Analysis of
Two methods of calculating equivalent units total costs.
and average cost per unit :
• Weighted average method and FIFO
7
 Weighted‐Average Method
• Work done in prior period & current period are not distinguished

Calculations for each cost category :

E q u iv a le n t U n its E q u iv a le n t u n its
u n its o f = tra n s fe rre d + in e n d in g W IP
p ro d u c tio n out in v e n to ry

Units transferred out of the department are

100% complete with respect to the work done in
the department.

Cost of beginning + Cost added

Cost per work in process inventory during the period
=
equivalent unit Equivalent units of production

Cost of units = Cost per × Units

transferred out equivalent unit transferred out

Cost of units in = Cost per × Equivalent units in

ending WIP inventory equivalent unit ending WIP inventory
8
 Weighted Average Method
Problem details:
Beginning work in process: 200 units
Materials: 55% complete 9,600
Conversion: 30% complete 5,575 15,175
Production started during May 5,000 units
Production completed during May 4,800 units
Costs added to production in May
Materials cost 368,600
Conversion cost 350,900
Ending work in process 400 units
Materials: 40% complete
Conversion: 25% complete

2. Calculation of Equivalent Units

Statement of Equivalent Units
Inputs Outputs Material Conversion
Units to be accounted for Units accounted for % units % units
Completed and
Opening WIP 200 Transferred Out 4800 100% 4800 100% 4800
Started into
1. Analysis of
production
physical flow of
5000 Closing WIP 400 40% 160 25% 100
units. 5200 5200 4960 9 4900
 Weighted Average Method 3. Computation of unit costs
Statement of Cost
Particulars Material Conversion Total Cost
Cost of Opening WIP 9,600 5,575 15,175
Cost added during the period 368600 350900 719,500
Total Cost to be accounted for 378,200 356,475 734,675
Equivalent Units 4960 4900
Cost per equivalent unit 76.25 72.75 149
378200/4960 equivalent units
Statement of Evaluation 76.25+ 72.75
4. Analysis of

Cost of units transferred out during the

total costs

period 4800 * 149 715200

Cost of Closing WIP
- Material 160*76.25 12200
- Conversion 100*72.75 7275 19475
734675
Dr. Process Account Cr.
Particulars Units Rs Particulars Units Rs
By Transfer to
To Opening WIP 200 15175 next process 4800 715200
To Materials 5000 368,600 By Closing WIP 400 19475
To Conversion Costs 350,900
5200 734675 5200 734675 10
10
 Problem 4‐30 (H12 e) (pg 161)
Albany Company accumulates costs for its product using process costing.
Direct material is added at the beginning of the production process, and conversion activity
occurs uniformly throughout the process.
 Problem 4‐30 (H12 e) : Partial Production Report: WA

1. Schedule of Equivalent Units Percentage of

Physical Completion Equivalent Units
Units with Respect to Direct
Conversion Material Conversion
Work in process, August 1 40,000 80%
Units started during August 80,000
Total units to account for 120,000
Units completed and transferred
out during August 100,000 100% 100,000 100,000
Work in process, August 31 20,000 30% 20,000 6,000
Total units accounted for 120,000 ______ ______
Total equivalent units 120,000 106,000

2. Direct
Material Conversion Total
Total costs to account for $ 1 3 8 ,0 0 0 $1,089,680 $1,227,680
Equivalent units 1 2 0 ,0 0 0 106,000
Costs per equivalent unit $1.15 $10.28 $11.43*

*$11.43 = $1.15 + $10.28

 Problem 4‐30 (H12 e) continued
3. Cost of goods completed and transferred out during August:
number of units total cost per
transferred out equivalent unit 100,000 × $11.43 $1,143,000

4. Cost remaining in August 31 work‐in‐process inventory:

a) Direct material: b) Conversion:
 number of   cost per   number of   cost per 
       
 equivalent   equivalent   equivalent   equivalent 
 units of    unit of  
 units of   unit of 
       
 direct material   direct material 
     conversion   conversion 
20,000 × $1.15 $23,000 6,000 × $10.28 61,680

Statement of Evaluation
Cost of units transferred out during the period 100000*11.43 1,143,000
Cost of Closing WIP
‐ Material 20000*1.15 23000
‐ Conversion 6000*10.28 61680 84,680
1,227,680
Finished-Goods Inventory 1,143,000
5. Journal entry:
Work-in-Process Inventory 1,143,000
Problem 4-35 (H12 e) (pg 164 )

The company uses weighted‐average process costing to

accumulate product costs.
However, for raw‐material inventories the firm uses FIFO
method.
 Problem 4-35 (12 e) (pg 164): Production Report: WA
1. PRODUCTION REPORT: MIXING DEPARTMENT
(Weighted‐Average Method) Equivalent Units
Physical Percentage Completion with Direct Conversion
Units Respect to Conversion Material

Work in process, November 1 4,000 75%

Units started during November 16,000

Total units to account for 20,000

Units completed and transferred 15,000 100% 15,000 15,000

out during November
Work in process, November 30 5,000 20% 5,000 1,000

Total units accounted for 20,000 ____ _ _ ____

Total equivalent units 20,000 16,000

2. Cost per Equivalent Unit for each Direct Material Conversion Total
cost factor
Work in process, November 1 $ 22,800 $ 46,510 $ 69,310
Costs incurred during November 81,600* 196,690† 278,290
Total costs to account for $104,400 $ 243,200 $347,600
Equivalent units 20,000 16,000
Costs per equivalent unit $5.22 $15.20 $20.42
Direct Materials - From WIP, Nov 1 Costs incurred WIP, Nov 1 Costs incurred
during November Conversion during November
Nov 1 : Opening 2000 pounds 10,000 Direct Labour 24,650 103, 350
Purchases: Nov 3 10,000 pounds 51,000 Deaprtmental Overhead 12,000 52,000
Purchases : Nov 18 Rs 51,500* Allocated Plant (0.4*103,350)
4000/10000 20,600 Overhead 9,860 =41,340
81,600 46,510 196,690
 Problem 4-35 (12 e) continued

3. Cost of goods completed and transferred out during November

 number of units   total cost per 
    
 transferre d out   equivalent unit 

4. Cost remaining in November 30 work‐in‐process inventory:

a) Direct material: b) Conversion:
 number of   cost per   number of   cost per 
       
 equivalent   equivalent   equivalent   equivalent 
 units of    unit of  
 units of   unit of 
       
 direct material   direct material 
     conversion   conversion 

Statement of Evaluation
Cost of goods completed and transferred out during November 15,000 ×$20.42 $306,300

Cost remaining in November 30 work-in-process inventory

- Material 5,000 × $5.22 $$26,100

- Conversion 1,000 × $15.20 15,200

Total cost of November 30 work in process $41,300

Total costs accounted for 347,600

16
 Problem 4‐35 (12 e) continued

2. a. Work-in-Process Inventory: Mixing Department 81,600

Raw-Material Inventory 81,600

b.Work-in-Process Inventory: Mixing Department 103,350

Wages Payable 103,350

c. Work-in-Process Inventory: Mixing Department 93,340*

Manufacturing Overhead 93,340

*[$93,340 = (0.40)($103,350) + ($52,000)]

d.Work-in-Process Inventory: Finishing Department 306,300

Work-in-Process Inventory: Mixing Department 306,300

17
Self Study Problems:
4-29, 4-39
Self Study Problems– 4-29 (H12e) (page 161)
 4-29 (H12e) (page 161)
1. Physical flow of units
Physical Units
Work in process, April 1 10,000
Units started during April 1,00,000
Total units to account for 1,10,000

Units complete and transferred out during April 80,000

Work in process, April 30 30,000
Total units accounted for 1,10,000
2. Calculation of equivalent units
Percentage Equivalent Units
Physical Units of Completion Direct Material Conversion
Work in process, April 1 10,000 20%
Units started during April 1,00,000
Total units to account for 1,10,000

Units completed and transferred out during April 80,000 100% 80,000 80,000
Work in process, April 30 30,000 33.33% 30,000 10,000
Total units accounted for 1,10,000
Total equivalent units 1,10,000 90,000
3. Computation of unit costs Direct Material Conversion Total
Work in process, April 1 $ 22,000 $ 4,500 $ 26,500
Costs incurred during April 1,98,000 1,58,400 3,56,400
Total costs to account for $ 2,20,000 $ 1,62,900 $ 3,82,900
Equivalent units 1,10,000 90,000
Costs per equivalent unit $ 2.00 $ 1.81 $ 3.81
4. Analysis of total costs
Costs of goods completed and transferred out during April: (80,000 * $3.81) = $ 3,04,800

Cost remaining in April 30 work-in-process inventory: Direct material: 60,000

Conversion: 18,100
Total cost of April 30 work-in-process $ 78,100

Check: Cost of goods completed and transferred out $ 3,04,800

Cost of April 30 work-in-process inventory 78,100
Total costs accounted for $ 3,82,900
Self Study Problem 4-39 (12 e) (p167)
 Problem 4-39 (12 e) continued
CALCULATION OF EQUIVALENT UNITS: LYCOMING LEATHER CO. - HARRISBURG PLANT
Weighted-Average Method
Physical Percentage of Equivalent Units
Units Completion
with Respect Direct Material Conversion
to Conversion
Work in process, October 1 400 25%
Units started during October 7,600
Total units to account for 8,000

Units completed and transferred

out during October 7,000 100% 7,000 7,000
Work in process, October 31 1,000 50% 1,000 500
Total units accounted for 8,000
Total equivalent units 8,000 7,500

CALCULATION OF COSTS PER EQUIVALENT UNIT: HARRISBURG PLANT

Weighted-Average Method
Direct Material Conversion Total
Work in process, October 1 $ 1,250 $ 300 $ 1,550
Costs incurred during October 25,150 20,700 45,850
Total costs to account for $26,400 $21,000 $47,400
Equivalent units 8,000 7,500
Costs per equivalent unit $3.30 $2.80 $6.10
 Problem 4-39 (12 e) continued

3. Cost of goods completed and transferred out during October

 number of units   total cost per 
    
 transferre d out   equivalent unit 

4. Cost remaining October 31 work‐in‐process inventory:

a) Direct material: b) Conversion:
 number of   cost per   number of   cost per 
       
 equivalent   equivalent   equivalent   equivalent 
 units of    unit of  
 units of   unit of 
       
 direct material   direct material 
     conversion   conversion 

ANALYSIS OF TOTAL COSTS: DALLAS PLANT (Weighted-Average Method)

Cost of goods completed and transferred out during October 7,000 × $6.10 42,700

Cost remaining in October 31 work-in-process inventory

- Material 1,000 × $3.30 $$3,300

- Conversion 500 ×$2.80 1,400

Total cost of October 31 work in process $$4,700

Total costs accounted for $47,400

 Self Study Problem 4-39 (12 e)

1. Equivalent units of material 8,000

Equivalent units of conversion 7,500

2. Cost per equivalent unit of material $3.30

Cost per equivalent unit of conversion $2.80

3. October 31 work-in-process inventory $4,700

Cost of goods completed and transferred out $42,700

4. Weighted-average unit cost of completed leather belts $6.10

• The firm's cost per belt used for planning and control, $5.35, is substantially lower than the
actual cost per belt incurred in October, $6.10
• Management should investigate this situation to determine whether production costs can
be reduced.
• If not, then the cost used for planning and control purposes should be changed to reflect
the firm's actual experience.
Problem 4-39 (12 e) continued

A Ltd overstated the percentage of work completed with respect to conversion cost on the ending work‐in‐
process inventory. What is the effect of this overstatement on conversion‐cost equivalent units and
physical units manufactured? Overstated, None
 Problem 4-39 (12 e) continued

5. Answer
• If the units were 60 percent complete as of October 31, there would be 7,600 equivalent units
with respect to conversion. (To see this, just change the 500 in the right‐hand column of the
equivalent‐units table in the solution to requirement (4) to 600. This changes the last number in
the right‐hand column from 7,500 to 7,600.)
• Now the unit cost of conversion drops from $2.80, as currently computed, to $2.76 (rounded,
$21,000 ÷ 7,600). Thus, the unit cost drops from $6.10 to $6.06 (rounded).
• As controller, Jeff Daley has an ethical obligation to refuse his friend's request to alter the
estimate of the percentage of completion. What Daley can do is to help Murray think of
some legitimate ways to bring about real cost reductions.
Thanks 
 Cost Management
Session 4 & 5 : MBA 2022

Activity Based Costing

Learning Goals:
– Problems of Traditional Costing System – Need for ABC –Explain & Justify
– Identify & classify activities by Cost Levels
– Analyse activity Costs, identify Cost pools, select Cost drivers, determine Activity
Rate or Pool Rate and Product costs as per ABC
– Comparison of Product Costs & Margins using Traditional costing Versus ABC
 Traditional Costing System
• All manufacturing costs are assigned to products ‐ whether or not they are caused by
the products
• Non‐manufacturing costs are not assigned to products
• Even if some non‐manufacturing costs that are caused by the products
• The entire facility or department may have only single overhead/indirect cost pool,
a single allocation base such as direct labour‐hours (a plant‐wide POHR to allocate
MOH costs to all products)

Changes in business Conditions – Direct Labour no longer a suitable basis

1. Greater use of machines, computers
• As a percentage of Total Costs, Direct labour is declining while Overheads is
increasing
2. Managers now believe that OH and Direct Labour costs are no longer highly
correlated, other factors drive OH costs
3. Increase in product diversity – Products of different complexity, batch size and
volume no longer create homogeneous demands on OH resources, create more OH
costs
 How is ABC different from Traditional ?
• ABC assigns both types of costs to products – but only on cause‐and‐effect basis
• But it doesn’t necessarily assign all manufacturing costs to products
• Traditional Costing uses volume‐based Plant‐wide OH rate, or Departmental OH rates.
ABC can use non‐volume allocation bases, ABC Uses more cost pools.

Manufacturing Non-manufacturing
costs costs

Some
All

Traditional ABC
product costing product costing
• Direct Material costs and Direct Labour costs are typically same under the two systems.
• The two methods handle Overheads differently
• Total costs for the entire firm remain the same—they are just allocated differently to the cost objects
within the firm
 Limitations of Traditional Method
1. Allocation of Overheads: Subjective basis
2. Cross‐subsidization of products which create diverse demands on resources
– Products produced in Lower volumes, of Higher Complexity
3. Usually rely on volume measures like Direct Labour Hours, Machine Hours for
allocating OH costs to products. Ignores other cost drivers.

Example of distortion of product cost under traditional method due to broad

averaging:
A firm produces 4,500 units of A and 500 units B ‐ the two variants of the same
product and the setup costs is Rs 10,000 per setup.
Under traditional method: Cost assigned for each product A and B will
be : Rs 20,000/ 5,000 = Rs 4 p.u.
If cost directly attributable to each unit is assigned to it, setup costs p.u. will be:
– For A: 10,000/ 4,500 = Rs 2.22 pu
– For B: 10,000/ 500 = Rs 20 pu
=> the product B with smaller volume was getting subsidized !
 Traditional Costing System  Distorts Product Costs

High Low High

Complexity

Volume Over-costed
Traditional Costing

Low Under-costed

Product Complexity Over‐costing: a product

• Small Batch sizes consumes a low level of
• Long Set Up Times resources but is allocated high
costs per unit
• Unique Components
• Special Inspection and tests
 ABC Concepts: Two Stages, Activities, Activity Cost Pools, Cost Driver
ABC – Two Stage Procedure to assign overhead costs to Products
Stage 1: Identify significant activities and assign overhead costs to each activity in proportion to
resources used.
Stage 2: Identify cost drivers appropriate to each activity and allocate overhead to the products

An event that causes the

Activity consumption of overhead
resources.
Four Levels of Activities

A “cost bucket” or meaningful

Activity Cost group in which costs related to
Pool a particular activity measure are
accumulated.

Activity Measure Allocation Base –

or Cost Driver Factor that causes change in cost
of an activity, Measurable

Two common Types of Cost Drivers

 Cost Hierarchy – Four Levels of Activities, Activity Cost Pools

1. Unit‐level activities are performed each time a unit is produced.

• Costs proportional to the number of units produced
• Providing power to run machine, Drilling holes in metal parts, labour
hours, machine hours, material
2. Batch‐level activities are performed each time a batch is handled or
processed  cost driven by number of batches
• Setting up machine for a new production run, purchasing material,
moving material, Inspection

3. Product‐ level activities support a specific product line

• Designing or advertising a product, Updating Product specification
• Such Costs are driven by products

4. Facility Level activities that are required are required for the entire
production process to occur
• Plant management salaries, Heating the factory, Building maintenance,
plant depreciation, property taxes
Exercise 5-33 (page 204)
Exercise 5-33 (12 e) (page 204)
 Exercise 5-33 (H12 e)

The activity of the Winery may be classified as follows:

U: Unit‐level
B: Batch‐level
P: Product‐sustaining‐level
F: Facility‐level

Activity Classification Activity Classification

(1) P (11) B
(2) P (12) B
(3) P (13) U
(4) P (14) U
(5) P (15) U
(6) P (16) U
(7) P (17) B
(8) B (18) F
(9) B (19) F
(10) B
 Two common types of Activity Cost Drivers
Activity Cost Driver Can be based on
1. Transaction‐ simple counts of the number of times an activity occurs like number
of set ups, number of receipts
 Assumes resources needed to perform an activity are same across products
2. Duration ‐ amount of time needed to perform an activity like setup hour

Selection of cost driver is “accuracy – cost” trade off

 3 Factors : Degree of Correlation, Cost of measurement, Behavioral effects
 Transaction Driver ‐ simplest but less accurate than Duration driver

Activity Cost Drivers

Activity Cost Pools Activity Type or Activity Measures
Run Machines Unit Level Machine hours
Shipping Number of shipping,
Set‐up Batch Level Number of Set ups
Product design Product sustaining Design hour
 Steps - Activity Based Costing (ABC)
Consumption of Resources (Resource Costs)Activities (design)Cost Objects (products)
1. Identify major Activities that takes place in an organization
• Events that cause consumption of OH resources are identified
• Can be at unit level, batch level, product level, facility level

2. Assigning Costs to Activity Cost Pools: To the extent possible directly Trace costs to cost objects and
then Assign rest of the costs to Activity Cost Pools
 Cost Pools are created to accumulate OH costs related to each of the activities, Calculate Total Cost

under each Cost pool

3. Select an appropriate Activity‐ Cost driver (based on cause & effect or factors that influence cost)
 An appropriate allocation base that drives a cost is selected & measured
 Total Activities or Cost driver quantity are measured for every Cost pool

4. Determine Activity Rates or Pool rates for each of the activities

 Rate per unit of activity for each cost pool (Total cost in activity cost pool ÷ Total activities i.e., cost
driver quantity) – average cost

5. Assign costs of Activities to the products (cost objects) based on

• Activities consumed by the product (i.e., cost driver quantity for each product line) × Activity Rate (or
the pool rate)

6. Compute Product (OH) cost per unit:

(Activity Costs for each product line ÷ Production volume of the product line)
 Activity-Based Costing- 2 stage allocation

Direct Direct Shipping

Overhead Costs
Materials Labor Costs
Traced Traced First-Stage Allocation
Traced

Customer Product Order Customer

Other
Orders Design Size Relations

Second-Stage Allocations

$/Order $/Design $/MH $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
 Simple Illustration
Annual Number of Number
Output Machine purchase of set
Product (Units) Hours orders ups
A 5,000 20,000 150 20
B 50,000 1,20,000 300 50
Annual OHs (Rs ) : Indirect Wages and Indirect Material 18,000
Other Manufacturing Overheads 19,00,000
For ABC : First stage allocation -
Indirect Wages & Indirect Material: Machine: Purchas e= 5:1
Other Manufacturing Overheads : Machine : Purchas e : Setup = 25:33:42

Required Cost per unit of product A and B

- Using traditional method (machine hrs based)

Traditional Method
(Rs)

Indirect Wages and Indirect material 18,000

Other Manufacturing Overheads 19,00,000
Total Manufaturing OHs 19,18,000
Cost per machine hour = =1918,000/140,000 = 13.70

Cost per unit of A =(20,000 hrs *13.70) / 5,000 54.80

Cost per unit of B (120,000 hrs *13.70) / 50,000 32.88
 Simple Illustration
Annual Number of Number
Output Machine purchase of set
Product (Units) Hours orders ups
A 5,000 20,000 150 20
B 50,000 1,20,000 300 50
Annual OHs (Rs ) : Indirect Wages and Indirect Material 18,000
Other Manufacturing Overheads 19,00,000
For ABC : First stage allocation -
Indirect Wages & Indirect Material: Machine: Purchas e= 5:1
Other Manufacturing Overheads : Machine : Purchas e : Setup = 25:33:42

Required Cost per unit of product A and B

- Using traditional method (machine hrs based)

Traditional Method
(Rs)

Indirect Wages and Indirect material 18,000

Other Manufacturing Overheads 19,00,000
Total Manufaturing OHs 19,18,000
Cost per machine hour = =1918,000/140,000 = 13.70

Cost per unit of A =(20,000 hrs *13.70) / 5,000 54.80

Cost per unit of B (120,000 hrs *13.70) / 50,000 32.88
 Simple Illustration
Annual Number of Number
Output Machine purchase of set
Product (Units) Hours orders ups
A 5,000 20,000 150 20
B 50,000 1,20,000 300 50
Annual OHs (Rs ) : Indirect Wages and Indirect Material 18,000
Other Manufacturing Overheads 19,00,000
For ABC : First stage allocation -
Indirect Wages & Indirect Material: Machine: Purchas e= 5:1
Other Manufacturing Overheads : Machine : Purchas e : Setup = 25:33:42

Required Cost per unit of product A and B

- Using traditional method (machine hrs based)

Traditional Method
(Rs)

Indirect Wages and Indirect material 18,000

Other Manufacturing Overheads 19,00,000
Total Manufaturing OHs 19,18,000
Cost per machine hour = =1918,000/140,000 = 13.70

Cost per unit of A =(20,000 hrs *13.70) / 5,000 54.80

Cost per unit of B (120,000 hrs *13.70) / 50,000 32.88
First Stage Allocation of Overheads under ABC
Machine Related Costs Purchase Related Costs Set up related costs
1900000*.25= 4,75,000 1900000*.33= 6,27,000 1900000*.42= 7,98,000
18000*5/6= 15,000 18000*1/6= 3,000 0
4,90,000 6,30,000 7,98,000

Product A Product B

Cost in Activity Activity (or Activity (or

Activity Activity i.e. Cost cost driver cost driver
Activity Cost Cost Cost driver Pool Rate quantity) ABC Cost ‐ quantity) ABC Cost ‐
Pools Pool(Rs) Driver quantity (Rs) consumed A consumed B
Machine Machine
related Costs 4,90,000 Hours 1,40,000 3.5 20,000 70,000 1,20,000 4,20,000
Number
of
Purchase purchase
related costs 6,30,000 orders 450 1,400 150 2,10,000 300 4,20,000
Number
Set up of set
related costs 7,98,000 ups 70 11,400 20 2,28,000 50 5,70,000
Activity Costs for each product line 5,08,000 14,10,000
ABC Cost per unit of the product for each product line : =508,000/5000 =1410,000/50,000
101.60 28.20
First Stage Allocation of Overheads under ABC
Machine Related Costs Purchase Related Costs Set up related costs
1900000*.25= 4,75,000 1900000*.33= 6,27,000 1900000*.42= 7,98,000
18000*5/6= 15,000 18000*1/6= 3,000 0
4,90,000 6,30,000 7,98,000

Product A Product B

Cost in Activity Activity (or Activity (or

Activity Activity i.e. Cost cost driver cost driver
Activity Cost Cost Cost driver Pool Rate quantity) ABC Cost ‐ quantity) ABC Cost ‐
Pools Pool(Rs) Driver quantity (Rs) consumed A consumed B
Machine Machine
related Costs 4,90,000 Hours 1,40,000 3.5 20,000 70,000 1,20,000 4,20,000
Number
of
Purchase purchase
related costs 6,30,000 orders 450 1,400 150 2,10,000 300 4,20,000
Number
Set up of set
related costs 7,98,000 ups 70 11,400 20 2,28,000 50 5,70,000
Activity Costs for each product line 5,08,000 14,10,000
ABC Cost per unit of the product for each product line : =508,000/5000 =1410,000/50,000
101.60 28.20
 Product Cost – Comparison, Distortion
1. Product costs based on Traditional,Volume Based Product Line A Product Line B
Product Costing system: (Rs per unit) (Rs per unit)

Direct material 100 150

Direct labor 150 100
Manufacturing OH based on Traditional POHR 54.80 32.88
Production Cost Per unit 304.80 282.88
Original Selling Price (cost *125%) 381.00 353.60
2. Product costs based on Activity‐based costing Product Line A Product Line B
system: (Rs per unit) (Rs per unit)
Direct material 100 150
Direct labor 150 100
Manufacturing OH based on ABC 101.60 28.20
Total Cost Per unit 351.60 278.20
New ABC Based Selling Price (cost *125%) 439.50 347.75
Output (units) 5,000 50,000
Traditional Costing Overprices (Underprices) ‐46.80 4.68
Cost Distortion (Rs) ‐2,34,000 2,34,000
Traditional costing understates the cost of complex, low volume products (A )
 Product Cost – Comparison, Distortion
1. Product costs based on Traditional,Volume Based Product Line A Product Line B
Product Costing system: (Rs per unit) (Rs per unit)

Direct material 100 150

Direct labor 150 100
Manufacturing OH based on Traditional POHR 54.80 32.88
Production Cost Per unit 304.80 282.88
Original Selling Price (cost *125%) 381.00 353.60
2. Product costs based on Activity‐based costing Product Line A Product Line B
system: (Rs per unit) (Rs per unit)
Direct material 100 150
Direct labor 150 100
Manufacturing OH based on ABC 101.60 28.20
Total Cost Per unit 351.60 278.20
New ABC Based Selling Price (cost *125%) 439.50 347.75
Output (units) 5,000 50,000
Traditional Costing Overprices (Underprices) ‐46.80 4.68
Cost Distortion (Rs) ‐2,34,000 2,34,000

Traditional costing understates the cost of complex, low volume products (A )

Problem 5‐56 (H12 e)
 Problem 5‐56 (page 210) (H12 e)
1. Using WGCC’s current product‐costing system:
a. Determine the company’s predetermined overhead rate using direct‐labor cost as the single cost driver.
b. Determine the full product costs and selling prices of one pound of Kona coffee and one
pound of Malaysian coffee
1. a. WGCC's predetermined overhead rate, using direct‐labor cost as the single
cost driver, is $5 per direct labor dollar, calculated as follows:
Total Manufacturing Overhead cost
Overhead Rate = Budgeted direct labor cost

= $3,000,000/$600,000
= $5 per direct‐labor dollar
1 b. The full product costs and selling prices of one pound of Jamaican and one
pound of Colombian coffee are calculated as follows:
Kona Malaysian
Direct material $3.20 $4.20
Direct labor .30 .30
Overhead (.30 *$5) 1.50 1.50
Full product cost $5.00 $6.00
Markup (30%) 1.50 1.80
Selling price $6.50 $7.80
 problem 5‐56 (12 e) (continued)
2. Develop a new product cost, using an activity‐based costing approach, for one pound of Jamaican coffee
and one pound of Colombian coffee.
2. A new product cost, under an activity‐based costing approach, is calculated as follows:
Calculation of Activity Rates :‐
Activity Cost Driver Budgeted Budgeted Unit
Activity Cost Cost
Purchasing Purchase orders 1,158 $579,000 $500

Material handling Setups 1,800 720,000 400

Quality control Batches 720 144,000 200

Roasting Roasting hours 96,100 961,000 10

Blending Blending hours 33,600 336,000 10

Packaging Packaging hours 26,000 260,000 10

Calculation of Activity Consumed 2000 lb. 100,000 lb.

Activity Consumed Units Kona Malaysian
Purchasing Orders Budgeted sales / order size 2000 lbs/500 =4 100,000 lbs/25,000= 4
Material handling Set ups Setup per batch * batches 3* 4 = 12 3 *10 =30
Batches Budgeted Sales / Batch size 2000/500= 4 100000/10,000 =10
Roasting Roasting hours @ 1 hour per 100 lb 2000/100*1=20 100,000/100*1 =1,000
Blending Blending hours @ 0.5 hour per 100 lb 2000/100*0.5 100,000/100*0.5= 500
=10
Packaging Packaging hours @ 0.1 hour per 100 lb 2000/100*0.1=2 100,000/100*0.1=100
 problem 5‐56 (12 e) (continued)
2. Develop a new product cost, using an activity‐based costing approach, for one pound of Jamaican coffee
and one pound of Colombian coffee.
2. A new product cost, under an activity‐based costing approach, is calculated as follows:
Calculation of Activity Rates :‐
Activity Cost Driver Budgeted Budgeted Unit
Activity Cost Cost
Purchasing Purchase orders 1,158 $579,000 $500

Material handling Setups 1,800 720,000 400

Quality control Batches 720 144,000 200

Roasting Roasting hours 96,100 961,000 10

Blending Blending hours 33,600 336,000 10

Packaging Packaging hours 26,000 260,000 10

Calculation of Activity Consumed 2000 lb. 100,000 lb.

Activity Consumed Units Kona Malaysian
Purchasing Orders Budgeted sales / order size 2000 lbs/500 =4 100,000 lbs/25,000= 4
Material handling Set ups Setup per batch * batches 3* 4 = 12 3 *10 =30
Batches Budgeted Sales / Batch size 2000/500= 4 100000/10,000 =10
Roasting Roasting hours @ 1 hour per 100 lb 2000/100*1=20 100,000/100*1 =1,000
Blending Blending hours @ 0.5 hour per 100 lb 2000/100*0.5 100,000/100*0.5= 500
=10
Packaging Packaging hours @ 0.1 hour per 100 lb 2000/100*0.1=2 100,000/100*0.1=100
 problem 5‐56 (12 e) (continued)

Standard cost per pound: Kona Coffee

Direct material $3.20
Direct labor .30
Activity Unit
Purchasing (4 orders*  $500/2,000 lb..) 1.00 Cost
Material handling (12 setups  $400/2,000 lb.) 2.40
Purchasing $500
Quality control (4 batches  $200/2,000 lb.) .40
Roasting (20 hours  $10/2,000 lb.) .10 Material 400
Blending (10 hours  $10/2,000 lb.) .05 handling
Quality 200
Packaging (2 hours  $10/2,000 lb.) .01 control
Total cost $7.46 Roasting 10
Standard cost per pound: Malaysian Coffee
Blending 10
Direct material $4.20
Direct labor .30 Packaging 10
Purchasing (4* orders  $500/100,000 lb.) .02
Material handling (30 setups  $400/100,000 lb.) .12
Quality control (10 batches  $200/100,000 lb.) .02
Roasting (1,000 hours  $10/100,000 lb.) .10
Blending (500 hours  $10/100,000 lb.) .05
Packaging (100 hours  $10/100,000 lb.) .01
Total cost $4.82
*Budgeted sales÷ purchase order size New product cost, under ABC approach, is
100,000 lbs.÷ 25,000 lbs. = 4 orders
$7.46 per pound of Kona and
$4.82 per pound of Malaysian coffee
 problem 5‐56 (12 e) (continued)

3. What are the implications of the activity‐based costing system with respect to:
a. The use of direct labor as a basis for applying overhead to products?
b. The use of the existing product‐costing system as the basis for pricing?

a) The ABC analysis indicates that several activities other than direct labor drive overhead.
The cost computations show that the current (traditional) system significantly under‐
costed Kona coffee, the low‐volume product, and over‐costed the high‐volume product,
Malaysian coffee.

Kona Malaysian
Traditional Costs $5.00 $6.00
ABC $7.46 $4.82

b) The implication of the ABC analysis is that the low‐volume products are using resources
but are not covering their share of the cost of those resources. The Kona blend is
currently priced at $6.50, which is significantly below its activity‐based cost of $7.46.
The company should set long‐run prices above cost. If there is excess capacity and many
of the costs are fixed, it may be acceptable to price some products below full activity‐
based cost temporarily in order to build demand for the product.
Otherwise, the high‐volume, high‐margin products are subsidizing the low‐volume, low‐
margin products.
Problem 5‐55 (H12 e) (P216)
Problem 5‐55 (H12 e) (P216)
 P5-55 (12 e) Advantages : ABC System
1. Identify at least four general advantages associated with activity-based costing.

General advantages associated with activity‐based costing include the

following:
1. Provides management with a more thorough understanding of complex
product costs and product profitability for improved resource
management and pricing decisions.
2. Allows management to focus on value‐added and non‐value‐added
activities, so that non‐value‐added activities can be controlled or
eliminated, thus streamlining production processes.
3. Highlights the relationship between activities and identifies opportunities
to reduce costs (i.e., designing products with fewer parts in order to
reduce the cost of the manufacturing process).
4. Provides a more appropriate means of charging overhead costs to
products.
 problem 5‐55 (12 e) (continued)
2. On the basis of Manchester’s unit cost data given in the problem, calculate the total amount that each of
the two product lines will contribute toward covering fixed costs and profit in 20x1.
2. Using unit cost data, the total contribution margin expected from the PC board is calculated as follows:
PC board Total for 40,000 Units

Per Unit
Revenue $300 $12,000,000
Direct material $140 $ 5,600,000
Material-handling charge (10% of material) 14 560,000
Direct labor ($14 per hr. * 4 hr.) 56 2,240,000
Variable overhead ($4 per hr. * 4 hr.)* 16 640,000
Machine time ($10 per hr. * 1.5 hr.) 15 600,000
Total Variable costs $241 $ 9,640,000
Unit contribution margin $ 59
Total contribution margin (40,000 * $59) $ 2,360,000
*Variable overhead rate: $11,20,000 ÷ 280,000 hr. = $4 per hr
Using unit cost data, the total contribution margin expected from the TV board is calculated as follows:
TV board Total for 65,000 Units

Per Unit
Revenue $150 $9,750,000
Direct material $ 80 $5,200,000
Material-handling charge (10% of material) 8 520,000
Direct labor ($14 per hr. * 1.5 hr.) 21 1,365,000
Variable overhead ($4 per hr. * 1.5 hr.)* 6 390,000
Machine time ($10 per hr. * .5 hr.) 5 325,000
Total Variable costs $120 $7,800,000
Unit contribution margin $ 30
Total contribution margin (65,000 * $30) $1,950,000
*Variable‐overhead rate: $11,20,000 ÷ 280,000 hr. = $4 per hr.
 problem 5‐55 (12 e) (continued)

3. Repeat requirement (2) but now use the

cost data from the activity‐based costing
system

3. The pool rates, which apply to both the PC board and the TV board, are calculated as follows:
Procurement $400,000/4,000,000 = $.10 per part
Production scheduling $220,000/110,000 = $2.00 per board
Packaging and shipping $440,000/110,000 = $4.00 per board
Machine setup $446,000/278,750 = $1.60 per setup
Hazardous waste disposal $48,000/16,000 = $3.00 per lb.
Quality control $560,000/160,000 = $3.50 per inspection
General supplies $66,000/110,000 = $.60 per board
Machine insertion $1,200,000/3,000,000 = $.40 per part

Manual insertion $4,000,000/1,000,000 = $4.00 per part

Wave soldering $132,000/110,000 = $1.20 per board

 problem 5‐55 (12 e) (continued)
Using activity-based costing, the total contribution margin
expected from the PC board is $15,94,000, calculated as
follows
Total for
40,000
Per Unit Units
Revenue $300.00 $12,000,000 Procurement $.10 per part
Direct material $140.00 $ 5,600,000
Procurement ($.10 per part * 55 parts) 5.50 220,000 Production scheduling $2.00 per board
Production scheduling 2.00 80,000 Packaging & shipping $4.00 per board
Packaging and shipping 4.00 160,000
Machine setup ($1.6 per setup * 3 setups) 4.80 192,000 Machine setup $1.60 per setup
Hazardous waste disposal ($3 per lb. * .35 lb.) 1.05 42,000 Hazardous waste disposal $3.00 per lb.
Quality control
($3.50 per inspection * 2 inspections) 7.00 280,000 Quality control $3.50 per inspection
General supplies .60 24,000 General supplies $.60 per board
Machine insertion ($.40 per part * 35 parts) 14.00 560,000
Manual insertion ($4 per part * 20 parts) 80.00 3,200,000 Machine insertion $.40 per part
Wave soldering 1.20 48,000
Total Variable costs $ 260.15 $10,406,000 Manual insertion $4.00 per part
Unit contribution margin $ 39.85
$ 1,594,000 Wave soldering $1.20 per board
Total contribution margin 39.85/ 300
=13.28%
 problem 5‐55 (12 e) (continued)

Using activity-based costing, the total contribution margin

expected from the TV board is $25,57,100, calculated as
follows:

Total for 65,000

Units
Per Unit Procurement $.10 per part
Revenue $ 150.00 $9,750,000
Direct material $ 80.00 $5,200,000 Production scheduling $2.00 per board
Procurement ($.10 per part * 25 parts) 2.50 162,500 Packaging & shipping $4.00 per board
Production scheduling 2.00 130,000
Packaging and shipping 4.00 260,000 Machine setup $1.60 per setup
Machine setups ($1.60 per setup * 2 setups) 3.20 208,000 Hazardous waste disposal $3.00 per lb.
Hazardous waste disposal ($3 per lb. * .02 lb.) .06 3,900
Quality control ($7.00 per inspection x 1 3.50 227,500 Quality control $3.50 per inspection
inspection) General supplies $.60 per board
General supplies .60 39,000
Machine insertion $.40 per part
Machine insertion ($.40 per part * 24 parts) 9.60 624,000
Manual insertion ($4.00 per part x 1 part) 4.00 260,000 Manual insertion $4.00 per part
Wave soldering 1.20 78,000
Total Variable costs $ 110.66 $7,192,900 Wave soldering $1.20 per board
Unit contribution margin $ 39.34
39.34/150 $2,557,100
Total contribution margin = 26.22%
 Problem 5-55 (12 e) (Continued)

4. Explain how a comparison of the results of the two costing methods may
impact the decisions made by Ultratech’s management group.
Answer 4
• The analysis using the previously reported costs indicates that the unit
contribution of the PC board is almost double that of the TV board. On this
basis, management is likely to accept the suggestion of the production
manager and concentrate promotional efforts on expanding the market for
the PC boards.

• However, the analysis using activity‐based costing does not support this
decision. This analysis shows that the unit dollar contribution from each of
the boards is not as different as previously believed, and the total
contribution from the TV board exceeds that of the PC board by almost $1
million. As a percentage of selling price, the contribution from the TV board
is almost double that of the PC board (26 percent versus 13 percent).
 Limitations of ABC system

• ABC doesn’t conform to GAAP

– Need for having two systems : Traditional & ABC
– Auditors uncomfortable with allocations based on subjective data

• Substantial resources required for implementation and maintaining ABC

– Do the benefits of increased accuracy outweigh the costs of
implementing & maintaining more detailed costing system?

• Non‐familiarity leads to resistance from managers. Needs

– Support of top management
– Full Participation of a cross functional team with representative from
each line area
– Should be linked to how people are evaluated and rewarded
Ordinarily Most companies use ABC as a Supplement to, rather than as
replacement for, traditional costing system
CASE: Classic Pen Company:
Developing an ABC Model
 Questions On: Classic Pen Company: Developing an ABC Model
1. What is the context in which the case was written?

2. How large are the expenses in indirect and support resources compared Direct Labour cost?

3. Are the products produced by the company homogeneous in resource demand? If not, what kind of product
diversity exists?

a. High volume ‐ Low volume products or

b. High Complexity ‐ Low Complexity products or both

4. How is the Overhead Allocated under the Traditional costing system?

5. Calculate product costs for four types of products, based on activity information collected by Dempsey?

a. Identify four activities performed by the company. What are their cost hierarchy levels – Unit level,
Batch Level, Product Level, or Organisation sustaining level?

b. What are the Total Costs in the Activity Cost Pools

c. What are the Cost drivers for each of the activity cost pool?

d. Calculate the Activity Rates

6. How are the costs calculated under ABC above different from the costs calculated under Traditional Costing
system (Absorption Costing)?

a. What is the impact of using ABC system in calculating Product Profitability?

7. What actions ABC product costs are likely to stimulate?

 Two Key Points: Classic Pen Company Case

• A large proportion of non‐unit‐level activities

• A unit‐level cost driver, such as direct labor, machine hours
will not be able to assign the costs of non‐unit‐level
activities accurately

• Product diversity
• When the consumption ratios differ widely between
activities, no single cost driver will accurately assign the
resulting overhead costs.
 When to use ABC ?

ABC will have greatest impact when

• Large component of Total Costs is in Overheads (indirect and support
resources)
• A large proportion of non‐unit level activities : significant number of
Activities are at batch and/or product levels
• High Diversity exists in products : Consumption differs between activities
– Product Diversity: Mature‐New, Standard‐ Specialty
– Volume Diversity : High Volume ‐ Low Volume

When would ABC and Traditional system determine similar product costs?
– Almost all expenses are direct material or direct labour which can be
directly traced to individual products. No overheads
– All activities are at unit level (no batch or product level activity)
– A Single Product or Homogeneous products are produced (creates
homogeneous demand on resources)
Thanks 
 Cost Management

Session 6 : MBA 2022

Cost‐Volume‐Profit Relationships
Prof. Arpita Ghosh
 Learning Goals
• Assumptions underlying CVP, Fixed Vs Variable Costs
• Basic CVP Relationships
– Contribution, Contribution Income Statement
– CVP Chart, Computing Contribution Margin Ratio or C/S Ratio
• Computing
– Break Even Point, Indifference Point
– Level of Sales needed to achieve Target Profit,
– Margin of safety,
– Multi‐product Break even point
• Cost Structure – Operating Leverage & linkage with MOS
• Exercises
 Assumptions Underlying ‐ CVP Analysis

1. Selling Price Per Unit is constant through out the entire relevant range
2. Total Costs are linear in nature over the relevant range
– Total cost can be accurately split into fixed and variable
components
– Total Fixed Cost, Variable cost per unit will not change during the
period
3. In multi product companies, sales mix is constant over relevant range
4. No change in inventory:
– Units Produced = Units sold during the period
 Income Statement – Traditional and Contribution Approach

Income Statement‐ Not Total Income Statement ‐

Traditional Approach disclosed (Rs) Contribution Approach Total(Rs)
Sales (1000 units) 1,00,000 Sales (1000 units) 100000
Less: Cost of Goods Sold
(COGS) Less: Variable Costs
Fixed 15,000 Variable Manufacturing 35000
Variable 35000 50,000 Variable Administrative 15000
Gross Margin 50,000 60000
Variable Selling 10000
Less: Operating Expenses
Contribution Margin 40000
Administrative Expenses
Fixed 10,000 Less: Fixed Costs
Variable 15,000 25,000 Fixed Manufacturing 15000
Selling Expenses Fixed Administrative 10000
Fixed 5,000
Variable 10,000 15,000 Fixed Selling 5000 30000
Operating Income 10,000 Operating Income 10000
 Income Statement – Traditional and Contribution Approach

Income Statement‐ Not Total Income Statement ‐

Traditional Approach disclosed (Rs) Contribution Approach Total(Rs)
Sales (1000 units) 1,00,000 Sales (1000 units) 100000
Less: Cost of Goods Sold
(COGS) Less: Variable Costs
Fixed 15,000 Variable Manufacturing 35000
Variable 35000 50,000 Variable Administrative 15000
Gross Margin 50,000 60000
Variable Selling 10000
Less: Operating Expenses
Contribution Margin 40000
Administrative Expenses
Fixed 10,000 Less: Fixed Costs
Variable 15,000 25,000 Fixed Manufacturing 15000
Selling Expenses Fixed Administrative 10000
Fixed 5,000
Variable 10,000 15,000 Fixed Selling 5000 30000
Operating Income 10,000 Operating Income 10000
 Contribution‐Margin Approach

Income Statement ‐ Contribution Approach Total (Rs) Per Unit (Rs)

Sales (1000 units) 100,000 100
Less: Variable Costs 60,000 60
Contribution 40,000 40
Less: Fixed Costs 30,000
Operating Income 10,000

So, Contribution = Sales ‐ Variable Cost = 100000 – 60000 = 40000

= Fixed Cost + Profits = 30000 + 10000 = 40000
Break Even Sales =>
Where, Profits = 0, i.e. Sales (or Total revenue) = Total Costs
or, Contribution = Total fixed Costs. Here, 750 units

The break‐even point is the point in the volume of activity

where the organization’s revenues and expenses are equal
 Contribution‐Margin Approach

Income Statement ‐ Contribution Approach Total (Rs) Per Unit (Rs)

Sales (1000 units) 100,000 100
Less: Variable Costs 60,000 60
Contribution 40,000 40
Less: Fixed Costs 30,000
Operating Income 10,000

So, Contribution = Sales ‐ Variable Cost = 100000 – 60000 = 40000

= Fixed Cost + Profits = 30000 + 10000 = 40000
Break Even Sales =>
Where, Profits = 0, i.e. Sales (or Total revenue) = Total Costs
or, Contribution = Total fixed Costs. Here, 750 units

The break‐even point is the point in the volume of activity

where the organization’s revenues and expenses are equal
 Cost‐Volume‐Profit Graph

Units sold 1000 750 250

Sales (100 p.u.) 100000 75000 25000
Less: Variable Costs (60 p.u.) 60000 45000 15000
Contribution 40000 30000 10000
Less: Fixed Costs 30000 30000 30000
Operating Income 10000 0 ‐20000
Rupees (Revenues, Costs)

Break‐even
point
125,000

100,000

75,000

50,000 Fixed expenses

25,000 MOS
(Units)

200 250 400 600 750 800 1,000 1,200

Units (Output or Sales)
 Profit‐Volume Graph
Focuses on Profits and Volumes

50,000

40,000

30,000
Break‐even
20,000 point
10,000
Profit

(10,000) 200 400 600 800 1000 1200

Units
(20,000)

(30,000)
 What is Contribution‐Margin Ratio ?
Contributi on margin
Contributi on  Margin Ratio   100
Sales
Contributi on - Margin Per Unit
  100
Selling Price Per unit
Change in contributi on - margin
  100
Change in Sales
Income Statement ‐
Contribution Per Unit
Approach Total (Rs) (Rs)
Profit = (s – v) q – F
Sales (1000 units) 100,000 100 100% or
Less: Variable Costs 60,000 60 60% Profit = c × q – F

Contribution 40,000 40 40% s = selling price per unit

Less: Fixed Costs 30,000 v = variable cost per unit
F = total fixed costs
Operating Income 10,000 q = sales in units
c= contribution per unit
If Sales increase by 250 units, Increase in contribution ?
 Break‐Even Point (in Units and in Rs)

EQUATION APPROACH
CONTRIBUTION MARGIN
APPROACH
q= Break‐Even Point in units
Break Even Sales (units)
Profits = Sales – Variable Expenses ‐ Fixed Expenses
= Total Fixed Expenses
Unit Sales Unit Sales Contribution‐Margin per unit
sales × volume variable × volume − Fixed = Profits
price in units expense in units Expenses = Rs 30000
Rs 40
100 q ‐ 60 q ‐ 30,000 = Break Even Profit = 0 = 750 Units
40 q = Rs 30,000
q = Rs 30,000 ÷ 40 units Break Even Sales (Rs)
q = 750 units =Break‐even Point ( in units) = Total Fixed Cost
Contribution‐Margin Ratio
S = Break‐even point in sales (Rs)
Sales – Variable Expenses ‐ Fixed Expenses = Break Even Profit = 0 = Rs 30000
S – 0.60 S – Rs 30,000 = 0 0.40
0.40S = Rs 30000 = Rs 75,000
Or, 750 units * Rs100 S = Rs 30,000 ÷ 0.40
= Rs 75,000 S = Rs 75000
 Level of Sales needed to achieve a desired Target Profit
Assume the company wants to earn a target profit of Rs 20000.
How many units should it sell to earn the target profit
EQUATION APPROACH CONTRIBUTION MARGIN APPROACH
q= Number of units to be sold to earn the Target Profit
Sales to earn target profit (units) =
Profits = Sales – Variable Expenses ‐ Fixed Expenses Total Fixed Expenses + Target Profit
Contribution‐Margin per unit
Unit Sales Unit Sales
sales × volume variable × volume − Fixed = Profits
= Rs 50000
price in units expense in units Expenses Rs 40
= 1,250 Units
100 q ‐ 60 q ‐ 30,000 = Target Profit = Rs 20,000
40 q = Rs 30,000 + Rs 20,000
q = Rs 50,000 ÷ 40 units Sales to earn target profit (Rs) =
q = 1,250 units Total Fixed Cost + Target Profit
S = Sales in Rupees to attain Target Profit Contribution‐Margin Ratio
Sales – Variable Expenses ‐ Fixed Expenses = Target Profit
S – 0.60 S – Rs 30,000 = Rs 20,000
= Rs 50000
0.40
0.40S = Rs 50000
Or, 1250 units * Rs100 = Rs 125,000
S = Rs 50,000 ÷ 0.40
= Rs 125,000
S = Rs 125,000
12
 Level of Sales needed to achieve a desired Target Profit
Assume the company wants to earn a target profit of Rs 20000.
How many units should it sell to earn the target profit
EQUATION APPROACH CONTRIBUTION MARGIN APPROACH
q= Number of units to be sold to earn the Target Profit
Sales to earn target profit (units) =
Profits = Sales – Variable Expenses ‐ Fixed Expenses Total Fixed Expenses + Target Profit
Contribution‐Margin per unit
Unit Sales Unit Sales
sales × volume variable × volume − Fixed = Profits
= Rs 50000
price in units expense in units Expenses Rs 40
= 1,250 Units
100 q ‐ 60 q ‐ 30,000 = Target Profit = Rs 20,000
40 q = Rs 30,000 + Rs 20,000
q = Rs 50,000 ÷ 40 units Sales to earn target profit (Rs) =
q = 1,250 units Total Fixed Cost + Target Profit
S = Sales in Rupees to attain Target Profit Contribution‐Margin Ratio
Sales – Variable Expenses ‐ Fixed Expenses = Target Profit
S – 0.60 S – Rs 30,000 = Rs 20,000
= Rs 50000
0.40
0.40S = Rs 50000
Or, 1250 units * Rs100 = Rs 125,000
S = Rs 50,000 ÷ 0.40
= Rs 125,000
S = Rs 125,000
 Margin of Safety
Margin of Safety (in Rs) = Total Sales (budgeted) – Break Even Sales
Margin of Safety (in Rs) = Profit
CM Ratio
Margin of Safety (in Units) = Profit
Contribution per unit
Margin of Safety Percentage = Margin of Safety (in Rs) * 100
Total Sales

Break‐even sales Actual sales

750 units 1000 units Percent
Sales (@ 100 p.u.) 75,000 100,000 100%
Less: variable expenses (@60 p.u.) 45,000 60,000 60%
Contribution margin 30,000 40,000 40%
Less: fixed expenses 30,000 30,000
Profit or Net income 0 10,000

1000 units – Rs (100,000 ‐ Rs 25,000

750 units 75,000) = Rs100,000
MARGIN OF SAFETY =250 units Rs 25,000 = 25%
 Margin of Safety
Margin of Safety (in Rs) = Total Sales (budgeted) – Break Even Sales
Margin of Safety (in Rs) = Profit = 10,000/.40 = Rs25,000
CM Ratio
Margin of Safety (in Units) = Profit
= 10,000/40 = 250
Contribution per unit
Margin of Safety Percentage = Margin of Safety (in Rs) * 100
Total Sales

Break‐even sales Actual sales

750 units 1000 units Percent
Sales (@ 100 p.u.) 75,000 100,000 100%
Less: variable expenses (@60 p.u.) 45,000 60,000 60%
Contribution margin 30,000 40,000 40%
Less: fixed expenses 30,000 30,000
Profit or Net income 0 10,000

1000 units – Rs (100,000 ‐ Rs 25,000

750 units 75,000) = Rs100,000
MARGIN OF SAFETY =250 units Rs 25,000 = 25%
 Cost Structure: Operating Leverage
Measures how a given percentage change in sales affects profits
Can you establish a relationship
Operating leverage factor or
between DOL & MOS% ?
Degree of Operating Leverage (DOL) = Contribution Margin
MOS % = 1/ DOL *100
Operating Profit
So, if DOL = 4 , what is MOS % ?
% Change in Profit = DOL × % Change in Sales
DOL Calculations Company X Company Y
Sales 100,000 100% 100,000 100%
Variable expenses 60,000 60% 20,000 20%
Contribution margin 40,000 40% 80,000 80%
Fixed expenses 30,000 70,000
Net operating income 10,000 10,000
Degree of operating leverage 4 8
If Sales increase by 10% what will be the impact on Profits ? For X: 4* 10% =40% increase
Company X Company Y
Sales 110000 110,000
Variable expenses 66000 22,000
Contribution margin 44000 88,000
Fixed expenses 30,000 70,000
Net operating income 14,000 18,000
Increase in net operating income (14000‐10000)/10000 = 40% (18000 – 10,000)/10,000 = 80 %
New DOL 3.14 4.88
 Cost Structure: Operating Leverage
Measures how a given percentage change in sales affects profits
Can you establish a relationship
Operating leverage factor or
between DOL & MOS% ?
Degree of Operating Leverage (DOL) = Contribution Margin
MOS % = 1/ DOL *100
Operating Profit
So, if DOL = 4 , what is MOS % ?
% Change in Profit = DOL × % Change in Sales
DOL Calculations Company X Company Y
Sales 100,000 100% 100,000 100%
Variable expenses 60,000 60% 20,000 20%
Contribution margin 40,000 40% 80,000 80%
Fixed expenses 30,000 70,000
Net operating income 10,000 10,000
Degree of operating leverage 4 8
If Sales increase by 10% what will be the impact on Profits ? For X: 4* 10% =40% increase
Company X Company Y
Sales 110000 110,000
Variable expenses 66000 22,000
Contribution margin 44000 88,000
Fixed expenses 30,000 70,000
Net operating income 14,000 18,000
Increase in net operating income (14000‐10000)/10000 = 40% (18000 – 10,000)/10,000 = 80 %
New DOL 3.14 4.88
7‐39 (p 320) on Operating Leverage (H‐12e)

18
 7‐39 on Operating Leverage (H‐12e)
2. Operating leverage refers to the use of fixed costs in an organization’s overall cost
structure. An organization that has a relatively high proportion of fixed costs and low
proportion of variable costs has a high degree of operating leverage.
1 and 3. Calculation of contribution margin and profit at 6,000 units of sales
Plan A Plan B
Sales revenue: 6,000 units x $80 $480,000 $480,000
Less: Variable costs:
• Cost of purchasing product: 6,000 units x $50 $300,000 $300,000
• Sales commissions: $480,00 x 10% 48,000 0
Total variable cost $348,000 $300,000
Contribution margin $132,000 $180,000
Fixed costs 22,000 66,000
Operating Profit $110,000 $114,000
Unit Contribution [80‐{(10%*80)+50}] (80 ‐50)
(A: 198,000/6,000; B: 270,000/6,000) = 22* =30 **
1. Break‐Even Point (units) = Fixed Costs = 22,000 66,000
Unit Contribution 22* 30 **
1,000 2,200
3. Operating Leverage Factor = Contribution margin = 132,000 180,000
Operating Profit 110,000 114,000
Plan B has the higher operating leverage factor  1.2 1.578 (Rd)
 7‐39 (H12e) continued
Operating Profit at 6,000 units of sales $110,000 $114,000
4 & 5 : Calculation of profit at 5,000 units Plan A Plan B
Sales revenue: 5,000 units x $80 $400,000 $400,000
Less: Variable costs:
• Cost of purchasing product: 5,000 units x $50 $250,000 $250,000
• Sales commissions: $400,000 x 10% 40,000 _0_
Total variable cost $290,000 $250,000
Contribution margin $110,000 $150,000
Fixed costs 22,000 66,000
Operating Profit $88,000 $84,000
Plan A profitability decrease:
$110,000 ‐ $88,000 = $22,000
$22,000 ÷ $110,000 = 20%
Plan B profitability decrease:
$114,000 ‐ $84,000 = $30,000
$30,000 ÷ $114,000 = 26.3% (rnd)
The Company will experience a larger percentage decrease in income if it adopts Plan B.
• This situation arises because Plan B has a higher degree of operating leverage.
• Stated differently, Plan B’s cost structure produces a greater percentage decline in profitability from the
drop‐off in sales revenue.
Note: The percentage decreases in profitability can be computed by multiplying the percentage decrease
in sales revenue by the operating leverage factor. Sales dropped from 6,000 units to 5,000 units, or
16.67%. Thus: Plan A: 16.67% x 1.2= 20%, Plan B: 16.67% x 1.578 = 26.3%
 7‐39 (H12e) continued

6. Heavily automated manufacturers have sizable investments in plant and equipment,

along with a high percentage of fixed costs in their cost structures. As a result, there is
a high degree of operating leverage.
– In a severe economic downturn, these firms typically suffer a significant decrease
in profitability. It will be less able to adapt to decline in consumer demand than a
company with labour intensive manufacturing process
– Such automated firms would be a more risky investment when compared with
firms that have a low degree of operating leverage.
– Of course, when times are good, increases in sales would tend to have a very
favorable effect on earnings in a company with high operating leverage.
 Break Even Point: Multiple ‐Products
Product A Product B
1000 units Per Unit 2000 units Per Unit
Sales 100,000 100 300,000 150 400,000 100%
Variable expenses 70,000 70 120,000 60 190,000 47.5%
Contribution 30,000 30 180,000 90 210,000 52.5%
Fixed expenses 141,750
Net operating income 68,250
Sales Mix in units =1000:2000 = 1: 2 1000 units 2000 units
% of Total 0.33 0.67
Contribution Margin per unit 30.00 90
Weighted Contribution Margin (% Total* CM) 10.0 60.0
Weighted average Contribution Margin per unit = 10+60 = Rs 70
Break Even Point (units) = Fixed expenses = 141,750 2,025
Weighted average Contribution Margin per unit 70.00 Combined units
Break Even Point (units) 675 1,350

Overall C/S ratio = 210,000 = 52.50%

400,000
Break Even Point Sales (Rs) = 141,750 = Rs 270,000 Combined
0.525
Sales Mix in Rs 100,000:300,000 =1:3 0.25 0.75
Break Even Point Sales (Rs) = 67,500 202,500
=675*100 =1350*150
How would the BEP change when Sales‐Mix changes say, 2000 units of A & 1000 units of B are sold ?
 Application of CVP: Impact of changes on BEP and Profits
Impact on Profits of three independent changes:
1. Increase in Selling Price (S.P.) by 10%  Profit Increases
2. Variable Cost (V.C.) increases by 10%  Profit Decreases
3. Fixed Cost (F.C) increases by 10%  Profit Decreases

old 1000 units Increase in Increase in Increase in

(In Rupees) p.u. S.P. V.C. F.C
Sales 100 100000 110000 100000 100000
Less: Variable Costs 60 60000 60000 66000 60000
Contribution 40 40000 50000 34000 40000
Less: Fixed Costs 30000 30000 30000 33000
Operating Income 10000 20000 4000 7000
BEP in units (old) = Rs30,000/40= 750 units
Impact on BEP of three independent changes:
1. Increase in Selling Price (S.P.) by 10%  CM per unit increases to Rs50
• BEP = 30,000/50= 600 units (Decreases)
2. Variable Cost (V.C.) increases by 10% CM per unit decreases to Rs34
• BEP = 30,000/34= 882.35 units (Increases)
3. Fixed Cost (F.C) increases by 10%‐‐> BEP =33,000/40= 825 units (Increases by 10%)
 Application of CVP: Impact of changes on BEP and Profits
Impact on Profits of three independent changes:
1. Increase in Selling Price (S.P.) by 10%  Profit Increases
2. Variable Cost (V.C.) increases by 10%  Profit Decreases
3. Fixed Cost (F.C) increases by 10%  Profit Decreases

old 1000 units Increase in Increase in Increase in

(In Rupees) p.u. S.P. V.C. F.C
Sales 100 100000 110000 100000 100000
Less: Variable Costs 60 60000 60000 66000 60000
Contribution 40 40000 50000 34000 40000
Less: Fixed Costs 30000 30000 30000 33000
Operating Income 10000 20000 4000 7000
BEP in units (old) = Rs30,000/40= 750 units
Impact on BEP of three independent changes:
1. Increase in Selling Price (S.P.) by 10%  CM per unit increases to Rs50
• BEP = 30,000/50= 600 units (Decreases)
2. Variable Cost (V.C.) increases by 10% CM per unit decreases to Rs34
• BEP = 30,000/34= 882.35 units (Increases)
3. Fixed Cost (F.C) increases by 10%‐‐> BEP =33,000/40= 825 units (Increases by 10%)
 Predicting Profit : Interdependent Changes in Key Variables 
Decrease in selling price, Increase in sales volume,
Increase in fixed costs and decrease in Variable costs

If Selling Price is cut by Rs10 per unit, Sales volume would increase to 2500 units.
Fixed costs are planned to be increased by Rs15000 and Variable Cost pu can be reduced by Rs20
Old (A) New( B)
Sales Volume 1000 units 2500 units
Sales (A:Rs100, B:Rs90) Rs 100000 Rs 225000
Less: Variable Costs (A:Rs60, B:Rs40) 60000 100000
Contribution 40000 125000
Less: Fixed Costs 30000 45000
Operating Income 10000 80000

Incremental Approach
Total Contribution Margin‐ New(B) (90‐40) *2500 125000
Total Contribution Margin ‐ Old (A) (100‐60) *1000 40000
Increase in total contribution Margin 85000
Less: Increase in Fixed costs 15,000
Increase in Operating Profit 70,000

Difference in profit caused by 1) different Contribution per unit (cut in Selling Price and
Variable Cost) 2) different sales volume and 3) Increase in Fixed Costs
7‐48 (p 325) on CVP Relationships (H‐12e)

26
 7‐48 on CVP Relationships (H‐12e)
1. Closing of Downtown store:
Loss of contribution margin at Downtown Store $(36,000)
Savings of fixed cost at Downtown Store (75% of $40,000) 30,000
Loss of contribution margin at Mall Store (10% of $48,000) (4,800)
Total decrease in operating income $(10,800)
Increase in Sales and Increase in Fixed costs
2. Promotional campaign:
Increase in contribution margin (10% of $36,000) $ 3,600
Increase in monthly promotional expenses ($60,000/12) (5,000)
Decrease in operating income $(1,400)

3. Elimination of items sold at their variable cost

We can restate the November 20x1 data for the Downtown Store as follows:
If Variable cost items are Eliminated Downtown Store
Items Sold at their
*$60,000 is one half of the Downtown Store's dollar sales for
November 20x1 Variable Cost Other items
Sales $ 60,000 $ 60,000
Less: Variable expenses (Downtown store :60+24= $84,00) 60,000 24,000
Contribution margin $ ‐ 0‐ $ 36,000
Decrease in Sales, Decrease in Fixed costs
If the items sold at their variable cost are eliminated:
Decrease in contribution margin on other items 20% of $36,000 $ (7,200)
Decrease in fixed expenses 15% of $40,000 6,000
Decrease in operating income $ (1,200)
27
 7‐48 on CVP Relationships (H‐12e)
1. Closing of Downtown store:
Loss of contribution margin at Downtown Store $(36,000)
Savings of fixed cost at Downtown Store (75% of $40,000) 30,000
Loss of contribution margin at Mall Store (10% of $48,000) (4,800)
Total decrease in operating income $(10,800)
Increase in Sales and Increase in Fixed costs
2. Promotional campaign:
Increase in contribution margin (10% of $36,000) $ 3,600
Increase in monthly promotional expenses ($60,000/12) (5,000)
Decrease in operating income $(1,400)

3. Elimination of items sold at their variable cost

We can restate the November 20x1 data for the Downtown Store as follows:
If Variable cost items are Eliminated Downtown Store
Items Sold at their
*$60,000 is one half of the Downtown Store's dollar sales for
November 20x1 Variable Cost Other items
Sales $ 60,000 $ 60,000
Less: Variable expenses (Downtown store : 60+24= $84,00) 60,000 24,000
Contribution margin $ ‐ 0‐ $ 36,000
Decrease in Sales, Decrease in Fixed costs
If the items sold at their variable cost are eliminated:
Decrease in contribution margin on other items 20% of $36,000 $ (7,200)
Decrease in fixed expenses 15% of $40,000 6,000
Decrease in operating income $ (1,200)
7‐53 (p 328) Break Even Analysis (H‐12e)
 7‐53 Break Even Analysis (H‐12e)
The break‐even point is calculated as follows:
COMPUTATION OF BREAK‐EVEN POINT
IN PATIENT‐DAYS: PEDIATRICS
FOR THE YEAR ENDED JUNE 30, 20X2
Total fixed costs:
Medical center charges $2,900,000
Supervising nurses ($25,000  4) 100,000
Nurses ($20,000  10) 200,000
Aids ($9,000  20) 180,000
Total fixed costs $3,380,000
Contribution margin per patient‐day:
Revenue per patient‐day $300
Variable cost per patient‐day:
($6,000,000 ÷ $300 = 20,000 patient‐days)
($2,000,000 ÷ 20,000 patient‐days) 100
Contribution margin per patient‐day $200
Total fixed costs $3,380,000
Break‐even point in patient‐days
Contribution margin per patient day $200

16,900 patient days

 7‐53 Break Even Analysis (H‐12e)
The break‐even point is 16,900 patient‐days calculated as follows:
COMPUTATION OF BREAK‐EVEN POINT
IN PATIENT‐DAYS: PEDIATRICS
FOR THE YEAR ENDED JUNE 30, 20X2
Total fixed costs:
Medical center charges $2,900,000
Supervising nurses ($25,000  4) 100,000
Nurses ($20,000  10) 200,000
Aids ($9,000  20) 180,000
Total fixed costs $3,380,000
Contribution margin per patient‐day:
Revenue per patient‐day $300
Variable cost per patient‐day:
($6,000,000 ÷ $300 = 20,000 patient‐days)
($2,000,000 ÷ 20,000 patient‐days) 100
Contribution margin per patient‐day $200
Total fixed costs $3,380,000
Break‐even point in patient‐days
Contribution margin per patient day $200

16,900 patient days

 7‐53 continued
2. Net earnings would decrease by $606,660 calculated as follows:
COMPUTATION OF PROFIT OR LOSS FROM RENTAL
OF ADDITIONAL 20 BEDS: PEDIATRICS
FOR THE YEAR ENDED JUNE 30, 20X2
A) Increase in revenue
(20 additional beds  90 days  $300 charge per day) $540,000
Increase in expenses:
Variable charges by medical center
(20 additional beds  90 days  $100 charge per day) $180,000
Fixed charges by medical center
($2,900,000  60 beds = $48,333 per bed)
($48,333  20 beds) 966,660
Salaries
(20,000 patient-days before additional 20 beds + 20 additional
beds  90 days = 21,800, which does not exceed 22,000 patient-days;
therefore, no additional personnel are required) - 0 -
B) Total increase in expenses ($1,146,660)

Net change in earnings from rental of additional 20 beds (A)- (B) $(606,660)
H‐12e : Case 2‐60 – Indifference Point
 H‐12e : Case 2‐60 : Understanding Cost Concepts
1 a. FastQ Company would be indifferent to acquiring either the small‐volume copier, 1024S, or the medium‐volume copier,
1024M, at the point where the costs for 1024S and 1024M are equal. This point may be calculated using the following
formula, where X equals the number of copies:
(Variable costS * XS) + fixed costS = (variable costM * XM) + fixed costM
1024S 1024M
$.14X + $8,000 = $.09X + $11,000
$.05X = $3,000
X= 60,000 copies

The conclusion is that the company would be indifferent to acquiring either the 1024S or 1024M
machine at an annual volume of 60,000 copies.
1 b. A decision rule for selecting the most profitable copier, when the volume can be estimated, would
establish the points where management is indifferent to each machine. The volume where the costs are
equal between alternatives can be calculated using the following formula, where X equals the number of
copies: (Variable cost * X) + fixed cost = (variable cost * X) + fixed cost
S S M M
For the 1024M machine compared to the 1024G machine:
1024M 1024G
$.09X + $11,000 = $.05X + $20,000
$.04X = $9,000
X = 225,000 copies

The decision rule is to select the alternative as shown in the following chart.
Anticipated Annual Volume Optimal Model Choice
060,000 1024S
60,000225,000 1024M
225,000 and higher 1024G
Self‐Study Problems
7‐46 (H12e) (p323)

39
 7‐46 (H12e)
1. $625,000  $375,000 4. Number of sales units required to earn target net profit,
Unit contributi on margin  given the manufacturing changes
25,000 units
Sales=25*25,000 =625,000 new fixed costs  target net profit
 $10 per unit 
VC= $(525,000‐150,000) new unit contributi on margin
fixed costs $153,000  $100,000 *
Break -even point (in units)  
unit contributi on margin $8
*Last year's profit:
$150,000  31,625 units ($25)(25,000) – $525,000
  15,000 units
$10 = $100,000
2. Number of sales units required to earn target net profit unit contribution margin
Contribution-marginratio 
fixed costs  target net profit sales price
 $10
unit contributi on margin Old contribution-marginratio   .40
$25*
$150,000  $140,000
  29,000 units
$10 5. Let P denote the price required to cover increased
DM cost & maintain the same CM ratio:
new fixed costs
3. New break -even point (in units)  P  $15 *  $2 †
new unit contributi on margin  .40
P
$150,000  ($18,000/6 ) * P  $17  .40 P
  19,125 units
$10  $2 † .60 P  $17
*Annual straight‐line depreciation on new machine P  $28.33 (rounded)
†$2.00 = $4.5 – $2.5 increase in the unit cost of the new part *Old VC pu = $15 = $375,000  25,000
Increase in direct‐material cost = $2
$28.33  $15  $2
New contribution-margin ratio 
Changes in Fixed expenses and VC pu on BEP (units) $28.33
 .40 (rounded)
 7‐40 (H12e)
fixed costs
1 Break even point in units
unit contribution margin
$468,000
$25.00 $19.80
90,000 units
fixed cost
2 Break even point in sales dollars
contribution margin ratio
$468,000
$25.00 $19.80
$25.00
$2,250,000
3. Number of sales units required fixed costs target net profit
to earn target net profit unit contribution margin

$468,000 $268,000
140,000 units
$25.00 $19.80
4 Margin of safety = budgeted sales revenue – break‐even sales revenue
= (120,000)($25) – $2,250,000 = $750,000

5 Break‐even point if direct‐labor costs increase by 8 percent:

New unit = $25.00 – $10.50 – ($5.00)(1.08) – $3.00 – $1.30
contribution margin = $4.80
fixed costs
Break‐even point
new unit contribution margin
$468,000
97,500 units
6. Let P denote sales price $4.80
required to maintain a P  $10.50  ($5.00)(1.08)  $3.00  $1.30
contribution‐margin ratio  .208
P
of .208. Then P is
P  $20.20  .208P
determined as follows:
.792P  $20.20
unit contributi on margin
Contribution margin ratio  Check : P  $25.51 (rounded)
sales price $25.51  $10.50  ($5.00)(1.08)  $3.00  $1.30
New CM ratio 
Old contribution‐margin ratio = .208 = $25.00 $19.80 $25.51
$25.00  .208 (rounded)
 7‐ 47 (12 e)

42
1. Memorandum
Date: Today
To: Vice President for Manufacturing, Jupiter Game Company
From: I.M. Student, Controller
Subject: Activity‐Based Costing

The $150,000 cost that has been characterized as fixed is fixed with respect to sales volume. This cost will not
increase with increases in sales volume. However, as the activity‐based costing analysis demonstrates, these
costs are not fixed with respect to other important cost drivers. This is the difference between a traditional
costing system and an ABC system. The latter recognizes that costs vary with respect to a variety of cost
drivers, not just sales volume.

2. New break-even point if automated manufacturing equipment is installed:

Sales price $26
Costs that are variable (with respect to sales volume):
Unit variable cost (.8 × $375,000 ÷25,000) 12
Unit contribution margin $24

Costs that are fixed (with respect to sales volume):

Setup (300 setups at $50 per setup) 15,000
Engineering (800 hours at $28 per hour) 22,400
Inspection (100 inspections at $45 per inspection) 4,500
General factory overhead 166,100
Total 2,08,000
Fixed selling and administrative costs 30,000
Total costs that are fixed (with respect to sales volume) $238,000
43
 fixed costs
Break - even point (in units) 
unit contributi on margin
$238,000

$14
 17,000 units fixed cost  target net profit
3. Sales (in units) required to show a profit of $280,000: 
unit contributi on margin
$238,000  $140,000

$14
Number of sales units required to earn target net profit  27,000 units

4. If management adopts the new manufacturing technology:

(a) Its break‐even point will be higher (17,000 units instead of 15,000 units).

(b) The number of sales units required to show a profit of $280,000 will be lower (27,000 units instead of
29,000 units)
(c) These results are typical of situations where firms adopt advanced manufacturing equipment and
practices. The break‐even point increases because of the increased fixed costs due to the large
investment in equipment. However, at higher levels of sales after fixed costs have been covered, the
larger unit contribution margin ($14 instead of $10) earns a profit at a faster rate. This results in the firm
needing to sell fewer units to reach a given target profit level.

5. The controller should include the break‐even analysis in the report. The Board of Directors needs a
complete picture of the financial implications of the proposed equipment acquisition. The break‐even
point is a relevant piece of information. The controller should accompany the break‐even analysis with
an explanation as to why the break‐even point will increase. It would also be appropriate for the
controller to point out in the report that the advanced manufacturing equipment would require fewer
sales units at higher volumes in order to achieve a given target profit, as in requirement (3) of this
problem.
Thanks
Cost Management

Session 7 & 8 : MBA 2022

RELEVANT COSTS
Prof. Arpita Ghosh
 1. Relevant Information for decision making : Identify
relevant costs and revenues
2. Decide whether to accept or reject a Special Order
Learning 3. Decide whether to Make or Buy (Outsource) a
component
Goals 4. Decide whether to Shut down or continue
5. Ascertaining Optimal Product‐Mix when resources are
constrained –Allocate constrained resources
6. CASE: Prestige Telephone Company
 The Decision‐Making Process

Accurate 1. Clarify the Decision Problem

Quantitative
Timely Analysis 2. Specify the Criterion

Relevant 3. Identify the Alternatives

Pertinent to a
decision problem.
4. Develop a Decision Model

Decision involves alternatives 5. Collect the Data

Which costs and benefits can be called Relevant ?
1. Costs and benefits which Differ between
alternative courses of action 6. Make a Decision
2. Costs and benefits which Affects Future
Qualitative
Analysis
 Which
Whichcostscosts
are relevant?
are relevant?
A company has no idle capacity and Machine X is its constraint.
Company is considering expanding production by buying a new machine Y.
The increase in volume will lead to increase in fixed manufacturing overhead but not in general
administrative expenses or fixed selling expenses
Relevant Not Relevant
Sales revenue X
Direct materials X
Direct labor X
Variable manufacturing overhead X
Book value—Machine X X
Depreciation—Machine X X
Disposal Value of Machine X X
Market Value – Machine Y (Cost) X
Fixed manufacturing overhead X
Variable selling expense X
Fixed selling expense X
General administrative overhead (consider
independent of new machine) X
 Which
Whichcostscosts
are relevant?
are relevant?
A company has no idle capacity and Machine X is its constraint.
Company is considering expanding production by buying a new machine Y.
The increase in volume will lead to increase in fixed manufacturing overhead but not in general
administrative expenses or fixed selling expenses
Relevant Not Relevant
Sales revenue X
Direct materials X
Direct labor X
Variable manufacturing overhead X
Book value—Machine X X
Depreciation—Machine X X
Disposal Value of Machine X X
Market Value – Machine Y (Cost) X
Fixed manufacturing overhead X
Variable selling expense X
Fixed selling expense X
General administrative overhead (consider
independent of new machine) X
 Cost Classification : Decisions
• Differential Costs: Net Difference in cost between any two alternatives, Relevant
Present1000 units Expansion1200 units Differential
Sales 20000 24000 4000
Less : Variable Expenses 5,000 6,000 1000
Contribution 15,000 18,000 3,000
Less : Fixed Expense 6000 7000 1000
Net Income 9000 11000 2000
(Rs)
Incremental Revenue (Increase in sales) 4000
Less: Differential costs (increase in costs) Variable 1000
Fixed 1000 2000
Decision to go for expansion 2000

• Opportunity Costs
– Potential benefit that is given up when one alternative is selected over another, Not
represent actual cash outlay – not recorded
– Relevant
• Sunk Cost
– Cost that has already been incurred
– Can’t be changed by any decision made now or in the future
– Irrelevant – should be ignored for decision making
• Y Bought a customized machine for 8 lakhs one year back, Has no resale value
• Depreciation
• Out of Pocket cost: A cost that requires a cash outlay, directly attributable to an activity. An entity
can avoid these expenses if it does not take up that activity
Introducing a New Product : 14‐46 (H12e)
 Introducing a New Product : 14‐46 (H12e)

1. Per‐unit contribution margins: Basic Enhanced

Selling price $250.00 $330.00
Less: Variable costs:
Direct material $28 $45
Direct labor 15 20
Variable manufacturing overhead 24 32
Sales commission
$250 x 10%; $330 x 10% 25 33
Total unit variable cost
92 130
Unit contribution margin $158 $200

2. The following costs are not relevant to the decision:

• Development costs—sunk
• Fixed manufacturing overhead—will be incurred regardless of which product is selected
• Sales salaries—identical for both products
• Market study—sunk
 14‐46 (H12e) continued
3. Johnson and Gomez, Inc. expects to sell 10,000 Basic units (40,000 units x 25%)
and 8,000 Enhanced units (40,000 units x 20%)
Basic Enhanced
Total contribution margin:
Standard: 10,000 units x $158 $1,580,000 $1,600,000
Enhanced: 8,000 units x $200
Less: Marketing and advertising 130,000 200,000
Income $1,450,000 $1,400,000

On the basis of this sales forecast, the company would be advised to select the Basic Model.

4. The quantitative difference between the profitability of Standard and Enhanced is

relatively small, which may prompt the firm to look at other factors before a final
decision is made. These factors include:
– Competitive products in the marketplace
– Data validity
– Growth potential of the Standard and Enhanced models
– Production feasibility
– Effects, if any, on existing product sales
– Break‐even points
Special Order, Ethics: 14‐56 (H12e)
 Special Order
• Accepting or rejecting special orders when there is idle production capacity
and the special orders has no long‐run implications
• Decision Rule: Does the special order generate additional operating income?
If Yes  accept, If No reject
• Compares relevant revenues and relevant costs to determine profitability

Special Order, Ethics: 14‐56 (H12e)

1. The costs that will be relevant in Donato’s analysis of the special order being considered
by Winner’s Circle, Inc. are those expected future costs that are applicable to a
particular decision (the costs that will differ between the alternatives of accepting or
rejecting the offer).
– Only the variable costs of labor and material are relevant.
– Since the order was received directly by Winner’s Circle, Inc, variable marketing is
not relevant, because additional marketing costs will not be incurred under this
order.
– Also, the fixed costs are not relevant, because no additional capital investments are
needed to meet the order. The firm is operating below full capacity and will be able
to absorb this order.
 14‐56 (H12e) continued
Current
Monthly Special Combined
Production Order Production a $175  7,500 units = $1,312,500
Units produced 7,500 2,500 10,000 b $100  2,500 units = $250,000
Sales $1,312,500a $250,000b $1,562,500 c($375,000/7,500 units)  2,500
Variable costs: units = $125,000
Direct labor $ 375,000 $125,000c $ 500,000 d($262,500/7,500 units)  2,500
Direct material 262,500 87,500d 350,000 units = $87,500
Marketing 187,500 — 187,500 eTotalvariable cost/units
Total variable costs $ 825,000 $212,500 $1,037,500 produced = variable incremental
cost per unit
Fixed costs:
fTotalfixed cost/units produced =
Manufacturing $ 275,000  $ 275,000
fixed cost per unit
Marketing 175,000  175,000 gTotalcost/units produced =
Total fixed costs $ 450,000  $ 450,000 average cost per unit
Total costs $1,275,000 $212,500 $1,487,500
Income before tax $ 37,500 $ 37,500 $ 75,000 212,500/2,500 =$85
Cost per unit
Variablee $110.00 $85.00 $103.75
Fixedf 60.00  45.00
What if there is no excess
Average unit costg $170.00 $85.00 $148.75
capacity ?
• Winner’s Circle, Inc. should accept the offer.
• Although the combined average unit cost of $148.75 is higher than the price offered of $100 ,
the incremental average unit cost is only $85.00 for the units in the special order.
• Accepting the special order will result in a contribution per unit of $15.00 ($100.00 less $85.00) and
a total additional contribution margin of $37,500 (2,500 units * $15).
 14‐56 continued
3. Other considerations that Cathy Donato should include in her analysis of the special order
include the following:
– Possible problems with other customers who pressure the company for similar
treatment.
– The future customer potential of the buyer of the special order, generating additional
revenues.
4. Cathy Donato could try to resolve the ethical conflict arising out of the controller’s
insistence that the company avoid competitive bidding by taking the following steps:
– She should follow the company’s established policies on such matters.
– If such policies do not exist, or if they do not resolve the conflict, she should discuss the
situation with her manager unless, as in this case, the manager is involved in the
conflict. Then, she should discuss the situation with the manager’s supervisor.
– If this approach does not help her resolve the matter, then she should continue going
to the next‐higher managerial level, including the audit committee of the board of
directors, if necessary.
– Donato should clarify relevant concepts by confidential discussions with an objective
advisor to obtain an understanding of possible courses of action.
– If the ethical conflict still exists after exhausting all of these avenues of internal review,
she may have to resign from the company and submit an informative memorandum to
the board of directors.
Make or Buy: 14‐49 (H12e)
 Make or Buy: 14‐49 (H12e)
• The analysis prepared by the engineering, manufacturing, and accounting departments of
CFT was not correct. However, their recommendation was correct, provided that
potential labor‐cost improvements are ignored.
• An incremental cost analysis similar to the following table should have been prepared to
determine whether the pump should be purchased or manufactured. In the following
analysis, fixed factory overhead costs and general & administrative overhead costs have
not been included because they are not relevant; these costs would not increase,
because no additional equipment, space, or supervision would be required if the pumps
were manufactured.
• Therefore, if potential labor cost improvements are ignored, CFT should purchase the
pumps because the purchase price of $68.00 is less than the $72.00 relevant cost to
manufacture. Purchase price < Avoidable Costs if you don’t make  BUY
Incremental cost analysis: Cost of
10,000 Unit
Assembly Run Per Unit
Purchased components $120,000 $12.00
Assembly labor 300,000 30.00
Variable manufacturing overhead 300,000 30.00
Total relevant cost $720,000 $72.00

Beware of Unitized Fixed Costs

 Make or Buy: Qualitative Factors

• Is the prospective vendor capable?

– To supply specified quality of the material needed : Technical
capability of the supplier
– To guarantee timely supply : Financial condition of the supplier

• Are we depending too much on the supplier with strong bargaining

power ?
– Might affect the stability of purchase price

• Is outsourcing a means to focus on core competence ?

– Is it harming the morale of the employees ?
– Is overtime/ hiring of machine not a better alternative ?

• Is there business risk involved ?

– Can the supplier emerge as competitor to capture the market share?
Shut down or Continue: 14‐47 (H12e)
 Shut down or Continue: 14‐47 (H12e)
1. The company will be worse off by $12,800 if it discontinues wallpaper sales.

Paint and
Supplies Carpeting Wallpaper
Sales $380,000 $460,000 $140,000
Less: Variable costs 228,000 322,000 112,000
Contribution margin $152,000 $138,000 $ 28,000

If wallpaper is closed, then:

Loss of wallpaper contribution margin $(28,000)
Remodeling (12,400)
Added profitability from carpet sales* 65,000
Fixed cost savings ($45,000 x 40%) 18,000
Decreased contribution margin from paint and supplies ($152,000 x 20%) (30,400)
Increased advertising (25,000)
Income (loss) from closure $ (12,800)

• The current contribution margin ratio for carpeting is 30% ($138,000 ÷ $460,000).
• This ratio will increase to 35%, producing a new contribution for the line of $203,000 [($460,000 +
$120,000) x 35%].
• The end result is that carpeting’s contribution margin will rise by $65,000 ($203,000 ‐ $138,000),
boosting firm profitability by the same amount.
 14‐447 (H12e) continued
2. This cost should be ignored. The inventory cost is sunk (i.e., a past cost that is not
relevant to the decision). Regardless of whether the department is closed, the company
will have a wallpaper inventory of $23,700.

3. The Internet‐ and magazine‐based firms likely have several advantages:

– These companies probably carry little or no inventory. When a customer places an
order, the firm simply calls its supplier and acquires the goods. The result may be
lower expenditures for storage and warehousing.
– These firms do not need retail space for walk‐in customers.
– Internet‐ and magazine‐based firms can conduct business globally. Contemporary
Trends, on the other hand, is confined to a single store in Des Moines

Shut down or Continue: Qualitative Factors

• Shutting down a segment of a product line might have a severe adverse impact on the
corporate image of the company
• Might dilute brand ‐ Might affect future business
• Shutting down highly visible projects might have an adverse impact on the employee morale
• Can lead to dysfunctional behaviour
• Might continue with unprofitable product if it helps sell other products or attracts customers
Product‐Mix under constraints: 14‐44 (H12e)
 Product‐Mix under constraints: 14‐44 (H12e)
Blender Mixer
Unit cost if purchased from an outside supplier $20 $38
Incremental unit cost if manufactured:
Direct material $ 6 $11
Direct labor 4 9
Variable overhead
$16 – $10 per hour fixed 6
$32 – (2)($10 per hour fixed) 12
Total $16 $32
Unit cost savings if manufactured $ 4 $ 6
Machine hours required per unit 1 2
Cost savings per machine hour if manufactured
$4 ÷ 1 hour $4
$6 ÷ 2 hours $ 3

Therefore, each machine hour devoted to the production of blenders saves the company
more than a machine hour devoted to food processor production.
Machine hours available 50,000
Machine hours needed to manufacture 20,000 blenders 20,000
Remaining machine hours 30,000
Number of mixers to be produced (30,000 ÷ 2 hr) 15,000
Conclusion: Manufacture 20,000 blenders
Manufacture 15,000 Mixers
Purchase 13,000 Mixers (Demand of 28,000 – manufacture 15,000)
 Product‐Mix under constraints: 14‐44 (H12e)
Blender Mixer
Unit cost if purchased from an outside supplier $20 $38
Incremental unit cost if manufactured:
Direct material $ 6 $11
Direct labor 4 9
Variable overhead
$16 – $10 per hour fixed 6
$32 – (2)($10 per hour fixed) 12
Total $16 $32
Unit cost savings if manufactured $ 4 $ 6
Machine hours required per unit 1 2
Cost savings per machine hour if manufactured
$4 ÷ 1 hour $4
$6 ÷ 2 hours $ 3

Therefore, each machine hour devoted to the production of blenders saves the company
more than a machine hour devoted to food processor production.
Machine hours available 50,000
Machine hours needed to manufacture 20,000 blenders 20,000
Remaining machine hours 30,000
Number of mixers to be produced (30,000 ÷ 2 hr) 15,000
Conclusion: Manufacture 20,000 blenders
Manufacture 15,000 Mixers
Purchase 13,000 Mixers (Demand of 28,000 – manufacture 15,000)
 14‐44 (H12 e)continued
2. If the company’s management team is able to reduce the direct material cost per mixer
to $6 ($5 less than previously assumed), then the cost savings from manufacturing a
mixer are are $11 per unit ($6 savings computed in requirement (1) plus $5 reduction in
material cost):
Blender Mixer
New unit cost savings if manufactured $4.00 $11.00
Machine hours required per unit 1 MH 2 MH
Cost savings per machine hour if manufactured
Blender: $4 ÷ 1 hour $4.00
Food Processor: $11.50 ÷ 2 hours $5.50

Therefore, devote all 50,000 hours to the production of 25,000 Mixers.

Conclusion: Manufacture: 25,000 Mixers

Purchase: 3,000 Mixers
Purchase: 20,000 Blenders
 Sunk Allocated
costs. fixed costs.

Pitfalls to Avoid

Unitized Opportunity
fixed costs. costs.
 Case:
Prestige Telephone Company
 Estimating Cost Behaviour
Total mixed cost can be expressed as: Y= a + bX where,
Y= Total Mixed cost (Manufacturing OH), a = Total Fixed cost (intercept),
b = Variable cost per unit (slope of the line ), A cost function: Mathematical
X= level of activity in units (cost driver – units) representation of how a cost
Diagnosing Mixed Costs (Quantitative Methods: Objective) changes with changes in the
1. Scatter graph method (Activity Plot) level of an activity relating to
that cost
• Intercept : TFC, Slope: VC
2. The High‐Low Method Y
Rs 1200
Variable Cost associated with Cost associated with
Cost per = { highest activity level - lowest activity level }
Rs1000
Unit of Activity Highest activity level - Lowest activity level
X
200 units
Total Costs Units
Y = FC + (VC pu * X) • Simple method of quantitative
1400 400 analysis
1300 300 Y = 1000 + 1 * X
1200 200
• Uses only the highest and lowest
1100 100 observed values
Varaible cost p.u. = (1400 - 1100)/ (400-100) = 1
Total variable cost at 400 units = 1 *400 =400 Fixed Costs =
Total Fixed Cost = Total Cost – Total Variable Cost Total Cost from either the highest or lowest
1000 => 1400 - 400 activity level - (VC per unit of activity * Activity
associated with above total cost) 26
1000 => 1100 - 100
 Estimating Cost Behaviour
3. Regression Method (Least Squares )
– a statistical method that measures the average amount of change in the dependent variable
associated with a unit change in one or more independent variables
– Uses all data points, So, More accurate estimate of fixed and variable portion of the mixed costs
– Can be used for estimating costs at a given level of activity.
Simple Regression : One independent variable
Multiple Regression : Two/more independent variables

Evaluating & Choosing Cost Driver (3 criteria)

• Economic plausibility
• Goodness of fit
• Significance of the independent variable

Illustration 1: High‐Low Method: regression analysis. Ruha the financial manager at the Casa Restaurant is checking if there is
any relationship between newspaper Advertising Costs & Sales Revenue at the restaurant. She obtains the following monthly
data for the past 6 months: Month Revenues (Rs.) Advertising Costs (Rs)
July 550,000 10,000
August 650,000 20,000
Use the high‐low method to
September 450,000 15,000
compute the cost function, relating October 800,000 40,000
the advertising costs & revenues November 550,000 25,000
December 600,000 25,000
Advertising Costs Revenues
Highest observation of cost driver Rs 40,000 Rs 8,00,000
Lowest observation of cost driver Rs 10,000 Rs 5,50,000
Difference Rs 30,000 Rs 2,50,000
Revenues = Rs 4,66,670 + (8.333  Advertising costs)
Self‐ Study Problems
14‐51 (H12 e)continued
 14‐51 (H12 e)
RNA‐1 is converted into Fastkil. RNA‐2 can be sold as is or converted into two new
products.

a. Management’s analysis is incorrect because it incorporates allocated portions of the

joint processing costs of VDB. The weekly cost of VDB ($246,000) will be incurred
whether or not RNA‐2 is converted through further processing. Thus, any allocation of
the common cost of VDB is strictly arbitrary and not relevant to the decision to market
DMZ‐3 and Pestrol.
The decision not to process RNA‐2 further is incorrect. This flawed decision
resulted in the company failing to earn an incremental $20,000 in gross profit per
week, as indicated by the following analysis.

b Revenue from further processing of RNA‐2:

DMZ‐3 (400,000  $57.50/100) $230,000
Pestrol (400,000  $57.50/100) 230,000
Total revenue from further processing $460,000
Less revenue from sale of RNA‐2 320,000
Incremental revenue $140,000
Less incremental cost* 120,000
Incremental profit $ 20,000
*The cost of VDB is not relevant and therefore is omitted from the solution.
14‐63 (H12e)
 14‐63 (H12e)

1. Memorandum
Date: Today
To: Alice Carlo, President, Alberta Gauge Company, Ltd.
From: I.M. Student
Subject: Suggested revision of product‐line income statement
a. The product‐line income statement presented is not suitable for analysis and decision
making. The statement does not distinguish between variable and fixed costs, which hinders
any analysis on the impact of volume changes on profit. In addition, the statement does not
distinguish between costs that are directly related (traceable) to a product line from those that
are shared among all products.
b. An alternative income statement format that would be more suitable for analysis and
decision making would incorporate the contribution approach. Expenses would be classified in
terms of variability and controllability such as: variable manufacturing, variable selling and
administrative, direct fixed controllable by segment, direct fixed controllable by others, and
common fixed. The common fixed costs would not be assigned to the product lines because
such an allocation would be arbitrary. The contribution approach is more suitable for analysis
and decision making because there is a meaningful assignment of costs to product lines.

2.a. The suggested discontinuance of the of the R‐gauges would be cost effective, but the
suggestions relating to E‐gauges and Q‐gauges would not be cost effective. These conclusions are
based on the following quarterly analysis.

32
 14‐63 (H12e)
2.a. The suggested discontinuance of the of the R‐gauges would be cost effective, but the suggestions relating to E‐gauges and
Q‐gauges would not be cost effective. These conclusions are based on the following quarterly analysis.
E‐Gauge Q‐Gauge R‐Gauge
Unit selling price $90 $200 $180 2b. Yes, the president was correct in
Unit variable costs
Raw material $17 $31 $50 eliminating the R-gauges. The R-
Direct labor 20 40 60 gauge sales price covers only its
Variable manufacturing
overhead 30 45 60
variable cost and does not contribute
Shipping expenses 4 10 10 anything to manufacturing overhead
Total 71 126 180 or promotion costs. Thus, the R-
Unit contribution margin $19 $ 74 $ 0
gauge has a zero-contribution
Increase (decrease) in units* margin.
E‐gauge: 10,000  50%  (5,000)

Q‐gauge: 8,000  15% 1,200
R‐gauge: 5,000  100%  (5,000)
Increase (decrease) in total
contribution margin $(95,000) $ 88,800 $ 0
Decrease (increase) in fixed costs 80,000† (100,000) 40,000
Increase (decrease) in segment
contribution $(15,000) $(11,200) $40,000
*Unit sales = sales dollars ÷ unit sales price, †$100,000 – $20,000

2 c. Yes, the president was correct in promoting the Q-gauge line rather than the E-gauge line, because the unit
contribution margin and contribution per labor dollar is greater for the Q-gauge line as follows:
E‐Gauge Q‐Gauge
Unit contribution $19.00 $74.00
Contribution per direct‐labor dollar .95 1.85

However, the president’s decisions regarding promotion expense do not seem well conceived. The
decreased promotion on the E-gauge line and the increased promotion on the Q-gauge line do not
produce sufficient contribution to offset the promotional costs.
 14‐63 (H12e)

2 d. No. The proposed course of action does not make effective use of capacity. The 15 percent
increase in production volume on the Q-gauge line will not require all of the capacity that has
been released by discontinuing the R-gauge line or reducing the E-gauge line by 50 percent.

3. Yes. The qualitative factors that management should consider before it decides whether to drop
the R-gauge line include:
 Customer relations. The sale of E-gauges and Q-gauges may be related to the sale of R-
gauges.
 Labor relations. Reducing employment may create labor problems.

34
Thanks 
 Cost Management
Session 8 & 9 : MBA 2022

Budgeting and Standard Costing

Prof. Arpita Ghosh

Learning Goals:
Purpose of Budgeting, Budgeting Process & Administration, Budgetary slack,
Prepare Master Budget & Cash Budget, Interrelationships among the supporting
schedules, Static and Flexible Budgets,
Elements of Cost Control system, Standard costs, Interpretation of Cost Variances
 Purpose and Administration of Budget
Budget: A detailed plan, expressed in quantitative terms, that specifies how resources will
be acquired and used during a specified forthcoming period of time

Budgetary System, Budgetary Control, Types of Budgets

Primary Purposes of Budgeting System
1. Planning
2. Facilitating Communication and Coordination
3. Allocating Resources
4. Controlling Profit and Operations
5. Evaluating Performance and Providing Incentives
Budgetary Process: Flow of budget data
Participative Budgeting
• Preparation of Budget:
Top Management
• Top‐Down (Authoritative) or
• Bottom Up (Participative)
Middle Middle
• Budget Administration: Budget director, Management Management

Budget Committee, Budget Manual

Supervisor Supervisor Supervisor Supervisor
(Budget Committee is responsible for all policy
matters relating to the budget and for coordinating Budgetary Slack: Padding the Budget
the preparation of the budget) • People often perceive that their performance will look better in their superiors’
eyes if they can “beat the budget.”
• Follow‐up and Revision • Underestimating budgeted revenues/overestimating budgeted costs, to 2make
budgeted targets more easily achievable.
 Preparing the Master Budget

Sales or Revenues Budget

Ending
Schedule of
Inventory expected cash
Production
Operating budgets

Budget collections
Work in Process Budget
and Finished
Goods

Ending
Inventory Direct Direct Manufacturing Selling, General &
Budget Materials Cost Labor Overhead costs Administrative, R&D
Direct Materials Budget Budget Budget Budget

COGS Budget

Cash Budget
Financial Budgets

Budgeted Income
Capital Expenditures Budget Budgeted Balance Statement
Sheet
Budgeted Statement of
Cashflows
9‐47 (H‐12e):
Master
Budget
 9‐47 (H‐12e): Master Budget

1. Sales budget
2. Cash receipts budget
3. Production budget
4. Direct‐material budget
5. Cash disbursements budget
6. Summary cash budget
7. Prepare a budgeted schedule of cost
of goods manufactured and sold for
the year 20x1.
8. Prepare Frame‐It’s budgeted income
statement for 20x1. (Ignore income
taxes.)
9. Prepare Frame‐It’s budgeted
statement of retained earnings for
20x1.
10. Prepare Frame‐It’s budgeted
balance sheet as of December 31, 20x1.
 9‐47 (H12e): Sales Budget
1. Sales Budget 20x0
20x1
4th Quarter 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year
S frame unit sales 50,000 55,000 60,000 65,000 70,000 250,000
 S sales price  $10  $10  $10  $10 x $10  $10
Sales revenue :S frame $500,000 $ 550,000 $ 600,000 $ 650,000 $ 700,000 $2,500,000

L frame unit sales 40,000 45,000 50,000 55,000 60,000 210,000

 L sales price  $15  $15  $15  $15  $15  $15

Sales revenue : L frame $600,000 $ 675,000 $ 750,000 $ 825,000 $ 900,000 $3,150,000

Total sales revenue $1,100,000 $1,225,000 $1,350,000 $1,475,000 $1,600,000 $5,650,000
Cash sales* (40% of total sales) $440,000 $490,000 $540,000 $590,000 $640,000 $2,260,000
†
Credit Sales (60% of total sales) $660,000 $735,000 $810,000 $885,000 $960,000 $3,390,000

20x1 80%
2. Cash receipts budget: 20% of previous 80%
quarter's credit sales.
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year
Cash sales $ 490,000 $540,000 $590,000 $640,000 $2,260,000
Cash collections from credit sales made during 588,000 648,000 708,000 768,000 2,712,000
current quarter* *80% of current quarter's credit sales
20% 20%
Cash collections from credit sales made during
previous quarter† 132,000 147,000 162,000 177,000 618,000
Total cash receipts $1,210,000 $1,335,000 $1,460,000 $1,585,000 $5,590,000
A/R end of the year ?
20% =
6 192,000
 9‐47 (H12e) continued: Production budget
FG units to be Produced = Expected Sales + Desired Ending FG Inventory – Expected Beginning FG Inventory

3. Production budget 20x0 20x1

4th Quarter 1st Quarter 2nd Quarter 3rd Quarter 4th Entire
From sales Quarter Year
budget
S frames:
Sales (in units) 50,000 55,000 20% 60,000 65,000 70,000 250,000
20%

Add: Desired ending inventory 11,000 12,000 13,000 14,000 15,000 15,000
Total units needed 61,000 67,000 73,000 79,000 85,000 265,000
Less: Expected beginning inventory 10,000 11,000 12,000 13,000 14,000 11,000
Units of S to be produced 51,000 56,000 61,000 66,000 71,000 254,000

L frames:
Sales (in units) 40,000 45,000 50,000 55,000 60,000 210,000
Add: Desired ending inventory 9,000 10,000 11,000 12,000 13,000 13,000
Total units needed 49,000 55,000 61,000 67,000 73,000 223,000
Less: Expected beginning inventory 8,000 9,000 10,000 11,000 12,000 9,000
Units of L to be produced 41,000 46,000 51,000 56,000 61,000 214,000
Units of S & L to be produced 92,000 102,000 112,000 122,000 132,000 468,000
Production Budget : Provides Basis for ‐ direct materials budget, direct labor budget, and manufacturing overhead budget
 9‐47 (H12e) continued: Production budget
FG units to be Produced = Expected Sales + Desired Ending FG Inventory – Expected Beginning FG Inventory

3. Production budget 20x0 20x1

4th Quarter 1st Quarter 2nd Quarter 3rd Quarter 4th Entire
From sales Quarter Year
budget
S frames:
Sales (in units) 50,000 55,000 20% 60,000 65,000 70,000 250,000
20%

Add: Desired ending inventory 11,000 12,000 13,000 14,000 15,000 15,000
Total units needed 61,000 67,000 73,000 79,000 85,000 265,000
Less: Expected beginning inventory 10,000 11,000 12,000 13,000 14,000 11,000
Units of S to be produced 51,000 56,000 61,000 66,000 71,000 254,000

L frames:
Sales (in units) 40,000 45,000 50,000 55,000 60,000 210,000
Add: Desired ending inventory 9,000 10,000 11,000 12,000 13,000 13,000
Total units needed 49,000 55,000 61,000 67,000 73,000 223,000
Less: Expected beginning inventory 8,000 9,000 10,000 11,000 12,000 9,000
Units of L to be produced 41,000 46,000 51,000 56,000 61,000 214,000
Units of S & L to be produced 92,000 102,000 112,000 122,000 132,000 468,000
Production Budget : Provides Basis for ‐ direct materials budget, direct labor budget, and manufacturing overhead budget
 9‐47 (H12e) continued: Direct‐material budget
20x0 20x1

4. Direct‐material budget 4th 1st 2nd 3rd 4th Entire Year

From Quarter Quarter Quarter Quarter Quarter
Metal strips: Production
S frames to be produced budget 51,000 56,000 61,000 66,000 71,000 254,000
 Metal quantity per unit (ft.)  2  2  2  2  2  2
Needed for S frame production 102,000 112,000 122,000 132,000 142,000 508,000
L frames to be produced 41,000 46,000 51,000 56,000 61,000 214,000
 Metal quantity per unit (ft.)  3  3  3  3  3  3
Needed for L frame production 123,000 138,000 153,000 168,000 183,000 642,000
Total metal needed for production; to be purchased (ft.) 225,000 250,000 275,000 300,000 325,000 1,150,000
 Price per foot  $1  $1  $1  $1  $1  $1
Cost of metal strips to be purchased: $225,000 $250,000 $275,000 $300,000 $325,000 $1,150,000

Glass sheets: From

S frames to be produced Production 51,000 56,000 61,000 66,000 71,000 254,000
 Glass quantity per unit (sheets) budget  .25  .25  .25  .25  .25  .25
Needed for S frame production 12,750 14,000 15,250 16,500 17,750 63,500
L frames to be produced 20% of GS needed 41,000 46,000 51,000 56,000 61,000 214,000
 Glass quantity per unit (sheets)  .5  .5  .5  .5  .5  .5
for next qtr prod
Needed for L frame production 20,500 23,000 25,500 28,000 30,500 107,000
Total glass needed for production (sheets) 33,250 20% 37,000 40,750 44,500 48,250 170,500
Add: Desired ending inventory 20% of 33,250 = 6,650 7,400 8,150 8,900 9,650 10,400 10,400
Total glass needs 40,650 45,150 49,650 54,150 58,650 180,900
Less: Expected beginning inventory 6,650 7,400 8,150 8,900 9,650 7,400
Glass Sheets to be purchased 34,000 37,750 41,500 45,250 49,000 173,500
 Price per glass sheet  $8  $8  $8  $8  $8  $8
Cost of glass to be purchased $272,000 $302,000 $332,000 $362,000 $392,000 $1,388,000
Total raw‐material purchases (metal and glass) $497,000 $552,000 $607,000 $662,000 $717,000 $2,538,000
9
RM units to be Purchased = RM Needed for production + Desired RM Ending Inventory – Expected Beginning RM Inventory
 9‐47 (H12e) : Direct‐material budget
20x0 20x1

4. Direct‐material budget 4th 1st 2nd 3rd 4th Entire Year

From Quarter Quarter Quarter Quarter Quarter
Metal strips: Production
S frames to be produced budget 51,000 56,000 61,000 66,000 71,000 254,000
 Metal quantity per unit (ft.)  2  2  2  2  2  2
Needed for S frame production 102,000 112,000 122,000 132,000 142,000 508,000
L frames to be produced 41,000 46,000 51,000 56,000 61,000 214,000
 Metal quantity per unit (ft.)  3  3  3  3  3  3
Needed for L frame production 123,000 138,000 153,000 168,000 183,000 642,000
Total metal needed for production; to be purchased (ft.) 225,000 250,000 275,000 300,000 325,000 1,150,000
 Price per foot  $1  $1  $1  $1  $1  $1
Cost of metal strips to be purchased: $225,000 $250,000 $275,000 $300,000 $325,000 $1,150,000
for 1st qtr , 2002 S L
Glass sheets: From Sales in units 75,000 65,000
Add: Desired ending
S frames to be produced Production 51,000 56,000 61,000
inventory 66,000
16,000 71,000
14,000 254,000
 Glass quantity per unit (sheets) budget  .25  .25  .25  .25
Total units needed 91,000  79,000
.25  .25
Less: Beginning
Needed for S frame production 12,750 14,000 15,250
inventory
16,500
15,000
17,750
13,000
63,500
L frames to be produced 20% of GS needed 41,000 46,000 51,000 in units
Production 56,000
76,000 61,000
66,000 214,000
 Glass quantity per unit (sheets)  .5  .5  .5 per
Materials(GS)  unit .5  0.25 .50.5  .5
for next qtr prod Total units needed (GS) 19,000 33,000
Needed for L frame production 20,500 23,000 25,500 28,000 30,500 107,000
Desired Inventory 20% of 52,000
Total glass needed for production (sheets) 33,250 20% 37,000 for40,750 44,500
4th qtr of 2001 48,250 170,500
Add: Desired ending inventory 20% of 33,250 = 6,650 7,400 8,150 8,900 9,650 10,400 10,400
Total glass needs 40,650 45,150 49,650 54,150 58,650 180,900
Less: Expected beginning inventory 6,650 7,400 8,150 8,900 9,650 7,400
Glass Sheets to be purchased 34,000 37,750 41,500 45,250 49,000 173,500
 Price per glass sheet  $8  $8  $8  $8  $8  $8
Cost of glass to be purchased $272,000 $302,000 $332,000 $362,000 $392,000 $1,388,000 COGS
Total raw‐material purchases (metal and glass) $497,000 $552,000 $607,000 $662,000 $717,000 $2,538,000 Budget

10
RM units to be Purchased = RM Needed for production + Desired RM Ending Inventory – Expected Beginning RM Inventory
 9‐47 (H12e) continued: Cash disbursements budget
From Direct Materials Budget
Total raw‐material purchases (metal and glass) $497,000 $552,000 $607,000 $662,000 $717,000 $2,538,000

5. Cash disbursements budget: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year
20x1 A/P
end of
Raw‐material purchases: 552,000 *80% =441,6000 the
year ?
†
Cash payments for purchases during the current quarter $441,600 20% $485,600 $529,600 $573,600 $2,030,400 20% =
143,200
Cash payments for purchases during the preceding quarter** 99,400 110,400 121,400 132,400 463,600
Total cash payments for raw‐material purchases $541,000 $ 596,000 $ 651,000 $ 706,000 $2,494,000

Direct labor: 497,000 *20% =99400

Frames produced (S and L) (from Production budget – slide 8) 102,000 112,000 122,000 132,000 468,000
 Direct‐labor hours per frame  .1  .1  .1  .1  .1
Direct‐labor hours to be used 10,200 11,200 12,200 13,200 46,800
 Rate per direct‐labor hour  $20  $20  $20  $20  $20
Total cash payments for direct labor $204,000 $ 224,000 $ 244,000 $ 264,000 $ 936,000 COGS
Budget
Production overhead:
Indirect material $10,200 $ 11,200 $ 12,200 $ 13,200 $ 46,800
Indirect labor 40,800 44,800 48,800 52,800 187,200
Other 31,000 36,000 41,000 46,000 154,000
Total cash payments for manufacturing overhead $82,000 $ 92,000 $102,000 $112,000 $388,000
Cash payments for selling and administrative expenses $100,000 $100,000 $100,000 $100,000 $400,000

Total cash disbursements $927,000 $1,012,000 $1,097,000 $1,182,000 $4,218,000

† 80% of current quarter’s purchases, **20% of previous quarter’s purchases

DL Cost = Units to be produced × DL hours per unit × Rate per DL hour

 Cash Budget
Purpose: Forecasting cash positions to provide information on probable cash needs
during the budget period

– Alerts the management about fluctuations in cash flows and cash needs well
in advance

Format of the Cash Budget ‐ The cash budget is divided into four sections:
1. Cash receipts listing all cash inflows excluding borrowing;
2. Cash disbursements listing all payments excluding repayments of principal and
interest;
3. Cash excess or deficiency
= Beg Cash Balance + Cash Receipts ‐ Disbursements
1. Excess: Use to repay previous borrowing or to make new investments
2. Deficiency : Management must arrange to borrow additional funds
4. The financing section listing all borrowings, repayments and interest.
 9‐47 (H12e) continued: Cash Budget
Cash Receipts Budget
Cash Disbursement Budget

6. Cash budget 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year
20x1
Cash balance, beginning of period 95,000 53,000 57,250 107,750 95,000

Add: Cash receipts [from req. (2)] (Slide 6) $1,210,000 $1,335,000 $1,460,000 $1,585,000 $5,590,000

Less: Cash disbursements [from req. (5)] (slide 11) 927,000 1,012,000 1,097,000 1,182,000 4,218,000
Change in cash balance due to operations $ 283,000 $ 323,000 $ 363,000 $ 403,000 $1,372,000

Purchase of equipment ‐1,000,000 ‐1,000,000

Excess (deficiency) of cash available over disbursements ‐622,000 376,000 420,250 510,750 467,000

Financing:
Payment of dividends ‐50,000 ‐50,000 ‐50,000 ‐50,000 ‐200,000
Borrowings [Proceeds from bank loan (Jan, x0) ] 1,000,000 1,000,000
Quarterly installment on loan principal ‐250,000 ‐250,000 ‐250,000 ‐250,000 ‐1,000,000
Quarterly interest payment* ‐25,000 ‐18,750 ‐12,500 ‐6,250 ‐62,500
Total Financing $ 675,000 ‐318,750 ‐312,500 ‐ 306,250 ‐ 262,500
Cash balance, end of period $ 53,000 $ 57,250 $ 107,750 $ 204,500 $ 204,500

*$1,000,000 * 10% * ¼ = $25,000, $750,000 *10% * ¼ = $18,750, $500,000 *10% * ¼ = $12,500, $250,000 *10%* ¼ = $6,250
 9‐47 (H12e) continued: Cash Budget
Cash Receipts Budget
Cash Disbursement Budget

6. Cash budget 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year
20x1
Cash balance, beginning of period 95,000 53,000 57,250 107,750 95,000

Add: Cash receipts [from req. (2)] (Slide 6) $1,210,000 $1,335,000 $1,460,000 $1,585,000 $5,590,000

Less: Cash disbursements [from req. (5)] (slide 11) 927,000 1,012,000 1,097,000 1,182,000 4,218,000
Change in cash balance due to operations $ 283,000 $ 323,000 $ 363,000 $ 403,000 $1,372,000

Purchase of equipment ‐1,000,000 ‐1,000,000

Excess (deficiency) of cash available over disbursements ‐622,000 376,000 420,250 510,750 467,000

Financing:
Payment of dividends ‐50,000 ‐50,000 ‐50,000 ‐50,000 ‐200,000
Borrowings [Proceeds from bank loan (Jan, x0) ] 1,000,000 1,000,000
Quarterly installment on loan principal ‐250,000 ‐250,000 ‐250,000 ‐250,000 ‐1,000,000
Quarterly interest payment* ‐25,000 ‐18,750 ‐12,500 ‐6,250 ‐62,500
Total Financing $ 675,000 ‐318,750 ‐312,500 ‐ 306,250 ‐ 262,500
Cash balance, end of period $ 53,000 $ 57,250 $ 107,750 $ 204,500 $ 204,500

*$1,000,000 * 10% * ¼ = $25,000, $750,000 *10% * ¼ = $18,750, $500,000 *10% * ¼ = $12,500, $250,000 *10%* ¼ = $6,250
 7. Budgeted Schedule of Cost of Goods Manufactured and Sold for the Year Ended December 31, 20x1
Direct material: (slide 9)
Raw‐material inventory, 1/1/x0 (given in the Opening Balance Sheet) $ 59,200
Add: Purchases of raw material [req. (4)] (Direct Materials Budget ‐ slide 10) 2,538,000
FRAME‐IT Company

Raw material available for use $2,597,200

Deduct: Raw‐material inventory, 12/31/x1 ([req. (4)] 10,400 * $8) (Glass sheets) 83,200
Raw material used $2,514,000
Direct labor [req. (5) slide 11] 936,000
Manufacturing overhead: (given in bullet 8)
Indirect material $46,800
Indirect labor 187,200
Other overhead 154,000
Depreciation 80,000
Total manufacturing overhead 468,000 *
Cost of goods manufactured ( since no WIP Inventory) Unit cost ($ ) S L $3,918,000†
Add: Finished‐goods inventory, 1/1/x0 (given) Material 4 7
167,000
Cost of goods available for sale $4,085,000
D. labour 2 2
Deduct: Finished‐goods inventory, 12/31/x1 (Slide 8) 235,000 **
Cost of goods sold MOH 1 1 3,850,000 †† Budgeted
IS

7 10 S Frames L Frames Grand total

9‐47 (H12e) continued †The cost of goods manufactured may be verified as follows:
*In the budget, budgeted and applied manufacturing Frames produced (from Production budget S‐8) 254,000 214,000
overhead are equal. The applied manufacturing Manufacturing cost per unit (given)  $7  $10
overhead may be verified independently as follows: Total manufacturing cost $1,778,000 $2,140,000 $3,918,000
**The finished‐goods inventory on 12/31/x1 may be verified as follows:
Total number of frames produced 468,000 Projected inventory on 12/31/x1 (From P. Bud S8) 15,000 13,000
 Direct‐labor hours per frame  .1 Manufacturing cost per unit  $7  $10
Total direct‐labor hours 46,800 Cost of ending inventory 105,000 130,000 $235,000
††The cost of goods sold may be verified independently as follows:
 Predetermined overhead rate per hour  $10
Frames sold (from Sales budget – slide 6) 250,000 210,000
Total manufacturing overhead applied $468,000 Manufacturing cost per unit  $7  $10
Cost of goods sold 15
$1,750,000 $2,100,000 $3,850,000
 8. Budgeted Income Statement for the Year Ended December 31, 20x1
Sales revenue (from sales budget – slide 6) $5,650,000
Less: Cost of goods sold 3,850,000
Gross margin $1,800,000
Selling and administrative expenses (100,000*4 qtrs) $400,000
FRAME‐IT Company

Interest expense (Financing section of cash budget – Slide 14) 62,500 462,500
Net income $1,337,500

9. Budgeted Statement of Retained Earnings for the Year Ended December 31, 20x1
Retained earnings, 12/31/x0 (Given) $3,353,800
Add: Net income (from IS) 1,337,500
Deduct: Dividends (50,000*4) 200,000
Retained earnings, 12/31/x1 $4,491,300

10. Budgeted Balance Sheet December 31, 20X1

Cash (from Cash budget – slide 14) $ 204,500
9‐47 (H12e) continued

Accounts receivable* (slide 6: Sales Budget) 192,000

Inventory:
†
Raw material (from COGS budget – slide 16) 83,200
Finished goods (from COGS budget – slide 16) 235,000
Plant and equipment (net of accumulated depreciation)** 8,920,000
Total assets $9,634,700
††
Accounts payable ( Materials Budget‐ slide 10‐11) $ 143,400
Common stock (given, no change) 5,000,000
Retained earnings 4,491,300
Total liabilities and stockholders' equity $9,634,700
†
*Fourth‐quarter credit sales *20% = $960,000 *20%, 10,400 units *$8, **$8,000,000 + $1,000,000 – $80,000 16
††
Fourth‐quarter purchases on account *20% = $717,000 (from DM budget)* 20%
 Session – 9
Static and Flexible Budgets
 Static Budget based Variance Analysis
Variance: Difference between standard and actual performance : F (U): If Favourable (Unfavourable) effect on Profit

Actual activity is below budgeted activity.

So, shouldn’t variable costs be lower if actual activity is lower?

Static Actual Static Budget

Budget Results Variances
Machine hours 10,000 8,000

Variable costs
Indirect labor $ 40,000 $ 34,000 $6,000 F

Indirect materials 30,000 25,500 4,500 F

Power 5,000 3,800 1,200 F

Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs $ 89,000 $ 77,350 $11,650 F

If the budget was static : Comparison – apples & oranges

 Static and Flexible Budgets

• Static (Fixed) Budget: What’s wrong ?

– Based on single planned level of activity
– Unrealistic for other levels of activity, if variable costs are significant
• Difficult to use when activity level in reality is different from planned level,
particularly for performance evaluation
– Variance : Actual & Budgeted Costs – Level of Activity, Effective use of resources

• Flexible Budget
– Recognizes differences in behaviour of Fixed and Variable Costs
– Are prepared at different levels of activity within relevant range (say 80% of
Target Sales/ Production)
– Variance reporting more meaningful : Actual results are compared with the level
which turn out to be the activity level in reality
 Preparing Flexible Budget and FB based Variance Analysis
Flexible budget is prepared for the
Total Budgeted OH costs same activity level (8,000 hours) as
= (Budgeted VC per activity unit× Total Activity Units) + Budgeted Fixed Costs actually achieved

Cost Total Flexible

Static Formula Fixed Flexible Actual Budget
Budget per Hour Cost Budget Results Variances

Machine hours 10,000 8,000 8,000 0

Variable costs are expressed as a
constant amount per hour.
Variable costs
Indirect labor $ 40,000 $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 30,000 3.00 24,000 25,500 1,500 U
Power 5,000 0.50 4,000 3,800 200 F
Total variable cost 75,000 $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed costs are expressed as a total
amount that does not change within
Fixed costs the relevant range of activity.

Depreciation 12,000 $ 12,000 $ 12,000 $ 12,000 $ 0

Insurance 2,000 2,000 2,000 2,050 50 U
There is no flex
Total fixed cost 14,000 in the fixed costs 14,000 $ 14,000 $ 14,050 50 U

Total overhead costs $ 89,000 $ 74,000 $ 77,350 $ 3,350 U

$11,650 F
 Preparing Flexible Budget and FB based Variance Analysis
Flexible budget is prepared for the
Total Budgeted OH costs same activity level (8,000 hours) as
= (Budgeted VC per activity unit× Total Activity Units) + Budgeted Fixed Costs actually achieved

Cost Total Flexible

Static Formula Fixed Flexible Actual Budget
Budget per Hour Cost Budget Results Variances

Machine hours 10,000 8,000 8,000 0

Variable costs are expressed as a
constant amount per hour.
Variable costs
Indirect labor $ 40,000 $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 30,000 3.00 24,000 25,500 1,500 U
Power 5,000 0.50 4,000 3,800 200 F
Total variable cost 75,000 $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed costs are expressed as a total
amount that does not change within
Fixed costs the relevant range of activity.

Depreciation 12,000 $ 12,000 $ 12,000 $ 12,000 $ 0

Insurance 2,000 2,000 2,000 2,050 50 U
There is no flex
Total fixed cost 14,000 in the fixed costs 14,000 $ 14,000 $ 14,050 50 U

Total overhead costs $ 89,000 $ 74,000 $ 77,350 $ 3,350 U

$11,650 F
 Flexible Budget Performance Report

Overhead Variance Analysis of $11,650 F

Static Flexible Actual
Overhead Overhead Overhead
Budget at Budget at at

10,000 Hours 8,000 Hours 8,000 Hours

$ 89,000 $ 74,000 $ 77,350

Activity Cost control

This $15,000F variance is due to This $3,350U

lower activity. variance is due
to poor cost control.

Total static‐budget variance Total flexible‐budget variance Total sales‐volume variance

11,650 (F) = 3,350 (UF) + 15,000 (F)
11‐43 (H‐12 e)
 LawnMate Company
1.Flexible Budget For the Month of May 11‐43 (H‐12e)
Revenue [4,800 × ($1,200,000/5,000 = 240)] $1,152,000
Deduct: Variable costs:
Direct material (4,800 × $60) $ 288,000
Direct labor (4,800 × $44) 211,200
Variable overhead (4,800 × $36) 172,800
Variable selling (4,800 × $12) 57,600
Total variable costs 729,600
Contribution margin $ 422,400
Deduct: Fixed costs:
Fixed overhead $ 180,000
Fixed general and administrative 120,000 300,000
Operating income $ 122,400
2. For the month of May, the company's Flexible Budget Flexible‐Budget
flexible‐budget variances are as follows Actual (given) (from1. above) Variance
Units 4,800 4,800 0
Revenue $1,152,000 $1,152,000 $ 0
Variable costs:
Direct material $ 320,000 $ 288,000 $32,000 U
Direct labor 192,000 211,200 19,200 F
Variable overhead 176,000 172,800 3,200 U
Variable selling 92,000 57,600 34,400 U
Deduct: Total variable costs $ 780,000 $ 729,600 $50,400 U
Contribution margin $ 372,000 $ 422,400 $50,400 U
Fixed costs:
Fixed overhead 180,000 $ 180,000 $0
Fixed general and administrative 115,000 120,000 5,000 F
Deduct: Total fixed costs $ 295,000 $ 300,000 $ 5,000 F
Operating income $ 77,000 $ 122,400 $ 45,400 F
 LawnMate Company
1.Flexible Budget For the Month of May 11‐43 (H‐12e)
Revenue [4,800 × ($1,200,000/5,000 = 240)] $1,152,000
Deduct: Variable costs:
Direct material (4,800 × $60) $ 288,000
Direct labor (4,800 × $44) 211,200
Variable overhead (4,800 × $36) 172,800
57,600 Actuals:
Variable selling (4,800 × $12)
• DM cost per unit =
Total variable costs 729,600
320,000/4800= 66.67
Contribution margin $ 422,400 • DL cost per unit =
Deduct: Fixed costs: 192,000/4800 =40
Fixed overhead $ 180,000 • VOH pu = 176/4.8 = 36.67
Fixed general and administrative 120,000 300,000 • VS pu= 92/4.8=19.16
Operating income $ 122,400 • Fixed Gen, Admn = 115,000
2. For the month of May, the company's Flexible Budget Flexible‐Budget
flexible‐budget variances are as follows Actual (given) (from1. above) Variance
Units 4,800 4,800 0
Revenue $1,152,000 $1,152,000 $ 0
Variable costs:
Direct material $ 320,000 $ 288,000 $32,000 U
Direct labor 192,000 211,200 19,200 F
Variable overhead 176,000 172,800 3,200 U
Variable selling 92,000 57,600 34,400 U
Deduct: Total variable costs $ 780,000 $ 729,600 $50,400 U
Contribution margin $ 372,000 $ 422,400 $50,400 U
Fixed costs:
Fixed overhead 180,000 $ 180,000 $0
Fixed general and administrative 115,000 120,000 5,000 F
Deduct: Total fixed costs $ 295,000 $ 300,000 $ 5,000 F
Operating income $ 77,000 $ 122,400 $ 45,400 U
 11‐43 (H‐12e) continued

The revised budget and variance data are likely to have the following impact :
– Richmond is likely to be encouraged by the revised data, since the major portion of
the variable‐cost variance (direct material and variable selling expense) is the
responsibility of others.
– The detailed report of variable costs shows that the direct‐labor variance is
favorable. Richmond should be motivated by this report because it indicates that the
cost‐cutting measures that he implemented have been effective.
– The report shows unfavorable variances for direct material and variable selling
expense. Richmond may be encouraged to work with those responsible (Purchase
and Sales Managers) for these areas to control costs.

4. If Actual Revenue = $1752,000 ? What would be the Flexible Budget Revenue Variance ? Reason ?

Flexible Budget Revenue Variance = 1752,000 (Actual Revenues) –1728,000 (Flex Budget Revenues) = $24,000

4800 units are actually sold at $365 per unit (1752K/4.8K) compared to Standard Selling Price of $360 (1728K/4.8K)
considered in the budget
 STANDARD COSTING
AND VARIANCE ANALYSIS
 Cost Control System, Standard Costs & Standard Costing
Elements of Cost Control System
1. A Benchmark or standard (Standard Costs)
2. A Measure of Actual performance (Actual Costs)
3. A comparison between Standard and Actual Performance (Variance)

Standard : Benchmark for measuring performance

o Quantity : How much of an input should be used to make a product (Task analysis, past data)
o Price : How much should be paid for each unit of the input (economic forecasts)
Set by combined efforts, Standards should be challenging yet attainable (practical & stretch)

Standard Cost:
– A standard cost for each product cost category (materials, labor, and overhead) is usually
calculated on a per‐unit basis, set once in a year Standard
– Carefully predetermined estimate, often used in preparing budgets Cost component SQ
DM ‐ Cloth
SP
2 M Rs 500/ M
Cost (Rs)
1,000
– Budgeted costs are on total basis D Labour 5 Hours Rs 100/ Hr 500
VOH 5 hours Rs 10 /Hr 50
FOH 5 hours Rs 20 /Hr 100
SC of making one Shirt : Rs 1,650
Standard Costing :
A control technique which compares standard costs with actual results to obtain variances which are
used to stimulate corrective action or revision of standard

If Cost Variance = (Actual Costs – Standard Costs) = Positive  Unfavourable  If Actual costs > Standard 30
costs
 Variance Analysis – A general model
Actual Costs Standard Costs
Actual Quantity Actual Quantity Standard Quantity
× × ×
Actual Price Standard Price Standard Price

Price Variance + Quantity or Volume Variance

[ (AQ × AP) – (AQ × SP) ] + [ (AQ × SP) – (SQ × SP) ]
= AQ (AP – SP) = SP (AQ ‐ SQ)
AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity (allowed for actual output)

Sub‐variances : Variable Manufacturing Costs

Variable
Standard Cost Variances Materials cost Labour cost
Overhead
variance variance
variance

Material VOH
Labour rate
Price Variance Quantity Variance Price Spending
variance
variance variance
The difference between The difference between
the actual price and the the actual quantity & Material Labour VOH
standard price. the standard quantity Usage Efficiency Efficiency
variance variance variance
 Variance Analysis – A general model
Actual Costs Standard Costs
Actual Quantity Actual Quantity Standard Quantity
× × ×
Actual Price Standard Price Standard Price

Price Variance + Quantity or Volume Variance

[ (AQ × AP) – (AQ × SP) ] + [ (AQ × SP) – (SQ × SP) ]
= AQ (AP – SP) = SP (AQ ‐ SQ)
AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity (allowed for actual output)

Sub‐variances : Variable Manufacturing Costs

Variable
Standard Cost Variances Materials cost Labour cost
Overhead
variance variance
variance

Material VOH
Labour rate
Price Variance Quantity Variance Price Spending
variance
variance variance
The difference between The difference between
the actual price and the the actual quantity & Material Labour VOH
standard price. the standard quantity Usage Efficiency Efficiency
variance variance variance
 Material Variances, Interpretation & Responsibility
Information: 30,000 lbs. of direct material was purchased.
It was used to make 1450 units of Output (cases of food). Actual Material Cost was $66000.
Standards : 20 lbs. of input per unit of output at $2 per pound

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price
30,000 lbs. $66000 30,000 lbs. 29,000 lbs.
30000 lbs. 20 lbs. per unit of
= $2.2 per lb. output  1450
× × × = 29,000 lbs.

$2.2 per pound $2.00 per pound $ 2.00 per pound

= $66,000 = $60,000 = $58,000

Materials Price variance (MPV) Materials Quantity variance (MQV)

$6,000 unfavorable $2,000 unfavorable Poorly trained/
Responsibility for variances motivated/supervised
MPV = AQ (AP ‐ SP) MQV = SP (AQ ‐ SQ)
workers;
= 30,00 lbs. ($2.20/lb. ‐ $2.00/lb.) Bulk Discounts, = $2.00/lb (30,000 lbs. – 29,000 lbs.)
Different Quality
= 30,000 lbs. ($0.20/lb.) = $2.00/kg (1000 lbs.)
= $6,000 UF Responsibility ? Purchase manager = $2,000 UF Responsibility ? Production manager
Controllability and Interactions of Variances
Poor scheduling by production manager might require rush orders causing UF price variance
Low quality material procured by purchase manager might lead to more use of material  UF quantity variance
 Labor Variances, Interpretation & Responsibility
Information: Employees actually worked for 8,000 direct labour hours at a total labour
cost of $151, 200 to make 1,450 units of Output (cases of food).
Standards : 5 hours per unit of Output at $18.00 per hour.
Actual Hours Actual Hours Standard Hours
× × ×
Actual Rate Standard Rate Standard Rate
8,000 hours 8,000 hours 7,250 hours
5 hrs per unit of
output  1,450
× $151,200  8,000 × × units
hrs = $18.90 per hr
= 7,250 hrs
$18.90 per hour $18.00 per hour $18.00 per hour
= $151,200 = $144,000 = $130,500

Labour Efficiency variance (LEV) Responsibility for variances

Labour Rate variance (LRV)
$7,200 unfavorable $13,500 unfavorable Responsibility ? ‐ Production manager
LEV = SR (AH ‐ SH)
LRV = AH (AR ‐ SR)
= $18.00 per hour (8000 hours – 7,250 hours)
= 8,000 hours ($18.90 per hour – $18.00 per hour)
= $18.00 per hour (750 hours)
= 8,000 hours ($0.90 per hour)
= $13,500 unfavorable
= $7,200 unfavorable
• Hiring & use of Under‐skilled labour
Labour with more than expected skills set • Poorly motivated workforce, Lack of proper training, poor supervision
• Inefficient scheduling of work
Controllability and Interactions of Variances • Might be due to poor maintenance of machines by maintenance department
• Might be caused by poor quality, cheap RM purchased by purchase manager
 10‐37 (H‐12 e)

AQ (AP – SP)

SP (AQ ‐ SQ)
 10‐37 (H‐12e) : Responsibility for Variances (Material and Labour)
1. No. The variances are favorable and small, with each being less than 2% of budgeted cost
amounts ($350,000). However, by simply reporting total variances for material and labor, one
cannot get a totally clear picture of performance.
Material Price & quantity variance, Labour rate and efficiency variances should be calculated for further insight

Direct‐material variances: AQ (AP – SP)

Price variance:
Actual quantity purchased x actual price
45,000 pounds x $7.70 $346,500
Actual quantity purchased x standard price
45,000 pounds x $8.80 396,000
Direct‐material price variance (MPV) $ 49,500 Favorable

Quantity variance: SP (AQ ‐ SQ)

Actual quantity used x standard price
45,000 pounds x $8.80 $396,000
Standard quantity allowed x standard price
39,900 pounds* x $8.80 351,120
Direct‐material quantity variance (MQV) $ 44,880 Unfavorable

*9,500 units x 4.2 pounds=39,900 pounds

Total direct‐material variance: $49,500F + $44,880U = $4,620F

 10‐37 (H‐12 e)

AH (AR – SR)
SR (AH ‐ SH)
 10‐37 (H‐12e) continued
Direct‐labor variances AH (AR – SR)
Rate variance:
Actual hours used x actual rate
20,900 hours x $16.25 $339,625
Actual hours used x standard rate
20,900 hours x $14.00 292,600
Direct‐labor rate variance (LRV) $ 47,025 Unfavorable

Efficiency variance: SR (AH ‐ SH)

Actual hours used x standard rate
20,900 hours x $14.00 $292,600
Standard hours allowed x standard rate
24,700 hours* x $14.00 345,800
Direct‐labor efficiency variance (LEF) $ 53,200 Favorable
*9,500 units x 2.6 hours per unit = 24,700 hours
Total direct‐labor variance: $47,025U + $53,200F = $6,175F

3. Yes. Although the combined variances are small, a more detailed analysis reveals the
presence of sizable, offsetting variances (all in excess of 12% of budgeted cost amounts).
A variance investigation should be undertaken if the likely benefits of the investigation
appear to exceed the costs.
 10‐37 (H‐12e) continued
4. No, things are not going as smoothly as the vice president believes.
 With regard to the new supplier, Santa Rosa is paying less than expected for direct
materials (Favourable Price Variance). However, the quality may be poor, as
indicated by the unfavorable quantity variance and increased usage.
 Turning to direct labor, the favorable efficiency variance means that the company is
producing units by consuming fewer hours than expected. This may be the result of
the team‐building/morale‐boosting exercises, as a contented, well‐trained work
force tends to be more efficient.
 However, another plausible explanation could be that Santa Rosa is paying
premium wages (as indicated by the unfavorable rate variance) to hire laborers
with above‐average skill levels.
 As a side note, the favorable direct‐labor efficiency variance may partially
explain the unfavorable material quantity variance. That is, laborers may be
rushing through their jobs and using more material than the standards allow.

5. Yes. Schmidt is the production supervisor. The prices paid for materials and the quality
of material acquired are normally the responsibility of the purchasing manager.
• The change to the new supplier may introduce problems of dealing with the unknown—
the supplier’s reliability, ability to deliver quality goods, etc.
• Finally, direct‐labor wage rates are often a function of market conditions, which would
likely be uncontrollable from Schmidt’s perspective.
 Management by Exception ‐ A Statistical Control Chart
Exceptions or Deviations worth investigating :
• Significantly large in size (in absolute terms, or say 25% of standard costs)
• Recurring Variances (outdated standard ?), Trends
• Following up on significant variances is called management by exception

Warning signals for investigation

Favorable

Statistical Control
Chart
• •
•

+1 SD
• •
Desired Value

0 • •

‐ 1 SD
Costs vs Benefits of Investigation •
Unfavorable

•
1 2 3 4 5 6 7 8 9
Variance Measurements week
What about Favourable variances, Non‐controllables ?
9‐33 (H‐12e)
 9‐33 (H‐12e) : Easy Problem
1. Schedule of cash collections:
January February March
Collection of accounts receivable:
$55,000 x 20% $ 11,000
Collection of January sales ($150,000):
60% in January; 35% in February 90,000 $ 52,500
Collection of February sales ($180,000):
60% in February; 35% in March 108,000 $ 63,000
Collection of March sales ($185,000):
60% in March; 35% in April 111,000
Sale of equipment 5,000
Total cash collections $101,000 $160,500 $179,000

2. Schedule of cash disbursements

January February March

Payment of accounts payable $ 22,000

Payment of January purchases ($90,000):
70% in January; 30% in February 63,000 $ 27,000
Payment of February purchases ($100,000):
70% in February; 30% in March 70,000 $ 30,000
Payment of March purchases ($140,000):
70% in March; 30% in April 98,000
Cash operating costs 31,000 24,000 45,000
Total cash disbursements $116,000 $121,000 $173,000
 9‐33 (H‐12e) continued

3. Schedule of cash needs

January February March

Beginning cash balance (Given) $ 20,000 $ 20,000 $ 44,300

Total receipts (Schedule of cash collections) 101,000 160,500 179,000

Subtotal $121,000 $180,500 $223,300

Less: Total disbursements (Schedule of cash disbursements) 116,000 121,000 173,000

Cash excess (deficiency) before financing $ 5,000 $ 59,500 $ 50,300

Financing:

Borrowing to maintain $20,000 balance 15,000

Loan principal repaid (15,000)

Loan interest paid (200)*

Ending cash balance $ 20,000 $ 44,300 $ 50,300

* $15,000 x 8% x 2/12
 9‐33 (H‐12e) continued

3. Schedule of cash needs

January February March

Beginning cash balance (Given) $ 20,000 $ 20,000 $ 44,300

Total receipts (Schedule of cash collections) 101,000 160,500 179,000

Subtotal $121,000 $180,500 $223,300

Less: Total disbursements (Schedule of cash disbursements) 116,000 121,000 173,000

Cash excess (deficiency) before financing $ 5,000 $ 59,500 $ 50,300

Financing:

Borrowing to maintain $20,000 balance 15,000

Loan principal repaid (15,000)

Loan interest paid (200)*

Ending cash balance $ 20,000 $ 44,300 $ 50,300

* $15,000 x 8% x 2/12
Thanks
 Cost Management
MBA 2022
Session 10
Responsibility Accounting
Prof. Arpita Ghosh

Learning Goals:
• Understand the role of responsibility accounting in fostering goal congruence
• Understand Responsibility Centers : Cost center, Revenue center, Profit center,
Investment center
• Prepare Segmented Income Statement
 Decentralization

Decision‐making authority is delegated to lower level managers

 Spread throughout the organization
Advantages
• Top Management is free to concentrate Disadvantages or Challenges
on strategy
• Lower level managers might take
• Lower level managers ‐ more detailed decisions without full understanding
information about local conditions
of the ‘big picture’
– Better operational decisions, Quick
response to customers
• Potential lack of coordination
• Gives lower level managers decision‐ among autonomous managers
making experience
– Grooming for future top level position • Lower level managers might have
• Empowers, Motivates lower level objectives which differ from
managers objective of the organization as a
– Job satisfaction, Employee Retention, whole
Improved performance
 Responsibility Accounting System
Responsibility accounting is used to measure the performance of people and departments to
foster goal congruence.
Goal congruence results when the managers of subunits throughout an organization strive to
achieve the goals set by top management.

Responsibility Centres – Subunit of the organization

 With Control over activities and Accountability for performance

• Revenue Centre – Control over revenue attributed to it

– Example: Sales Department of a manufacturer, Reservations Department of Railways or
Airlines
– Evaluation : Standard Sales Variances

• Cost Centre – Control over costs

– Example: Service Dept. like Personnel, Manufacturing Facilities
– Evaluation : Standard cost variance

• Profit Centre ‐ Control over both costs and revenue, hence over profits
– Example: Company’s cafeteria, Product line manager
– Evaluation : Comparing actual profit to budgeted profit

• Investment Centre‐ Control over cost, revenue, and investments in operating assets
– Example: Corporate HQ, Evaluation : Return on Investment, RI
Organizational View of Responsibility Centres
Caveman Software operates stores within five regions. Regional
managers are held accountable for marketing, advertising, and
sales decisions, and all costs incurred within their region. In
addition, regional managers decide whether new stores will open,
where the stores will be located, and whether the stores will
lease or purchase the facilities. Store managers, in contrast, are
accountable for marketing, advertising, sales decisions, and costs
incurred within their stores.
Ideally, on the basis of this information, what type of
responsibility center should the software company use to
evaluate its regions ……….. and stores………..?
Cost center/Revenue center/profit center/Investment center
Regions : Investment Center; Stores : Profit Center

Segmented
Reporting

Company Showplace Homes, Inc.

Divisions Paris Milan Abu

Dhabi

P1 P2
AE AW
Sub‐divisions
 12‐44
(H12e)

Segment Revenue
Less: Segment Variable Costs
Segment Contribution Margin
Less: Fixed expenses traceable to segment, & controllable by segment manager
Profit margin controllable by segment manager
Less: Fixed expenses traceable to segment, but controllable by others
Segment profit margin
 12‐44 (H12e)
Segmented income statement:
Show‐Off, Inc. Las Vegas Reno Sacramento
Sales revenue $1,332,000 $444,000 $451,000 $437,000
Variable operating expenses:
Cost of goods sold $ 705,000 $203,500 $225,500 $276,000
Sales commissions 79,920 26,640 27,060 26,220
Total $ 784,920 $230,140 $252,560 $302,220
Segment contribution margin $ 547,080 $213,860 $198,440 $134,780
Less: Fixed expenses controllable by segment
manager (and traceable):
Local advertising $ 81,000 $ 11,000 $ 22,000 $ 48,000
Sales manager salary 32,000 ‐‐‐‐ ‐‐‐‐ 32,000
Total $ 113,000 $ 11,000 $ 22,000 $ 80,000
Profit margin controllable by segment manager $ 434,080 $202,860 $176,440 $ 54,780
Less: Fixed expenses traceable to segment, but
controllable by others:
Local property taxes $ 12,500 $ 4,500 $ 2,000 $ 6,000
Store manager salaries 108,000 31,000 39,000 38,000
Other (non‐controllable costs) 28,200 5,800 4,600 17,800
Total $ 148,700 $ 41,300 $ 45,600 $ 61,800
Segment profit margin $ 285,380 $161,560 $130,840 $ (7,020)
Less: Common fixed expenses 192,300
Net income $ 93,080
Sales revenue: Las Vegas, 37,000 units x $12.00; Reno, 41,000 units x $11.00; Sacramento, 46,000 units x $9.50
Cost of goods sold: Las Vegas, 37,000 units x $5.50; Reno, 41,000 units x $5.50; Sacramento, 46,000 units x $6.00
Sales commissions: Las Vegas, $444,000 x 6%; Reno, $451,000 x 6%; Sacramento, $437,000 x 6
 12‐44 (H12e)
Segmented income statement:
Show‐Off, Inc. Las Vegas Reno Sacramento
Sales revenue $1,332,000 $444,000 $451,000 $437,000
Variable operating expenses:
Cost of goods sold $ 705,000 $203,500 $225,500 $276,000
Sales commissions 79,920 26,640 27,060 26,220
Total $ 784,920 $230,140 $252,560 $302,220
Segment contribution margin $ 547,080 $213,860 $198,440 $134,780
Less: Fixed expenses controllable by segment
manager (and traceable):
Local advertising $ 81,000 $ 11,000 $ 22,000 $ 48,000
Sales manager salary 32,000 ‐‐‐‐ ‐‐‐‐ 32,000
Total $ 113,000 $ 11,000 $ 22,000 $ 80,000
Profit margin controllable by segment manager $ 434,080 $202,860 $176,440 $ 54,780
Less: Fixed expenses traceable to segment, but
controllable by others:
Local property taxes $ 12,500 $ 4,500 $ 2,000 $ 6,000
Store manager salaries 108,000 31,000 39,000 38,000
Other (non‐controllable costs) 28,200 5,800 4,600 17,800
Total $ 148,700 $ 41,300 $ 45,600 $ 61,800
Segment profit margin $ 285,380 $161,560 $130,840 $ (7,020)
Less: Common fixed expenses 192,300
Net income $ 93,080
Sales revenue: Las Vegas, 37,000 units x $12.00; Reno, 41,000 units x $11.00; Sacramento, 46,000 units x $9.50
Cost of goods sold: Las Vegas, 37,000 units x $5.50; Reno, 41,000 units x $5.50; Sacramento, 46,000 units x $6.00
Sales commissions: Las Vegas, $444,000 x 6%; Reno, $451,000 x 6%; Sacramento, $437,000 x 6
 12‐44 (H12e) continued
2. Sacramento is the weakest segment because of several factors:
– Las Vegas and Reno have much higher markups on cost [118% ($6.50/$5.50) and 100%
($5.50/$5.50), respectively]. However, Sacramento’s markup is only 58% ($3.50/ $6.00).
– Despite being the only store that has a sales manager and spending considerably more on
advertising than Las Vegas and Reno, Sacramento has the lowest gross dollar sales of the three
stores. Sacramento’s return on these outlays appears inadequate.
– Sacramento’s “other” noncontrollable costs are much higher than those of Las Vegas and Reno.

3. Show‐Off uses a responsibility accounting system, meaning that managers and centers are evaluated
on the basis of items under their control. Since this is a personnel‐type decision, the decision should
be made by reviewing the profit margin controllable by the store (i.e., segment) manager.
– The segment contribution margin excludes fixed costs under a store manager’s control;
– In contrast, a store’s segment profit margin would reflect all traceable costs whether
controllable or not.

On a segmented income statement, common fixed expenses will have an effect on a company's:
a. segment contribution margin.
b. profit margin controllable by the segment manager.
c. segment profit margin.
d. segment contribution margin and segment profit margin.
e. None of the other answers are correct.
A Brief Course Summary
 Wrapping Up
• Session 1 : Introduction
– Understand the need for cost management
– Learn the cost terms and concepts
– Cost, Cost Object, Cost Centre, Cost Unit, Cost Drivers
– Cost Classification by ‐ Element, Function and Behaviour
– Prepare Schedule of Cost of Goods Manufactured and Schedule of COGS and IS

• Session 2: Product Costs : Job Costing

– Explain the flow of costs through manufacturing accounts in job costing system
– Compute pre‐determined overhead rate and allocate overheads
– Learn disposition of under‐applied or over‐applied overhead

• Session 3 : Product Costs: Process Costing

– Explain the flow of costs in process costing system
– Compute Equivalent Units of Production, Cost per equivalent unit using Weighted average
method

• Session 4 and 5: Activity Based Costing (ABC) – Case: Classic Pen Company
– Explain and justify Activity Based Costing
– Explain and classify activities by cost levels
– Analyze activity costs, identify activity cost pools, select cost drivers
– Compute activity rate and product costs under ABC system
– Compare product costs under Traditional and ABC costing
 Wrapping‐up
• Session 6: Cost‐Volume‐Profit Relationships
– Understand the assumptions underlying CVP relations
– Understand basic CVP relationships, Prepare and interpret contribution income statement
– Compute contribution margin ratio, break even point and margin of safety (including multi‐product
environment)
– Compute degree of operating leverage and understand its relation to Margin of safety.
– Indifference point
• Session 7 & 8 : Relevant Costs for decision making – Case: Prestige Telephone Company
– Identify relevant costs and revenues
– Decide whether to accept special order
– Decide whether to make or outsource
– Decide whether to continue or shut down operations/ product line / department
– Ascertain optimal product‐mix decision when resources are constrained
• Session 8 & 9 : Budgeting and Standard costing
– Explain the purpose of budgeting system, understand the budget administration and the budgetary slack
– Prepare master budget, explain the interrelationships among its supporting schedules, prepare cash
budget, Prepare static and flexible budgets
– Elements of Cost Control system, Standard Cost, Cost Variances: Interpretation, Interactions, and
responsibility
• Session 10 : Responsibility Accounting
– Understand the role of responsibility accounting in fostering goal congruence
– Understand Responsibility Centres
– Prepare Segmented Income Statement
Thanks, and Best of Luck 