Summary Complete Cost Management Exam Revision Notes PDF

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Summary - complete - Cost management- Exam revision

notes
Cost Management (University of Melbourne)
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Terms:
COST OBJECT: anything for which a separate measurement of costs is required (e.g. products/services,
customers, projects, departments).
COST POOL: a grouping of individual cost items. Should be homogeneous; the individual costs in the pool
should share the same cost driver. This ensures more accurate allocation of indirect costs.
COST DRIVER: conceptual and usually not quantifiable. Drives/determines occurrence of costs, so that changes
in cost driver quantity cause changes in cost incurred. E.g. complexity of machinery used to make a product,
number of research projects, labour hours on a project, number of units produced, number of customers
(from distribution perspective), number of sales personnel, sales, hours spent servicing products.
CONVERSION COSTS : all manufacturing costs OTHER than direct material cost.
INDIRECT COST : costs allocated to cost object (consider feasibility – economic, material, information) Costs are
recorded (accumulated) then assigned (allocated). Can be manufacturing (fixed – factory machinery
depreciation) or non-manufacturing (variable – sales commissions paid). Usually industries that require heavy
investment in infrastructure and software incur significant indirect costs.
Allocate to
- Provide information for economic decisions

- Motivate managers and employees
- Justify costs or calculate reimbursement
- Measure income and assets for external reporting
Things to decide upon:
1. Which HQ and other divisional costs to include in the indirect cost pool that is to be allocated to the
cost object
2. How many costs pools to have (for the HQ and other divisional costs that are to be included from (1).
Minimum by GAAP is single plant-wide cost pool with single allocation rate.
3. What allocation base to use for each of the cost pool in (2) to allocate the indirect cost to the different
divisions
4. What allocation base to use to allocate the indirect costs which has been allocated Division A to the
individual units of Product X
DIRECT COST: costs directly traceable to a cost object.
VARIABLE COST: total cost changes as level of activity changes (usually volume). E.g. Labour if workers are paid
per product made. Cost per unit remains same as output increases.
FIXED COST: total cost remains same despite changes in activity levels. E.g. labour if shift-based pay. Cost per
unit declines as output increases.
INVENTORIABLE COSTS : Product cost in financial statements. These costs form part of the inventory value. Note:
R&D, Design, Marketing, Admin costs are not Inventoriable.
Merchandising – cost of purchase + freight-in. Manufacturing – stages of production (cost of raw materials
purchased + freight-in + cost of conversion). Service – no inventory.

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ALLOCATION BASE: used to allocate the pool(s) of indirect costs to associated cost objects. It is a quantifiable,
practical representation of cost driver. Differences/changes in the measured quantity of allocation base units
will correspond to changes in the proportion/amount of overhead costs incurred by the firm to produce that
cost object. E.g. number of square metres in factory floor occupied by each product to determine engineering
maintenance cost allocation amounts.
Total cost
AVERAGE COST /UNIT COST: =$ X per unit
Total number of units
COGS: Beginning stock + additions (flow) = total goods available for sale – ending stock (finished goods) =
COGS (flow).
COGM (COST OF GOODS MANUFACTURED ):

Direct materials used (open stock + purchases – closing stock )+ Direct labour + Indirect manufacturing costs+Open
.
OPERATING INCOME : Salesrevenue – COGS=Gross margin – Operatingexpenses
Note: Merchandising – finished goods. Manufacturing – WIP, Raw Materials, Direct Labour. Service – no
inventory.
COST OF PURCHASE : Net purchases + Freight-in costs. Includes: purchase price, import duties/taxes non-
refundable, transport, costs of getting asset to place/condition for use/sale.
COST OF CONVERSION : Costs of converting inventories into finished products – includes labour (direct) and
manufacturing overhead.
VALUE CHAIN COSTS: costs incurred throughout the value chain from end to end (i.e. R&D to distribution) that
need to be allocated to products/other cost objects for pricing decisions.
TRANSFERRED -IN COSTS : One firm’s finished goods may be another’s raw materials. The same may be for
departments within a firm. EUs=beginning WIP+added ¿
ABSORPTION COSTING : stock costing method; all variable manufacturing costs and all fixed manufacturing costs
are included as Inventoriable costs.
DIFFERENTIAL COST : difference in total cost between two alternatives; (net relevant cost).
DECISION FACILITATING : information gained gives experience that guides future performance (e.g. perform
poorly on assignment 1 → as a result, try harder on assignment 2).
RELEVANT RANGE : the specific range (of units/volume/output) over which the behaviour classification of a cost
is valid (i.e. remains fixed). If outside the relevant range, cannot extrapolate/extend the cost relationship (in a
reliable way).
DECISION INFLUENCING : influences behaviour; gets people to behave in certain ways (e.g. I will check your
homework → gets people to do homework)
Actual costing
WHAT IS IT ?
Can have one indirect cost pool or multiple cost pools from which costs are allocated

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Simplest allocation method: one manufacturing overhead cost pool plant wide; all other non-manufacturing
indirect costs expensed for the period – not allocated to the cost object.
HOW IS IT DONE?
1. Determine allocation base

2. Measure actual units of allocation base for all cost objects ‘supported’ by the indirect cost
Total indirect cost recorded
3. Calculate allocation rate:
Total units of allocation base
Total cost ∈ MFG overhead pool
MFG overhead rate =
Allocation Base
4. Allocate the indirect cost: Actualunits of allocationbase × Allocation rate
*Allocation can only be done at end of reporting period once total indirect costs incurred is known. However,
management needs timely information to make decision. Therefore, normal costing is implemented.
BUDGED OR ACTUAL?
Normal costing → more timely, relevant information (information obtained in advance; able to be used for
decision making). Will need to adjust though to correct figures to the actual figures.
Actual costing → more reliable/accurate information. Not timely…
Normal costing.
WHAT IS IT ?
Budgeted amounts will likely differ from actual amounts:
Actual manufacturing overhead ≠ budgeted manufacturing overhead

Actual allocation base quantity ≠ budgeted allocation base quantity
Actual overhead rate ≠ predetermined overhead rate (incurred overhead ≠ applied overhead)
HOW IS IT DONE?
i) Predict period indirect manufacturing costs and allocation base quantity at beginning of period
ii) Calculate a predetermined overhead rate and use it to allocate
iii) Adjust difference between actual incurred overhead and budgeted overhead at end of period if
prediction ≠ actual amounts/costs
*Note: predetermined mfg overhead applied =

Total budgeted ind
Actualtotal units of allocation base( e . g . actual total machine labour hours )×
Total budgeted units of allocation bas
Different approaches for adjusting for over/under allocation:
(1) C LOSE TO COGS
Advantages: quick, simple, cheap. Argument for: this account usually has the largest balance compared to WIP
and FG; therefore the allocation error (and profit) should be relatively small and considering goods produced
are going to be sold eventually, the costs will all flow into COGS account eventually.
DR COGS

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CR MFG Overhead (control) Debit COGS for the difference between MFG Overhead
actually incurred and that which was ‘applied’/allocated.
Disadvantages: least accurate of the methods
(2) PRO-RATA: ALLOCATE DIFFERENCE PROPORTIONALLY RELATIVE TO TOTAL SIZE OF ACCOUNT
Advantage: less complex than (3)
Disadvantage: less accurate cost figures compared to (3)
The entire account balance ( e . g . WIP )

¿ ×difference between allocated OH ∧actual OH
The combined account balances(WIP , FG , COGS)
DR COGS
DR FG
DR WIP
CR MFG Overhead (control) Debit each account for its share of the ‘underallocated’ overhead that
is now being applied through the adjustment. Alternatively, if overallocated and need to reduce the account
balances, switch the entries around (CR for the accounts, DR MGF Overhead control).
(3) PRO-RATA: ALLOCATE DIFFERENCE BY RELATIVE PROPORTION OF CURRENT MFG OVERHEAD IN EACH ACCOUNT
Advantage: is equivalent to (4) – therefore accurate cost figures
Disadvantage: more complex than (2)
MFG OH ∈that account ( e . g . WIP )

¿ × difference between allocated OH∧actual OH
MFGOH total all acc ounts(WIP , FG ,COGS)
DR COGS
DR FG
DR WIP
CR MFG Overhead (control) Debit each account for its share of the ‘underallocated’ overhead that
is now being applied through the adjustment. Alternatively, if overallocated and need to reduce the account
balances, switch the entries around (CR for the accounts, DR MGF Overhead control).
(4) ADJUSTED RATE – NOT REALLY ITS OWN CATEGORY .
Compute what rate should have been, then re-cost everything using corrected rate and adjust accounts [on
balance day when actual costs known].
Advantage: highly accurate cost figures
Disadvantage: not feasible – however computerised accounting systems have made this possible

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Job Costing:
WHAT IS IT ?
The cost of a product/service is obtained by assigning costs to a distinct unit/batch of product/service. Costs
are accumulated for each specific job on the Job Cost Record – unit costs derived from this.
Suitable for: organisations with unique/variable goods/services, lower volume of output,

manufacturing/service/merchandising entity.
*Direct job costs are same under both normal and actual costing because the difference only occurs for
indirect (i.e. same wage rate/allocation rate, same labour hours worked/allocation base units incurred)
HOW IS IT DONE? HOW IS IT RECORDED ?
May require some averaging if the job involves making multiple units of the one particular product. Otherwise
no averaging → costs are for individual jobs, which use different quantities of manufacturing resources.
Issues when: mismeasurement/misreporting, allocation base(s) do not reflect underlying cost driver, high
proportion of indirect costs.
*Note: the purchase of materials/payment of advertising is not record on job costing sheet – rather it is the
use of materials, use of labour, allocated mfg overhead that is written on the sheet, as well as unit cost and
total cost.
*Over or under allocated mfg overhead may be allocated to COGS, WIP or FG accounts (the latter two under
the two pro-rata allocation methods for adjusting for over/under allocations). See print-out.
*Unit costs, are derived from the cost of the job as a whole by:
Total job cost
Number of units completed as part of the job
Activity based costing

Refines allocation of indirect costs by recognising that two products make different use of various activities.
Allocates indirect cost on the basis of the cost of each activity and the two products’ use of those activities.
Other costing systems known as traditional costing systems – volume-based (more indirect costs allocated to
products produced in higher quantity, where such allocation bases include: machine hours, direct labour
hours) allocation bases to assign indirect cost to cost objects. If sole allocation base is direct labour hours, then
products that are labour-intensive but use minimal other inputs will be overpriced and products that are
labour non-intensive but have expensive machine set-up costs or other custom expensive inputs will be
underpriced. This distorts information for management → could invest in a product mix that is unprofitable.
To identify the cost pools and allocation bases, need to identify the activities that cause indirect costs to be
incurred. ABC focuses on individual activities as cost objects (e.g. designing products, machine set-up).
*Costs incurred that are not directly caused by producing a unit of product/service (e.g. idle direct labour paid
for not working because overstaff; factory floor space used for non-production purposes) can be allocated in a
random way by companies or not allocated to a unit of product/service at all.

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*Companies that benefit from ABC tend to: produce very diverse products/services which do not consume
resources in proportion to volume produced; have a large proportion of costs that are indirect’ operate in
highly competitive markets.
*ABC costing permits: better design decisions concerning production process/factory layout; cost reduction
initiatives; better budgeting/planning.
ACTIVITY COST POOL:
Cost pool Allocation base

Orders No. orders
Order size Cubic metres
Drafting Drafting direct labour hours
Machining Machining machine hours
Assembly Assembly direct labour hours
Selling Sales revenue
E.g. Foreman’s wages: 20% orders, 30% machining, 50% assembly. Therefore this resource cost – foreman’s
wages – has 3 activity pools.
HOW IS IT DONE?
1. Cost pools are chosen

a. Capture different causes of cost variability
i. Some costs incurred when order is received regardless of what order, some costs are
incurred in proportion to physical size of order, others are incurred in proportion to
labour input, others in proportion to machine time input.
2. Costs are assigned to activity cost pools
The cost assigned to a particular cost pool =

% of total cost contributed ¿ by one particular cost pool ×cost of theitem , do this for each of the cost
pools. E.g. Foreman’s wages: 20% orders, 30% machining, 50% assembly. Then the order cost pool might have
20% X 280,000 = 56,000.
Allocation/Activity rate =total cost contriubted by that cost pool/total amoun t of activity
*See lecture 5 example.
HIERARCHIES :
Categorises costs into different cost pools on basis of different types of cost driver/allocation bases.
Unit-level: resources sacrificed on activities performed on each individual unit (e.g. manufacturing operation
costs such as machine repair, electricity consumed). These costs depend on the number of units produced.
To find cost:Unit activity cost ×number of allocationbase units
E.g. Unit activity cost = $20 per person X (5 people per trip X 5 trips per year) = $1500
Batch level: resources sacrificed on activities related to a group of units of products – costs depend on the
number of batches processed. E.g. placing purchase orders, arranging for shipments to customers, machine
set-up – i.e. An oven with 1 cake or 4 cakes in it will cost the same to set-up.
To find cost: Batch activity cost × number allocation base units

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E.g. Batch activity cost = $7 per kilometre X 100 km = $700
Product/Service sustaining: resources sacrificed on activities undertaken to support individual

products/services. E.g. design costs for each product, engineering costs to change a product’s design. Costs
depend on number of products/services associated with the cost.
To find the cost: Total Product sustaining cost /number of products the cost serves
E.g. $750 cost for advertising for two hiking trips (two products) = $750/2 = $375 per product. For Hike A, 10
trips per year, so batch cost = $375/10 = $37.5. Unit cost = $2.5 since 15 people in each trip. For Hike B, 5 trips
per year, so batch cost = $75. Unit cost = $3 since 25 people in each trip.
Facility sustaining: resources sacrificed on activities which support the organisation as a whole. E.g. general
admin costs.
ISSUE WITH MACHINE HOURS AS SOLE ALLOCATION BASE:
The (volume-based) normal costing system allocated indirect cost as if those costs were driven by units of
production. If the cost drivers are not volume of production, then allocated amounts of indirect costs will not
necessarily reflect true allocations of indirect costs. E.g. materials ordering costs are not driven by volume of
production, but rather by the number of orders placed for materials.
Incorrect cost allocation can result in over-costing or under-costing products. Consequently, an increase in the
sales of a particular product will not increase profits if the price premium on that product does not cover the
consumption of resources (i.e. it is underpriced).
Process costing
WHAT IS IT ?
Cost of product/service obtained by assigning costs to masses of similar units. Uses extensive averaging to
calculate unit costs. Used by mass producers; high-volume, maximum efficiency, homogeneous products.
Focus on production process – well define inputs, standardised procedures and outputs.
*Indirect costs are not distinguished and are lumped into conversion costs because they are assumed (usually)
to be added evenly throughout the production process. By contrast, the direct materials are assumed to all be
added at one point in time (usually start of process).
HOW IS IT DONE?
1. Direct materials are traced to a particular product line

2. Direct costs are assigned to each unit:
Total direct costs traced ¿ product line ¿
Total units produced during period
HOW IS IT RECORDED ?
Physical units – real units, quantity not altered by material inputs/conversion costs.
Equivalent units – for costing purposes, increases with addition of material inputs and conversion costs.
ph ysical units C∧T /O+ physical units WIP × % completion withrespect ¿ direct materials∨conversion costs
WIP ending =
( physical units WIP end × % completion with respect¿direct materials∨conversion costs ) ×WAC per EU

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WEIGHTED AVERAGE VS. FIFO
Choice of FIFO or weighted average makes no difference if:
- Material costs dominate

- Costs (mats and conversion) remain relatively stable over time
o Rising material/conversion costs means FIFO will have lower COGS figure than W/Ave, hence
higher profit figure. If falling costs, then reverse is true.
- WIP is low/non-existent
FIFO – assumes EU in beginning WIP are completed first and transferred out (assigns cost of previous period’s
EU in opening WIP stock to first units C&T/O). Assigns cost of EU worked on during current period first to
complete beginning WIP then to start and complete new units and finally to units in closing WIP stock.
Weighted average – finds cost of work done in EU to date (regardless of period) and assigns cost to WIP
closing and EU C&T/O. Weighted average cost = total accumulated cost divided by total EU.
Operation costing
Hybrid between job and process costing systems. Used when wide variety of closely related services/products
are produced. Some inputs (work materials) can be work-order specific and basic cost object is work order –
like job costing. Similar to process costing in that products within a certain operation are treated alike – using
identical amounts of resources. Products may have a unique combination of operations though.
Work Order 46 Work Order 47
DIRECT MATERIALS (use job Wool Polyester

costing approach) Satin full lining Rayon partial lining
Pearl buttons Plastic buttons
OPERATIONS (use process costing approach)
1. Cutting Cloth Use Use
2. Checking Edges Use Don’t Use
3. Sewing Body Use Use
4. Checking Seams Use Don’t Use
5. Machine Sewing Collars and Don’t Use Use

Lapels
6. Hand Sewing Collars and Lapels Use Don’t Use
Which costing system to choose?

One system will likely be more suitable than the others for any given organisation – that will be the system
that most closely matches the pattern of resource consumption. The accounting system must match the
pattern of resource consumption of the products/services produced by the organisation i.e., identical for each
unit OR different consumption of resources by the units produced.
Support department costs

3 approaches to assigning costs of support departments to products/services:
(i) Ignore interdependence – Direct method. See – attached example
*Remember: do not include support department share in denominator!
(ii) Partial recognition of interdependence – Step-down method

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*Select as the primary department the one that provides the most services to the other support departments.
Start the sequence with allocating the costs of this department first* See – attached example
(iii) Full recognition – Reciprocal method. See – attached example
*The greater the recognition, the greater the accuracy but the more complex/expensive the system is.
*Remember: for simultaneous equations, A/HR = 0.1IS + 600,000. The 0.1 comes from the 10% of IS used by A/
HR and the 600,000 is the total costs of A/HR!
Cost-volume-profit analysis
WHAT FOR:
- Calculating breakeven point (where selling price = variable costs)

- Calculating units/revenues required to achieve target profit
- Calculate margin of safety = excess of budgeted revenues over breakeven revenues.
- Sensitivity analysis: answers ‘what if’ questions on the impact of changes to key variables on profit
(e.g. if sales price changes, what will profit be?)
REVENUE DRIVER :
Factors affecting revenues – output sold, selling prices.
NET PROFIT
Total revenue – Total costs – Income tax.
OPERATING PROFIT
Total revenues (from operations; excludes interest revenues and other once-off revenues such as disposal of
PPE) – Total operating costs (excludes interest expense)
*Note: Net profit = Operating profit – Income Tax (assume non-operating revenues/costs = 0).
ASSUMPTIONS:
1. Total costs and revenues are linear with respect to output volume.
2. Unit selling price, unit variable cost and fixed costs are kept constant and are known
3. Product mix remains constant as the total number of units sold.
4. Zero time value of money.
5. Variable costs and revenues have a single common driver – output volume
CONTRIBUTION MARGIN :
Contribution towards covering fixed costs. = Revenue – Variable costs
Total CM = Total revenue – Total variable costs
CM per unit = Selling price – Variable cost per unit
CM ratio = (Selling price – Variable cost per unit)/Selling price.
Operating profit = Total contribution margin – Total fixed costs.

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[ Total ¿costs+Target profit ]

Volume ( N )=
[ Unit Sales price – Unit Variable costs ]
WEIGHTED AVERAGE CONTRIBUTION MARGIN :
The average of the products’ unit CMs, weighted by the relative sales units of each product (sales mix). Since
we assume sales mix is unchanged, WACM is unchanged. WACM is required when a company sells multiple
products.
Break-even units = Fixed costs / WACM.
OPERATING LEVERAGE :
Degree of operating leverage affects sensitivity of operating profits to changes in sales volume. Operating
leverage depends upon the proportion of cost that is fixed (higher proportion of total costs as fixed costs =
higher operating leverage = higher sensitivity of profit to changes in sales volume). High leverage means
changes in sales volume will have greater effects on profit than if the leverage was low.
Total Contribution margin

Operating leverage=
Operating profit
*Ignore effect of taxes.
Note: CVP is not compatible with ABC costing because it assume there is only one driver – volume. The
presence of costs that are variable with respect to non-output volume cost drivers would produce inaccurate
CVP analysis. Such costs are not represented by either the fixed horizontal line (fixed costs) nor the linear
variable cost line. Also note: at the batch level and product level, fixed costs (with respect to output volume)
may be variable with respect to different cost drivers.
COST ESTIMATION:
This reveals how costs behave when business conditions (quantity of cost driver) change.
Allows costs to be predicted under different situations (different quantities of cost driver), helps management
estimate profit and enables businesses to plan/improve operations (i.e. make/buy or outsource decisions).
ASSUMPTIONS:
Cost behaviour is linear within the relevant range of the cost driver. Also, there is only one cost driver (but this
can be any cost driver – not restricted to volume output).
COST FUNCTION: use to predict how costs will behave, and in turn, predict profits.
Equation: y=a+bx . (y = component of total cost {e.g. maintenance cost} OR total cost, a = intercept (fixed
cost), b = variable cost per unit (slope), x = total units of cost driver).
Non-statistical (managerial judgement, engineering) or statistical (visual fit – line of best fit, high-low, OLS
regression) approaches to estimating the equation.
CONSIDERATIONS IN CHOOSING COST DRIVER :
- Availability of data, quality of data, relevance of data, regression statistics.

- Existence of plausible cause/effect relationship (not merely correlation) between cost driver and cost.

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*BEWARE: y-intercept if not inside relevant range because not enough data to confidently estimate the cost
when the volume of cost driver is 0 ∴ may not be a good representation of fixed costs.
HIGH-LOW METHOD: take the highest and lowest (in relevant range) ‘x’ cost driver values and their cost ‘y’
y high− y low
figures. Apply to find the gradient ‘b’. Then solve the equation by substituting either y high, xhigh or
x high−x low
ylow, xlow to find ‘a’ (a = y – bx).
Pros – unambiguous result, cheap to do, easy. Cons – only considers information from 2 data points → may be
unrepresentative of whole dataset.
OLS REGRESSION:
Fits a line using all of the data in a systematic and reliable way that minimises the squared distance between
the line and all the data points. Takes into account all the data points (compared to high – low which only
takes into account 2 data points).
LIMITATIONS OF STATISTICAL METHODS: data adequacy (need ≥ 30 data points to get reliable estimate), relevance
(exclude data no longer relevant due to changes in process/etc), impact of outliers
STEP-VARIABLE COSTS :
Cost is constant over small ranges of the cost driver/activity, before increasing to the next constant level. This
is because machine set-up cost is necessary when a new batch is produced.
STEP-FIXED COSTS :
Cost is constant over large ranges of the cost driver. E.g. depreciation of machine (as the cost driver output
units increases, a new machine might need to be turned on = higher total depreciation, hence step-up).
NON-LINEAR COSTS :
Due to learning-curve effects, labour hours per unit of output declines as production increases.
Experience curve is a broader application of learning curve, where the full product cost per unit (which
includes manufacturing, marketing distribution, selling costs…etc…) declines as units of output increases.
Linear cost assumptions violated when multiple cost drivers and when the relationship changes over time.
Short-term decisions:
SHORT TERM DECISIONS:
 Some costs cannot be varied (e.g. lease/rent or some other fixed costs) due to the nature of the
commitment already made
 Less likely to have major lasting implications on future profitability
 E.g. special orders, make vs. buy, product mix
Key short-term success measures:
1) Increase contribution margin (maximise difference between selling price and variable costs).
Can increase either total revenues or total variable costs. In short-term, some of the variable costs will be
unable to be changed (i.e. might have deals in place with suppliers for fixed price per unit of direct materials →

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therefore unable to renegotiate for lower price on short-term) and similarly revenues has an upper limit given
the fixed capacity limit in short-term.
To increase Operating profit in the short-term, need to focus on Total contribution margin since Total fixed
costs are unchangeable.
2) Increase capacity utilisation. Cannot change capacity itself in short-term, but can change utilisation.
E.g. if capacity of 100 units per day and only currently making 60 per day, can increase capacity (so
long as positive contribution margin – otherwise unprofitable).
Note: better capacity utilisation can increase total contribution margin (if the contribution margin per unit is
positive) because more sales = proportionately more revenue than the resulting increase in variable costs.
Reduce idle capacity. This will be profitable so long as revenue earned for each additional unit of capacity used
> variable costs.
3) Don’t compromise long-term profitability/sustainability/performance of firm though.
Careful that pursuing a higher CM does not lead to:
- Sacrificing quality (either to reduce input costs or due to higher production volume) –hurts reputation
- The lower price for a special order is leaked to other customers → existing customers want lower
price → damage revenues in long-run and/or damage relationships if customers do not get this price.
- Choose to avoid producing certain products customers like due to their higher cost which damages
customer relationships
- Buying certain components from external suppliers may damage reputation/credibility as a high
quality supplier for example.
LINEAR PROGRAMMING :
In reality, there could be multiple binding constraints and can be solved using linear programming under
certain assumptions. Not considered in this subject.
RELEVANT COSTS /REVENUES:
- Those expected in the future that differ between alternatives are RELEVANT.
- Costs already incurred & revenues already earned are irrelevant
- Costs/revenues that are the same across all alternative choices being considered are irrelevant
- Controllability is not always necessary
- Qualitative factors are also relative (difficult to numerically measure)
o Employee morale
o Reputation/trust in customers towards your firm
o Quality
SPECIAL ORDERS :
- One-off orders (could become a long-term customer possibly)

- Usually no impact on long-run demand or pricing because it is a one-time order from a customer
outside normal markets/channels/customer base
- Fixed costs = sunk costs.
- Usually uses idle capacity to fulfil order
o However, if no idle capacity, firm needs to choose between whether to fulfil the special order
and drop one of its regular customers’ orders.

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- If excess capacity, lowest acceptable price per unit is a price that would give a zero CM. ∴ price per
unit = variable costs per unit ∴ profit is not increased. Generally speaking, an acceptable order is one
which would increase profit and result in a positive CM (Selling price > Variable costs per unit).
Implicitly, this is a short-term pricing decision.
- No need to incur additional fixed costs because there is usually excess capacity the special order can
fill ∴ fixed costs are irrelevant
- Consider qualitative factors:
o Taking on special order to motivate employees
o Positive reputational impact is possible if one-off customer is a big player in market-place
o May have adverse consequences affecting existing customer relationships if existing
customers find out about special order being priced lower than regular orders
MAKE OR BUY DECISIONS :
- Decision whether the firm itself will make a particular component of the final product or buy from
external producer.
- Note: outsourcing – long-term decision (strategic) which is not easily reversible and will reduce fixed
costs likely (plant lease terminated, equipment sold off)
o In this case, both fixed and variable costs are relevant.
- Make/buy is a short-term decision that is easily reversible and does not result in reduction of fixed
costs (no equipment is sold, etc). You intend to keep open the option of making the component again
yourself in the future.
o Only variable costs are relevant as fixed costs have already been paid for in past and/or they
do not differ between alternatives
o If business has insufficient capacity, then the choice to buy can free-up capacity that can be
used to fulfil additional orders
- Quantitative factors:
o What is the cost vs. benefit of buying as opposed to making? Is it profitable to buy or make?
- Consider qualitative factors:
o Quality of products supplied by external supplier
o Ability for external supplier to make timely & reliable deliveries
o Reputational impact on existing customers if they discovered that firm doesn’t make own
components.
PRODUCT MIX :
- Which products to focus on (produce as much as possible) and which to de-prioritise (produce as
much as required to fill the remainder of capacity after producing most profitable products)
- Can arise due to capacity constraint
- Think: when capacity is constrained, which product mix maximises profit because can’t sell unlimited
quantities of each product.
- To max profit:
o Find where constraint is in the system (e.g., limited machine hours, limited labour hours etc.)
o Then, maximise the contribution margin per unit of the binding constraint
o Therefore, a product that may appear more profitable (due to having the highest contribution
margin), may not be the product that we should focus on if it uses significant amounts of the
constrained resources (higher variable costs)
- Quantitative factors:
o Which product has the highest CM per unit?

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o What product mix will maximise profit and maximise use of constrained resources?
- Qualitative factors to consider:
o How likely are customers who do not get their order for the product that has been de-
prioritised fulfilled to also stop buying your other products?
o E.g., if your largest customers buys both your products – Product A and Product B. Due to
constrained labour resources, you have decided to only produce Product A. Would your
largest customer be willing to still buy Product A from you while having to look for another
supplier for Product B?
TYPICALLY IRRELEVANT COSTS:
- Costs of labour (employment costs remain unchanged because contract guarantees X hours of work –
shift work). If paid per hour worked, then relevant.
- Store/PPE/factory rent/lease
- Equipment depreciation.
- Sales assistant’s labour and commission
Note: opportunity cost – making component parts is an opportunity cost as capacity is used on this instead of
additional products to sell. Consider this.
Note: with outsourcing, if cost of purchasing from external supplier is < total cost per unit of manufacturing,
then outsource.
Long-term decisions:
LONG TERM DECISIONS :
 Where all costs can potentially be varied

 Likely to have major lasting implications on future profitability
 E.g. long-run pricing, activity-based management, outsource or not
LONG TERM RELEVANT COSTS:
- Variable costs
- ‘Capacity’ costs => fixed costs (manufacturing and non-manufacturing). Capacity costs are incurred to
ensure the presence of necessary infrastructure or “capacity” to produce or deliver some volume of
output.
o Organisation-sustaining, product-sustaining, , facility-sustaining, and product-sustaining costs
- Opportunity cost if quantifiable
ABSORPTION COSTING :
All manufacturing costs (fixed, indirect, direct, variable) are absorbed into individual units of inventory that
are produced. I.e. costs are included in the balance sheet as part of inventory value (i.e. these costs are
inventoriable) and are only expensed when the inventory is sold => COGS. All non-manufacturing costs are
recognised as a period expense => expensed immediately when incurred.
Revenue A
Cost of Goods
Opening X
Variable manufacturing X
Fixed manufacturing X
Available for sale SUM

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Ending inventory B
COGS SUM – B
Gross margin A – (SUM – B)
Period expense (all non manufacturing costs) Y
Operating profit A – (SUM – B) – Y
Pros:
- IFRS Compliant
- Partially captures ‘capacity costs’ in its costing of inventory (i.e., includes fixed manufacturing costs)
which makes it slightly better than VC for long-term decision making. But, does not include fixed non-
manufacturing costs ∴ not ideal.
Cons:
- May encourage dysfunctional behaviour by management – if management bonuses based on profit ∴

increase profits by producing (even without selling) more, because if end inventory balance increases,
profits increase => inefficiencies, waste, obsolescence of inventory…
- Information produced on the cost of inventory is not useful for short term decision making (because it
includes fixed manufacturing costs which is typically not relevant)
VARIABLE COSTING :
Only attaches variable manufacturing costs to units of inventory (and therefore the value of inventory in the
balance sheet). Expensed as part of COGS when inventory is sold. Fixed manufacturing, fixed non-
manufacturing and variable non-manufacturing costs are treated as period expenses.
Revenue A
Cost of Goods
Opening X
Variable manufacturing X
Available for sale SUM
Ending inventory B
COGS SUM – B
Variable non mfg expense (e.g. marketing costs) C
Total contribution margin A – (SUM – B – C)
Fixed manufacturing costs D
Fixed non-manufacturing costs E
Operating profit A – (SUM – B – C) – D – E
Pros:
- Information produced on inventory cost is more useful than AC for short term decision making
(however still not ideal as the inventory cost under VC does not include non-manufacturing variable
costs which may be a relevant cost to consider in the short term)
Cons:
- Is not GAAP/IFRS compliant
- Not suitable for long-term decision making; omits capacity costs (fixed costs) in costing the inventory

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EFFECT OF VC OR AC ON PROFIT :
Absorption costing profit – Variable costing profit = Fixed mfg costs in closing inventory stock – Fixed mfg costs
in opening stock. ∴ Absorption costing profit > Variable costing profit if fixed manufacturing costs in closing
stock (under absorption costing) > fixed manufacturing costs in opening stock (under absorption costing).
This is because fixed manufacturing costs in closing stock = fixed mfg costs from current period deferred to
future periods under absorption costing. Similarly, fixed manufacturing costs in opening stock is the amount of
fixed cost from previous periods that has been expensed in the current period under absorption costing
(unless some of the opening inventory stock remains unsold and becomes part of closing stock). Therefore, if
fixed manufacturing costs in closing stock (under AC) > fixed manufacturing costs in opening stock (under AC),
then more fixed costs have been deferred to future period(s) than the amount of fixed costs from previous
periods that were expensed this period and consequently since costs are lower profit is higher than under
variable costing. If vice versa, then VC profit > AC profit.
If stock levels INCREASES (higher closing inventory ∴ sales < production) during the accounting period, AC
profit will generally be higher than VC profit. This is because AC would defer more fixed mfg cost than the
amount of fixed mfg costs incurred in previous periods that is expensed in the current period. Under VC, fixed
costs expensed during the period = fixed costs incurred in the period.
If stock levels DECREASES (lower closing inventory ∴ sales > production) during the accounting period, AC
profit will generally be lower than VC profit. This is because more fixed mfg costs from previous periods are
being expensed than the amount of fixed mfg costs in the current period that is being deferred to future
periods under AC.
LONG-RUN PRICING
Pricing decisions that will be made now and maintained for an extended period.
There are 3 main influences of pricing for non-commodity products (if commodity => price taker):
1. Customers
a. Need to understand how much customers will be willing to pay for product. This would
depend on their preferences. Also enables businesses to engage in discriminatory pricing
(charging different prices for different customers => e.g. cinema tickets cheaper for
pensioners/children compared to adults
2. Competitors
a. How much competitors charge and the features of their similar products will influence how
customers will react to our prices
3. Costs
a. Need to sell at a price that exceeds the costs of making the product (i.e. Selling price > Cost
per unit {includes both fixed costs per unit and variable costs per unit})
There are 2 long-run pricing approaches:
TARGET PRICING:
1. Evaluate the market (what customers want/willingness to pay, how competitors will react to our
actions). Choose a target price based on customers perceived value for the product and the prices of
competitors charge
2. Decide on a target operating profit per unit

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3. Derive the target cost per unit by subtracting the target operating profit per unit from the target
price. This target cost is based on full product cost (i.e., include all manufacturing and non-
manufacturing costs such as R&D, design, marketing, customer service costs)
4. Perform value engineering to achieve target costs (to reduce costs to target levels). Value engineering
re-evaluates the value chain to look for cost savings while satisfying customer needs. It can result in
improvements in product design, changes in materials specs, modifications in the production process
and post-production process (e.g., distribution)
VALUE ENGINEERING:
Eliminates/reduces non-value added costs/activities.
NON VALUE -ADDED COSTS /ACTIVITIES : those that customers are not willing to pay for/don’t want (e.g. costs of
rework, costs of rush order of raw materials, unnecessary transport costs for moving raw materials from
storage to factory)
VALUE -ADDED COSTS /ACTIVITIES : design, tools/machinery, assembly, testing. Note: if design includes designing a
feature consumers don’t want, this is a non-value added cost component of a value added cost.
LOCKED-IN COSTS: costs that have not yet been incurred but that will be incurred in the future on the basis of
decisions already made (e.g., type of materials to use, processor speed, amount of on-board memory).
Cost incurrence occurs when a resource is sacrificed or used up. For some products, this can happen long after
costs have been locked-in.
Therefore, when a significant fraction of the cost is locked in at the design phase, the value engineering / cost
reduction effort needs to be ramped up during this phase as well.
COST PLUS:
- Start with an evaluation of the (unit) cost of the product the firm sells
- Add a mark-up (%) on top of this unit cost to get the unit selling price for the product that will deliver
the target profit.
Price=Cost base + Mark−up
Can be used even when there are no similar competitor products in the market place
DETERMINING THE MARK-UP:
Use the target return on investment which is linked to what the shareholders (and debt-holders) would like to
earn on their investment. To do this, the amount of capital (total fixed and current assets) that has been
invested in a particular product line needs to be determined. Return demanded depends upon risk of
investment.
E.g. 15% ROI (return on investment) for investment of $1 million means this product should earn a profit of
Target profit
$150,000. If management expects to sell 50,000 units, its mark-up over cost = be sold ¿ =
Unitsexpected ¿
150000/50000 = $3.00 per unit

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DETERMINING THE COST BASE:
The full value chain product cost should be used in the long-run (ensures the firm can recover all its costs and
therefore continue to operate in long-run). Helps promote price stability (as minimises short-term price cutting
tactics that aim to boost contribution margin).
Note: care not to assign indirect costs to products arbitrarily i.e., need to choose the allocation base that
reflects the underlying cost driver. However, despite our best efforts, some indirect costs would still have to be
allocated to products rather arbitrarily. If arbitrary allocation happens, then the pricing that is based on this
cost base will be somewhat distorted.
Note: ensure that the price covers full product costs and meets ROI target requires the estimate on the
quantity sold to be met. E.g. If the company expects 50,000 units of Product A to be sold, incurs a fixed cost of
$100,000 per year and a variable cost of $3 per unit. The full cost base of Product A is ($100,000) / 50,000
units + $3 = $5 per unit. However a price of $5/unit (assuming zero mark up) will only cover its full cost (and
therefore breakeven) if the company sells 50,000 units.
STANDARD ORDER PRICING :
- All costs (i.e., full costs) are relevant because in long-run, the fixed costs (rent, mechanic labour, etc)
would not be incurred if the component that is currently made by the company is outsourced.
o Note: depreciation → is a past cost… (irrelevant) but alternatively, it could be used as an
approximation of the costs of replacing equipment in the future (relevant).
ACTIVITY BASED MANAGEMENT:
Management decisions that use activity-based costing information to increase customer satisfaction and/or
increase profitability. Decisions can involve pricing, cost reduction, process improvement, product design
decisions and customer –related decisions* our focus.
ABC can be used to allocate & trace costs to different customers (since each customer can be a cost object).
This is important because different customers demand different levels of organisational resources and to
determine customer profitability, we need to know this. By tracing / allocating activity costs to customers, you
could:
- Prioritise / protect your most profitable customers

- Reprice expensive services, based on cost-to-serve (e.g., if a customer orders a lot of rush deliveries
that are costing the business a lot, then can increase the price to this customer)
- Discount, if necessary to gain more business with customers who are low-cost
- Negotiate changes in customer behaviour that lowers cost-to-serve and lowers prices charged i.e.,
win-win (e.g. get customers to order in larger order sizes so can reduce order placing costs).
- Decide to stop servicing unprofitable customers
Example of customer-related costs (and their typical cost drivers)
 Order costs: number of orders received

 Sales visit costs: number of sales visit
 Product-handling costs: number of units sold

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These costs are possibly fixed cost
 The cost associated with these costs is mainly the salaries of staff employed to do these activities.
These tend to be permanent employees whose salaries are fixed (i.e. irrespective of the orders
received, sales visits made)
 Therefore, if a customer is dropped, resulting in lower total orders, total order costs would not fall in
the near term as the order clerk will likely remain employed in near term and paid the same amount.
 In this situation, what would happen if total orders dropped is that the cost per order would increase
as the same total order cost (mainly the salary of the order clerk) is spread across fewer orders
However, in the long term, all costs can be altered including fixed costs.
 Therefore, dropping customers can lead to (for example) lower total order costs in the long run once
we are able reduce the number of order clerks
 ABM/ABC largely deals with fixed costs that can only be altered in the long run
RULE OF ONE:
Argument that assignment of selling, marketing, distribution and administration expenses to cost objects such
as customers would be arbitrary and misleading since these costs are fixed costs.
However if these expenses are handled by departments that are staffed by more than 1 person, it is likely to
be because the amount of work (created by customer demand) that needs to be done is significant and more
than 1 person can handle (can justify hiring more staff and can allocate these costs directly to the particular
customer(s) that cause the additional work and hence extra costs).
Ultimately, we allocate costs less arbitrarily, more based on cause-effect.
Then understanding the nature of demand for work in these departments should give us insights into the
activities performed and the basis for allocating the costs of these activities to the different customers.
CUMULATIVE CUSTOMER PROFITABILITY :
See lecture page printout.
Introduction to budgeting
BUDGET
 Is a quantitative representation of management’s plan for a future time period (NPV, predicted sales
price, predicted contribution margin, predicted profit…etc).
 It assists mgmt with planning and control
o Budgets are part of the organisation’s plans that need to be followed in the upcoming period
o Control = tracking the actual numbers against the budget to help ensure that the
organisation’s goals are met
 Can cover both financial and non financial aspects
ROLES OF BUDGET :
1. Helps ensure that company’s strategy (e.g. strategy to launch new product) is implemented effectively
a. Sales from the new product lines would be included in the sales budget
b. Costs associated with the development and launch of new product lines will also be included
in the budget to ensure resources are forecast and set aside to facilitate the launch

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2. Performance evaluation
a. Individuals will be made accountable for different parts of the budget (department heads,
managers…)
b. Better than using past performance to evaluate current performance if circumstances have
changed (e.g., macroeconomic conditions) or if new unchartered territory for the business
(e.g. if many new customers this year or restructuring of business)
3. To motivate staff – e.g., reward staff if budgets are met
4. Coordination: ensure the different parts of the organisation (sales team, production team,
distribution team etc) work together effectively
a. E.g., if the sales team expects an increase in unit sales in the upcoming year, this would be
communicated to the production team during the budgeting process to ensure that the
additional units can actually be produced
5. Communicates management’s plans to those in the organisation who have access to the budget
ISSUES WITH BUDGET :
 Fast changing circumstances may render budgets obsolete (e.g., the budgeted sales numbers may not
be achievable if economic downturn, entrance of new competitor). Consequently, the budget that was
formulated in the past may no longer be a good benchmark to evaluate performance, motivate staff,
and coordinate between the various departments
 Meeting the budget may not result in meeting the company’s overall financial objectives (e.g.,
operating profits, ROI). Rigidity in the use of the budget may be counterproductive.
o E.g., ensuring each expense item is less than the budgeted amount (e.g., labour cost, raw
materials etc.) may have adverse impact on revenues due to lower staff morale (since they are
paid less), quality compromises etc. Not wanting to exceed budgeted costs may lead to firm
deciding not to purchase more materials to make more products to sell to additional profitable
customers that budget demand didn’t forecast.
o Sometimes it is ok to be above (below) the cost (revenue) budget if the benefits gained (cost
avoided) are greater than the additional cost incurred (revenues forgone)
 Trade-off between performance evaluation/motivation vs. planning
o If budgets are used to evaluate performance and administer rewards, then this creates
incentives for employees to negotiate for a budget that is easy to achieve (e.g., lower the
sales revenue target, increase the salary budget to allow more staff to be hired).
 May affect effectiveness of budgets as planning and coordinating tool – e.g., if sales
revenues targets are exceeded significantly (because they are too ‘soft’), production
department may struggle to keep pace with the higher than budgeted sales, might
have problems meeting ending inventory & raw materials stock targets.
RESOLVING BUDGET ISSUES :
 Re-evaluate budget/plans when significant changes in the operating environment.

 Consider rolling budgets – are updated periodically by adding a new budget period to replace the
period had just past so that there is always a 12 month budget period for example.
 Evaluate performance and reward staff based on multiple measures (not just on performance against
budget), including how the company has performed relative to its competitors.
 Administer budgets with some degree of flexibility e.g., allow costs to exceed the budgeted amount
sometimes if this increases likelihood of achieving the company’s overall financial objectives or if the
benefits likely exceed the additional cost.

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TYPES OF BUDGET :
The master budget consists of a number of separate but interdependent budgets that lays out the company’s
sales, production and financial goals.
- Operating budget: budgeted P/L statement and supporting budget schedules including the sales
budget, production budget, direct materials budget, direct labour budget, selling and admin budget,
manufacturing overhead budget and closing inventory budget
- Financial budget: cash budget, budgeted balance sheet and budgeted statement of cash flows
*See handout for order of preparing budgets.
Sales budget – forecast sales, revenue. Production budget – quantity of product output required to meet
forecast sales. Selling/admin budget – what supporting costs are required to meet target sales. Inventory
budget – level of target closing stock, prepared at same time as production budget to determine how much
needs to be made. Direct mats budget – how much direct mats needs to be bought to meet production and
closing stock figure. Direct labour budget – what will labour cost for desired production. Manufacturing
overhead budget – what will manufacturing overheads be for desired production. Cash budget – schedule of
expected cash receipts and payments. Capital budget – spending on investments, returns on them.
*Note: if service-based organisation, start with revenue budget rather than sales budget.
RESPONSIBILITY ACCOUNTING:
Managers should be held accountable only for those items that they can control (to a significant extent). This
is called the ‘controllability principle’. If people are held accountable for items they cannot control, this is a
source of significant demotivation. E.g. the head of the sales team should not be held accountable for
achieving the targeted profit since he/she does not control the production process and SG&A expenses –
which is where most of the costs are incurred.
TYPES OF RESPONSIBILITY CENTRES:
Cost centre: A type of responsibility centre wherein the manager is accountable for costs only. Example-
maintenance department of hotel chain
Revenue centre: A type of responsibility centre wherein the manager is responsible for revenues only.
Example- Sales department of hotel chain
Profit centre: A type of responsibility centre wherein the manager is accountable for revenues and costs.
Example- Hotel Manager
Investment centre: A type of responsibility centre wherein the manager is accountable for investments,
revenues and costs. Example-regional manager of hotels who has the discretion to open new hotels
Flexible budgets, Standard costs, Variance analysis

*Note: Denominator = Allocation Base
STATIC BUDGET :
A budget based on one level of output – it is not adjusted or altered after it is set, regardless of changes in
actual output. It is developed at the start of the period.

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FLEXIBLE BUDGET :
A budget that is adjusted for ensuing changes in actual output (since it is likely that actual output is not the
same as the output assumed in the static budget). It is developed at the end of the period.
Flexible budget = what our static (original) budget would have looked like if developed based on the actual
quantity of output produced. I.e. standard quantity X standard price given ACTUAL output for period.
Flexible budget facilitates performance analysis. Comparing the actual results against the flexible budget
would allow us to get a sense of how different our actual and budgeted costs are, after ‘equalizing’ the
production volume
*Note: both static and flexible budgets use the same standard (or budgeted) unit selling prices, unit variable
costs and fixed cost
Steps to produce:
1. Determine the budgeted selling price per unit, the budgeted variable costs per unit, and the
budgeted fixed costs
2. Determine the actual quantity of the revenue driver (e.g. units sold)
3. Determine the flexible budget for the revenue based on the budgeted unit revenue and the actual
quantity of the revenue driver
4. Determine the actual quantity of the cost driver (e.g., units produced)
5. Determine the flexible budget for costs based on the budgeted unit variable costs and fixed costs and
the actual quantity of the cost driver
STANDARD COSTS :
Benchmarks/norms for measuring performance (by comparing actual costs to the standard). Two types:
Quantity standards – specify how much of an input should be used to make a product/provide service
¿ quantity expected ¿ be used per product × number of products expected ¿ be made
Price standards – specify how much should be paid for each unit of input.
amount actually p aid for inputs

¿
quantity of inputs purchased
*Note: Budgeted price = standard price. Budgeted quantity = standard quantity
MANAGEMENT BY EXCEPTION : deviations from standards deemed ‘significant’ (either favourable or unfavourable
variances) are brought to the attention of management, so that the cause of the variance can be identified
(e.g. standard might be inappropriate, performance might just have been very good or bad and why).
VARIANCES:
STATIC BUDGET VARIANCE : (LEVEL 1) breaking down level 0 static budget variance.
Difference between actual results and the static (original/start-of-period) budget

Actual output (units)
Forecast output (units)
( Standard quantity (total) × Standard per unit price )−( Actual quantity (total) × Actual per unit price)

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SALES VOLUME VARIANCE : (LEVEL 2)
Difference between static budget amount and the flexible-budget amount for both revenue and cost items.
Both static and flexible budgets use the same standard (or budgeted) unit selling prices, unit variable costs and
fixed cost. Therefore, this variance arises due to difference between budgeted units sold/produced vs. actual
units sold/produced
Forecast output (units) Actual output (units)
( Standard quantity (total) × Standard per unit price )−(Standard quantity (total )× Standard per unit price)
FLEXIBLE BUDGET VARIANCE : (LEVEL 2)
Difference between actual results and the flexible budget

Actual output (units) Actual output (units)
( Standard quantity (total) × Standard per unit price )−( Actual quantity (total) × Actual per unit price)
PRICE VARIANCE : (LEVEL 3) purchasing manager responsible
Difference between actual price and standard price

( Actual quantity (total) × Standard per unit price ) −( Actual quantity (total )× Actual per unit price)
Favourable if positive number, unfavourable if not. State why: because price paid > or < standard price, poor
price negotiation, charged extra for rush order, higher or lower quality of input purchased.
*Note: use quantity of input PURCHASED.
QUANTITY/EFFICIENCY VARIANCE : (LEVEL 3) production manager responsible
Difference between actual quantity and standard quantity of materials expected to be used to produce the
product.
( Standard quantity (total) × Standard per unit price )−( Actual quantity (total)× Standard per unit price)
Favourable if positive number, unfavourable if not. State why: because quantity used > or < standard quantity,
input used more/less efficiently than standard expected, increased skill of workers.
*Note: use quantity of input CONSUMED.
LEVEL 0 ANALYSIS : finding Static-budget variance of operating profit.
ANALYSING VARIANCES:
Analyse variances → identify questions → receive explanations → take corrective action → conduct next
period’s operations → prepare flexible budget → repeat.
WHEN TO INVESTIGATE :
In reality, the standard is a range of possible acceptable outcomes and therefore, the fact that there is a
variance between the actual vs. the standard may not necessarily mean that action needs to be taken.
BENCHMARK : the budgeted amount is the benchmark (point of reference to which comparisons are made)
EFFECTIVENESS : degree to which a predetermined objective/target is met
EFFICIENCY : relative amount of inputs used to achieve a given level of output

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Management would need to decide what is an acceptable range for each variance and a threshold beyond
which before an investigation is triggered (i.e., management by exception).
An alternative approach to ‘management by exception’ is ‘continuous improvement’ where management

looks at all costs items (irrespective of whether large variance or not) to see if they could be reduced and
whether the standard can be reduced.
VARIANCE USES:
1. Evaluate performance
a. Need to understand cause of variance E.g., an unfavourable materials efficiency variance could
be due to poor hiring practices as opposed to poor production practices
b. Are the standards reasonable? Too easy to meet? Too hard?
c. Overemphasis of any single performance measure may cause dysfunctional behaviour E.g.,
sole focus on price variance to evaluate performance of purchasing manager may lead to
quality compromises
d. Quantitative and qualitative standards
2. Organisational learning
a. E.g., an unfavourable materials efficiency variance could lead to:
i. Redesign products / processes.
ii. Changing suppliers
iii. Workforce training
iv. Changing the assignment of staff to tasks
v. Better scheduling of materials delivery
Variance Analysis of Indirect Costs

Focus on flexible budget variable manufacturing overhead variance analysis; VMOH rate/spending variance
and VMOH efficiency variance. (Level 3 analysis). I.e. ignore non-manufacturing indirect costs.
Variable Manufacturing Overhead Variance” = Flexible Budget Variable Manufacturing Overhead Variances
VARIABLE MFG O/H VARIANCES:
*Note: denominator = allocation base.
RATE/SPENDING VARIANCE
Difference between actual rate and standard rate

( Actual quantity of cost driver(total)× Standard per unit rate )−( Actual quantity of cost driver (total )× Actual per u
E.g. 2500 hours X $4.00 per hour – 2500 hours X $4.20 per hour. If negative = unfav. If positive = fav.
Alternatively: VMRV = Actual hours ×( Actual rate – Standard rate)
Actual variable manufacturing overhead expenses incurred

*Note: Actual rate = .
Actual number of labour hours
*Note: variable manufacturing overhead that should have been incurred = Standard rate X Actual hours.
This variance arises due to any of the following:

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- The actual price per unit of energy and/or indirect materials differ from the standard
- The actual usage of energy and/or indirect materials per unit of DLH differed from the standard
EFFICIENCY VARIANCE
Difference between actual rate and standard rate

( Standard quantity of cost driver (total )× Standard per unit rate )−(Actual quantity of cost driver (total) × Standard
E.g. 2500 hours X $4.00 per hour – 2400 hours X $4 per hour. If negative = unfav. If positive = fav.
Alternatively: VMEV =Standard rate ×( Actual hours – Standard hours )
*Note: Standard per unit rate X Standard quantity of cost driver (total) = variable manufacturing overhead in
flexible budget.
*Note: Standard hours =

Standard ( as set by management ) hours ¿ make each unit × Numberof output units actually produced .
*Note that this variance does NOT necessarily reflect how efficient the company was with respect to the use
of energy and indirect materials
This variance indicates whether the actual quantity of the allocation base is more or less than the standard
quantity of the allocation base (that is allowed for the actual qty of output produced) i.e., how efficient they
were with the allocation base i.e., DLH.
If the allocation base is a good representation of the variable OH’s cost driver, then more efficient use of the
allocation base, should also result in a more efficient use of the variable OH.
FIXED MFG O/H VARIANCES:
BUDGET VARIANCE
Budget variance=Actual ¿ overhead −Budgeted ¿ overhead
Variance is driven by actual fixed overhead incurred being different to budgeted amount.
VOLUME VARIANCE
Volume variance=Budgeted ¿ overhead−¿ overhead applied

¿ ¿ portion of predetermined overhead rate ×(Budgeted denominator qu antity based on output∧standard rate−Sta
*Note: If Budget Variance split up into the Fixed Overhead Flexible Budget Variance and the Fixed Overhead
Static Budget variance, these are always the same. This is because the static and flexible budget numbers for
fixed overheads do not differ.
Variance is driven by actual quantity of allocation base being different from that which was expected.
Budgeted total mfg overhead cost

Predetermined overhead rate=
Budgeted total amount of allocationbase
*Note: there will be a fixed and variable component of the budgeted total mfg overhead cost. Budgeted total
amount of allocation base will be the same for fixed and variable denominators.

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STANDARD COSTING : calculating overhead applied.
Overhead applied=Predetermined overhead rate × Standard quantity of allocation base given actual output
The standard costing system’s approach of applying/allocating indirect cost. Different to normal costing and
actual costing
Overhead applied under Normal costing =

Predetermined overhead rate× Actual quantity of the allocation base
Overhead applied under Actual costing = Actual overhead rate × Actual quantity of the allocationbase .
Both standard costing and normal costing results in a potential difference between total overhead applied
and the total overhead incurred (actual).
DISCRETIONARY COSTS: arise from periodic (yearly) decisions regarding the maximum outlay to be incurred. Not
tied to a clear cause-and-effect relationship between inputs and outputs. E.g. advertising, executive training,
R&D, corporate staff costs.
ENGINEERED COSTS : costs that result specifically from a clear cause-and-effect relationship between inputs and
outputs. E.g. direct: direct materials costs and direct manufacturing labour costs, indirect: energy costs,
indirect materials costs, indirect support labour costs.
INFRASTRUCTURE COSTS : costs that arise from having PPE and a functioning organisation. E.g. depreciation, long-
run lease rental and acquisition of long-run technical capabilities.
SET -UP COSTS: costs incurred whilst preparing a machine/manufacturing cell for production.

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Additional notes
DEPARTMENTAL COSTING : using separate indirect-cost rates for each department to allocate indirect costs. ABC
is a further refinement of this costing system.
INCREMENTAL COSTS : additional costs to obtain an additional quantity over and above existing or planned
quantities of a cost object.
OTHER COST ESTIMATION METHODS :
Statistical: visual fit
Non-statistical: managerial judgement → conference method, account analysis method, engineering.
VISUAL FIT : plot data points, then draw straight line through points ensuring equal number of points lie above
and below the line. Identify 2 points on the line, and solve for cost function.
DUAL-RATE COST ALLOCATION: allocation method that classifies costs in one cost pool into two sub pools
(variable cost sub pool and fixed cost sub pool). Each sub pool has a different allocation rate or a different
allocation base.
COST ESTIMATION : measurement of past cost relationships.
PLANNING : choosing goals, predicting results under various ways of achieving goals and then deciding how to
attain the desired goals
CONTROL: covers both the action that implements the planning decision and the performance evaluation of
personnel and operations
STEP-DOWN: allows partial recognition of services rendered by support departments to other departments
*when support departments provide services to one another reciprocally, step-down and direct are less
accurate.

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Summary - complete - Cost management- Exam revision

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- Provide information for economic decisions

Things to decide upon:

DIRECT COST: costs directly traceable to a cost object.

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COGM (COST OF GOODS MANUFACTURED ):

OPERATING INCOME : Salesrevenue – COGS=Gross margin – Operatingexpenses

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1. Determine allocation base

Actual costing → more reliable/accurate information. Not timely…

Budgeted amounts will likely differ from actual amounts:

Actual manufacturing overhead ≠ budgeted manufacturing overhead

*Note: predetermined mfg overhead applied =

Different approaches for adjusting for over/under allocation:

(1) C LOSE TO COGS

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Disadvantages: least accurate of the methods

(2) PRO-RATA: ALLOCATE DIFFERENCE PROPORTIONALLY RELATIVE TO TOTAL SIZE OF ACCOUNT

Advantage: less complex than (3)

Disadvantage: less accurate cost figures compared to (3)

The entire account balance ( e . g . WIP )

Advantage: is equivalent to (4) – therefore accurate cost figures

Disadvantage: more complex than (2)

MFG OH ∈that account ( e . g . WIP )

(4) ADJUSTED RATE – NOT REALLY ITS OWN CATEGORY .

Advantage: highly accurate cost figures

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Suitable for: organisations with unique/variable goods/services, lower volume of output,

HOW IS IT DONE? HOW IS IT RECORDED ?

Activity based costing

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ACTIVITY COST POOL:

Cost pool Allocation base

1. Cost pools are chosen

The cost assigned to a particular cost pool =

*See lecture 5 example.

To find cost:Unit activity cost ×number of allocationbase units

To find cost: Batch activity cost × number allocation base units

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E.g. Batch activity cost = $7 per kilometre X 100 km = $700

Product/Service sustaining: resources sacrificed on activities undertaken to support individual

ISSUE WITH MACHINE HOURS AS SOLE ALLOCATION BASE:

1. Direct materials are traced to a particular product line

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WEIGHTED AVERAGE VS. FIFO

Choice of FIFO or weighted average makes no difference if:

- Material costs dominate

Work Order 46 Work Order 47

DIRECT MATERIALS (use job Wool Polyester

OPERATIONS (use process costing approach)

1. Cutting Cloth Use Use

2. Checking Edges Use Don’t Use

3. Sewing Body Use Use

4. Checking Seams Use Don’t Use

5. Machine Sewing Collars and Don’t Use Use

6. Hand Sewing Collars and Lapels Use Don’t Use

Which costing system to choose?

Support department costs

(i) Ignore interdependence – Direct method. See – attached example

*Remember: do not include support department share in denominator!

(ii) Partial recognition of interdependence – Step-down method