Acct 323 Notes

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COST TERMS
January 15, 2021 11:26 AM
Manufacturing costs
• Direct materials (DM): raw material that are directly consumed in the manufacturing process and are measurable in an economically feasible way (these
materials are physically incorporated into the final product)
• Direct Labour
• Manufacturing overhead
Direct Materials (DM)

• DMs are removed from raw materials inventory and placed into the production process
• Materials that go into the final product are called raw materials
○ Raw materials may include both direct and indirect materials
• DMs may include both direct and indirect materials
○ Direct materials: materials that become an integral part of the product and that can be physically and conveniently traced directly to it
○ Indirect materials: not worth the expense or effort to trace the costs to the end product. They are included as part of manufacturing overhead
• Ex: materials used to support the production process (lubricants and cleaning supplies used in the automobile assembly plant)
Direct labour (ML)

• DL consists of labour costs that can be easily (physically and conveniently) traced to individual units of product
○ Ex: cost of salaries, wages (regular wage/h), and fringe benefits of employees who work directly on the manufacturing of the product
• Labour costs that cannot be traced to the creation of products (or it would be costly or inconvenient to trace) are called indirect labour and are treated
as part of manufacturing overhear
○ Ex: maintenance workers janitor and security guards
Manufacturing Overhead (MO)

• Includes all costs of manufacturing except direct material and direct labour
○ Ex:
• Rent for the production facility
• Depreciation on the production equipment
• Insurance on the production equipment
• Indirect materials used in producing records
• Indirect labour related to the CEO's supervision of the production process (20% of her time)
• The overtime premiums (overtime premiums-extra compensation from working overtime) for all factory workers are usually considered to be part of
manufacturing overhead
○ Product specific overtime premiums are part of direct labour
○ Idle time-full amount: sth breaks down and then workers are idle while waiting for it to be fixed
Non-manufacturing costs
• Marketing or selling costs: costs necessary to get the order and deliver the product
• Administrative costs: all executive, organizational, and clerical costs
• Product costs: DMs, DL, and MO (Mcost) (blue)
• Ex: manufacturing equipment depreciation, direct materials costs, electrical costs to light the production facility
• Period costs: selling costs and administrative costs (Non Mcost) (white)
• Ex: property taxes on corporate headquarters; sales commissions
Balance Sheet
• Raw materials: materials waiting to be processed
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• Work in process: partially complete products, some material, labour, or overhead has been added
• Finished goods: completed products awaiting sale
○ Conversion costs are costs incurred to convert the DM into a finished products
○ Prime costs: DM and DL
Income Statement
• COGS for manufacturers differs only slightly from COGS for merchandisers
• All manufacturing costs incurred during the period are added to the beginning balance of work in process
Cost Classifications for Predicting Cost Behaviour

• How a cost will react to changes in the level of activity within the relevant range
○ Fixed Cost: do not change in total with regard to changed in volume or level of activity within the relevant range (range in which the company expects
to operate in) (total FC remained unchanged when activity changes)
○ Variable Cost: change in direct proportion to changes in volume or level of activity within the relevant range (total VC changes when activity changes)
• Ex: the cost of ice cream; the cost of napkins for customers (baskin robbins)
• Cost driver
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• Relevant range: the range of activity within which the assumptions about variable and fixed cost behaviour are valid
• Mixed costs: contain variable and fixed cost elements
• direct materials is a variable cost

• depreciation is a fixed cost (a straight-line basis)
Assigning Costs to Cost Objects
• Cost objects: any unit of analysis for which cost data are desired, including products, customers, jobs, and organizational subunits
• For assigning costs to cost objects, we have Direct vs Indirect Costs:
○ Direct cost: costs that can be traced to a particular cost object in an economically feasible way
• Ex: direct material, direct labour
○ Indirect object: costs that can be traced to a particular cost object not in an economically feasible way (president's salary -> classroom object)
• Ex: manufacturing overhead
○ Classifying a cost as either direct or indirect depends upon the cost objective to which the cost is being related
Differential Cost and Revenue

• A difference in cost (revenues) between any two alternatives is known as a differential cost (revenue)
• A differential cost is also known as an incremental cost (an increase in cost from one alternative to another)
• Outlay cost: cost that requires a cash disbursement
Types of Cost Classifications

• Financial reporting
• Predicting cost behaviour
• Assigning costs to cost objects
• Decision making
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NOTE
• $2000 of raw materials has been drawn from the storeroom and used in the production of Job 110, but that no entry has been made in the accounting records for
the use of these materials. Job 110 has been completed but it is unsold at year end.
• Finished goods to be understated by 2000 at year end
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JOB-ORDER COSTING
January 23, 2021 10:59 PM
Types of Product Costing Systems

• Process costing
○ A company produces many units of a single product
○ One unit of product is indistinguishable from other units of products
○ The identical nature of each unit of product enables assigning the same average cost per
unit
○ Example companies: retail, service
• St. Mary's Cement (cement mixing)
• Petro-Canada (refining oil)
• Coca-Cola (mixing and bottling beverages)
• Scott Paper Company for Kleenex
• Heinz for ketchup
• Job-order costing
○ Many different products are produced each period
○ Products are manufactured to order
○ The unique nature of each order requires tracing or allocating costs to each job, and
maintaining cost records for each job
○ Example companies: manufacturing industries
• Bombardier (aircraft manufacturing)
• Bechtel international (large scale construct)
• Hallmark (greeting card design and printing)
• Architects
• Caterer for a wedding reception
• Builder of commercial fishing vessels
Job-order Costing Overview

• Change direct material and direct labour costs to each job as work is performed
• Manufacturing Overhead, including indirect materials and indirect labour,are allocated to all jobs
rather than directly traced to each job
Measuring Direct Materials Cost

• Bill of materials: A record that lists the type and quantity of each major item of the materials
required to make a product.
• Materials requisition form: A detailed source document that specifies the type and quantity of
materials that are to be drawn from the storeroom and identifies the job to which the costs of
materials are to be charged
○ The form controls the flow of materials into production and also makes entries in the
accounting records
• Job cost sheet: A form prepared for each job that records the materials, labour, and overhead
costs charged to the job, after being notified that the production order has been issued
Measuring Direct Labour Cost

• DLC is handled in a similar way as direct materials cost
• DL consists of labour charges that are easily traced to particular job
• Many companies use a computerized systems to maintain employees time tickets
• Only direct labour costs get posted to the job cost sheet, whereas indirect labour is part of
manufacturing overhead and does not get posted on a job cost sheet
• Today many companies rely on computerized systems (rather than paper and pencil) to maintain
employee time tickets
○ Time ticket: A detailed source document that is used to record an employee’s hour-by-hour
activities during a day
Computing Predetermined Overhead

• Manufacturing overhead must be included with direct materials and direct labour on the job cost
sheet, since manufacturing overhead is also a product cost.
• Assigning manufacturing overhead to units of product can be a difficult task.
○ Manufacturing overhead costs are indirect costs. This means that it is either impossible or
difficult to trace these costs directly to a particular product or job.
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○ Manufacturing overhead consists of many different items, ranging from the grease used in
machines to the annual salary of the production manager.
○ Even though output may fluctuate due to seasonal or other factors, manufacturing
overhead costs tend to remain relatively constant due to the presence of fixed costs.
○ The timing of payment of manufacturing overhead costs often varies.
• The only way to assign overhead costs to products is to use an allocation process:
○ Allocation base: A measure of activity, such as direct labour-hours (DLH) or machine-hours
(MH), that is used to assign costs to cost objects
○ Choice of an Allocation base:
• Should drive the overhead cost
• A cost driver is a factor that causes overhead costs
• If the base used does not drive the costs then the results will be inaccurate overhead
rates and distorted product costs
• A common allocation base is direct
• Predetermined overhead rate (POHR): A rate used to charge overhead costs to jobs; the rate is
established in advance for each period using estimates of total manufacturing overhead cost and
of the total allocation base for the period.
○ Ideally the allocation base is a cost driver that causes overhead

○ POHR is based on estimated rather than actual results because the predetermined
overhead rate is computed before the period begins and is used to apply overhead cost to
jobs throughout the period.
○ The process of assigning overhead cost to jobs is called overhead application
• Overhead application: The process of charging manufacturing overhead cost to job
cost sheets and to the Work in Process account
• When the allocation base is direct labour-hours, the formula becomes "Normal cost
system"
• Normal cost system: A costing system in which overhead costs are applied to
jobs by multiplying a predetermined overhead rate by the actual amount of the
allocation base incurred by the job.
• The Need for a POHR

○ 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
○ Predetermined rate is based on estimates rather than actual results
○ Predetermined overhead rate is computed before the period begins and used to apply
overhead cost to jobs throughout the period
• Computation of the unit cost
○ The average unit cost should not be interpreted as the costs that would actually be incurred
if an additional unit was produced
○ Fixed overhead would not change if another unit was produced, so the incremental coast of
another unit may be somewhat less than the average unit cost
The Purchase and Issue of Materials

• Raw material purchases are recorded in an inventory account
• Direct materials issued to a job increase Work in Process and decrease Raw Materials
• Indirect materials used are charged to Manufacturing Overhead and also decrease Raw
Materials
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• The recording of labour cost

○ The cost of direct labour incurred increases Work in Process and Manufacturing Overhead
• Recording actual Manufacturing Overhead

○ In addition to indirect materials and indirect labour, other manufacturing overhead costs
are charged to the manufacturing overhead account as they are incurred
• The application of MO
○ Work in Process is increased when Manufacturing Overhead is applied to jobs
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• The concept of a clearing account
• The cost of a completed job consists of the actual materials cost of the job, the actual labour cost
of the job, and the overhead cost applied to the job.
• Actual overhead costs are not charged to jobs and don't appear on the job cost sheet, nor do they
appear in the Work in Process account. Only the applied overhead cost, based on the
predetermined overhead rate, appears on the job cost sheet and in the Work in Process account.
Non-Manufacturing Cost
• These costs are not assigned to individual jobs; rather they are expensed in the period incurred
• Non-manufacturing costs should not go into the Manufacturing Overhead account.
• Examples:
○ Salary expenses of employees who work in a marketing, selling, or administrative capacity
○ Depreciation and salaries should be classified as product costs if related to manufacturing

but are classified as period costs and expensed if related to non-manufacturing activities.
○ Advertising expenses are expensed in the period incurred
Cost of Goods Manufactured (COGM)

• As jobs are completed, the COGM is transferred to Finished Good from Work in Process.
• The sum of all amounts transferred between WIP and Finished Goods represents the COGM for
the period
Cost of Goods Sold (COGS)

• When finished goods are sold, 2 entries are required
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○ To record the sale
○ To record COGS and reduce Finished Goods Inventory
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Complications of Overhead Application

• The difference between the overhead cost applied to WIP and the actual overhead costs of a
period is referred to as either underapplied or overapplied overhead
○ Underapplied overhead: A debit balance in the Manufacturing Overhead account that arises
when the amount of overhead cost applied to Work in Process is less than the amount of
overhead cost actually incurred during a period.
○ Overapplied overhead: A credit balance in the Manufacturing Overhead account that arises
when the amount of overhead cost applied to Work in Process is greater than the amount
of overhead cost actually incurred during a period. (slide 45, txt 206)
Disposition of Underapplied or Overapplied Overhead

• Current accounting standards applicable in Canada ( IAS 2) state that: Unallocated overheads are
recognised as an expense in the period in which they are incurred. In periods of abnormally high
production, the amount of fixed overhead allocated to each unit of production is decreased so
that inventories are not measured above cost
• The balance in the account must be treated in one of two ways
○ If overhead was underapplied, the remaining balance is closed out to Cost of Goods Sold
• Ex: close 5000 of underapplied overhead to COGS
○ If overhead was overapplied, the remaining balance is allocated among Work in Process,
Finished Goods, and Cost of Goods Sold in proportion to the overhead applied during the
current period in the ending balances of these accounts.
• Allocate overapplied overhead among accounts
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Multiple Predetermined Overhead Rates

• To this point, we have assume that there is a single predetermined overhead rate called a
plantwide overhead rate
The Use of Information Technology

• Technology plays an important part in many job-order cost systems
• When combined with electronic data interchange (EDI) or a web-based programming language
called Extensible Markup Language (XML), bar coding eliminates the inefficiencies and
inaccuracies associated with manual clerical processes
Predetermined Overhead Rate and Capacity

• Calculating POHR using an estimated, or budgeted amount of the allocation base has been
criticized because:
○ Basing the predetermined overhead rate upon budgeted activity results in product costs
that fluctuate depending upon the activity level
○ Calculating predetermined rates based upon budgeted activity charges products for costs
that they do not use
• Solution: using estimated total units in the allocation base at capacity in teh denominator of the
predetermined overhead rate calculation
• When capacity is used in the denominator of the predetermined rate, the predetermined
overhead rate stays the same, it is not affected by changed in activity
• When estimated activity is used in the denominator of the predetermined rate, the
predetermined overhead rate goes up when activity goes down
• IAS 2 now prohibits basing predetermined overhead rates on capacity for external reports
• Predetermined overhead rates based on capacity could still be used for internal reporting
• Managers would need to examine the benefits of improved decision making against the costs of
having to calculate inventory values and COGS using 2 different methods
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COST BEHAVIOUR
February 9, 2021 10:09 PM
Variable Cost Hours of Operating Time Total costs: Variable co

• In total: total variable cost is proportional to the activity level within the relevant range Total costs . Cost per hour: Variable cost.. Fixed cost
252,000 $279,000 4.50 4200 46.50 7,000 $ 31,500 25
• Per unit: variable cost per unit remains the same over wider ranges of activity (constant within the
$ 36000 252,000 $288,000 450 31.50 36.00 9,000 $ 4
relevant range)
32.50
• The proportion of variable costs differs across organizations.
○ A public utility with large investments in equipment will tend to have fewer variable costs
○ A service company will normally have a high proportion of variable costs
○ A merchandising company usually will have a high proportion of variable costs, like cost of sales
○ A manufacturing company will often have many variable costs
• True variable cost: direct materials is a true of proportionately variable cost because the amount used
during a period will vary in direct proportion to the level of production activity
• Step-variable costs: a resource that is obtainable only in large chunks (such as maintenance workers) and
whose costs increase or decrease only in response to fairly wide changes in activity
○ Small changes in the level of production are not likely to have any effect on the number of
maintenance workers employed
○ Only fairly wide changes in the activity level will cause a change in the number of maintenance
workers employed
○ Ex: supervisory salaries

• The linearity assumption and the relevant range
○ In dealing with variable costs, we have assumed a strictly linear relationship between cost and
volume, except in the case of step-variable costs.
○ Many costs classified by accountants as variable actually behave in a curvilinear fashion
○ Curvilinear costs show a curved relationship between cost and activity rather than a straight-line
relationship
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○ The variable cost rate should not change within the range
Fixed Cost
• In total: total fixed cost remains the same even when the activity level changes within the relevant range
(constant within the relevant range)
• Per unit: fixed cost per unit goes down as activity level goes up (vary with the level of activity)
• Fixed costs are most easily (and most safely) dealt with on a total basis, rather than on a unit basis, in cost
analysis work.
• 2 types:
○ Committed fixed costs: long-term, cannot be significantly reduced in the short term (depreciation
on equipment and real estate/property taxes, salaries of maintenance personnel)
○ Discretionary fixed costs: may be altered in the short-term by current managerial decisions (ad and
research and development)
• The trend in many industries is toward greater fixed costs relative to variable
○ Knowledge workers are demanded for their minds rather than their muscles
• The cost to compensate these valued employees is relatively fixed rather than variable
• The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is
flat
○ All cost behaviour assumptions are assumed to be valid

○ The total fixed costs should not change within the range
○ The total fixed sots and the average variable cost will probably be different at higher relevant
ranges
○ The width of the steps relates to the volume or level of activity. The width of the steps depicted for
step-variable costs is much narrower than the width of the steps depicted for the fixed costs
• For step-variable costs, the width of a step may be 40 hours of activity or less when dealing
with a cost such as maintenance labour.
• For fixed costs, the width of a step may be thousands or even tens of thousands of hours of
activity when dealing with a committed cost related to production equipment
Mixed Costs
• A mixed cost has both fixed and variable components (utility cost)
• The total mixed cost line can be expressed as an equation: Y = a + bX

○ Y = the total mixed cost
○ a = the total fixed cost (the vertical intercept of the line)
• the basic minimum costs of having an activity ready and available for use
○ b = the variable cost per unit of activity (the slop of the line)
• The cost incurred for actual consumption of the activity
○ X = the level of activity
• Common methods used for estimating the fixed and variable components
of a mixed cost:
○ Account analysis: Each account is classified as either variable or fixed based on the analyst's
knowledge of how the account behaves
○ Engineering approach: cost estimates are based on an evaluation of production methods, and
material, labour, and overhead requirements
○ High-low method
○ Regression analysis: multiple regression model: A regression model in which more than one
independent variable is used to predict the dependent variable
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The High-Low Method

• A method of separating a mixed cost into its fixed and variable elements by analyzing the change in cost
between the high and low levels of activity.
○ Based on the rise-over-run formula for the slop of a straight line
○ If the relationship between cost and activity can be represented by a straight line, then the slope of
the straight line is equal to the variable cost per unit of activity
○ Using the high–low method to analyze the relation between electrical costs and occupancy-days
• In some cases, this method might over-estimate the fixed cost and underestimate the variable cost per
unit since a line drawn through the high and low points would have a slope that is too flat
• If X is well outside of the relevant change -> DO NOT USE THE FORMULA, since both fixed and variable
costs could increase if the level of activity is higher than the normal range
○ Additional mechanics may need to be hired
○ More repair equipment may be needed
○ Facilities may need to be expanded
Least-Squares Regression Method

• A method used to analyze mixed costs if a scatter graph plot reveals an approximately linear relationship
between the X and Y variables
• Provides the most accurate estimate because it uses all the data points to estimate the fixed and variable
cost components of a mixed cost
• The goal: to fit a straight line to the data that minimizes the sum of the squared errors
• Provides a statistic called the R^2, which is a measure of the goodness of fit of the regression line to the
data points
○ Shows the percentage of the variation in total cost explained by the activity
• Problems frequently encountered in data collection

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○ Outliers
○ Missing data
○ Mismatched time period
○ Trade-offs in choosing the time period
The contribution format

• An income statement format where costs are separated into variable and fixed categories.
○ This is because the traditional format income statement is organized by function and fixed and
variable costs are not distinguished
• Used primarily for external reporting
○ Separating costs into fixed and variable elements is often crucial in making decisions
○ Contribution format facilities planning, control, and decision
○ Used primarily by management
• Contribution margin: The amount remaining from sales revenues after all variable expenses have been
deducted.
• This format is used for

○ Cost-volume-profit analysis
○ Budgeting
○ Pricing
○ Use of scarce resources
○ Make of buy analysis
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COST-VOLUME-PROFIT
February 20, 2021 11:02 PM
Definition
• Cost-volume-profit (CVP) analysis is a powerful tool that helps managers understand the
relationships among cost, volume, and profit.
• The most important assumptions underlying CVP analysis are: Selling price, variable cost per unit,
and total fixed costs remain constant through the relevant range.
• CVP focuses on how profits are affected by the following five elements:
○ Prices of products.
○ Volume or level of activity.
○ Per unit variable costs.
○ Total fixed costs.
○ Mix of products sold.
Basics of CVP Analysis

• The contribution income statement is helpful to managers in judging the impact on profits of
changes in selling price, cost, or volume (emphasize on cost behaviour)
○ Contribution Margin (CM) is the amount remaining from sales revenue after variable
expenses have been deducted
• The higher the CM ratio, the more money is available to cover the business's
overhead expenses, or fixed costs.
• CM ratio = CM per Unit / Sales per Unit
• Sales, variable expenses, and contribution margin can also be expressed on a per unit basis
• For each additional speaker, $100 more in CM will become available to help cover the fixed
expenses. If a second speaker is sold, for example, then the total CM will increase by $100 (to a
total of $200) and the company’s operating loss will decrease by $100, to $34,800
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• If enough speakers are sold to generate $35,000 in CM, then all of the fixed costs will be covered
and the company will have managed to at least break even for the month. To reach the break-
even point, the company has to sell 350 speakers in a month, since each speaker sold yields $100
in CM:
• To estimate profit: multiply the number of units sold above break-even point by the contribution
margin per unit
○ Ex: if 400 units are sold, the net operating income will be: 50 * 250 = 12,500
CVP Relationships in Graphic Form

• Cost–volume–profit (CVP) graph: The relationships among revenues, costs, and level of activity
presented in graphic form.
• Unit volume is usually on the horizontal X axis and dollars on the vertical Y axis
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• The profit increases to the right of the break-even point as the sales volume increases and that
the loss becomes increasingly larger to the left of the break-even point as the sales volume
decreases.
Contribution Margin Ratio
• CM Ratio = (Avg selling price - avg variable expense)/avg selling price = (sales - variable expenses)
/ sales
• Ex: for each dollar increase in sales, total CM will increase by 40 cents ($1 sales × CM ratio of 40%).
Operating income will also increase by 40 cents, assuming that fixed costs are not affected by the
increase in sales.
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• Ex: if Acoustic Concepts plans a $30,000 increase in sales during the coming month, the CM will
increase by $12,000 ($30,000 increased sales × CM ratio of 40%).
Change in Fixed Cost and Sales Volume:

• The sales manager feels that a $10,000 increase in the monthly advertising budget would increase
monthly sales by $30,000 to a total of $130,000.
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○ Assuming no other factors need to be considered, the increase in the advertising budget
should be approved since it would lead to an increase in operating income of $2,000.
○ Both approaches involve an incremental analysis—they consider only those items of

revenue, cost, and volume that will change if the new program is implemented
Change in Variable Costs and Sales Volume

• increase variable costs (and thereby reduce the CM) by $10 per speaker
• The $10 increase in variable costs will decrease the unit CM by $10—from $100 to $90.
• the sales manager predicts that the higher overall quality would increase sales to 480 speakers
per month
○ the higher-quality components should be used.
Change in Fixed Costs, Selling Price, and Sales Volume

• To increase sales, the sales manager would like to reduce the selling price by $20 per speaker and
increase the advertising budget by $15,000 per month.
• unit sales will increase by 50% to 600 speakers per month
• A decrease of $20 per speaker in the selling price will cause the unit CM to decrease from $100 to
$80.
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○ the changes should not be made
Change in Variable Cost, Fixed Cost, and Sales Volume

• pay the salespeople a commission of $15 per speaker sold, rather than the flat salaries that now
total $6,000 per month.
• The sales manager is confident that the change will increase monthly sales by 15% to 460
speakers per month
• Fixed costs will decrease by $6,000, from $35,000 to $29,000.
• Variable costs per unit will increase by $15, from $150 to $165
• the unit CM will decrease from $100 to $85
○ the change should be made
Change in Regular Selling Price

• The company has an opportunity to make a bulk sale of 150 speakers to a wholesaler if an
acceptable price can be worked out.
○ This sale would not affect the company’s regular sales and would not impact total fixed
expenses.
• Acoustic Concepts wants to increase its monthly profits by $3,000
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Break-Even Analysis
• Break-Even Computations: The break-even point can be computed using either the equation
method or the formula method—the two methods are equivalent.
○ Equation method: A method of computing breakeven sales using the contribution format
income statement.
○ Formula method: A method of computing the break-even point where the fixed expenses
are divided by the contribution margin per unit.
• Unit contribution margin = selling price - variable expenses
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• This approach, based on the CM ratio, is useful when a company has multiple product
lines and wishes to compute a single break-even point for the company as a whole
Target Operating Profit Analysis: a target operating profit of $40,000 per month
• Equation method
• Formula method
○ Unit CM = unit selling price - unit variable expense
After-Tax Analysis
• With: t as tax, B as operating profit before taxes
•
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The Margin of Safety

• The excess of budgeted (or actual) sales over the breakeven volume of sales.
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CVP Considerations in Choosing a Cost Structure

• Cost Structure and Profit Stability: it is not obvious which cost structure is better. Both have
advantages and disadvantages
• Operating Leverage: A measure of how sensitive operating income is to a given percentage
change in sales. It is computed by dividing the contribution margin by operating income.
○ Same increase in sales can lead to different increase in operating income
○ Degree of operating leverage: A measure, at a given level of sales, of how a percentage
change in sales volume will affect profits. The degree of operating leverage is computed by
dividing contribution margin by operating income.
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VARIABLE COSTING
March 1, 2021 9:04 PM
Absorption Costing (full costing)

• Absorption costing method will produce the highest values for work in process and finished goods
inventories
• Absorption costing treats all manufacturing costs as product costs, regardless of whether they are
variable or fixed, therefore, it is not well suited for CVP computations
• Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of
product, along with the variable manufacturing costs
○ Fixed manufacturing overhead cost deferred in inventory
• If there is an ending inventory, the fixed manufacturing costs associated with the
inventory will be carried forward as a balance sheet account, Inventory, rather than
being treated as a period cost.
• Operating income is affected by changes in production under absorption costing even though the
number of units sold is the same each year
○ Absorption costing income is influenced by changes in unit sales and units of production
○ Net operating income can be increased simply by producing more units even if those units
are not sold
• Fixed manufacturing costs must be assigned to products to properly match revenues and costs
○ Absorption costing treats fixed MO as a variable cost, which can
• Lead to faulty pricing decisions and keep-or-drop decisions
• Produce positive net operating income even when the number of units sold is less
than the breakeven point
• Absorption costing is required for external reports in the US and is the predominant method used
in Canada
○ For income tax purposes in Canada, the Canada Revenue Agency permits both variable and
absorption costing for determining taxable income
○ Since top executives are usually evaluated based on external reports to shareholders, they
may feel that day to day decisions should be based on absorption cost income
Variable Costing (direct costing or marginal costing)

• A costing method that includes only variable manufacturing costs—direct materials, direct labour,
and variable manufacturing overhead—in the cost of a unit of product.
• Fixed manufacturing overhead is treated as a period cost, and, like selling and administrative
expenses
• Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced
• Operating income is not affected by changes in production under variable costing
○ Variable costing income is only affected by changes in unit sales and not affected by the
number of units produced, therefore:
• The income statements are easier to understand
• Net operating income figures that are more consistent with managers' expectations
○ As a general rule, when sales go up, net operating income goes up, and vice versa
○ When the number of units sold exceeds the number produced, the operating income will be
higher for a manufacturer
• Advantages:
○ Management finds it more useful
○ Consistent with CVP analysis
○ Net operating income is closer to net cash flow
○ Consistent with standard costs and flexible budgeting
○ Easier to estimate profitability of products and segments
○ Profit is not affected by changes in inventories
○ Impact of fixed costs on profits are emphasized
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Example:
• The variable costing data in Exhibit 8–2 can be used immediately in CVP computations
• The ending inventory figure under the variable costing method is $5,000 less than it is under the
absorption costing method. This is because under variable costing, only the variable
manufacturing costs are assigned to units of product and therefore included in inventory:
○ Variable manufacturing costs: 1,000 units × 7 = $7,000
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○ Operating income is $5,000 more under absorption costing since$5,000 of fixed
manufacturing overhead cost has been deferred in inventory to the next period under that
costing method
• In a lean production (JIT) inventory system. Productions tends to be equal to sales, so the
difference between variable and absorption income tends to disappear
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BUDGETING
March 16, 2021 11:24 PM
Basic Framework of Budgeting

• Budget: a detailed plan for the future that is typically expressed in quantitative terms.
○ The act of preparing a budget is called budgeting
○ The use of budgets to control a firm’s activities is known as budgetary control
○ Master budget: A summary of a company’s plans in which specific targets are set for sales,
production, distribution, administrative, and financing activities; it generally culminates in a
cash budget, a budgeted income statement, and a budgeted balance sheet.
• Planning and Control: An effective budgeting system provides for both planning and control
○ Planning involves developing objectives and preparing various budgets to achieve these
objectives.
○ Control involves gathering feedback to assess the extent to which the objectives developed
at the planning stage are being attained.
• Responsibility accounting: A system of accountability in which managers are held responsible for
those items of revenue and cost - and only those items - over which they can exert significant
influence
○ Managers are held responsible for differences between budgeted and actual results
• Choosing a Budget Period: the annual operating budget may be divided into quarterly or monthly
budgets
○ Continuous or perpetual budget: A 12-month budget that rolls forward one month (or
quarter) as the current month (or quarter) is completed.
• The participative (self-imposed) budget (PB): A method of preparing budgets in which managers
prepare their own budget estimates. These budget estimates are then reviewed by the manager’s
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supervisor, and any issues are resolved by mutual agreement, leading to a completed budget.
○ Advantages:
• Individuals at all levels of the organization are recognized as members of the team
whose views and judgments are valued by top management
• Budget estimates prepared by front-line managers are often more accurate and
reliable than estimates prepared by top managers, who have less detailed knowledge
of market factors and day-to-day operations.
• Motivation is generally higher when individuals participate in setting their own goals
than when the goals are imposed from above. Participative budgets create
commitment to attaining the goal
• A manager who is not able to meet a budget that has been imposed from above can
always say that the budget was unrealistic and impossible to meet. With a
participative budget, this excuse is not available.
○ Budgetary slack: The difference between the revenues and expenses a manager believes can
actually be achieved and the amounts included in the budget. PB should be reviewed by
higher levels of management to prevent such slacks.
• Slack will exist when revenue budgets are intentionally set below expected levels and
expense budgets are set above expected levels.
○ Budget committee: A group of key management personnel responsible for overall policy
matters related to the budget program, coordinating the preparation of the budget,
handling disputes related to the budget, and approving the final budget.
○ Behavioral factors in budgeting:
○ The Sales Budget: the starting point in preparing the master budget
• Multiplying the budgeted sales in units by the selling price
• Ex: At Patterson Framing, experience has shown that 60% of sales is collected in the
quarter in which the sale is made and the remaining 40% is collected in the following
quarter.
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○ The Production Budget: A detailed plan showing the number of units that must be produced
during a period to meet both sales and inventory needs.
○ Inventory purchases: merchandising firm
○ The DM purchases budget
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○ DL
○ MO
○ Selling and admin
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NOTE:
• The preparation of a master budget involves numerous interrelated schedules and begins with the
development of the sales budget, which is based on the sales forecast. For a manufacturing
company, once the sales budget has been set, the production budget can be prepared since it
depends on how many units are to be sold. The production budget determines how many units
are to be produced. After it has been prepared, the various manufacturing cost budgets and
selling and administrative budgets can be developed
• After the detailed budget schedules have been completed, the cash budget, budgeted income
statement, and budgeted balance sheet can be prepared, which collectively provide an overall
financial summary of the budget.
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STANDARD COSTS & OVERHEAD ANALYSIS

March 21, 2021 2:19 PM
Standard Costs
• A standard is a benchmark or “norm” for measuring performance
• Standards and budgets are very similar. The major distinction between the two terms is that a
standard is a unit amount, whereas a budget is a total amount
○ A standard can be viewed as the budgeted cost for one unit of product
• 2 types:
○ Quantity standards specify how much of an input should be used to make a unit of product
or provide a unit of service.
○ Cost (price) standards specify how much should be paid for each unit of the input
• If either the quantity or the cost of inputs departs significantly from the standards, managers
investigate the discrepancy to find and eliminate the cause of the problem. This process is called
management by exception
○ Differences between standard prices and actual prices and standard quantities and actual
quantities are called variances
○ This basic approach to identifying and solving problems is used in the variance analysis cycle
Setting Standard Costs

• Setting price and quantity standards ideally combines the expertise of everyone who is
responsible for purchasing and using inputs. In a manufacturing setting, this might include
accountants, purchasing managers, engineers, production supervisors, line managers, and
production workers.
• Standard cost record: A detailed listing of the standard amounts of materials, labour, and
overhead that should go into a unit of product or service, multiplied by the standard price or rate
that has been set for each cost element.
• Ideal standards: Standards that allow for no machine breakdowns or other work interruptions and
that require peak efficiency at all times
• Practical standards: Standards that allow for normal machine downtime and other work
interruptions and can be attained through reasonable, although highly efficient, efforts by the
average employee.
• Setting DM standards
○ The standard price per unit for direct materials should reflect the final, delivered cost of the
materials including shipping, receiving, and other such costs, net of any discounts taken (it
reflects a particular grade of material (top-grade) delivered by a particular type of carrier
(truck))
○ The standard quantity per unit for direct materials should reflect the amount of material
required for each unit of finished product, as well as an allowance for unavoidable waste,
spoilage, and other normal inefficiencies.
• Once the price and quantity standards have been set, the standard cost of materials
per unit of finished product can be computed as
3.0 kilograms per unit × $4 per kilogram = $12 per unit
• This $12 cost figure will appear as one item on the standard cost record of the
product.
• Setting DL Standards
○ The standard rate per hour for direct labour includes not only wages earned but also
employee benefits (e.g., Employment Insurance, extended medical insurance) and other
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labour costs.
○ Standard hours per unit The amount of labour time that should be required to complete a
single unit of product, including allowances for breaks, machine downtime, cleanup, rejects,
and other normal inefficiencies.
• The single most difficult standard to determine.
• Once the rate and time standards have been set, the standard labour cost per unit of
product can be computed as
2.5 hours per unit × $21 per hour = $52.50 per unit
• This $52.50 cost figure appears along with direct materials as one item on the
standard cost record of the product
• Setting Variable MOH Standards
○ Price standards: the rate is the variable portion of the predetermined OH rate
○ Quantity standards: the quantity is the activity in the allocation base used to calculate the
predetermined overhead
○ Standard cost per unit: The standard cost of a unit of product as shown on the standard
cost card; it is computed by multiplying the standard quantity or hours by the standard price
or rate for each cost element.
• Model for Variance Analysis

○ A price variance is called a materials price variance in the case of direct materials
○ A labour rate variance in the case of direct labour
○ An overhead spending variance in the case of variable manufacturing overhead
○ Standard quantity allowed: The amount of materials that should have been used to
complete the period’s output, as computed by multiplying the actual number of units
produced by the standard quantity per unit.
○ Standard hours allowed: The time that should have been taken to complete the period’s
output, as computed by multiplying the actual number of units produced by the standard
hours per unit.
• This could be more or less than the materials, labour, or overhead that were actually
used, depending on the efficiency or inefficiency of operations
○ When a standard costing system is being used, the flexible budget is based on the standard
quantity allowed for the actual output achieved multiplied by the standard price per unit
DM Variances
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• A price variance is labelled unfavourable (denoted by U) if the actual price exceeds the standard
price and vice versa
• A quantity variance is labelled favourable if the actual quantity is less than the standard quantity
and vice versa
○ The production manager is ordinarily responsible for the quantity variance.
○ If the actual price was used in the calculation of the quantity variance, the production
manager would also be held responsible for the performance of the purchasing manager.
• Companies compute the materials price variance when materials are purchased rather than when
they are used in production because:
○ Delaying the computation of the price variance until the materials are used would result in
less-timely variance reports if there is a time gap between the purchase of materials and
their use in production.
○ By computing the price variance at the time of purchase, materials can be carried in the
inventory accounts at their standard cost.
• A materials price variance measures the difference between what is paid for a given quantity of
materials and what should have been paid according to the standard that has been set multiplied
by the quantity purchased.
○ MPV is computed on the entire quantity purchased
• MPV increases if quantity purchased increases
○ Isolation of Variances: Variances should be isolated and brought to the attention of

management as quickly as possible so that problems can be identified and corrected on a
timely basis.
• The most significant variances should be viewed as red flags
○ Responsibility for the Variance:
• Materials Quantity Variance: measures the difference between the quantity of materials used in
production and the quantity that should have been used, according to the standard that has been
set. (stated in dollar terms)
○ MQV is computed only on the quantity used
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Negative -> F, vice versa
DL Variances
• Labour rate variance: A measure of the difference between the actual hourly labour rate and the
standard rate, multiplied by the number of hours worked during the period
• Labour efficiency variance: A measure of the difference between the actual hours taken to
complete a task and the standard hours allowed, multiplied by the standard hourly labour rate.
○ Actual rate < standard rate: F

○ Actual hours of input < standard hours allowed: F
○ Total budget variance = efficiency variance - rate variance
• TBV > 0: U, vice versa
Variable manufacturing overhead variances

• Variable overhead spending variance: The difference between the actual variable overhead cost
incurred during a period and the standard cost that should have been incurred based on the actual
activity of the period.
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○ Actual rate < Standard rate: F, vice versa

○ Interpreting the Spending Variance: when the actual variable overhead costs vary in
proportion with the actual number of hours worked in a period, the variable overhead
spending variance can be informative.
• Can occur if:
• the actual purchase price of the variable overhead items differs from the
standards
• the actual quantity of variable overhead items used differs from the standards
• This variance is an estimate of the indirect effect on variable overhead costs of
efficiency or inefficiency in the use of the activity base
• Variable overhead efficiency variance: The difference between the actual activity (direct labour-
hours, machine-hours, or some other base) of a period and the standard activity allowed,
multiplied by the variable part of the predetermined overhead rate.
○ Actual hours < standard hours: F

○ Interpreting the Efficiency Variance: the variable overhead efficiency variance is useful only
if the cost driver for variable overhead really is the actual hours worked.
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Overhead Rates and Fixed Overhead Analysis

• Denominator activity: The estimated total units in the base of the formula for the predetermined
overhead rate (mau so)
○ It remains unchanged throughout the year, even if the actual activity turns out to be
different from the original estimate.
○ The reason for not changing the denominator is to maintain stability in the amount of
overhead applied to each unit of product, regardless of when it is produced during the year
Overhead Application and Fixed Overhead Variances

• Overhead Application in a Standard Costing System: overhead is applied to work in process on the
basis of the standard hours allowed for the actual output of the period rather than on the basis of
the actual number of hours worked.
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• Budget variance: the difference between the actual fixed overhead costs incurred during the
period and the budgeted fixed overhead costs as contained in the flexible budget (>0: U)
• Volume variance: a measure of utilization of plant facilities. The variance arises whenever the
standard hours allowed for the actual output of a period are different from the denominator
activity level that was planned when the period began (>0: U)
• Graphic Analysis of Fixed Overhead Variances
○ Since a denominator level of 4,167 direct labour-hours was used for June, the applied cost
line crosses the budget cost line at exactly the 4,167 direct labour-hours point.
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○ Thus, if the denominator hours and the standard hours allowed for the output are the same,
there can be no volume variance, since the applied cost line and the budget cost line will be
the same on the graph.
• Overhead Variances and Under- or Overapplied Overhead Cost
○ The overhead variances we have computed in this chapter break down the under- or
overapplied overhead into variances that can be used by managers for control purposes. =>
the sum of the overhead variances equals the under- or overapplied overhead cost for a
period .
• unfavourable variances are equivalent to underapplied overhead: more was spent on
overhead than the standards allow.
• Underapplied overhead occurs when more was spent on overhead than was
applied to products during the period.
• In a standard costing system, the standard amount of overhead allowed is
exactly the same as the amount of overhead applied to products =>
unfavourable variances and underapplied overhead are the same thing, as are
favourable variances and overapplied overhead.
• favourable variances are equivalent to overapplied overhead.
Overhead reporting, variance investigations, and capacity analysis
• Capacity analysis
○ Theoretical capacity: The volume of activity resulting from operations conducted 24 hours
per day, 7 days per week, 365 days per year, with no downtime.
○ Practical capacity: The productive capacity possible after subtracting unavoidable downtime
from theoretical capacity.
• Advantages of Standard Costs:
○ Management by exception
○ Promotes economy and efficiency
○ Simplified bookkeeping
○ Enhances responsibility accounting
• Potential problems
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REPORTING FOR CONTROL

April 7, 2021 3:23 PM
Decentralization and Segment Reporting

• Decentralized organization: An organization in which decision making is spread throughout the
organization rather than being confined to a few top executives.
• A segment is defined as a part or activity of an organization about which managers would like cost,
revenue, or profit data
○ A company’s operations can be segmented in many ways, by geographic region, by
individual store, by the nature of the merchandise (i.e., fresh foods, canned goods, paper
goods), by brand name, and so on
Segment Reporting
• Segmented income statements can be prepared for activities at many levels in a company. The
divisions are segmented according to their major product lines.
• Notice that as we go from one segmented statement to another, we are looking at smaller and
smaller pieces of the company
• The order of results breakdown depends on what information is desired. Certainly it might be
advantageous to begin with each sales territory
○ Ex: break down results by divisions first, product lines next, and then sales territories ->
permits a product-line comparison between divisions
• Sales territory can be online sales and retail sales
Traceable and Common Fixed Costs

• Traceable fixed costs: Fixed costs that can be identified with a particular segment and that arise
because of the existence of the segment. If the segment were eliminated, the fixed cost would
disappear (ex: the maintenance cost for the building in which the product is assembled)
○ 2 classes: discretionary fixed costs are under the immediate control of the manager,
whereas committed fixed costs are not
○ The amount remaining after deducting the discretionary fixed costs, sometimes called a
segment performance margin, should then be used as a basis for evaluating the segment
manager’s performance.
○ Use ABC method to identify if it's traceable or not
• Ex: rent a warehouse -> eliminate a segment may mean renting less space (traceable)
only if the company does not own the whole warehouse itself
• Common fixed cost: A fixed cost that supports the operations of more than one segment but is not
traceable in whole or in part to any one segment. Even if the segment were entirely eliminated,
there would be no change in a true common fixed cost
○ not allocated to segments—the total amount is deducted to arrive at the income for the
company as a whole
○ "such allocations tend to reduce the usefulness of segmented statements": The reason is
that arbitrary allocations draw attention away from those costs that are traceable to a
segment and that should form a basis for appraising performance.
○ Any attempt to allocate common fixed costs among segments may result in misleading data
or may obscure important relationships between segment revenues and segment earnings
• often results in a segment appearing to be unprofitable, whereas it may be
contributing substantially above its own traceable costs toward the overall
profitability of a firm.
○ Any allocation of common costs to segments reduces the value of the segment margin as a
guide to long-run segment profitability and segment performance.
• Traceable Costs Can Become Common
○ Ex: The $10,000 is the monthly salary of the manager of the Consumer Products Division.
This salary is a traceable cost of the division as a whole but is a common cost of the
division’s product lines.
• The manager’s salary is a necessary cost of having the two product lines, but even if
one of the product lines were discontinued entirely, the manager’s salary would
probably not be cut
• Segment margin: is obtained by deducting a segment’s traceable fixed costs from the segment’s
CM ~ long-run
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○ the best gauge of the long-run profitability of a segment, because it includes only those
costs that are caused by the segment
○ most useful in major decisions that affect capacity, such as dropping a segment while the
CM is most useful in decisions relating to short-run changes, such as pricing of special orders
that involve temporary use of existing capacity
Responsibility Centers
• Responsibility centre: Any business segment whose manager has control over cost or profit or the
use of investment funds.
○ Responsibility accounting: Depreciation on equipment is ordinarily not controllable by the
manager of an assembly line and should not appear on his/her performance report.
• Cost centre: A business segment whose manager has control over cost but has no control over
revenue or the use of investment funds.
• Profit centre: A business segment whose manager has control over cost and revenue but has no
control over the use of investment funds.
• Investment centre: A business segment whose manager has control over cost and revenue and
also has control over the use of investment funds.
Evaluating investment center performance _ ROI

• Return on investment (ROI): Operating income divided by average operating assets. ROI also
equals margin multiplied by turnover.
○ Operating income: Income before interest and income taxes have been deducted
○ Operating assets: Cash, accounts receivable, inventory, plant and equipment, and all other
assets held for productive use in an organization.
○ Margin: Operating income divided by sales.
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• Margin is ordinarily improved by increasing sales or reducing operating expenses,
including cost of goods sold and selling and administrative expenses.
• Inefficient use of operating assets can be just as much of a drag on profitability as
excessive operating expenses, which depress margin.
○ Turnover: The amount of sales generated in an investment centre for each dollar invested in
operating assets. Sales divided by average operating assets.
• Excessive funds tied up in operating assets (e.g., cash, accounts receivable,
inventories, plant and equipment, and other assets) depress turnover and lower ROI
• A major issue in ROI computations is the dollar amount of plant and equipment that should be
included in the operating assets base.
○ include only the plant and equipment’s net book value—that is, the plant and equipment’s
original cost less accumulated depreciation
○ ignore depreciation and include the plant and equipment’s entire gross cost in the operating
assets base
• Any increase in ROI must involve at least one of the following

○ Increased sales.
○ Reduced operating expenses.
○ Reduced operating assets.
• When sales are increased without an increase in operating assets, both the margin and turnover
are likely to be affected
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○ if the percentage increase in sales exceeds the percentage increase in operating expenses,
ROI will always improve, if no additional operating assets are required to generate the new
sales.
• Decreased Operating Expenses with No Change in Sales or Operating Assets
○ Ex: reduce operating expenses by $1,000 without any effect on sales or operating assets ->
increase operating income by $1,000
○ When margins or profits are being squeezed, the first line of attack is often to cut costs.
Discretionary fixed costs are particularly vulnerable to cuts.
• Invest in Operating Assets to Increase Sales
○ Ex: invest in a new machine that boosts sales by 4000 but requires additional operating
expenses of 1000 -> operating income increase by 3000
○ the investment had no effect on turnover -> there has to be an increase in margin in order
to improve the ROI.
• Criticisms of ROI:
Residual Income
• Residual income: The operating income that an investment centre earns above the required
return on its operating assets.
• Economic value added (EVA®): A concept similar to residual income
• The residual income approach encourages managers to make investments that are profitable for
the entire company but that would be rejected by managers who are evaluated by the ROI
formula.
• Reject any project whose rate of return is below the division’s current ROI even if the rate of
return on the project is above the minimum required rate of return for the entire company
○ any project whose rate of return is above the minimum required rate of return for the
company will result in an increase in residual income and thus add value for the
shareholders
• Criticisms
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• Residual income cannot be used to compare the performance of divisions of different sizes.
• You cant promote solely something just because it generates the highest amount of revenue.
Instead, consider the CM of every product to see if you can allocate the sales properly
• Company B has lower turnover than Company A

○ Is the company keeping an inventory larger than necessary for its sales volume?
○ Are receivables being collected promptly?
○ did Company A acquire its fixed assets at a price level, which was much lower than that at
which Company B purchased its plant?
• Increase turnover: either by increasing sales or by reducing assets
• Why would C have such a low margin? Is it due to
○ Inefficiency
○ geographical location (thereby requiring higher salaries or transportation charges)
○ excessive materials costs
• pare down its operating expenses
• 549 36
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RELEVANT COSTS
April 8, 2021 10:38 PM
• Relevant cost: A cost that differs among the alternatives in a particular decision and will be
incurred in the future. In managerial accounting, this term is synonymous with avoidable cost and
differential cost.
○ It determines the objective cost of a business decision, which is the extent of cash outflows
that results from the decision
○ It ignores costs that do not affect the cash flows
○ The key: its ability to filter what is and isnt relevant to a business decision
○ Ex:
• The original cost of the car is a sunk cost (depreciation)
• The cost of gasoline consumed by driving to Moncton is clearly a relevant cost
• The annual cost of auto insurance and licence is not relevant.
• The cost of maintenance and repairs is relevant
Adding or dropping product lines and other segments
• Drop whichever line has negative CM
• Avoidable: salaries expense represents salaries paid to employees working directly in each
product-line area; advertising expense in each area; insurance carried on inventories
• Unavoidable: utilities, depreciation, rent, selling and admin expenses
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Make or Buy Decision

• The costs that remain after by eliminating (1) the sunk costs and (2) the future costs that will
continue and (3) opportunity costs
○ If these avoidable costs are less than the outside purchase price, then the company should
continue to manufacture its own shifters and reject the outside supplier’s offer
Special order: A one-time order that is not considered part of the company’s normal ongoing business.
Joint Product Costs and the Sell or Process Further Decision

• Joint products: Two or more items that are produced from a common input.
• Joint product costs: Costs that are incurred up to the split-off point in producing joint products.
• Split-off point: That point in the manufacturing process where some or all of the joint products
can be recognized as individual products
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• A typical approach is to allocate the joint product costs according to the relative sales value of the
end products.
Sell or Process Further Decisions

• A decision as to whether a joint product should be sold at the split-off point or processed further
and sold at a later time in a different form
• It will always be profitable to continue processing a joint product after the split-off point as long as
the incremental revenue from such processing exceeds the incremental processing cost incurred
after the split-off point.
NOTE:
• Target Costing: recognizes that a significant portion of a product's cost are committed before
production begins
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○ Price - Profit Margin = Cost
• To give the administrator of the entire organization a clearer picture of the financial viability of
each of the organization’s programs, the general administrative overhead should not be
allocated.
○ It is a common cost that should be deducted from the total program segment margin.
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Chapter 11
Reporting for Control
Centralization vs. Decentralization
Decentralization: Autonomy of individual managers to make decisions:

Pros:
 More information available.
 Help in training managers to move up the ranks.
 Higher status.
 Suited to profit seeking companies.
Cons:
 Goal incongruence.
 Duplication of activities.
 More reports to prepare (which is costly) and explain to top management.
 Difficult to evaluate what non-profit company managers are doing.
Responsibility Centers
A set of activities assigned to the manager(s) to create ownership/responsibility

of its management decisions.
Should report on:

 The results of the activities
 Manager’s influence on those activities
 Effects of uncontrollable events
Five Centers
 Cost Center: Manager is accountable only for costs (to minimize them).
 Expense/Discretionary Cost Center: Must attain its service objectives and
spend its budget.
 Revenue Center: Responsibility to maximize total revenues (usually
constrained by expense budget).
 Profit Center: Responsible for controlling costs, expenses, and revenues.
 Investment Center: Responsible for profits and investment decisions.
Segmented Income Statement
Segment: Subunit of a company.

This I/S uses the Contribution Margin Approach
 Include Traceable Costs: Fixed costs that exist when the segment exists and
do not when the segment is gone.
 Remove Common Costs (Unallocated): Costs that would remain regardless of
the segment’s existence.
 Differentiate between controllable and uncontrollable costs by segment
manager where possible.
Example: See Pages 14 and 15 of
“Fall 2020 in class handouts” on D2L
Transfer Pricing
Where a seller of an intermediate product “X” exists within a

company “A” that also has a buyer for X (which uses X to create Y),
there may be opportunities to transfer X within the company
instead of relying on external markets. Doing this could save money
for the company as a whole.
Transfer Pricing
GENERAL TRANSFER PRICING RULE
Minimum TP (Seller) =
(VC/Unit on internal transfer) + (Lost CM/Unit on external sales)
Maximum TP (Buyer) =
Lesser of:
a) External (Market) purchase price
b) Selling price of the final product less other costs incurred to finish
product.
Transfer Pricing Example
Scenario 1: Selling Division has
NO EXCESS CAPACITY
Minimum TP (Seller) = $65/unit + ($80/unit - $65/unit) = $80/unit
Maximum TP (Buyer) = Lesser of a) $80/unit & b) ($190/unit - $75/unit) = $115/unit
= $80/unit
Now, from the company as a whole:
Transfer No Transfer
Frame Glass Net
Revenue $190/unit $80/unit $190/unit $270/unit
VC (Frame) $65/unit $65/unit $80/unit (external) $145/unit
VC (Glass) $75/unit - $75/unit $75/unit
CM/Unit $50/unit $15/unit $35/unit $50/unit
In this scenario, the company is indifferent in transferring OR buying externally.

Scenario 1 Continued…
Now, suppose the VC/unit for making the frames is $63/unit when transferring within
the company, but still $65/unit when selling outside. Further, suppose that the only
other option for purchasing frames from the market for the glass buyer is $84/unit
rather than $80/unit.
Minimum TP (Seller) = $63/unit + ($80/unit - $65/unit) = $78/unit
Maximum TP (Buyer) = Lesser of a) $84/unit & b) ($190/unit - $75/unit) = $115/unit
= $84/unit
Thus, the transfer price range is: $78-$84/unit
Now, from the company as a whole:
Frame Glass Net
Revenue $190/unit $80/unit $190/unit $270/unit
VC (Frame) $63/unit $65/unit $84/unit (external) $149/unit
Scenario 2: Seller division has
EXCESS CAPACITY
Minimum TP (Seller) = $63/unit + $0/unit = $63/unit
Maximum TP (Buyer) = Lesser of a) $84/unit & b) $115/unit = $84/unit
Thus, the transfer price range is: $63-$84/unit
Now, for the company as a whole:

Frame Glass Net
Revenue $190/unit - $190/unit $190/unit
VC (Frame) $63/unit - $84/unit (external) $84/unit
Transfer Pricing
Negotiated Transfer Price
When # of units transferred internally differs from # of units that must be foregone:
Minimum TP (Seller) =
[(VC/Unit on internal transfer)
+ (Total lost CM on external sales / # of units transferred internally)]
Transfer Pricing Example
Seller Division Capacity = 10,000 Units
Buyer Division Needed = 2,000 Units
When selling to the market:

Seller Division: DM = $5; DL = $10; vMOH = $15; vSelling = $4; VC/Unit = $34/unit
The seller sells to the market at $100/unit
When transferring:
Seller Division: DM = $5; DL = $10; vMOH = $12; vSelling = $8; VC/Unit = $35/unit
Three Scenarios
1) Seller is selling 10,000 units externally
Minimum TP = $35/unit + ($100/unit - $34/unit) = $101/unit
Minimum TP = $35/unit + $0/unit = $35/unit
$100 $34
− ×1,500 units
unit unit
Minimum TP = $35/unit + = $84.50/unit
2,000 units
Example: Problem 12-35
Minimum TP = $127/unit† + $108/unit§ = $235/unit
† $60/unit(DM) + $49/unit(DL) + $18/unit(vMOH) = $127/unit
§ Lost CM/unit:
Selling Price $170/unit
VC:
DM $38/unit *
Total Selling Costs $390,000
DL $27/unit
Less: Fixed Selling Costs $350,000
vMOH $10/unit Variable Selling Costs $40,000
vSelling $5/unit *
On 8,000 units sold, variable selling costs
CM/unit $90/unit per unit:
$90
×3,000 units
unit
Lost CM/unit = 2,500 units
= $108/unit vSelling =
$40,000
= $5/unit
8,000 units
Alternatives to the general TP Rule
Cost based TP: (Standard or Actual)

 VC
 Absorption/Full Cost
 Absorption/Full Cost plus mark up
Market based TP:

 Market price minus selling and delivery expenses
 Problem: May not be a market for the intermediate product
Transfer prices and taxes
Multinational companies use TP to minimize overall duties, tariffs and taxes.
If division A is the seller and division B is the

buyer, the TP should be as high as possible.
If division B is the seller and division A is the

buyer, the TP should be as low as possible.
Investment Center Performance Measures
 Return on Investment (ROI)

 Residual Income
Return on Investment (ROI)
ROI = (Operating Income (EBIT)) / (Average Operating Assets)

ROI Example
Investment Center 1 Investment Center 2

Income $200,000 $900,000
Average Investment $1,000,000 $6,000,000
ROI 20% 15%
Even though investment center 2 is six times larger by asset value, it is not
generating six times the income of center 1.
ROI = (Sales Margin) × (Capital Turnover)
Income Income Revenue

= ×
Investment Revenue Investment
ROI may result in Goal Incongruence

ROI and RI example
Suppose a company’s cost of obtaining capital is 10%.
oject’s ROI
Suppose a manager is evaluated based on ROI and their income is $2,000 for $10,000
in investment, so the manager’s ROI is:
$2,000 / $10,000 = 0.20 = 20%
A new project comes along that would boost income by $300 through an investment
of $2,000 (ROI of 15%). Since the manager is evaluated based on ROI, they are
incentivized to not take on the new project as it would decrease their net ROI.
Residual Income
RI = Income – (Investment × Imputed Interest Rate)

Imputed interest rate can also be called:
 Minimum rate of return
 Company’s cost of capital
RI should not be used to compare divisions of different sizes.

Residual income can solve this goal incongruence. The manager’s residual income
is:
($2,000 – ($10,000 × 10%)) = +$1,000
The new project’s residual income is:
($300 – ($2,000 × 10%)) = +$100.
If the manager is evaluated based on RI rather than ROI, the interests of the
manager and company become aligned as both are incentivized to take on the
new project.
ROI and RI
project’s ROI P10% Company RI Manager

10+% > Accept + Accept
10-% < Reject - Reject
10% = Indifferent 0 Indifferent
Gross Book Value vs Net Book Value
NBV is consistent with external reporting standards but is

misleading and there is less incentive for managers to
replace old equipment when necessary.
Depreciation and NBV/GBV
Chapter 12
Relevant costs for decision making
Terminology
 Opportunity Cost: Maximum amount of profit foregone by not using a limited

resource in its best alternative use.
 Differential/Incremental cost: Difference in cost under two alternatives.
 Outlay Cost: Cost that requires a cash disbursement.
 Sunk cost/revenue-costs that have already been incurred
Decision making information
Useful information is:

 Accurate
 Timely
 Relevant
Relevant Information
Two criteria information to be relevant:

1. Affects future cash flows
2. Differs amongst competing alternatives
* Exception: Opportunity cost is always relevant if it exists.

Relevant Information Exercise
 Sunk Costs: Irrelevant

 Accumulated Depreciation or Depreciation Expense: Irrelevant
 NBV or Carrying amount: Irrelevant
 Selling an asset:
 Dr. Accumulated Depreciation → Irrelevant
 Cr. Asset → Irrelevant
 Dr. Cash → Relevant
 Cr. Loss or Gain on Sale → Irrelevant
One time only special orders
Incremental cash inflows

vs.
(Incremental cash outflows + Opportunity cost)
 > Accept
 < Reject
 = Indifferent
Example:
Without Effect of Order
Order
Total Per Unit
Sales $11,000,000 $660,000 $4.40/unit
Variable COGS $3,500,000 $322,500† $2.15/unit†
Variable Selling (Commissions) $330,000* - -
Variable Selling (Others) $470,000* $35,250§ $0.235/unit§
Contribution Margin $6,700,000 $302,250 $2.015/unit
Fixed Manufacturing Overhead $3,000,000 - -
Fixed Selling $2,200,200 - -
Income $1,500,000 $302,250 $2.015/unit
* $3,000,000 - $2,200,000 = $800,000 = Variable Selling
Commissions = 3% × $11,000,000 = $300,000
Others = $800,000 - $330,000 = $470,000
$3,500,000 $1.75 $0.40 $2.15

† 2,000,000 units
= unit
+ unit
= unit
→ $2.15/unit × 150,000 units = $322,500
$470,000
§ 2,000,000 units
= $0.235/unit → $0.235/unit × 150,000 units = $35,250
Insourcing vs. Outsourcing
 Cost to make: Incremental Cash Outlay + Opportunity Cost

 Cost to buy: External purchase price
Example:
Part 1
Buy:
Purchase Price $15,000
Material Handling $3,000 (20% of direct material cost)
Total $18,000
Make:
DM $1,000
Material Handling $200
DL $8,000
vMOH $4,000 (1/3 × $12,000)
Total $13,200 + $0
Save $4,800 by making.

Part 2
Buy:
$18,000/unit × 10 units = $180,000
Make:
Cash Outlay $132,000 ($13,200/unit × 10 units)
Opportunity Cost $25,000
Total $157,000
Still, making is the better option as we would save $23,000.

Part 3
Buy:
$18,000/unit × 10 units = $180,000
Make:
Cash Outlay $132,000 ($13,200/unit × 10 units)
Opportunity Cost $52,000
Total $184,000
Now it makes more sense to buy as we would save $4,000.

Add/Drop Product lines/Departments
Avoidable (R)
Unavoidable (I)
Textbook Problem Page 566, p12-21
CM $12,950
Costs:
Flight Promo $750
Fuel $5,800
Liability Insurance $1,400 (1/3 x $4,200)
Flight Assistant Salaries $1,500
Overnight Expenses for Crew $300
Segment Margin $3,200
Decisions involving limited resources
DLH Available = 30 (Constraint)
Product CM/unit DLH/Unit
uno $3/unit 1 DLH/unit
dos $12/unit 6 DLH/unit
The long way:

uno = (30 DLH / 1 DLH/unit) x $3/unit = $90 CM ✓
dos = (30 DLH / 6 DLH/unit) x $12/unit = $60 CM
The short way:
Contribution Margin
Maximize sales of the products that have the highest:
Unit of Scarce Resource (DLH)
uno = ($3/unit) / (1 DLH/unit) = $3/DLH ✓

Dos = ($12/unit) / (6 DLH/unit) = $2/DLH
Joint Products – Sell or Process Further
Joint Products Continued…
Joint Products Continued…
Sell at Split-Off Further Process
Thigh Breast Cordon Bleu Parmesan
Relevant Cash Flows $10 $13 $14 $19
Relevant Cash Outflows - - $8 $4
Net Cashflows $10 ✓ $13 $6 $15 ✓
The thigh should be sold without being processed further because further
processing would reduce net cashflows by $4.
The breast should be further processed because doing so would increase

cashflows by $2.

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5/4/2021 OneNote

Direct Materials (DM)

Direct labour (ML)

Manufacturing Overhead (MO)

• Raw materials: materials waiting to be processed

Cost Classifications for Predicting Cost Behaviour

• direct materials is a variable cost

Differential Cost and Revenue

Types of Cost Classifications

Types of Product Costing Systems

Job-order Costing Overview

Measuring Direct Materials Cost

Measuring Direct Labour Cost

Computing Predetermined Overhead

○ Ideally the allocation base is a cost driver that causes overhead

• The Need for a POHR

The Purchase and Issue of Materials

• The recording of labour cost

• Recording actual Manufacturing Overhead

• The concept of a clearing account

○ Depreciation and salaries should be classified as product costs if related to manufacturing

○ Advertising expenses are expensed in the period incurred

Cost of Goods Manufactured (COGM)

Cost of Goods Sold (COGS)

Complications of Overhead Application

Disposition of Underapplied or Overapplied Overhead

Multiple Predetermined Overhead Rates

The Use of Information Technology

Predetermined Overhead Rate and Capacity

Variable Cost Hours of Operating Time Total costs: Variable co

○ Ex: supervisory salaries

○ All cost behaviour assumptions are assumed to be valid

• The total mixed cost line can be expressed as an equation: Y = a + bX

The High-Low Method

Least-Squares Regression Method

• Problems frequently encountered in data collection

The contribution format

• This format is used for

Basics of CVP Analysis

CVP Relationships in Graphic Form

Contribution Margin Ratio

Change in Fixed Cost and Sales Volume:

○ Both approaches involve an incremental analysis—they consider only those items of

Change in Variable Costs and Sales Volume

○ the higher-quality components should be used.

Change in Fixed Costs, Selling Price, and Sales Volume

○ the changes should not be made

Change in Variable Cost, Fixed Cost, and Sales Volume

○ the change should be made

Change in Regular Selling Price

• Unit contribution margin = selling price - variable expenses

○ Unit CM = unit selling price - unit variable expense

• With: t as tax, B as operating profit before taxes

The Margin of Safety

CVP Considerations in Choosing a Cost Structure

Absorption Costing (full costing)

Variable Costing (direct costing or marginal costing)

Basic Framework of Budgeting

○ Inventory purchases: merchandising firm

○ The DM purchases budget

○ Selling and admin

STANDARD COSTS & OVERHEAD ANALYSIS

Setting Standard Costs

• Model for Variance Analysis