Chapter 1: Management Accounting and the business environment

Describes what managers do and why they need accounting information

Management accounting is providing information to managers for use in planning and controlling
operations and in decision making.

Financial accounting is providing information to shareholders, creditors and others outside the
organization.

Management accounting managers activity:

1. Planning: identify
alternatives and then
select from among
alternative the one that
does the best job of
furthering the
organizations objectives
and targets. The
organizational process by
which the budget is made
(budgeting)
a. Budget: A detailed
plan for the
acquisition and use
of financial and other resources over a specified time period.
2. Directing and motivating: To oversee day to day activities to keep the organization
functioning smoothly
3. Controlling: To make sure the plan is being followed which can be done by compares
budgeted to actual results (performance report). Performance report suggest where
operations are not proceeding as planned and where some parts of the organization may
require additional attention.
4. Decision Making: Selecting a course of action from competing alternatives.
Lo.2 Identify major differences financial and management accounting

Review the impact of organizational and technological change on management

accounting
Many companies have gone through several of improvement by starting with Just in Time (JIT  A
production and inventory control system in which materials are purchased and units are
produced only as needed to meet actual customer demand ) and passing on to Total Quantity
Management (TQM  An approach to continuous improvement that focuses on customers
and using teams of front-line workers to systematically identify and solve problems )
The installation of integrated real time management information systems known as ERP.

Chapter 2: An introduction to cost terms, concepts and classifications

Identify 3 basic cost elements
A. Direct Materials (DM): those materials that become an integral part of finished product that
can be physically and conveniently traced to it.
- Raw materials: The materials that go into the final product are called Raw materials
refer to any materials that are used in the final product; and the finished product of one
company can become raw material of another company.
- Indirect materials: an integral part of a finished product but are traceable to the product
only at great cost or inconvenience.
B. Direct Labour (DL): labour cost that can easily be traced to individual units of product (touch
labour)
 - Indirect labour: other factory workers that cannot easily and conveniently be traced
directly to particular products.
C. Manufacturing overhead (MoH): includes all cost of manufacturing except DM and DL. MoH
includes indirect materials, indirect labour, maintenance, taxes, depreciation and
insurance. Various name for MoH such as; indirect manufacturing cost, factory overhead,
production overhead etc.
- MoH + DL = conversion cost
- DL + DM = prime cost

Non-manufacturing cost:
1. Marketing or selling cost: All costs necessary to secure customer orders and get the finished
product or service into the hands of the customer. For example: advertising, shipping, sales
travel, sales salaries
2. Administrative costs: All executive, organizational and clerical costs associated with the
general management of an organization rather than with manufacturing, marketing or
selling. For example: all administrative cost include compensations, general accounting etc.

Lo.2.2 Distinguish between product cost and period cost

1. Product costs: All costs that
are involved in the purchase
or manufacture of goods. In
the case of manufactured
goods, these costs consist of
direct materials, direct labour,
and manufacturing overhead.
See also Stock-related costs 
2. Period costs: Those costs that
are taken directly to the profit
and loss account as expenses
in the period in which they
are incurred or accrued; such
costs consist of selling
(marketing) and
administrative expenses.

** difference: costs are recognized as

expense when a resource/asset is
consumed or sold for the purpose of
generating revenue of the year is
made.

Cost classifications on financial statements

1. Balance sheet merchandising company vs manufacturing companies  manufacturing have
3 classes:
a. raw materials: The materials that go into the final product
 b. work in progress: Goods that are only partially complete and will require further
work before they are ready for sale.
c. finished goods: Goods that have been completed but not yet sold to customers.
2. Statement of P/L

COGS manufacturing

*we need to know beginning and ending balancesin the Finished goods inventory account to get
COGM

**COGM  The manufacturing costs associated with the goods that were finished during the
period.
Beg finished goods inventory + COGM = Ending finished goods inventory + COGS

COGS = Beg finished goods inventory + COGM - Ending finished goods inventory

COGS merchandising

* to determine the COGS in merchandising company, we only need the beginning and end balances

** total purchases can be simply adding together all purchases from suppliers

Beg merchandise inventory + purchases = Ending merchandise + COGS

COGS = Beg merchandie inventory + purchases – ending merchandise

Lo.2.5 Difference between costing for manufacturing vs services
- Services cannot be stored as inventory
- Service output are often customized for client
 o The output are ofter heterogenous with intangible characteristics which hard to
define output
- In service, the customer is usually present in the delivery process
- Labour cost normally represents high percentage of Total Cost

Lo.6 Identify and give examples of VC and FC

Cost behaviour is which a cost react or respond to changes in the level of business activity

- Variable cost (cost that varies, in total, in direct propotion to changes in the level of
activity)
o E.g. COGS merchandising, DM, DL, MoH or indirect materials
o VC must be respect with ‘something’ is its activity base
 Activity base is measure of whatever cause the incurrence of cost or also
referred as cost driver
 Cost driver A factor, such as machine-hours, beds occupied,
computer time, or flight-hours, that causes overhead costs.
*when we speak cost as being variable, it means total variable cost =

- Fixed cost (cost that remain constant, regardless of level of activity)

- Direct cost (cost easily to traced)

- Indirect cost (cannot easily and conveniently be traced) e.g. common cost ( is a cost that is common
to a number of costing object but cannot be traced to them individualy)

Lo.2.7 Cost classifications for decision making

1. Diferential cost / Incremental cost  a difference cost between 2 alternatives
2. Different revenue  a difference in revenenue between 2 alternatives
3. Opportunity cost  potential benefit that is given up when one alternative is selected over
another
4. Sunk cost  cost that already incurred and cannot be changed.
Chapter 3: Management Accounting and the business environment
There is a third behaviour pattern, generally known as mixed or semi variable cost: For example a
firm might have many fixed cost but few variable or mixed costs. Alternatively, it might have many
variable costs but few fixed or mixed costs. A firm cost structure can have impact on decisions

Lo.3.1 Variable costs

The variable costs remains constant if expressed on per unit basis. For the cost to be variable, it
must be variable with respect to activity base/cost driver.

Variable cost behaviour:

Total cost graph (left) has upwards to

the right trend  means that the total
cost of the meal is directly
proportional to the number of guest

The graph of the per unit cost of meal

is flat, because the cost of the meal
per guest is constant at $30/guest

 VC must be hand in
hand with activity
base/cost driver
 o For example: direct labour hour, machine hours, unit produced and units sold
 Merchandising company usually have high proportions of variable cost in the cost structure
 Example of variable cost:

 two types of variable cost

o True variable cost
 The amount used during a period will vary in direct proportion to the level of
production activity
 Any amount of purchase but not used can be stored
o Step variable cost
 Wages of maintenance worker are often consider as VC but this labour cost
does not behave in the same way as DM
 Difference between DM and step variable cost: any maintenance
time not utilized cannot be stored as inventory and carried forward
to the next period. If the time is not used effectively, it is gone for
ever.
 The higher the volume, the bigger is the total cost
 Strategy of reducing step VC in maintenance worker:
 be to obtain the fullest use of services possible for each separate
step. Great care must be taken in working with these kinds of costs
to prevent ‘fat’ from building up in an organization. There may be a
tendency to employ additional help more quickly than needed, and
there is a natural reluctance to lay people off when volume declines

Lo.3.2 Fixed costs

 price stay the same in regards to relevant range of activity
 Type of fixed costs
o Committed fixed costs
 Relate to investment in facilities, equipment and the basic organizational
structure of a firm
 Example: insurance, salaries of LTE, taxes on real estate,
depreciation
 FC cannot be reduced to zero without impairing the profitability or long run
goals
o Discretionary fixed costs
 Annual decisions by management to spend in certain fixed cost areas
 For example: advertising, research, public relations, internship for
student
 Two key differences discretionary FC and Committed FC
 the planning horizon for a discretionary fixed cost is fairly short term
– usually a single year
 discretionary fixed costs can be reduced for short periods of time
with minimal damage to the long-run goals of the organization.
 o For example, a firm that has been spending £50,000
annually on management development programmes may be
forced, because of poor economic conditions, to reduce its
spending in that area during a given ye

Lo.3.3 Mixed costs /semi variable costs

 Contains both variable and fixed cost elements

For example: company must pay license

fee 25.000/year + 3 per pony party to
the North Yorkshire Park. IF the
company runs 1000 pony treks this year,
then Total fees paid= 25000 + ( 3 x 1000)
= 28.000

Semi variable cost formula=

x  level of activity (independent

variable)

Y total mixed cost (dependent variable)

a total FC

n number of observations

b the variable cost per unit of activity level

Lo.3.4 The analysis of mixed cost using High and Low method
 Way to get estimate the slope and intercept of a mixed cost

Step 1: identifies the period with lowest level of activity and the period with the highest level of
activity

Step 2: find the variable cost / change in cost

Step 3: Find fixed cost element

Patient days Maintenance cost incurred

High activity level 8000 9800
Low activity level 5000 7400
 Change = 3000 = 2400
Variable change 2400 / 3000 = 0.8 patient day
FC element = TC – VC element
=9800 – ( 0.8 x 8000) 3400

Lo.3.7 Contribution approach

 Contribution margin (CM) is the amount remaining from sales revenue after variable
expenses have been deducted

Comparison traditional approach vs Contribution approach

Chapter 4: Job order and service department costing

LO.4.1 Process costing
 Process costing is where the company use many units of a single product (such as frozen
orang juice) for long periods at a time.
 Assumption manufacturing overhead is the same, doesn’t matter the quantity of products
are produced.
o Characterized by homogenous product that flows evenly through production
process on a continuous basis
o Formula of process costing:

LO.4.2 Job order costing

 Where many different products are produced each period
 o For example: Levi’s make different types of jeans for men and women during a
month
 A particular order might consist of 1000 jeans for different DV, and these 1000 jeans is called
batch/a job
 Cost is found by:
o Allocate to jobs and then
o The cost of the job are divided by number units  average cost per unit

LO.4.3 Predetermined overhead rate

a. Absorption costing approach
 Manufacturing overhead must be included with DM and DL on the job cost since, its part of
product cost
o MoH is an indirect cost  either impossible or difficult to trace
o MoH consist of many different items ranging from the grease used in machines
o Total MoH relatively constant from one period
 MoH assigned to use predetermine overhead rate (based on estimated)
o Predetermine compute before the period begins and is used to apply overhead cost
to job throughout the period

 Overhead cost formula base incurred by the job:

 Overhead cost formula base is direct labour hours:

Why predetermined is important?

Lo.4.4 Job order costing – the flow of cost
Journal for issue of DM and Indirect materials

The £2,000 charged to Manufacturing

Overhead in entry (2) represents indirect
materials used in production during April.
Observe that the Manufacturing Overhead
account is separate from the Work in
Progress account. The purpose of the
Manufacturing Overhead account is to
accumulate all manufacturing overhead costs
as they are incurred during a period.

Journal for issue of DM only

Journal for issue of DL

Journal manufacturing overhead cost
 Recall that all costs of operating the factory other than direct materials and direct labour
are classified as manufacturing overhead costs. These costs are entered directly into the
Manufacturing Overhead account as they are incurred
Lo.4.4 Summary of cost flows

Schedule of COGM
COGM
DM
Beginning: Raw materials inventory Xxx
(+) Purchase of raw materials Xxx
Total raw material available Xxx
(-) Raw materials, ending (Xxx) XXX
DL XXX
Moh XXX
 Total manuf.cost =DM+DL+Moh
(+) Beginning: WIP inventory XXX
(-) End WIP (XXX)
COGM =TM + Beg wip
inventory – end.WIP
Schedule COGS
COGS
Beginning: Finished goods inventory XXX
(+) COGM XXX
Goods available for sale XXX
(-) Ending, Finished goods inventory (Xxx)
Unadjusted COGS XXX
(+) underapplied overhead XXX
Adj. COGS XXX
Underapplied and overapplied overhead
If Predetermined overhead cost is < less than actual overhead cost = Underapplied (kekurangan)

What to do if its underapplied or overapplied:

We can choose either
alternative 1 or 2

Lo.4.8 The predetermined overhead rate and capacity

 Predetermined overhead rates on the estimated, or budgeted, amount of the allocation
base for the upcoming period
Appendix 4A: Service department costing
How much of a service departments cost is to be allocated to each of the units that it serves?

Interdepartmental services
Problem: allocating costs when service departments provide services to each other

3 solutions:

1. Direct method
- Cost of serviced between service departments are ignored and all costs are allocated directly to
operating departments.
2. Step method
- Service department costs are allocated to other service and operating departments
- Once a service departments costs are allocated, other service department costs are not
allocated back to it.
- Custodial will have a new total to allocate to operating departments: its own costs plus those
costs allocated from the cafeteria.
3. Reciprocal method

Chapter 6: Cost Volume Profit relationships

CVP studies behavior and relationship among total revenue, total cost and income as changes occur
in the units sold, selling price, the variable cost per unit or the fixed cost of a product.

How do managers use CVP analysis to make decisions? Examine the effect of other decisions. One
should compare the changes in CM (through the effects on selling price, variable cost and quantities
of units sold) to the changes in FC and then we can choose the alternative that provides the highest
operating income
Sales mix  proportation in different product in revenue. For example, your pop-up restaurant
might plan to sell 500 sandwiches and 500 burgers, for a 50-50 sales mix. However, if you actually
sold 1,200 sandwiches and 800 burgers, your sales mix would be 60-40.

Lo.6.1 Contribution Margins

a. OI = Rev – VC – FC
b. CM = Total revenues – Total Variable Cost

CM indicates why operating income changes as the number of units sold changes

c. CM margin / unit = Selling price – VC/unit

Useful tool for calculating CM and Operating income

d. CM percentage /ratio = CM per unit / Selling price or revenue – variable cost / revenue

Lo.6.2 Contribution Margins ratio

(how CM affect the sales (it is important the marginal benefit of producing one more unit)

e. CM = CM% * revenues in dollars

Lo.6.3 Expressing CVP relationship:

1. The equation method

Revenue – VC – FC = OI

Revenue = Selling Price x Quantity sold

VC = VC per unit x Q sold

2. The CM method

(Selling P - VC per unit) x Q sold – FC = OI

(CM per unit x Q sold) – FC = OI

3. The Graph Method

Lo.6.4 BEP analysis:

A. BEP is when operating income is 0

CM per unit x Q unit sold – FC = OI

At BEP, OI = 0
CM per unit x BEP numbers of unit = FC

BEP numbers of unit = FC / CM per unit

BEP revenues = break even per unit x Selling price

CM % = FC / SP

Breakeven revenues = FC / CM %

B. Target OI

Q units of sold = FC + Target OI / Selling Price – VC per unit

After we defined Q unit sold, then we can find Revenue, VC and OI

Compute and use the contribution margin ratio

 To find how many units must be sold to break even, divide the total fixed costs by the unit

contribution margin:

Lo.6.7 The margin of safety

 The margin of safety is the excess of budgeted (or actual) revenue over the break-even
revenue. It states the amount by which revenue can drop before losses begin to be incurred.


Lo.6.8 Operating leverage

 a measure of how sensitive profit is to percentage changes in revenue. Operating leverage
acts as a multiplier. If operating leverage is high, a small percentage increase in revenue can
produce a much larger percentage increase in profit
 a degree of operating leverage is a given level of revenue
if revenue increase by 10%, then we can expect the
profit of Bogside Farm to increase by four times this
amount, or by 40%, and the profit of Sterling Farm to
increase by seven times this amount, or by 70%

Lo.6.9 The concept sales mix

 The reason is that different products will have different selling prices, different costs and
different contribution margins. Consequently, the break-even point will depend on the mix
in which the various
 In preparing a break-even analysis, some assumption must be made concerning the sales
mix

Chapter 7 Profit reporting using Variable and Absorption costing

 Absorption cost  all cost of productions
o DM;DL; Both VoC and FoH
 Variable cost  only cost of production that vary with output are treated as product cost
o DM; DL: variable portion of MoH

Lo.7.2 Profit comparison absorption vs variable costing

 Variable cost has less profit than absorption
 under absorption cost: Increase in
inventory, then some of Fixed
manufacturing cost of the current period
will appear in balance sheet but not in
P&L
 Under variable cost  fixed manuf cost
has been treated as expense
 End inventory in variable cost is 5000
lower than absorption because only
variable manuf cost are assigned to units
of product
 No distinction between FC and VC
  Essentially, the difference between the absorption costing method and the variable costing
method centres on timing. Advocates of variable costing say that fixed manufacturing costs
should be expensed immediately in total, whereas advocates of absorption costing say that
fixed manufacturing costs should be charged against revenues bit by bit as units of product
are sold. Any units of product not sold under absorption costing result in fixed costs being
inventoried and carried forward as assets to the next period. We will defer discussing the
arguments presented by each side in this dispute until after we have a better understanding
of the two methods. Nevertheless, as we shall see in the following situation, the use of
absorption costing can sometimes produce strange effects on statements of profit or loss

Lo.7.3 Extended comparison of profit data

Lo.7.4 Impact of JIT methods

 variable and absorption costing will produce different profit figures whenever the number of
units produced is different from the number of units sold – in other words, whenever there
is a change in the number of units in inventory.
 Under JIT, goods are produced to customers’ orders and the goal is to eliminate finished
goods inventory entirely and reduce work in progress inventory almost to nothing. If there is
very little inventory, then changes in inventory will be very small and both variable and
 absorption costing will show basically the same profit figure. In that case, absorption costing
profit will move in the same direction as movements in sales.

Chapter 8 Performance measurement and reporting on segments

that investment centre managers are able to generate on their assets (managers in each segment,
because of the decentralization). Its called return on investment.

The return on investment (ROI) formula

The higher the return on investment of a business segment, the greater the profit generated per
pound invested in the segment’s operating assets.

Operating profit and operating assets

Operating profit = profit before interest and taxes (EBIT)

- Used because the profit figure used should be consistent with the base to which it is applied

Operating assets = include cash, accounts receivable, inventory, plant and equipment, and all other
assets held for operating purposes.

- Often computed as the average of the operating assets between the beginning and the end
of the year

Plant and equipment: net book value or gross cost?

What amount of plant and equipment should the company include with its operating assets in
computing ROI? Net book value (after depreciation) or include the plants entire gross cost? Net book
value is mostly used.

Arguments for using net book value to measure operating assets in ROI computations:

1. The net book value is consistent with how plant and equipment are reported on the balance
sheet (cost less accumulated depreciation to date)
2. The net book value method is consistent with the computation of operating profit, which
includes depreciation as an operating expense.

Arguments for using gross cost to measure operating assets in ROI computations:

1. The gross cost method eliminates both the age of equipment and the method of
depreciation as factors in ROI computations.
 2. The gross cost method does not discourage replacement of old, worn out equipment (Net
book value method with new equipment will have a dramatic effect on ROI).

Controlling the rate of return

Margin: is a measure of management’s ability to control operating expenses

in relation to revenue. The lower the operating expenses per pound of
revenue, the higher the margin earned.

Turnover: is a measure of the revenue that is generated for each pound

invested in operating assets.

The two formulas of ROI give the same answer; however the margin and turnover formulation
provides some additional insights.

Some managers focus too much on margin and ignore turnover. Excessive funds tied up in operating
assets, which depresses turnover, can be just as much of a drag on profitability as excessive
operating expenses, which depresses margin.

Du Pont pioneered the ROI concept and recognized the importance of looking at both margin and
turnover in assessing the performance of a manager.
An investment centre manager can increase ROI in three ways:

1. Increase revenue
2. Reduce expenses
3. Reduce assets
- Eliminate unneeded inventory (JIT)
- Speeding up the collection of accounts receivable

Criticisms of ROI
1. Increasing ROI is not that easy – and may be inconsistent with the company’s strategy. ROI is
best used as part of a balanced scorecard.
2. A manager who takes over a business segment typically inherits many committed costs over
which she has no control.
3. A manager who is evaluated on ROI may reject profitable investment opportunities
Residual income – another measure of performance
Residual income is another approach to measuring an investment centres performance. Residual
income is the operating profit that an investment centre earns above the minimum required return
on its operating assets.

Economic value added (EVA) is a similar concept that differs in some details from residual income.
Here, funds used for research and development are treated as investments rather than as expenses.
Here; no distinction between them.

Purpose is to maximize the total amount of residual income or economic value added, not to
maximize overall ROI.

Motivation and 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.

A manager who is evaluated based on ROI will reject any project whose rate of return is below the
divisions 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. Since it is in the best interests of the company as a whole to
accept any project whose rate of return is above the minimum required rate of return, managers
who are evaluated based on residual income will trend to make better decisions concerning
investment projects than managers who are evaluated based on ROI.

Divisional comparison and residual income

Residual income approach has one major disadvantage:

- It cannot be used to compare the performance of divisions of different sizes. More residual
income is not necessarily because they are better managed, but simply because of the bigger
numbers involved.

The problem of single-period metrics: the bonus bank approach

ROI, RI and EVA are all single-period metrics. Although it can be shown that under certain
assumptions the capitalized value of residual income equals the net present value of the company, a
one-period measure cannot capture the economic value of a division or investment. Investment
decisions based on these techniques will not be identical to those based on the correct NPV rule.
Chapter 9 Activity based cost analysis
 Non-manufacturing as well as manufacturing costs may be assigned to product
 Some manufacturing costs may be excluded from product costs
 There are numbers of overhead cost pools
o Some is allocated to products
o And other costing object using its own unique measure of activity
 Allocation base often differ from those used in traditional cost system

Manufacturing costs and activity-based cost

Plantwide overhead rate (single overhead rate)
 Overhead that being used throughout the entire factory that the allocation base was direct
labour hours or machine hours
 Why plant wide is no longer satisfactory?
o First, in many companies, direct labour may no longer be highly correlated with
overhead costs.
o Second, because of the large variety of activities encompassed in overhead, no
single allocation base may be able to reflect adequately the demands that products
place on overhead resources

Departmental overhead rates

 Many companies use departmental overhead rates
 (-) not applicable when company has a range of products that differ in volume, batch and
size or complexity of production
 This is because the departmental approach usually relies on volume as the factor in
allocating overhead cost to products

Designing an ABC system

The implementation of ABC down into the following six basic steps:

1. Identify and define activities and activity pools

2. Wherever possible, directly trace costs to activities and cost objects
3. Assign costs to activity cost pools
4. Calculate activity rates
5. Assign costs to cost objects using the activity rates and activity measures
6. Prepare management reports.

Step 1: Identify
Organize the activities into five levels:

1. Unit-level activities
- Performed each time a unit is produced

2. Batch-level activities
- Performed each time a batch is handled or processed, regardless of how many units are in
the batch

3. Product-level activities
- Relate to specific products and typically must be carried out regardless of how many batches
are run or units of product are produced or sold
4. Customer-level activities
- Relate to specific customers
- sales calls, catalogue mailings and general technical support

5. Organization-sustaining activities
- Are carried out regardless of which customers are served, which products are produced,
how many batches are run or how many units are made
Cleaning, executive offices, providing a computer network, arranging for loans

Assigning costs to activity cost pools

When an overhead department are involved in several of the activities that are tracked in the ABC
system, the costs of the department are divided among the activity cost pools via an allocation
process called first-stage allocation. Activity cost pool is a bucket in which costs are accumulated
that relate to a single activity in the ABC system.

- “What percentage of the available resource is consumed by this activity?”

ABC product costs – an action analysis

The sixth step in implementing an ABC system is preparing management reports.

Ease of adjustment codes

The ease of adjustment code reflects how easily the cost could be adjusted to changes in activity.

Costs that adjust automatically to changes in activity without management action:

- Direct materials
- Shipping
Costs that could be adjusted to changes in activity, but management action would be required:

- Direct labour
- Factory utilities
- Administrative wages and salaries
- Office equipment depreciation
- Marketing wages and salaries
- Selling expenses
Costs that are difficult to adjust to changes in activity, and management action would be required:

- Factory equipment depreciation

 - Factory building lease
- Administrative building lease

The action analysis view of the ABC data

An action analysis report is a report showing what costs have been assigned to the cost object, such
as a product or customer, and how difficult it would be to adjust the cost if there is a change in
activity.

By measuring the resources consumed by products, a best practice ABC system provides a much
better basis for decision makin than a traditional cost accounting system that spreads overhead costs
around without much regard for what might be causing the overhead. A well-designed ABC system
provides managers with estimates of potentially relevant costs that can be a very useful starting
point for management analysis.

Service costing and management: the benefits of an ABC approach

The traditionally high levels of regulation in service sectors, protected companies from serious
competition and a need to access detailed cost and revenue information.

Apart from this, there are technical reasons to why activity-based costing is particularly suitable:

1. Service companies often have a very large proportion of fixed costs

2. The marginal cost in service companies is often zero but providing capacity eventually need to
be recovered
3. There is a lack of direct link between customer decisions that generate revenues and managerial
decisions that incur costs

Finally, service companies cannot usually rely on a proprietary technology in order to gain and hold
on to customers, but customized service is both important and expensive. ABC offers greater detail
on customer profitability and a much greater understanding of what is driving costs. ABC analysis
may reveal that some customers are expensive to serve because they are constantly requesting
after-sales service or insisting on small orders or expensive methods of payment.

Time-driven ABC
Time-driven activity-based costing, is the latest innovation in ABC.

- Rather than gathering data on the percentage of time spent on different areas of work, TD-
ABC estimates the cost per time unit of the resources supplied.
- This is done by dividing the cost of resources supplied by the practical capacity of the
resources (the theoretical capacity – time spent on the process (sick, breaks, training)
Advantages:

1. Easy do update the cost per time unit if changes occur (resources or practical capacity)
2. Flexible tool when it comes to combining different activities
3. Forward-looking as it builds on estimations and planning purposes
4. TD-ABC avoids the tendency of staff to allocate 100 % of their time to work activities

Activity-based costing and external reporting

Why isn´t activity-based costing used for external reports (more accurate product costs than
traditional costing):
1. External reports are less detailed than internal reports
2. It is often very difficult to make changes in a company’s accounting system
3. An ABC system does not conform to externally regulated accounting principles
4. Auditors are likely to be uncomfortable with allocations that are based subjective data

=Most companies uses ABC to special studies for management, and not attempt to integrate activity-
based costing into their formal cost accounting systems.

Three types of drivers:

1. Transaction drivers:
- Number of times
2. Duration drivers:
- Cost per time unit the activity is performed
3. Insensitivity drivers:
- Direct cost tracing

Chapter 10 Relevant cost for decision masking

- Making decisions is one of the basic functions of a manager
- Need to tell the difference between relevant and irrelevant data
- Must be able to correctly use the relevant data in analyzing alternatives

In deciding, the costs and benefits of one alternative must be compared to the costs and
benefits of other alternatives. Relevant costs are the costs that differ between the alternatives.

Distinguishing between relevant and irrelevant cost and benefit data is critical for two reasons:

1. Irrelevant data can be ignored and not be analyzed – saves time

2. Bad decisions can easily result from erroneously including irrelevant cost and benefit data when
analyzing alternatives.

Cost concepts for decision making

Identifying relevant costs and benefits
- Only those costs and benefits that differ in total between alternatives are relevant in a decision

Avoidable cost is a cost that can be eliminated in whole or in part by choosing one alternative over
another.

- Avoidable costs are relevant costs

- Unavoidable costs are irrelevant costs
- Sunk costs are irrelevant costs
- Future costs that do differ between alternatives are relevant costs
- Future costs that do not differ between alternatives are irrelevant costs

How to identify costs that are avoidable (differential) in a particular decision situation (relevant):
1. Eliminate costs and benefits that do not differ between alternatives. These irrelevant costs
consist of (a) sunk cost and (b) future costs that do not differ between alternatives.
2. Use the remaining costs and benefits that do differ between alternatives in making the decision.
The costs that remains are the differential, or avoidable, costs.

Different costs for different purposes

- Costs that are relevant in one decision situation are not necessarily relevant in another

Sunk costs are not relevant costs

- Regardless of the kind of sunk cost involved, the conclusion is always the same

Book value of old equipment

- The investment made in an old machine is a sunk cost

Focusing on relevant costs:

Reduction in variable expense promised by a new machine – cost of the new machine + disposal
value of the old machine = net advantage of the new machine

Why isolate relevant costs?

1. Only rarely will enough information be available to prepare a detailed profit statement for both
alternatives
2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention from
the matters that are really critical. An irrelevant piece of data may also be used improperly,
resulting in an incorrect decision.

Adding and dropping product lines and other segments

- Decisions relating to whether old product lines or other segments of a company should be
dropped, and new ones added, are the most difficult to make.
- Final decision hinges primarily on the impact the decision will have on net profit

Example
- If by dropping a segment, the company is able to avoid more in fixed costs than is loses in
contribution margin, then it will be better off if the line is eliminated, since overall profit should
improve.
- If a company is not able to avoid as much fixed costs as it loses in contribution margin, then the
segment should be retained.

A comparative format

- Managers may choose to retain an unprofitable product line if the line is necessary to the sale of
other products or if it serves as a “magnet” or “loss-leader” to attract customers.
The make or buy decision
A decision to produce a fabricated part internally, rather than to buy the part externally form a
supplier (vertical integration), is called a make or buy decision.

- Meet its own needs internally or to buy externally

Example
- Eliminate the sunk costs and the future costs that will continue regardless
- The cost that remains are the avoidable costs, if the company purchase outside
- If these avoidable costs are less than the outside purchase price, then the company should
continue to manufacture and reject the outside suppliers offer.

The matter of opportunity cost

- Idle space that has no alternative use has an opportunity cost of zero
- If the new space can be used for other purposes, the company has an opportunity cost
- Opportunity costs represent economic benefits that are forgone as a result of pusuing some
course of action.

Special orders
- Managers often must decide whether a special order should be accepted, and if the order is
accepted, the price that should be changed.
- Special order is a one-time order that is not considered part of the company´s normal ongoing
business
- Only incremental costs and benefits are relevant.
- A special order is profitable as long as the incremental revenue form the special order exceeds
the incremental costs of the order.
- We must however make sure that there is idle capacity and that the special order does not cut
into normal sales.
- If a company is operating at capacity, opportunity costs would have to be taken into account as
well as incremental costs

Utilization of constrained resources

- When a limited resource of some type restricts the company’s ability to satisfy demand, the
company is said to have a constraint.
- Because of the constrained resource, the company cannot fully satisfy demand, so the manager
must decide how the constrained resource should be used.
- Usually, fixed costs are not affected by this particular decision, so management can focus on
maximizing total contribution margin.

Contribution in relation to a constrained resource

- To maximize total contribution margin, a firm should not necessarily promote those products
that have the highest unit contribution margin
- Rather total contribution margin will be maximized by promoting those products or accepting
those orders that provide the highest unit contribution margin in relation to the constrained
resource.

- The machine or process that is limiting overall output is called the bottleneck – it’s the
constraint.
Managing constraints
- Effectively managing an organization´s constraints is a key to increased profits
- Profits can (in addition to the above) be increased by increasing the efficiency of the bottleneck
operation and by increasing its capacity (relaxing the constraint).

The capacity of a bottleneck can be effectively increased in a number of ways:

- Working overtime on the bottleneck

- Subcontracting some of the processing that would be done at the bottleneck
- Investing in additional machines at the bottleneck
- Shifting workers form processes that are not bottlenecks to the process that is the bottleneck
- Focusing business process improvement efforts on the bottleneck
- Reducing defective units. Each defective unit that is processed through the bottleneck and
subsequently scrapped takes the place of a good unit that could have been sold.

The problem of multiple constraints in the short run: linear programming

What to do if a firm has more than one potential constraint?

- The proper combination/mix of products can be found by use the of a quantitative method
known as linear programming.
- With two products, the main principles can be illustrated graphically
- The best or optimal combination of product is the output that maximizes total contribution.

Sensitivity analysis
- The value of the graphical model is that is illustrates the main principles behind linear
programming as well as possible extensions such as sensitivity analysis.
- This involves asking what-if questions.

Shadow prices
- Each constraint will have an opportunity cost, which is the profit forgone by not having an
additional unit of the resource
- In linear programming, opportunity costs are known as shadow prices and are defined at the
increase in value that would be created by having one additional unit of a limiting resource.

The limitations of the linear programming model as a management account technique

- Ignores marketing considerations
- Has an excessive focus on the short term
- Most production resource can be varied even in the short term through overtime and buying-in.

Joint product costs and the contribution approach

- In some industries, a number of end products are produced form a single raw material input.
- Two or more products that are produced from a common input are known as joint products
- The split-off point is the point in the manufacturing process at which the joint products can be
recognized as separate products
- Joint cost is used to describe the costs incurred up to the split-off point.

The pitfalls of allocation

- Typical approach is to allocate the joint costs according to the relative sales value of the end
products
Sell or process further decisions
- Joint product costs are irrelevant in decisions regarding what to do with a product form the split-
off point forward, because by the time one arrives at the split-off point, the joint product costs
have already been incurred and therefore are sunk costs.
- It will always be profitable to continue processing a joint product after the split-off point as long
as the incremental revenue form such processing exceeds the incremental processing cost
incurred after the split-off point.
- Joint product costs that have already been incurred up to the split-off point are sunk costs,
which are always irrelevant in decisions concerning what to do from the split-off point forward.

Activity-based costing and relevant costs

- Activity-based costing can be used to help identify potentially relevant costs for decision-making
purposes.
- The costs provided by a well-designed activity-based costing system are only potentially
relevant.
- A cost traceable to a segment, is not automatically an avoidable cost

Chapter 11 Profit planning and the role budgeting

James McKinsey described budgetary control as involving the following :

1. The statement of the plans of all the departments of the business for a certain period of time in
the form of estimates.

2. The co-ordination of these estimates into a well-balanced programme for the business as a whole.
3. The preparation of reports showing a comparison between the actual and the estimated
performance, and the revision of the original plans when these reports show that such a revision is
necessary.

The basic framework of budgeting

Definition of budgeting
A budget is a detailed plan for the acquisition and use of financial and other resources over a
specified time period.

- Represent a plan for the future expressed in formal quantitate terms

- The use of budgets to control a firm´s activities is known as budgetary control

Master budget is a summary of a company´s plans that sets specific targets

for sales, production, distribution and financing activities

- Represents a comprehensive expression of management´s plans for the

future and how these plans are to be accomplished.

The master budget culminates:

- Cash budget
- Budgeted statement of profit or loss
- Budgeted statement of financial position
Personal budgets
- Estimates of their income and plan expenditures for food, clothing, housing and so on.

Differences between planning and control

Planning involved developing objectives and preparing various budgets to achieve these objects. Key
concerns are resource allocation and activity coordination.

Control involves the steps taken by management to increase the likelihood that the objectives set
down at the planning stage are attained, and to ensure that all parts of the organization function in a
manner consistent with organizational policies.

Advantages of budgeting
1. Budgets define objectives and goals that can serve as benchmarks for controlling and evaluating
subsequent performance.
2. Budgets provide a means of communicating management´s plans throughout the organization
3. Budgets force managers to think about and plan for the future. In the absence for the necessity
to prepare a budget, too mange managers would spend all their time dealing with daily
emergencies.
4. The budgeting process provides a means of allocating resources to those parts of the
organization where they can be used most effectively
5. The budgeting process can uncover potential bottlenecks before they occur
6. Budgets co-ordinate the activities of the entire organization by integrating the plans of the
various parts
7. Budgeting helps to ensure that everyone in the organization is pulling in the same direction

Responsibility accounting
=A manager should be held responsible for those items – and only those items – that they can
actually control to a significant extent.

- Each line item (revenue or cost) in the budget is made the responsibility of a manager, and that
manager is held responsible for subsequent deviations between budgeted goals and actual
results
- A manager should take the initiative to correct any unfavorable discrepancies, the source of
them and prepare to explain them

Choosing a budget period

- Operating budgets are ordinarily set to cover a one-year period
- Many companies divide the budget year into quarters and the upcoming quarter into months

A continuous, perpetual or rolling budget is a 12-moth budget that rolls forward one month (or
quarter) as the current month (or quarter) is completed.

- Keeps managers focused on the future, at least one year ahead

- Less danger with focused on short-term results
- Time-consuming

The participative or self-imposed budget

The success of a budget programme will be determined in large part by the way which the budget is
developed. The most successful budget programmes involve managers with sales or control
responsibilities in preparing their own budget estimates – rather than having a budget composed
from above (particularly if the budget is to be used to control and evaluate a manager’s activities).
Called participative budget.

- Most effective method of budget preparation

- Prepared with the full co-operation and participation of managers at all levels
Flow of Budget Data:

Advantages:

1. Individuals at all levels of the organization are recognized as members of the team whose views
and judgements are valued by top management.
2. The person in direct contract with an activity is in the best position to make budget estimates.
Therefore, budget estimates prepared by such persons tend to be more accurate and reliable
than estimates prepared by top managers who have less intimate knowledge of markets and
day-to-day operations.
3. People are more likely to work at fulfilling a budget that they have participated in setting than
they are to work at fulfilling a budget that is imposed from above
4. A self-imposed budget contains its own unique system of control in that, if people are not able
to meet budget specifications, they have only themselves to blame. If a budget is imposed from
above, they can always say that the budget was unreasonable or unrealistic to start with, and
therefore was impossible to meet.

- Budget estimates prepared by lower-level managers must be accepted by higher level of

managers / superiors
- All levels in an organization should work together to produce the budget (co-operative effort)

The matter of human relations

Whether or not a budget programme is accepted by lower management personnel will be reflective
of:

1. The degree to which top management accepts the budget programme as a vital part of the
company’s activities
2. The way in which top management uses budgeted data

- A budget must have complete acceptance and support of the persons who occupy key
management positions
- Top management should not use budgets as a way to find someone to blame for a particular
problem (breed hostility, tension and mistrust)
- Should be a positive instrument to assist in establishing goals, measuring operating results and
isolating areas that are in need of extra effort or attention
- How challenging should budget targets be? A highly achievable budget may be challenging, but
can almost always be met by competent managers exerting reasonable effort.

The Budget Committee

The budget committee will be responsible for overall policy matters relating to the budget
programme and for coordinating the preparation of the budget itself. A standing committee formed
of managing directors of various functions such as sales, production and purchasing.

- Resolves difficulties and disputes between segments

- Approves the final budget an receives periodic reports on progress

The master budget inter-relationships

The master budget consists of a number of separate but interdependent budgets that formally lay
out the company’s sales, production and financial goals.

The sales budget

= A detailed schedule showing the expected sales for the budget period.

- The key to the entire budgeting process (units and pounds)

- All other parts of the master budget are dependent on the sales budget
The production budget
=Used to determine the budgets for manufacturing costs:

- Direct material budget

- Direct labour budget
- Manufacturing overhead budget
- Combined with data from the sales budget

The direct material budget

=Details the raw materials that must be purchased to fulfil the production budget and to provide for
adequate inventories.

The direct labour budget

Direct labour requirements must me computed so that the company will know whether sufficient
labour time is available to meet production needs.

for example, that Hampton Freeze has 50 workers who are classified as direct labour and each of
them is guaranteed at least 480 hours of pay each quarter at a rate of £7.50 per hour. In that case,
the minimum direct labour cost for a quarter would be as follows:

50 workers x 480 hours x 7.50 = 180.000 Would need to be increased

Manufacturing overhead budget

The manufacturing overhead budget provides a schedule of all costs of production other than direct
materials and direct labour.

Ending finished goods inventory budget

- To determine cost of goods sold on the budgeted statement of profit or loss
- To know what amount to put on the statement of financial position inventory account for unsold
units.

Selling and administrative expense budget

The selling and administrative expense budget lists the budgeted expenses for areas other than
manufacturing
The cash budget
=Detailed plan showing how cash resources will be acquired and used over some specified time
period. Composer of four major sections:

- The receipts section

- The disbursements section
- The cash excess or deficiency section
- The financing section

Preparing the master budget

1. A sales budget, including a schedule of expected cash collections
2. A production budget (or merchandise purchases budget for a merchandising company)
3. A direct materials budget, including a schedule of expected cash disbursements for raw
materials
4. A direct labour budget
5. A manufacturing overhead budget
6. An ending finished goods inventory budget
7. A selling and administrative expense budget
8. A cash budget
9. A budgeted statement of profit or loss
10. A budgeted statement of financial position

The budgeted statement of profit or loss

It shows the company’s planned profit for the upcoming budget period, and it stands as a
benchmark against which subsequent company performance can be measured.

The budgeted statement of financial position

Developed by beginning with the current statement of financial position and adjusting it for the data
contained in the other budgets.

Activity-based budgeting
- It is unlikely that all variable overhead in a complex organization is driven by a single factor such
as the number of units produced or the number of labour-hours or machine-hours.

- The activity-based costing provides a way of recognizing a variety of overhead cost drivers and
thereby increasing the accuracy of the costing system.

- The actual spending in each overhead cost pool can be independently evaluated using the
techniques discussed in this chapter. The cost formulas for the variable overhead costs are the
only difference, and will be stated in terms of different kinds of activity instead of all being
stated in terms of units or a common activity.

- Activity analysis may be used to develop activity-based budgeting (ABB).

Advantages:

- More sophisticated approach to capacity adjustments issues

- More sophisticated approach to improving communication across departments and up and
down the organization
- Avoids unnecessary financial balancing
- Avoids incorporates operational issues (inefficiencies and bottlenecks) that are usually left out of
traditional budgets
- Managers and employees talk in operational rather than financial terms

Some criticisms of budgeting as a performance management system

- Too historically based
- Budgets makes organizations inflexible and unable to respond to uncertainty
o Budgeting is mechanistic with rigid, formalized and tightly coupled systems
o Too slow to react to changes
- Too time consuming
- Focus on cost control rather than value creation
- Top down
o Encourage gaming and opportunism
o Reinforces departmental berries and hinders knowledge sharing
- People feel undervalued

- Not focused on the importance of intellectual capital

o Need to adopt to a network, rather than hierarchical, departmental structure

- Budgets produce a particular type of constrained management style

- They concentrate on easy to measure events and they are too historically based
- Budgets tend to be incrementalist (marginal or incremental increases or decreases in particular
departmental budgets)
- Budgeting makes organizations inflexible and unable to respond to uncertainty
- It is mechanistic with rigid, formalized and tightly coupled systems
- Too time consuming
- Tend to focus on cost control rather than value creation
- Tends to be top down
- Encourages gaming and opportunism
- Reinforces departmental barriers
- Hinders knowledge sharing
- Marked people feel undervalued

Reform or abandon budgeting?

Two main practice-led approaches to the criticism:

1. Improve budgeting
2. Abandon budgeting

Two issues with the budgeting:

1. The questions of predictability

 2. Organizational and time-frame problems

The beyond budgeting round table

Abandon budgeting: budgets are still used for cash management and other financial purposes, but
not for performance evaluation.

Chapter 12 Standard cost and variance analysis

Availability of quantitative measures of performance can yield two types of benefits:

1. Performance feedback can help improve the production process through a better understanding
of what works and what doesn’t.
2. Feedback on performance can sustain motivation and effort because it is encouraging and/or
because it suggests that more effort is required for the goal to be met.

Standard costs – management by exception

Standard = benchmark or norm for measuring performance.

- In management accounting they relate to quantity and cost of inputs used in manufacturing
goods or providing services.
- Managers (assisted by engineers and accountants) set these standards

- Based on carefully predetermined amounts

- Used for planning labour, material and overhead requirements
- The expected level of performance
- Benchmarks for measuring performance

Quantity standard: indicate how much of an input should be used in manufacturing a unit of
product or in providing a unit of service.

Cost (price) standard: indicate what the cost, or purchase price, of the input should be.

- Actual quantities and actual costs are compared to these standards

- If significantly departs: managers investigate the discrepancy

Management by exception: find the cause of the problem and eliminate it so it does not recur.

The variance analysis circle is the basic approach to identifying and solving problems.

Starting with the preparing of the

standard cost performance report, which
report highlights the variances
(differences between actual results and
what should have occurred according to
the standards).
Who uses standard costs?
- Manufacturing, service, food and not-for-profit organizations
- Manufacturing companies often have highly developed standard costing systems, with standards
listed on a standard cost card

Setting standard costs

- Difficult and requires combined expertise
o Accountants, engineers, personnel administrators, production managers
- Standards should be designed for future operations
o Based on experience and expectations

Ideal versus practical standards

Standards tend to fall in two categories:

1. Ideal standards
- Based on perfection, unattainable
- Only attained under the best circumstances
- Do not allow for machine breakdowns or other work interruptions
- Level off efforts attained by the most skilled and efficient employees (100%)
- Motivational – rarely meet the standard
- Discourage – large variances are normal

2. Practical standards
- Set at levels that are currently attainable with reasonable and efficient effort
- Tight but attainable
- Allow for normal machine downtown
- Employee rest periods and average workers
- Variances are useful, they represent fall outside of normal operating conditions
- Can be used in forecasting cash flows and planning inventories

Setting direct materials standards

The standard price per unit for direct materials should reflect the final, delivered cost of the
materials, net of any discounts taken.
The standard quantity per unit for direct materials should reflect the amount of material going into
each unit of finished product, as well as an allowance for unavoidable waste, spoilage and other
normal inefficiencies.
The standard cost of material per unit of finished product = standard price per unit x standard quantity per unit

Setting direct labour standards

The standard rate per hour for direct labour would include not only wages earned, but also benefits
and other labour costs.

The standard hours per unit is the standard direct labour time required to complete a unit of
product and are the most difficult to determine. Approaches:

- Divide each operation performed on the product into elemental body movements
- Conduct a time and motion study, clocking the time required for certain tasks (standard time
should include breaks, personal needs and machine downtime)
The standard labour cost per unit of product = the standard rate per hour c the standard hours per unit

Setting variable manufacturing overhead standards

As with direct labour, the price and quantity standards for variable manufacturing overhead are
generally expressed in terms of rate and hours.

Are standards the same as budgets?

- Similar
- Standard is a unit amount
- Budget is a total amount
- Therefore, a standard can be viewed as the budgeted cost for one unit of product

A general model for variance analysis

We separate standards into price and quantity, because different managers are usually responsible
for buying and using inputs, and because they occur at different points in time.

Price and quantity variances

A general model for computing standard cost variances for variable costs:

- Isolate price variances from quantity variances and how each of these is computed
- Price variance and quantity variance can be computed for all three variable cost elements (direct
materials, direct labour and variable manufacturing overhead)
- All price variances and quantity variances are computed the exactly same way
The variance analysis is a type of input-output analysis:

- Inputs are the actual quantity of direct materials, direct labour and variable MOH
- Outputs represents the good production of the period, expressed in terms of the standard
quantity allowed for the actual output
Allowed = that should have been used to produce the actual output of the period.

- Variances point to causes of problems and directions for improvement

- Variances trigger investigations in departments having responsibility for incurring the costs

Using standard costs – direct materials variances

- A quantity variance is labelled unfavorable if the actual quantity exceeds the standard quantity
- A quantity variance is labelled favorable if the actual quantity is less than the standard quantity.
- Companies often purchase materials well in advance of use and store the materials in
warehouses while awaiting the production process (and therefore compute the material price
variance when materials are purchased rather than when the materials are placed into
production)

Materials price variance – a closer look

A materials price variance measures the difference between shat is paid for a given quantity of
materials and what should have been paid according to the standard that has been set.

Isolation of variances

At what point should variances be isolated and brought to the attention of the management?

- The earlier the better

- Significant variances should be red flags

Responsibility for the variance

Who is responsible for the materials price variance?

- Purchasing manager has control over the price paid for goods and therefore responsible for any
price variances
- But production can be scheduled in a way – production manager?

Materials quantity variance – a closer look

The 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.
Isolation of variances

- The materials quantity variance is best isolated at the time materials are used in production

Responsibility for the variance

- Production department to see that materials usage is kept in line with standards
- Not? Faulty machines, inferior quality of materials, untrained workers and poos supervision.
- Also purchasing department, responsible for purchasing inferior quality materials in effort to
economize on price.

Using standard costs – direct labour variances

Labour rate variance – a closer look
A labour rate variance is the price variance for direct labour and measures deviation from standard
in the average hourly rate paid to direct labour workers.

- Most firms have predictable rates paid to workers

- Skilled workers with high hourly rates of pay may be given duties that require little skill and low
hourly rates of pay, and will result in unfavorable labour rate variances.
- Supervisors bear responsibility for seeing that labour rate variances are kept under control

Labour efficiency variance – a closer look

The labour efficiency variance is the quantity variance for direct labour and measures the
productivity of labour time.

- Unfavorable labour efficiency: poorly trained or motivation workers; poor quality materials,
requiring more labour time in processing, faulty equipment, causing breakdowns and work
interruptions, poor supervision of workers, inaccurate standards.
- With fixed labour hours and reduce unfavorable labour efficiency: keep everyone busy all the
time

Using standard costs – variable manufacturing overhead variances

Manufacturing overhead variances – a closer look
Structure of performance reports
- The performance report communicates the variance data to management
- Start at the bottom and build upwards, with managers at each level receiving information on
their own performance, as well a information of each manager under them in the chain of
responsibility.

Variance analysis and management by exception

- Management by exception means that the managers attention should be directed toward those
part of the organization where plans are not working out for some reason
- All variances are not worth investigating – because they will almost always occur
- How to decide what to investigate? Size of the variance, size of the variance relative to the
amount of spending involved
- Can also plot variance data on a statistical control chart – where random fluctuations in
variances from period to period are normal and expected
- Variance should only be investigated when it is unusual relative to that normal level of random
fluctuation.
- Rule of thumb: investigate all variances that are more than X standard deviations from zero.
- Big value of C will result in fewer investigations and higher probability that a real problem will be
overlooked

Evaluation of controls based on standard costs

Advantages of standard costs
1. Standard costs are a key element in a management by exception approach. As long as costs
remain within the standards, managers can focus on other issues.
2. So long as standards are viewed as reasonable by employees, they can promote economy and
efficiency. Provide benchmarks that individuals can use to judge their own performance.
3. Simplifies bookkeeping, because instead of recording actual costs for each job, the standard
costs for materials, labour and overhead can be charged to jobs.
4. Standard costs fit naturally in an integrated system of “responsibility accounting”. The standards
establish what costs should be, who should be responsible for them and whether actual costs
are under control.

Potential problems with the use of standard costs

1. Standard cost variance reports are usually prepared on a monthly basis and are often released
long after the end of the month, which the information in the reports may be so outdated that it
is almost useless.
2. If managers are sensitive and use variance reports as a club, moral may suffer. Employees may
be tempted to cover up unfavorable variances and take actions that are not in the best interests
of the company.
3. Labour quantity and efficiency make an assumption that if labour works faster, output will go up
– that’s not the case in many companies, rather speed of machines. The computations also
assume that labour is a variable cost.
4. In some cases, a favorable variance can be as bad or worse than an unfavorable variance.
5. Tendency with standard cost reporting systems to emphasize meeting the standard to the
exclusion of other important objectives (maintain and improving quality, on-time delivery,
customer satisfaction).
6. Just meeting standards may not be sufficient; continual improvement may be necessary to
survive in the current competitive environment. Kaizen costing involves the reduction of cost
during production through continuous gradual improvements that reduce waste and increase
efficiency.

Chapter 13 Flexible budgets and performance reporting from Blocher:

Sales variance in multi product
- Overhead is a major cost in most large companies
- Control of overhead costs poses special problems (costs like direct materials and direct labour
are easier to understand, and therefore control)
- Overhead is usually made up of many separate costs
- Some overhead costs are variable, and some are a mixture between fixed and variable
- The problems can largely be overcome by the use of flexible budgets

Flexible budgets
Characteristics of a flexible budget
Earlier studied static budgets, which are prepared before the period begins and valid only for the
planned level of activity.

- Good for planning purposes, not inadequate for evaluating how well costs are controlled
- If actual activity differs from the planned, it would be misleading to compare actual costs to the
static budget

The flexible budgets take into account changes in costs that should occur as a consequence of
changes in activity. It provides estimates of what cost should be for any level of activity within a
specified range.

- When used in performance evaluation, actual costs are compared to what costs should have
been for the actual level of activity during the period

How much of the favorable cost variance is due to lower activity, and how much is due to good cost
control?

How a flexible budget works

- The basic idea: the budget can be adjusted to show what costs should be for the actual level of
activity
- Show revenues and expenses that should have occurred at the actual level of activity
- May be prepared for any activity level in the relevant range
- Reveal variances due to good cost control or lack of cost control
- Improve performance evaluation
Using the flexible budgeting concept in performance evaluation
- Budget based on the actual number of client-visits for the month
- Prepared by multiplying the actual level of activity by the cost formula for each of the variable
cost categories
- Now actual costs are compared to what costs should have been at the actual level of activity
- Not so simple; variety of products and services, and the number of units produced, or customers
served may not be an adequate measure of overall activity (Sony CD vs. Sony TV)

The measure of activity – a critical choice

What should be used as the measure of activity when the company produces a variety of products
and services? At least three factors are important in selecting an activity base for an overhead
flexible budget:

1. There should be a causal relationship between the activity base and variable overhead costs.
Ideally, variable overhead costs in the flexible budget should vary in direct proportion with
changes in the activity base. Remember that total fixed costs remain unchanged within the
relevant range.
2. The activity base should not be expressed in pounds sterling or other currency. Rather
physical rather than financial measures of activity in flexible budgets.
3. The activity base should be simple and easy understood, unless confusion and
misunderstanding – difficult to control the costs.

Variable overhead variances – a closer look

- Problem when the flexible budget is based on hours of activity (such as labour-hours) rather
than on units of products or number of customers served.
- Whether actual hours or standard hours should be used to develop the flexible budget?

The problem of actual versus standard hours

- If actual hours are used, only a spending variance will be computed.
- If the standard hours are used, both a spending and an efficiency variance will be computed.

There are two primary reasons for unfavorable variable overhead variances:

1. Spending too much for resources

2. Using the resources inefficiently

Spending variance alone

- Results from paying more or less than expected for overhead items and from excessive usage of
overhead items

Interpreting the spending variance

- Spending variance is only useful if the cost driver for variable overhead really is the actual hours
worked.
- Then the flexible budget based on actual hours worked is a valid benchmark that tells us how
much should have been spent in total on variable overhead items during the period.
The actual overhead costs would be larger than the benchmark (unfavorable variance) if:

1. The variable overhead items cost more to purchase than the standards allow or
2. More variable overhead items were used than the standards allow

- Includes both price and quantity variances

Both spending and efficiency variances

- Together, the spending and efficiency variances make up the total variance

Interpreting the efficiency variance

- The efficiency variance is controlled by managing the overhead cost driver

- Like variable overhead spending, the variable overhead efficiency variance is useful only if the
cost driver for variable overhead really is the actual hours worked.
- Any increase in hours actually worked should then result in additional variable overhead costs
- If too many hours were used to create the actual output, results in an increase in variable
overhead
- The variable overhead efficiency variance is an estimate of the effect on variable overhead costs
of inefficiency in the use of the base
- If more hours are worked than allowed at standard, then overhead efficiency variance will be
unfavorable (in the use of the base itself).

Control of the efficiency variance

- Whoever responsible for the base, is responsible for control of the variance
- If the base is direct labour-hours then the supervisor responsible for the use of labour time will
be responsible for any overhead efficiency variance.

Flexible budgets and overhead rates

- Fixed costs come in large, indivisible pieces that by definition do not change with changes in the
level of activity within the relevant range.
- This creates a problem in product costing, since a given level of fixed overhead cost spread over
a small number of units will result in higher cost per unit than if the same amount of cost is
spread over a large number of units.
- The fixed portion of unit cost should be stabilized so that a single unit cost figure can be used
throughout the year (accomplished through the use of the POHR).

Denominator activity

- The estimated total units in the base in the formula for the predetermined overhead rate is
called the denominator activity.
- Once an estimated activity level (denominator activity) has been chosen, it remains unchanged
throughout the year, even if the actual activity turns out to be different from what was
estimated (to maintain stability).

Computing the overhead rate

- The predetermined overhead rate can be computed using the following variation on the basic
formula for the predetermined overhead rate.
- The company can also break its predetermined overhead rate down into variable and fixed
elements rather than using a single combined figure

- The flexible budget therefore provides the estimated overhead cost needed to compute the
predetermined overhead rate.

Overhead application in a standard cost system

The fixed overhead variances

The budget variance – a closer look:

= Actual fixed cost – flexible budget fixed overhead cost
- Difference between how much should have been spent (according to the flexible budget) and
how much was actually spent.

- Results from paying more or less than expected for overhead items
- Results from operating at an activity level different from the denominator activity

The volume variance – a closer look:

=Fixed portion of the predetermined overhead rate x (denominator hours – standard hours allowed)

- A measure of utilization of plant facilities

- An unfavorable variance would mean that the company operated at an activity level below that
planned for the period, and vica versa (not over or under-spending, just underutilization or a
higher utilization of available facilities than was planned).

Graphic analysis of fixed overhead variances

Cautions in fixed overhead analysis

- Treating the fixed costs as they were variable and depended on activity is necessary for product
costing purposes but has some dangers.
- The manager can easily be misled and start thinking of the fixed costs as if they were in fact
variable.
- In fact, increases or decreases in activity have no effect on total fixed costs within the relevant
range of activity.

Overhead variances and under- or overapplied overhead cost

- The sum of overhead variances equals the under- or overapplied overhead cost of a period.
- In a standard costing system, unfavorable variances and underapplied overhead rate are the
same thing, as are favorable variances and overapplied overhead.

Chapter 15 Pricing and transfer prices

Chapter 16 Management accounting in strategic context

Chapter 19

Lecture 9
 Understand the purpose and content of different cost and management accounting models
 Define and apply specific context for recommendation
 Asses the strength and weakness of specific context

Cost has different behaviour (VC), changing depending on level activity and there is cost that remain
stable (Fixed cost).

1. Job order costing vs process costing (only allocating manuf cost)

- There is homogenous production  you can split them to total units
- If there are non-homogenous  we cannot take all manuf. Cost and split them to total
units
o We need to allocate by unit produce  this is what we called job order costing
*the tricky part is overhead  where we need to define predeterminant cost
- Predeterminant rate  you set the rate when you get through process
2. CVP analysis
- Help to determine the BEP, total amount of sales until it becomes profitable
3. ABC (allocating manuf cost and non-manuf cost)
4. Planning  when it comes to planning, we use different tools:
a. Budget  detailed for the acq and use of resources over a specified time period 
to control our activity

Chapter 12: Standard Costing and Variance analysis

Flexible budget and Standards
 Standard  relate to quantity and cost of inputs used in manufacturing goods or providing
services
 Important number to input:
 o Quantity standard (SQ)  indicates how much of an input should be used in
manufacturing a unit of product or in providing a unit of services
o Cost price standard (SP) the cost or purchase price of the input should be
o Actual quantities (AQ) and Actual cost of inputs (AP)  compared to the standard
 If either the quantity or cost of inputs departs significantly from the standard/there is
discrepancy, then we need to find the cause of the problem and then eliminate. This
processed called management by exeption
 Variance analysis cycle begin with:
1. Prepare standard
cost performance
repot  can be
highlights the
variances between
the actual and
what should have
occurred
according to the
standards
2. Corrective actions
should be carried
out if there is significant variances

Ideal vs Practical standards

Ideal standard  can be attained only under the best circumstances. For example: Put a system
under system. You would have breakdowns, highly skilled people will work 100%. No downtime.
Ideal standard can be demotivating and cant be compared.

Practical standards are tight but attainable. They allow to have downtime and employee rest
period.

Static budget  forecast or budgeted cost

Lo.1 Explain how DM standards and DL standards are set

Setting direct materials standards
b. Standard Price per unit
 SP should reflect the final, delivered cost the materials, handling cost minus any discounts
 c. Standard Quantity per unit
 Should reflect the amount of material going into each unit of finished product, as well as for
waste, spoilage and other normal inefficiencies.
d. Standard cost of material per unit of finished goods (SP)
 It is just SP per unit x SQ per unit

**Standard and Budgets are very familiar  the major distinction between the two terms is that
Standard is a unit amount, whereas budget is a total amount**

Setting direct labour standards

 Usually expressed in terms of labour rate and labour hour
 Standard hours per unit needs to be found in order to find Standard labour cost per unit of
product
 SP= Standard labour hour per unit of product x Standard rate per labour hour

Setting direct labour standards

 Expressed in terms of rate and hours
o Need to find predetermined overhead rate (usually machine hours or direct labout
hours)
 SP = Predetermined overhead cost x hours per unit

Lo.12.2 Variance Analysis

- In variance we have expectations and experience

- If we use predetermined  it means the are some expectations of performance  it
can be expectations of DM, DL, or overhead then we can benchmark for measuring
actual performance

The northern division received bids

- 480 dollars from Thompson

- 430 from west paper  customer
- 432 from eire papers  customer

Eire papers will buy outside liner from

- Southern division 90 boxes

- 30 printed by Thompson – 25 dollar would be out of packet cost

Chapter 16:
SMA & BSC
- Draw top to bottom
- Read from bottom to top
- Strategy map: visualisation of your strategy as communication tools
-