01 05 Strategic Costing Midterm

Chapter 9: Standard Costing: A Functional-Based Control
Approach
Price and Quantity Standards and unit standard Cost

• Price standards: Specify how much should be
paid for the quantity of the input to be used
• Quantity standards: Specify how much of the
input should be used per unit of output
• Unit standard cost: Product of standard price (S
P) and standard quantity (S Q)
Standards
• Sources of quantitative standards

o Historical experience
o Engineering studies
o Input from operating personnel
• Price standards are the joint responsibility of operations,
purchasing, personnel, and accounting
o Choices are limited by market forces, trade

unions, and other external forces
Classification of Standards
• Ideal standards Standard Costing systems
o Demand maximum efficiency • Standard costs are developed for direct
o Achieved only if everything operates perfectly materials, direct labor, and overhead used in
• Currently attainable standards producing a product or service
o Can be achieved under efficient operating
• Total of standard costs yields the standard cost
conditions
per unit
o Allowance is made for normal breakdowns,
interruptions, and less than perfect skill o Standard cost sheet: Provides the detail
underlying the standard unit cost
Kaizen Standards
Purpose of a Standard Cost Sheet
• Continuous improvement standards
• Reveals the quantity of each input that should be
• Reflect planned improvement and are a type of
used to produce one unit of output
currently attainable standard
o Unit quantity standards can be used to
• Focus on cost reduction compute the total amount of inputs allowed
Standards and activity-based costing for the actual output
• Activity cost is determined by the amount of • Helps in the computation of standard

resources consumed by each activity quantity of materials allowed (S Q) and
the standard hours allowed (S H) for the
o Standard consumption patterns are
actual output
identified based on historical experience
Total Budget Variance
o Use standards for control
• Difference between the actual cost of the input and
o Activities are classified as either value-
its standard cost
added or non-value-added
o Total budget variance = (A P × A Q) − (S P × S Q)
• Purpose of standards
• A P = Actual price per unit
o To facilitate cost assignments
• A Q = Actual quantity of direct material
Reasons for Adopting Standard Costing Systems
used in production
• Cost management • S P = Standard price per unit
• Planning and control
• Decision making and product costing

Components of total Budget Variance o Actual yogurt usage: 745,000 ounces (no
beginning or ending yogurt inventory)
• Price (rate) variance
o Actual price paid per ounce of yogurt: $0.05
o Difference between the actual and standard unit
prices of an input multiplied by the actual quantity • Unit quantity standard: 25 ounces of yogurt
of input per quart
• Usage (efficiency) variance • Standard price of yogurt: $0.04 per ounce
o Difference between the actual and standard • Direct labor standard: 0.01 direct labor hour
quantity of input multiplied by the standard unit per quart
price of the input
• Calculate the ounces of yogurt that should have
Favorable and Unfavorable Variance been used (S Q) for the actual production of
frozen yogurt for the month of April
• Favorable (F) variance: Occurs whenever actual
prices or usage of inputs are lesser than standard • Calculate M P V and M U V for April using the
prices or usage formula approach and the graphical approach
• Unfavorable (U) variance: Occurs whenever • Calculate the total direct materials variance for
actual prices or usage of inputs are greater than yogurt for April
standard prices or usage
Direct materials price variance (M P V)

• M P V = (A P × A Q) − (S P × A Q) or
• M P V = (A P − S P)A Q
o M P V is unfavorable if the actual price is
greater than the standard price
o M P V is favorable if the actual price is
less than the standard
• Computed at one of two points:
o When the direct materials are issued for

use in production
o When they are purchased
Direct Materials Usage Variance (M U V)

• M U V = (S P × A Q) – (S P × S Q) or
• M U V = (A Q – S Q)S P
o If the actual quantity is greater than the
standard quantity, the M U V is
unfavorable
• Total direct materials variance
o If the actual quantity is less than the
standard, the M U V is favorable = (A P × A Q) − (S P × S Q) = M P V + M U V
• Should be computed as direct materials are = ($0.05 × 745,000) − ($0.04 × 750,000)
issued for production
= $37,250 − $30,000
o Companies use standard bill of materials,
= $7,250 U
color-coded excessive usage forms, and
color-coded returned-materials forms to Standard Bill of Materials
facilitate the process
• Identifies the quantity of direct materials that should
Direct Materials Price and Materials Usage Variances be used to produce a predetermined quantity of
output
• Helado Company provided the following information
for the production of deluxe strawberry frozen yogurt • Acts as a materials requisition form
during the month of April:
• Product: Quarts of Deluxe Strawberry Frozen Yogurt
o Actual production: 30,000 quarts
• Output: 30,000 Quarts
Accounting for Direct Materials Price and Usage • Calculate the direct labor hours that should have
Variances been worked (S H) for the actual production of
frozen yogurt for the month of April
• Calculate L R V and L E V for April using the
formula and graphical approaches
• Calculate the total direct labor variance for

yogurt for April
• Solution:
• All inventories are carried at standard
o S H = Unit quantity standard × Actual output
o Direct materials price variance is computed at = 0.01 × 30,000
the point of purchase = 300 hours
• Rules for recording variances
o Unfavorable variances are always debits

o Favorable variances are always credits
• Journal entry associated with the purchase of direct

materials
o Assumptions
• Unfavorable M P V
• A Q is defined as direct materials purchased
• Journal entry to record the issuance and usage of

direct materials
o Assumption - Unfavorable M U V
Direct labor rate variance (L R V) and Direct Labor Accounting for Direct Labor Rate and Efficiency
Efficiency Variance (L E V) Variances
• Assumptions
• L R V = (A R × A H) − (S R × A H) or (A R − S R)A H o Favorable direct labor rate variance
o A R = Actual hourly wage rate o Unfavorable direct labor efficiency variance
o S R = Standard hourly wage rate
o A H = Actual direct labor hours used
• L E V = (A H × S R) − (S H × S R) or (A H − S H)S R
Establishing Acceptable Range of Performance
o A H = Actual direct labor hours used
o S H = Standard direct labor hours that • Acceptable range is the standard set by the
should have been used management, plus or minus one allowable deviation
o S R = Standard hourly wage rate
• Control limits: Top and bottom measures of the
Direct Labor Rate and Efficiency Variances – Example allowable range
• Helado Company provided the following information o Upper control limit - Standard plus the allowable
for the production of deluxe strawberry frozen yogurt deviation
during the month of April:
o Lower control limit - Standard minus the
o Actual production: 30,000 quarts allowable deviation
o Actual direct labor hours worked: 325 hours
o Actual rate paid per hour to direct labor: $15.90 o Set based on past experience, intuition, and
judgment
Responsibility for the Direct Materials Variances Variable Overhead Spending Variance and Variable
Overhead Efficiency Variance
• Price variance can be influenced by quality,
quantity discounts, and distance of the source from
the plant
o Factors are under the control of the purchasing
agent
• Production manager is responsible for direct

materials usage
o Standard can be met by minimizing scrap,

waste, and rework Variable Overhead Spending and efficiency Variances –
• Limitations in using price variance to evaluate Example
performance of purchasing • Helado Company provided the following
o Emphasis on meeting or beating the standard information for the month of May:
can produce undesirable outcomes
o Applying the usage variance to evaluate
performance can lead to undesirable behavior
Responsibility for the Direct Labor Variances

• Direct labor rate variances occur when:
o An average wage rate is used for the

• Calculate the variable overhead spending variance
rate standard
using the formula approach
o More skilled and more highly paid
• Calculate the variable overhead efficiency variance
laborers are used for less skilled tasks
• Use of direct labor is controllable by the
production manager • Calculate the variable overhead spending variance
and variable overhead efficiency variance using the
Disposition of Direct Materials and Direct Labor Variances three-pronged graphical approach
• Immaterial variances are assigned to Cost of
Goods Sold
o Cost of Goods Sold must be increased at
the end of the year to reflect the higher
actual cost for unfavorable variances
• Materials variances are prorated among Work in
Process, Finished Goods, and Cost of Goods Sold
o Direct materials and direct labor
variances can be assigned in proportion
to the total prime costs in each of the
inventory accounts
Four-Variance Method for Calculating Overhead

Variances
• Calculates two variances for variable overhead
and two variances for fixed overhead
• Total variable overhead variance is divided into:
o Variable overhead spending variance Interpreting Variable Overhead Variances

o Variable overhead efficiency variance • Variable overhead spending variance
• Total fixed overhead variance is divided into: o Affected by price changes and how efficiently
an overhead is used
o Fixed overhead spending variance
o Variable overhead items are affected by
o Fixed overhead volume variance
several responsibility centers
• Assigning the cost to a specific area of
responsibility requires that cost be
traced to the area
• Variable overhead efficiency variance
o If variable overhead is driven by direct

labor hours, the variance is caused by
efficient or inefficient use of direct labor
• Calculate the fixed overhead spending variance

• Calculate the volume variance using the formula

approach
• Calculate the fixed overhead spending variance

and volume variance using the three-pronged
graphical approach
Fixed Overhead Spending Variance (F O S V)

• FOSV=AFOH−BFOH
o A F O H = Actual fixed overhead

o B F O H = Budgeted fixed overhead
Interpreting Fixed Overhead Variances
• If less is spent on fixed overhead items than was
budgeted, the spending variance is favorable • Fixed overhead spending variance
and vice versa o Budget variance is usually small
Fixed Overhead Volume Variance • Many fixed overhead costs are affected
• Volume variance = Budgeted fixed overhead – primarily by long-run decisions and not by
Applied fixed overhead changes in production levels
• If actual production is less than budgeted • Fixed overhead volume variance

production, the volume variance will be o Measure of planned utilization of capacity if the
unfavorable and vice versa budgeted volume is the amount that management
believed could be produced and sold
• Volume variance is a direct measure of
capacity utilization if practical capacity is
used as the budgeted volume
Direct Materials Yield Variance
• Yield variance = (Standard yield − Actual yield)S P y
o Standard yield = Yield ratio × Total actual inputs

o Yield ratio = Total output ÷ Total input
o S P y = Standard cost of the yield (equal to total
cost of a standard batch divided by the
amount of the yield)
Accounting for Overhead Variances
• Applying overhead to production

o Work in Process is accumulated on the debit side
o Variance and fixed overhead control accounts
are accumulated on the credit side
• Recognizing the incurrence of actual overhead

o Variable and fixed overhead control accounts
are debited
o Value of various accounts is credited

• Recognizing variances
o Fixed overhead control account, fixed overhead

spending variance account, and variable
overhead spending and efficiency variance
accounts are debited
o Variable overhead control account and fixed
overhead volume variance account are credited
• Overhead variance reports are prepared periodically
• Closing the variances to cost of goods sold

o Fixed overhead volume variance account is
debited and cost of goods sold is credited
o Another entry is made to debit cost of goods sold

and credit variable overhead spending and
efficiency variance accounts and fixed
overhead spending variance account
Mix and Yield Variances: Materials and Labor
• Mix variance: Created whenever the actual mix
of inputs differs from the standard mix
• Yield variance: Occurs whenever the actual yield

(output) differs from the standard yield
Direct Materials Mix Variance

• S M - Quantity of each input that should have
been used given the total actual input quantity
o S M = Standard mix proportion × Total

actual input quantity
• If relatively more of a more expensive input is
used, the mix variance will be unfavorable and
vice versa
Cornerstones of cost
management, 4e
Chapter 11
Strategic cost management
© 2019 Cengage. All rights reserved.

Learning objectives
1. Explain what strategic cost management is and how it

can be used to help a firm create a competitive
advantage
2. Discuss value-chain analysis and the strategic role of
activity-based customer and supplier costing
3. Tell what life-cycle cost management is and how it can
be used to maximize profits over a product’s life cycle
4. Identify the basic features of JIT purchasing and
manufacturing
5. Describe the effect JIT has on cost traceability and
product costing
Introduction
© 2019to Cost management
Cengage. All rights reserved.
Strategic Decision Making and Cost
Management
• Strategic decision making
– Choosing among alternative strategies
 Goal - Selecting a strategy that provides a company with
reasonable assurance of long-term growth and survival
• Strategic cost management
– Use of cost data to develop and identify superior
strategies that will produce a sustainable competitive
advantage
Introduction
Competitive Advantage, Total Product, and
Post-Purchase Costs
• Competitive advantage: Creating better customer
value for the same or lower cost than offered by
competitors
– Customer value: Difference between customer
realization and customer sacrifice
• Total product: Complete range of tangible and
intangible benefits that a customer receives from a
purchased product
• Post-purchase costs: Costs of using, maintaining,
and disposing of the product
Introduction
Strategies For Increasing Customer Value
To Achieve Competitive Advantage
• Cost leadership
– Looks to provide the same or better value to customers
at a lower cost than offered by competitors
• Differentiation
– Strives to increase customer value by increasing what
the customer receives
• Focusing
– Places emphasis on a market or customer segment
Introduction
Strategic Positioning
• Process of selecting the optimal mix of three general

strategic approaches
• Role of cost management
– Reduce costs
– Strengthen the chosen strategic position
Introduction
Value-Chain Framework
• Industrial value chain: Linked set of value-creating

activities
– Firm must understand the entire value chain in order to
create and sustain a competitive advantage
• Compelling approach to understanding a firm’s
strategically important activities
– Recognition of complex linkages and interrelationships
among activities within and beyond the firm is vital
Introduction
Types of Linkages
• Internal linkages: Relationships among activities that

are performed within a firm’s portion of the value chain
• External linkages: Relationship of a firm’s value-chain
activities that are performed with its suppliers and
customers
– Types - Supplier linkages and customer linkages
Introduction
Identification and Selection of Firm’s
Activities
• Firm’s activities can be used to produce or sustain a
competitive advantage
• Help exploit a firm’s internal and external linkages
• Classification of activities
– Organizational activities
– Operational activities
Introduction
Organizational Activities and Cost Drivers
• Types of organizational activities

– Structural activities: Determine the underlying
economic structure of the organization
– Executional activities: Define the processes and
capabilities of an organization
• Organizational cost drivers: Structural and
executional factors that determine the long-term cost
structure
– Types - Structural and executional cost drivers
Introduction
Exhibit 11.2 - Organizational Activities
and Drivers (1 of 2)
Structural Activities Structural Cost Drivers
Building plants Number of plants, scale, degree of
centralization
Management structuring Management style and philosophy
Grouping employees Number and type of work units
Complexity Number of product lines, number of
unique processes, number of unique
parts, degree of Complexity
Vertically integrating Scope, buying power, selling power
Selecting and using process Types of process technologies,
technologies experience

Exhibit 11.2 - Organizational Activities
Executional Activities Executional Cost Drivers

Using employees Degree of involvement
Providing quality Quality management approach
Providing plant layout Plant layout efficiency
Designing and producing Product configuration
products
Providing capacity Capacity utilization

Operational Activities and Drivers
• Operational activities: Day-to-day activities performed

as a result of the structure and processes selected by
the organization
• Operational cost drivers: Factors that drive the cost
of operational activities
Introduction
Exhibit 11.3 - Operational Activities
Unit-Level Activities Unit-Level Drivers
Grinding parts Grinding machine hours
Assembling parts Assembly labor hours
Drilling holes Drilling machine hours
Using materials Pounds of material
Using power Number of kilowatt-hours
Batch-Level Activities Batch-Level Drivers
Setting up equipment Number of setups
Moving batches Number of moves
Inspecting batches Inspection hours
Reworking products Number of defective units

Exhibit 11.3 - Operational Activities
Product-Level Activities Product-Level Drivers
Redesigning products Number of change orders
Expediting Number of late orders
Scheduling Number of different
products
Testing products Number of procedures

Exhibit 11.4 - Organizational and
Operational Activity Relationships

Value-Chain Analysis
• Identifying and exploiting internal and external linkages

to strengthen a firm’s strategic position
– Exploitation of linkages relies on analyzing how costs and
other nonfinancial factors vary
• Objective - To control cost drivers better than
competitors
Introduction
Exploiting Internal Linkages
• Relationships between activities are assessed and

used to reduce costs and increase value
• Knowing the cost drivers of activities is crucial for
understanding and exploiting linkages
Introduction
Exhibit 11.5 - Internal value chain

Exploiting Supplier Linkages
• Managing linkages in order for the company and the

external parties to receive increased benefits
• Suppliers provide inputs and can have a significant
effect on a user’s strategic positioning
Introduction
Managing procurement costs using activity-
based costing (1 of 2)
• Purchasing managers should choose suppliers whose
quality, reliability, and delivery performance are
acceptable
– Requirements
 Suppliers should be evaluated based on total cost and not
just purchase price
 Supplier costs are assigned to products using causal
relationships
Introduction
Managing procurement costs using activity-
based costing (2 of 2)
• Activity-based costing
– Defines suppliers as cost objects and traces costs
related to purchase, quality, reliability, and delivery
performance to suppliers
– Defines products as cost objects and traces supplier
costs to specific products
Introduction
Managing customer costs
• Failure to assign customer-servicing costs accurately

will prevent sales representatives from managing the
customer mix effectively
– Customer-related costs allow the firm to classify
customers as profitable or unprofitable
– Once identified, actions can be taken to strengthen the
strategic position of the firm
Introduction
Product Life-Cycle Viewpoints
• Product life-cycle: Can refer to a product class as a

whole, to specific forms, and to specific brands or
models
– Revenue-producing life: Time a product generates
revenue for a company
– Consumable life: Length of time that a product serves
the needs of a customer
• Viewpoints are marketing-oriented and production-
oriented
Introduction
Exhibit 11.7 - General Pattern of Product
Life Cycle: Marketing Viewpoint

Production Viewpoint
• Defines stages of the life cycle by changes in the type

of activities performed
• Emphasizes life-cycle costs
– Life-cycle costs: All costs associated with the product
for its entire life cycle
– Costs include:
 Research and development
 Production and logistics support
Introduction
Exhibit 11.8 - Product Life Cycle:
Production Viewpoint

Consumable Life-Cycle Viewpoint
• Related to activities that define the stages of

purchasing, operating, maintaining, and disposal
• Emphasizes product performance for a given price
– Price is the costs of ownership that includes purchase,
operating, maintenance, and disposal costs
• Total customer satisfaction is affected by purchase
price and post-purchase costs
Introduction
Life-cycle management
• Consists of actions taken that cause a product to be:

– Designed and developed
– Produced, marketed, distributed, and operated
– Maintained, serviced, and disposed
• Helps maximize life-cycle profits by taking advantage
of revenue enhancement and cost reduction
opportunities
Introduction
Relationships among life-cycle viewpoints
• Marketing viewpoint is revenue-oriented

• Production viewpoint is cost-oriented
• Consumable life-cycle viewpoint is customer value–
oriented
Introduction
Exhibit 11.9 - Typical Relationships of
Product Life-Cycle Viewpoints (1 of 2)
Marketing Product Life Cycle:
Attributes Introduction Growth Maturity Decline
Sales Low Rapid growth Slow growth, Declining
peak sales
Production Life Cycle:

Expenses:
Product R&D High Moderate Moderate Low
Product R&D Moderate High Moderate Low
Plant & equipment Low to moderate High Moderate Low
Advertising Moderate to high High Moderate Low
Service Low Moderate High Low

Exhibit 11.9 - Typical Relationships of
Product Life-Cycle Viewpoints (2 of 2)
Consumable Life Cycle:
Customer value:
Customer type Innovators Mass market Mass market, Laggards
differentiated
Performance High High High Moderate
sensitivity
Price sensitivity Low Moderate High Moderate
Competition None Growing High Low
Profits Negligible Peak levels Moderate Low
to loss to high

Revenue Generation and Cost reduction
strategies (1 of 2)
• Revenue-generating strategies depend on marketing
life-cycle stages and customer value effect
– For viable revenue enhancement, customers must be
willing to pay a premium for any improvement in product
performance
• Cost reduction strategies
– Actions taken in early stages of the production life-cycle
can lower costs for later production and consumption
stages
Introduction
Revenue Generation and Cost reduction
strategies (2 of 2)
– Careful product design and process design can help
reduce:
 Manufacturing costs
 Logistical support costs
 Post-purchase costs
– Activity-based costing information is critical for life-cycle
cost reduction decisions
 Produces information about activities and cost drivers
 Encourages good life-cycle planning
Introduction
Target Costing
• Useful tool for establishing cost reduction goals during

the design stage
– Target cost: Difference between the sales price needed
to capture a predetermined market share and the
desired per-unit profit
– Requires close interaction between the firm and its
suppliers
• Cost reduction methods
– Reverse engineering
– Value analysis
– Process improvement
Introduction
Exhibit 11.10 - Target-Costing Model

JUST-IN-TIME (JIT) MANUFACTURING (1 of 2)
• Demand-pull system
• Objective is to eliminate waste by producing a product
only when it is needed
• Assumes that all costs other than direct materials are
driven by time and space drivers
• Improves quality, increases productivity, reduces lead
times, inventories, and setup times, and lowers
manufacturing costs
Introduction
JUST-IN-TIME (JIT) MANUFACTURING (2 of 2)
• JIT manufacturers emphasize long-term contracts

– Help reduce the uncertainty in demand for the supplier
and establishes the mutual confidence and trust
– Reduce the number of orders placed
 Helps drive down ordering and receiving costs
– Reduce the cost of parts and materials
– Ensure reasonably stable demand for a supplier’s
products
Introduction
JIT Purchasing
• Requires suppliers to deliver parts and materials just in

time to be used in production
• Utilizes supplier linkages by:
– Negotiating long-term contracts with a few suppliers
located close to the production facility
– Establishing more extensive supplier involvement
• Vital considerations
– Performance
– Commitment
Introduction
JIT - Plant Layout
• Follows a pattern of manufacturing cells

– Manufacturing cells: Contain machines that are
grouped in families, usually in a semi-circle
– Each cell is viewed as a mini-factory
• Executional cost driver for a JIT setting is cell structure
– Cell structure increases the ability of an organization to
execute successfully and affects structural activity
– Labor is multiskilled and not specialized
Introduction
Exhibit 11.11 - Plant Layout Pattern:
Traditional versus JIT

JIT - Grouping of Employees and Employee
Empowerment
• Each cell requires easy and quick access to support
services
– Centralized service departments are scaled down, and
employees are reassigned to work directly with
manufacturing cells
• Employee empowerment increases productivity and
overall cost efficiency
– Fewer managers are required when workers assume
greater responsibilities, and the organizational structure
becomes flatter
Introduction
JIT - Total Quality Control
• JIT cannot be implemented without a commitment to

total quality control (TQC)
– Acceptable quality level (AQL): Approach to managing
quality that is diametrically opposed to the traditional
doctrine
 Permits or allows defects to occur provided they do not
exceed a predetermined level
Introduction
Exhibit 11.12 - Comparison of JIT Approaches
with Traditional Manufacturing and Purchasing
JIT Traditional
1. Pull-through system 1. Push-through system
2. Insignificant inventories 2. Significant inventories
3. Small supplier base 3. Large supplier base
4. Long-term supplier contracts 4. Short-term supplier contracts
5. Cellular structure 5. Departmental structure
6. Multiskilled labor 6. Specialized labor
7. Decentralized services 7. Centralized services
8. High employee involvement 8. Low employee involvement
9. Facilitating management style 9. Supervisory management style
10. Total quality control 10. Acceptable quality level
11. Buyers’ market 11. Sellers’ market
12. Value-chain focus 12. Value-added focus

Exhibit 11.13 - Product Cost Assignment:
Traditional versus JIT Manufacturing
Manufacturing Cost Traditional Environment JIT Environment
Direct labor Direct tracing Direct tracing
Direct materials Direct tracing Direct tracing
Materials handling Direct tracing Direct tracing
Repairs and maintenance Direct tracing Direct tracing
Energy Direct tracing Direct tracing
Operating supplies Direct tracing Direct tracing
Supervision (department) Allocation Direct tracing
Insurance and taxes Allocation Allocation
Plant depreciation Allocation Allocation
Equipment depreciation Direct tracing Direct tracing
Custodial services Allocation Direct tracing
Cafeteria services Direct tracing Direct tracing

Effect of JIT on Product Costing
• JIT manufacturing converts many common costs to

directly attributable costs
– Increase in directly attributable costs increases the
accuracy of product costing
• All batch-level activities are converted into unit-level
activities
Introduction
JIT's Effect on Job-Order and Process-
Costing Systems
• In implementing JIT in a job-order setting, the firm
should first separate its repetitive business from its
unique orders
– Costs are accumulated at the cellular level
• Process costing is simplified
– Need to compute equivalent units vanishes
– Calculating product costs involves collecting costs for a
cell for a period of time and dividing the costs by the
units produced for that period
Introduction
Backflush Costing
• Uses trigger points to determine when manufacturing

costs are assigned to key inventory and temporary
accounts
• Varying the number and location of trigger points
creates different types of backflush costing
– Trigger points - Events that prompt the accounting
recognition of certain manufacturing costs
Introduction
Backflush Costing - Variations of trigger
points
• Purchase of raw materials and the completion of goods
• Purchase of raw materials and the sale of goods
• Completion of goods
• Sale of goods
Introduction
Chapter 17
Activity Based Costing (ABC)

And Just in Time Costing (JIT)
The principal purpose of any costing system is to allocate the costs of

production (direct materials, and manufacturing overhead) to the units
purchased. The traditional costing systems are job order costing and
process costing. Candidates should also familiar with the other costing
systems such as the Activity Based Costing (ABC) and Just in Time (JIT)
costing systems.
ACTIVITY BASED COSTING
Activity based costing (ABC) is a refinement of the traditional costing

system of allocating manufacturing overhead to the units produced.
Traditional costing systems always use volume-related measures, such as
direct labor hours or machine hours to allocate overheads to products.
ABC allocates overhead costs to products on the basis of resources

consumed by each activity involved in the design, production, and
distribution of a particular product. This is accomplished by assigning costs
to cost pools that represent specific activities and allocating these costs
using the appropriate cost drivers to the product. Cost drivers are those
activities which have a direct cause and effect relationship to the
investment of a particular cost.
Comparison of Traditional Costing System and ABC
CPAR produces products two products: L and H. Both are produced on the same
equipment and use similar processes. Production data are as follows:
Product L Product H
Machine hours per unit 2 2
Direct labor hours per unit 4 4
Units produced 1,000 10,000
Total machine hours 2,000 20,000
Total direct labor hours 4,000 40,000
Number of purchase orders 80 160
Number of set-ups 40 60
The overhead cost of the activities is as follows:

Volume-related P 110,000
Purchasing-related 120,000
Set-up-related 210,000
Total overhead cost P 440,000*
(a) Traditional costing system:
Overhead rate per machine hour (P440,000/22,000 hours) P20

Overhead rate per direct labor hour (P440,000/44,000 hours) P10
Cost per unit of:
Product L – based on machine hours (2 hrs x P20) P40
Product H – based on direct labor hours (4 hrs x P10) P40
(b) ABC system

Volume-related Purchasing-related Set-up related
Overhead costs P110,000 P120,000 P210,000
Cost drivers 22,000 machine hrs 240 purchase orders 100 set-ups
Overhead cost per unit of
consumption P5/machine hr. P500/per order P2,100 per set-ups
Allocated costs to products:
L P10,000(2,000xP5) P40,000(80xP500) P84,000(40xP2100)
H P100,000(20,000xP5) P80,000(160xP500) P126,000(60xP2100)
Overhead cost per unit:
Product L = P134 (P10,000+P40,000+84,000)/1,000 units
Product H = P30.60 (P100,000+P80,000+P126,000)/10,000 units
JUST IN TIME SYSTEMS
Just in time (JIT) manufacturing is production systems in which each component in a

production line is produced immediately as needed by the next step in the production
line. The aim of JIT systems is to produce the required items, of high quality, exactly at
the time they are required. JIT systems are characterized by:
A move towards zero inventory

Elimination of non-value added activities
An emphasis on perfect quality ie, zero defects
100% time deliveries
Demand-pull manufacture
It is the latter characteristics which gives rise to the name of Just in Time. Production
only takes place when there is actual customer demand for the product so JIT works on
a pull-trough basis which means that products are not made to go into stock. JIT
systems result in reduction in inventories so that inventory valuation becomes less
relevant. Simplified accounting procedures can be used for allocation costs between
cost of sales and inventories. This simplified procedure is known as backflush costing.
Candidates should be familiar with the features and the accounting procedures of
backflush costing.
Backflush Costing
Backflush costing is a costing system that omits recording some or all of the journal
entries relating to the cycle from purchase of direct materials (stage 1) to production
resulting in Work in Process (stage 2) to manufacture of finished goods (stage 3) and to
the sale of finished goods (stage 4). When journal entries for one or more stages in the
cycle are omitted, the journal entries for subsequent stage use normal or standard costs
to work backward to flush out the costs in the cycle for which journal entries were not
made. No separate accounting for work in process is made.
Actual conversion costs are recorded as incurred, just the same as conventional
recording systems. Conversion costs are then applied to products at various trigger
points. It is assumed that any conversion cost not applied to products are carried
forward and disposed of a year-end.
Under backflush costing, costs are applied to products when production is completed.
The following three methods illustrate backflush costing. The three method differ in the
number of trigger points at which journal entries are made in the accounting system.
Method 1 Method 2 Method 3
Trigger points 1. Purchase of raw materials 1. Purchase of raw materials

2. Completion of finished goods 1. Completion
of finished goods
3. sale of finished goods 2. sale of finished goods 2. sale of
of finished goods
Inventory a/c 1. Raw and in process (RIP) Raw and in process (RIP) Finished Goods a/c
Account a/c
2. Finished goods a/c
Main features 1. three trigger points 1. Two trigger points 1. simplest of all
2. use if combined raw 2. use of combined raw 2. two trigger point
Materials and in process materials and in process
3.Nofinished goods a/c
In all three methods, there are no journal entries in the accounting system for work in
process (stage2). These three methods are usually used where the amounts of work in
process are small.
The following data will be used to illustrate the three methods:
Materials purchase on credit for the period P195,000

Conversion costs for the period 120,000
Number of units manufactured 10,000 units
Number of finished units sold 9,900 units
The cost per unit is P31 (19 materials + P12 conversion costs). There are no opening
stocks and for simplicity it is assumed that there are no variances. Using the backflush
Costing the journal entries under the three methods are:
Method 1: Three Trigger Points
Transaction Journal Entries
(a) Purchase of raw materials Raw and in process (RIP) 195,000

Accounts payable 195,000
(b) Incur conversion costs Conversion costs 120,000

Various accounts 120,000
(c) Completion of finished goods Finished goods 310,000

(10,000units x P31 = P310,000) Raw and in process (RIP) 190,000
Conversion costs 120,000
(d) Cost of goods sold Cost of goods sold 306,900

(9,900 units x P31 = P306,900) Finished goods 306,900
Entry C gives backflush costing its name. Note, costs have not been recorded
sequentially with the flow of product along its production route through work in process
and finished goods. Instead, the output trigger point reaches back and pulls the direct
materials costs From Raw and in Process account and the conversion costs for
manufacturing the finished goods
Method 2: Two Trigger Points

Transactions Journal Entries
(a) Purchase of raw materials Raw and Process 195,000

(b) Incur conversion costs Conversion costs 120,000

(c) Completion of finished goods No entry

Raw and in process 188,100
The cost of finished units is computed only when finished goods are sold [which
corresponds to entry(d)]: 9,000 units sold x P31 per unit = P306,900, which is comprised
of direct materials costs (9,900units xP19per unit = P188,100) and conversion cost
(9,900 units xP12per unit = P118,800). The under-allocated (120,000-
118,800)conversion costs is closed to Cost of goods sold account.
608 Practical Accounting - 2
Method 3: Two Trigger Points
Transactions Journal Entries

(a) Purchase of raw materials No Entry
(b) Incur conversion costs Conversion Costs 120,000

(c) Completion of finished goods Finished goods 310,000


Finished goods 306,900
The above method doesn’t record accounts payable for direct materials until the
products being manufactured are completed. This method of backflush costing is
feasible only if there is a short log between receipts of direct materials and completion
of production.
Problems
1. Uratex company manufactures a variety of classroom chairs. Its job-costing system
uses an activity-based approach. There are two direct-cost categories (direct materials
and direct labor) and there indirect cost pools. The cost pools represent three activity
areas at the plant.
Manufacturing Budgeted Cost Driver used Cost-allocation

Activity Area Cost for 2013 as Allocation Base rate
Materials Handling P200,00 Parts P0.25

Cutting 2,000,000 Parts 2.50
Assembly 2,000,000 direct labor hours 25,000
Two styles of chairs were produced on March, the high school chair, and the college
chair. Their quantities, direct material costs, and other data for March 2013 are as
follows:
Direct Direct
Units Materials Number Manufacturing
Produced Costs of Parts Labor hours
High school chair 5,000 P600,000 100,000 7,500

College chair 100 25,000 3,500 500
The direct labor rate is P20 per hour. Assume no begging or ending inventory.
What are the unit cost of the high school chair and college chair?
a. P240.50 and P571.75 respectively

b. P242.50 and 570.25 respectively
c. P252.50 and P571.25 respectively
d. P242.50 and P571.25 respectively
2. The manila company manufactures and sells packaging machines. It recently used
an activity-based approach to refine the job costing system at its BulacanPlant.. The
resulting job costing system has one direct-cost category (direct materials) and four
indirect manufacturing cost pools. These four indirect cost pools and their allocation
bases are:
Indirect Manufacturing Cost-Allocation Budgeted Cost-

Cost Pool base Allocation rate
1. Material handling Component parts P8 per part

2. Machining machine- hours P68 per hour
3. Assembly assembly-hours P75 per hour
4. Inspection inspection-hours P104 per hour
Manila Company recently sold 50 can-packaging machines to Ilocos Company. Each
machine has direct material costs of P3,000 requires 50 component parts, 12 machine
hours, 15 assembly hours, and 4 inspection hours.
Manila Company’s previous costing system had one direct-cost category (direct
materials) and one indirect-cost category (manufacturing overhead allocated at therate
of P100 per assembly-hour).
In comparison to the traditional costing system used by Manila Company, the total
manufacturing cost of the machines sold under the ABC is:
a. P114,850 higher
b. P141,850 lower
c. P114,950 higher
d. Equal
3. Believing that its traditional cost system may be providing misleading information,
BMW company is considering an activity based costing approach, it now employs a full
cost system and has been applying its manufacturing overhead on the basis of machine
hours.
No. 3 –Continued
The company plans on using 50,000 direct labor hours and 30,000 machine hours
in the coming year. The following data show the manufacturing overhead that is
budgeted.
Activity Cost Driver Budgeted Activity Budgeted Cost

Material handling No. of parts handled 6,000,000 P720,000
Setup costs No. of setups 750 315,000
Machine costs Machine hours 30,000 540,000
Quality control No. of batches 500 225,000
Cost, sales, and production data for one of the company’s product for the coming year
are as follows:
Prime Costs:
Direct material cost per unit P4.40
Direct labor cost per unit, .05 direct labor
hour@P15 per hour 0.75
Sales and production data:
Expected sales 20,000 units
Batch size 5,000 units
Setups 2 per batch
Total parts per finished unit 5 parts
Machine hours required 90 machine hours per batch
If the company employs an activity-based costing system, the cost per unit for the
product described for the coming year will be:
a. P6.00
b. P6.08
c. P6.21
d. P6.30
4. Tamiya Corporation has use a traditional costing system to apply quality control costs
uniformly to all products at a rate of 14.5% of direct labor cost. Monthly direct labor
cost for its Product X is P275,000. in an attempt to distribute quality control costs more
equitable, Tamiya is considering activity-based costing (ABC). The June data shown
below have been gathered for Product X.
Activity Cost Driver Cost Rates Quantity

1. Material handling Type of materials P115 per type 12 types
2. Inspection Number of units P1.40 per unit 17,500 units
3. Production certification Per order P770 per order 25 orders
No. 4 – Continued
What is the monthly quality control assigned to product X using the ABC?
a. P686.40 per order

b. 5,255 higher than the traditional costing system
c. P85,000.5
d. P5,255 lower than the traditional costing system
5. Yokomo Inc. accumulated the following cost information for its products, A and B.
Product A Product B
Units produced 2,000 1,000
Total direct labor hours 5,000 20,000
Set-up cost per batch P1,000 P2,000
Batch size 100 50
Total setup cost incurred P20,000 P40,000
Direct labor hour per unit 2 1
A traditional costing system would allocate setup costs on the basis of direct labor
hours. An ABC system would trace costs by spreading the cost per batch over the units
in a batch. What is the setup cost per unit of Product A under each costing system?
Traditional costing ABC
a. P4.80 P10
b. P2.40 P10
c. P40.00 P200
d. P4.80 P20
6. Product ABC uses 200 hours of direct labor and has 2,000 machine set-ups. Larry Tan,
the cost accountant, has been considering using either direct labor hours or machine
set-ups as the cost driver. The ratio of overhead cost to direct labor hours is P60. The
assignment of overhead cost to Product ABC using direct labor hours would result in a
higher charge by P4,000 than if machine set-ups were used as the cost driver.
What is the ratio of overhead cost to machine set-up?
a. P6
b. P2
c. P60
d. P4
7. Mactan Enterprise is a Philippine exporter of souvenir items manufactured in the

capital city of Cebu. The following overhead cost data have been accumulated.
Amount
Activity Center Cost Driver of activity Center Costs
Material handling Kilos handled 100,000 grams P50,000

Painting Units painted 50,000 units 200,000
Assembly Labor hours 4,000 hours 120,000
Job RST contains 3,000 units. It weights 10,000 kilos and uses 300 hours of labor
What is the total overhead cost assigned to Job RST?
a. P31,955
b. P27,750
c. P26,000
d. P32,000
Numbers 8 and 9 are based on the following data:
Omega Company is preparing its annual profit plan. As part of its analysis of the
profitability of individual products, the controller estimates the amount of overhead
that should be allocated to the individual product lines from the information given as
follows:
Wall Specialty
Mirrors Windows
Units produced 25 25
Material moves per product line 5 15
Direct labor hours per unit 200 200
Budgeted materials handling costs P50,000
Under a costing system that allocates overhead on the basis of direct labor hours
(traditional), the materials handling costs allocated to one unit of wall mirrors would be
a. P1,000
b. P500
c. P2,000
d. P5,000
9. Under activity based costing (ABC), what is the materials handling costs allocated to
one unit of wall mirrors?
a. P1,000
b. P500
c. P1,500
d. P2,000
10. Delta Machine Toll Incorporated produces a varied product line without the use of
direct labor. An extensive setup procedure is required. Because no single base for a
predetermined overhead rate will provide Delta with reliable product cost information,
overhead is classified into two cost pools and two predetermined overhead rates are
used. For 2013, it is estimated that total overhead cost will consist of P525,000 of
overhead related to setups and P900,000 of overhead related to machine usage. Total
machine usage is expected to be 3,600 hours for the year, and the total number of
setups is expected to be 300.
Job RST requires parts and materials costing P56,000, 70hours of machine time, and
four setups.
What is the cost of Job RST?
a. P80,500
b. P78,500
c. P83,050
d. P79,500
11. The Love Company seeks to streamline the costing system at its Manila plant. It will
use a backflush costing system with three trigger points:
Purchase of raw materials

Completion of finished goods
Sale of finished goods
There are no beginning inventories. The following data pertain to April 2013:
Raw materials purchased P880,000

Raw materials used 850,000
Conversion cost incurred 422,000
Conversion allocated to finished goods 400,000
Costs transferred to finish goods 1,250,000
Cost of goods sold 1,190,000
No. 11 – Continued
Assume no materials variances. The balance or RIP account at the end of April
2013 is:
a. P30,000
b. P880,000
c. P850,000
d. P0
12. The Futaba Manufacturing Company uses raw and in process (RIP) inventory
account. At the end of each month, all inventories are counted, their conversion costs
components are estimated, and inventory account balances are adjusted accordingly.
Raw materials cost is backflushed from RIP account to finished goods account. The
following data is for the month of August:
Beginning balance of RIP account P38,700

Conversion costs incurred 4,800
Raw materials purchased 680,000
Conversion costs allocated 5,300
Ending balance of RIP account 41,900
The amount of direct materials and conversion costs to backflushed to finished goods
are:
a. P676,800 and P4,800 respectively

b. P680,000 and P4,800 respectively
c. P676,800 and P5,300 respectively
d. P680,000 and P5,300 respectively
13. The Action Corporation manufactures electrical meters. For May, there were no
beginning inventories of raw materials and no beginning and ending work in process.
Action uses JIT manufacturing system and backflush costing with three trigger points for
making entries in the accounting system:
Purchase of raw materials – debited to raw and in process account

Completion of finished goods – debited to finished goods account
Sale of finished goods
No. 13 – Continued
Action’s May standard costs per meter are direct materials, p25; and conversion
costs, P20. The following data apply to May manufacturing:
Raw materials and components purchased P550,000

Conversion costs incurred P440,000
Number of finished units manufactured 21,000
Number of finished units sold 20,000
The balance of raw and in process and finished goods inventory accounts at the
end of May are:
a. P25,000 and P945,000 respectively

b. P550,00 and P45,000 respectively
c. P25,000 and P45,000 respectively
d. P550,000 and P945,000 respectively
14. The Pit Shop Company produces telephones. For June, there were no beginning
inventory of raw materials and no beginning and ending work in process. Pit Shop uses
JIT manufacturing system and backflush costing with two trigger points for making
entries in its accounting system.
Purchase of raw materials

Sales of finished goods
Pit Shop’s standard cost per unit of telephone in June is direct materials, P26; and
conversion costs, P15. The following data apply to June production:
Raw materials purchased P5,300,000

Conversion costs incurred 3,080,000
Number of finished units manufactured 200,000
Number of finished units sold 192,000
The balances of Raw and in process and cost of goods sold accounts at the end of June
are:
a. P308,000 and P7,872,000 respectively

b. P5,300,000 and P7,872,000 respectively
c. P308,000 ad P4,992,000 respectively
d. P4,992,000 and P2,880,000 respectively
15. The Hudy manufacturing company uses raw and in process (RIP) inventory account
and expensed all conversion costs to the cost of goods sold account. At the end of each
month, all inventories are counted, their conversion cost components are estimated,
and inventory account balances are adjusted accordingly. Raw materials cost is
backflushed fro RIP to finished goods. The following information is for the month if Pril:
Beginning balance of RIP account, including P1,400

of conversion cost P31,000
Raw materials received on credit 367,000
Ending RIP inventory per physical count, including
P1,800 conversion cost estimate 33,000
What is the amount of materials used to be backflushed from RIP to finished goods?
a. P365,000
b. P368,600
c. P367,000
d. P365,400
16. The HPI manufacturing company produces only for customers order and most work
is shipped within thirty-six hour after the receipt of an order. HPI uses a raw and in
process (RIP) inventory account and expensed all conversion costs to the cost of goods
sold account. Work is shipped immediately upon completion, so there is no finished
goods account. At the end of each month, inventory is counted, its conversion cost
component is estimated, and the RIP to cost of goods sold. The following information is
for the month of May:

of conversion P12,300
P2,100 conversion cost estimate 12,100
What is the amount of raw materials used to be backflushed from RIP to cost of goods
sold?
a. P246,000
b. P246,200
c. P247,000
d. P245,000
Use the following data in answering Numbers 17 and 18
Mike Tuazon general manager of a highly automated coffee production plant in

Bulacan has provided the following information for transactions that occurred
during October. The production plan uses a JIT costing system.
a. Raw materials costing P300,000 were purchased.

b. All materials P300,000 were requisitioned for production.
c. Direct labor cost of P200.000 were incurred.
d. Actual factory overhead costs amounted to P995,000.
e. Conversion costs allocated totaled P1,300,000. This includes the direct
labor cost.
f. all units are completed and immediately sold.
17. What is the over-allocated or under-allocated conversion costs for the month?
a. P305,000 over-allocated
b. P195,000 under-allocated
c. P105,000 over-allocated
d. P105,000 under-allocated
18. Assuming no adjustment has been made for over-allocated or under-allocated

conversion cost, what is the balance of the cost of goods sold account on October 31?
a. P1,300,000
b. P1,495,000
c. P1,600,000
d. P1,195,000
19. Basilio Company has a cycle time of 3 days, uses raw and in process (RIP) account,
and charges all conversion costs to cost of goods sold. At the end of each month, all
inventories are counted, their conversion costs components are estimated, and
inventory account balances are adjusted. Raw material cost is backflushed from RIP to
finished goods. The following information is for June:

Of conversion costs P29,250
Beginning balance of finished goods account,
Including P10,000 of conversion costs 30,000
Direct labor cost, P375,000; factory overhead applied,
P450,000 825,000
P4,500 of conversion costs 32,000
Ending finished goods inventory per physical count,
Including P8,750 of conversion costs 26,250
What is the conversion costs of units sold in June?
a. P825,250
b. P825,000
c. P840,000
d. P824,750
20. If Edsa Company has material cost of P10,000 in the June 1 RIP inventory account,
and P12,500 in June 30 RIP inventory account and the amount or raw materials used
backflushed from RIP inventory account on June 30 is P202,500, what is the amount of
raw materials purchased on credit for the month of June?
a. P205,000
b. P200,000
c. P225,000
d. P200,000
ANSWERS
1. d 6. d 11. a 16. c
2. a 7. c 12. c 17. c
3.d 8. a 13. c 18. c
4.b 9.b 14. a 19. d
5. a 10. a 15. d 20. a
SOLUTIONS AND EXPLANATIONS
1. High school chair:
Direct materials P600,000

Direct labor (7,500xP20) 150,000
Overhead:
Material handling (100,000xP0.25) P25,000
Cutting (100,000x2.50) 250,000
Assembly (7,500xP25) 187,500 462,500
Total cost P1,212,500
Units produced /5,000
Unit cost P242.50*
College chair:

Direct labor (500xP20) 10,000
Overhead:
Material handling (3,500xP0.25) P875
Cutting (3,500xP2.50) 8,750
Assembly (500xP25) 12,500 22,125
Total cost P57,125
Units produced /100
Unit cost P571.25*
2. Traditional costing system:
Direct materials (50xP3,000) P150,000

Overhead (50x15)xP100 75,000
Total cost P225,000
Activity based costing system:

Overhead:
Materials handling (50x50)xP8 20,000
Machining (50x12)xP68 40,800
Assembly (50x15)xP75 56,250
Inspection (50x14)xP104 72,800 P339,850
Higher P114,850*
3. Overhead rates:
Material handling (P720,000/6,000,000 parts) P0.12
Setup costs (P315,000/750 setups) 420
Machining costs (P540,000/30,000 hours) 18.00
Quality control activity (225,000/500 batches) 450
Overhead costs:
Material handling (20,000 units x 5 parts)xP0.12 P12,000
Setup cost activity (20,000 units / 5,000 x 2 setups)xP420 3,360
Machining activity (20,000 units / 5,000 x 80 hrs.)xP18 5,760
Quality control activity (20,000 units / 5,000)xP450 1,800
Total P22,920*
Overhead cost per unit (P22,920/20,000 units) P1.15

Direct material cost per unit 4.40
Direct labor cost per unit 0.75
Total unit cost P6.30*
4. ABC:
Material handling (115x12) P1,380

Inspection (P1.40x17,500) 24,500
Production certification (P770x25) 19,250 P45,130
Traditional costing (P275,000x14.5%) 39,875
ABC higher than the traditional costing by p5,255*
5. Traditional costing [(60,000/25,000)x2 direct labor hours)] P4.80*
ABC (P1,000/100) P10.00*
6. Overhead charge using labor hours: P60x200 P12,000

Overhead charge using machine hours: P12,000-P4,000 P8,000
Ratio of overhead costs to machine set-ups
P8,000/2,000 P4/set-up
7. Cost Assignment:
Materials handling (P50,000/100,000)x10,000 P5,000
Painting (P200,000/50,00)x3,000 12,000
Assembly (P120,000/4,000)x300 9,000
Total P26,000*
8. The P50,000 of costs is allocated over 10,000 hours [(P25x200 hours)/(25x200

hours)]. Thus, the overhead cost per hour is P5 (P50,000/10,000hrs.),and the per unit
overhead cost of wall mirrors is P1,000 (P5x200 direct labor hours).
Answer (b) is incorrect because P500 is the allocation based on number of material
moves. Answer (c) is incorrect because P2,000 assumes that all the overhead is allocated
to the wall mirrors. Answer (d) is incorrect because P5,000 assumes overhead of
P250,000.
9. ABC allocates overhead costs on the basis of some casual relationship between the
incurrence of cost and activities. Because the moves for wall mirrors constitute 25%
(5/20) of total moves, the mirrors should absorb 25% of the total materials handling
costs, or P12,500 (25%xP50,000). The remaining P37,500 is allocated to specialty
windows. The cost per unit of wall mirrors is P500 (P12,500/25)
Answer (a) is incorrect because P1,000 uses direct labor as the allocation basis. Answer
(c) is incorrect because P4,500 is the allocation per unit of specialty windows. Answer
(d) is incorrect because P2,500 is not based on the number of material moves.
10. Overhead rates:
Per machine hour P900,000/3,600 machine hours P250*
Per setup P525,000/300 setups P1,750*
Cost of Job RST:

Parts and materials P56,000
Applied overhead:
Machine hours (70xP250) P17,500
Setup (4xP1,750) 7,000 24,500
Total cost of Job RST P80,500*
11. Raw materials purchased (debit to RIP) P880,000

Raw materials used (credit to RIP) 850,000
Balance of RIP P30,000*
12. RIP account, beginning balance P38,700

Raw materials purchased 680,000
RIP account, ending balance (41,900)
Direct materials to be backflushed P676,800*
Conversion costs allocated to be backflushed P5,300*
13. Raw materials purchased – Dr. to RIP P550,000

Direct materials to be backflushed – Cr. To RIP (21,000xP25) 525,000
Balance of RIP account P25,000*
Cost of completed units (21,000 units xP45) P945,000

Cost of goods sold (20,000 units xP45) 900,000
Balance of finished goods inventory account P45,000*
14. Raw materials purchased – Dr. to RIP P5,300,000

Direct materials to be backflushed (192,000 units x P26)
- Cr. To RIP 4,992,000
Balance of RIP P308,000*
Cost of goods sold (192,000 units xP41) P7,872,000*
15. Materials in begging in balance of RIP account (P31,000-P1,400) P29,600

Add materials received on credit 367,000
Total 396,600
Less materials in ending balance of RIP account (P33,000-P1,800) 31,200
Materials used to be backflushed from RIP to finished goods P365,400*
16. Materials in beginning balance or RIP account (P12,300-P1,300) P11,000

Add raw materials received on credit 246,000
Total 257,000
Less materials in ending balance of RIP account (P12,100-P2,100) 10,000
Materials used to be backflushed form RIP to cost of goods sold P247,000*
17. Actual factory overhead P995,000

Direct labor cost incurred 200,000
Total actual conversion costs 1,195,000
Conversion costs allocated to production 1,300,000
Over-allocated conversion costs P105,000*
18. Materials used to be backflushed from RIP to cost of goods sold P300,000
Applied conversion costs to production 1,300,000
Cost of goods sold balance, October 31 P1,600,000*
19. Total conversion costs P825,000

Adjustments: increase in conversion costs in RIP
(P4,500-P3,000) (1,500)
Decrease in conversion costs in FG
(P10,000-P8,750) 1,250
Conversion costs of units sold in June P824,750*
20. Raw materials backflushed from RIP account P202,500

Materials in RIP inventory, June 30 12,500
Materials in RIP inventory, June 1 (10,000)
Raw materials purchased on credit during June P205,000*
PRICING AND
PROFITABILITY ANALYSIS
CHAPTER 18
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protected website for classroom use.
CHAPTER 18 OBJECTIVES
1. Discuss basic pricing concepts

2. Calculate a markup on cost and a target
cost
3. Discuss the impact of the legal system and
ethics on pricing
4. Explain why firms measure profit, and
calculate measures of profit using
absorption and variable costing
5. Compute the sales price, sales volume,

contribution margin, contribution margin
volume, sales mix, market share, and
market size variances
6. Discuss the variations in price, cost, and
profit over the product life cycle
7. Describe some of the limitations of profit
measurement
BASIC PRICING CONCEPTS
“A business that does not make a profit for the

buyer of a commodity, as well as for the seller,
is not a good business. Buyer and seller must
both be wealthier in some way as a result of a
transaction, else the balance is broken.”
Henry Ford, 1926
LO-1
Demand and Supply

• With all else equal, customers will buy more at lower
prices and less at higher prices
• Factors other than price that influence demand
include consumer income, quality of goods offered
for sale, availability of substitutes, demand for
complementary goods, whether or not the good is
a necessity or a luxury
• Price elasticity and market structure are two factors
that influence companies’ ability to adjust price
LO-1
Price Elasticity of Demand

• Measured as the percentage change in quantity
divided by the percentage change in price
• If demand is relatively elastic, a small percent
change in price will lead to a greater percent
change in quantity demanded (the opposite is true
for inelastic demand)
LO-1
Market Structure and Price

• The perfectly competitive market has many buyers
and sellers—no one of which is large enough to
influence the market—a homogeneous product,
and easy entry into and exit from the industry
• In a monopoly, barriers to entry are so high that
there is only one firm in the market and the product
is unique
• The monopolistic firm is a price setter
• Monopolistic competition has characteristics of
both monopoly and perfect competition, but it is
much closer to the competitive situation
LO-1
Market Structure and Price

• An oligopoly is characterized by a few sellers
• Barriers to entry are high, and they are usually cost
related
LO-1
EXHIBIT 18.1—CHARACTERISTICS OF THE
FOUR BASIC TYPES OF MARKET STRUCTURE
LO-1
COST AND PRICING POLICIES
Two Approaches to Pricing
• Cost-based pricing: prices are established using

‘cost’ plus markup
• Markup is a percentage applied to base cost; it
includes desired profit and any costs not included in
the base cost
Markup on COGS = (Selling and administrative expenses +
Operating Income)/COGS
Markup on DM = (Direct labor + Overhead + Selling and
administrative expense + Operating income)/
Direct materials
LO-2
Two Approaches to Pricing
• Target costing and pricing: sets the cost of a

product or service based on the price (target price)
that customers are willing to pay
• Involves more upfront work than cost based pricing
LO-2
Other Pricing Policies
• Penetration pricing: the pricing of a new

product at a low initial price to build market
share quickly
• Not predatory pricing; not meant to destroy
competition
• Price skimming: a higher price is charged
when a product or service is first introduced
LO-2
Other Pricing Policies
• Price gouging: occurs when firms with

market power price products ‘too high’
LO-2
THE LEGAL SYSTEM AND PRICING
Predatory Pricing
• Practice of setting prices below cost for the purpose
of injuring competitors and eliminating competition
• Predatory pricing on the international market is
called dumping
LO-3
THE LEGAL SYSTEM AND PRICING
Price Discrimination
• Refers to the charging of different prices to different
customers for essentially the same product
• Robinson-Patman Act 1936, passed to outlaw price
discrimination, allows price discrimination under
certain circumstances
• If the competitive situation demands it
• If costs can justify the lower price
LO-3
MEASURING PROFIT
• Profit is a measure of the difference between what

a firm puts into making and selling a product or
service and what it receives
Reasons for Measuring Profit
• Determine the viability of the firm
• Measure managerial performance
• Determine whether or not a firm adheres to
government regulations
• Signal the market about the opportunities for others
to earn a profit
LO-4
MEASURING PROFIT
Absorption-Costing Approach to Measuring

Profit
• Also called full costing
• Required for external financial reporting
• Assigns all manufacturing costs, direct materials,
direct labor, variable overhead and a share of fixed
overhead to each unit of product
• Each unit of product absorbs some of the fixed
manufacturing overhead in addition to its variable
manufacturing costs
LO-4
EXHIBIT 18.2—CHANGES IN INVENTORY
UNDER ABSORPTION AND VARIABLE COSTING
LO-4
EXHIBIT 18.3—ALDEN COMPANY ABSORPTION-
COSTING INCOME STATEMENT (IN THOUSANDS
OF DOLLARS)
LO-4
MEASURING PROFIT
Variable-Costing Approach to Measuring

Profit
• Also called direct costing
• Assigns only unit level variable manufacturing costs
to the product
• These costs include direct materials, direct labor, and
variable overhead
• Fixed overhead is treated as a period cost and is
not inventoried with the other product costs
• It is expensed in the period incurred
LO-4
EXHIBIT 18.4—ALDEN COMPANY VARIABLE-
COSTING INCOME STATEMENT (IN THOUSANDS
OF DOLLARS)
LO-4
ANALYSIS OF PROFIT RELATED VARIANCES
Sales Price and Sales Volume Variances

Sales price variance = (Actual price – Expected
price) × Quantity sold
Sales volume variance = (Actual volume – Expected

volume) × expected price
Overall sales variance = Sales price variance + Sales

volume variance
LO-5
Contribution Margin Variance

Contribution margin variance = Annual contribution
margin − Budgeted contribution margin
Contribution margin volume variance =
(Actual quantity sold – Budgeted quantity sold) ×
Budgeted average unit contribution margin
LO-5
Sales mix variance = [(Product 1 actual units –

Product 1 budgeted units) ×
(Product 1 budgeted unit
contribution margin – Budgeted
average unit contribution
margin] + [(Product 2 actual
units – Product 2 budgeted
units) × (Product 2 budgeted
unit contribution margin –
Budgeted average unit
contribution margin]
LO-5
Market Share Variance

• Market share gives the proportion of industry sales
accounted for by a company
Market share variance = [(Actual market share

percentage – Budgeted
market share percentage) ×
(Actual industry sales in
units)] × Budgeted average
unit contribution margin
LO-5
Market Size Variance

• Market size is the total revenue for the industry
Market size variance = [(Actual industry sales in units –

Budgeted industry sales in
units) × (Budgeted market
share percentage)] ×
Budgeted average unit
contribution margin
LO-5
THE PRODUCT LIFE CYCLE
• Describes the profit history of the product

according to four stages
• Introduction
• Growth
• Maturity
• Decline
• Helps the firm understand the different
competitive pressures on a product in each
stage
LO-6
EXHIBIT 18.5—PRODUCT LIFE CYCLE AND
PROFITABILITY
LO-6
EXHIBIT 18.6—IMPACT OF THE PRODUCT
LIFE CYCLE ON COST MANAGEMENT
LO-6
EXHIBIT 18.7—PRODUCT LIFE-CYCLE COSTS
IN THE ABC CATEGORIES
LO-6
LIMITATIONS OF PROFIT MEASUREMENT
• Limitations of profit include

• Focus on past performance
• Uncertain economic conditions
• Difficulty of capturing all important factors in
financial measures
• Successful firms measure far more than
accounting profit
• Impact on the community
• Employees
LO-7
END OF CHAPTER 18
BUDGETING FOR
PLANNING AND CONTROL
CHAPTER 8
1. Define budgeting, and discuss its role in

planning, controlling, and decision making
2. Prepare the operating budget, identify its
major components, and explain the
interrelationships of the various
components
3. Identify the components of the financial
budget, and prepare a cash budget
4. Define flexible budgeting, and discuss its

role in planning, control, and decision
making
5. Define activity-based budgeting, and
discuss its role in planning, control, and
decision making
6. Identify and discuss the key features that a
budgetary system should have to
encourage managers to engage in goal-
congruent behavior.
THE ROLE OF BUDGETING IN
Budgets
• Quantitative plans for the future
• Stated in either physical or financial terms or both
Control
• Process of setting standards, receiving feedback on
actual performance, and taking corrective action
LO-1
EXHIBIT 8.1—THE MASTER BUDGET AND ITS
INTERRELATIONSHIPS
LO-1
Purposes of Budgeting
• Forces managers to plan
• Provides resource information to improve decision
making
• Aids in the use of resources and employees that
can be used for evaluation of performance
• Improves communication and coordination
LO-1
The Budgeting Process

• Directing and Coordinating
• Budget director: works under the direction of the
budget committee; usually the controller or someone
who reports to the controller
• Budget committee: responsible for reviewing the
budget, providing policy guidelines and budgetary
goals, resolving differences, approving the final
budget, and monitoring the actual performance
LO-1
The Budgeting Process

• Types of Budgets
• Master budget: financial plan for the year made
up of various individual departmental and activity
budgets
• Operating budgets: concerned with the income-
generating activities
• Financial budgets: concerned with the inflows and
outflows of cash and with financial position
• Continuous (or rolling) budget: a moving 12-
month budget
LO-1
EXHIBIT 8.2—COMPONENTS OF MASTER
BUDGET
LO-1
PREPARING THE OPERATING BUDGET
• Sales budget: describes expected sales for

each product in units and dollars
• Production budget: describes how many

units must be produced in order to meet
sales needs and satisfy ending inventory
requirements
Units to be produced = Unit sales + Desired units in
ending inventory – Units in
beginning inventory
LO-2
• Direct materials purchases budget: based

on the amount of materials needed for
production and the inventories of direct
materials
Purchases = Expected usage + Desired ending

inventory of direct materials –
Beginning inventory of direct
materials
LO-2
• Direct labor budget: shows the total direct

labor hours and direct labor cost needed for
the number of units in the production
budget
• Overhead budget: shows the expected cost

of all indirect manufacturing items
LO-2
• Ending finished goods inventory budget:

supplies information for the balance sheet
and serves as an input for the cost of goods
sold budget
• Cost of goods sold budget: used in

preparing the budgeted income statement
LO-2
• Marketing expense budget: outlines

planned expenditures for selling and
distribution activities
• Administrative expense budget: consists of

estimated expenditures for the overall
organization and operation of the company
LO-2
• Research and development expense

budget: contains planned expenditures for a
separate department devoted to new
product research and development
• Budgeted income statement: culmination of

the operating budget
LO-2
PREPARING THE FINANCIAL BUDGET
• Capital expenditures budget: financial plan

outlining the expected acquisition of long-
term assets
LO-3
Cash Budget
• Detailed plan that shows all expected sources and
uses of cash
• Five main sections
1. Total cash available
2. Cash disbursements
3. Cash excess or deficiency
4. Financing
5. Cash balance
LO-3
EXHIBIT 8.4—THE CASH BUDGET
LO-3
Budgeted Balance Sheet

• Represents the culmination of the financial events
of the coming year
• Shows management where the company is
expected to be at the end of the year
LO-3
EXHIBIT 8.5—BALANCE SHEET FOR ABT,
INC.
LO-3
EXHIBIT 8.6—BUDGETED BALANCE SHEET
FOR ABT, INC.
LO-3
Shortcomings of the Traditional Master Budget

Process
1. Department oriented and does not recognize the
interdependencies among departments
2. Static, not dynamic
• Static budget: developed for a single level of activity
• Incremental approach: current budget based on last
year’s amounts as adjusted for inflation
• Zero-base budgeting: prior year’s budgeted level is not
taken for granted
LO-3
Shortcomings of the Traditional Master Budget

Process
3. Results, not process, oriented
• Managers concentrate on resources and may fail to
see the link between resources and output
LO-3
FLEXIBLE BUDGETS FOR PLANNING
AND CONTROL
Static Budgets versus Flexible Budgets

• Static budgets: developed around a single level of
activity
• Flexible budgets: there are two types
• A flexible budget (1) provides expected costs for a
variety of activity levels, or (2) provides budgeted
costs for the actual level of activity
LO-4
AND CONTROL
Flexible Budgets
• Total budgeted production costs increase as output
increases
• Sometimes referred to as a variable budget
• Flexible budget variances are generated by
comparing budgeted costs for the actual level of
activity with actual costs for the same level
LO-4
AND CONTROL
• Budgets can be used to examine the

efficiency and effectiveness of a company
• Efficiency is achieved when the business process
is performed in the best possible way, with little or
no waste
• Effectiveness means that a manager achieves or
exceeds the goals described by the static budget
LO-4
EXHIBIT 8.7—ABT PERFORMANCE REPORT FOR
QUARTER 1: COMPARISON OF ACTUAL WITH STATIC
(MASTER) BUDGET AMOUNTS
LO-4
EXHIBIT 8.8—MANAGERIAL PERFORMANCE REPORT:
QUARTERLY PRODUCTION (IN THOUSANDS)
LO-4
ACTIVITY-BASED BUDGETS
• Flexible budgeting allows creation of

budgets for varying levels of activity
• Begins with output and then determines the
resources necessary to create that output
• Works backward from activities and their
drivers to the underlying costs
LO-5
EXHIBIT 8.9—TRADITIONAL BUDGET
FOR THE SECURE-CARE DEPARTMENT
LO-5
EXHIBIT 8.10—FLEXIBLE BUDGET FOR
THE SECURE-CARE DEPARTMENT
LO-5
EXHIBIT 8.11—ACTIVITY-BASED BUDGET
FOR THE SECURE-CARE DEPARTMENT
LO-5
ACTIVITY-BASED BUDGETS
• Feature costing: assigns costs to activities

and products or services based on the
product’s or service’s features
LO-5
THE BEHAVIORAL DIMENSION OF
BUDGETING
• Budgets are often used to judge the actual

performance of managers
• The alignment of managerial and
organizational goals is often referred to as
goal congruence
• Dysfunctional behavior involves individual
behavior that is in basic conflict with the
goals of the organization
LO-6
THE BEHAVIORAL DIMENSION OF
BUDGETING
Characteristics of a Good Budgetary System

• Frequent Feedback on Performance
• Monetary and Nonmonetary Incentives
• Participative Budgeting
• Realistic Standards
• Controllability of Costs
• Multiple Measures of Performance
LO-6
END OF CHAPTER 8

01 05 Strategic Costing Midterm

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01 05 Strategic Costing Midterm

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Chapter 9: Standard Costing: A Functional-Based Control

Price and Quantity Standards and unit standard Cost

• Sources of quantitative standards

o Choices are limited by market forces, trade

• Activity cost is determined by the amount of • Helps in the computation of standard

• Decision making and product costing

Direct materials price variance (M P V)

o When the direct materials are issued for

Direct Materials Usage Variance (M U V)

• Calculate the total direct labor variance for

o Unfavorable variances are always debits

• Journal entry associated with the purchase of direct

• Journal entry to record the issuance and usage of

• Production manager is responsible for direct

o Standard can be met by minimizing scrap,

Responsibility for the Direct Labor Variances

o An average wage rate is used for the

Four-Variance Method for Calculating Overhead

o Variable overhead spending variance Interpreting Variable Overhead Variances

o If variable overhead is driven by direct

• Calculate the fixed overhead spending variance

• Calculate the volume variance using the formula

• Calculate the fixed overhead spending variance

Fixed Overhead Spending Variance (F O S V)

o A F O H = Actual fixed overhead

• If actual production is less than budgeted • Fixed overhead volume variance

o Standard yield = Yield ratio × Total actual inputs

Accounting for Overhead Variances

• Applying overhead to production

• Recognizing the incurrence of actual overhead

o Value of various accounts is credited

o Fixed overhead control account, fixed overhead

• Closing the variances to cost of goods sold

o Another entry is made to debit cost of goods sold

• Yield variance: Occurs whenever the actual yield

Direct Materials Mix Variance

o S M = Standard mix proportion × Total

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1. Explain what strategic cost management is and how it

• Process of selecting the optimal mix of three general

• Industrial value chain: Linked set of value-creating

• Internal linkages: Relationships among activities that

• Types of organizational activities

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Executional Activities Executional Cost Drivers

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• Operational activities: Day-to-day activities performed

© 2019 Cengage. All rights reserved.

© 2019 Cengage. All rights reserved.

© 2019 Cengage. All rights reserved.

• Identifying and exploiting internal and external linkages

• Relationships between activities are assessed and

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• Managing linkages in order for the company and the

• Failure to assign customer-servicing costs accurately

• Product life-cycle: Can refer to a product class as a

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• Defines stages of the life cycle by changes in the type

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• Related to activities that define the stages of

• Consists of actions taken that cause a product to be:

• Marketing viewpoint is revenue-oriented

Production Life Cycle: