Pre-Course Package

Fundamentals of
Management Control
Pre-Course Package
Contents and further reading
Bhimani, A, Horngren, CT, Datar, SM, Rajan, M

2015, Management and Cost Accounting,
Pearson, Harlow.
▪ Part 1 – Management and cost accounting

fundamentals
(Chapters 01-07)
▪ Part 2 – Accounting information for decision
making
(Chapters 08-13)
Pre-course package adapted from slide deck

accompanying the book by Pearson Education
Limited
PAGE 2 FUNDAMENTALS OF MANAGEMENT CONTROL

Chapter 1
The accountant’s role in the organisation
Why study management control?
▪ Modern cost accounting provides key

information to managers for their
decision making process.
▪ The study of modern cost accounting
gives an insight into both the manager’s
role and the accountant’s role in an
organisation.

What are we talking about?
Management accounting measures and reports financial and non-financial

information that helps managers make decisions to fulfil the goals of an
organisation.
Financial accounting focuses on reporting to external parties.
▪ It measures and records business transactions.
▪ It provides financial statements based on generally accepted accounting
principles
Cost accounting provides information for both management accounting and
financial accounting.
▪ It measures and reports financial and non-financial data that relates to the
cost of acquiring or consuming resources by an organisation.
Cost management describes the activities of managers in short-run and
long-run planning and control of costs.
▪ It entails the continuous reduction of costs.
▪ It is a key part of general management strategies and their implementation.

Why is management accounting
important for strategy?
Companies…
▪ Focus increasingly on expansionist, risky and entrepreneurial strategies.
▪ Aim to create, not preserve shareholder value in the short term.
▪ Increase focus to external sources for opportunities.
All this means an increased role for management accountants, who have to…
▪ Assist management to make balanced decisions.
▪ Monitor and evaluate strategic and operational progress.

Major purposes of accounting
systems
Formulating overall strategies and long-range plans:

1 internal non-routine reporting
Resource allocation decisions, e.g. product and customer emphasis

2 and pricing: internal routine reporting
Cost planning and cost control of operations and activities:

3 internal routine reporting
Performance measurement and evaluation of people:

4 internal non-routine reporting
Meeting external regulatory and legal reporting requirements:

5 external reporting

Different types of reporting
Internal routine reporting External reporting

Information provided for Information provided to
decisions that occur with • Investors
some regularity e.g.
• Government authorities
• Daily reports
• Other outside company
• Weekly reports stakeholders
Internal non-routine on the organisation’s
reporting • Financial position
Information for decisions that • Operations
occur irregularly or even
• Related activities
without precedent e.g.
• Outsourcing
• Design of a special cost
control tracking system

How accounting influences planning,
control & decision making
MGMT DECISIONS MGMT ACCOUNTING SYSTEM
Planning Budgets
• Deciding on organisation goals Quantitative expressions of a
proposed plan of action by
• Predicting results under
management for a future time
various alternative ways of
period and an aid to the
achieving those goals
coordination and implementation
• Deciding how to attain those of the plan
desired goals
Feedback
Examining past Control Accounting system
performance • Deciding and taking actions that Recording transactions and
and implement the planning classifying them in the accounting
systematically decisions records
exploring
alternative
ways to make • Deciding on performance Performance reports
better informed evaluation and the related
decisions in the feedback that will help future • A report that compares actual
future decision making results with budgeted amounts
• For an example, see the
following slides

Example: The Sporting News
MGMT DECISIONS MGMT ACCOUNTING SYSTEM
Planning Budgets
• Increase advertising rates by • Expected advertising pages sold,
4% rates per page, and revenue
Control Accounting system

Action: • Source documents (invoices and
payments received)
• Implement a 4% increase in
Feedback advertising rates • Recording in ledgers
Performance evaluation: Performance reports

• Advertising revenues 5.4% • Actual advertising pages sold,
lower than budgeted average rate per page, and
revenue

Example: Performance report I
Surrey Specialty Ltd, Year 2014

Budget Actual Variance
Revenues 57,000 60,000 3,000 F
Costs of goods sold 40,000 43,400 3,400 U
Wages 6,700 7,000 300 F
General 1,300 900 400 F
Fixed costs 5,000 5,000 ------
Operating income €4,000 €3,700 €300 U
The performance report indicates that although actual revenues exceeded the
budgeted amount by €3,000, operating income was €300 less than budgeted.
The report could spur investigation and further decisions.
Did the purchasing department pay more than expected for the merchandise?

Example: Performance report II
Surrey Specialty Ltd, Year 2014

Budget % Actual %
Revenues 57,000 100 60,000 100
Costs of goods sold 40,000 70 43,400 72
Gross margin €17,000 30 €16,600 28
Yes, actual cost of goods sold were 72% of revenues instead of the budgeted
70%.

Functions of management accounting
Scorekeeping involves accumulating data and reporting reliable results to all

levels of management.
▪ This role asks: how is the business doing?
Attention directing involves helping managers properly focus their attention.

▪ Attention directing should focus on all opportunities to add value to an
organisation, not just cost-reduction opportunities.
▪ This role asks: which opportunities and problems should be emphasised
first?
Problem solving involves comparative analysis for decision making with an

element of analytical review.
▪ This role asks: of the several alternatives available, which is the best?

Management accountants serve
different roles
Management accountants serve each of these three roles in both planning

and control decisions:
▪ The problem-solving role is most marked for planning decisions.

▪ The scorekeeping and attention-directing roles are most important for
control decisions.
▪ Management accountants often simultaneously perform two or all of the
problem-solving, scorekeeping and attention-directing roles.
▪ Management accountants increasingly are viewing managers as their
customers.

Economic benefits and costs:
key guidelines
1 Cost–benefit approach:
A cost–benefit approach should be used in order to spend resources if
they promote decision making that better achieves organisational goals
in relation to the costs of those resources.
2 Full recognition to behavioural as well as technical considerations:
A management accounting system should have two simultaneous
missions for providing information:
▪ To help managers make wise economic decisions.
▪ To help managers and other employees to aim and strive for goals of
the organisation.
3 Use of different costs for different purposes:
A cost concept used for the external reporting purpose does not have to
be the appropriate concept for the purpose of internal routine reporting
to managers.

Key themes in management
accounting
Customer focus
Value-chain and Success factors

Continuous
supply-chain (time, quality,
improvement
analysis cost, innovation)

Key themes explained I
Customer focus
The challenge managers face is to continue investing sufficient (but not
excessive) resources in customer satisfaction so that profitable customers
are attracted and retained.
Continuous improvement
Continuous improvement by competitors creates a never-ending search for
higher levels of performance within many organisations.
Key success factors

Key success factors are operational factors that directly affect the
economic viability of the organisation.
Cost – Quality –Time – Innovation

Key themes explained II
Value-chain and supply-chain analysis

This theme has two related aspects:
1 Treat each of the business functions in the value chain as an essential
and valued contributor.
2 Integrate and coordinate the efforts of all business functions in addition
to developing the capabilities of each individual business function.
Product/
Customer
R&D Service Production Marketing Distribution
Service
design
Management accounting

Forces of change
Change in role: Different foci in different decades, the role of management

accounting is constantly evolving.
Enterprise structure: Organisational change towards integrated, cross-

functional operations, move to flexible production, shifting mass market focus
towards a more niche market, higher margin initiative.
Digitisation: Requirements for accelerated decision-making, an interactive

relationship with suppliers/customers and the aim for seamless integration of
management information and reporting become increasingly important.
Intellectual capital and knowledge management is now recognised as

one of the principal assets of an organisation. Firms are focusing on
maintaining, expanding and measuring the level of intellectual capital and are
actively trying to manage their knowledge resources and harness the learning
they have achieved.

Chapter 2
An introduction to cost terms and
purposes
Cost and terminology I
Cost is a resource sacrificed or foregone to achieve a specific objective. It is

usually measured as the monetary amount that must be paid to acquire goods
and services.
An actual cost is the cost incurred (a historical cost) as distinguished from
budgeted costs.
A cost object is anything for which a separate measurement of costs is
desired.
There are two basic stages of accounting for costs:

▪ Cost accumulation is the collection of cost data in some organised way by
means of an accounting system.
▪ Cost assignment to various cost objects encompasses
▪ Tracing accumulated costs to a cost object and
▪ Allocating accumulated costs to a cost object.

Cost and terminology II
Cost object
Cost accumulation Cost object
Cost object
Cost
assignment

Direct vs indirect costs I
Direct costs Indirect costs

▪ Related to a given cost object ▪ Related to a particular
(product, department, etc.) cost object but cannot be traced to
▪ Can be traced to it in an it in an economically feasible way
economically feasible way ▪ Cost allocation describes the
▪ Cost-tracing describes the assigning of indirect costs to a
assignment of direct costs to a particular cost object
particular cost object
Several factors affect the classification of a cost as direct or indirect:

▪ The materiality of the cost in question
▪ Available information-gathering technology
▪ Design of operations
▪ Contractual arrangements
The direct/indirect classification depends on the choice of the cost object.

Direct vs indirect costs II
Example:
Gnomes Ltd has two production departments, Assembly and Finishing and two
service departments, Maintenance and Personnel.
Direct costs
Maintenance department 30,000
Personnel department 24,000
Assembly department 70,000
Finishing department 50,000
Assume that Maintenance department costs are allocated equally among the
production departments. How much is allocated to each department?

Direct vs indirect costs III
Maintenance
€30,000
Assembly Finishing
Direct costs Direct costs
€70,000 €50,000
€15,000 Allocated €15,000

Cost behaviour patterns I
Fixed costs do not

Variable costs change
change in total for a
in total in proportion to
given time period despite
changes in the related
wide changes in the
level of total activity or
related level of total
volume.
activity or volume.
Total costs

Cost behaviour patterns II
Example:
Assume that Kruger Bicycles buys a handlebar at €52 for each of its bicycles.
Total handlebar cost is an example of a cost that changes in total in proportion
to changes in the number of bicycles assembled (variable cost).
Total costs (€000)

What is the total handlebar cost when €182
1,000 bicycles are assembled?
1,000 units × €52 = €52,000
What is the total handlebar cost when

3,500 bicycles are assembled?
3,500 units × €52 = €182,000 €52
0 1,000 3,500 Units

Cost behaviour patterns III
Assume that Kruger Bicycles incurred €94,500 in a given year for the leasing of
its plant.
This is an example of fixed costs with respect to the number of bicycles
assembled.
These costs are unchanged in total over a designated range of the number of
bicycles assembled during a given time span.
What is the leasing (fixed) cost per bicycle when Kruger assembles 1,000
bicycles?
€94,500 ÷ 1,000 = €94.50
What is the leasing (fixed) cost per bicycle when Kruger assembles 3,500
bicycles?
€94,500 ÷ 3,500 = €27

Relevant range
Relevant range is the band of the level of activity or volume in which a specific
relationship between the level of activity or volume and the cost in question is
valid.
Example:
Assume that fixed (leasing) costs are €94,500 for a year and that they remain
the same for a certain volume range (1,000 to 5,000 bicycles).
1,000 to 5,000 bicycles is the relevant range.
Total fixed costs

(€000)
If annual demand for Kruger’s €94.5
Relevant range
bicycles increases, and the company

needs to assemble more than 5,000
bicycles, it would need to lease
additional space which would
increase its fixed costs.
0 1,000 5,000 Volume

Relationship between types of costs
Direct cost Indirect cost

Variable cost Cost object: Cost object:
Assembled car Assembled car
Example: Example:
Tires used in Power cost where
assembly of car power usage is
metered only to
plant
Fixed cost Cost object: Cost object:
Assembled car Assembled car
Example: Example:
Salary of Annual lease cost
supervisor on at Symbol plant
Renault Symbol line
assembly

Total vs unit cost
Unit cost (average cost): computed by dividing some amount of cost total by
some number of units (e.g. hours worked, packages delivered)
Attention: Use unit costs cautiously as fixed costs per unit decrease with
increasing number of units produced/assembled.
Example:
Bikes assembled: 1,000 Bikes assembled: 3,500
Variable cost/bike: 52 Variable cost/bike: 52
Total fixed cost 94,500 Total fixed cost 94,500
Total variable cost 52,00 Total variable cost 182,000
Total cost €146,500 Total cost €276,500
Unit cost €146.5 Unit cost €79
For decision making, managers should think in terms of total costs rather than
unit costs.

Different types of stock
Manufacturing Merchandising Service company

company company
• Direct materials: • Product in its original • No stock of tangible
used to calculate the purchased form products
cost of materials
used
• Work-in-progress:
used to calculate the
cost of goods
manufactured
• Finished goods: used
to calculate the cost
of goods sold

Classification of manufacturing costs
Direct material costs Direct manufacturing Indirect

labour costs manufacturing costs
• Acquisition costs of • Compensation of all • All manufacturing
all materials that manufacturing labour costs that are part of
eventually become (that can be traced the cost object, but
part of the cost in an economically that cannot be traced
object feasible way) to that cost object in
• Can be traced • Wages and fringe an economically
economically benefits paid to e.g. feasible way
• Purchase costs machine operators, • Other terms:
include inward assembly-line Manufacturing/
delivery charges, VAT workers factory overhead
and other customs costs
duties

Capitalised vs revenue costs
Capitalised costs: Revenue costs:

▪ All costs of a product that are ▪ All costs in the profit and loss
regarded as an asset when they are account other than cost of goods
incurred sold
▪ Included in work-in-progress and ▪ Recorded as expenses of the
finished goods stock accounting period in which they are
▪ Flow to the profit and loss account incurred
as cost of the goods sold ▪ E.g. research and development,
▪ E.g. manufacturing costs, costs of distribution, etc.
purchased goods, etc.

Measuring costs requires judgement
▪ Judgement is frequently required when measuring costs and differences

can exist in the way accounting terms are defined.
▪ Misunderstandings can be avoided if managers, accountants, suppliers,
etc. agree on the meanings of technical terms.
▪ Managers can assign different costs to the same cost object depending on
their purpose.
▪ Different purposes include

▪ Pricing and product emphasis decisions: the costs included are all
areas of the value chain
▪ Contracting with government agencies: companies must follow the
guidelines provided on the allowable and non-allowable items in a
product-cost amount
▪ Preparing financial statements for external reporting under
generally accepted accounting principles: the focus is on capitalised
costs

Chapter 3
Job-costing systems
Building blocks of costing systems
Direct costs of a cost object Cost object

Costs that are related to the Cost tracing Anything for which a
particular cost object and can be separate measurement
traced to it in an economically of costs is desired
feasible way
Indirect costs of a cost object

Costs that are related to the Cost allocation
particular cost object but cannot
be traced to it in an economically
feasible way
Cost pool Cost allocation base

A grouping of individual cost A factor that is the common
items denominator for systematically
linking an indirect cost or group
of indirect costs to a cost object
Job-costing vs process-costing
Job costing: Process costing:

• The cost object is an • The cost object is
individual unit, batch masses of identical or
or lot of a distinct similar units of a
product or service product or service.
called a job. • Costs are allocated
among all the
products
manufactured during
that period.

Step-by-step approach to job-costing
I
The following six-step approach is used to assign actual costs to

individual jobs:
1 Identify the chosen cost object(s).

2 Identify the direct costs of the job.
3 Select the cost-allocation base(s).
4 Identify the indirect costs associated with each cost-allocation base.
5 Compute the rate per unit of each cost-allocation base used to
allocate indirect costs to the job.
6 Compute the cost of the job by adding all direct and indirect costs
assigned to it.

II
Example:
D.L. Sports manufactures various sporting goods. D.L. is planning to sell a
batch of 25 special machines (Job No. 100) to Healthy Gym for €104,800.
A key issue for D.L. Sports in determining this price is the cost of doing the
job.
▪ Step 1: The cost object is Job No. 100
▪ Step 2: Identify the direct costs of Job No. 100.
▪ Direct material = €45,000
▪ Direct manufacturing labour = €14,000
▪ Step 3: Select the cost-allocation base.
▪ D.L. chose machine hours as the only allocation base for linking all
indirect manufacturing costs to jobs.
▪ Job No. 100 used 500 machine hours.
▪ 2,480 machine hours were used by all jobs.

III
▪ Step 4: Identify the indirect costs.

▪ Actual manufacturing overhead costs were €65,100.
▪ Step 5: Compute the rate per unit.
▪ Actual indirect cost rate is €65,100 ÷ 2,480 = €26.25 per machine
hour.
▪ Step 6: Compute the indirect costs allocated to the job.
▪ €26.25 per machine hour × 500 hours = €13,125.
▪ Compute the cost of Job No. 100.
Direct materials 45,000

Direct labour 14,000
Factory overhead 13,125
Total €72,125

Actual costing vs normal costing
Actual costing: Normal costing:

• Uses actual costs to • Allocates indirect costs
determine the cost of based on the
individual jobs budgeted indirect-cost
• Traces indirect costs to rate(s) times the
a cost object by using actual quantity of the
the actual direct-cost cost allocation base(s)
rate(s) times the
actual quantity of the
direct cost input(s)

Source documents used in job-
costing systems
A job cost record is a document that records and accumulates all the
costs assigned to a specific job. It is the basic record for product costing.
Examples:
Material requisition Labour time

records records

Transactions in a job-costing system
Purchase of
materials and Conversion Conversion Sale of
other manu- into work in into finished finished
facturing progress goods goods
inputs

Transactions – example I
Purchase of
materials and
Purchase of €80,000 worth of materials (direct and indirect)
other manu-
facturing on credit.
inputs
Materials control Accounts payable control

1. 80,000 1. 80,000

Transactions – example II
Conversion Materials costing €70,000 were sent to the manufacturing

into work in plant floor. €45,000 were issued to Job No. 100 and €10,000
progress to Job No. 102. €15,000 of indirect materials were issued.
Materials control Work-in-progress control

1. 80,000 2. 70,000 2. 55,000
Job No. 100

Manufacturing overhead 2. 45,000
control
2. 15,000
Job No. 102
2. 10,000

Transactions – example III
Total manufacturing payroll for the period was €22,000. Job

Conversion
No. 100 incurred direct labour costs of €14,000 and Job No.
into work in
progress 102 incurred direct labour costs of €3,000. €5,000 of indirect
labour was also incurred.
Wages payable control Work-in-progress control

3. 22,000 2. 55,000
3. 17,000
Job No. 100

Manufacturing overhead 2. 45,000
control 3. 14,000
2. 15,000
3. 5,000 Job No. 102
2. 10,000
3. 3,000
Transactions – example IV
Conversion
into work in Wages payable were paid.
progress
Wages payable control Cash control

4. 22,000 3. 22,000 4. 22,000

Transactions – example V
Assume that depreciation for the period is €26,000. Other

Conversion
manufacturing overhead incurred amounted to €19,100.
into work in
progress
What is the balance of the Manufacturing Overhead Control?
Manufacturing overhead Depreciation control

control 5. 26,000
2. 15,000
3. 5,000
5. 45,100
Bal. 65,100
Various accounts
5. 19,100

Transactions – example VI
Conversion
€62,000 of overhead was allocated to the various jobs of
into work in
progress which €12,500 went to Job No. 100.
Manufacturing overhead Work-in-progress control

control 2. 55,000
2. 15,000 6. 62,000 3. 17,000
3. 5,000 6. 62,000
5. 45,100 Bal. 134,000
Bal. 3,100
Job No. 100

2. 45,000
3. 14,000
6. 12,500
Bal. 71,500

Transactions – example VII
Jobs costing €104,000 were completed and transferred to

Conversion
finished goods, including Job No. 100.
into finished
goods
What effect does this have on the control accounts?
Work-in-progress control Finished goods control

2. 55,000 7. 104,000 7. 104,000
3. 17,000
6. 62,000
Bal. 30,000

Transactions – example VIII
Job No. 100 was sold for €104,800.

Sale of
finished
goods What is the journal entry?
What is the balance in the Finished Goods Control account?
Accounts receivable control Revenues

8. 104,800 8. 104,800
Finished goods control Costs of goods sold

7. 104,000 8. 71,500 8. 71,500
Bal. 32,500

Budgeted indirect costs
▪ Budgeted indirect-cost rates can be assigned to individual jobs on an

ongoing and timely basis.
▪ However, budgeted rates are based on estimates made up to 12 months
before actual costs are incurred.
▪ Adjustments may need to be made by year end.
Underallocated indirect costs Overallocated indirect costs

Occur when the allocated amount Occur when the allocated amount
of indirect costs in an accounting of indirect costs is greater than the
period is less than the actual actual amount incurred.
amount incurred.
Under- or overallocated indirect costs =

Indirect costs incurred – indirect costs allocated.

End-of-period adjustments
Approaches to disposing of underallocated or overallocated

overhead:
1 Adjusted allocation rate approach Most accurate

Restating all entries in the general and subsidiary records of
ledgers by using actual cost rates rather than budgeted individual job
cost rates. costs
2 Proration approaches Most accurate

Spreading of under- or over-allocated overhead among stock and costs
ending Work-in-Progress, Finished Goods and Cost of of goods sold
Goods Sold. figures
3 Immediate write-off to Cost of Goods Sold Simplest

approach approach

Chapter 4
Process-costing systems
When is process-costing appropriate?
▪ In a process-costing system, the unit cost of a product or service is

obtained by assigning total costs to many identical or similar units.
▪ The principal difference between process costing and job costing is the
extent of averaging used to compute unit costs of products or services.
▪ When similar or identical units of products or services are mass
produced, and not processed as individual jobs, process costing
averages production costs over all units produced.
Direct materials, Department A Department B

direct labour,
indirect
manufacturing costs
Finished goods Cost of goods sold

Step-by-step approach to
process-costing I
1. Summarise the flow of physical units of output.

2. Compute output in terms of equivalent units.
3. Compute equivalent unit costs.
4. Summarise total costs to account for.
5. Assign total costs to units completed and to units in ending work-in-
progress stock.
Conversion costs
added evenly during
process
Assembly Transfer Testing

department department
Direct materials
added at beginning
of process

process-costing II
Equivalent units:
▪ A derived amount of output units that takes the quantity of each input
in units completed or in work-in-progress and converts it into the
amount of completed output units that could be made with that quantity
of input
▪ Calculation necessary when all physical units of output are not uniformly
completed during the period
Example:
Snowdon Ltd, a manufacturer of skiing accessories: ending work-in-
progress stock is 100% complete for materials and 20% complete for
conversion.

process-costing III
Step 1: Physical units
Flow of production Physical units

Work-in-progress, opening 0
Started during current period 35,000
To account for 35,000
Completed and transferred out during current period 30,000
Work-in-progress, closing (100%/20%) 5,000
Accounted for 35,000

process-costing IV
Step 2: Compute equivalent units
Flow of production Direct materials Conversion costs

Completed and transferred out 30,000 30,000
Work-in-progress, closing 5,000 1,000
Current period work 35,000 31,000
Step 3: Compute equivalent unit costs

Total production costs are €146,050.
Direct materials Conversion costs

Production costs 84,050 62,000
Equivalent units 35,000 31,000
Cost per equivalent unit €2.4041 €2.00

process-costing V
Step 4: Total costs to account for: €146,050.
Step 5: Assign total costs
Calculations Costs
Completed and transferred out 30,000 x 4.4014 132,043
Work-in-progress-closing (5000 units):
Direct materials 5,000 x 2.4014 12,007
Conversion costs 1,000 x 2.00 2,000
Total €146,050

Journal entries in process-costing I
▪ Journal entries in process-costing systems are basically like those made

in job-costing systems with respect to direct materials and conversion
costs.
▪ Main difference: separate work-in-progress account for each department
rather than for each job.
Example: Continued from before.

Snowdon Ltd has two processing departments – Assembly and Finishing.
Snowdon Ltd purchases direct materials for €84,050.
Journal entry for material:

Accounts payable control Work-in-progress,
1. 84,050 Assembly
1. 84,050

Journal entries in process-costing II
Journal entry for conversion costs:
Various accounts Work-in-progress,

2. 62,000 Assembly
1. 84,050
2. 62,000
Journal entry to transfer completed goods from Assembly to Finishing:
Work-in-progress, Work-in-progress, Finishing

Assembly 3. 132,043
1. 84,050 3. 132,043
2. 62,000

Journal entries in process-costing III
Accounts payable control Work-in-progress, Ass.

1. 84,050 1. 84,050 3. 132,043
2. 62,000
14,007
Various accounts
2. 62,000
Work-in-progress, Finishing
3. 132,043
Finished goods Costs of goods sold

Weighted-average method I
▪ The weighted-average process-costing method calculates the average

equivalent unit cost of the work done to date (regardless of the period in
which it was done).
▪ It assigns this cost to equivalent units completed and transferred out,
and to equivalent units in closing work-in-progress stock.
▪ The weighted-average cost is the total of all costs entering the work-in-
progress account divided by total equivalent units of work done to date.
Example:
Snowdon Ltd had 1,000 units in the Assembly Department opening work-
in-progress stock. These units were 100% complete for materials (€2,350)
and 60% complete for conversion (€5,200). Closing work-in-progress stock
consisted of 5,000 units (100% materials) and (20% conversion).

Weighted-average method II
Step 1: Physical units

Work-in-progress, opening 1,000
Units in progress 35,000 36,000
Units transferred out 31,000
Units in closing stock 5,000 36,000
Material 100%
Conversion costs 20%

Weighted-average method III
Step 2: Partially completed units are converted into equivalent units.

Closing stock is only 20% complete for conversion which equals 1,000
equivalent units (5,000 × 20%).
Flow of production Materials Conversion
Completed and transferred out 31,000 31,000
Closing stock 5,000 1,000
Direct materials Conversion costs

Production costs 84,050 62,000
Cost per equivalent unit €2.4041 €2.00

Weighted-average method IV
Materials Conversion
Opening stock 2,350 5,200
Current costs 84,050 62,000
Total €86,400 €67,200
Cost per unit €2.40 €2.10

Weighted-average method V
Step 4: Total costs to account for
WIP opening stock

Materials 2,350
Conversion 5,200
Total opening stock 7,550
+ Current costs in Assembly
Materials 84,050
Conversion 62,000
Costs to account for €153,600

Weighted-average method VI
Step 5: Assign total costs
Calculations Costs
Costs transferred out 31,000 x (2.40 + 2.10) 139,500
Work-in-progress-closing 5,000 x 2.40 + 1,000 x 2.10 14,100
Total costs accounted for €153,600
Journalising overview:
Work-in-progress stock, Assembly

Opening stock 7,550 Transferred to
Materials 84,050 finishing 139,000
Conversion 62,000
Balance 14,600

First-in, first-out method I
▪ FIFO process-costing method assigns the cost of the prior accounting

period’s equivalent units in opening work-in-progress stock to the first
units completed and transferred out.
▪ It assigns the cost of equivalent units worked on during the current
period first to complete opening stock, then to start and complete new
units and finally to units in closing work-in-progress stock.
▪ This method assumes that the earliest equivalent units in the work-in-
progress, Assembly account are completed first.
▪ A distinctive feature of the FIFO process-costing method is that work
done on opening stock before the current period is kept separate from
work done in the current period.
Example:
Same example as before, now assume that Snowdon Ltd uses FIFO.

First-in, first-out method II
Step 1: Physical units – same as for weighted average method

Units transferred out 31,000
Units in closing stock 5,000 36,000
Step 2: Compute equivalent units
Completed and transferred Materials Conversion

From opening stock 0 400
Started and completed 30,000 30,000
Closing stock 5,000 1,000
Total 35,000 31,400

First-in, first-out method III
Completed and transferred 31,000 31,000
Closing stock 5,000 (100%) 1,000 (20%)
36,000 32,000
Opening stock 1,000 (100%) 600 (20%)
Current costs 84,050 62,000
Cost per unit €2.40 €1.975

First-in, first-out method IV
Steps 4 & 5: Summarise and assign total costs
Work-in-progress opening stock 7,550

Material 84,050
Conversion 62,000
Total €153,600
→ Same as using weighted-average

Costs transferred out WIP closing stock
From opening stock 7,550 Materials 12,000
Conversion cost added 790 Conversion 1,975
8,340 Total €13,975
From current production 131,250
Total €139,590

First-in, first-out method V
Costs transferred out 139,590

+ Costs in closing stock 13,975
Total €153,565
(€35 rounding error)
Alternative approach:
Costs to account for 153,600
- Costs in closing stock 13,975
Costs transferred out €139,625
Journalising overview:
Work-in-progress stock, Assembly
Opening stock 7,550 Transferred to
Materials 84,050 finishing 139,625
Conversion 62,000
Balance 13,975

Comparison of weighted average and
FIFO method
Weighted average FIFO Difference

Costs of units completed and 139,500 139,625 +125
transferred out
Work-in-progress, closing 14,100 13,975 -125
Total costs accounted for €153,600 €153,600 0
▪ The weighted-average closing stock is higher than the FIFO closing

stock by €125.
▪ This results in a lower cost of goods sold and hence higher operating
income and higher income taxes than from the FIFO method
▪ Differences in equivalent unit costs of opening stock and work done
during the current period account for the differences in weighted-
average and FIFO costs.

Chapter 5
Cost allocation
Cost objects in costing systems I
Cause-and-effect Benefits received

• Identification of the • Identification of the
variable(s) that cause beneficiaries of the
resources to be output of the cost object
consumed • The costs are allocated in
• Allocation likely to be the proportion to the benefits
most credible to received
operating personnel • E.g. cost of a corporate-
• E.g. hours of testing as wide advertising
variable for allocating the programme allocated on
costs of quality-testing to the base of division
products revenues
Frequently used criteria

Cost objects in costing systems II
Fairness or equity Ability to bear

• Often cited on • Allocation of costs in
government contracts proportion to the cost
when cost allocations are object’s ability to bear
the basis for finding a them
price satisfactory to the • E.g. the allocation of
government & suppliers corporate executive
• Cost allocation is viewed salaries on the basis of
as a “reasonable” or division operating income
“fair” means of
establishing a selling
price
Less frequently used criteria

The role of dominant criteria
▪ The criteria used to guide cost-allocation decisions affect both the

number of indirect cost pools and the cost-allocation base for each
indirect cost pool.
▪ Managers must first choose the purpose for a particular cost allocation
and then select the appropriate criterion.
• IMPORTANT: Cost-benefit approach when designing and

implementing cost-allocation systems
• HOWEVER: Costs are highly visible, benefits are difficult to
measure and less visible

Purposes of cost allocation
1 To provide information for economic decisions
2 To motivate managers and other employees
3 To justify costs or compute reimbursements
4 To measure income and assets for reporting to external parties
▪ The allocation of a particular cost does not have to satisfy all four purposes
simultaneously.

Allocating corporate costs
▪ Some companies allocate all corporate costs to divisions because...

▪ It sparks interest on the part of division managers regarding how
corporate costs are planned and controlled.
▪ To calculate the full costs of products.
▪ Some companies do not because…

▪ They maintain that division managers generally have no say or role in
incurring these costs.
▪ Other companies allocate only those costs for which there is widespread
agreement, such as human resources.

Determining cost pools
If corporate costs are allocated, the company has to decide on one or more
cost pools.
Homogeneity is a key decision factor for cost pools:

▪ All costs have the same or a similar cause-and-effect or benefits-
received relationship with the cost-allocation base.
▪ If each cost category has a different cost driver, companies may
prefer to maintain separate cost pools for these costs.

Single-rate and dual-rate methods of
cost allocation
Single-rate method Dual-rate method

• Pools together all costs in • Classifies costs in each
a cost pool cost pool into two cost
• Allocates these costs to pools: a variable-cost and
cost objects using the a fixed-cost cost pool
same rate per unit of the • Each of these pools uses
single allocation base a different cost-allocation
• No distinction between base
costs in the cost pool in
terms of cost behaviour

Budgeted vs actual rates
▪ The decision of whether to use budgeted cost rates or actual cost rates
affects the level of uncertainty user divisions face.
Budgeted rates allow long-run planning

• The user department knows in advance the cost rates they will be
charged
• Easier for users to determine the amount of the service to request
• Help motivate the supplier department to improve efficiency
The supplier department bears the risk of unfavourable cost variances

because the user departments do not pay for any costs that exceed the
budgeted rates!

Allocating support department costs
I
Three methods are widely used to allocate the costs of support

departments to operating departments:
Direct allocation Step-down method Reciprocal method

method
Allocates support Allocates support Allocates costs by
department costs to department costs to including the mutual
operating departments other support services provided
only. departments and to among all support
operating departments. departments.
Most accurate when

support departments
provide services to one
another reciprocally!

II
Example:
The Sandy Corporation/Paris division:
▪ 2 operating departments (Assembly and Finishing)
▪ 2 support departments (Maintenance and Human Resources).
▪ Total area: 255,000 sq.ft
▪ Total number of employees: 95
→ Maintenance is allocated using area, Human Resources are allocated
using number of employees.

III
Maintenance HR
Budgeted costs before allocation €300,000 €2,160,000
Area 5,000 30,000
Number of employees 8 15
Assembly Finishing
Budgeted costs before allocation €1,700,000 €900,000
Area 110,000 110,000
Number of employees 48 24

IV
Direct method: allocates support department costs to operating departments

only.
▪ Maintenance to Assembly: 110,000/220,000 x €300,000 = €150,000

▪ Maintenance to Finishing: 110,000/220,000 x €300,000 = €150,000
▪ HR to Assembly: 48/72 x €2,160,000 = €1,440,000
▪ HR to Finishing: 24/72 x €2,160,000 = €720,000
Assembly Finishing
Original costs 1,700,000 900,000
Maintenance 150,000 150,000
HR 1,440,000 720,000
Total €3,290,000 €1,770,000

V
Step-down method: allocates support department costs to other support

departments and to operating departments.
→ Maintenance provides 12% of its services to HR (allocated first because
higher percentage of support to other support department).
→ HR provides 10% of its services to Maintenance.
▪ Maintenance to HR: 30,000/250,000 x €300,000 = €36,000

▪ Maintenance to Assembly: 110,000/250,000 x €300,000 = €132,000
▪ Maintenance to Finishing: 110,000/250,000 x €300,000 = €132,000
Costs before all. Allocated costs

Maintenance 300,000 (300,000)
HR 2,160,000 36,000
Assembly 1,700,000 132,000
Finishing 900,000 132,000

VI
▪ HR to Assembly: 48/72 x €2,196,000 = €1,464,000

▪ HR to Finishing : 24/72 x €2,196,000 = €732,000
Costs before all. All. costs All. costs Total

HR 2,160,000 36,000 (2.196,000)
Assembly 1,700,000 132,000 1,464,000 €3,296,000
Finishing 900,000 132,000 732,000 €1,764,000

VII
Reciprocal method: Allocates costs by including the mutual services

provided among all support departments.
M HR A F
Maintenance - 12% 44% 44%
HR 10% - 60% 30%
▪ M = €300,000 + 0.10HR
▪ HR = €2,160,000 + 0,12M
▪ M = €300,000 + 0.10(€2,160,000 + 0.12M) = €516,000

▪ HR = €2,160,000 + 0.12(€522,267) = €2,222,672

VIII
Before all. All. costs All. costs Total

Maintenance 300,000 (522,267) 222,267
HR 2,160,000 62,672 (2,222,672)
Assembly 1,700,000 229,797 1,333,603 €3,263,400
Finishing 900,000 229,797 666,802 €1,796,599

IX
Comparison of methods using overhead rates:

▪ Overhead rate for Assembly: direct labour cost as a denominator
▪ Overhead rate for Finishing: machine-hours as the denominator
Assembly Finishing
Direct labour cost €698,880 €349,440
Machine-hours 24,000 23,500
Overhead rates Assembly Finishing

Direct method 471% €75.32
Step-down method 472% €75.06
Reciprocal method 467% €76.45

Allocating common costs
A common cost is a cost of operating a facility, activity, or cost object

that is shared by two or more users.
Methods for allocating common costs are:

▪ The stand-alone cost allocation method uses information pertaining
to each user of a cost object as a separate entity to determine the cost-
allocation weights.
▪ The incremental cost allocation method ranks the individual users of
a cost object and then uses this ranking to allocate costs among those
users.
▪ The primary party is allocated costs up to the cost of it as a stand-
alone user.
▪ The incremental party is allocated the additional cost that arises from
there being two users instead of only the primary user.

Cost hierarchy reports
Managers have become increasingly interested in cost hierarchies, which

are a categorisation of costs into different cost pools, based on either
different classes of cost drivers, or different degrees of difficulty in
determining cause-and-effect relationships.
An example of the different hierarchies for product costs would be:

▪ Output unit-cost level
▪ Batch-level costs
▪ Product-sustaining costs
▪ Facility-sustaining costs

Chapter 6
Cost allocation: joint-cost situations
Joint-cost basics
Joint costs are the costs of a single production process that yields
multiple products simultaneously.
Joint products (if multiple products have relatively high sales value) By-product Scrap
Main product (if only one product has a relatively high sales value)
High Relative sales value Minimal
▪ The split-off point is the juncture in the production process where one
or more products in a joint-cost setting become separately identifiable.
▪ Separable costs are all costs (manufacturing, marketing, distribution,
etc.) incurred beyond the split-off point that are assignable to one or
more individual products.

Purposes of allocating joint products
Stock-costing: joint cost allocation is important for external and

1
internal financial reporting
Cost reimbursement contracts: joint cost allocation is required when

2
only a a portion of a business’ products or services is sold to a single
customer (government agency)
Insurance settlements: joint cost allocation is necessary when
3 damage claims made by businesses with joint products are based on
cost information
Rate regulation: joint cost allocation is required if one or more of the

4
jointly produced products or services are subject to price regulation
Litigation: joint cost allocation is important in litigation involving one

5 or more joint products

Methods of allocating joint costs I
Approach 1:
Allocate costs using market-based data such as profits.
1. The sales value at split-off method: allocates joint costs to joint
products on the basis of the relative sales value at the split-off point of the
total production of these products during the accounting period.
→ Widely used (objective, meaningful, simple)
1. The estimated net realisable value (NRV) method: The estimated NRV
method allocates joint costs to joint products on the basis of the relative
estimated NRV. The estimated NRV is the expected final sales value in the
ordinary course of business minus the expected separable costs of the total
production of these products during the accounting period.
2. The constant gross-margin percentage NRV method: The constant
gross-margin percentage NRV method allocates joint costs to joint products
in such a way that the overall gross-margin percentage is identical for each
of the individual products.

Methods of allocating joint costs II
Example: the sales value at split-off method

Lubbock Company incurred €200,000 of joint costs to produce the following:
▪ Product A: 10,000 units, €20,000, sales value/unit €10
▪ Product B: 10,500 units, €48,000, sales value/unit €30
▪ Product C: 11,500 units, €12,000, sales value/unit €20
SV at split-off point = 10,000x€10 + 10,500x€30 + 11,500x€20 = €645,500
Joint cost allocation:

Product A: €100,000/€645,000 × €200,000 = €31,008
Product B: €315,000/€645,000 × €200,000 = €97,674
Product C: €230,000/€645,000 × €200,000 = €71,318
Total €200,000

Methods of allocating joint costs III
Joint production costs/unit:

Product A: €31,008 ÷ 10,000 = €3.10
Product B: €97,674 ÷ 10,500 = €9.30
Product C: €71,318 ÷ 11,500 = €6.20
Assume all of the units produced of B and C were sold. 2,500 units of A (25%)
remain in stock. What is the gross margin percentage of each product?
Product A: €75,000 – €23,256 = €51,744

€51,744 ÷ €75,000 = 69%
Product B: (€315,000 – €97,674) ÷ €315,000 = 69%
Product C: (€230,000 – €71,318) ÷ €230,000 = 69%
Note that this method uses the sales value of the entire production of the
accounting period, not just the part sold. The sales value at split-off method
produces an identical gross margin percentage for each product.

Methods of allocating joint costs IV
Example: the estimated net realisable value (NRV) method

Assume that Lubbock Company can process products A, B and C further
into A1, B1 and C1. The new sales values after further processing are:
▪ A1: 10,000 × €12 = €120,000
▪ B1: 10,500 × €33 = €346,500
▪ C1: 11,500 × €21 = €241,500
Additional processing (separable) costs are as follows:
▪ A1: €35,000
▪ B1: €46,500
▪ C1: €51,500
What is the estimated NRV of each product at the split-off point?
Product A1: €120,000 − €35,000 = €85,000
Product B1: €346,500 − €46,500 = €300,000
Product C1: €241,500 − €51,500 = €190,000
Total €575,000

Methods of allocating joint costs V
How much of the joint cost is allocated to each product?
Product A1: 85/575 × €200,000 = €29,565

Product B1: 300/575 × €200,000 = €104,348
Product C1: 190/575 × €200,000 = €66,087
Total €200,000
All. joint costs Separable costs Stock costs

A1 29,565 35,000 64,565
B1 104,348 46,500 150,848
C1 66,087 51,500 117,587
Total €200,000 €133,000 €333,000
What is the production cost per unit?

Product A1: €64,565 ÷ 10,000 = €6.46
Product B1: €150,848 ÷ 10,500 = €14.37
Product C1: €117,587 ÷ 11,500 = €10.22
Methods of allocating joint costs VI
Example: the sales value at split-off method

What is the expected final sales value of total production during the
accounting period?
Product A1: €120,000
Product B1: €346,500
Product C1: €241,500
Total €708,000
Step 1: Compute the overall gross-margin percentage.

Expected final sales value: €708,000
Deduct joint and separable costs: €333,000
Gross margin €375,000
Gross margin percentage: €375,000 ÷ €708,000 = 52.966%

Methods of allocating joint costs VII
▪ Step 2: Deduct the gross margin.
Sales value Gross margin COGS

A1 120,000 63,559 56,441
B1 346,500 183,527 162,973
C1 241,500 127,913 113,587
Total €708,000 €375,000 €333,000
▪ Step 3: Deduct separable costs
COGS Separable costs Joint costs all.

A1 56,441 35,000 21,441
B1 162,973 46,500 116,473
C1 113,587 51,500 62,087
Total €333,000 €133,000 €200,000

Methods of allocating joint costs VIII
Approach 2 – Physical measure method:

The physical measure method allocates joint costs to joint products on the
basis of the relative weight, volume or other physical measure, at the split-
off point of the total production of these products during the accounting
period.
Example:
Recall that Lubbock Company incurred €200,000 of joint costs to produce
products A, B and C.
▪ Product A: 10,000 units, €20,000
▪ Product B: 10,500 units, €48,000
▪ Product C: 11,500 units, €12,000
What are the joint costs allocated to each product using the number of €
produced as the physical measure?
▪ Product A: 20,000/80,000 × €200,000 = €50,000
▪ Product B: 48,000/80,000 × €200,000 = €120,000
▪ Product C: 12,000/80,000 × €200,000 = €30,000

Methods of allocating joint costs IX
What is the cost per € for each product?

Product A: €50,000 ÷ 20,000 = €2.50
Product B: €120,000 ÷ 48,000 = €2.50
Product C: €30,000 ÷ 12,000 = €2.50
It is possible to obtain the cost per € (€200,000 ÷ 80,000 = €2.50) and
use this amount to distribute the joint costs.
Note: The physical measure method is less preferred under the benefits-
received criterion because it has no relationship to the profit-producing
power of the individual products.

Irrelevance of joint costs for decision
making
▪ Joint costs incurred up to the split-off point are past (sunk) costs
irrelevant to the decision to sell a joint (or main) product at the split-off
point or to process it further.
▪ No techniques for allocating joint-product costs should guide decisions
about whether a product should be sold at the split-off point or
processed beyond split-off.

Accounting for by-products I
Although by-products have much lower sales value than joint or main
products do, the presence of by-products can affect the allocation of joint
costs.
1. Method A, the production by-product method, recognises by-products
in the financial statements at the time their production is completed.
2. Method B, the sale by-products method, delays recognition of by-
products until the time of their sale.

Accounting for by-products II
Example:
The following data relate to Running Man Ltd, a manufacturer of special
clothes used by joggers.
Main products (meters) By-products (meters)

Production 1,000 400
Sales 800 300
Closing stock 200 100
Sales price 13.00/meter 1.00/meter
Joint production costs for joint (main) products and by-products:

Material 2,000
Manufacturing labour 3,000
Manufacturing overhead 4,000
Total production cost €9,000

Accounting for by-products III
Method A: NRV assigned to by-products stock.

What is the value of closing stock of joint (main) products?
▪ €9,000 (total production cost) − €400 (NRV of the by-product) =
= €8,600 net production cost for the joint products
▪ 200 ÷ 1,000 × €8,600 = €1,720 value assigned to the 200m closing stock
What is the cost of goods sold?
Joint production costs 9,000
Less by-product profit 400
Less main product stock 1,720
Cost of goods sold €6,880
What is the gross margin? What are the stock costs?
Profits (800 metres × €13) 10,400 ▪ Main product:
Cost of goods sold 6,880 200 ÷ 1,000 × €8,600 = €1,720
Gross margin €3,520 ▪ By-product:
Gross margin percentage 33.85% 100 × €1.00 = €100

Accounting for by-products IV
Method B: The sale by-products method.

What is the value of closing stock of joint (main) products?
200 ÷ 1,000 × €9,000 = €1,800
This method assigns no value to the 400 metres of by-products at the time of
production.
The €300 resulting from the sale of by-products is reported as profits.
What are the profits and the gross margin? What are the stock costs?
Main product (800 × €13) €10,400 ▪ Main product:
By-products sold 300 200 ÷ 1,000 × €9,000 = €1,800
Total profits €10,700 ▪ By-products: 0
Joint production costs 9,000
Less main product stock 1,800
7,200
Gross margin percentage 29.91%
Chapter 7
Income effects of alternative
stock-costing methods
Stock-costing methods
Variable costing and absorption costing method differences are based on

the treatment of fixed manufacturing overhead.
Variable costing Absorption costing

Fixed manufacturing overhead Fixed manufacturing overhead
costs are excluded from stock costs are stock costs and become
costs and are a cost of the period expenses only when a sale
in which they are incurred. occurs.
All variable manufacturing costs
are assigned to production and
become part of the unit cost.
Fixed costs are charged to the
P&L account.
Under both methods all non-manufacturing costs in the value chain

(e.g. R&D, marketing, etc.), whether variable or fixed, are recorded as
expenses when incurred.

Comparing P&L accounts
Example: The following data relates to Fredonia fixtures.
Information (per unit):

Finished Year 1 Year 2 Total
Sales price: €71.00 goods
Variable manufacturing costs:
Opening stock 0 2,000 0
Direct materials: €4.00
Produced 10,000 11,500 21,500
Direct manuf. labour: €21.00
Sold 8,000 13,000 21,500
Indirect manuf. costs: €24.00
Closing stock 2,000 500 500
Fixed manuf. costs: €4.50
▪ Total fixed production costs are €54,000 at a normal capacity of 12,000

units.
▪ Fixed non-manufacturing costs are €30,000 per year.
▪ Variable non-manufacturing costs are €2.00 per unit sold.

Comparing P&L accounts:
Absorption costing I
What are the revenues for Year 1?

8,000 × €71 = €568,000
8,000 × €53.50 = €428,000
Is there a volume variance?
(12,000 − 10,000) × €4.50 = €9,000 under all. fixed manufacturing costs
What is the gross margin?
€568,000 − (€428,000 + €9,000) = €131,000
What are the non-manufacturing costs?
8,000 units sold × €2.00 = €16,000 variable costs + €30,000 fixed costs =
€46,000
What is the operating profit before taxes?
€131,000 − €46,000 = €85,000

Absorption costing II
Absorption
Revenues 568,000
Cost of goods sold 428,000
Volume variance 9,000
Non-manufacturing costs 46,000
Operating profit €85,000

Variable costing I
Revenues for Year 1 are €568,000.

8,000 × €49 = €392,000
What is the manufacturing contribution margin?
€568,000 − €392,000 = €176,000
What is the net contribution margin?
€176,000 − €16,000 variable non-manufacturing costs = €160,000 net
contribution margin
€160,000 − €54,000 fixed indirect manufacturing costs − €30,000 fixed
non-manufacturing costs = €76,000

Variable costing II
Variable
Revenues 568,000
Cost of goods sold 392,000
Variable non-manufacturing costs 16,000
Contribution margin €160,000
Fixed manufacturing costs 54,000
Fixed non-manufacturing costs 30,000
Operating profit €76,000

Absorption costing III
What are revenues and cost of goods sold for Year 2?

Revenue: 13,000 × €71 = €923,000
COGS: 13,000 × €53.50 = €695,500
Is there a volume variance?
(12,000 − 11,500) × €4.50 = €2,250 under all. fixed manufacturing costs
What is the gross margin?
€923,000 − (€695,500 + €2,250) = €225,250
What are the non-manufacturing costs?
13,000 units sold × €2.00 = €26,000 variable costs + €30,000 fixed costs
= €56,000

€225,250 − €56,000 = €169,250
What is the operating profit for the two years combined?
€85,000 + €169,250 = €254,250

Absorption costing IV
Year 1 Year 2 Combined

Revenues 568,000 923,000 1,491,000
Cost of goods sold 428,000 695,500 1,123,500
Volume variance 9,000 2,250 11,250
Gross margin €131,000 €225,250 €356,250
Non-mfg costs 46,000 56,000 102,000
Operating profit €85,000 €169,250 €254,250

Variable costing III
Revenue for Year 2 is €923,000.

13,000 × €49 = €637,000
What is the manufacturing contribution margin?
€923,000 − €637,000 = €286,000
What is the net contribution margin?
€286,000 − €26,000 variable non-manufacturing costs = €260,000 net
contribution margin
€260,000 − €54,000 fixed manufacturing costs − €30,000 fixed non-
manufacturing costs = €176,000
What is the combined operating profit for the two years under variable
costing?
€76,000 + €176,000 = €252,000

Variable costing IV
Year 1 Year 2 Combined

Revenues 568,000 923,000 1,491,000
Cost of goods sold 392,000 637,000 1,029,000
Mfg contr. margin €176,000 €286,000 €462,000
Variable non-mfg 16,000 26,000 42,000
Net contr. margin €160,000 €260,000 €420,000
Fixed mfg costs 54,000 54,000 108,000
Fixed non-mfg costs 30,000 30,000 60,000
Operating profit €76,000 €176,000 €252,000

Comparison of variable and
absorption costing
▪ Stock values are smaller for variable costing because it capitalises only
€49.00 variable cost as asset.
▪ Stock values using absorption costing have an additional €4.50 fixed
factory overhead per unit.
→ This leads to differences in operating profits.
Absorption costing operating profit
Variable costing operating profit
Fixed manufacturing costs in closing stock under absorption costing
Fixed manufacturing costs in opening stock under absorption costing

Absorption costing and stock
build-up
Absorption costing enables a manager to increase operating profit in a

specific period by increasing the production schedule, even if there is no
customer demand for the additional production.
There are some undesirable effects of such a stock build-up:

▪ Production of items that absorb minimal fixed manufacturing costs may
be delayed.
▪ A plant manager may accept a particular order to increase production,
even though another plant in the same company is better suited to
handle that order.
▪ A plant manager may defer maintenance.
Therefore, it is important to carefully revise performance evaluation

according to the following guidelines:

Revising performance evaluation
1
1 Budget carefully and use stock planning.
2 Discontinue the use of absorption costing for internal reporting and

2 instead use variable costing.
3 Incorporate a carrying charge for stock.
4
4 Change the time period used to evaluate performance.
5 Include non-financial as well as financial variables in the measures

5 used to evaluate performance.

Alternative denominator-level
concepts
The choice of the denominator used to allocate budgeted fixed manufacturing

costs to products can greatly affect the numbers a costing system will report
prior to the end of an accounting period.
Theoretical capacity Practical capacity

• Also called maximum or ideal • Reduces theoretical capacity by
capacity unavoidable operating
• Based on producing at full (peak) interruptions
efficiency all the time • Practical capacity is required by
the IRS (USA)
Normal capacity Master-budget capacity

• Based on the level of capacity • Based on the expected level of
utilisation that satisfies average capacity utilisation for the next
customer demand over several budget period
periods (includes seasonal,
cyclical and trend factors)

Effects on financial statements
▪ The use of these four denominator levels (denominator-level capacity)

can affect the budgeted fixed manufacturing overhead rate.
▪ Therefore, the choice of denominator level affects also the magnitude of the
operating profit and stock costs in an absorption costing system.
The smaller the denominator level, the larger the proportion of fixed
manufacturing overhead cost per output unit that can be allocated to
stock → reported stock costs and the operating profit will be higher!

Chapter 8
Cost-volume-profit relationships
Cost-volume-profit analysis
Cost–volume–profit analysis is one of the most basic planning tools

available to managers and examines the behaviour of total revenues,
total costs and operating profit as changes occur in the output level,
selling price, variable costs per unit or fixed costs.
▪ In a general case of profit planning, we realise that a business has many cost
drivers and revenue streams that are fundamental to its profitability.
▪ In CVP analysis, we assume a much more simple model, where the following
restrictions are used:

Cost–volume–profit assumptions
and terminology I
1 Changes in the level of revenues/costs arise only because of changes

1 in the number of product (or service) units produced and sold.
1 Total costs can be divided into a fixed component and a component

2 that is variable with respect to the level of output.
The behaviour of total revenues and total costs is linear in relation to

3 output units within the relevant range (and time period).
The unit selling price, unit variable costs and fixed costs are known
4 and constant.

and terminology II
The analysis either covers a single product or assumes that the sales
5 mix when multiple products are sold will remain constant.
All revenues and costs can be added and compared without taking
6 into account the time value of money.
▪ Operating profit = Total revenues - total cost

▪ Net profit = Operating profit + non-operating revenues (such as interest
revenue) - non-operating costs (such as interest cost) - profit taxes
▪ Contribution margin = Total revenues − Total variable costs
▪ Contribution margin per unit = Selling price − Variable cost per unit
▪ Contribution margin percentage (contribution margin ratio) =
contribution margin per unit ÷ the selling price.

and terminology III
Example: Dresses by Mary

▪ The shop Dresses by Mary can purchase dresses for €32 from a local factory;
other variable costs amount to €10 per dress.
▪ Mary can return all unsold dresses and receive a full €32 refund per dress
within one year.
▪ Assume that the average selling price per dress is €70 and total fixed costs
amount to €84,000.
How much revenue will she receive if she sells 2,500 dresses?
2,500 × €70 = €175,000
How much variable costs will she incur?
2,500 × €42 = €105,000
Would she show an operating profit or an operating loss?
An operating loss: €175,000 − 105,000 − 84,000 = (€14,000)

and terminology IV
What is Mary’s contribution margin per unit?

€70 − €42 = €28 contribution margin per unit
What is the total contribution margin when 2,500 dresses are sold?
2,500 × €28 = €70,000
What is Mary’s contribution margin percentage?
€28 ÷ €70 = 40%
If Mary sells 3,000 dresses, revenues will be €210,000 and the contribution
margin would equal 40% × €210,000 = €84,000.

Breakeven point I
The breakeven point is the sales level at which operating profit is zero. At the
breakeven point…
• …Sales minus variable expenses = Fixed expenses
• …Total revenues = Total costs
Breakeven can be calculated using three different methods:

▪ Equation approach:
(Unit sales price × Quantity) − (Var. unit cost × Quantity) − Fixed expenses
= Operating profit
Example: €70Q – €42Q – €84,000 = 0 → €28Q = €84,000 → Q = 3,000 units
▪ Contribution margin method:
(Unit sales price – Var. unit cost) x Quantity = Fixed costs + Operating profit
(Unit contribution margin) x Quantity = Fixed costs + Operating profit
Quantity = (Fixed costs + Operating profit) ÷ Unit contribution margin
Example: €84,000 ÷ €28 = 3,000 units → €84,000 ÷ 40% = €210,000

Breakeven point II
▪ Graph method:
In this method, we plot a line for total revenues and total costs. The
breakeven point is the point at which the total revenue line intersects the
total cost line.
The area between the two lines to the right of the breakeven point is the
operating profit area.
€ (000) Revenue
245
Breakeven point Total costs
210
84
3,000 Units
Target operating profit
Target operating profit can be determined by the same three methods. Insert
the target operating profit in the formula and solve for target sales either in
€ or units.
Example:
Assume that Mary wants to have an operating profit of €14,000.
How many dresses must she sell?
(€84,000 + €14,000) ÷ €28 = 3,500
What € sales are needed to achieve this profit?
(€84,000 + €14,000) ÷ 40% = €245,000

Sensitivity analysis and
uncertainty I
Sensitivity analysis is a “what if” technique that examines how a result will
change if the originally predicted data are not achieved or if an underlying
assumption changes.

Sensitivity analysis and
uncertainty II
Example:
Assume that Dresses by Mary can sell 4,000 dresses. Fixed costs are €84,000.
Contribution margin ratio is 40%. At the present time Dresses by Mary cannot
handle more than 3,500 dresses. To satisfy a demand for 4,000 dresses,
management must acquire additional space for €6,000.
Should the additional space be acquired?
Revenues at breakeven with existing space: €84,000 ÷ 0.40 = €210,000

Revenues at breakeven with additional space: €90,000 ÷ 0.40 = €225,000
Operating profit at €245,000 revenues with existing space:
(€245,000 × 0.40) − €84,000 = €14,000
(3,500 dresses × €28) − €84,000 = €14,000
Operating profit at €280,000 revenues with additional space:
(€280,000 × 0.40) − €90,000 = €22,000
(4,000 dresses × €28) − €90,000 = €22,000

Alternative fixed/variable cost
structures I
Example:
Suppose that the factory from which Dresses by Mary obtains the products
offers Mary the following:
Decrease the price they charge Mary from €32 to €25 and charge an
annual administrative fee of €30,000.
New contribution margin: €70 – (€25 + €10) = €35 → increase by €7

New contribution margin percentage: €35 ÷ €70 = 50%
New fixed costs: €84,000 + €30,000 = €114,000
Management questions what sales volume would yield an identical

operating profit regardless of the arrangement:

Alternative fixed/variable cost
structures II
Sales volume:
28x – 84,000 = 35x – 114,000
114,000 – 84,000 = 35x – 28x
7x = 30,000
x = 4,286 dresses
Cost with existing arrangement = Cost with new arrangement

0.60x + 84,000 = 0.50x + 114,000
0.10x = €30,000
x = €300,000
(€300,000 × 0.40) – €84,000 = €36,000
(€300,000 × 0.50) – €114,000 = €36,000

Operating leverage I
Operating leverage measures the relationship between a company’s

variable and fixed expenses. It is greatest in organisations that have high
fixed expenses and low per unit variable expenses.
▪ The degree of operating leverage shows how a percentage change in
sales volume affects profit.
▪ Degree of operating leverage = Contribution margin ÷ Operating profit
Example:
What is the degree of operating leverage of Dresses by Mary at the 3,500
sales level under both arrangements?

Operating leverage II
Existing arrangement:
3,500 × €28 = €98,000 contribution margin
€98,000 contribution margin − €84,000 fixed costs = €14,000 operating
profit
€98,000 ÷ €14,000 = 7.0
New arrangement:
3,500 × €35 = €122,500 contribution margin
€122,500 contribution margin − €114,000 fixed costs = €8,500
€122,500 ÷ €8,500 = 14.4

Effects of revenue mix on profit I
The revenue mix (or sales mix) is the combination of products that a business
sells.
Example:
Assume that Dresses by Mary is considering selling blouses. This will not
require any additional fixed costs. It expects to sell 2 blouses at €20 each for
every dress it sells. The variable cost per blouse is €9.
What is the new breakeven point?
Contribution margin/dress = €70 selling price – €42 variable cost = €28
Contribution margin/blouse = €20 – €9 = €11.
Contribution margin/mix = €28 + (2 × €11) = €28 + €22 = €50.
€84,000 fixed costs ÷ €50 = 1,680 packages

1,680 × 2 = 3,360 blouses 3,360 blouses x €20 = €67,200
1,680 × 1 = 1,680 dresses 1,680 dresses x €70 = €117,600
Total units = 5,040 Total volume €184,800

Effects of revenue mix on profit II
What is the weighted average budgeted contribution margin?

1 × €28 + 2 × €11 = €50 ÷ 3 = €16.667
Breakeven point for the two products is:
€84,000 ÷ €16.667 = 5,040 units
5,040 × 1/3 = 1,680 dresses
5,040 × 2/3 = 3,360 blouses
Change in revenue mix: Assume the revenue mix in € is 63.6% dresses and
36.4% blouses.
Weighted contribution would be:
40% × 63.6% = 25.44% dresses
55% × 36.4% = 20.02% blouses
45.46%
Breakeven sales is €84,000 ÷ 45.46% = €184,778

Chapter 9
Determining how costs behave
Cost behaviour estimation
To decided what price to charge, whether to make or buy, or answer

other questions related to costs, managers need to have an
understanding of how costs change in relation to various factors.
Two assumptions are frequently used in cost-behaviour estimation:

1. Changes in total costs can be explained by changes in the level of a
single activity.
▪ Variation in machine-hours can explain variations in total cost.
▪ Variation in labour-hours can explain variations in total cost.
2. Cost behaviour can adequately be approximated by a linear function of
the activity level within the relevant range.
▪ A linear cost function is a cost function in which the graph of total
cost versus the level of a single activity is a straight line.

Cost functions
A cost function is a mathematical expression describing how costs

change with changes in the level of an activity (e.g. output produced,
direct manufacturing labour-hours, machine hours, batches of production).
Example: y
Fixed costs: €3,000
Variable costs: €24
Cost function: y = €3,000 + €24x
Total costs Constant Number of units 3,000
Slope of the cost function
x

Cost classification
▪ Choice of cost object

A cost item may be variable with respect to one cost object and fixed with
respect to another.
Example: Taxi company
Cost object = taxi → annual licence costs = variable cost
Cost object = miles driven/year in specific taxi → licence costs = fixed cost
▪ Time span
Whether a cost is variable or fixed with respect to a particular activity
depends on the time span. More costs are variable with longer time spans.
▪ Relevant range
Variable and fixed cost behaviour patterns are valid for linear cost functions
only within the given relevant range. Costs may be non-linear outside the
range.

Cost estimation I
Cost estimation is the attempt to measure a past cost relationship

between costs and the level of an activity.
Managers are interested in estimating past cost-behaviour functions

primarily because these estimates can help them make more accurate
cost predictions.
There are various approaches to cost estimation:

1. Industrial engineering method
2. Conference method
3. Account analysis method
4. Quantitative analysis methods

Cost estimation II
Industrial engineering method Conference method

• Also called the work- • Estimates cost functions on the
measurement method basis of analysis and opinions
• Estimates cost functions by about costs and their drivers
analysing the relationship gathered from various sources
between inputs and outputs in • Involves the pooling of expert
physical terms knowledge
Account analysis method Quantitative analysis methods

• Estimates cost functions by • Use a formal mathematical
classifying cost accounts in the method to fit linear cost functions
ledger as variable, fixed or mixed to past data observations
with respect to the identified
activity
• Typically, qualitative rather
than quantitative analysis based
on experience and judgement
Steps in estimating a cost function I
1. Choose the dependent variable

2. Identify the independent variable cost driver(s)
3. Collect data on the dependent variable and the cost driver(s)
4. Plot the data
5. Estimate the cost function
6. Evaluate the estimated cost function.
Step 1:
The choice of the dependent variable depends on the purpose for estimating a
cost function.
Step 2:
The independent variable is the factor used to predict the dependent variable.
Two important aspects when identifying a cost driver:
▪ An economically plausible relationship with the dependent variable
▪ Accurate measurability

Steps in estimating a cost function II
Step 3:
Cost analysts obtain data from company documents, from interviews with
managers and through special studies.
▪ Time-series data
▪ Cross-sectional data.
Step 4:
▪ The general relationship between the cost driver and the dependent
variable can readily be observed in a plot of the data.
▪ The plot highlights extreme observations that analysts should check.
Step 5:
▪ High–low method
▪ Regression analysis
Step 6:
A key aspect of estimating a cost function is choosing the appropriate cost
driver.

High-low method
▪ Choose the highest and lowest value of the cost driver and their respective
costs.
▪ Determine a and b using algebra.
Example:
▪ High capacity – December: 55,000 machine-hours, cost of electricity: €80,450
▪ Low capacity – September: 30,000 machine-hours, cost of electricity: €64,200
What is the variable rate?
Variable rate = (€80,450 − €64,200) ÷ (55,000 − 30,000) = €0.65
What is the fixed cost?
€80,450 = Fixed cost + 55,000 x €0.65 → €44,700
€64,200 = Fixed cost + 30,000 × €0.65 → €44,700
Cost function:
y = €44,700 + (€0.65 × Machine-hours)

Regression analysis
▪ Regression analysis is used to measure the average amount of change in a

dependent variable, that is associated with unit increases in the amounts of
one or more independent variables, such as machine-hours.
Simple regression analysis Multiple regression analysis

• Estimates the relationship • Estimates the relationship
between the dependent variable between the dependent variable
and one independent variable and multiple independent
variables
▪ The regression equation and regression line are derived using the least-
squares technique. The objective of least-squares is to develop estimates of
the parameters a and b.
▪ The vertical difference (residual term) measures the distance between the
actual cost and the estimated cost for each observation.
The regression method is more accurate than the high–low method.

Three criteria to evaluate and choose
cost drivers
1 Economic plausibility
2 Goodness of fit
3 Slope of the regression line
Goodness of fit Slope of regression line

• The coefficient of determination • A relatively steep slope indicates
(r2) expresses the extent to a strong relationship between the
which the changes in (x) explain cost driver and costs, a flat slope
the variation in (y). indicates a weak relationship.
• An (r2) of 0.80 indicates that • The closer the value of the
more than 80% of the change in correlation coefficient (r) to ±1,
the dependent variable can be the stronger the statistical
explained by the change in the relation between the variables.
independent variable.

Non-linear cost functions
A non-linear cost function is a cost function in which the graph of total costs
versus the level of a single activity is not a straight line within the relevant
range.
▪ Economies of scale
Economies of scale in advertising may enable an advertising agency to
double the number of advertisements for less than double the cost.
▪ Quantity discounts
Quantity discounts on direct material purchases produce a lower cost per
unit purchased with larger orders.
▪ Step cost functions
A step cost function is a cost function in which the cost is constant over
various ranges of the level of activity, but the cost increases by discrete
amounts as the level of activity changes from one range to the next.

Chapter 10
Relevant information for decision making
The decision process
A decision model is a formal method for making a choice, often involving

quantitative and qualitative analysis.
1 1 Gathering information
2 1 Making predictions
3 1 Choosing an alternative
4 1 Implementing the decision
5 1 Evaluating performance

The meaning of relevance
Relevant costs and relevant revenues are expected future costs and
revenues that differ among alternative courses of action.
▪ Historical costs are irrelevant to a decision but are used as a basis for
predicting future costs.
▪ Sunk costs are past costs which are unavoidable.
▪ Differential profit (net relevant profit) is the difference in total
operating profit when choosing between two alternatives.
▪ Differential costs (net relevant costs) are the difference in total costs
between two alternatives.
Quantitative factors Qualitative factors

Outcomes that are measured in Outcomes that cannot be measured
numerical terms: in numerical terms
• Financial
• Non-financial

Decision: One-time-only special
order I
Example: Gabriela & Co. manufactures bath towels in Jersey. The plant
has a production capacity of 44,000 towels each month. Current monthly
production is 30,000 towels. The assumption is made that costs can be
classified as either variable with respect to units of output or fixed.
Variable costs/unit Fixed costs/unit

Direct materials 6.50 0
Direct labour 0.50 1.50
Manufacturing costs 1.50 3.50
Total €8.50 €5.00
Total fixed direct manufacturing labour amounts to €45,000. Total fixed

overhead is €105,000. Marketing costs per unit are €7 (€5 of which is
variable).

Decision: One-time-only special
order II
What is the full cost per towel?
Variable 13.50
Fixed 7.00
Total €20.50
A hotel in Southampton has offered to buy 5,000 towels from Gabriela & Co.
at €11.50 per towel for a total of €57,500. No marketing costs will be incurred
for this one-time-only special order.
Should Gabriela & Co. accept this order?
The relevant costs of making the towels are €42,500:
€8.50 × 5,000 = €42,500 incremental costs
€57,500 − €42,500 = €15,000 incremental revenues
€11.50 − €8.50 = €3.00 contribution margin per towel
YES, the should. Decision criterion: Accept the order if the revenue
differential is greater than the cost differential.

Potential problems in relevant-cost
analysis
General assumptions Unit-cost data

• Do not assume that all Can potentially mislead decision
variable costs are relevant. makers:
• Do not assume that all fixed • Irrelevant costs are included.
costs are irrelevant. • The same unit costs are used
at different output levels.

Make-or-buy decisions I
Outsourcing is the process of purchasing goods and services from outside

sellers rather than producing goods or providing services within the
organisation, which is called insourcing.
Decisions about whether to outsource or produce within the organisation
are often called make-or-buy decisions.
Most important decision factors:
▪ Quality
▪ Dependability of supplies
▪ Costs
Example:
Gabriela & Co. also manufactures bath accessories. Management is
considering producing a part it needs (#2) or using a part produced by
Alec Enterprises.

Make-or-buy decisions II
▪ Gabriela & Co. has the following costs for 150,000 units of Part #2:

Mixed overhead 29,000
Variable overhead 15,000
Fixed overhead 30,000
Total €120,500
▪ Mixed overhead consists of material handling and set-up costs.

▪ Gabriela & Co. produces the 150,000 units in 100 batches of 1,500 units
each.
▪ Total material handling and set-up costs equal fixed costs of €9,000 plus
variable costs of €200 per batch.

Make-or-buy decisions III
What is the cost per unit for Part #2?

€120,500 ÷ 150,000 units = €0.8033/unit
Alec Enterprises offers to sell the same part for €0.55.

Should Gabriela & Co. manufacture the part or buy it from Alec Enterprises?
The answer depends on the difference in expected future costs between the
alternatives.
▪ Gabriela & Co. anticipates that next year the 150,000 units of Part #2
expected to be sold will be manufactured in 150 batches of 1,000 units
each.
▪ Variable costs per batch are expected to decrease to €100.
▪ Gabriela & Co. plans to continue to produce 150,000 next year at the same
variable manufacturing costs per unit as this year.
▪ Fixed costs are expected to remain the same as this year.

Make-or-buy decisions IV
What is the variable manufacturing cost per unit?

Variable overhead 15,000
Total €61,500
€61,500 ÷ 150,000 = €0.41 per unit

Expected relevant cost to make Part #2:
Manufacturing 61,500
Material handling, set-ups 15,000
Total relevant costs to make €76,500
Cost to buy: (150,000 × €0.55) = €82,500

Gabriela & Co. will save €6,000 by making the part.

Make-or-buy decisions V
▪ Now assume that the €9,000 in fixed clerical salaries to support material
handling and set-up will not be incurred if Part #2 is purchased from Alec
Enterprises.
Should Gabriela & Co. buy the part or make the part?
Variable 76,500
Fixed 9,000
Total €85,500
Cost to buy: €82,500

Gabriela would save €3,000 by buying the part.

Opportunity costs I
▪ Opportunity cost is the contribution to profit that is foregone (rejected)

by not using a limited resource in its next-best alternative use.
▪ Opportunity costs are not recorded in formal accounting records since
they do not generate cash outlays.
▪ These costs also are not ordinarily incorporated into formal reports.
▪ The opportunity cost of holding stock is the profit forgone from tying up
money in stock and not investing it elsewhere.
▪ Carrying costs of stock can be a significant opportunity cost and should
be incorporated into decisions regarding lot purchase sizes for materials.

Opportunity costs II
Example: Assume that annual estimated Part #2 requirements for next

year is 150,000. Cost per purchase order is €40. Cost per unit when each
purchase is of 1,500 units = €0.55. Cost per unit when each purchase is
equal to or greater than 150,000 = €0.54.
Average investment in stock is either:
(1,500 × 0.55) ÷ 2 = €412.50 or
(150,000 × €0.54) = €40,500
Annual interest rate for investment in government bonds is 6%.
€412.50 × 0.06 = €24.75
€40,500 × 0.06 = €2,430

Opportunity costs III
▪ Option A: Make 100 purchases of 1,500 units:

Purchase order costs (100 x €40) 4,000.00
Purchase costs (150,000 x €0.55) 82,500.00
Annual interest profit that could be earned 24.75
Relevant costs €86,524.75
▪ Option B: Make 1 purchase of 150,000 units:
Purchase order costs (1 x €40) 40
Purchase costs (150,000 x €0.54) 81,000
Annual interest profit that could be earned 2,430
Relevant costs €83,470
In this case purchasing all 150,000 units at the beginning of the year is
preferred because the higher purchase and ordering costs exceeds the
lower opportunity cost of holding smaller stock.

Product mix decisions under capacity
constraints I
▪ What product should be emphasised to maximise operating profit in the

face of capacity constraints?
▪ Decision criterion: Aim for the highest contribution margin per unit of the
constraining factor.
▪ When multiple constraints exist, optimisation techniques such as linear
programming can be used in making decisions.
Example:
Gabriela & Co. produces Product #2 and Product #3. The company has
3,000 machine hours available to produce these products.
Per unit Product #2 Product #3

Sales price 2.11 14.50
Variable expenses 0.41 13.90
Contribution margin €1.70 €0.60
Contribution margin ration 81% 4%

Product mix decisions under capacity
constraints II
▪ One unit of Product #2 requires 7 machine hours.

▪ One unit of Product #3 requires 2 machine hours.
What is the contribution of each product per machine hour?

Product #2: €1.70 ÷ 7 = €0.24
Product #3: €0.60 ÷ 2 = €0.30
Which product should be emphasised?
The product with the highest contribution margin per unit of the
constraining resource.

Irrelevance of past costs I
▪ The book value of existing equipment is irrelevant since it is neither a

future cost nor does it differ among any alternatives (sunk costs never
differ).
▪ The disposal price of old equipment and the purchase cost of new
equipment are relevant costs and revenues because they are future costs
or revenues that differ between alternatives to be decided upon.
Example:
Assume that Gabriela & Co. is considering replacing a cutting machine with
a newer model. The new machine is more efficient than the old machine.
Revenues will be unaffected.
Ignoring the time value of money and profit taxes, should Gabriela replace
the existing machine?

Irrelevance of past costs II
Existing machine Replacement machine

Original cost 80,000 105,000
Useful life 4 years 4 years
Accumulated depreciation 50,000
Book value 30,000
Disposal price 14,000
Annual costs 46,000 10,000
▪ Cost savings per year: €36,000

▪ Cost savings over a 4-year period: €36,000 × 4 = €144,000
▪ Investment = €105,000 − €14,000 = €91,000
▪ Advantage of the replacement machine: €144,000 − €91,000 = €53,000
→ Yes, the existing machine should be replaced.

Chapter 11
Activity-based costing
Activity-based costing I
Activity-based costing (ABC) systems help companies make better pricing

and product mix decisions and assist in cost management decisions by
improving processes and product designs.
▪ Activities generate transactions.
▪ Transactions generate costs.
▪ ABC traces costs to activities.
Activity-based management (ABM) describes management decisions that

use activity-based costing information to satisfy customers and improve
profits.
1. Product pricing and mix decisions
2. Cost reduction and process improvement decisions
3. Design decisions

Activity-based costing II
1. Product pricing and mix decisions

▪ ABC gives management insights into the cost structures for making
and selling diverse products.
▪ It provides more accurate product cost information and more detailed
information on costs of activities and the drivers of those costs.
2. Cost reduction and process improvement decisions
▪ Manufacturing and distribution personnel use ABC systems to focus
on cost reduction efforts.
▪ Managers set cost-reduction targets in terms of reducing the cost per
unit of the cost-allocation base.
3. Design decisions
▪ Management can identify and evaluate new designs to improve
performance by evaluating how product and process designs affect
activities and costs.
▪ Companies can work with their customers to evaluate the costs and
prices of alternative design choices.

Undercosting and overcosting of
products
▪ Product undercosting:
A product consumes a relatively high level of resources but is reported
to have a relatively low total cost.
▪ Product overcosting:
A product consumes a relatively low level of resources but is reported to
have a relatively high total cost.
Example:
▪ Jane, Mercedes and Cherie meet occasionally for lunch. Each one orders
separate items.
Jane’s order amounts to €14, Mercedes consumed €30 and Cherie’s
order is €16, the bill in total amounts to €60.
▪ Assuming they divide the bill equally, the average cost per lunch is
€60 ÷ 3 = €20
▪ Jane and Cherie are overcosted. Mercedes is undercosted.

Existing single indirect-cost pool
system I
Example:
Oculus Ltd manufactures two types of lenses – a normal lens (NL) and a
complex lens (CL). To cost products, Oculus currently uses a single indirect-
cost rate job costing system. The cost objects are the total costs of
manufacturing and distributing 80,000 normal lenses (NL) and 20,000
complex lenses (CL).
Normal lenses (NL) Complex lenses (CL)
Direct materials 1,520,000 Direct materials 920,000
Direct mfg labour 800,000 Direct mfg labour 260,000
Total direct costs €2,320,000 Total direct costs €1,180,000
Direct costs/unit €29 Direct costs/unit €59
▪ Indirect costs of €2,900,000 are grouped into a single overhead cost pool.
▪ 50,000 direct manufacturing labour hours are used as the cost-allocation
base.

system II
▪ Oculus uses 36,000 direct manufacturing labour-hours to make NL and

14,000 direct manufacturing labour-hours to make CL.
What is the indirect cost rate?
€2,900,000 ÷ 50,000 = €58
How much indirect costs are allocated to each product?
NL: 36,000 × €58 = €2,088,000
CL: 14,000 × €58 = €812,000
What is the total cost?
NL: €2,320,000 + €2,088,000 = €4,408,000
CL: €1,180,000 + €812,000 = €1,992,000
What is the cost per unit?
NL: €4,408,000 ÷ 80,000 = €55.10
CL: €1,992,000 ÷ 20,000 = €99.60

system III
▪ Normal lenses sell for €60 each and complex lenses for €142 each.
Normal Complex
Revenue 60.00 142
Cost 55.10 99.60
Income €4.90 €42.40
Margin 8.2% 29.9%

Guidelines for refining a costing
system
Direct-cost tracing
• Classify as many of the total costs as direct costs as is
economically feasible.
Indirect-cost pools
• Expand the number of cost pools until each of these pools
is homogeneous.
Cost-allocation basis
• Identify the preferred cost-allocation base for each
indirect-cost pool

Activity-based costing system I
▪ ABC systems refine costing systems by focusing on individual activities

as the fundamental cost object.
▪ ABC calculates the costs of individual activities and assigns costs to cost
objects such as products and services on the basis of the activities
undertaken to produce each product or service.
Fundamental cost
objects
Activities Cost of activities
Assignments to Cost of product,

other cost objects service, customer

Activity-based costing system II
Example: At Oculus Corporation these key activities were identified:

▪ Design products and processes.
▪ Set up moulding machine.
▪ Operate machines to manufacture lenses.
▪ Maintain and clean the moulds.
▪ Set up batches of finished lenses for shipment.
▪ Distribute lenses to customers.
▪ Administer and manage all processes at Oculus.
Set-up data NL CL
Quantity produced 80,000 20,000
No. produced/batch 250 50
Number of batches 320 400
Set-up time per batch 2 hours 5 hours
Total set-up hours 640 2,000

Activity-based costing system III
▪ Total set-up costs are €409,200.

What is the set-up cost per set-up hour?
€409,200 ÷ 2,640 hours = €155
What is the set-up cost per direct manufacturing labour hour?
€409,200 ÷ 50,000 = €8.184
Cost allocation using direct manufacturing labour-hours:
NL: €8.184 × 36,000 = €294,624
CL: €8.184 × 14,000 = €114,576
Cost allocation using set-up-hours:
NL: €155 × 640 = €99,200
CL: €155 × 2,000 = €310,000
How should Oculus allocate set-up costs?
Set-up costs should be allocated on the basis of set-up hours because there
is a strong cause-and-effect relationship between set-up related overhead
costs and set-up hours.

Cost hierarchies I
A cost hierarchy is a categorisation of costs into different cost pools on the basis
of the different types of cost drivers (cost-allocation bases) or different degrees
of difficulty in determining cause-and-effect relationships.
ABC systems commonly use a four-part cost hierarchy:
1 1 Output unit-level costs
2 1 Batch level costs
3 1 Product-sustaining costs
4 1 Faculty-sustaining costs

Cost hierarchies II
1 1 Output unit-level costs
Resources sacrificed on activities performed on each individual unit of product or

service.
▪ Energy
▪ Machine depreciation
2 1 Batch level costs
Resources sacrificed on activities that are related to a group of units of

product(s) or service(s) rather than to each individual unit of a product or
service.
▪ Set-up hours
▪ Procurement costs

Cost hierarchies III
3 1 Product-sustaining costs
Resources sacrificed on activities undertaken to support individual products

or services.
▪ Design costs
▪ Engineering costs
4 1 Faculty-sustaining costs
Resources sacrificed on activities that cannot be traced to individual

products or services but support the organisation as a whole.
▪ General administration
▪ Rent
▪ Building security

Implementing activity-based
costing I
Example:
Step 1: Identify the chosen cost objects.
The objective is to calculate the total costs of designing, manufacturing
and distributing NL and CL.
Step 2: Identify the direct costs of the product.
Oculus identifies direct material costs and direct manufacturing labour as
direct costs.
Mould cleaning and maintenance costs of €360,000 are also identified as
direct costs of the lenses.
The existing cost system classifies mould cleaning and maintenance costs
as part of the €2,900,000 indirect costs.
Recall that indirect costs were allocated to products using direct
manufacturing labour-hours.
Cleaning and maintenance costs of €360,000 are direct batch-level costs
because these costs consist of workers’ wages for cleaning moulds after
each batch of lenses is run.
costing II
Normal lenses
Direct materials Unit-level 1,520,000
Direct mfg labour Unit-level 800,000
Cleaning Batch-level 160,000
Total direct costs €2,480,000
Complex lenses
Direct materials Unit-level 920,000
Direct mfg labour Unit-level 260,000
Cleaning Batch-level 200,000
Total direct costs €1,380,000

costing III
Step 3: Select the cost-allocation bases to use in allocating indirect costs

to the products.
Six activities were identified:
1. Design 4. Shipment set-up
2. Moulding machine set-ups 5. Distribution
3. Manufacturing operations 6. Administration
Step 4: Identify the indirect costs associated with each cost-allocation

base.
Overhead costs incurred are assigned to activities, to the extent possible,
on the basis of a cause-and-effect relationship.
Total set-up costs are €409,200.

costing IV
Step 5: Compute the rate per unit of each cost allocation base used to
allocate indirect costs to the products.
NL CL Total
Set-up hours 640 2,000 2,640
Rate per unit: €409,200 ÷ 2,640 = €155

Step 6: Compute the indirect costs allocated to the products.
Total cost of set-up activity:
NL: €155 × 640 = €99,200
CL: €155 × 2,000 = €310,000
Step 7: Compute the costs of the products by adding all direct and indirect
costs assigned to them.

ABC system design and
organizational context I
Implementing ABC systems is most beneficial when…

▪ Significant amounts of indirect costs are allocated using only one or two
cost pools.
▪ All or most costs are identified as output unit-level costs.
▪ Products make diverse demands on resources because of differences in
volume, process steps, batch size or complexity.
▪ Products that a company is well suited to make and sell show small
profits while products for which a company is less suited show large
profits.
▪ Complex products appear to be very profitable and simple products
appear to be losing money.
▪ Operations staff have significant disagreements with the accounting staff
about the costs of manufacturing and marketing products and services.

ABC system design and
organizational context II
However…
▪ The main limitations of ABC are the measurements necessary to
implement the system.
▪ ABC systems require management to estimate costs of activity pools
and to identify and measure cost drivers for these pools.
▪ Activity-cost rates also need to be updated regularly.
▪ Very detailed ABC systems are costly to operate and difficult to
understand.

Chapter 12
Pricing, target costing and customer
profitability analysis
Pricing decisions I
▪ Pricing decisions are management decisions about what to charge for

the products and services that companies deliver.
▪ To maximise operating profit, companies produce and sell units as long
as the revenue from an additional unit exceeds the cost of producing it.
▪ The price of a product or service is the outcome of the interaction
between the demand for the product or service and its supply.
There are three major influences on pricing decisions:

1. Customers
2. Competitors
3. Costs

Pricing decisions II
1. Customers influence prices through their effect on demand.

▪ Companies must always examine pricing decisions through the eyes
of their customers.
▪ Too high a price may cause customers to reject a company’s product.
2. Competitors influence prices through their actions.
▪ Alternative or substitute products of a competitor may affect demand
and force a business to lower its prices.
▪ Fluctuations in the exchange rates of different countries’ currencies
also affect pricing decisions.
3. Costs influence prices because they affect supply.
▪ The lower the cost relative to the price, the greater the quantity of
product the company is willing to supply.

Time horizon of pricing decisions
Most pricing decisions are either short run or long run:

▪ Short-run decisions typically have a time horizon of less than a year.
▪ Long-run decisions involve a time horizon of a year or longer.
Two key differences when pricing for the long run relative to the short run:
Costs that are often irrelevant for Profit margins in long-run pricing
short-run pricing decisions (fixed decisions are often set to earn a
costs) are often relevant in the long reasonable return on investment.
run.

Costing and pricing for the short run
I
Example:
The Corleone Corporation operates a plant with a monthly capacity of 500,000
cases of tomato sauce. Corleone is presently producing 300,000 cases per
month. Supermarket Ltd has asked Corleone and two other companies to bid on
supplying 150,000 cases each month for the next four months.
Cost per case

Variable manufacturing 38
Variable marketing and distribution 13
Fixed manufacturing 14
Fixed marketing and distribution 15
Total €80
If Corleone makes the extra 150,000 cases, the existing total fixed
manufacturing overhead (€4,200,000 per month) would continue, plus an
additional €165,000 of fixed overhead will be incurred per month. Total fixed
marketing and distribution costs will not change.
Costing and pricing for the short run
II
What price should Corleone bid?

Relevant costs
Variable manufacturing 38.00
Fixed manufacturing 1.10
Total €39.10
→ Any bid above €39.10 will improve Corleone’s profitability in the short
run.
▪ Suppose that Corleone believes that Supermarket will sell the tomato
sauce in Corleone’s current markets, but at a lower price than Corleone.
▪ Relevant costs of the bidding decision should include revenues lost on
sales to existing customers.

Costing and pricing for the long run I
Example:
Taquisha Computer Corporation manufactures two brands of computers:
Simple Computer (SC) and Complex Computer (CC). Taquisha uses a long-
run time horizon to price Complex Computer (CC).
Direct materials costs vary with the number of units produced. Direct
manufacturing labour costs vary with direct manufacturing labour hours.
Ordering and receiving, testing and inspection and rework costs vary with
their chosen cost drivers.
Manufacturing activity Cost driver Cost per unit of cost driver

Ordering and receiving Number of orders €78
Testing and inspection Testing hours €2
Rework Rework hours €38

Costing and pricing for the long run
II
Taquisha uses the following information to calculate the cost of

manufacturing 100,000 units of Complex Computer.
Cost per unit

Direct materials 450.00
Direct labour 3.5 hours at €19/hour 66.50
Total €516.50
▪ Number of orders placed: 17,000

▪ Number of testing hours: 3,000,000
▪ Number of units reworked: 8,000
▪ The direct fixed costs of machines used exclusively for the manufacture
of Complex Computer total €7,000,000.
What is the cost of producing 100,000 units of Complex Computer?

Costing and pricing for the long run
III
Costs
Direct material and labour 51,650,000
Direct fixed costs 7,000,000
Ordering 1,326,000
Testing 6,000,000
Rework 304,000
Total €66,280,000
Cost of producing one computer: €66,280,000 ÷ 100,000 units = €662.80/unit

Target pricing and costing I
▪ Target price: the estimated price for a product (or service) that
potential customers will be willing to pay
▪ The target price, calculated using customer and competitors’ inputs,
forms the basis for calculating target costs.
▪ Target sales price per unit - Target operating profit per unit = Target
cost per unit
Steps in developing target pricing and costing:

1. Develop a product that satisfies the needs of potential customers
2. Choose a target price
3. Derive a target cost per unit
4. Perform value engineering to achieve target costs.

Target pricing and costing II
Example:
▪ Taquisha’s management wants a 15% target operating profit on sales
revenues of CC.
▪ Target sales revenue is €750 per unit.
What is the target cost per unit?
€750 × 0.15 = €112.50
€750 − €112.50 = €637.50
Current full cost per unit of CC is €662.80.
Value engineering is a systematic evaluation of all aspects of the value-

chain business function, with the objective of reducing costs while
satisfying customers’ needs.

Value-added vs non-value added
costs
Value-added cost Non-value-added cost

A cost that customers perceive A cost that customers do not
as adding value, or utility, to a perceive as adding value, or
product or service, e.g. utility, to a product or service,
• Adequate memory e.g.
• Pre-loaded software • Cost of expediting
• Reliability • Rework
• Easy-to-use keyboards • Repair

Cost incurring and locked-in costs
▪ Cost incurrence arises when a resource is sacrificed or forgone to

meet a specific objective, e.g.
▪ Research and development
▪ Design
▪ Manufacturing…
▪ Locked-in costs are those costs that have not yet been incurred but
which, based on decisions that have already been made, will be incurred
in the future (designed-in costs).
→ It is difficult to alter or reduce costs that are already locked in.
▪ Wide divergence between the time when costs are locked in and the
time when those costs are incurred.
→ At the end of the design stage, direct materials, direct manufacturing
labour and many manufacturing, marketing, distribution and customer
service costs are all locked in.

Cost-plus pricing I
The general formula for setting a cost-based price is to add a mark-up

component to the cost base.
Example: Assume that Taquisha’s engineers have redesigned CC into CCI
at a new cost of €637.50. Taquisha desires a 20% mark-up on the full unit
cost.
What is the prospective selling price?
Cost base 637.50

Mark-up component 127.50
Prospective selling price €765.00
How is the 20% determined?

→ Choose a mark-up to earn a target rate of return on investment.

Cost-plus pricing II
Assume that the capital investment needed for CCI is €75 million, and
Taquisha’s (pre-tax) target rate of return on investment is 17%.
What is the target annual operating profit that Taquisha needs to earn
from CCI?
€75,000,000 × 0.17 = €12,750,000
What is the target operating profit per unit?
€12,750,000 ÷ 100,000 units = €127.50/unit
The 17% target rate of return on investment expresses the company’s

expected annual operating profit as a percentage of investment.
The 20% mark-up expresses operating profit per unit as a percentage of
the full product cost per unit.

Cost-plus pricing III
Advantages of using full costs:

▪ Full recovery of all costs of the product
▪ Price stability
▪ Simplicity
Alternative cost-plus methods:

▪ Variable manufacturing costs
▪ Variable costs of the product
▪ Manufacturing function costs
A company will choose a cost base that it regards as reliable and a

mark-up percentage based on its experience in pricing products to recover
its costs and earn a desired return on investment.

Life-cycle budgeting I
▪ The product life cycle spans the time from original research and
development, through sales, to when customer support is no longer
offered for that product.
▪ A life cycle budget estimates revenues and costs of a product over its
entire life.
▪ Features that make life-cycle budgeting important:
1. Non-production costs
2. Development period for R&D and design
3. Other predicted costs

Life-cycle budgeting II
1. Non-production costs
▪ They are less visible on a product-by-product basis.
▪ When non-production costs are significant, identifying these costs by
product is essential for target pricing, target costing, value
engineering and cost management.
2. Development period for R&D and design
▪ When a high percentage of total life-cycle costs are incurred before
any production begins and before any revenues are received, it is
crucial for the company to have as accurate a set of revenue and
cost predictions for the product as possible.
3. Other predicted costs
▪ Many of the production, marketing, distribution and customer service
costs are locked in the R&D and design stage.
▪ Life cycle budgeting facilitates value engineering at the design stage
before costs are locked in.

Customer revenues
▪ Customer revenues are greatly affected by price discounting.

▪ This is where sales staff reduce the selling price in order to encourage
an increase in purchases by customers.
There are two reporting options:
1. Reporting income and the discount separately: enables the more
detailed analysis of discounts as a way of understanding why
customers may not be as profitable as first envisaged.
2. Net the income and discount to give the actual price sold and report
that figure.

Cost hierarchy in customer costing
There are five key ways in which the cost hierarchy can be used for
customer costing:
1 Customer output-unit-level costs: resources sacrificed on activities

1 performed to sell each unit to a customer
1 Customer batch-level costs: resources sacrificed on activities that

2 relate to a group of units sold to a customer
1 Customer-sustaining costs: resources sacrificed on activities to

3 support individual customers, regardless of the number of units sold
1 Distribution-channel costs: resources sacrificed on activities that are

4 related to a particular distribution channel rather than prod. units
1 Corporate-sustaining costs: resources sacrificed on activities that

5 cannot be traced to individual customers/distribution channel

Cost hierarchy in customer costing
There are numerous ways in which customers can be ranked and their
value be assessed:
1 Ranking customers on how much they contribute to revenue/profit –

1 both in the short run and the long run
2 1 Likelihood of customer retention
3 1 Potential for customer growth
1 Having well-known customers (e.g. The Royal Warrant on certain

4 goods)
5 1 Ability to learn from customers through feedback

Chapter 13
Capital investment decisions
Life-cycle costing and capital
budgeting
▪ There are two different dimensions of cost analysis:
Project dimension Accounting period
▪ The accounting system that corresponds to the project dimension is

termed life-cycle costing:
▪ Accumulates revenues and costs on a project-by-project basis
▪ Computes cash flow or income over the entire project covering many
accounting periods
▪ Capital budgeting is…

▪ The making of long-run planning decisions for investments in projects
and programmes.
▪ A decision-making and control tool that focuses primarily on projects
or programmes that span multiple years.

Capital budgeting: a six-step process
1. Identification stage: To distinguish which types of capital expenditure

projects are necessary to accomplish organisation objectives.
2. Search stage: To explore alternative capital investments that will
achieve organisation objectives.
3. Information-acquisition stage: To consider the expected costs and
the expected benefits of alternative capital investments.
4. Selection stage: To choose projects for implementation.
5. Financing stage: To obtain project funding.
6. Implementation and control stage: To get projects underway and
monitor their performance.

The time value of money
▪ The life of the project is usually longer than one year, so capital
budgeting decisions consider revenues and costs over relatively long
periods.
▪ They do this by considering the time value of money. This takes into
consideration the fact that €1 today may be worth €1.03 next year,
given inflation.
▪ The real rate of return is therefore the nominal rate of return, taking the
time value of money into account.

Discounted cash flow
▪ Discounted cash-flow (DCF) methods measure all expected future cash

inflows and outflows of a project, as if they occurred at a single point in
time.
▪ The discounted cash-flow methods incorporate the time value of money.
▪ There are two main DCF methods:
Net present value (NPV) Internal rate-of-return (IRR)

• Computes the expected net • Calculates the discount rate at
monetary gain or loss from a which the present value of
project by discounting all expected cash inflows from a
expected cash flows to the project equals the present value
present point in time, using the of expected cash outflows
required rate of return
• Investm. = expected annual net
• Only projects with a zero or cash inflow × PV annuity factor
positive net present value are
• Investm. ÷ expected annual net
acceptable
cash inflow = PV annuity factor

Net present value method I
Example:
▪ Healthy Living plans to invest in a new machine. This proposed
investment will yield net cash savings of €125,000, €130,000 and
€110,000 over its life.
▪ The working capital investment of €5,000 is expected to be recovered at
the end of year 3.
▪ Operating cash flows are assumed to occur at the end of the year.
▪ Assume that the required rate of return for Healthy Living is 10%.
Year 0 1 2 3
Net initial investment (€250,000)

Annual cash inflow €125,000 €130,000 €115,000

Net present value method II
Year 10% col. Net cash inflows NPV of net cash inflows
1 0.909 125,000 113,625
2 0.826 130,000 107,380
3 0.751 115,000 86,365
Total PV of net cash inflows €307,370
Investment €250,000
Net present value of project €57,370
This project is acceptable because its net present value is €57,370.

Internal rate-of-return method
Example:
Assume that Healthy Living is considering investing €303,280 in a scanning
machine that will yield net cash savings of €80,000 per year over its five-
year life.
What is the IRR of this project?
€303,280 ÷ €80,000 = 3.791 (PV annuity factor)
The annuity table shows that 3.791 is in the 10% column for a five-
period row in this example.
Therefore, 10% is the internal rate of return of this project.
If the minimum desired rate of return is 10% or less, Healthy Living
should undertake this project.

Comparison of NPV and IRR
Net present value (NPV) Internal rate-of-return (IRR)

• End result of the • The IRR of individual projects
computations is expressed in cannot be added or averaged
money and not in percentage to derive the IRR of a
• Individual projects can be combination of projects
added to see the effect of
accepting a combination of
projects
• Can be used in situations
where the required rate of
return varies over the life of
the project

Relevant cash flows
▪ Relevant cash flows are expected future cash flows that differ among
the alternatives.
▪ Capital investment projects typically have three major categories of
cash flows:
Net initial investment Cash flow from CF from terminal
operations disposal of assets/
working cap. recovery
Three components: Cash inflows may result A machine’s terminal
• Initial asset from producing and disposal price may be
investment selling additional goods zero/an amount
or services, from considerably less than
• Initial working capital savings in cash initial investment.
investment operating costs, etc. The initial investment in
• Current disposal Depreciation is working capital is
value of old asset irrelevant in DCF (non- usually fully recouped
cash allocation). when the project is
terminated.
Payback method
Payback measures the time it will take to recoup, in the form of expected
future cash flows, the initial investment in a project.
Example:
Assume that Healthy Living is considering buying some equipment for
€210,000, with an estimated useful life of 11 years, and zero predicted
residual value. Managers expect use of the equipment to generate €35,000
of net cash inflows from operations per year.
How long would it take to recover the investment?
€210,000 ÷ €35,000 = 6 years
6 years is the payback period.

Accounting rate-of-return method I
The accounting rate-of-return (ARR) method divides an accounting

measure of income by an accounting measure of investment.
Example:
Healthy living is considering to invest in a scanning machine with a cost
€303,280, no residual value, expected annual net cash savings of €80,000
and a useful life of 5 years. The IRR of this machine is 10%.
What is the average operating income?
Straight-line depreciation is €60,656 per year
€80,000 − €60,656 = €19,344
Average operating income is €19,344
What is the ARR?
ARR = (€80,000 − €60,656) ÷ €303,280 = 6.38%

Accounting rate-of-return method II
▪ An ARR of 6.38% indicates the rate at which a € of investment

generates operating income.
▪ Projects, whose ARR exceeds an accrual accounting required rate of
return for the project, are considered desirable.
▪ The ARR method is similar to the IRR method in that both methods
calculate a rate-of-return percentage.
▪ While the ARR calculates return using operating income numbers after
considering accruals, the IRR method calculates return on the basis of
cash flows and the time value of money.

Qualitative factors in capital
budgeting
There are three key qualitative factors to consider when reviewing a

capital-budgeting system:
1 Predicting the full set of benefits and costs (both financial and non-
1 financial)
2 1 Recognising the full time horizon of the project
3 1 Performance evaluation and the selection of projects

Income tax considerations I
Although depreciation is a non-cash expense, it is a deductible cost for

calculating tax outflow.
Taxes saved as a result of depreciation deductions increase cash flows in
discounted cash-flow (DCF) computations.
Example:
Assume Geneva Transit is considering the replacement of an old piece of
equipment with new, more modern equipment. The income tax rate is 40%. The
company uses straight-line depreciation. The tax effects of cash inflows and
outflows occur at the same time that the inflows and outflows occur.
Old equipment
Current book value 50,000
Current disposal price 3,000
Terminal disposal price (5 years) 0
Annual depreciation 10,000
Working capital 5,000
Income tax considerations II
Current disposal price of old equipment 3,000

Deduct current book value of old equipment 50,000
Loss on disposal of equipment €47,000
How much is the tax saving?

€47,000 × 0.40 = €18,800
What is the after-tax cash flow from current disposal of old equipment?
Current disposal price 3,000

Tax savings on loss 18,800
Total €21,800

Income tax considerations III
New equipment
Current book value 225,000
Current disposal price Irrelevant
Terminal disposal price (5 years) 0
Annual depreciation 45,000
Working capital 15,000
How much is the net investment for the new equipment?
Current cost 225,000

Add increase in working capital 10,000
Deduct after-tax cash flow from -21,800
current disposal of old equipment
Net investment €213,200

Income tax considerations IV
Assume €90,000 pre-tax annual cash flow from operations (excluding

depreciation effect).
What is the after-tax flow from operations?
Cash flow from operations 90,000

Deduct income tax (40%) 36,000
Annual after-tax flow from operations €54,000
What is the difference in depreciation deduction?
Annual depreciation of new equipment 45,000

Deduct annual depreciation of old 10,000
equipment
Difference €35,000

Income tax considerations V
What is the annual increase in income tax savings from depreciation?

Increase in depreciation 35,000
Multiply by tax rate x 0.40
Income tax cash savings from add. depreciation €14,000
What is the cash flow from operations, net of income taxes?
Annual after-tax flow from operations 54,000

Income tax cash savings from add. depreciation 14,000
Cash flow from operations, net of income taxes €68,000

Real vs nominal rate of return
Real rate of return Nominal rate of return

Rate of return required Rate of return required to
to cover return and cover return, investment
investment risk risk and inflation
Example:
Xanadu Consulting: rate of return for investment is 20%, expected inflation
is 10%.
Nominal rate of return
= (1 + real rate of return)(1 + inflation rate) − 1
= {(1.20 × 1.10) − 1} = 0.32
Real rate of return
= {[(1 + real rate of return) / (1 + inflation rate)] − 1}
= {[(1.20)/(1.10)] − 1} = 0.20

Assumptions in the NPV and IRR
methods
▪ Managers using the IRR implicitly assume that the reinvestment rate is
the indicated rate of return for the shortest lived project.
▪ The NPV method assumes that the funds obtained from competing
projects can be reinvested at the company’s required rate of return.
▪ Conceptually, the NPV is regarded as superior by nearly all financial
texts because of the problems associated with the ranking of projects of
unequal lives or unequal investments (where there are problems with
the IRR approach).
▪ As the two methods have different assumptions, they can rank projects
differently.

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Fundamentals of

Bhimani, A, Horngren, CT, Datar, SM, Rajan, M

▪ Part 1 – Management and cost accounting

Pre-course package adapted from slide deck

PAGE 2 FUNDAMENTALS OF MANAGEMENT CONTROL

▪ Modern cost accounting provides key

PAGE 4 FUNDAMENTALS OF MANAGEMENT CONTROL

Management accounting measures and reports financial and non-financial

PAGE 5 FUNDAMENTALS OF MANAGEMENT CONTROL

PAGE 6 FUNDAMENTALS OF MANAGEMENT CONTROL

Formulating overall strategies and long-range plans:

Resource allocation decisions, e.g. product and customer emphasis

Cost planning and cost control of operations and activities:

Performance measurement and evaluation of people:

Meeting external regulatory and legal reporting requirements:

PAGE 7 FUNDAMENTALS OF MANAGEMENT CONTROL

Internal routine reporting External reporting

PAGE 8 FUNDAMENTALS OF MANAGEMENT CONTROL

MGMT DECISIONS MGMT ACCOUNTING SYSTEM

PAGE 9 FUNDAMENTALS OF MANAGEMENT CONTROL

MGMT DECISIONS MGMT ACCOUNTING SYSTEM

Control Accounting system

Performance evaluation: Performance reports

PAGE 10 FUNDAMENTALS OF MANAGEMENT CONTROL

Surrey Specialty Ltd, Year 2014

PAGE 11 FUNDAMENTALS OF MANAGEMENT CONTROL

Surrey Specialty Ltd, Year 2014

PAGE 12 FUNDAMENTALS OF MANAGEMENT CONTROL

Scorekeeping involves accumulating data and reporting reliable results to all

Attention directing involves helping managers properly focus their attention.

Problem solving involves comparative analysis for decision making with an

PAGE 13 FUNDAMENTALS OF MANAGEMENT CONTROL

Management accountants serve each of these three roles in both planning

▪ The problem-solving role is most marked for planning decisions.

PAGE 14 FUNDAMENTALS OF MANAGEMENT CONTROL

PAGE 15 FUNDAMENTALS OF MANAGEMENT CONTROL

Value-chain and Success factors

PAGE 16 FUNDAMENTALS OF MANAGEMENT CONTROL

Key success factors

Cost – Quality –Time – Innovation

PAGE 17 FUNDAMENTALS OF MANAGEMENT CONTROL

Value-chain and supply-chain analysis

PAGE 18 FUNDAMENTALS OF MANAGEMENT CONTROL

Change in role: Different foci in different decades, the role of management

Enterprise structure: Organisational change towards integrated, cross-

Digitisation: Requirements for accelerated decision-making, an interactive

Intellectual capital and knowledge management is now recognised as

PAGE 19 FUNDAMENTALS OF MANAGEMENT CONTROL

Cost is a resource sacrificed or foregone to achieve a specific objective. It is

There are two basic stages of accounting for costs:

PAGE 21 FUNDAMENTALS OF MANAGEMENT CONTROL

Cost accumulation Cost object

PAGE 22 FUNDAMENTALS OF MANAGEMENT CONTROL

Direct costs Indirect costs

Several factors affect the classification of a cost as direct or indirect:

PAGE 23 FUNDAMENTALS OF MANAGEMENT CONTROL

PAGE 24 FUNDAMENTALS OF MANAGEMENT CONTROL

€15,000 Allocated €15,000

PAGE 25 FUNDAMENTALS OF MANAGEMENT CONTROL

Fixed costs do not

PAGE 26 FUNDAMENTALS OF MANAGEMENT CONTROL

Total costs (€000)

What is the total handlebar cost when