P1 1C.50c9001 Notes

PART 1
PART 1 UNIT 4
4
1C. Performance Management
Module
1 C.1. Cost and Variance Measures: Part 1 3
2 C.1. Cost and Variance Measures: Part 2 11
3 C.2. Responsibility Centers 37
4 C.2. Transfer Pricing 47
5 C.3. Performance Measures: Part 1 61
6 C.3. Performance Measures: Part 2 73

PART 1 UNIT 4
NOTES
4–2 © Becker Professional Education Corporation. All rights reserved.

1
MODULE
PART 1 UNIT 4
C.1. Cost and Variance

Measures: Part 1
Part 1
Unit 4
This module covers the following content from the IMA Learning Outcome Statements.
CMA LOS Reference: Part 1—Section C.1. Cost and Variance Measures: Part 1
The candidate should be able to:

a. analyze performance against operational goals using measures based on revenue,
manufacturing costs, nonmanufacturing costs, and profit depending on the type of
center or unit being measured
b. explain the reasons for variances within a performance monitoring system
c. prepare a performance analysis by comparing actual results to the master budget,
calculate favorable and unfavorable variances from the budget, and provide
explanations for variances
d. identify and describe the benefits and limitations of measuring performance by
comparing actual results to the master budget
e. analyze a flexible budget based on actual sales (output) volume
f. calculate the sales-volume variance and the sales-price variance by comparing the
flexible budget to the master (static) budget
g. calculate the flexible-budget variance by comparing actual results to the flexible budget
n. calculate a sales-mix variance and explain its impact on revenue and contribution margin
1 Budgets and Variances LOS 1C1a
LOS 1C1b
Managers compare actual performance with expected (budgeted) results to determine
variances. The review and analysis of variances are done periodically as a control and
performance management tool. Managers of cost centers are evaluated based on actual costs
and how much they deviate from planned costs; managers of revenue centers are evaluated
based on the revenues they actually achieve compared with budgeted revenues; and managers
of profit centers are evaluated based on the level of profit their units achieve compared with
the planned level of profits. Variances occur when volume, costs, and/or sales prices differ from
budget and when resources are used more or less efficiently than planned.
© Becker Professional Education Corporation. All rights reserved. Module 1 4–3 C.1. Cost a
1 C.1. Cost and Variance Measures: Part 1 PART 1 UNIT 4
LOS 1C1c 2 Variance Analysis Using the Master Budget
Comparison of actual results to the master budget is the most basic form of variance analysis.
2.1 Annual Budgets and Performance Reports

The master budget (also called the annual budget or annual business plan) is prepared
assuming a single level of activity. This level of activity is the forecasted sales volume that was
estimated at the beginning of the budget process.
Example 1 Budget vs. Plan Performance Report
Facts: Neostar Corporation has prepared its annual business plan for Year 1. The
organization anticipated that it would sell 10,000 units of its product at $15 apiece, that
its contribution margin percentage would be 20 percent, and that its fixed costs would be
$25,000. Actual units sold numbered only 8,000 (totaling $112,000 in revenue); variable
expenses materialized at $100,800 and fixed costs materialized at $24,000.
Required: Prepare a performance report comparing actual versus budgeted results.
Solution:
Budget Actual Variance

Revenue $150,000 $112,000 $(38,000) Unfavorable
Variable expenses (120,000) (100,800) 19,200 Favorable
Contribution margin 30,000 11,200 (18,800) Unfavorable
Fixed costs (25,000) (24,000) 1,000 Favorable
Operating income $ 5,000 $ (12,800) $(17,800) Unfavorable
Variances need significant analysis before they are useful. The favorable variance in
variable expenses, for example, does not represent efficiencies. Budgeted contribution
margin ratios are 20 percent; actual contribution margin ratios are 10 percent. Sales in
units were off budget by 20 percent, yet revenue was down by 25 percent. Something is
very wrong at Neostar, but what?
2.2 Benefits and Limitations of Measuring Actual

LOS 1C1d Performance Based on Master Budget Variances
Performance reports based on the master budget can be used to identify variances that require
further investigation. However, they do not produce effective management by exception data
because variance analysis using the master budget does not isolate variances due to efficiencies
or inefficiencies from variances due to volume (i.e., selling or producing more or less than the
amounts in the master budget).
4–4 Module 1 C.1. Cost

© Becker Professional Education and Variance
Corporation. Measures:
All rights reserved.Part 1
PART 1 UNIT
1 4 C.1. Cost and Variance Measures: Part 1
2.3 Use of Flexible Budgets to Analyze Performance LOS 1C1e

Budget variance analysis using flexible budgets allows managers to separate LOS 1C1g
volume variances from efficiency variances. Flexible budgets are budgets presented for multiple
sales volumes, more accurately reflecting expected costs based on actual output. Flexible budget
variances are a better measure of performance than master budget variances because they
compare actual revenues and actual costs with budgeted revenues and budgeted costs for the
same level of output.
Example 2 Flexible Budget Performance Report
Facts: Management at Neostar has heard that flexible budgeting can provide more
meaningful information.
Required: Prepare a flexible budget using the same information described in Example 1.
Solution:
Neostar Corporation
Flexible Budget Performance Report
For the year ended December 31, Year 1
Flexible
Budget Sales
Actual Flexible @ Actual Activity
Results Budget (Planned (Volume) Master
@ Actual Variances Cost) Variances Budget
Units 8,000 8,000 10,000
Sales $112,000 $ (8,000) $120,000 $(30,000) $150,000
Variable costs (100,800) (4,800) (96,000) 24,000 (120,000)
Contribution margin 11,200 (12,800) 24,000* (6,000) 30,000*
Fixed costs (24,000) 1,000 (25,000) – (25,000)
Operating income $ (12,800) $(11,800) $ (1,000) $ (6,000) $ 5,000
Flexible budget variances (11,800)

Sales activity (volume) variances (6,000)
Total master budget variances (17,800)
*24,000 / 120,000 = 20%

30,000 / 150,000 = 20%
Flexible budget variances show that revenue per unit was less than expected and variable
costs per unit were greater than expected. The company has performed $11,800 worse
than expected. Meanwhile, differences in volume produced a $6,000 unfavorable variance,
yielding a total variance from the budget of $17,800.
The variance does not identify the problem, but points management in the right direction.
Revenue is not materializing as expected despite efforts to discount our selling price
(producing an unfavorable sales price variance of $8,000), and expenses are over budget
(producing an unfavorable variable cost variance of $4,800 despite a favorable fixed-cost
variance of $1,000).
LOS 1C1f 3 Sales Variances
Sales variance analyses can be used to evaluate the effectiveness of an entity's identification of
target markets and its strategies to capture those markets.
3.1 Sales Variance Analysis

The sales variance (the difference between actual sales revenue and budgeted sales revenue)
has two main components: the sales price variance and the sales volume variance.
Sales price variance
= Actual quantity sold × (Actual price – Standard price)
= AQsold × (AP – SP)
Sales
variance
Sales volume variance
= Standard Price × (Actual quantity – Standard quantity)
= SP × (AQ – SQ)
3.1.1 Sales Price Variance

The sales price variance measures the aggregate effect of an actual sales price that differs from
the budgeted sales price.
= Actual quantity sold × (Actual price – Standard price)

Sales price
variance
= AQsold × (AP – SP)
A favorable variance exists when the actual selling price is higher than budget and an
unfavorable variance occurs when the actual selling price is less than the budgeted sales price.
Example 3 Sales Price Variance
Facts: In Cascade Company's January budget, the company shows 3,000 budgeted units
sold, a sale price of $16 per unit, and variable costs of $10 per unit. The company actually
sells 4,000 units at a price of $14 per unit.
Required: Calculate Cascade's sales price variance for January.
Solution: Sales price variance = AQsold × (AP – SP) = ($14 – $16) × 4,000 = $8,000 unfavorable.
This variance is unfavorable because the per-unit selling price was less than anticipated.

PART 1 UNIT
3.1.2 Sales Volume Variance

The sales volume variance is a flexible budget variance that quantifies the degree to which total
sales variances are traceable to variances in sales volume or the number of units sold. The basic
sales volume variance is:
= Standard Price × (Actual quantity – Standard quantity)
Sales
volume
variance
= SP × (AQ – SQ)
A favorable variance exists when more units are sold than budgeted, and an unfavorable
variance occurs when fewer units are sold than budgeted.
Example 4 Sales Volume Variance
Facts: In Cascade Company's January budget, the company shows 3,000 budgeted units
sold, a sale price of $16 per unit, and variable costs of $10 per unit. The company actually
sells 4,000 units at a price of $14 per unit.
Required: Calculate Cascade's sales volume variance for January.
Solution: Sales volume variance = SP × (AQ – SQ) = $16 × (4,000 – 3,000) = $16,000
Favorable. This variance is favorable because the company sold more units than it
anticipated.
3.2 Sales Mix Variance LOS 1C1n
The sales mix variance considers the impact of multiple products on the projected and actual
sales volume of an organization. Anticipated sales revenue is often derived from the sale of
multiple products with different contribution margins. If sales volume meets projections but
occurs in a ratio different from the anticipated sales mix, sales revenue and net income may
differ from the budget.
Actual Budgeted Total number Budgeted

sales mix sales mix of units of contribution
Sales mix variance
ratio for ratio for all products margin per
a product a product sold u n it of product
Illustration 1 Sales Mix Variance
Neostar Corporation has two products: the Nova and the Sunbeam. Despite the total
combined sales volume of both products (in units) having materialized as expected, the
company's net income has not met management's expectations. Sales mix variance
analysis can be used to analyze this variance.
Begin by comparing the master budget with the actual results for the period, determining
the difference in the sales mix ratio, and then applying that difference to the contribution
margin per unit and weighting that result by total units.
Neostar Corporation
Sales Mix Variance
Master Budget
Nova Sunbeam Total
Total Per Unit Total Per Unit Total Per Unit
Units 4,000 6,000 10,000
Sales $100,000 $ 25.00 $45,000 $ 7.50 $ 145,000 $ 14.50
Variable costs (80,000) (20.00) (20,000) (3.33) (100,000) (10.00)
Contribution margin 20,000 $ 5.00 25,000 $ 4.17 45,000 $ 4.50
Fixed costs (10,000) (15,000) (25,000)
Operating income $ 10,000 $10,000 $ 20,000
Actual Results
Nova Sunbeam Total
Total Per Unit Total Per Unit Total Per Unit
Units 1,000 9,000 10,000
Sales $ 25,000 $ 25.00 $67,500 $ 7.50 $ 92,500 $ 9.25
Variable costs (20,000) (20.00) (30,000) (3.33) (50,000) (5.00)
Contribution margin 5,000 $ 5.00 37,500 $ 4.17 42,500 $ 4.25
Fixed costs (10,000) (15,000) (25,000)
Operating income $ (5,000) $22,500 $ 17,500
Computation of Sales Mix Ratio

Budgeted
Product Budgeted Units Sales Mix* Actual Units Actual Sales Mix**
Nova 4,000 40% 1,000 10%
Sunbeam 6,000 60% 9,000 90%
Total 10,000 100% 10,000 100%
*4,000 ÷ 10,000 = 40%; 6,000 ÷ 10,000 = 60%

**1,000 ÷ 10,000 = 10%; 9,000 ÷ 10,000 = 90%
(continued)

PART 1 UNIT
(continued)
(E)
(A) (B) (C) = (B) – (A) (D) Contribution (C) × (D) × (E)
Budget Actual Difference Total Units Margin Variance
Nova sales mix 40% 10% (30%) 10,000 5.00 (15,000)
Sunbeam sales mix 60% 90% 30% 10,000 4.17 12,500
Total (2,500)
The unfavorable sales mix variance of $2,500 comprises a $15,000 unfavorable sales
mix variance for Nova and a $12,500 favorable sales mix variance for Sunbeam.
Selling more of the product with the lower contribution margin has created the overall
unfavorable variance.
Question 1 MCQ-12095
Sellex Co. prepared the following master budget at the beginning of the current year on
forecasted sales of 100,000 units of output.
Sales revenue $1,500,000

Direct materials 300,000
Direct labor 200,000
Factory overhead 500,000
Selling and administrative expenses 120,000
Operating income $ 380,000
Sixty percent of the factory overhead costs are fixed and 20 percent of the selling and
administrative costs are fixed.
At the end of the period, actual sales volume was lower than forecasted due to changes
in the economic environment. Actual sales volume was 85,000 units. The flexible budget
operating income at the end of the year is:
a. $323,000
b. $274,400
c. $598,400
d. $425,000
A company sells books and CDs. The following information is collected from the records of
the company showing actual sales and budgeted sales of each item. Also, the standard and
actual contribution margins are presented in the table showing results for the year.
Actual Actual Standard

Quantity Contribution Contribution Budgeted
Sold Margin Margin Sales
Books 10,000 $40 $38 12,000
CDs 8,000 $12 $10 10,000
Given this information, the sales mix variance for the period is:
a. $5,100 favorable
b. $5,000 unfavorable
c. $110,100 unfavorable
d. $96,000 unfavorable

2
MODULE
PART 1 UNIT 4
C.1. Cost and Variance

Measures: Part 2
Part 1
Unit 4
CMA LOS Reference: Part 1—Section C.1. Cost and Variance Measures: Part 2

h. investigate the flexible-budget variance to determine individual differences between
actual and budgeted input prices and input quantities
i. explain how budget variance reporting is utilized in a management-by-exception
environment
j. define a standard cost system and identify the reasons for adopting a standard
cost system
k. demonstrate an understanding of price (rate) variances and calculate the price
variances related to direct material and direct labor inputs
l. demonstrate an understanding of efficiency (usage) variances and calculate the
efficiency variances related to direct material and direct labor inputs
m. demonstrate an understanding of spending and efficiency variances as they relate to
fixed and variable overhead
o. calculate and explain a mix variance
p. calculate and explain a yield variance
q. demonstrate how price, efficiency, spending, and mix variances can be applied in
service companies as well as manufacturing companies
r. analyze factory overhead variances by calculating variable overhead spending
variance, variable overhead efficiency variance, fixed overhead spending variance, and
production volume variance
s. analyze variances, identify causes, and recommend corrective action
1 Management by Exception and Standard Costing
1.1 Management by Exception LOS 1C1i
Management by exception is a practice in which managers focus on areas that have the largest
variances from standards or budget, whether positive or negative. The objective is to focus
efforts on the problem areas that require analysis and correction. Analysis of both favorable and
unfavorable variances can lead to performance improvements.
LOS 1C1j 1.2 Standard Costing System

A standard costing system is the accounting system that captures standard costs per unit of
output. It can be used with a job-order costing system or a process costing system. Standard
costing systems are the most common cost measurement systems. Aggregate standard costs
measure the costs the firm expects to incur during production. In a standard costing system,
standard costs are budgeted for all manufacturing costs (i.e., raw materials, direct labor, and
manufacturing overhead).
Standard costing systems are needed when a company uses flexible budgeting; one is useless
without the other. Under standard costing, costs are applied to each unit of product as follows:
The standard input is the quantity of input allowed for a unit of actual output.
The standard price of a unit of input is the estimated price per unit of input used in the
production of a unit of output.
The standard cost of a unit of production includes all factors of production; direct materials
(DM), direct labor (DL), and factory overhead (OH).
1.2.1 Standard Direct Materials

The standard direct materials cost is applied to a unit of output by multiplying the standard
quantity of materials allowed for the production of one unit of output by the standard price per
unit of materials.
Standard quantity
Standard price of materials
Standard DM = ×
per unit allowed for one
unit of production
1.2.2 Standard Direct Labor

The standard direct labor cost is applied to a unit of output by multiplying the standard quantity
of hours allowed for the production of one unit of output by the standard rate per direct
hour of labor.
Standard hours
Standard rate per unit allowed
Standard DL = ×
per labor hour for one unit of
production
1.2.3 Standard Overhead

The standard overhead cost is applied by multiplying a predetermined overhead application
rate per direct labor hour (or another appropriate cost driver) by the standard number of hours
allowed for the production of a unit of output.
Standard
Standard cost
Standard OH = (predetermined) ×
driver per unit
application rate

PART 1 UNIT
1.3 Purposes of Standard Costing Systems

A standard costing system is used to estimate the allowed cost of the production processes. It
starts with estimating the standard materials, labor, and manufacturing overhead allowed for
the production of one unit of output. Actual production is then recorded at the standard cost
and compared with the actual costs of production at the end of the accounting period. This
system serves the following purposes:
Cost Control: The standard costing system is useful for product costing and cost control.
Performance Evaluation (Variance Analysis): Standard costing allows for the calculation
of variances at the end of the accounting period through the accumulation of both actual
and standard cost information.
Process Improvement: Management can improve the production process using periodic
evaluation and revision of standards.
Simplified Bookkeeping: Only records of quantities are kept, and cost is the standard cost
set for the period. For example, in process costing, when large quantities of similar items are
produced, the cost of each equivalent unit is determined using standard cost, eliminating
unnecessary unit cost fluctuation.
1.4 Variance Calculations Using Standards LOS 1C1h
The objective of using a standard costing system is to attain a realistic, predetermined cost
for use in the budget process, planning, and decision making. To better control operations,
flexible budget cost variances can be divided into materials variances, labor variances, and
manufacturing overhead variances. Comparing actual costs of inputs with those allowed per the
budget standard provides information on the efficiency and effectiveness of operations.
1.4.1 Evaluating Variances From Standard

A variance may be either favorable (F is used in the examples to identify favorable variances) or
unfavorable (U is used in the examples to identify unfavorable variances). Favorable variances
cause operating income to be higher than the budgeted income for the actual level of activity,
either due to higher actual revenue or lower actual expenses when compared with the budget.
Unfavorable variances cause actual operating income to be lower than the budgeted income for
the actual level of activity, either due to lower actual revenue or higher actual expenses when
compared with the budget. If a variance from standard could have been prevented, it is called a
controllable variance; if not, the variance is known as an uncontrollable variance.
1.4.2 Product Costs Subject to Variance Analysis

Product costs consist of direct materials, direct labor, and manufacturing overhead. Variances
are typically calculated for each of the following cost elements:
Direct materials (DM)
Direct labor (DL)
Variable manufacturing overhead (VOH)
Fixed manufacturing overhead (FOH)
LOS 1C1k
2 Direct Materials and Direct Labor Variance
LOS 1C1l
LOS 1C1s For direct materials (DM) and direct labor (DL), two variances are typically calculated: a price
(rate) variance and a quantity (efficiency) variance. The price (rate) variance relates to the actual
amount paid compared with the standard price (rate) allowed. The quantity (efficiency) variance
relates to the amount of a resource actually used compared with the standard amount allowed.
Variance calculations may be calculated with an equation or placed in a tabular format.
2.1 Calculations: Equation Format
DM price variance
= Actual quantity purchased × (Actual price – Standard price)
= AQpurchased × (AP – SP)
DM quantity usage variance
= Standard price × (Actual quantity used – Standard quantity allowed)
= SP × (AQused – SQallowed)
DL rate variance
= Actual hours worked × (Actual rate – Standard rate)
= AH × (AR – SR)
DL efficiency variance
= Standard rate × (Actual hours worked – Standard hours allowed)
= SR × (AH – SH)
Materials and labor variances are expense variances. When the actual price/rate or the actual
quantity/hours exceed standard amounts, variances are unfavorable. If actuals are less than
standards, variances are favorable.

PART 1 UNIT
2.2 Calculations: Tabular Format

The tabular format results in the same variance as the equation. Using the tabular format, the
variance is computed by comparing two totals. If a figure on the left (actual) is larger than a figure
on the right (standard), then the variance is unfavorable; if the figure on the left (actual) is less than
the figure on the right (standard), the variance is favorable. The specific variances follow:
Tabular Format
Direct materials
Actual quantity Actual quantity Standard quantity

purchased × Actual purchased × Standard allowed × Standard
price price price
[AQpurchased × AP] [AQpurchased × SP]
Price variance
Actual quantity used × Standard quanity
Standard price allowed × Standard price
[AQused × SP] [Actual output × SQallowed × SP]
Quantity usage variance
Note that the materials price variance is calculated at the point of purchase
based on quantities purchased, while the usage variance is based on
quantities of materials used.
Direct labor
Actual hours used × Actual hours used × Standard hours allowed ×
Actual rate Standard rate Standard rate
[AH × AR] [AH × SR] [SH × SR]
Rate variance Efficiency variance
Illustration 1 Materials Variances Using Equation and Tabular Formats
Actual quantity purchased 200 units

Actual quantity used 110 units
Units standard quantity 100 units
Actual price paid $8 per unit
Standard price $10 per unit
DM price variance = AQpurchased × (AP − SP)

= 200 units × ($8/unit – $10/unit)
= $400 Favorable
DM quantity variance = SP × (AQused – SQallowed)
= $10/unit × (110 units – 100 units)
= $100 Unfavorable
(continued)
(continued)
Actual quantity Actual quantity Standard quantity

purchased × Actual price purchased × Standard price allowed × Standard price
200 × $8 = $1,600 200 × $10 = $2,000 100 × $10 = $1,000
Price variance = $400 F
Actual quantity used × Standard price
Quantity usage variance
110 × $10 = $1,100
= $100 U
A favorable price variance means the purchasing department was able to purchase
materials at a lower price (e.g., a volume discount or lower-quality item). An unfavorable
quantity usage variance could be due to inefficiencies in the production process or
low‑quality materials.
Illustration 2 Labor Variances Using Equation and Tabular Formats
Actual hours worked 450 hours

Standard hours 500 hours
Actual paid rate $20 per hour
Standard rate $15 per hour
DL rate variance = AHworked × (AR − SR)

= 450 hours worked × ($20/hour − $15/hour)
= $2,250 Unfavorable
DL efficiency variance = SR × (AHworked − SHallowed)
= $15/hour × (450 hours worked − 500 hours allowed)
= $750 Favorable
Actual hours × Actual rate Actual hours × Standard rate Standard hours
allowed × Standard rate
450 × $20 = $9,000 450 × $15 = $6,750 500 × $15 = $7,500
Rate variance = $2,250 U Efficiency variance = $750 F
Paying a higher rate to workers may mean that higher-skilled labor was employed to
perform the job. Well-trained workers with more experience tend to make higher wages,
but may be more efficient in performing work, resulting in a favorable efficiency variance.

PART 1 UNIT
2.3 Multiple Materials Variances LOS 1C1o

When more than one type of material is used to produce a unit, the materials quantity variance LOS 1C1p
is further divided into a mix variance and a yield variance. Variances will result because of the
change in the relative mix of the different materials used in production. For example, changing
the mixture from 40 percent of Material A and 60 percent of Material B to 30 percent of A and 70
percent of B will cause variances from plan.
To calculate these subvariances, the weighted average price of the actual mix (WASPA mix)
is compared with the weighted average price of the standard mix (WASPS mix). The materials
quantity mix variance results from changes in the actual mix of materials used compared with
the planned standard mix of materials. The materials yield variance results from changes in
the actual total quantity used of all types of materials compared with the planned quantity for
the actual output. Changing the mix of ingredients is possible in some industries, such as the
production of cereals or animal feed, but impossible in other industries, such as the production
of medicine.
Weighted average standard price for the actual mix (WASPA mix):
(Actual quantity of Material A × Standard price)
+ (Actual quantity of Material B × Standard price)
WASPA mix =
Actual quantity of Material A
+ Actual quantity of Material B
Weighted average standard price for the standard mix (WASPS mix):
(Standard quantity of Material A × Standard price)
+ (Standard quantity of Material B × Standard price)
WASPS mix =
Standard quantity of Material A
+ Standard quantity of Material B
The sum of
DM mix variance = total quantities × (WASPA mix – WASPS mix)
of materials used
 The sum of The sum of 

DM yield variance = WASPS mix ×  total quantities − total quantities 
 
of materials used of materials allowed
Illustration 3 Materials Price and Efficiency Variances
Actual output 1,500 units

Actual quantity of Material X used to produce the actual output 5,000 kg
Actual quantity of Material Y used to produce the actual output 6,500 kg
Standard units of Material X needed for the production of one unit 3 kg per unit @ $3/kg
Standard units of Material Y needed for the production of one unit 5 kg per unit @ $4/kg
Actual price paid for Material X $2.50 per kg
Actual price paid for Material Y $5.00 per kg
Actual quantity × Actual quantity × Standard quantity

Actual price Standard price allowed × Standard price
X: 5,000 × $2.50 = $12,500 X: 5,000 × $3.00 = $15,000 X: (1,500 × 3 kg) × $3.00 = $13,500
Y: 6,500 × $5.00 = $32,500 Y: 6,500 × $4.00 = $26,000 Y: (1,500 × 5 kg) × $4.00 = $30,000
Total = $45,000 Total = $41,000 Total = $43,500
Price variance = $4,000 U Efficiency variance = $2,500 F
The total price variance is unfavorable because the total price paid exceeds the planned combined
standard price for both materials. The efficiency variance is favorable because the total actual
quantity of all materials used to produce the actual output is less than the standard quantity of all
materials allowed for actual production.
The materials quantity (efficiency) variance of $2,500 F can be further understood by calculating the
mix and yield variances:
1. Calculate the weighted average standard price for the actual mix and the standard mix as follows:
a. The weighted average standard price for the actual mix (WASPA mix) = $3.565 calculated as
follows:
(A) (B) (A) × (B)
Actual Standard Total Standard
Materials Quantity Price/Unit Price
X 5,000 kg $3.00 $15,000
Y 6,500 kg $4.00 $26,000
Total 11,500 kg $41,000
$41,000
WASPA mix = = $3.565
11,500
(continued)

PART 1 UNIT
(continued)
b. The weighted average standard price for the standard mix (WASPS mix) = $3.625 calculated
as follows:
(A) (B) (A) × (B)
Quantity Allowed for Standard Total Standard
Materials Actual Production Price/Unit Price
X 1,500 × 3 kg = 4,500 kg $3.00 $13,500
Y 1,500 × 5 kg = 7,500 kg $4.00 $30,000
Total 12,000 kg $43,500
$43,500
WASPS mix = = $3.625
12,000
2. The second step is to calculate the variances using the aggregate quantities and the weighted
average price as follows (calculated in 1a and 1b above):
Actual mix × WASPA mix Actual mix × WASPS mix Standard mix × WASPS mix
11,5001(a) × $3.5651(a) = $41,000 11,5001(a) × $3.6251(b) = $41,688 12,0001(b) × $3.6251(b) = $43,500
Mix variance = $688 F Yield variance = $1,812 F
Materials efficiency (quantity) variance = $2,500 F
Note that calculating the mix variance is similar to calculating a price variance. Because
the weighted average standard price for the actual mix ($3.565) is lower than the weighted
average standard price for the standard mix ($3.625), the mix variance is favorable. The
yield variance is similar to efficiency variance, focusing on the total quantity of materials
used in production. The actual kilograms of materials used in production are 11,500 kg
compared with 12,000 kg allowed for production, resulting in a favorable variance.
2.4 Multiple Labor Class Variances

When multiple classes of labor that are paid different rates are used to produce a unit of output,
the labor efficiency variance can be divided into a mix variance and a yield variance. Hiring an
engineer to perform a task that a machinist can perform will lead to a higher total cost because
the engineer is likely paid a higher hourly rate compared with the machinist.
The labor mix variance results from changes in the weighted average rate for labor used
because of a change in the actual mix compared with the standard mix. The labor yield variance
results from changes in the actual total of hours used by all classes of labor compared with the
planned hours allowed for the actual output.
Weighted average standard rate for the actual mix (WASRA mix):
(Actual hours of group A × Standard rate)
+ (Actual hours of group B × Standard rate)
WASRA mix =
Actual hours of group A
+ Actual hours of group B
Weighted average standard rate for the standard mix (WASRS mix):
(Standard hours of group A × Standard rate)
+ (Standard hours of group B × Standard rate)
WASRS mix =
Standard hours of group A
+ Standard hours of group B
The sum of
DL mix variance = total hours × (WASRA mix – WASRS mix)
worked
The sum of The sum of

DL yield variance WASRS mix total hours total hours

worked allowed

PART 1 UNIT
Illustration 4 Labor Mix and Yield Variances
Actual output 1,500 units

Actual quantity of skilled labor hours used to produce the actual output 5,000 hours
Actual quantity of unskilled labor hours used to produce the actual output 6,500 hours
Standard hours of skilled labor allowed to produce one unit of output 3 hours per unit
@ $10/hour
Standard hours of unskilled labor allowed to produce one unit of output 6 hours per unit
@ $4/hour
Actual rate paid for skilled labor $12.00 per hour
Actual rate paid for unskilled labor $5.00 per hour
Actual hours × Actual hours × Standard hours

Actual rate Standard rate allowed × Standard rate
Skilled: 5,000 × $12.00 Skilled: 5,000 × $10.00 Skilled: (1,500 × 3 hours) × $10.00
= $60,000 = $50,000 = $45,000
Unskilled: 6,500 × $5.00 Unskilled: 6,500 × $4.00 Unskilled: (1,500 × 6 hours) × $4.00
= $32,500 = $26,000 = $36,000
Total = $92,500 Total = $76,000 Total = $81,000
Rate variance = $16,500 U Efficiency variance = $5,000 F
The rate variance is unfavorable because the actual rate paid to both groups exceeds the standard
rates. The efficiency variance is favorable because the total number of actual hours worked for the
actual output is less than the number of hours allowed for actual production.
The labor efficiency variance of $5,000 favorable can be further divided into two variances as follows:
1. Calculate the weighted average standard price for the actual mix and the standard mix as follows:
a. The weighted average standard rate for the actual mix (WASRA mix) = $6.609 calculated
as follows:
(A) (B) (A) × (B)
Actual Standard Total Standard
Labor Hours Price/Hour Rate
Skilled 5,000 hours $10.00 $50,000
Unskilled 6,500 hours $4.00 $26,000
Total 11,500 hours $76,000
$76,000
WASRA mix = = $6.609
11,500
(continued)
(continued)
b. The weighted average standard rate for the standard mix (WASRS mix) = $6.00 calculated
as follows:
(A) (B) (A) × (B)
Hours Allowed for Standard Total Standard
Labor Actual Production Rate/Hour Rate
Skilled 1,500 × 3 hours = 4,500 hours $10.00 $45,000
Unskilled 1,500 × 6 hours = 9,000 hours $4.00 $36,000
Total 13,500 hours $81,000
$81,000
WASRS mix = = $6.00
13,500
2. The second step is to calculate the variances using the aggregate number of hours and the
weighted average rates as follows (calculated in 1a and 1b above):
Actual mix × WASRA mix Actual mix × WASRS mix Standard mix × WASRS mix
11,5001(a) × $6.6091(a) = $76,000 11,5001(a) × $6.001(b) = $69,000 13,5001(b) × $6.001(b) = $81,000
Mix variance = $7,000 U Yield variance = $12,000 F
Labor efficiency variance = $5,000 F
The mix variance is similar to a price variance. Because the weighted average standard rate for the
actual mix ($6.609) is higher than the weighted average standard rate for the standard mix ($6), the
mix variance is unfavorable. The yield variance is similar to the efficiency variance, focusing on the
total number of hours used in production. The production hours are 11,500 actual hours compared
with 13,500 standard hours allowed at the actual volume, leading to a favorable variance.

PART 1 UNIT
3 Manufacturing Overhead Variances LOS 1C1m
LOS 1C1r
The analysis of manufacturing overhead starts with a comparison of the actual overhead
incurred with applied overhead in that same period, also known as the one-way variance.
Overapplied overhead (actual < applied) is favorable, and underapplied overhead
(actual > applied) is unfavorable. Overhead is estimated and applied based on a predetermined
overhead application rate.
3.1 Overhead Variance Methods

Four different levels of overhead variance analysis can be performed. Four-way variance analysis
is the most informative because it separates fixed overhead variances from variable overhead
variances. The one-, two- and three-way analyses are less detailed and do not focus on the
separation of actual overhead costs into fixed and variable components.
3.1.1 One-way Variance

One-way variance analysis of overhead focuses on the difference between actual overhead costs
and applied overhead costs (called underapplied or overapplied overhead).
The overapplied or underapplied OH = Total actual OH – Total OH applied
Total overhead overapplied or underapplied

(all overhead costs)
Applied OH:
Actual OH: (1) Fixed OH = Actual output × Standard

− FOH rate/hour
Total fixed and variable overhead
(2) Variable OH = Actual output × Hours
allowed/unit × Standard VOH rate/hour
3.1.2 Two-way Variance

Two-way variance analysis of overhead divides the one-way variance into the flexible budget
variance and the volume variance.
Overapplied or Flexible budget Production

= +
underapplied OH OH variance volume variance
Where:
Flexible budget Flexible budget total OH

= Actual total OH –
OH variance (based on hours allowed)
Production Flexible budget Fixed OH applied

= –
volume variance* fixed OH to actual production
*Production volume variance is also calculated using the shortcut:
FOH application rate × (Actual output – Forecasted output)
Actual OH: Flexible budget (based on hours Applied OH:

allowed to produce actual output):
Total (1) Fixed OH = Actual output ×
fixed and (1) Fixed OH is the amount Hours allowed/unit × Standard
variable budgeted in total FOH rate/hour
overhead
(2) Variable OH = Actual output × (2) Variable OH = Actual output ×
Hours allowed/unit × Standard Hours allowed/unit × Standard
VOH rate/hour VOH rate/hour
Flexible budget
Production volume
overhead variance
variance (fixed OH only)
(all overhead costs)
Flexible Budget Overhead Variance

This is a measure of the difference between actual total overhead and the flexible budget
overhead built on the basis of inputs allowed for the production of actual output.
Production Volume Variance
Fixed overhead costs are typically applied using a cost driver. When the actual volume
produced differs from the amount used to calculate the budgeted fixed overhead
application rate, there will be a variance. A favorable variance occurs when volume is higher
than anticipated; more units were produced using the same amount of fixed resources,
which represents proper utilization of capacity. An unfavorable variance occurs when
volume is lower than anticipated, which means capacity was not fully utilized.

PART 1 UNIT
3.1.3 Three-way Variance

Three-way variance analysis further divides the flexible budget overhead variance into a
spending variance and an efficiency variance.
Flexible budget Total OH spending Variable OH

= +
OH variance variance efficiency variance
Where:
Total OH spending Flexible budget total OH

= Actual total OH –
variance (based on actual hours used)
Variable OH Flexible budget variable OH Flexible budget variable OH

= –
efficiency variance (based on actual hours) (based on hours allowed)
Actual OH: Flexible budget Flexible budget Applied OH:

(based on actual (based on hours
Total hours used to allowed to produce (1) Fixed OH =
fixed and produce actual actual output): Actual output ×
variable output): Hours allowed/
overhead (1) Fixed OH is unit × Standard
(1) Fixed OH is the amount FOH rate/hour
the amount budgeted in
budgeted in total (2) Variable OH =
total Actual output ×
(2) Variable OH = Hours allowed/
(2) Variable OH = Actual output × unit × Standard
Actual hours Hours allowed/ VOH rate/hour
used × Standard unit × Standard
Total OH spending Variable

variance (both fixed OH Production volume
and variable OH efficiency variance (fixed OH only)
combined) variance
Total Overhead Spending Variance

The total overhead spending variance represents the difference between the amounts
actually spent for both fixed and variable overhead costs compared with the amounts that
should have been spent for the actual hours used based on the standard rates.
Variable Overhead Efficiency Variance
When direct labor hours are used as the cost driver, the efficiency variance isolates the
amount of total variable overhead variance due to actual hours compared with budgeted
hours, based on actual production. A favorable variance results from using fewer labor
hours than budgeted, and an unfavorable variance comes from using more labor hours
than budgeted. The variance is unfavorable if production takes more hours per unit
than anticipated.
3.1.4 Four-way Variance

Four-way variance analysis is the most informative, and it further divides the total overhead
spending variance into a variable overhead spending variance and a fixed overhead spending
variance.
Total OH Variable OH Fixed OH

= +
spending variance spending variance spending variance
Where:
Variable OH Flexible budget variable OH

= Actual variable OH –
spending variance (based on actual hours used)
Fixed OH Flexible budget fixed OH

= Actual fixed OH –
spending variance (based on actual hours used)
Actual OH: Flexible budget Flexible budget Applied OH:

(based on actual (based on hours
(1) Total fixed hours used to allowed to produce (1) Fixed OH =
and variable produce actual actual output): Actual output ×
(in one-, two-, output): Hours allowed/
and three-way (1) Fixed OH is unit × Standard
variance) (1) Fixed OH is the amount FOH rate/hour
the amount budgeted in total
(2) Fixed is budgeted in total (2) Variable OH =
separated (2) Variable OH = Actual output ×
from variable (2) Variable OH = Actual output × Hours allowed/
for a four-way Actual hours Hours allowed/ unit × Standard
analysis used × Standard unit × Standard VOH rate/hour
Spending variance
Efficiency
Fixed Variable variance Production volume
OH OH (variable variance (fixed OH only)
spending spending
OH only)
variance variance
Variable Overhead Rate (Spending) Variance

Assuming direct labor hours are used as the cost driver, a favorable variance occurs when
the actual rate is less than the standard rate, which is beneficial to a company because it
means that it paid less per labor hour than anticipated. An unfavorable variance occurs
when the actual rate exceeds the standard rate, which means that the company paid more
per labor hour than expected.
Fixed Overhead Budget (Spending) Variance
The fixed overhead budget variance compares actual expenses with budgeted expenses. An
unfavorable variance results when actual fixed overhead costs exceed the budgeted amount
for fixed overhead.

PART 1 UNIT
Example 1 Overhead Variance Calculations
Facts: The following information is taken from the records of a company:

Fixed budgeted overhead costs = $300,000
Variable budgeted overhead = $600,000
Total budgeted units of production = 200,000 units
Standard number of hours needed to produce one unit of output is two hours.
Actual overhead costs for the year = $860,000
Actual number of units produced = 192,000 units using 430,000 labor hours
The company uses the number of labor hours as the basis for allocating overhead costs.
Required:
1. Using the one-way variance, calculate the overapplied or the underapplied overhead.
2. Using the two-way variance, calculate the flexible budget variance and the production
volume variance.
3. Using the three-way variance, calculate the spending variance, the efficiency variance,
and the production volume variance.
4. Using the four-way variance, calculate the spending variance (both fixed and variable
components), the efficiency variance and the production volume variance.
Solution: To properly solve these questions, first determine the overhead application rates
as follows:
Budgeted FOH $300,000

Fixed overhead = = $0.75/hour
= Budgeted
application rate 200,000 units × 2 hours/unit)
number of hours
Budgeted VOH $600,000

Variable overhead = = $1.50/hour
= Budgeted
application rate 200,000 units × 2 hours/unit)
number of hours
1. One-way variance:
Two figures are needed to calculate this variance: the total actual OH and the total
applied OH.
a. Total actual OH is given = $860,000
b. Applied overhead = Fixed overhead applied + Variable overhead applied
= (192,000 units × 2 hours × $0.75) + (192,000 units × 2 hours × $1.50)
= $288,000 + $576,000 = $864,000
c. Actual overhead < Applied overhead → Overapplied → Favorable variance
= $860,000 – $864,000 = $4,000 Favorable
(continued)
(continued)
2. Two-way variance:
Three figures are needed: the total actual OH, the total flexible budget OH based on
hours allowed, and the total applied OH.
b. Applied overhead (from 1b above) = $864,000
c. Total flexible budget OH = Budgeted FOH + VOH based on inputs allowed
= $300,000 + (192,000 units × 2 hours × $1.50) = $300,000 + $576,000 = $876,000
d. Flexible budget variance = Total actual OH – Total flexible budget OH
= $860,000 – $876,000 = $16,000 Favorable
e. Production volume variance = Flexible budget OH – Applied OH
= $876,000 – $864,000 = $12,000 Unfavorable
Note: The sum of the flexible budget variance and the production volume variance
($16,000 favorable + $12,000 unfavorable = $4,000 favorable) is equal to the
overapplied OH calculated in the one-way variance.
3. Three-way variance:
Four figures are needed: the total actual OH, the total flexible budget OH based on
hours allowed, the total applied OH, and a flexible budget based on actual hours used
in production.
b. Applied overhead (from 1b above) = $864,000
c. Total flexible budget OH based on hours allowed (from 2c above) = $876,000
d. Total flexible budget OH based on actual hours used = Budgeted FOH + VOH based
on actual hours
= $300,000 + (430,000 hours × $1.50) = $300,000 + $645,000 = $945,000
e. Spending variance = Total actual OH – Flexible budget OH based on actual hours used
= $860,000 – $945,000 = $85,000 Favorable
f. Efficiency variance = Flexible budget OH based on actual hours used – Flexible
budget based on hours allowed
= $945,000 – $876,000 = $69,000 Unfavorable
g. Production volume variance (from 2e above) = $12,000 Unfavorable
Note: (1) The sum of the flexible budget variance and the efficiency variance ($85,000
favorable + $69,000 unfavorable = $16,000 favorable) is equal to the flexible budget
variance (2d above). (2) The sum of the flexible budget variance, the efficiency variance,
and the production volume variance ($85,000 favorable + $69,000 unfavorable +
$12,000 unfavorable = $4,000 favorable) is equal to the overapplied OH calculated in
the one-way variance.
(continued)

PART 1 UNIT
(continued)
4. Four-way variance:
Four figures are needed: same as the three-way variance with the exception of actual
overhead costs, which is divided into fixed and variable components.
a. Assume the actual fixed overhead cost is $320,000 while the actual variable cost is
$540,000. That is a total of $860,000.
b. The total spending variance of $85,000 favorable (3e above) is divided into:
i. Fixed OH cost spending variance = Actual FOH – Flexible budget FOH cost
= $320,000 – $300,000 = $20,000 Unfavorable
ii. Variable OH cost spending variance = Actual VOH – Flexible budget based on
actual input (from 3d above) $540,000 – $645,000 = $105,000 Favorable
Illustration 5 Summary of Overhead Variances
Actual OH: Flexible budget (based on Applied OH:

Flexible budget (based
hours allowed to produce
(1) Total fixed on actual hours used to (1) Fixed OH =
actual output):
and variable produce actual output): Actual output ×
(in one-, two-, (1) Fixed OH is the amount Hours allowed/
(1) Fixed OH is the amount
and three-way budgeted in total unit × Standard
budgeted in total
variance) FOH rate/hour
(2) Variable OH = Actual
(2) Variable OH = Actual
(2) Fixed is output × Hours allowed/ (2) Variable OH =
hours used × Standard
separated unit × Standard VOH Actual output ×
VOH rate/hour
from variable rate/hour Hours allowed/
for a four-way unit × Standard
analysis VOH rate/hour
Spending variance
Efficiency
Fixed Variable variance Production volume
4-way
OH OH (variable variance (fixed OH only)
spending spending OH only)
variance variance
Spending variance Efficiency

(both fixed and variance Production volume
3-way
variable OH (variable variance (fixed OH only)
combined) OH only)
Flexible budget overhead variance Production volume

2-way
(all overhead costs) variance (fixed OH only)
Total overhead over- or underapplied (all overhead costs) 1-way
Example 2 Manufacturing Overhead Variance: Four-way Analysis
Facts: Lucy Inc. produces widgets and applies overhead costs based on direct labor hours. The table
below provides budgeted and actual information on the number of widgets, labor hours, variable
overhead costs, and fixed overhead costs for January.
Required: Using this information, calculate the rate and efficiency variable overhead variances, the
budget and volume fixed overhead variances, and the overall overhead variance.
Solution:
Number of Widgets
Budgeted number of widgets 4,000 widgets
Actual number of widgets 3,800 widgets
Labor Hours
Standard labor hours required per widget 1.00 labor hour
Standard labor hours total (based on actual 3,800 hours (3,800 widgets × 1.00 labor hour per widget)
production)
Actual labor hours used 3,900 hours
Variable Overhead
Standard VOH rate $1.50 per hour
Actual VOH rate $1.60 per hour
Actual VOH costs $6,240 (3,900 hours × $1.60 per hour)
Fixed Overhead
Standard FOH per widget $3.00 per hour
Budgeted FOH costs $12,000 (4,000 budgeted widgets × 1.00 labor hour
per widget × $3.00 per hour)
Actual FOH costs $10,560
VOH rate (spending): AH × (AR – SR) = 3,900 hours × ($1.60 – $1.50) = $390 Unfavorable since the
actual rate paid per hour is higher than the standard rate per hour.
VOH efficiency: SR × (AH – SHallowed) = $1.50 × [3,900 hours – (3,800 × 1.00 hour)] = $150 Unfavorable
since the actual number of hours worked exceed those allowed for actual production.
FOH budget (spending): Actual FOH – Budgeted FOH = $10,560 – $12,000 = $1,440 Favorable since
the actual spending was less than budgeted.
FOH volume: Budgeted FOH – Standard FOHapplied = $12,000 – *$11,400 = $600 Unfavorable
*3,800 hours budgeted (for production of 3,800 widgets) × $3 per hour
FOH production volume variance is calculated as the difference between the budgeted output (4,000
units) and the actual output (3,800 units) multiplied by the predetermined fixed overhead application
rate ($3 per hour). When the actual output is less than budgeted, the variance is unfavorable because
of unused capacity. The planned capacity of 4,000 units was not achieved.
Adding all of the variances produces a total overall favorable variance of $300: $390U + $150U –
$1,440F + $600U = $300F
Overall variance: Actual total OH – Applied total OH = $16,800 actual – $17,100 applied = $300
favorable, or overapplied. The overapplied overhead must be closed at the end of the accounting
period by reducing the cost of goods sold (if immaterial), or reducing the cost of goods sold, the
finished goods inventory, and work-in-process (when the variance is considered material).
Actual overhead (FOH + VOH): $16,800
Actual FOH: $10,560
Actual VOH: $6,240
(continued)

PART 1 UNIT
(continued)
Applied overhead (FOH + VOH): $17,100

Applied FOH: $11,400 [3,800 standard labor hours (to produce 3,800 widgets) × $3.00 per hour]
Applied VOH: $5,700 [3,800 standard labor hours (to produce 3,800 widgets) × $1.50 per hour]
Summary of results:
One-way analysis:
Overapplied OH = $300 Favorable
Two-way analysis:
Flexible budget variance = $900 Favorable
Volume variance = $600 Unfavorable (fixed only)
Three-way variance:
Spending variance = $1,050 Favorable
Efficiency variance = $150 Unfavorable (variable only)
Four-way variance:
Fixed OH spending variance = $1,440 Favorable (spent less than anticipated on FOH)
Variable OH spending variance= $390 Unfavorable (VOH rate was higher than anticipated)
Efficiency variance = $150 Unfavorable (variable only)
Visual Solution of Overhead Variances:
Actual OH: Flexible budget (based Flexible budget (based Applied OH:
on actual hours used to on hours allowed to
(1) Total fixed and produce actual output): (1) Fixed OH = Actual
produce actual output):
variable (in one-, output × Hours
two-, and three- (1) Fixed OH is the (1) Fixed OH is the allowed/unit × Standard
way variance) amount budgeted in amount budgeted in FOH rate/hour = 3,800
total = $12,000 total = $12,000 × $3 = $11,400
(2) Fixed is
separated from (2) Variable OH = Actual (2) Variable OH = Actual (2) Variable OH = Actual
variable for hours used × Standard output × Hours output × Hours
four-way analysis VOH rate/hour = 3,900 allowed/unit × allowed/unit × Standard
× $1.50 = $5,850 Standard VOH rate/ VOH rate/hour = 3,800
FOH = $10,560 × $1.50 = $5,700
hour = 3,800 × $1.50 =
VOH = $6,240 Total = $17,850
$5,700
Total OH = $16,800 Total = 17,100
Total = $17,700
Spending variance
(fixed (variable Efficiency
OH OH variance Production volume variance
4-way
spending spending (variable OH (fixed OH only) = $600 U
variance) variance) only) = $150 U
= $1,440 F = $390 U
Spending variance Efficiency

(both fixed and variance Production volume variance
(fixed OH only) = $600 U 3-way
variable OH combined) (variable OH
= $1,050 F only) = $150 U
Flexible budget overhead variance (all Production volume variance

2-way
overhead costs) = $900 F (fixed OH only) = $600 U
Total overhead over- or underapplied (all overhead costs) = $300 F 1-way
LOS 1C1q 4 Variances for Service Companies
Like manufacturing companies, service companies prepare annual master budgets and flexible
budgets. Service company product costs include direct labor costs to provide services to
customers and overhead costs.
For example, in an audit practice, the major product input is the number of billable hours
worked on an audit. The entity calculates labor efficiency and rate variances. If it uses more
hours to perform its services than planned or pays a higher rate per hour than planned, it will
end up having unfavorable efficiency and rate variances.
Likewise, if the practice sells more services than planned, then it will have a favorable revenue
quantity variance. If the practice charges a higher rate per hour of service to its clients, then the
sales price variance would be favorable. If the entity provides more than one service, the sales
volume variance is divided into sales mix and quantity variances.
A detailed accounting system able to integrate the budget process and separate revenues and
costs per service is required to perform variance analysis.
Example 3 Service Companies Spending and Efficiency Variances
Facts: Tornado is a fast-delivery company in a major metropolitan area that uses

motorcycles to avoid traffic jams in the city. Tornado allocates variable and fixed overhead
costs based on delivery time. The following information is taken from the records of
Tornado in its first year of operations:
Actual Results Master Budget

Number of deliveries 8,832 10,000
Hours per delivery 2/3
Hours of delivery time 5,800
Variable overhead cost per hour $1.79 $1.55
Variable overhead costs for the year $10,382 $10,333
Fixed overhead costs for the year $39,200 $35,000
Fixed overhead rate per unit $3.50
Fixed OH rate per hour $5.25
The standard hours allowed for actual production = 8,832 × 2/3 = 5,888 hours
Required:
a. Calculate the spending and the efficiency variances for Tornado's variable overhead
costs for the first year of operations.
b. Calculate the spending and production volume variance (denominator-level variance)
for Tornado's fixed overhead costs for the first year of operations.
c. Analyze overhead based on the results from variance analysis.
(continued)

PART 1 UNIT
(continued)
Solution:
a. Variable Overhead Variances
VOH spending variance = Actual hours × (Actual rate – Standard rate) = AH × (AR – SR)
VOH spending variance = 5,800 × ($1.79 – $1.55) = $1,392 Unfavorable
The VOH spending variance is unfavorable because the actual rate paid per hour is $1.79,
which is higher than the standard rate per hour ($1.55).
VOH efficiency variance = Standard rate × (Actual hours – Standard hours allowed for
actual volume)
VOH efficiency variance = SR × (AH – SH) = $1.55 × (5,800 – 5,888) = $163.40 Favorable
b. Fixed Overhead Variances
FOH budget (spending) variance = Actual fixed overhead – Budgeted fixed overhead
= AFOH – BFOH
FOH budget (spending) variance = $39,200 – $35,000 = $4,200 Unfavorable
FOH production volume variance = Budgeted fixed overhead – Standard fixed overhead
cost applied to production* = BFOH – SFOHapplied
FOH production volume variance = $35,000 – (5,888 × $5.25) = $4,088 Unfavorable
Or:
Step 1: C
alculate the fixed overhead application rate = $35,000 ÷ (10,000 delivery ×
2/3 hour) = $5.25 per hour
Step 2: L
ost capacity = Actual hours – Budgeted hours = 5,888 – 6,666.67* = 778.67 hours
*The number of budgeted hours = 10,000 × 2/3 hours = 6,666.67 hours
Step 3: P
roduction volume variance = FOH application rate × (Actual output –
Forecasted output)
Production volume variance = $5.25 × 778.67 hours = $4,088 Unfavorable
c. Analysis
The spending variances for variable and fixed overhead are both unfavorable. This means
that Tornado had actual costs in excess of budget in both cost pools. The favorable
efficiency variance for variable overhead costs results from more efficient use of the cost
allocation base—each delivery takes less than the budgeted 0.66 hours (5,800 hours ÷
8,832 deliveries).
Tornado can manage its fixed overhead costs through long-term capacity planning. This
involves planning to undertake only value-added, fixed-overhead activities and then
determining the appropriate level for those activities. Most fixed overhead costs are
committed well before they are incurred.
For variable overhead, costs are efficiently managed through a mix of long-run planning
and daily monitoring. Tornado should plan to undertake only value-added, variable
overhead activities (a long-run focus) and then manage the cost drivers of those activities
in the most efficient way (a short-run focus). There is no production volume variance for
variable overhead costs. The unfavorable production volume variance for fixed overhead
costs arises because Tornado has unused capacity.
A company produces widgets and budgets 2 pounds of direct materials at a cost of $5 per
pound per widget. Direct labor is budgeted at 0.5 hour per widget at a rate of $15 per hour.
Actual direct material usage in the current year is 25,000 pounds, and it took 3,000 hours to
produce 10,000 widgets. What was the direct labor efficiency variance?
a. $25,000 Favorable
b. $25,000 Unfavorable
c. $30,000 Favorable
d. $30,000 Unfavorable
A company uses standard costing systems for budgeting and control purposes. In the
year just ended, the company used 5,000 pounds of materials to produce 1,700 units of its
finished product. The actual price paid per pound of materials is $4, while the standard price
is $4.50 per pound. Given that the materials quantity (usage) variance is $450 favorable, what
is the standard quantity of materials allowed per unit of finished items?
a. 2.94 pounds per unit
b. 3.00 pounds per unit
c. 4.50 pounds per unit
d. 4.00 pounds per unit
A company produces breakfast cereal using a mix of corn and wheat. The following
information is taken from the records of the company for the month of May:
Actual Quantity Allowed

Materials Used Actual Standard for Actual Output
(Pounds) Price/Pound Price/Pound (Pounds)
Corn 1,000 $10 $9.50 1,250
Wheat 2,000 $14 $12.00 1,750
Using this information, what is the value of materials yield variance for the month of May?
a. $625 Unfavorable
b. $625 Favorable
c. $0 materials yield variance

PART 1 UNIT
A company uses a standard costing system. At the end of the current year, the company
provides the following overhead information:
Variable overhead $90,000

Fixed overhead $62,000
Budgeted fixed overhead $65,000
Variable overhead rate (per direct labor hour) $8.00
Standard hours allowed for actual production 12,000
Actual labor hours used 11,000
What amount is the variable overhead efficiency variance?

a. $8,000 Favorable
b. $8,000 Unfavorable
c. $6,000 Favorable
Using the standard costing system, the company's accountant accumulated the following
data relevant to overhead costs for the month of April:
2,500 Actual units of output

0.50 hours Allowed per unit of output
$19,000 Budgeted fixed OH
1,900 units Budgeted quantity of output
$15 Variable OH rate per hour
Given that information, the fixed overhead production volume variance for the month
of April is:
a. Only calculated for variable overhead
b. $6,000 Favorable
c. $3,750 Favorable
Alberta Manufacturing Co. uses a standard costing system in which it estimates that each
unit of output requires 2 kilograms of material to produce. The standard price per kilogram
of material is $13. The purchasing manager approached a supplier to place an order for the
materials needed for the coming month's production. The supplier offered lower-quality
materials at a lower price. The purchasing manager immediately placed an order to take
advantage of lower prices, which will reflect positively on his performance review. The
possible effect of this decision on labor efficiency variance and the responsible decision
maker for the efficiency variance will be:
Labor Efficiency Variance Responsible Manager

a. Favorable Purchasing manager
b. Unfavorable Purchasing manager
c. Favorable Production manager
d. Unfavorable Production manager

3
MODULE
PART 1 UNIT 4
C.2. Responsibility
Centers
Part 1
Unit 4
CMA LOS Reference: Part 1—Section C.2. Responsibility Centers

a. identify and explain the different types of responsibility centers
b. recommend appropriate responsibility centers given a business scenario
c. calculate a contribution margin
d. analyze a contribution margin report and evaluate performance
e. identify segments that organizations evaluate, including product lines, geographical
areas, or other meaningful segments
f. explain why the allocation of common costs among segments can be an issue in
performance evaluation
g. identify methods for allocating common costs such as stand-alone cost allocation and
incremental cost allocation
1 Types of Responsibility Centers LOS 1C2a
LOS 1C2b
Responsibility centers, or strategic business units (SBUs), are generally classified by four
financial measures (performance objectives) for which managers may be held accountable. SBUs
are highly effective in organizing performance requirements and in establishing accountability
for financial responsibility. Performance reporting for each of these SBUs is tailored to reflect
the nature of the financial measure.
Cost Center
Managers are responsible for controlling costs.
Revenue Center
Managers are responsible for generating revenues.
Profit Center
Managers are responsible for producing a target profit (accountability for both revenues
and costs).
Investment Center
Managers are responsible for return on the assets invested to produce the earnings
generated by the SBU.
© Becker Professional Education Corporation. All rights reserved. Module 3 4–37

3 C.2. Responsibility Centers PART 1 UNIT 4
Illustration 1 Examples of Responsibility Centers
Cost Center
A cleaning department at a department store is a cost center. The goal of the cleaning
department is to minimize costs while keeping the store clean. The cleaning department
manager and the upper-level managers must work together to set the goals of the cost
center to satisfy the strategic goals of the business; that is, maintaining a clean store
while minimizing the cleaning department costs. Other examples of cost centers within a
company include human resources and IT departments.
Revenue Center
The sales department of a merchandising firm is an example of a revenue center. The
employees should be well-trained in providing excellent customer service, handling
customer complaints, and converting customer interactions into sales. Upper-level
managers evaluate the performance of the sales department manager based on the
amount of revenue his/her department generates. Each salesperson may be considered
a revenue center because the person's performance is evaluated based on the sales
(revenues) he or she generates for the company.
Profit Center
A store location of a chain of restaurants is a profit center. The manager of the store is
responsible for maximizing revenues and minimizing costs to maximize store profits. This
should be done while meeting the overall strategic goals of the organization.
Investment Center
A subsidiary located in a certain region is an investment center. The head of the subsidiary
is responsible for determining the amounts to be invested in capital assets in new projects
and is also responsible for the revenues and costs generated from these investments.
Return on investment is an appropriate performance measure.
LOS 1C2e 2 Reporting Segments
The effectiveness of each responsibility center is often subdivided into additional areas of
accountability, including:
Product Lines or Service
Some strategic business units involve multiple products or services. Costs, sales, profits,
or returns associated with each of these products or services can be analyzed for further
insight into the sources of profits or losses. If a company produces three products, a
manager for each product line is identified. That manager is responsible for all activities
related to that product.
Geographic Areas
Strategic business units also cross geographic boundaries. Performance can generally
be traced by geographic location or geographic market to provide additional insight into
results. When a company operates in different regions, a manager is identified for each
geographic region.
4–38 Module 3 C.2. Responsibility

© Becker Professional Education Corporation. Centers
All rights reserved.
PART 1 UNIT
3 4 C.2. Responsibility Centers
Customer
Often the most significant segment classification is a classification by major customer.
The relative profitability or losses associated with any one customer may influence
management's decisions to either drop the customer or to reevaluate the relationship in
regard to any marginal benefits to the business (e.g., contribution of the customer to fixed
costs, etc.). A bank may create segments by customer types such as corporate banking,
agricultural banking, and real estate lending.
Process
A company with a manufacturing process that includes several discrete processes may use
process segmentation. A manufacturer of garments may have cutting, sewing, hemming,
finishing, packaging, and sales processes. Each process is supervised by a different manager.
Time
A company that operates in shifts may need to segment its operations based on time.
A manager is appointed for the morning shift, another manager for the afternoon shift, and
a third one for the night shift.
Distribution Channels
A company may base its segments on the channels it uses to distribute its products or
intermediaries. It can have a segment focusing on agent distribution (acts as an extension of
the company, does not take direct ownership), another one on wholesale distribution (takes
title to goods, sells to other intermediaries), and a third one on retail distribution (takes title
to goods, sells to end users).
3 Responsibility Center Measurements LOS 1C2c
LOS 1C2d
Profit SBUs are normally responsible for generating a level of profit in relation to controllable
costs. Contribution reporting formats show the degree to which an SBU's profit has covered
variable or controllable costs.
3.1 Contribution Margin

Contribution margin measures the excess of revenues over variable costs for a company or
division. All variable costs are deducted from total sales revenue to arrive at the contribution
margin, which is the dollar amount that contributes to cover fixed costs and, after all fixed costs
are covered, profits.
Sales revenue
– Variable costs
Contribution margin ← Amount available to contribute to fixed costs and profits
3.2 Contribution Reporting

Managers should only be held responsible for costs or other measurements over which they
have influence. Contribution by responsibility center represents the difference between
contribution margin and controllable fixed costs. Controllable fixed costs are those costs that
managers can affect in less than one year (e.g., advertising and sales promotion). Controllable
margin is used as a good measure of a manager's short-term performance.

Example 1 Contribution Calculations
Facts: Delta Company produces gadgets. Manufacturing costs for one unit of gadgets are
as follows:
Direct materials $45 per unit
Direct labor $15 per unit
Variable overhead costs $10 per unit
Fixed costs per month $17,000 (60% are controllable by the plant manager)
Sales commission 10%
Shipping cost $10 per unit
1,000 gadgets were sold during the month of April at a price of $150 each.
Required:
1. Calculate the unit contribution margin.
2. Calculate the total contribution margin for the month of April.
3. Calculate the controllable margin.
4. Calculate operating income for the month of April.
Solution:
1. Unit contribution margin (CM) = Unit selling price – Total variable cost
Unit CM = $150 – ($45 + 15 + 10 + [10% × ($150)] + 10) = $150 – $95 = $55/unit
2. Total contribution margin = $55 × 1,000 unit = $55,000
3. Controllable margin = Contribution margin – Controllable fixed costs
Controllable margin = $55,000 – (60% × $17,000) = $55,000 – $10,200 = $44,800
4. Operating income for April = Contribution margin – Fixed costs = $55,000 – $17,000 =
$38,000
Or:
Operating income = Controllable margin – Noncontrollable fixed costs = $44,800 – (40%
× $17,000) = $44,800 – $6,800 = $38,000
3.3 Common Costs

Common costs are shared by more than one responsibility center. These costs include the costs
of the accounting department, IT department, HR department, and other departments that
provide services to all. These costs should be allocated among all benefiting departments and
responsibility centers.
Common costs are not controllable. Approaches to the rational allocation of central
administrative costs (common costs) must be understood by SBU managers and must be
fair and logical. Employees are more motivated to achieve corporate goals if they believe
that common costs do not represent an arbitrary burden. Allocation of common costs forces
managers to accept they are part of the larger organization and their departments must work
toward achieving the overall goals of the organization.

PART 1 UNIT
Pass Key
Controllable margin is used as an indicator of the manager's short-term performance.

Contribution margin by responsibility center is an indicator of the manager's long-term
performance.
Illustration 2 Contribution Reporting
Delta Manufacturing has four regions that it has organized into profit-strategic business
units. Delta's management has designed a financial performance evaluation report that
focuses on contribution margin and controllable margins. The report is designed as follows:
Delta Manufacturing Performance Evaluation

(in thousands)
Untraceable
Region 1 Region 2 Region 3 Region 4 Costs Total
Revenues $ 200 $ 300 $ 150 $ 450 – $1,100
Variable costs (150) (250) (125) (350) – (875)
Contribution margin 50 50 25 100 – 225
Controllable fixed costs (25) (25) (10) (50) – (110)
Controllable margin 25 25 15 50 – 115
Noncontrollable fixed costs (15) (15) (6) (44) – (80)
Contribution by SBU 10 10 9 6 – 35
Untraceable costs – – – – (20) (20)
Operating income $ 10 $ 10 $ 9 $ 6 $ (20) $ 15
3.4 Methods of Common Cost Allocation LOS 1C2g
Common cost allocation must be fair and logical to motivate employees; otherwise, it can be
seen as an arbitrary burden. Dual cost allocation, stand-alone cost allocation, and incremental
cost allocation are methods that can be used to allocate common costs to segments for
accountability purposes.
3.4.1 Dual Allocation

Dual allocation, also known as dual pricing, is based on the separation of fixed and variable
overhead costs, and then allocating the variable overhead costs according to utilization and the
fixed overhead costs according to capacity.

Example 2 Overhead Allocation
Facts: Assume that a company established a plant maintenance department that provides
all needed maintenance services to the sales department and the production department.
Management wants to allocate the common cost of the maintenance department to the
two departments it serves.
The following information is also made available:
Total fixed cost of the maintenance department is $240,000, which includes the cost of
facilities and administration of the department. The variable costs associated with the
services provided by the maintenance department are measured at $40 per hour.
The budgeted number of service hours as set at the beginning of the accounting period is
as follows:
Total budgeted number of hours to serve the sales department = 6,000 hours
Total budgeted number of hours to serve the production department = 10,000 hours
Actual service hours provided in Year 1 are as follows:
Total actual number of hours to serve the sales department = 5,000 hours
Total actual number of hours to serve the production department = 12,000 hours
Required:
1. Calculate the fixed overhead costs allocated to each department.
2. Calculate the variable overhead costs allocated to each department.
3. Calculate the total overhead costs allocated to each department.
Solution:
1. The fixed costs are allocated using the budgeted number of hours as follows:
a. The sales department's share of fixed costs
(Budgeted hours to serve the sales department)
= × Total fixed cost
(Total budgeted hours to serve both departments)
6,000
= × $240,000
16,000
= $90,000
b. The production department's share of fixed costs
(Budgeted hours to serve the production department)

= × Total fixed cost
(Total budgeted hours to serve both departments)
10,000
= × $240,000
16,000
= $150,000
(continued)

PART 1 UNIT
(continued)
2. The variable costs are allocated based on actual number of hours as follows:
a. The sales department's share of variable costs
= Actual number of hours to serve the sales department × Variable cost per hour
= 5,000 × $40
= $200,000
b. The production department's share of variable costs
= Actual number of hours to serve the production department × Variable cost
per hour
= 12,000 × $40
= $480,000
3. The total cost allocated to the two departments is as follows:
a. Sales department's costs = Fixed + Variable = $90,000 + $200,000 = $290,000
b. Production department's costs = Fixed + Variable = $150,000 + $480,000 = $630,000
3.4.2 Stand-Alone Cost Allocation

Under the stand-alone cost allocation method, each user department is allocated part of the
common costs on the basis of usage. For example, the common cost of the central registrar's
office at a university is allocated to the different schools based on the number of students each
school has enrolled in its programs.
Example 3 Allocating Common Costs
Facts: Assume that the cost of the central registrar's office is $400,000 per year. The
university administration wants to allocate this common cost to the various schools it
serves. The allocation base is the number of students in each school:
Number of
School Students Enrolled
Engineering 1,000
Business 2,000
Sciences 1,500
Nursing 2,500
Arts 3,000
Total 10,000
(continued)

(continued)
Required: Allocate the common cost of the registrar's office to the different schools
receiving the services of the registrar's office.
Solution:
Number of Cost
School Students Enrolled % Usage Allocated
Engineering 1,000 10% $40,000
Business 2,000 20% 80,000
Sciences 1,500 15% 60,000
Nursing 2,500 25% 100,000
Arts 3,000 30% 120,000
Total 10,000 100% $400,000
3.4.3 Incremental Cost Allocation

Using the incremental cost allocation method requires the company to rank the user
departments by size, from largest to smallest. The largest unit (also called the primary user)
will be allocated costs that are equal to what it would cost if the primary user had been the
only department benefiting from the common service. This results in the largest department
being allocated all fixed common costs and part of the variable costs. The rest of the costs are
allocated to all other departments using a reasonable allocation basis.
Illustration 3 Service Department Allocation
Assume that a company has a human resources department that serves both production
and administration. The human resources department's annual costs are $260,000, of
which 60 percent are fixed. The production department is the primary department with a
total of 900 workers. The other 100 employees are in charge of administration.
Because the production department is the major or primary department receiving the
service of the HR department, it will absorb costs equal to the amount that it will incur
had it been the only department of the company. Management estimated that it will
cost the production department $210,000 to outsource the services had it been the only
department operating within the company. Therefore, $210,000 of the common costs will
be allocated to the production department and the other $50,000 will be allocated to the
administration departments. This allocation depends on the cost of outsourcing the service
by the primary department. Allocating $210,000 to the production department covers the
fixed cost ($260,000 × 60% = $156,000) and part of the variable cost ($210,000 – $156,000 =
$54,000). The $50,000 allocated to administration is variable cost.

PART 1 UNIT
3.5 Issues With Common Cost Allocation LOS 1C2f

Common costs are important even if they are not traceable to specific units within the
organization. If any one segment of the business is discontinued, common costs will continue
to be allocated to the other operating departments. Common costs do not cease to occur if one
unit is discontinued.
Centralized departments provide services to many other departments to control costs. Sharing
services of a common department is more reasonable and affordable. The main issue for proper
allocation is to identify a reasonable method of allocation of common costs that managers of the
various departments will consider fair.
Regardless of the method used to allocate common costs, all common costs must be allocated
to the different segments. If common costs are not allocated, the company may be exposed
to the risk of not covering all costs of the organization when setting prices for its products.
Common costs, although not controllable by the manager, must be factored in the price charged
to customers. This approach will help management recover all costs associated with providing
goods or services to its customers.
In many cases, management must implement information gathering systems to be able
to allocate these costs. Management must also invest in training individual managers to
understand cost allocation methods and benefits. The costs should never exceed the benefits of
implementing a system.
Sara Bellows, manager of the telecommunication sales team, has the following department
budget:
Target billings—long distance $350,000

Target billings—phone card 75,000
Target billings—toll-free 265,000
Her responsibility center is best described as a:

a. Cost center.
b. Revenue center.
c. Profit center.
d. Investment center.

The production manager of the Super T-shirt Co. is responsible for the activity of her
department and the costs associated with production. Super T-shirt adheres to a
responsibility center budget process, and the manager's performance is measured by how
well she performs to budget. Recently, the dark horse team won the local college basketball
tournament. As a result, the sales department, which operates as a profit center, received
an order for 10,000 t-shirts, but only if they could be delivered in three days. The production
manager said she could meet the schedule, but only by incurring overtime pay that would
cause her to be over budget for hourly wages paid. What would be the best course of action
for the sales department and the production manager to undertake in this case?
a. Accept the order and charge the overtime to the production manager's budget.
b. Refuse the overtime and produce only what the production department is capable
of while staying within the budget.
c. Accept the order and ignore the effect on the production department budget
when conducting the performance review.
d. Charge the overtime to the sales department's budget.
A college has a central copying facility. The copying facility has two main users: the business
and the arts departments. The following data are assembled from the budget prepared for
the coming year:
Fixed costs per year $60,000

Variable cost per copy $0.05
Budgeted usage for the business department 120,000 copies
Budgeted usage for the arts department 240,000 copies
Actual usage for the business department 80,000 copies
Actual usage for the arts department 200,000 copies
The college allocates the fixed copying costs using the budgeted usage, while the variable
costs are allocated based on actual usage.
If the dual-rate allocation method is used, what amount of the copying facility costs will be
allocated to the arts department?
a. $40,000
b. $52,857
c. $52,000
d. $50,000

4
MODULE
PART 1 UNIT 4
C.2. Transfer Pricing

Part 1
Unit 4
CMA LOS Reference: Part 1—Section C.2. Transfer Pricing

h. define transfer pricing and identify the objectives of transfer pricing
i. identify the methods for determining transfer prices and list and explain the
advantages and disadvantages of each method
j. identify and calculate transfer prices using variable cost, full cost, market price,
negotiated price, and dual-rate pricing
k. explain how transfer pricing is affected by business issues such as the presence of
outside suppliers and the opportunity costs associated with capacity usage
l. describe how special issues such as tariffs, exchange rates, taxes, currency restrictions,
expropriation risk, and the availability of materials and skills affect performance
evaluation in multinational companies
1 Transfer Pricing LOS 1C2h
Transfer pricing is the determination of an exchange price for a product or service when
different units of the same organization buy and sell from each other. Transfer pricing is most
relevant in vertically integrated organizations in which one department produces a component
used by another department within the same company. These component units are called
intermediary products.
Transfer prices are prices charged by one department of a company for goods sold to another
department of the same company. The second department may sell the units it produces to
another internal user or to external customers. Transfer pricing is a managerial decision that
has no effect on the financial statements. The selling department recognizes a sale and the
purchasing department recognizes an expense. These internal revenues and expenses are
eliminated when preparing consolidated financial statements.
Transfer pricing is important for the determination of departmental operating income. Each
department reports its performance separately. The internal performance of each department
is affected by the transfer price, although the operating results of the company as a whole are
not affected.

4 C.2. Transfer Pricing PART 1 UNIT 4
Illustration 1 Transfer Pricing
Assume that XYZ Co. produces a product through two departments: A and B. The items
produced by department A are intermediary components used exclusively by department B
to complete its production process. Department B has no other suppliers of this component.
The following is compiled from the records of the company:
Department A Department B
Cost of production $600 $400
Price to transfer to B $900
Selling price to third parties $1,800
At a departmental level, department A records revenues of $900 upon transferring the item
to department B. Department B records a cost of $900 for the item it transferred in from
department A.
Department A Department B Eliminations XYZ Co.
Revenue $ 900 $ 1,800 $ (900) $ 1,800
Production cost (600) (400) (1,000)
Transfer-in cost 0 (900) 900 0
Operating income $ 300 $ 500 $ 0 $ 800
The above analysis shows that the company makes $800 in operating income, which is
divided between the two operational departments: A and B.
If A charges a higher transfer price when transferring items to B, A will achieve a higher
operating income, while B achieves a lower operating income. The company earns the
same operating income. If department A has the option to sell the component it produces
to external customers and department B has the option to purchase the item from external
suppliers, the change in transfer prices might motivate the manager of each department to
make different decisions.
1.1 Objectives of Transfer Pricing

Transfer pricing helps managers in different divisions focus on achieving the overall objectives of
the company in the following ways:
Strategic Objectives
Buying internally is done at a price that is usually lower than the market price. Excess
capacity can be used to supply items to other internal departments without sacrificing any
contribution margin. In addition to cost savings to the company, selling internally enables a
higher-quality product and facilitates timely delivery to meet the specifications of the buying
department, resulting in better overall company performance.
Coordination
Establishment of transfer prices involves the coordination of the finance, marketing, and
production departments. The finance department provides information that is helpful to
make the pricing decision, the marketing department provides information about market
prices and the quality of items available on the market, and the production divisions
negotiate the transfer price based on the available information.
4–48 Module 4 © Becker Professional Education Corporation. AllC.2. Transfer

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PART 1 UNIT
4 4 C.2. Transfer Pricing
Vertical Integration
Companies that are vertically integrated (i.e., each sequential function builds to a final
product) use transfer pricing. Transferring components internally helps a company to better
use its available and distinct technology, knowledge, and production methods to achieve a
competitive advantage. Transfer pricing creates the needed synergies among the various
departments.
Illustration 2 Example of a Vertically Integrated Company
Company ABC
Department A
Department A produces an
intermediary product and
transfers to Department B.
Department B
Department B produces an
intermediary product and
transfers to Department C.
Market
Department C
(external)
1.2 Issues Relevant to Transfer Pricing

Changes in transfer prices result in changes to departmental operating income. Departmental
management responds to changes in the following ways:
Departmental Decision Making
If the selling department sets prices high, the manager of the buying department may be
tempted to stop producing the item that consumes the intermediary product, or purchase
the component from an external supplier if offered at a cheaper price.
Evaluation of Departmental Performance
Increasing transfer prices results in higher operating income, gross profit percentage, return
on investment, and residual income for the selling department. The buying department will
have the lower results for each item, resulting in the buying department becoming a target
for shutting down based on its poor performance.

Performance-Based Compensation of Department Managers

A selling department tends to push transfer prices up, whereas a buying department tends
to push transfer prices down to achieve the best results for the department. The successful
department has a higher profit and a higher compensation to its managers. Transfer pricing
decisions allocate the overall profit from sales among all departments involved in the
production of the intermediary items.
Motivational Tool for Managers
By selling at a price that exceeds variable costs (or variable costs plus opportunity cost if
capacity is fully utilized), the selling department earns a slightly smaller margin than selling
to external parties and the buying department purchases at a lower cost than purchasing
externally. The company is rewarded with overall operating income that is slightly higher.
When transfer prices are set too high, they become demotivating to the buying department
because departmental profit is reduced.
Alignment of Departmental Goals With Corporate Goals
Managers of the trading departments achieve their departmental goals at the same
time as they achieve the organizational goals as a whole (goal congruence). The trading
departments reduce the overall cost to the company (by transferring a lower price than they
could buy externally) while adhering to internal quality standards.
Different Tax Jurisdictions
When the trading departments are located in two tax jurisdictions, transfer prices determine
the profit reported by each department and departmental profit is taxed in the jurisdiction
where it is earned. If the selling department is in a low tax rate jurisdiction, it will be better
for the whole company to earn the major part of the company's profits in that department
because it will result in paying less taxes.
LOS 1C2i 2 Transfer Pricing Methodologies

LOS 1C2j
There are five recognized transfer pricing methods: variable cost, full cost, market price,
negotiated price, and dual-rate pricing.
2.1 Variable Cost Method

The variable cost method establishes the transfer price at the amount of the incremental
variable costs incurred by the selling unit. The variable cost method is used when the selling
division is operating below full capacity.
Advantages
When transfer pricing is set at the sum of variable costs, managers are encouraged to buy
internally rather than buying from external producers at a higher price.
Disadvantages
The variable cost method reduces net income of the selling division because setting the
transfer price at variable costs does not help the selling division earn profits. It is seen as
unfair by the selling department, because only the variable costs of production are covered;
fixed production costs are not covered, causing a loss to the selling division. If compensation
is based on performance, managers of selling departments are penalized.

rights Pricing
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PART 1 UNIT
Example 1 Transfer Pricing and Operating Profits
Facts: In a vertically integrated production process, department X produces components

that are used by department Y within the same company. Department X does not sell
externally. Department Y completes production and sells items to third parties. The
following data is accumulated from the record of the company:
Selling price to third parties $100
Materials cost per unit $13 $17
Labor cost per unit $10 $7
Variable overhead per unit $3 $4
Fixed cost for the period $10,000 $14,000
Transfer out at variable cost per unit $26
Transfer in at variable cost per unit $26
Required: Describe the effect of the above scenario on the operating income of each
department and on the company as a whole assuming that 1,000 units are produced and
transferred from A to B and then to third parties after completion.
Solution: The transfer price is determined at variable cost only (DM + DL + VOH =
$13 + $10 + $3 = $26 per unit).
Department A Department B Company
Selling price to third parties
(1,000 × $100) $ 100,000 $ 100,000
Materials cost $ (13,000) $ (17,000) $ (30,000)
Labor cost $ (10,000) $ (7,000) $ (17,000)
Variable overhead $ (3,000) $ (4,000) $ (7,000)
Fixed cost for the period $ (10,000) $ (14,000) $ (24,000)
Transfer out at variable cost $ 26,000 Eliminated
Transfer in at variable cost $ (26,000) Eliminated
Operating income $ (10,000) $ 32,000 $ 22,000
This illustrates why the selling department manager considers the variable cost method
unfair. Department A plays an important role in the production process, yet no profits are
allocated to department A. All of the profits earned by the company are treated as if they
were earned by department B. If a department manager is compensated based on financial
performance, then only department B's manager will enjoy the benefits.

2.2 Full Cost Method

The full cost method establishes the transfer price at the variable cost per unit plus fixed cost of
the selling unit. The full cost approach is used when the responsibility centers are organized as
cost centers in which case managers will intend to cover all of the costs incurred.
Advantages
Transfer pricing at variable costs plus the fixed costs is easy to implement and understand,
and is preferred by taxing authorities over the variable cost method.
Disadvantages
Inclusion of fixed costs in the transfer price may subject the price to manipulation unless
standard costs are used. If actual costs are used, inefficiencies of the selling division are
transferred to the buying division, creating little incentive for the selling division to control
costs. If standard full cost is used, then the selling division will bear all its inefficiencies,
creating incentive for the selling division to control costs.
2.3 Market Price Method

The market price method sets the transfer price at the current external selling price between a
willing buyer and a willing seller. The market price method is viewed as the optimal method for
establishing transfer prices and is used when the market is well established.
Advantages
Selling at the current market price makes compliance with arm's-length transaction
standards easier and provides incentives for units to remain autonomous and maintain
competitive pricing.
Disadvantages
Not all items transferred have a readily available market price. Cost savings associated with
reduced selling prices are not recognized; any sales discount that an external supplier may
offer for quantity purchases are not recognized when setting internal transfer prices at
market price.
2.4 Negotiated Price Method

The negotiated price method involves the negotiation of prices between the purchasing
managers and the selling manager as the basis for establishing the transfer price.
Advantages
A negotiation process invites honest participation among units and may be a practical way
to resolve conflicts. This is successful when market information is available and known
to all negotiating parties, each manager is free to buy and sell externally, and top-level
management supports all departments.
Disadvantages
Arm's-length standards may not be met because negotiations are between related parties.
Negotiation may inhibit autonomy; each department is interested in imposing its own
interests. Powerful or more experienced managers exert greater influence in transfer price
negotiations. In many cases, negotiating managers cannot reach a decision by themselves,
so higher-level managers may have to settle the dispute by imposing a solution. Negotiating
transfer prices is a time-consuming activity.

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PART 1 UNIT
2.5 Dual Pricing Method

Dual pricing, which is a combination of different methods, involves recording transfers at
different amounts for the buying and selling departments. Under the dual pricing method, the
selling department records the sale at market price, and the buying department records the
purchase at the variable cost of the selling department.
Advantages
Both departments benefit from this arrangement. The selling department records a sale at
market price, earning a profit on this transfer. The buying department records the purchase
at the variable cost of the selling department, which minimizes the cost to the buyer as
well. This method encourages internal transfers by providing a share of the profit to each
involved department.
Disadvantages
This method of setting transfer pricing creates complexities in accounting records. At the end
of the accounting period, both transfers must be eliminated at their original prices, causing a
temporary creation of a pending account until the transactions are reduced to zero.
Example 2 Negotiated Transfer Prices
Facts: Company XYZ has two departments: A and B. The materials used by department B
are currently purchased from outside suppliers at $40 per unit. These same materials are
produced by department A. Operating income, assuming no transfers between divisions, is
$1,900,000 for department A and $1,060,000 for department B.
Department A has unused capacity and can produce the materials needed for
department B at a variable cost of $25 per unit. The two divisions have recently negotiated
a transfer price of $32 per unit for 40,000 units.
Required: Based on the agreed-upon transfer price, with no reduction in the current sales
of department A:
1. How much would department A's operating income increase?
2. How much would department B's operating income increase?
3. How much would Company XYZ's operating income increase?
Solution:
1. Department A's operating income is affected by the following:
a. Department A will produce an additional 40,000 units and transfer them to
department B for $1,280,000 (40,000 × $32).
b. Incremental costs of producing the additional units at department A will be
$1,000,000 (40,000 × $25).
c. The net increase in department A's operating income = $1,280,000 – $1,000,000 =
$280,000.
(continued)

(continued)
2. Department B's operating income is affected by the following:

d. Department B will save $320,000 on the purchase of 40,000 units through buying
internally at $32 instead of paying $40 to external suppliers ($8 × 40,000).
e. The net increase in department B's operating income = $320,000.
f. The following schedule shows the effect of this transaction on each department as
well as on the company as a whole:
Department A Department B Company

(A) Operating income $1,900,000 $1,060,000 $2,960,000
before the internal
transfer
(B) from 1c Additional cost (1,000,000) (1,000,000)
of producing the
40,000 units
(C) (40,000 × $40) Savings when 1,600,000 1,600,000
buying 40,000
internally
(D) from 1a Transfer price 1,280,000 (1,280,000) 0
(E) = (A) + (B) + (C) Operating income 2,180,000 1,380,000 3,560,000
(F) = (E) – (A) Net increase in $ 280,000 $ 320,000 $ 600,000

operating income
3. The effect on the company's operating income = $600,000 increase.
Illustration 3 Transfer Pricing: Comparison of Methods
Assume that XYZ Co. produces a product through two departments: A and B. Also assume
that items produced by department A are used exclusively by department B to complete
its production process and sell on the market. Department B has the option to buy the
component from an outside supplier at similar quality for $800.
The following is compiled from the records of the company:
Variable cost of production $360 $200
Fixed cost of production 240 200
Selling price to third parties $1,800
(continued)

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PART 1 UNIT
(continued)
The following are possible transfer prices:
Method Transfer Price Analysis

Variable cost $360 Perceived as good by department B but not
attractive to department A.
Full cost $600 Department A makes no profit; all profits will
be allocated to department B; a satisfactory
solution if fixed costs of department A will
continue even if production stops.
Market price $800 This is a good pricing methodology for both
departments and the company unless market
prices are not determinable.
Dual pricing $360; $800 Department A records the sale at $800 and
department B records the purchase at $360.
This provides incentives to both managers.
Negotiated price Higher than $360 For department A to be willing to sell
but lower than $800 internally, it must cover the variable costs.
For department B to buy internally, the price
should not exceed the market price.
The following table shows the effect of each possible transfer price on the contribution
margin of each department and the company as a whole.
Variable Cost = $360 Full Cost = $600

A B Eliminate Total A B Eliminate Total
Revenue $ 360 $1,800 $(360) $1,800 $ 600 $1,800 $(600) $1,800
Variable costs (360) (200) (560) (360) (200) (560)
Transfer-in cost – (360) 360 – – (600) 600 –
CM – 1,240 1,240 240 1,000 1,240
Fixed costs (240) (200) (440) (240) (200) (440)
Operating income $(240) $1,040 $ 800 $ – $ 800 $ 800
Market Price = $800 Dual Pricing = $360; $800

A B Eliminate Total A B Eliminate Total
Revenue $ 800 $1,800 $(800) $1,800 $ 800 $1,800 $(800) $1,800
Variable costs (360) (200) (560) (360) (200) (560)
Transfer-in cost – (800) 800 – – (360) 360 –
CM 440 800 1,240 440 1,240 1,240
Fixed costs (240) (200) (440) (240) (200) (440)
Operating income $ 200 $ 600 $ 800 $ 200 $1,040 $ 800
(continued)

(continued)
Negotiated Price = $700

A B Eliminate Total
Revenue $ 700 $1,800 $(700) $1,800
Variable costs (360) (200) (560)
Transfer-in cost – (700) 700 –
CM 340 900 1,240
Fixed costs (240) (200) (440)
Operating income $ 100 $ 700 $800
If department A sets the transfer price at $1,000, which is a good price for A, department
B prefers to buy the component from an outside supplier that offers the component at
the same quality for $800. Therefore, a price higher than the market price will not work.
If department B offers to pay a price of $350, which is good for the manager of B,
department A will not accept because this is a low price and it does not cover the
variable costs of producing it at department A.
Although operating income for the company is the same in all cases, the manager of
department A is penalized with an unfair operating income distribution. Department A
may decide instead to sell to an external customer if market prices are higher. This is not
in the best interest of the company as a whole.
If the price is set above $800, department B may buy from an external supplier that can
offer the same component at a lower price.
LOS 1C2k 3 Special Issues in Transfer Pricing
Although transfer pricing mechanisms are established to account for the transactions that
occur between related strategic business units, other issues may arise that interfere with the
administration of these policies.
3.1 Existence of Outside Suppliers

Outside suppliers are alternative sources for components and materials. The use of outside
suppliers can disrupt vertical integration within a company and may result in lower overall profit
if it costs the company less to produce a component than to buy it from an external supplier.
If transfer prices are set higher than market prices, the buying department will prefer to buy
externally because it costs less. Although buying externally is preferable in this case for the
manager of the buying department, it works to the detriment of the company as a whole.
3.2 Opportunity Costs

Outside markets or other uses for productive capacity create opportunity costs. The minimum
transfer price is the variable cost of the selling department, but only if the selling department
has excess capacity to serve the buying department. If the selling department is currently
operating at full capacity, then transferring items internally requires a sacrifice of external sales.
The contribution margin lost by not selling to external buyers should be considered when setting
the transfer price to make it appealing to the selling department.

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PART 1 UNIT
In a perfectly competitive market for intermediate products, a manager might be tempted to

buy a component unit directly from an external supplier if the purchase price is lower than the
internal transfer price. A production department may wish to sell an item to external purchasers
if it can receive a higher price than the internal transfer price. Without internal negotiations
for a fair price for both departments, goal congruence is not promoted and the manager of
each department will begin to focus on ways to maximize the department's operating income
regardless of the overall effect on the company's bottom line (tunnel vision).
Pass Key
The decision rule to set a transfer price acceptable to both the selling and the buying
departments is:
Variable cost + Opportunity cost ≤ Transfer price ≤ Market price
Example 3 Determination of Transfer Price
Facts: Department A can purchase a certain part it uses in production on the market for $50
per unit. Department B generally produces and delivers this part at a variable cost of $30 per
unit. Department B is currently operating at full capacity. Department B produces the item
that department A requires in addition to another item it sells to external customers.
Department A is interested in buying 200 units of the item it requires from department B.
In order for department B to produce the quantity needed by A, it must stop producing and
selling item X to an external customer. The records of department B show that this decision
will deprive department B of $2,000 in contribution margin it generally generates from
selling product X to the external customer.
In order to produce the item at the higher-quality specifications set by department A,
materials cost for department B will increase by $1.50 per unit, but $0.50 will be saved per
unit in marketing and distribution costs.
Required: Determine the range of acceptable prices that must be considered by both
departments.
Solution: In order to determine the transfer price that is beneficial to the selling
department, the buying department, and the company, the following must be considered:
The price should be at least equal to the Variable cost + Opportunity cost of the
producing department. That is, Variable costs of $31 ($30 + $1.50 – $0.50) + Opportunity
cost of $10 ($2,000 ÷ 200) = $41 per unit.
The price should not exceed the market price of $50.
Therefore, the range for the transfer price is depicted in the following formula:
$41 ≤ Transfer price ≤ $50.
The transfer price should be negotiated within this range by the buying and
selling managers.

4 Effect of International Operations

LOS 1C2l on Transfer Pricing
International operations conducted by multinational corporations (MNCs) deal with a variety of

operational and transactional issues that impact transfer pricing.
4.1 Expropriation
Foreign governments may seize the assets of an MNC with little or no compensation. The
potential for abrupt loss of assets is a significant risk. Expatriate units (units located outside
the country of domicile) mitigate this risk through transfer pricing. A department producing a
component unit in an area with high risk of expropriation will lower its transfer prices when
selling to a department located in another country. Doing so will reduce the amount of profits
generated by the expatriate unit, lowering the value of the unit that is exposed to risk of
expropriation.
4.2 Minimization of Customs Charges and Tariffs

The establishment of transfer prices impacts customs charges. Low transfer prices reduce
customs charges and tariffs to be paid by the importing (buying) department. The importing
company pays tariffs to its government based on the invoice price of the imported goods. The
lower the price, the fewer tariffs paid.
4.3 Currency Restrictions

Foreign governments occasionally restrict the withdrawal of earnings denominated in the
foreign currency from that country. Reduced transfer prices limit foreign-subsidiary profits and
eliminate or reduce the restrictions associated with these earnings.
4.4 Exchange Rate Fluctuation

Managers facing exposure to fluctuating exchange rates attempt to manage risk through hedge
contracts to mitigate risk or by changing transfer prices. Managers tend to move funds out of
weak currencies. Managers may decide on transfer prices designed to protect the company
against fluctuations in exchange rates.
4.5 Availability of Skills and Materials

The availability of appropriate skills and materials at the appropriate price in a local economy
affects operational staffing and material availability. Any requirement to import skills and
materials may affect transfer prices. For example, many countries offer tax incentives to foreign
companies operating in the country if the companies increase local employment and labor skill
levels. These incentives may lead to higher transfer prices due to the tax incentives available.
4.6 Arm's-Length Standard Used for Taxation Purposes

The Organisation for Economic Co-operation and Development's model treaty establishes
valuation of transfer prices using an arm's-length test. Transfer prices between units should be
valued in the same manner as third-party transactions in order to ensure that taxation is not
avoided by undervaluing transactions. The arm's-length standard is used by taxing authorities to
eliminate the possibility that unreasonable transfer prices are used to reduce taxes.

rights Pricing
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PART 1 UNIT
Illustration 4 International Transfer Pricing
If a component that is produced in country A at a cost of $9 per unit is transferred to

country B, managers would tend to set transfer prices as high as possible if country A's tax
rate is lower than that in country B. If country A increased the transfer price to $50, earning
$41 of profits in country A where tax rates are low, overall company profits would be
higher due to decreased tax payments. Because the cost in country B is now $50 per unit,
selling it for $55 creates a profit of only $5 that is taxed at the higher country B rate. Taxing
authorities in country B would examine transfer prices to make sure that the price is close
to what would have been paid by an unrelated party; otherwise, authorities can impose
fines and adjust transfer prices.
4.6.1 Comparable Price Method

Taxing authorities set transfer prices at an arm's-length value established using the market
prices for unrelated firms. If the headquarters in country A purchases component units
produced by a foreign related party, the transfer price is set by the authorities at the prevailing
external market price if it is easily discernable.
4.6.2 Resale Price Method

Arm's-length value can be established using the sales price less the markup normally associated
with unrelated parties. This method is preferred for distributors and marketing units. If the
selling price for the item is $55, and the normal markup is 60 percent of cost, the transfer price
would be estimated at $34.40 ($55 ÷ 1.6); the normal markup is backed out of the selling price to
establish the transfer price.
4.6.3 Cost-Plus Method

Arm's-length value can be established by using the cost-plus method. If the cost of production is
$9 in country A and a normal markup is estimated to be 50 percent of cost, then the acceptable
transfer price is equal to $13.50 ($9 × 1.50).
4.6.4 Advance Pricing Agreements

Advance pricing agreements (APAs) are agreements between the MNC and taxing authorities
to preestablish transfer prices. The APA is introduced in different countries. It requires a prior
agreement between the company (taxpayer) and the taxing authorities on how to determine
transfer prices. This reduces the possibility of any future dispute between the taxpayer and the
taxing authorities for the period covered by the agreement.
Which one of the following is an incorrect description of transfer pricing?

a. It measures the value of goods or services furnished by a profit center to other
responsibility centers within a company.
b. If a market price exists, this price may be used as a transfer price.
c. It measures exchanges between a company and external customers.
d. If no market price exists, the transfer price may be based on cost.

Manhattan Corp. has several divisions that operate as decentralized profit centers. At the
present time, the Fabrication division has excess capacity of 5,000 units with respect to the
UT-371 circuit board, a popular item in many digital applications. Information about the
circuit board follows:
Market price $48

Variable selling/distribution costs on external sales 5
Variable manufacturing cost 21
Fixed manufacturing cost 10
Manhattan's Electronic Assembly division wants to purchase 4,500 circuit boards either
internally, or else use a similar board in the marketplace that sells for $46. The Electronic
Assembly division's management feels that if the first alternative is pursued, a price
concession is justified, given that both divisions are part of the same firm. To optimize
the overall goals of Manhattan, the minimum price to be charged for the board from the
Fabrication division to the Electronic Assembly division should be:
a. $21.
b. $26.
c. $31.
d. $46.
Department A produces a component unit that can be used by department B or sold

on the market as a component for other producers. The total cost of producing the
component is $50, of which $30 is fixed. Department A has excess capacity. If department B
can purchase the component unit in the open market for $46, the highest transfer price
that the manager of department A can negotiate is:
a. $50.
b. $46.
c. $30.
d. $20.

rights Pricing
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5
MODULE
PART 1 UNIT 4
C.3. Performance
Measures: Part 1
Part 1
Unit 4
CMA LOS Reference: Part 1—Section C.3. Performance Measures: Part 1

a. explain why performance evaluation measures should be directly related to strategic
and operational goals and objectives; why timely feedback is critical; and why
performance measures should be related to the factors that drive the element being
measured, e.g., cost drivers and revenue drivers
b. explain the issues involved in determining product profitability, business unit
profitability, and customer profitability, including cost measurement, cost allocation,
investment measurement, and valuation
c. calculate product-line profitability, business unit profitability, and customer profitability
d. evaluate customers and products on the basis of profitability and recommend ways to
improve profitability and/or drop unprofitable customers and products
1 Performance Measures LOS 1C3a
Management establishes strategic objectives and then sets operational goals and objectives in
alignment with its strategy. To achieve its aims and to measure progress, management must
have a means for evaluating employee performance relative to these goals and objectives. This
linkage between entity-wide goals and objectives, and the individual employees and functions
that are needed to meet the goals and objectives, is critical to firm success.
Illustration 1 Alignment of Performance Measures and Goals
A grocery store generates revenue from people coming to the store and buying food.
People choose a grocery store for reasons such as proximity to their homes, availability
of food, cleanliness of the store, customer service, and prices (including sales/discounts
offered). A grocery store incurs costs from the food itself, employee labor costs, and
overhead costs such as electricity, water, and property taxes. The performance measures
for the manager of the store as well as the staff should directly tie to the elements above
that the manager can directly influence and control. Some elements above, such as
proximity to customers and property taxes, are not controllable and should not be tied to
performance measures. But the cleanliness of the store, customer service, food availability,
and the balance between availability and overstocking are reasonable elements to measure
for performance purposes.
© Becker Professional Education Corporation. All rights reserved. Module 5 4–61 C.3. P
5 C.3. Performance Measures: Part 1 PART 1 UNIT 4
1.1 Assessment of Performance Measures and Goals

To assess performance, consider measures that drive success, such as:
Profitability
Productivity
Quality
Inventory management
Preventive maintenance
Performance to schedule
Capacity utilization
Innovation and internal processes
Human resource management
Once drivers are identified, metrics are identified to track performance against the drivers.
Metrics should be quantifiable and may include both financial and nonfinancial components.
Financial measures track actual revenues and costs, which are compared with budgeted
revenues and costs and incorporated into financial ratios and profitability analyses. Nonfinancial
measures capture elements such as time, effort spent (hours), and outputs relative to inputs.
The balanced scorecard is a performance tool used to gather information across multiple
critical success factors in financial measures, internal business processes, customer satisfaction,
advancement of innovation, and human resource development. Typically, the scorecard
describes the factors, strategic goals, tactics, and related measures associated with strategic and
tactical goals.
1.2 Feedback and Approach

Management must regularly assess whether it is meeting its strategic and operational goals
and objectives. Assessments are accomplished by evaluating critical performance measures
and by providing feedback to the employees tasked with helping the entity achieve its aims.
Feedback must be accurate and timely to be effective. The following characteristics enhance the
effectiveness of feedback.
Tangible and Actionable: The recipient of the feedback must have at least some degree of
control over the measures he or she is held accountable for achieving, and must be able to
take actions based on the feedback provided.
Aligned With Goals: The feedback should directly tie to the goals the employee and the
firm overall are trying to accomplish.
User-Friendly and Transparent: Performance measures and the feedback based on those
measures should be easily understood by the recipient.
Timely: If goals and objectives are reviewed once per month, annual feedback is not enough;
feedback frequency should align with the frequency of goal and objective assessments.
Ongoing: Feedback does not need to occur only formally at regularly scheduled intervals;
informal feedback on an ongoing basis is also critical to success.
Consistent: Feedback should not leave the employee with confusion or doubt.
4–62 Module 5 © Becker Professional EducationC.3. Performance

PART 1 UNIT
5 4 C.3. Performance Measures: Part 1
1.3 Relevant Information and Measures LOS 1C3b

An entity is profitable if it generates revenues that exceed costs. Management conducts a
deeper analysis of profitability by looking at the products and services provided, business units
within the entity, and customers to determine where revenues generated may not be exceeding
costs. Based on that analysis, decisions are made regarding whether to invest more resources to
reach profitability or to shift resources into other, more profitable areas.
1.3.1 Product Profitability Analysis

Product profitability analysis is used to evaluate profitability for a product over a given period
and the relative profitability of several products at a point in time. Product profitability analysis
can help management identify products that are not profitable in order to take proper actions
such as discontinuing, repricing, or modifying the production process to make the product more
profitable. The focus for decision making on whether to continue to invest resources is based on
marginal costs. Marginal costs (incremental costs) are the additional costs incurred to produce
an additional amount of the unit over the present output. These costs are relevant costs, and
include all variable costs and any avoidable fixed costs associated with a decision.
Nonfinancial measures are also used, such as the opportunity cost of investing in maintaining a
product instead of investing in research to launch a new product or the physical capacity used
for one product versus another. Considering the role of loss leaders is also important. Products
sold at a loss may attract customers who end up buying highly profitable items. Discontinuing an
unprofitable product line may cause an adverse reaction from customers who relied on the product.
In making a decision to discontinue a product, managers ask questions, including:
Does the product have a positive contribution margin?
Can any of the fixed costs be avoided if the product is discontinued?
Can the capacity used to produce the product be used for another more profitable purpose?
Will the discontinued product influence sales revenue of other segments?
What is the effect on employee morale?
1.3.2 Business Unit Profitability Analysis

As part of normal business operations, managers make decisions such as whether to continue
operating in certain areas or whether to close entire segments or units within the business. From
a financial perspective, a firm should compare the avoidable fixed costs with the contribution
margin that will be lost if the segment is dropped. If the contribution margin lost exceeds
avoidable fixed costs, the unit should be kept to contribute to the overall company profitability. If
the lost contribution margin is less than avoided fixed costs, the unit should be dropped, which will
increase overall company profitability.
Similar to product profitability, when making decisions regarding business units, managers ask
questions, including:
Does the business unit have a positive contribution margin?
Can any of the fixed costs be avoided if the segment is discontinued?
Can the capacity be used for another more profitable purpose?
Will the discontinued segment influence sales revenue of other segments?
What is the effect on employee morale?
1.3.3 Customer Profitability Analysis

Management uses customer profitability analysis to understand its profitable customers and the
resources consumed by each customer. Customer profitability analysis helps managers identify
customers who make the largest contributions to the company's operating income. Once the
most profitable customers are identified, managers can ensure that the profitable customers
receive the highest level of attention from the company. Customers contributing relatively
low contribution margins and unprofitable customers are identified and either converted into
profitable customers or eliminated.
1.4 Challenges in Determining Profitability

Financial information must be segregated by business unit, product, or customer to be useful
in decision making. Once profitable segments are separated from unprofitable segments,
profitable segments are maintained and maximized. Unprofitable segments are eliminated or
reengineered into profitable ones.
There are many challenges associated with conducting profitability assessments. These
challenges include:
Cost Measurement: Not all costs are easy to accurately measure. Some costs are known
immediately, and others may require time before the true costs are known.
Cost Allocation: Direct costs are costs that can easily be measured and attributed to an
individual unit, product, or customer. Indirect (overhead) costs cannot be easily measured
and attributed, which means they must be allocated. Allocation decisions should be made
based on the use of cost drivers. If costs are allocated in arbitrary ways, there are risks
associated with incorrect cost attribution.
Investment Measurement: Companies make investments in products, units, and
customers over lengthy time periods. It is difficult to trace individual investments made over
time, making it difficult to see a comprehensive picture of investment. Investment decisions
require accurate assessments of resources required, and the timing and amount of when
those resources will be needed. Incorrect estimates may distort the accuracy of the analysis.
Valuation: As part of the analysis, a product, unit, or customer is assigned revenues and
costs and may also be assigned specific assets and liabilities. In some cases, determining the
true value of these financial measures can be a challenge.
LOS 1C3c 2 Conducting Profitability Analysis

LOS 1C3d
Profitability analysis is applicable to any cost object under evaluation, such as a product,
business unit, or customer. Managers must collect relevant information that changes based
on the course of action taken. Whether the decision is to continue or discontinue a product, a
business unit, or a customer relationship, relevant cost and revenue data are needed to perform
analysis and make the decision. Irrelevant costs and revenues will not change regardless of any
decisions made by the entity and can be ignored for decision-making purposes.
2.1 Product Profitability and Business Unit Analysis

Product profitability analysis matches product revenues with product costs. The analysis
helps managers determine next steps for either improving contribution margins or dropping
a particular product. A crucial component of the decision is the allocation of fixed costs and
whether those costs are avoidable or unavoidable.

PART 1 UNIT
Example 1 Fixed Costs Are Unavoidable
Facts: The executives at Chowderhead Industries are evaluating each of their product lines.
A variable costing analysis by product shows that the company's clam and corn chowder
products are profitable but its conch chowder product is not.
Description Clam Conch Corn Total

Sales $125,000 $75,000 $50,000 $250,000
Variable costs 90,000 60,000 25,000 175,000
Contribution margin 35,000 15,000 25,000 75,000
Fixed costs 20,000 20,000 20,000 60,000
Operating Income $ 15,000 $ (5,000) $ 5,000 $ 15,000
The conch chowder fixed costs are unavoidable.

Required: Determine whether Chowderhead should eliminate its conch chowder
product line.
Solution: If the conch chowder fixed costs are unavoidable, they will be incurred even if
conch chowder is eliminated.

Sales $125,000 – $50,000 $175,000
Variable costs 90,000 – 25,000 115,000
Contribution margin 35,000 – 25,000 60,000
Fixed costs 20,000 20,000 20,000 60,000
Net Income $ 15,000 $(20,000) $ 5,000 –
The conch chowder product line should not be eliminated. Elimination of the product
would eliminate company-wide profits because the product makes a positive contribution
to covering the entity's fixed costs.
Example 2 Some Fixed Costs Are Avoidable
Facts: Assume that $16,000 of the conch chowder fixed costs are avoidable advertising
costs that will not be incurred if the product is eliminated.
Required: Given these new facts, determine whether Chowderhead Industries should
eliminate its conch chowder product line.
(continued)
(continued)
Solution: If $16,000 of the fixed costs are avoidable, then only $4,000 are unavoidable and
will be incurred even if conch chowder is eliminated.
Sales $125,000 – $50,000 $175,000
Variable costs 90,000 – 25,000 115,000
Contribution margin 35,000 – 25,000 60,000
Unavoidable fixed costs 15,000 4,000 16,000 35,000
Avoidable fixed costs 5,000 – 4,000 9,000
Operating Income $ 15,000 $ (4,000) $ 5,000 $ 16,000
The Chowderhead executives should eliminate the conch chowder product line because
the avoidable fixed costs exceed the contribution margin that is lost when the product is
eliminated. In this case, elimination of the conch chowder product line improves overall
productivity from $15,000 to $16,000.
Business unit decisions are similar to product decisions because the focus is on contribution
margins and if revenues cover variable costs. Unit managers should only be held accountable for
controllable costs. Fixed costs that are allocated by higher levels of management should not be
included in the analysis.
Example 3 Unit Analysis by Contribution Margin
Facts: A company is organized into three main divisions: Detergent, Fresh Food, and
Preserved Food. The general manager wants to conduct a profitability analysis to better
understand the performance of each division. The manager accumulated financial
information from the company's accounting records:
Detergent Fresh Food Preserved Food
Sales revenue $51,000 $56,000 $46,000
Cost of goods sold $32,000 $39,000 $30,000
The following information was accumulated for selling and administrative expenses:
Cost Driver Usage by Division
Cost Fresh Preserved
per Cost Detergent Food Food
Activity Driver Cost Driver Division Division Division
Product ordering $50.00 Number of 21 48 9
purchase
orders
Product deliveries $40.00 Number of 69 59 23
deliveries
Setting up the stores $8.00 Number of 132 227 21
hours
Customer support $0.30 Number of 11,500 18,700 5,700
items sold
(continued)

PART 1 UNIT
(continued)
Required: Calculate the contribution margin by business unit and advise the manager of a
proper action.
Solution: The contribution margin for each division is determined after allocating the cost
of all relevant activities to each division:
Detergent Fresh Food Preserved Food
Sales revenue $51,000 $56,000 $46,000
Variable costs:
Cost of goods sold 32,000 39,000 30,000
Product ordering ($50 × no. of orders) 1,050 2,400 450
Product delivery ($40 × no. of deliveries) 2,760 2,360 920
Store set-up ($8 × no. of hours) 1,056 1,816 168
Customer support ($0.30 × no. of items) 3,450 5,610 1,710
Total variable costs $40,316 $51,186 $33,248
Contribution margin $10,684 $4,814 $12,752
Contribution margin ratio
(contribution margin/sales) 20.95% 8.60% 27.72%
As measured by both the contribution margin and the contribution margin ratio, the
Preserved Food division is the most profitable division and the Fresh Food division is the
least profitable division. The Fresh Food division consumes a disproportionate share of
both cost of goods sold and selling and administrative resources indicated by the cost
drivers above. The manager should evaluate the possibility of increasing selling prices for
products in the Fresh Food division and reduce the usage of the most expensive resources.
Better marketing regarding the health benefits of fresh food could also improve the
division's profitability.
2.2 Customer Profitability Analysis

Conducting a customer profitability analysis consists of the following steps:
1. Divide the customer base into segments by considering relevant characteristics that fit
the company's strategies. Product, geographic, demographic, or customers' needs are
common segments.
2. Calculate total revenue for each segment by adding up all revenue from each customer
within the segment.
3. Allocate direct and overhead costs to each segment. Direct costs include direct materials
and labor. Indirect (overhead) costs are allocable based on various cost drivers. Variable
costs are subtracted from revenue to determine the contribution margin for each customer.
4. Analyze customer segments to determine relative customer profitability. Multiyear data
should be used to understand the trend and changes over a longer period.
5. Decide a course of action based on the analysis. Keep highly profitable customers happy
by improving services provided. Unprofitable customers are analyzed to determine if the
customer should no longer be targeted by the company's marketing campaigns or if prices
should be increased to make the segment more profitable. Increasing prices may also make
the company's products less attractive to unprofitable customers.
6. Review implemented strategies to evaluate the effect on overall company profitability.
Illustration 2 Customer Revenue Analysis
A company sells its main product to five customers. Sales are at the list price of $18.50 per
unit, but in some instances, the company offers special price discounts to encourage the
purchase of larger quantities. It costs the company $11.50 to produce a unit of its main
product. This data is from the company records for its first year of operations:
Customer
A B C D E Total
Units sold 22,000 28,000 40,000 52,000 5,000 147,000
Selling price per unit $18.50 $18.50 $18.50 $18.50 $18.50
Special discount $4.50 $2.00 $1.50 $5.50 $4.00
Net selling price $14.00 $16.50 $17.00 $13.00 $14.50
Total revenues $308,000 $462,000 $680,000 $676,000 $72,500 $2,198,500
Customer cost analysis (customer-level costs)

In addition to the manufacturing costs of $11.50 per unit, management calculates other
variable costs (such as shipping and customer service) and assigns them to each customer
in the amounts shown in the table below.
Customer
A B C D E Total
Units handled 22,000 28,000 40,000 52,000 5,000
Cost of goods sold $253,000 $322,000 $460,000 $598,000 $57,500 $1,690,500
($11.50/unit)
Other variable costs $ 47,924 $ 58,557 $ 73,514 $ 96,872 $ 9,695 $ 286,562
Total costs $300,924 $380,557 $533,514 $694,872 $67,195 $1,977,062
Customer profitability analysis and customer ranking

All data gathered is summarized and the customers are ranked by their contribution
margin ratios:
Customer
A B C D E Total
Total revenes $308,000 $462,000 $680,000 $676,000 $72,500 $2,198,500
Total variable costs $300,924 $380,557 $533,514 $694,872 $67,195 $1,977,062
Contribution margin $7,076 $81,443 $146,486 $(18,872) $5,305 $221,438
Contribution margin ratio 2.30% 17.63% 21.54% (2.79%) 7.32% 10.07%
Rank 4 2 1 5 3
Upon review of the facts, management finds some special discounts are excessive. Customers
A, E, and D (the three lowest-ranked customers) are all receiving excessive discounts, reducing
the company's profitability. The highest-ranking customer (and most profitable—Customer
C) is receiving the lowest discount which, if discovered by Customer C, may negatively affect
the company's relationship. Even though Customer D accounts for just under a third of the
company's sales, the discount Customer D receives is so significant that sales fail to cover total
variable costs and produces a negative contribution margin. The other variable costs should
be examined in more detail to determine potential gains in cost savings or efficiencies.

PART 1 UNIT
2.3 Advantages and Disadvantages of Profitability Analysis

The advantages of implementing profitability analysis include:
Eliminating nonprofitable customers, product lines, or business units and enhancing
processes and services to maximize contribution earned from profitable customers to
improve total profitability.
Better understanding of costs for each customer, segment, or product line. When all costs,
including nonmanufacturing costs, are allocated, managers are forced to examine cost
structure and profitability.
Analysis over time helps managers understand long-term profitability.
Better data analysis leads to more informed decisions by management.
There are disadvantages as well:
Investing in a system that captures all required data could be high.
Implementing advanced management and cost accounting techniques, such as cost
allocation and activity-based costing, is a challenging task.
The customer profitability analysis may not lead to proper decisions if management is not
aware of customer needs. Dropping unprofitable products or services may lead to the loss
of profitable customers.
Profitability analysis does not give the best information to management unless it is
considered over a long period of time.
2.3.1 Other Factors to Consider

Before making a decision to discontinue a product line, business unit, or customer because it is
not profitable, a manager must consider other nonfinancial factors such as:
Growth and Long-Term Potential. If the probability of growth in sales to the customer
or growth of the product is high, devoting more resources and time may prove to be more
profitable than exiting too soon.
Market Share Potential. Does the product, even if not profitable, help establish a foothold
in certain markets for the company's other profitable products?
Marketing and Advertising. Are there marketing or advertising reasons for the lack of
success of a product that can be remedied?
Resource Alignment. For products and business units that are not profitable, is the
alignment of needs and resources appropriate?
Leadership and Management. Is the right leadership in place to make a product or
business unit successful, or to build on relationships with customers?
Customer Loyalty. Is the customer likely to continue with the company for the long term?
It may be better to work with a customer who is loyal to the company to help make the
relationship profitable rather than discontinue the relationship.
Network. If nonprofitable customers are well-known businesses that may introduce
other important customers to the company, continuing the relationship may be the
best alternative.
Based on this analysis by product level, business unit level, or customer level, a manager may:
Change the pricing structure
Identify which products to promote
Identify where to focus promotional efforts
Identify what customer segments to target and maintain
Identify potential customers, products, or business units to target for growth and
improvement
Identify unprofitable business units, products, or customers for action or discontinuation
ABC Co. is a retailer with four customers. The manager of the marketing department
assembled the following information from the records of the company:
Customer A Customer B Customer C Customer D

Units sold 12,000 24,000 42,000 60,000
Sales $120,000 $180,000 $240,000 $300,000
Cost of goods sold 60,000 72,000 84,000 90,000
Delivery costs 12,000 30,000 36,000 85,000
Order-taking costs 18,000 24,000 30,000 60,000
Other variable costs 12,000 14,000 18,000 23,000
Fixed general/ 36,000 36,000 36,000 36,000
administration costs
Depreciation 24,000 24,000 24,000 24,000
allocation (fixed)
Based on the contribution margin ratios per customer, the customers ranked from the
highest profitability to the lowest profitability are:
a. A, B, C, D
b. C, B, A, D
c. D, A, B, C
d. B, A, C, D

PART 1 UNIT
A company has two business units (Division 1 and Division 2) that are currently operating
as profit centers. Management is evaluating the possibility of discontinuing Division 2
because of the operating losses it has experienced over the last few years. Select
information from the operating budget for the upcoming fiscal year is shown below.
Division 1 Division 2
Sales $800,000 $400,000
Cost of goods sold 300,000 250,000
Gross margin 500,000 150,000
Variable selling and administrative expenses 100,000 80,000
Fixed selling and administrative expenses 75,000 75,000
Operating income (loss) $325,000 $ (5,000)
Fixed selling and administrative expenses are allocated equally between the two units.
If Division 2 is discontinued, fixed selling and administrative expenses are expected to
decrease by 20 percent from the current level, and Division 1's sales are expected to
increase by 15 percent. Based on the budget information above, should the company
discontinue Division 2, and why?
a. Yes, because operating income will increase by $80,000.
b. Yes, because operating income will increase by $20,000.
c. No, because operating income will decrease by $40,000.
d. No, because operating income will decrease by $10,000.
NOTES

6
MODULE
PART 1 UNIT 4
C.3. Performance
Measures: Part 2
Part 1
Unit 4
CMA LOS Reference: Part 1—Section C.3. Performance Measures: Part 2

e. define and calculate return on investment (ROI)
f. analyze and interpret ROI calculations
g. define and calculate residual income (RI)
h. analyze and interpret RI calculations
i. compare and contrast the benefits and limitations of ROI and RI as measures of
performance
j. explain how revenue and expense recognition policies may affect the measurement of
income and reduce comparability among business units
k. explain how inventory measurement policies, joint asset sharing, and overall asset
measurement policies may affect the measurement of investment and reduce
comparability among business units
l. define key performance indicators (KPIs) and discuss the importance of these
indicators in evaluating a firm
m. define the concept of a balanced scorecard and identify its components
n. identify and describe the perspectives of a balanced scorecard, including financial,
customer, internal process, and learning and growth
o. identify and describe the characteristics of successful implementation and use of a
balanced scorecard
p. demonstrate an understanding of a strategy map and the role it plays
q. analyze and interpret a balanced scorecard and evaluate performance on the basis of
the analysis
r. recommend performance measures and a periodic reporting methodology given
operational goals and actual results
1 Measures of Profitability
Profitability measures, including the return on investment (ROI), return on assets (ROA), return on
equity (ROE), and residual income (RI), are commonly used by managers to evaluate performance.
LOS 1C3e 1.1 Return on Investment (ROI)

ROI provides for the assessment of a company's percentage return relative to its capital
investment. The ROI is an ideal performance measure for investment strategic business units
(SBUs). In simplest terms, ROI is expressed as income divided by invested capital; however, ROI
is also expressed as a product of profit margin and investment turnover.
ROI = Income / Investment capital
Or:
ROI = Profit margin × Investment turnover
1.1.1 Components of ROI

ROI can be analyzed as the product of profit margin (income as a percentage of sales) and
investment turnover (sales as a percentage of invested capital). The higher the percentage
return, the better the performance.
Illustration 1 ROI Flowchart
Return on investment (ROI)
Profit margin 3 Investment turnover
Income 4 Sales Sales 4 Invested capital
Example 1 ROI
Facts: Assume that sales are $1,000,000, net income is $40,000, and invested capital is
$250,000. The organization's required rate of return (hurdle rate) is 12 percent.
Required: Determine whether the organization is meeting performance expectations
using ROI.
Solution:
$40,000 $1,000,000 $40,000

× = = 16%
$1,000,000 $250,000 $250,000
The organization is meeting its requirements based on ROI computations. The ROI of
16 percent exceeds the required rate of return of 12 percent.

PART 1 UNIT
1.2 Return on Assets (ROA)

ROA uses average total assets in the denominator. Return on assets measures how efficient a
company is in utilizing its assets to generate income.
ROA is best used when comparing similar entities or when evaluating an entity's performance
over time. It is preferable to ROE since ROA takes into account all sources of funding,
including liabilities.
ROA is used to evaluate a company, and ROI is used to evaluate a specific investment. ROI may
also be used to determine the incremental effect of a new investment.
Net income
ROA =
Average total assets
1.2.1 Variations in Asset Valuation LOS 1C3f
Asset valuations used in ROI and ROA computations affect the results. The appropriate asset
valuation depends on the strategic objectives of the company and the direction that leadership
wants to give its managers. The following terms define different asset valuations.
1. Book Measures
The accounting records of a company provide useful information for ROI calculation. Book
values are easy to obtain since they are reported on the balance sheet of each entity.
Managers may use either the net book value or the historical cost of the operational assets.
Older organizations own assets that have been depreciated over longer periods of time
or have historical costs that are much lower than historical costs of assets that younger
companies own.
Using book values as the denominator for the ROI calculation will result in a higher return
compared with new companies that own new assets not yet depreciated and/or with
recently purchased assets. Analysts avoid using book values as a denominator when
comparing ROI for companies of different ages. Higher ROI does not necessarily mean
better performance; it may only mean older assets were used to generate that income.
The denominator of the ROI ratio can be:
Net Book Value: Historical cost less accumulated depreciation presented in accordance
with generally accepted accounting principles (U.S.).
Gross Book Value: Historical cost prior to the reduction for accumulated depreciation.
2. Market Measures
Using market measures to determine the denominator of the ROI ratio results in a return
that is lower than that calculated using book values. In general, market values are higher
than book values. The higher the denominator, the lower the ratio.
Using market measures for the value of assets is considered good for the comparison of
the different companies with assets of different ages. This reduces the effect of different
accounting methods being used in calculating depreciation; it also reduces the effect of
assets' age. Unfortunately, market values are not easily determinable and can require
judgments and appraisals. Increases in land values will cause ROI to decline. Using market
measures to value land, companies located in regions that face a fast development and
increase in the value of land will reflect lower returns even when compared with less
successful companies operating in areas that do not face the same fast and significant
increase in land values. Stable property values generate consistent returns.
The denominator of the ROI ratio can be:

yy Replacement Cost: The cost to replace assets at their current level of utility.
yy Liquidation Value: The selling price of productive assets.
Illustration 2 Effect of Different Asset Valuation Methods on ROI
The XYZ Corp. operates in three regions. The schedule below shows return on investment
analyzed by different investment valuation methods by region. The investment bases include:
Net Book Value: Historical cost net of accumulated depreciation as displayed on the
financial statements
Gross Book Value: Net book value plus accumulated depreciation
Replacement Cost: Replacement cost in the identified region
Liquidation Cost: Sales or liquidation value in the identified region
XYZ Corp.
Return on Investment by Region and by Investment Base
Net Book Gross Book Replacement Liquidation

Region Income Value Value Cost Cost
Financial Data
Region 1 181,000 1,815,000 2,500,000 3,500,000 3,000,000
Region 2 18,100 190,000 250,000 500,000 600,000
Region 3 50,000 500,000 690,000 700,000 695,000
Return on Investment
Region 1 10.0% 7.2% 5.2% 6.0%
Region 2 9.5% 7.2% 3.6% 3.0%
Region 3 10.0% 7.2% 7.1% 7.2%
As investment values in region 3 show some stability, ROI is stable as well. Less so in
region 2, where there is a significant increase in the market values of investments.
1.2.2 Other Asset Valuation Issues

Capitalization Policy
The policy used by the organization to classify items as fixed assets or expenses creates
differences in basis of the ROI calculation.
Treatment of Unproductive Assets
Companies may remove unproductive assets, including idle or surplus factories, facilities
under construction, surplus inventories, surplus cash, and deferred charges from the
invested capital base.
Treatment of Intangible Assets
Companies may remove intangible assets from the invested capital base if management is
unsure of the value or earnings contributions of intangibles.

PART 1 UNIT
Pass Key
The higher the denominator used in the ROI computation, the lower the return.
1.2.3 Benefits and Limitations of ROI LOS 1C3i
ROI, like any performance measure, is designed to evaluate managers' achievement of corporate
objectives and provide a basis for incentives. Using ROI has the following benefits:
Simple measure used to evaluate investments.
Compares several available investment opportunities or competitors.
Compares performance over several accounting periods.
Limitations of the ROI computation includes:
Short-Term Focus: Use of ROI exclusively as a performance measure may inadvertently
overemphasize maximizing short-term returns; also called investment myopia. A balanced
scorecard can better focus managers on business processes, customers, and human
resource issues.
Disincentive to Invest: Profitable units may become reluctant to invest in additional
productive resources because they could reduce ROI in the short term.
1.3 Return on Equity (ROE)

ROE shows how effective management is at employing investors' capital in producing value to
shareholders. ROE is different from ROA in that ROE excludes liabilities from the denominator.
The less equity used in financing operations (or the more liabilities are used, increasing leverage)
the higher the return on equity will be, but the overall financing risk will be higher, as well.
Net income
ROE =
Equity
The advantage of ROE is that it is simple to compute. However, breaking out the components of
ROE provide management with a much clearer picture of the efficiencies and leverage of a given
company's operations.
1.3.1 DuPont Analysis

The three-step DuPont model breaks ROE into three distinct components: Net profit margin,
asset turnover, and financial leverage. The DuPont analysis is useful because it highlights each
of the components and allows an investor to determine what financial activities are contributing
the most to the changes in ROE.
The first component (net profit margin) measures operating efficiency, the second (asset
turnover) measures the efficiency of using assets, and the third (financial leverage) measures
the extent of using debt in financing operations. DuPont analysis can help understand whether
a company's profitability, use of assets, or debt is driving ROE. If a company has a high ROE at
the same time it has low net profit margin and/or asset turnover ratio, then the high ROE is the
result of high leverage. This is an indicator of higher risk taken by management.
Net Profit Margin

Net profit margin is a measure of operating efficiency.
Net income
Net profit margin =
Sales
Asset Turnover
Asset turnover is a measure of the degree of efficiency with which a company is using its assets.
Sales
Asset turnover =
Assets
Financial Leverage
Financial leverage measures the extent to which a company uses debt in its capital structure.
Assets
Financial leverage =
Equity
All three components are put together in the DuPont ROE formula:
DuPont ROE = Net profit margin × Asset turnover × Financial leverage
Net income Sales Assets

= × ×
Sales Assets Equity
Note that net profit margin and asset turnover can be multiplied to calculate return on assets
(ROA). Therefore, DuPont ROE can also be calculated as:
DuPont ROE = ROA × Financial leverage

PART 1 UNIT
1.3.2 Extended DuPont Model

The extended DuPont model further breaks out net profit margin into three distinct
components: Tax burden, interest burden, and the operating income margin. This refines the
profit margin ratio into the operating profit margin ratio by taking out the effects arising from
taxes and interest expense. As a result, it provides both management and the financial analyst
with deeper understanding about a company and its immediate competitors.
It is important to note that all methods of calculating ROE (initial calculation, DuPont, and
extended DuPont) produce the same number. By breaking out the calculation into different
components, management can get a better understanding of the factors driving ROE and how
those factors compare relative to competing companies and to the industry overall.
Tax Burden
The tax burden is the extent to which a company retains profits after paying taxes.
Net income
Tax burden =
Pretax income
Interest Burden
The interest burden reflects how much in pretax income a company retains after paying
interest to debt holders.
Pretax income
Interest burden =
Earnings before interest and taxes (EBIT)
EBIT Margin
The EBIT margin is a measure of company profits earned on sales after paying operating
and nonoperating costs (other than interest and taxes).
EBIT
EBIT margin =
Sales
Extended DuPont ROE Formula

The last two components of the ROE calculation remain the same, with the extended model
shown below:
Extended Tax Interest EBIT Asset Financial

= × × × ×
DuPont ROE burden burden margin turnover leverage
Net Pretax
income income EBIT Sales Assets
= × × × ×
Pretax EBIT Sales Assets Equity
income
Pass Key
Average assets and average equity should be used when calculating ROE. However, if an
exam question only gives ending assets and/or ending equity, these amounts may be used
to calculate ROE.
Example 2 Return on Equity—DuPont Models
Facts: Blake Co. reports the following in its Year 5 financial statements:
Sales $500,000 Assets $900,000
COGS 275,000 Liabilities 300,000
Gross profit 225,000 Equity 600,000
SG&A 150,000
EBIT 75,000
Interest expense 15,000
Pretax income (EBT) 60,000
Tax (30% rate) 18,000
Net income $ 42,000
Required: Calculate each of the individual component ratios for Blake, as well as the ROE
for Blake using both the DuPont model and the extended DuPont model.
(continued)

PART 1 UNIT
(continued)
Solution:
Net profit margin = Net income / Sales
= $42,000 / $500,000
= 0.084
Tax burden = Net income / Pretax income
= $42,000 / $60,000
= 0.70
Interest burden = Pretax income / EBIT
= $60,000 / $75,000
= 0.80
EBIT margin = EBIT / Sales
= $75,000 / $500,000
= 0.15
Asset turnover = Sales / Assets
= $500,000 / $900,000
= 0.56
Financial leverage = Assets / Equity
= $900,000 / $600,000
= 1.50
DuPont ROE = Net profit margin × Asset turnover × Financial leverage
= 0.084 × 0.56 × 1.50
= 0.07 or 7%
Extended DuPont ROE = Tax burden × Interest burden × EBIT margin × Asset turnover
× Financial leverage
= 0.70 × 0.80 × 0.15 × 0.56 × 1.50
= 0.07 or 7%
Illustration 3 Return on Investment by Product Line
The XYZ Corp. has three product lines. The schedule below shows product line results for
Year 1 and Year 2. The total return on investment generated by the XYZ Corp. represents
the combined results of each of its product lines.
XYZ Corp.
Return on Investment by Product Line
Income Investment Sales

Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Product line 1 16,000 16,000 100,000 90,000 250,000 250,000
Product line 2 100,000 150,000 1,000,000 1,500,000 2,000,000 2,500,000
Product line 3 25,000 15,000 250,000 225,000 500,000 400,000
Total 141,000 181,000 1,350,000 1,815,000 2,750,000 3,150,000
Return on Sales Asset Turnover Return on Investment

Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Product line 1 6.4% 6.4% 2.5 2.8 16.0% 17.8%
Product line 2 5.0% 6.0% 2.0 1.7 10.0% 10.0%
Product line 3 5.0% 3.8% 2.0 1.8 10.0% 6.7%
Total 5.1% 5.7% 2.0 1.7 10.4% 10.0%
Identifying the return on investment by product line helps managers identify performance
that either improves or hinders overall performance.
Total Return on Sales Is Improving: Total income increased 28 percent, from $141,000 to
$181,000, faster than the sales growth rate of 15 percent, from $2,750,000 to $3,150,000.
Total Asset Turnover is Declining: Total sales increased by only 15 percent, from
$2,750,000 to $3,150,000, while the total investment base increased 34 percent, from
$1,350,000 to $1,815,000.
Total Return on Investment is Declining: Total income increased 28 percent, from
$141,000 to $181,000, which is less than the 34 percent growth in the investment base.
Product line No. 1 shows consistent income and return on sales on a declining asset base.
Although return on sales is constant (6.4 percent), asset turnover and return on investment
are improving from 2.5 to 2.8 and from 16 percent to 17.8 percent, respectively.
Product line No. 2 shows increasing income in response to increasing investment and sales.
Return on sales improved from 5 percent to 6 percent, but asset turnover declined from 2
to 1.7 only and overall return on investment remained constant at a rate of 10 percent.
Product line No. 3 shows decreasing income, declining investment, and decreasing sales.
Return on sales (declined from 5 percent to 3.8 percent), asset turnover (declined from 2 to
1.8 only), and return on investment (declined from 10 percent to 6.7 percent only) suffer.
Managers at XYZ reviewing the return on investment by product line and the components
of each computation have some new insight into why aggregate returns have suffered:
Product line No. 3 is not performing.

PART 1 UNIT
1.4 Residual Income LOS 1C3g

Residual income measures the excess of actual income earned by an investment over the return LOS 1C3h
required by a company's management. The rate of return, or hurdle rate, for the company may
be its weighted average cost of capital (WACC), cost of equity, or the target return established by
management. Although ROI provides a percentage measurement, residual income provides a
measurement amount. Like ROI, residual income is a performance measure for investment SBUs.
The formula for residual income is as follows:
Residual income = Net income (from the income statement) − Required return
Where:
Required return = Net book value (Equity) × Hurdle rate
A positive residual income indicates that performance is meeting standards, and a negative
residual income indicates that performance is not meeting standards.
Example 3 Residual Income
Facts: Instafab Manufacturing has an investment in its Southeast regional plant with a
net book value of $200,000. Instafab's expected hurdle rate is 10 percent, and the division
produces net income of $30,000.
Required: Calculate residual income.
Solution:
Net income $30,000

Net book value $200,000
Hurdle rate × 10%
Required return (20,000)
Residual income $10,000
The $10,000 represents the excess of Southeast income over the hurdle rate set by
management. The Southeast division not only earns the 10 percent required rate of
return, but also earns an additional $10,000. This investment achieves the targets set by
management.
LOS 1C3i 1.4.1 Benefits and Limitations of Residual Income Performance Measures
In comparing the ROI with RI as measures of performance, the following can be summarized:
Return on Investment (ROI) Residual Income (RI)

Purpose Used to calculate percentage of Used to measure profitability of
return on investment of a division, an investment, especially a new
product, or company as a whole investment using monetary values,
rather than percentages
Benefits Useful when measured against an Positive residual income may
appropriate hurdle rate, measured indicate investment in new project
by management
Limitations May be misleading if entities are Difficult to establish a target rate
using different accounting policies of return, dependent on target
and/or different valuation methods rate set by management using
for investments judgment
Use in assessing managers' Distorts comparisons among units
performance may discourage that are unequally sized because
managers from investing in new the measurement is a dollar value,
property and machinery because rather than a percentage
less investment in new assets
results in a higher ROI
LOS 1C3j 2 Measurement Issues Affecting Profitability

LOS 1C3k
Performance evaluation techniques are designed to compare economic performance to
standards and to compare economic performance of similar entities. Various accounting
practices reduce comparability between business units. There are several accounting issues that
must be considered, including the following:
2.1 Revenue and Expense Recognition Issues

There are several accounting issues related to revenue and expense recognition that an analyst
must consider in the evaluation process, including:
non-recurring items may result in distortions to income, which reduces comparability
between units or divisions;
high promotion costs associated with a new product rollout by one division may distort
comparison and may reduce comparability among the various divisions;
significant gains on disposition of assets in one division compared with the other divisions
may reduce comparability; and
differing depreciation methods reduce comparability between units or divisions.
2.2 Inventory Measurement Issues

Inventory costing methodologies can result in different net income and inventory valuations.
Last in, first out (LIFO) costing produces higher cost of goods sold amounts and lower inventory
amounts than first in, first out (FIFO) costing in periods of inflation. Two divisions or units that do
not use identical inventory costing methods will not produce comparable results.

PART 1 UNIT
2.3 Other Measurement Issues

The selection of accounting policies affects not only revenues and expenses of a company but may
also affect the value of the assets used as a denominator for ROI calculation. These issues include:
Joint Asset Sharing
Changing the methods used to allocate costs among divisions or units or allocating the value
of assets that are shared by different divisions affects the amount of return or the amount
of the investment base of each division.
Overall Asset Measurement
Valuation of assets at their net book value, gross book value, replacement cost, or
liquidation value impacts the basis of any ROI or related computation. Variability in the
valuation and measurement of the assets changes the base for the computation of the rate
or amount of return. Variations in practice reduce comparability.
Asset Capitalization Policies
Some divisions might have a policy to capitalize expenditures above a certain value upon
purchase. If the expenditure is capitalized rather than expensed, net income and the
assets' base will increase. If, however, it is expensed, net income in the year of purchase will
decrease, affecting the calculation of ROI.
Use of Full Costing
If a division uses full absorption costing rather than variable costing to determine
inventoriable costs, its operating income will increase as the volume of inventory increases.
Therefore, management should make sure that all divisions are using the same method of
inventory cost determination when comparing the operations of these divisions. Although
this is an important consideration when comparing divisions internally, it is not an issue
when an analyst compares different companies' performance based on published financial
information. All companies must use absorption costing for external reporting per GAAP
and IFRSs.
Disposition of Manufacturing Variances
When a company uses a standard costing system, any resulting variances should be
disposed of at the end of the reporting period. Disposition should be through an adjustment
to cost of goods sold if the amount is deemed immaterial or could be prorated (if material)
among cost of goods sold, work-in-process, and finished inventory. If manufacturing
variances are closed in the cost of goods sold account only, income will be distorted and
therefore the calculation of ROI will be distorted, as well.
3 Balanced Scorecards (BSC) LOS 1C3m
LOS 1C3n
The balanced scorecard gathers information on multiple dimensions of an organization's
performance, as defined by the critical success factors necessary for the organization to LOS 1C3q
accomplish its strategic mission.
3.1 Critical Success Factors in the BSC

Critical success factors are classified as:
Financial Measures: Includes return on assets (ROA), return on investment (ROI), profit
margins, asset turnover ratios, and other traditional ratio measures used by managers.
Internal Business Processes: Nonfinancial measures such as quality and efficiency of the
organization's performance related to its products and services.
Customer Satisfaction: Nonfinancial measures including customer retention and number
of customer repeat visits.
Advancement of Innovation and Human Resource Development (or learning and
growth): Nonfinancial measures that focus on the human resources of the organization.
The human resource perspective is seen by many as the most important of the four critical
success factors. A satisfied employee may be more innovative and may engage in developing
internal processes and products, which will lead to customer satisfaction. Satisfied customers
help the company achieve its financial goals.
3.2 Balanced Scorecard Contents and Format

Typically, the scorecard describes the classifications of critical success factors, the strategic goals,
the tactics, and the related measures associated with strategic and tactical goals.
The strategy of the company must be the core of a balanced scorecard.
The number of measures must be limited, identifying those that are most crucial (such as
the key performance indicators).
Short-term and long-term sustainability objectives must be balanced. Reducing
R&D will lead to higher profits in the short-run but could negatively affect long-term
sustainability objectives.
Illustration 4 Balanced Scorecard
Instafab Manufacturing is building its business using a cost leadership strategy. The
management of Instafab has identified four strategic goals, one associated with each
classification of critical success factors, to help its business grow. The strategic goals are:
1. Capturing additional market share
2. Maintaining low costs that are supported by low prices
3. Becoming a low-price leader
4. Linking strategy with reward and recognition
Help Instafab design tactics to achieve its strategic goals, define measures it might use, and
organize them in the manner of a balanced scorecard.
(continued)

PART 1 UNIT
(continued)
Tactics Measures
Financial Perspective
Strategic goals Capture increasing market share Company vs. industry growth
Critical success factors Maintain customer base Volume trend line
Tactics and measures Steadily expand services Percentage of sales from
new products
Internal Business Processes

Strategic goals Maintain low costs that are Costs compared to
supported by low prices competitor
Critical success factors Maintain consistent production First pass rates
Tactics and measures Improve distribution efficiency Percentage of perfect orders
Customer Perspective
Strategic goals Become a low-price leader Our cost vs. competition
Critical success factors Anticipate customer needs Percentage of products in
before competitors R&D being test-marketed
Tactics and measures Increase customer satisfaction Customer surveys
Advance Learning and Innovation (Human Resources)

Strategic goals Link strategy with reward Net income per dollar of
and recognition variable pay
Tactics and measures Promote entrepreneurial culture Annual reports
3.3 Characteristics of a Successful Balanced Scorecard Process LOS 1C3o
Successful implementation of a balanced scorecard system requires:

Top-level managers committed to lead the process.
Employees at the different levels within the organization involved in discussions and
prioritization of the scorecard objectives.
The resulting balanced scorecard must be communicated to all employees within the
organization. Employees must understand the links between the different perspectives to help
in the successful implementation of the scorecard. The scorecard is not set to control behavior
but rather to allow employees to develop, learn, and grow.
Employees should understand that management could use the balanced scorecards as a basis
for measuring performance and setting rewards. This should motivate employees to focus on
nonfinancial measures as well.
LOS 1C3p 3.4 Strategy Map

A strategy map is a graphical depiction of the strategy of a company. It is usually prepared
during the planning stage and is used again during the monitoring phase to evaluate and review
progress toward the achievement of strategic objectives. A strategy map outlines the overall
strategic goals of a company and helps employees understand where they fit in the achievement
of the overall goals. When management designs a strategy map, the four perspectives of a
balanced scorecard are usually linked to the map to help prioritize goals and objectives.
Learning and growth of employees leads to employee satisfaction.
Employee satisfaction increases employee engagement in improving internal processes and
systems through innovation.
The result are higher customer satisfaction leading to improved sales growth and profits.
If links between the four critical success factors in the BSC are clear to employees, then goal
congruence is easier to achieve.
Illustration 5 Sample Strategy Map
Enhance growth Improve cost

Financial Perspective
opportunities structure
Improve
Excellent On-time
Customer Perspective customer
quality delivery
experience
Customer Cost Service delivery

Internal Processes Perspective
management management management
Increase Motivation Enhance

Learning and Growth Perspective expertise of employees knowledge

PART 1 UNIT
3.5 Performance Measures and Strategy LOS 1C3r

The performance measurement method used by management must be aligned to the entity's
strategy. The goals set by management during strategic planning define the types of measures
managers need to use to evaluate performance.
For example, if the main objective of a company is to grow its market share by 10 percent over
the coming three years, then management must set measures that tie to this main objective.
Managers want to maximize the ROI to exceed the industry average by 2 percent annually; to
achieve a positive RI of $50,000; increase annual sales by 6 percent; and improve products to be
measured by reduction of warranty cost by 15 percent annually.
4 Key Performance Indicators LOS 1C3l
Key performance indicators (KPI) are the key indicators of progress toward objectives. KPIs focus
on strategic and operational improvement, create an analytical basis for decision making, and
bring attention to the priorities of management as set in the strategic plan. Managing with KPIs
starts with setting targets and then monitoring progress toward these targets.
4.1 Types of KPIs

KPIs can be quantitative and qualitative. Management should link KPI identification to the four
critical success measures in the balanced scorecard: financial measures, internal business
processes, customer satisfaction, and learning and growth of human resources.
Useful KPIs provide objective evidence of progress toward organizational goal achievement. A
useful KPI should measure what they were intended to measure, may be used as indicators for
development over time, and are used to measure whether the company is achieving its goals set
during the planning stage.
If a company is using the balanced scorecards to plan for the future, indicators should be
identified to collect evidence relevant to the goals identified in the strategic plan. The following
are examples of the KPIs related to each of the balanced scorecards:
Financial Perspective Indicators: Sales volume and changes thereof (measured as
percentage change in sales); profit margins and changes thereof (measured in percentage
points); ROI (measured in percentage points).
Internal Business Processes Indicators: Number of new products offered to the
customers; order throughput time (measured in hours); percentage of defective items
(measured in rate of goods returned as defective).
Customer Satisfaction Perspective: Number of repeat customers (measured in number of
repeat orders); number of new customers; waiting time to respond to a customer call.
Learning and Growth Perspective: Knowledge of employees about the products
(measured in terms of number of customer referrals to supervisors); employee innovation
(measured in number of project proposals presented by employees to management).
For several years, Northern Division of Marino Company has maintained a positive residual
income. Northern is currently considering investing in a new project that will lower the
division's overall return on investment (ROI) but increase its residual income. What is the
relationship between the expected rate of return on the new project, the firm's cost of
capital, and the division's current ROI?
a. The expected rate of return on the new project is higher than the division's current
return on investment, but lower than the firm's cost of capital
b. The firm's cost of capital is higher than the expected rate of return on the new
project, but lower than the division's current return on investment.
c. The division's current return on investment is higher than the expected rate of
return on the new project, but lower than the firm's cost of capital.
d. The expected rate of return on the new project is higher than the firm's cost of
capital, but lower than the division's current return on investment.
Which of the following financial measures of performance are expressed as a monetary

amount?
I. Residual income
II. PE ratio
III. EPS
IV. ROI
a. I only
b. I and III only
c. III only
d. II and IV only

Class Question Explanations Part 1
UNIT 4
Unit 4, Module 1
1. MCQ-12095
Choice "b" is correct. The flexible budget is prepared using the actual quantity of output. Variable
elements of the budget are the same as planned in the master budget on a per-unit basis, while
fixed costs remain the same regardless of volume.
From the master budget, the selling price per unit is $15 ($1,500,000 ÷ 100,000 units); direct
materials are $3 per unit ($300,000 ÷ 100,000 units); direct labor is $2 per unit ($200,000 ÷
100,000 units); variable overhead is $200,000 (40% × $500,000) or $2 per unit ($200,000 ÷
100,000 units); and variable selling and administrative costs are $96,000 (80% × $120,000) or
$0.96 per unit. Therefore, the total variable cost is $7.96 ($3 + $2 + $2 + $0.96). Fixed costs for
the period are estimated to be $324,000 ($300,000 fixed factory overhead + $24,000 fixed selling
and administrative).
The flexible budget is:
Sales revenue ($15 × 85,000) $1,275,000

Direct materials ($3 × 85,000) 255,000
Direct labor ($2 × 85,000) 170,000
Variable FOH ($2 × 85,000) 170,000
Fixed FOH 300,000
Variable selling and administrative expenses ($0.96 × 85,000) 81,600
Fixed selling and administrative expenses 24,000
Operating income $ 274,400
Choice "a" is incorrect. If the total operating income for the 100,000 units is averaged, then the
operating income per unit is $3.80 ($380,000 ÷ 100,000). Using this average operating income
per unit and applying it to 85,000 units will result in an operating income of $323,000.
Choice "c" is incorrect. This is the contribution margin for 85,000 units, calculated by subtracting
all variable costs from sales revenue:
Sales revenue ($15 × 85,000) $1,275,000

Direct materials ($3 × 85,000) 255,000
Direct labor ($2 × 85,000) 170,000
Variable FOH ($2 × 85,000) 170,000
Variable selling and administrative expenses ($0.96 × 85,000) 81,600
Contribution margin $ 598,400
Choice "d" is incorrect. Total manufacturing cost of $1,000,000 ($300,000 DM + $200,000 DL +

$500,000 VOH) / 100,000 units = $10 per unit). Income was incorrectly calculated by multiplying
85,000 times the $15 selling price minus the $10 manufacturing cost [85,000 × ($15 − $10)].
© Becker Professional Education Corporation. All rights reserved. CQ–51

Part 1 Class Question Explanations
2. MCQ-12096
Choice "a" is correct. The sales mix variance is the change in the standard contribution margin
earned because of a change in the actual mix of sales compared to standard mix.
To calculate the sales mix variance, the weighted average standard CM for the actual mix
is compared to the weighted average standard CM for the standard mix. The difference is
multiplied by the actual sales. The weighted average standard CM for the actual mix = [(10,000
books × $38) + (8,000 CDs × $10)] ÷ [10,000 + 8,000] = $25.56; the weighted average standard CM
for the standard mix = [(12,000 books × $38) + (10,000 CDs × $10)] ÷ [12,000 + 10,000] = $25.27.
Therefore, the sales mix variance = [$25.56 − $25.27] × [10,000 + 8,000] = $5,100 favorable.
This is a favorable variance because the actual mix resulted in a higher weighted average
contribution margin.
Choice "b" is incorrect. The variance is favorable because the weighted average contribution
margin for the actual mix was higher than the weighted average contribution margin for the
standard mix.
Choice "c" is incorrect. The $110,100 unfavorable variance is the sales quantity variance.
Choice "d" is incorrect. The $96,000 unfavorable is the sales volume variance.
Unit 4, Module 2
1. MCQ-12097
Choice "c" is correct. Labor efficiency variance results from the difference between the actual
number of hours used in production and the standard number of hours allowed (the budgeted
standard) for actual output. The difference in number of hours is then multiplied by the
standard rate per hour of labor. 10,000 widgets were produced using 3,000 labor hours, which is
less than the number of hours allowed for actual production (10,000 widgets × 0.50 hour each =
5,000 hours). The actual labor hours were 2,000 less than allowed. That is a 2,000 hours savings
multiplied by $15 per hour equals $30,000 in savings (favorable variance).
Choice "a" is incorrect. The $25,000 is materials variance, not labor variance, which happens to
be unfavorable.
Choice "b" is incorrect. The $25,000 unfavorable variance is the materials variance, not labor
variance.
Choice "d" is incorrect. The labor variance is favorable because the number of hours actually
used (3,000) is less than the standard hours allowed of 5,000 (10,000 output units × 0.5 hour
per unit).
CQ–52 © Becker Professional Education Corporation. All rights reserved.

2. MCQ-12098
Choice "b" is correct. The materials quantity (usage) variance is the difference between the
standard price of quantity of materials used in production and the standard price of the quantity
of materials allowed to be used for the quantity produced. It is favorable when the actual
quantity used is less than the quantity allowed to be used.
The 3 pounds per unit is calculated as follows:
yyThe standard price of the actual materials used = 5,000 pounds × $4.50 = $22,500.
yyBecause the usage variance is favorable, this means that the standard price of the actual
materials used is less than the standard price of the standard quantity allowed by $450;
therefore, the quantity of materials allowed at the standard price is $22,950.
yyThe quantity of materials allowed to be used = $22,950 ÷ $4.50 = 5,100 pounds.
yyBecause 5,100 pounds were used to produce 1,700 units of output, 3 pounds (5,100 / 1,700)
are allowed per unit of output.
Choice "a" is incorrect. 2.94 pounds per unit is the actual quantity used to produce a unit of output.
Choice "c" is incorrect. 4.50 pounds per unit is the standard price per unit of materials.
Choice "d" is incorrect. 4.00 pounds per unit is the actual price per unit of materials.
3. MCQ-12099
Choice "c" is correct. The materials yield variance results from changes in the actual total
quantity used for all types of materials compared to the planned quantity for the actual output.
The total quantity used of corn and wheat is 3,000 pounds (1,000 corn + 2,000 wheat); the
total quantity allowed is also 3,000 pounds (1,250 corn + 1,750 wheat). This means that there
is no yield variance. There will be a mix variance, because more corn and less wheat was used
than planned.
Choice "a" is incorrect. The mix variance is $625 unfavorable.
Choice "b" is incorrect. The mix variance is $625 unfavorable.
Choice "d" is incorrect. The price variance is $4,500 unfavorable.
4. MCQ-12100
Choice "a" is correct. The variable overhead efficiency variance results from the difference
between the actual hours worked compared to the standard hours allowed at the actual output
level. The difference is then multiplied by the standard rate per hour. If the actual number of
hours worked is less than that allowed, the variance is favorable, otherwise it is unfavorable. The
difference between actual hours worked and hours allowed is 1,000 hours (11,000 − 12,000).
The actual hours worked is 1,000 hours less than the number allowed. By multiplying the
difference by the standard rate per hour, the result will equal 8,000 favorable.
Choice "b" is incorrect. Because the actual number of hours worked (11,000) is less than the
number of hours allowed for the current production (12,000 hours), the variance is favorable.
Choice "c" is incorrect. The $6,000 is the total variable overhead variance, not the efficiency
variance. It is the difference between the variable overhead applied (12,000 × $8 = $96,000) and
the actual variable overhead ($90,000).
Choice "d" is incorrect. The $2,000 is the unfavorable variable overhead spending variance. It is
the difference between the actual variable overhead ($90,000) and the flexible budget variable
overhead based on actual hours worked $88,000 (11,000 × $8).

5. MCQ-12101
Choice "b" is correct. The production volume variance results for capacity usage. If the quantity
produced exceeds the budgeted production quantity, a better utilization of capacity results
in a favorable variance that is equal to the difference between the quantity produced and the
budgeted quantity multiplied by the fixed overhead application rate.
The quantity planned for production is 1,900 units, while the actual output is 2,500 units.
The quantity produced exceeds the budgeted quantity by 600 units. FOH rate per unit is $10
($19,000 ÷ 1,900 units). The production volume variance = 600 × $10 = $6,000. This is favorable
because the quantity produced is higher than that budgeted.
Choice "a" is incorrect. Production volume variance is not calculated for variable overhead.
Choice "c" is incorrect. The $3,750 is a favorable variable overhead efficiency variance.
Choice "d" is incorrect. Because actual production is higher than budgeted, the production
volume variance must be favorable.
6. MCQ-12102
Choice "b" is correct. One of the causes of labor variances is the quality of materials used
in production. If the quality of materials is below standard, workers may waste time during
the production process to separate usable materials from unusable materials. Workers may
also inadvertently use substandard materials that break or are otherwise scrapped during
production due to inferior quality, resulting in fewer units that take longer to make. The person
who made the decision to purchase lower-grade materials is the person responsible for any
resulting unfavorable variances.
The most likely outcome is that the labor efficiency variance will be unfavorable because of the
decision of the purchasing manager. The purchasing manager's decision to buy lower-quality
materials than the standard specified means he will be held responsible for wasted hours.
Choice "a" is incorrect. Using lower-quality materials is unlikely to help workers be more efficient.
Choices "c" and "d" are incorrect. Although an investigation into the labor variance would likely
start with the production manager, the decision to purchase lower-quality materials would be
discovered and the purchasing manager held responsible for the unfavorable variance.

Unit 4, Module 3
1. MCQ-12103
Choice "b" is correct. Responsibility accounting requires dividing a company into strategic
business units (SBU), called responsibility centers, to facilitate performance measurement and
management. A revenue center is a department whose manager is responsible for generating
revenues and is accountable for the revenue his/her department generates.
Choice "a" is incorrect. Cost centers are centers whose managers are responsible and
accountable for costs incurred during a period. Examples include maintenance departments
where the person in charge must keep an eye on the costs incurred while not being responsible
for revenues or profits of the entity. The manager of the telecommunications team mentioned in
the question is responsible for revenues, not costs. The performance of the telecommunication
manager is based on achieving the targeted billing volume or sales volume.
Choice "c" is incorrect. Profit centers are departments whose managers are responsible
and accountable for the amount of profits they generate compared to budgeted amounts.
A manager responsible for product "X" for example, is held accountable for all revenues
generated and all costs incurred, therefore, the profits of his/her division. The manager of the
telecommunications team mentioned in the question is responsible for revenues, not profits.
Choice "d" is incorrect. Investment centers are evaluated by owners who had invested their money.
They evaluate based on the return on investment. That is, profits compared to amounts invested. A
newly created branch of the company is an investment center. The manager of the telecommunications
team mentioned in the question is responsible for revenues, not return on investment.
2. MCQ-12104
Choice "d" is correct. A manager is responsible for all activities that fall under his/her control.
A production manager is therefore responsible for costs associated with the production
department that he/she can control. Any costs that are incurred because of another manager's
decision should not be charged to the production department manager's performance report
because the production department does not control them. All costs within a company are
controllable by someone and should be reported on the performance report of that manager.
Because this sales department operates as a profit center and accepts a rush order, it should
report the extra cost of the rush order. The overtime required should not be charged to the
production department because the manager may reject the order as not beneficial to the
department goals. The key issue is to ask the question, "Who made the decision?" In this
question, it is the sales manager who made the decision to accept the rush order, therefore, she
is the person who controls the costs associated with this decision.
Choice "a" is incorrect. The production manager did not accept the order and may even reject
the order based on the negative effect it will reflect on his performance report. The sales
manager made the decision to accept the rush order; therefore, the additional costs of the rush
order are controllable by the sales manager, not the production manager.
Choice "b" is incorrect. The rush order may be of value to the company as a whole. The
incremental revenues resulting from accepting this order may be higher than the incremental
costs of accepting the rush order, and would make this choice incorrect. There is not enough
information in the problem to determine if this is the correct answer. In general, candidates
should not assume additional information other that what the case explicitly states.
Choice "c" is incorrect. No incremental costs that result from accepting the rush order can be
ignored. The incremental costs must be charged to the performance report of the department
manager who made the decision to accept the rush order. All costs incurred are controllable by
some manager. The manager who decides is the manager in control and must be charged with
the incremental costs resulting from his/her decision.

3. MCQ-12105
Choice "d" is correct. Dual allocation is based on the separation of fixed and variable costs
accumulated into overhead cost pools, and then allocating the variable cost according to
utilization and the fixed costs according to capacity.
$50,000 will be allocated to the arts department as follows:
Fixed cost allocated based on budgeted copies

($60,000 ÷ 360,000) × 240,000 copies $40,000
Variable cost allocated based on actual usage
$0.05 × 200,000 copies $10,000
Total cost allocated to the arts department $50,000
Choice "a" is incorrect. $40,000 will be allocated to the arts department only if the fixed cost is
allocated equally to both users as follows:

($60,000 ÷ 2) $30,000
$0.05 × 200,000 copies $10,000
Choice "b" is incorrect. $52,857 will be allocated to the arts department only if the fixed cost is
allocated based on actual usage as follows:

($60,000 ÷ 280,000) × 200,000 copies $42,857
$0.05 × 200,000 copies $10,000
Choice "c" is incorrect. $52,000 will be allocated to the arts department only if the variable cost is
allocated on the basis of budgeted usage as follows:

($60,000 ÷ 360,000) × 240,000 copies $40,000
$0.05 × 240,000 copie $12,000

Unit 4, Module 4
1. MCQ-12106
Choice "c" is correct. Transfer pricing refers to pricing by one department of the company when
it sells an item to another department within the same company. Transfer pricing is needed to
evaluate performance per department as if it is autonomous. Transfer pricing is needed when
transferring items within the same company, from department to department, or between a
parent and a subsidiary.
All of the choices given in this question are therefore correct except for choice "c." Transfer pricing
occurs between two internal departments, not between the company and an external customer.
Choice "a" is incorrect. Because transfer pricing refers to pricing when items are transferred
from one department to another within the same company, choice "a" represents a true
statement. The question, however, asks for a false statement to be identified.
Choice "b" is incorrect. It is true that a transfer price could be the market price if known and
available. Because the question asks candidates to identify a false statement, choice "b" should
not be selected because it is true as stated.
Choice "d" is incorrect. It is true that a transfer price could be based on cost whether full cost,
variable cost, or variable cost plus opportunity cost. Because the question asks candidates to
identify a false statement, then choice "d" should not be selected because it is true as stated.
2. MCQ-12107
Choice "a" is correct. Transfer pricing refers to pricing by one department of the company
when it "sells" an item to another department within the same company. Transfer prices could
be determined in several ways, including the market price, the total cost of production, total
variable costs only, a negotiated price, etc. In case of excess capacity, use the rule: Variable cost
≤ Transfer price ≤ Market price. In cases of no capacity available, use the rule: Variable cost +
Opportunity cost ≤ Transfer price ≤ Market price.
The Fabrication division has excess capacity of 5,000 units, which makes it possible to produce
the 4,500 additional units needed without sacrificing any opportunity cost incurred. The
minimum selling price is therefore $21, which covers all variable manufacturing costs.
Choice "b" is incorrect. Variable selling/distribution costs incurred by selling to external
customers should not be considered when selling internally.
Choice "c" is incorrect. Fixed costs are not incremental costs resulting from the additional
production; they are paid whether the internal order is satisfied or not. Therefore, fixed costs
should not be considered in determining transfer prices.
Choice "d" is incorrect. This represents the maximum price that the purchasing department is
willing to pay for the purchase of the item internally. The question asks for the minimum price
the seller could charge, not the maximum price the buyer would pay.

3. MCQ-12108
Choice "b" is correct. In determining the transfer price, both departments must reach an
agreement to set a price that is considered fair to both. The fair price must fall between the
variable cost (minimum) and the market price (maximum).
The manager of department A will target the highest possible price, which is $46.
Choice "a" is incorrect. The full price is not a possible transfer price because it exceeds the
market price. It includes all fixed costs that are allocated to the unit of output.
Choice "c" is incorrect. Transfer pricing does not target the coverage of fixed costs allocated to
the component unit.
Choice "d" is incorrect. The variable cost is the minimum price, not the highest price.
Unit 4, Module 5
1. MCQ-12147
Choice "b" is correct. The contribution margin is calculated by comparing revenues to variable
costs relevant to a specific customer. The contribution margin ratio compares the contribution
margin to total sales. Any fixed general and administrative costs and depreciation costs allocated
to a customer that will still be incurred regardless of whether the customer relationship
continues or not should not be considered in the analysis.
The ranking of the customers from highest to lowest contribution margin ratios is C, B, A, D,
determined as follows:
Customer A Customer B Customer C Customer D

Sales $120,000 $180,000 $240,000 $300,000
Cost of goods sold 60,000 72,000 84,000 90,000
Delivery costs 12,000 30,000 36,000 85,000
Order-taking costs 18,000 24,000 30,000 60,000
Other variable costs 12,000 14,000 18,000 23,000
Contribution margin $ 18,000 $ 40,000 $ 72,000 $ 42,000
Contribution margin ratio 15.0% 22.2% 30.0% 14.0%
Choice "a" is incorrect. Customer C has the highest contribution margin ratio.
Choice "c" is incorrect. Customer D has the lowest contribution margin ratio.
Choice "d" is incorrect. Customer B is ranked second based on the contribution margin ratio.

2. MCQ-12148
Choice "b" is correct. In evaluating profitability of a division, all relevant revenues and costs must
be considered. These are revenues and costs that are expected to change in the future due to
selective different alternatives.
Discontinuing Division 2 will result in an overall increase in company's profits in the amount of
$20,000, determined as follows:
Division 1
Sales ($800,000 × 1.15) $ 920,000
Cost of goods sold ($300,000 × 1.15) 345,000
Gross margin 575,000
Variable selling and administrative expenses ($100,000 × 1.15) (115,000)
Fixed selling and administrative expenses ($150,000 × 80%) (120,000)
Operating income (loss) $ 340,000
The operating income is expected to increase from $320,000 ($325,000 − $5,000) to $340,000,
which is a $20,000 increase.
Choice "a" is incorrect. When Division 2 is discontinued, the fixed cost in total (that is the
$150,000) must be considered, not only the $75,000 allocated to Division A.
Choices "c" and "d" are incorrect. The operating income will increase due to the discontinuation
of Division 2.
Unit 4, Module 6
1. MCQ-11959
Choice "d" is correct. ROI is a percentage calculation. ROI is the ratio of income earned on the
investment to the investment made to earn that income. ROI is a profitability measure that
evaluates the performance of a business by dividing net profit (Income) by the investment.
Investment refers to the assets that the company has to generate profit. Normally, assets not
being utilized in the revenue generation are not included in the investment.
Residual income is a performance accounting measure of income. Residual income is a dollar
amount. Residual income = Profit – (Invested capital × Cost of capital), where the cost of capital is
the company's required rate of return.
In order to increase residual income, the expected return (Profit) on the new project must be
higher than the cost of capital (required rate of return) multiplied by the invested capital. If the
expected rate of return on the new project is higher than the firm's cost of capital but lower than
the division's current return on investment, it will increase residual income.
Choice "a" is incorrect. If the expected rate of return on the new project is higher than the
division's current return on investment but lower than the firm's cost of capital, it will not
increase residual income. Residual income = Profit – (Invested capital × Cost of capital), where
the cost of capital is the company's required rate of return.
Choice "b" is incorrect. If the firm's cost of capital is higher than the expected rate of return on
the new project but lower than the division's current return on investment, it will not increase
residual income. Residual income = Profit – (Invested capital × Cost of capital), where the cost of
capital is the company's required rate of return.
Choice "c" is incorrect. If the division's current return on investment is higher than the expected
rate of return on the new project but lower than the firm's cost of capital, it will not increase
residual income. Residual income = Profit – (Invested capital × Cost of capital), where the cost of
capital is the company's required rate of return.

2. MCQ-12377
Choice "b" is correct. Some financial measures of performance are expressed as a monetary
amount whereas others are expressed as a percentage, and some are expressed as a multiple.
Residual income (RI) measures the amount of monetary return ($) that is provided to the
company by a department or division. RI for a division is calculated as the amount of return
(operating income before taxes) that is in excess of a targeted amount of return on the division's
assets. Residual income is the operating income earned after the division has covered the
required charge for the funds that have been invested by the company in its operations.
Operating income of business unit $

– (Assets of business unit $ × Required rate of return %)
= Residual income $
The price to earnings (PE) ratio is expressed as a percentage. The formula for PE is: Stock
price per share / Earnings per share. The formula for earnings per share (EPS) is: Earnings
(Income) $ / Average number of shares issued and outstanding. The formula for return on
investment (ROI) is: Income of business unit / Assets of business unit.
Both residual income and earnings per share are expressed as a monetary amount.
Choice "a" is incorrect. This answer is incomplete because EPS is also expressed as a monetary
amount.
Choice "c" is incorrect. This answer is incomplete because residual income is also expressed as a
monetary amount.
Choice "d" is incorrect. PE ratio is expressed as a multiple and ROI is expressed as a percentage.

P1 1C.50c9001 Notes

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PART 1

1 C.1. Cost and Variance Measures: Part 1 3

2 C.1. Cost and Variance Measures: Part 2 11

3 C.2. Responsibility Centers 37

4 C.2. Transfer Pricing 47

5 C.3. Performance Measures: Part 1 61

6 C.3. Performance Measures: Part 2 73

4–2 © Becker Professional Education Corporation. All rights reserved.

C.1. Cost and Variance

The candidate should be able to:

1 Budgets and Variances LOS 1C1a

LOS 1C1c 2 Variance Analysis Using the Master Budget

2.1 Annual Budgets and Performance Reports

Example 1 Budget vs. Plan Performance Report

Budget Actual Variance

2.2 Benefits and Limitations of Measuring Actual

4–4 Module 1 C.1. Cost

2.3 Use of Flexible Budgets to Analyze Performance LOS 1C1e

Example 2 Flexible Budget Performance Report

Flexible budget variances (11,800)

*24,000 / 120,000 = 20%

LOS 1C1f 3 Sales Variances

3.1 Sales Variance Analysis

Sales price variance

= Actual quantity sold × (Actual price – Standard price)

= AQsold × (AP – SP)

Sales volume variance

= Standard Price × (Actual quantity – Standard quantity)

3.1.1 Sales Price Variance

= Actual quantity sold × (Actual price – Standard price)

= AQsold × (AP – SP)

Example 3 Sales Price Variance

4–6 Module 1 C.1. Cost

3.1.2 Sales Volume Variance

= Standard Price × (Actual quantity – Standard quantity)

Example 4 Sales Volume Variance

3.2 Sales Mix Variance LOS 1C1n

 Actual Budgeted Total number Budgeted

Illustration 1 Sales Mix Variance

Computation of Sales Mix Ratio

*4,000 ÷ 10,000 = 40%; 6,000 ÷ 10,000 = 60%

4–8 Module 1 C.1. Cost

Sales revenue $1,500,000

Actual Actual Standard

4–10 Module 1 C.1. Cost

C.1. Cost and Variance

The candidate should be able to:

1 Management by Exception and Standard Costing

1.1 Management by Exception LOS 1C1i

LOS 1C1j 1.2 Standard Costing System

1.2.1 Standard Direct Materials

1.2.2 Standard Direct Labor

1.2.3 Standard Overhead

4–12 Module 2 C.1. Cost

1.3 Purposes of Standard Costing Systems

1.4 Variance Calculations Using Standards LOS 1C1h

1.4.1 Evaluating Variances From Standard

1.4.2 Product Costs Subject to Variance Analysis

2.1 Calculations: Equation Format

= Actual quantity purchased × (Actual price – Standard price)

= AQpurchased × (AP – SP)

DM quantity usage variance

= Standard price × (Actual quantity used – Standard quantity allowed)

Actual Budgeted Total number Budgeted

The sum of The sum of

Flexible Budget Overhead Variance

Total Overhead Spending Variance

Variable Overhead Rate (Spending) Variance