MAS-02: Cost Behavior Regression Analysis: - T R S A

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

CPA Review Batch 41 May 2021 CPA Licensure Examination Weeks 1-2
MANAGEMENT ADVISORY SERVICES A. Lee E. Ara–as K. Manuel
MAS-02: COST BEHAVIOR WITH REGRESSION ANALYSIS

COST BEHAVIOR
Cost behavior patterns indicate how costs change in response to changes in production or sales. A
thorough understanding of cost behavior is necessary in order to perform cost-volume-profit analysis and to
prepare for production and sales budgets.
As activity increases, some costs remain the same (constant) while some costs will vary or change.
Consider the following cost behavior patterns, assuming activity is based on production:
TOTAL costs PER UNIT costs
Decreases as production increases
FIXED Constant
(i.e., inverse relationship)
Increases as production increases
VARIABLE Constant
(i.e., direct relationship)
MIXED Increases less proportionately (vs. total Decreases less proportionately (vs. unit
(semi-variable) variable costs) as production increases fixed costs) as production increases
COST BEHAVIOR ASSUMPTIONS and LIMITATIONS

RELEVANT RANGE Assumption
Relevant range refers to the range of activity within which the cost behavior patterns are valid. It is
also the level of activity where cost relationships exhibit linear relationship.
TIME PERIOD Assumption
The cost behavior patterns identified are true only over a specified period of time. Beyond this, the
cost may show a different cost behavior pattern.
COST ESTIMATION: SEGREGATING VARIABLE & FIXED COSTS

The Cost Function: Y = a + bX
[Y] - total costs (dependent variable) [X] - activity or cost driver (independent variable)
[a] - total fixed costs (Y-axis intercept) [b] - variable cost per unit (slope of the line)
[bX] 3 the total variable costs
1) HIGH-LOW POINTS Method
The fixed and variable components of the mixed costs are computed from the highest and lowest
points based on activity or cost driver.
Change in Costs (YH Ð YL)
Variable cost per unit (b) =
Change in Activity (XH Ð XL)
2) SCATTERGRAPH (Scatter Diagram) Method
All observed costs at different activity levels are plotted on a graph. Based on sound judgment, a
regression line is then fitted to the plotted points to represent the line function.
3) LEAST-SQUARES REGRESSION Method
A statistical technique that determines the "line of best fit" for all the data points by minimizing the
sum of the squared deviations between line and the data points.
¥ If there is only one independent variable, the analysis is known as SIMPLE regression.
¥ If the analysis involves multiple independent variables, it is known as MULTIPLE regression.
4) Other Cost Estimation Methods:
A) Industrial Engineering method Ð study between physical inputs and outputs especially meant for
totally new activities; engineering estimates indicate what how much costs should be.
B) Account Analysis method Ð each account is classified as either fixed or variable based on
experience and judgment of accounting and other qualified personnel in the organization.
C) Conference method Ð costs are classified based on opinions from various company departments
such as purchasing, process engineering, manufacturing, employee relations and so on.
CORRELATION ANALYSIS
CORRELATION ANALYSIS is used to measure the strength of linear relationship between two or more
variables. The correlation between two variables can be seen by drawing a scatter diagram.
COEFFICIENT OF CORRELATION (r) measures the relative strength of linear relationship between two (2)
variables. Its value ranges from Ð 1.0 to + 1.0:
"r" Linear Relationship Scatter Diagram/Graphical Representation
-1.0 Inverse Downward Sloping Line
0 None No Apparent Pattern (Random Points)
+1.0 Direct Upward Sloping Line
COEFFICIENT OF DETERMINATION (r2) indicates the degree to which the behavior of independent variable
predicts the dependent variable. The closer r2 is to 1.0, the better (i.e., more confidence) the independent
variable predicts the behavior of the dependent variable.
NOTE: Correlation & regression analyses do not establish cause-and-effect; it merely indicates a relationship.
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ReSA Ð THE REVIEW SCHOOL OF ACCOUNTANCY MAS-02

Weeks 1-2: COST BEHAVIOR with REGRESSION ANALYSIS
EXERCISES: COST BEHAVIOR with REGRESSION ANALYSIS

1. Variable Costs vs. Fixed Costs
Akio Company manufactures and sells a single product. A partially completed schedule of costs over a
relevant range of 20 to 60 units produced each year is given below:
Units Produced
(I) 20 units (II) 40 units (III) 60 units
TOTAL COSTS:
(A) Variable costs P 40 ? ?
(B) Fixed costs ? P 600 ?
(C) Total costs ? . ? . ? .
PER UNIT COSTS:
(D) Variable costs ? P2 ?
(E) Fixed costs ? ? ?
REQUIRED:
1. Determine the correct amounts of those with (?) mark.
2. Which two (2) specific costs remain constant over the relevant range?
3. Which two (2) specific costs are directly related with production?
4. Which specific cost is inversely related with production?
5. Express the cost formula based on the line equation form ÔY = a + bX.Õ
6. If the company produces 50 units, then how much is the expected total costs?
(Managerial Accounting by Garrison & Noreen)
2. High-Low Method
The controller of SUREDEAD Hospital would like to come up with a cost formula that links Admitting
Department cost to the number of patients admitted during a month. The Admission DepartmentÕs costs
and the number of patients admitted during the past nine months follow:
Month Number of Patients Admission DepartmentÕs Cost
April 18 P 15,600
May 19 P 15,200
June 17 P 13,700
July 15 P 14,600
August 15 P 14,300
September 11 P 13,200
October 11 P 12,800
November 48 P 72,500
December 16 P 14,000
REQUIRED: Using the high-low method, determine the admission departmentÕs:

1. Variable cost per unit
2. Total annual fixed costs
3. Monthly cost function
4. Estimated cost assuming 12 patients will be admitted next month.
(Managerial Accounting by Garrison & Noreen)
3. Correlation Analysis
3A) The closeness of the linear relationship between the cost and the activity is known as
a. Correlation c. Deviation
b. Variation d. Standard error
3B) Looking at the following scatter diagrams, we can conclude that:
Cost A Cost B
Costs (P) Costs (P)
Units Units
a. Cost A will be easier to predict than cost B.
b. Cost B will be easier to predict than cost A.
c. Cost B has no variable component.
d. Cost A is out-of-control.
3C) Which correlation coefficient represents strongest relationship between two variables?
a. + 0.50 c. - 0.05
b. - 0.75 d. + 1.05
(Adapted: Managerial Accounting by Louderback)
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4. Least-Squares Regression Method

Sydney CompanyÕs total overhead costs at various levels of activity are presented below:
Month Machine Hours Total Overhead Costs
March 500 P 970
April 400 P 851
May 600 P 1,089
June 700 P 1,208
The breakdown of the overhead costs in April at 400 machine-hour level of activity is as follows:
Supplies (Variable) P 260
Salaries (Fixed) 300
Utilities (Mixed) 291
Total P 851
REQUIRED:
1. How much of JuneÕs overhead cost of P 1,208 consisted of utilities cost?
2. Using high-low method, determine the cost function for utilities cost.
3. Using high-low method, determine the cost function for total overhead cost.
4. Using least-squares method, determine the cost function for total overhead costs.
5. What would be the total overhead costs if operating level is at 450 machine hours?
(Adapted: Managerial Accounting by Garrison & Noreen)
SOLUTION GUIDE (Requirement 1)
April (400 hrs) June (700 hrs)
Supplies (Variable) P 260
Salaries (Fixed) 300
Utilities (Mixed) 291 . ________
Total Overhead Costs P 851 P 1,208
SOLUTION GUIDE (Requirement 4 Ð Least Squares method)
Month X (Hours) Y (Total Costs) XY X2

Mar 500 970
Apr 400 851
May 600 1,089
Jun 700 1,208 ___________ ____________
SUM
WRAP-UP EXERCISES
1. Consider the following graphic representation of certain costs:
Costs
Units
Which of the following costs are most likely represented by the above graph?
a. Total fixed costs, total variable costs c. Unit fixed costs, total variable costs
b. Total fixed costs, unit variable costs d. Unit fixed costs, unit variable costs
2. In cost analysis using the line equation Y = a + bX, "b" or unit variable cost is regarded as the
a. Dependent variable c. Slope of the line
b. Independent variable d. Y-axis intercept
3. A company has developed a production cost equation for its lone product: Y = 100 + 2X, where X is
based on the number of labor hours. Assuming a relevant range of 10 to 20 labor hours, what is the
estimated production cost at zero (0) labor hour?
a. P 100
b. P 120
c. P 140
d. The exact amount cannot be determined without additional information
4. If the coefficient of correlation (r) between two variables is + 1, then a scatter diagram will appear to
be a regression line that
a. Slopes upward to the left c. Slopes downward to the right
b. Slopes upward to the right d. Appears to be horizontal or vertical
5. A data point that falls far away from other data points in a scatter diagram is called a (an)
a. Outlier c. Standard deviation
b. Margin of error d. Coefficient of determination
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6. Ana Company is interested in the relationship between sales (dependent variable) and occurrence of
rain (independent variable). Using the proper formula, the coefficient of correlation (r) is computed as
Ð 0.99. What conclusion about the sales and rain occurrence could one make?
a. An increase in sales causes an increase in rain occurrence.
b. An increase in sales causes a decrease in rain occurrence.
c. An increase in rain occurrence causes a decrease in sales.
d. An increase in rain occurrence causes an increase in sales.
7. What is the appropriate range for the coefficient of determination (r2)?
a. 0 to +1 c. - 1 to 0
b. 0 to -1 d. -1 to +1
8. Using statistical normal relationships, the least-squares method uses which of the following equations?
a. y = na + bx
Sxy = aSx + bSx2
b. y = na + bSx
Sxy = ax + bSx
c. y = a + bx2
Sy = na + bSx
d. Sy = na + bSx
Sxy = aSx + bSx2
9. What cost segregation technique gives the most mathematically precise cost estimate?
a. Scatter diagram method c. High-low method
b. Least-squares method d. Calendar method
10. Under Cost-Volume-Profit (CVP) analysis, a mixed cost should be:
a. Disregarded
b. Treated as a fixed cost
c. Treated as a variable cost
d. Separated into fixed and variable components
SELF-TEST QUESTIONS (with suggested answers)

1. Hunger Company has estimated the following cost formulas for overhead:
Cost Formula
Lubricants P 1,500 plus P 0.50 per machine-hour
Utilities P 2,000 plus P 0.60 per machine-hour
Depreciation P 1,000
Maintenance P 200 plus P 0.10 per machine-hour
Machine setup P 0.30 per machine-hour
Based on the cost formulas, what is the total expected overhead cost at 300 machine hours?
D a. P 4,700 c. P 5,000
b. P 4,950 d. P 5,150
2. Which of the following statements is true?
D a. The higher is the production within the relevant range, the higher is the variable cost per unit
b. The higher is the production within the relevant range, the higher is the fixed cost per unit
c. The lower is the production within the relevant range, the lower is the total fixed cost
d. The lower is the production within the relevant range, the lower is the total variable cost
3. Within the relevant range, the amount of variable cost per unit
D a. Differs at each production level c. Decreases as production increases
b. Increases as production increases d. Remains constant at each production level
4. Which of the following best describes a fixed cost?
C a. It is constant per unit of changes in production.
b. It may change in total when such change is related to changes in production.
c. It may change in total when such change is unrelated to changes in production.
d. It may change in total when such change depends upon production or within the relevant range.
5. What are fixed costs that cannot be reduced or avoided within a short period of time?
A a. Committed c. Avoidable
b. Variable d. Unnecessary
6. What would be an example of a discretionary fixed cost?
D a. Depreciation on equipment c. Salaries of top management
b. Rent on a factory building d. Research and development
7. Which of the following best describes a step cost?
D a. It is partly variable and partly fixed c. It increases proportionately with volume
b. It remains constant in all cases d. It increases abruptly outside the relevant range
8. In describing the cost formula equation Y = a + bX, which of the following statements is correct?
D a. 8Y9 is the independent variable
b. 8a9 is the variable rate
c. 8a9 and 8b9 are valid for all levels of activity
d. In the high-low method, 8b9 equals the change in cost (Y) divided by the change in activity (X)
9. The fixed cost of a semi-variable cost is comparable to the mathematical concept of
A a. Y-intercept c. Dependent variable
b. Slope of the line d. Independent variable
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10. Mock Company applies the high-low method of cost estimation to customer order data for the first 4 months of 2021:
Month Orders Cost (P)
January 1,200 3,120
February 1,300 3,185
March 1,800 4,320
April 1,700 3,895
What is the estimated variable cost component per order?
A a. P 2.00 c. P 2.48
b. P 2.42 d. P 2.50
11. Dawn Company estimated its materials handling cost at two activity levels as follows:
Kilos Handled Cost
80,000 160,000
60,000 132,000
What is Dawn9s estimated cost for handling 75,000 kilos?
B a. P 150,000 c. P 157,500
b. P 153,000 d. P 165,000
12. In March, Starbox had electrical costs of P 225.00 when the total volume was 4,500 cups of coffee served. In April,
electrical costs were P 227.50 for 4,750 cups of coffee. Using the high-low method, what is the estimated fixed cost of
electricity per year?
D a. P 180 c. P 225
b. P 200 d. P 2,160
13. Night Inc. uses the high-low method to derive the cost formula for electrical power cost. According to the cost
formula, the variable cost per unit of activity is P 3 per machine hour. Total electrical power cost at the high level of
activity was P 7,600 and the low level of activity was P 7,300. If the high level of activity was 1,200 machine-hours,
then what was the low level of the activity?
D a. 800 machine-hours c. 1,000 machine-hours
b. 900 machine-hours d. 1,100 machine-hours
14. Black Co. has an average unit cost of P 45 at 10,000 units and P 25 at 30,000 units. What is the unit variable cost?
B a. P 10.00
b. P 15.00 Average unit cost = Total Costs ÷ Number of units
c. P 20.00
d. An amount that cannot be determined without more information
15. Total production costs of prior periods for a company are listed below. Assume that the same cost behavior patterns
can be extended linearly over the range of 3,000 to 35,000 units and that the cost driver for each product is the
number of units produced.
Production per month (units) 3,000 9,000 16,000 35,000
Product X P 23,700 P 52,680 P 86,490 P 178,260
Product Y 47,280 141,840 252,160 551,600
What is the average cost per unit at a production level of 8,000 units for product X?
B a. P 7.90 c. P 5.85
b. P 5.98 d. P 4.83
16. White, Inc. provides you with the following flexible budget of factory overhead at three different capacity levels:
Capacity Factory Overhead
60% P 98,000
70% 106,000
85% 118,000
What will be the flexible budget of factory overhead at 90% capacity?
B a. P 112,000 c. P 130,000
b. P 122,000 d. P 132,000
17. The major objective of preparing a scatter diagram is to
B a. Determine the relevant range
b. Derive an equation to predict future costs
c. Perform regression analysis on the results
d. Find the high and low points to use for the high-low method of estimating costs
18. The principal advantage of the scatter-diagram method over the high-low method is that the scatter-diagram method
A a. Considers more than two points
b. Includes cost outside the relevant range
c. Gives a precise mathematical fit of the points to the line
d. Can be used with more types of costs than the high-low method
19. Which is an equation required for applying least square method of computing fixed and variable costs?
C a. Sy = aSx + bSx2 c. Sy = na + bSx
b. Sxy = na + bSx d. Sxy = na + bS x2
20. An analysis of maintenance cost at four levels of plant operations is shown below:
Hours Cost Hours x cost Hours Squared
40 P 1,000 40,000 1,600
30 900 27,000 900
60 1,300 78,000 3,600
50 1,150 57,500 2,500
180 P 4,350 202,500 8,600
Under the least-squares regressions method, how much is the fixed cost of the maintenance?
A a. P 480 c. P 520
b. P 500 d. P 600
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21. The following cost data for different hours of operations are made available to you by Florida Manufacturing Company
for your analysis:
Number of Months 10
Sum of Hours 350
Sum of Costs 1,000
Sum of Hours x Costs 39,200
Sum of Hours Squared 14,250
How much is the monthly fixed cost?
A a. P 26.50 c. P 318.00
b. P 35.00 d. P 420.00
22. Simple regression analysis involves
A a. One dependent variable and one independent variable
b. One dependent variable and many independent variables
c. Many dependent variables and one independent variable
d. Many dependent variables and many independent variables
23. Multiple regression analysis involves
B a. One dependent variable and one independent variable
b. One dependent variable and many independent variables
c. Many dependent variables and one independent variable
d. Many dependent variables and many independent variables
24. In determining cost behavior, the cost function is often expressed as Y = a+ bX. Which of the following cost
estimation methods should not be used in estimating fixed and variable costs for the equation?
D a. Graphic method c. High and low point
b. Simple regression d. Multiple regression
25. A scatter diagram that manifests a regression line sloping down to the right would most likely show a correlation
coefficient (r) of
C a. + 0.95 c. - 0.95
b. + 9.50 d. - 9.50
26. If coefficient of correlation (r) between two variables is zero, how might a scatter diagram of these variables appear?
A a. Random points
b. A least squares line that slopes up to the right
c. A least squares line that slopes down to the right
d. Under this condition, a scatter diagram could not be plotted on a graph.
27. R-squared (r2) is a measure of
D a. The fixed cost component
b. The variable cost per unit of activity
c. The spurious relationship between cost and activity
d. How well the regression line accounts for the changes in the dependent variable
28. After constructing a scatter chart, the internal auditor of Madagascar Company provided you with the following
information:
Independent variable: 1,000,000
Slope of the line: 0.25
Y-axis intercept: 7,500
Based on the above data, what is the estimated cost?
B a. P 250,500 c. P 1,000,000
b. P 257,500 d. P 1,007,500
29. Elirie Company uses regression analysis to develop a model for predicting overhead costs. Two different cost drivers
(machine hours and direct materials weight) are under consideration as the independent variable. Relevant data were
run on a computer using one of the standard regression programs, with the following results:
Coefficient Coefficient
MACHINE HOURS DIRECT MATERIALS WEIGHT
Y-intercept 2,500 Y-intercept 4,600
B 5.0 B 2.6
r2 = 0.70 r2 = 0.50
What regression equation should be used?
A a. Y = 2,500 + 5.0X c. Y = 4,600 + 2.6X
b. Y = 2,500 + 3.5X d. Y = 4,600 + 1.3X
30. The statistician of Sir K has developed the following cost-prediction equation, using observations from 12,000 to
30,000 machine hours:
¥ Y = P 236,837 + 3.7625X
¥ R-squared = 0.81
¥ Standard error = P 24,363
¥ Several 8outliers9 are noted within tolerable limits
¥ Y (dependent variable) = total maintenance cost
¥ X (independent variable) = machine hours
30A) What percentage of the variation in maintenance costs is explained by the independent variable?
C a. 95% c. 81%
b. 90% d. 66%
30B) Compute the estimated maintenance cost at 20,000 machine hours.
C a. P 236,837 c. P 312,087
b. P 252,790 d. P 336,450
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CPA Review Batch 41  May 2021 CPA Licensure Examination  Week No. 2
MANAGEMENT ADVISORY SERVICES C.P. Lee  E.S Arañas  K.L. Manuel
MAS-03: COST-VOLUME-PROFIT (CVP) ANALYSIS

CVP ANALYSIS - is a profit planning tool that deals with profit’s relationship with costs and sales volume.
CONTRIBUTION MARGIN (CM) is a measure of company’s ability to cover variable costs with revenues. It is
also known as marginal income, profit contribution, contribution to fixed cost or incremental contribution.
 CM = Sales – Variable Costs
 Unit CM = Unit Selling Price – Unit Variable Costs
 CM Ratio = CM ÷ Sales = Unit CM ÷ Unit Selling Price = Δ CM ÷ Δ Sales
CM Ratio is also known as marginal ratio or profit-volume (P/V) ratio.
BREAK-EVEN POINT (BEP) is the sales level at which profit is zero (i.e., total revenues = total costs).
 BEP (units) = Fixed Costs ÷ Unit CM
 BEP (peso sales) = Fixed Costs ÷ CM Ratio
 BEP Ratio = BEP ÷ Sales
 Sales (units) with Target Profit = (Fixed Costs + Target Profit*) ÷ Unit CM
 Sales (peso sales) with Target Profit = (Fixed Costs + Target Profit*) ÷ CM Ratio
 Sales (peso sales) with Target Profit Ratio = Fixed Costs ÷ (CM Ratio – Profit Ratio)
* Target Profit must be expressed before tax: Pre-tax Profit = After-tax Profit ÷ (100% - tax rate)
MARGIN of SAFETY is the maximum amount by which sales could decrease without incurring a loss.
 Margin of Safety (MS) = Sales – Breakeven Sales = Profit ÷ CM Ratio
 MS Ratio = MS ÷ Sales = Profit Ratio ÷ CM Ratio = 100% - BEP Ratio
Like BEP, safety margin can also be expressed in units or in peso sales.
INDIFFERENCE POINT is the level of volume at which total costs, and hence profits, are the same between
two alternatives under consideration.
Alternative A Alternative B .
 (Unit CM x Q) – Fixed Costs = (Unit CM x Q) – Fixed Costs
 Fixed Costs + (Unit VC x Q) = Fixed Costs + (Unit VC x Q)
Legend: Q – number of units (indifference point)
SALES MIX (a.k.a. product mix) is the proportion of different products that comprise the company’s total sales.
 Overall BEP (units) = Fixed Costs ÷ Weighted Average Unit CM
 Overall BEP (peso sales) = Fixed Costs ÷ Weighted Average CM Ratio
DEGREE of OPERATING LEVERAGE (DOL) measures how sensitive the profit is to sales volume increases and
decreases. It is also known as operating leverage factor.
 DOL = Contribution Margin ÷ Profit before tax = 1 ÷ MS Ratio
 Δ% in Sales x DOL = Δ% in profit before tax
CVP analysis assumptions and limitations
 Behavior of both sales and costs (variable and fixed) is linear and predictable throughout the entire
relevant range of activity and within a specified time span.
 Fixed costs, unit variable costs, selling price and sales mix must behave as constants.
 There are no changes in inventory levels (i.e., production equals sales).
 Volume is the only factor affecting sales, variable costs and profit.
 Time value of money is ignored.
EXERCISES: COST-VOLUME-PROFIT ANALYSIS
1. Ana Company sells a single product. The company’s sales and expenses for a recent month follows:
Sales (15,000 units) P 375,000
Less: Variable Costs 150,000
Contribution Margin P 225,000
Less: Fixed Costs 150,000
Profit P 75,000
REQUIRED:
1. Determine the following:
A) Unit selling price B) Unit variable cost C) CM ratio (CMR)
2. For profit planning purposes, compute the following:
A) Break-even point in units B) Break-even peso sales
3. What unit sales are required to earn P 90,000 profit for the month?
4. What peso sales are required to earn an after-tax profit of P 81,000 (assuming tax rate is 10%)?
5. Assuming Ana is currently selling 8,000 units per month, the company president believes that sales
would increase if advertising were increased by P 60,000. How many units should sales increase to
give Ana the same profit or loss that it is currently earning?
(NOTE: although you know that 8,000 units are being sold at present, you do not need this
information to solve the problem.)
6. What is the margin of safety at its present sales of P 375,000?
7. At present, Ana pays its salespeople a monthly salary of P 40,000 without any commission. It
considers a plan whereby salespeople receive a 10% commission, but their monthly salary would
fall to P 25,000. What sales level will Ana be indifferent between the two compensation plans?
(Management Accounting by Louderback, et.al.)
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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-03
Week No. 2: COST-VOLUME-PROFIT ANALYSIS
2. Tong-Its Company sells two products, tables and chairs. Following is income budget for next month:
Chairs Tables Total
Unit sales 60 u 15 u 75 u
Sales P 750.00 P 300.00 P 1,050.00
Variable Costs 600.00 225.00 825.00
Contribution Margin P 150.00 P 75.00 P 225.00
Fixed Costs 90.00
Profit P 135.00
REQUIRED:
1. How many units of chairs should be sold next month to break-even?
2. How many units of tables should be sold to earn a profit of P 150?
3. Sir K has recently opened a Fitness Gym. The income statement for its first year of operations follows:
Sales P 250,000
Variable Costs (100,000)
Fixed Costs (120,000)
Profit P 30,000
Sir K is not happy about the results of the gym’s first year of operations. He observed that despite the high
contribution margin, profit was still low because of the high fixed costs. He therefore concludes that an
increase in sales would not result a satisfactory increase in profit.
REQUIRED:
1. Explain to Sir K that his conclusion is not right by computing the operating leverage factor.
2. If sales increase by 10%, then how many percent would profit increase, ceteris paribus?
(NOTE: determine the percentage Δ in profit by using the operating leverage factor.)
(Managerial Accounting by Garrison, et.al.)
4. UP’s break-even sales are P 528,000. The variable cost ratio is 60% while the profit ratio is 8%.
REQUIRED: Determine the following:

1. Fixed Costs 5. Margin of Safety
2. Sales 6. Margin of Safety Ratio
3. Profit 7. Degree of Operating Leverage
4. Break-Even Ratio
(AICPA)
WRAP-UP EXERCISES
1. At the break-even point, total contribution margin is
a. Zero c. Equal to total costs
b. Equal to total fixed costs d. Equal to total variable costs
2. Which of the following does NOT affect a company’s break-even point?
a. Total fixed costs c. Unit selling price
b. Unit variable cost d. Number of units sold
3. Contribution margin is best defined as the amount available to cover
a. Variable costs c. Variable costs and profit
b. Fixed costs and profit d. Variable costs and fixed costs
4. An increase in the income tax rate
a. Raises the break-even point
b. Lowers the break-even point
c. Increases sales required to earn a particular after-tax profit
d. Decreases sales required to earn a particular after-tax profit
5. A company with a negative margin of safety also has a (an)
a. Operating loss c. Sales above its break-even point
b. Operating profit d. Sales equal to its break-even point
6. Under CVP analysis, which of the following is NOT assumed to be constant?
a. Unit variable cost c. Unit fixed cost
b. Unit selling price d. Sales mix
7. Operating leverage factor =
a. Gross margin ÷ profit after tax c. Contribution margin ÷ profit after tax
b. Gross margin ÷ profit before tax d. Contribution margin ÷ profit before tax
8. Degree of operating leverage measures how sensitive the profit is to a given change in
a. Selling price c. Fixed costs
b. Sales volume d. Variable costs
9. One of the assumptions in Cost-Volume-Profit analysis is that:
a. Production is higher than sales c. Production and sales are equal
b. Production is less than sales d. Production and sales are not equal
10. If inventories are expected to change, the type of costing that provides the best information for
breakeven analysis is
a. Job-order costing c. Joint costing
b. Variable costing d. Absorption costing
Page 2 of 6
SELF-TEST QUESTIONS - with suggested answers

(Sources: CMA/CIA/RPCPA/AICPA/Various test banks)
1. Which cost is NOT subtracted from selling price to calculate contribution margin per unit?
D a. Variable manufacturing overhead c. Direct labor
b. Variable selling expenses d. Fixed manufacturing overhead
2. Which of the following would decrease unit contribution margin the most?
A a. A 15% decrease in selling price c. A 15% decrease in variable expenses
b. A 15% increase in variable expenses d. A 15% increase in fixed expenses
3. Jo Company sells its only product for P 60 per unit and incurs the following variable costs per unit:
Direct material P 16
Direct labor 12
Manufacturing overhead 7
Total variable manufacturing overhead P 35
Selling expenses 5
Total variable costs P 40
Jo’s annual fixed costs are P 880,000. If prime costs increased by 20% and all other values remained the same, what
would be Jo Company’s contribution margin ratio (to the nearest whole percentage)?
C a. 75% c. 24%
b. 30% d. 20%
4. In planning its operations for 2022 based on a sales forecast of P 6,000,000, Cynthia, Inc. prepared the following
estimated data:
Cost and Expenses
Variable Fixed
Direct materials P 1,600,000
Direct labor 1,400,000
Factory overhead 600,000 900,000
Selling expenses 240,000 360,000
Administrative expenses 60,000 140,000
P 3,900,000 P 1,400,000
What would be the amount of peso sales at the break-even point?
C a. P 2,250,000 c. P 4,000,000
b. P 3,500,000 d. P 5,300,000
5. The most likely strategy to reduce the breakeven point would be to
C a. Increase both the fixed cost and the contribution margin
b. Decrease both the fixed costs and the contribution margin
c. Decrease the fixed costs and increase the contribution margin
d. Increase the fixed costs and decrease the contribution margin
6. For the period just ended, Val Company generated the following operating results in percentages:
Revenues 100%
Cost of sales:
Variable 50%
Fixed 10%
Total 60%
Gross profit 40%
Operating expenses:
Variable 20%
Fixed 15%
Total 35%
Net operating income 5%
Total sales amounted to P 3 million. How much was the break-even sales?
B a. P 1,875,000 c. P 2,850,000
b. P 2,500,000 d. P 3,750,000
7. Once the breakeven point has been reached, operating income will increase by the
B a. Gross margin per unit for each additional unit sold
b. Contribution margin per unit for each additional unit sold
c. Fixed costs per unit for each additional unit sold
d. Variable costs per unit for each additional unit sold
8. The following data refer to cost-volume-profit relationship of Albert Company:
Break-even point in units 1,000
Variable cost per unit P 250
Total fixed cost P 75,000
How much will be contributed to operating income by the 1,001 st unit sold?
C a. P 250 c. P 75
b. P 325 d. Zero
9. Which of the following would cause the break-even point to change?
D a. Sales increased
b. Total production decreased
c. Total variable costs increased as a function of higher production
d. Fixed costs increased owing to additional equipment in physical plant
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10. A company manufactures a single product. Estimated cost data regarding this product and other information for the
product and the company are as follows (effective income tax rate: 40%):
Sales price per unit P 40
Total variable production cost per unit 22
Sales commission (on sales) per unit 5%
Fixed costs and expenses:
Manufacturing overhead P 5,598,720
General and administrative P 3,732,480
What number of units must the company sell in the coming year in order to reach its breakeven point?
C a. 388,800 units c. 583,200 units
b. 518,400 units d. 972,000 units
11. The present break-even sale of Beng Company is P 550,000 per year. It is computed that if the fixed cost will go up
by P 60,000, the sales required to break-even will also increase to P 700,000, without any change in the selling price
per unit and on the variable expenses. How much is the total fixed cost after the increase of P 60,000?
C a. P 200,000 c. P 280,000
b. P 220,000 d. P 330,000
12. One of the major assumptions limiting the reliability of breakeven analysis is that
C a. Efficiency and productivity will continually increase
b. Total variable costs will remain unchanged over the relevant range
c. Total fixed costs will remain unchanged over the relevant range
d. The cost of production factors varies with changes in technology
13. How much will income change if a company makes an advertising campaign given the following data?
Cost of advertising campaign P 25,000
Increase in sales P 60,000
Variable expense as a percentage of sales 42%
B a. P 200 increase c. P 15,000 increase
b. P 9,800 increase d. P 25,200 increase
14. August Company sells Product Rhea for P 5 per unit. The fixed cost is P 210,000 and the variable cost is 60% of the
selling price. What amount of sales is needed to realize a profit of 10% of sales?
A a. P 700,000 c. P 472,500
b. P 525,000 d. P 420,000
15. Dalen Company prepared the following preliminary forecast concerning Product D for 2022:
Selling price per unit P 10
Unit sales 100,000
Variable costs P 600,000
Fixed costs P 300,000
Based on a market study, Dalen estimates that it could increase the unit selling price by 15% and increase the unit
sales volume by 10% if P 100,000 was spent in advertising. Assuming that Dalen incorporates these changes in its
2022 forecast, what should be the operating income for Product D?
C a. P 175,000 c. P 205,000
b. P 190,000 d. P 365,000
16. Alice Corp. aims to earn a 25% return on its P 500,000 investment in equipment used in the manufacture of Product Y.
Based on estimated sales of 10,000 units of Product Y, the cost per unit were estimated as follows:
Variable manufacturing cost P 25
Fixed selling and administrative cost 10
Fixed manufacturing cost 5
What should be the price of Product Y?
C a. P 45.00 c. P 52.50
b. P 50.00 d. P 55.00
17. Chris Company has fixed costs of P 100,000 and breakeven sales of P 800,000. What is its profit at P 1,200,000 sales?
A a. P 50,000 c. P 200,000
b. P 150,000 d. P 400,000
18. Delfin Company sells a product to retailers for P 200. The unit variable cost is P 40 plus a selling commission of 10%.
Fixed manufacturing cost totals P 1,000,000 per month, while fixed selling and administrative cost equals P 420,000.
The income tax rate is 30%. What will be the required sales to achieve an after-tax profit of P 123,200?
D a. 19,950 units c. 15,640 units
b. 18,750 units d. 11,400 units
19. Heth Electronics Company is developing a new product, surge protectors for high-voltage electrical flows. The cost
information for this product is as follows:
Unit costs
Direct materials P 3.25
Direct labor P 4.00
Distribution P 0.75
The company will also be absorbing P 120,000 of additional fixed costs associated with this new product. A corporate
fixed charge of P 20,000 currently absorbed by other products will be allocated to this new product. Heth Electronics’
effective income tax rate is 40%. How many surge protectors (rounded to nearest hundred) must Heth Electronics sell
at a selling price of P 14 per unit to increase after-tax income by P 30,000? (Hint: consider only additional fixed cost)
D a. 10,700 units c. 20,000 units
b. 12,100 units d. 28,300 units
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20. A company has just completed the production of its only product. The product has taken 3 years and P 6,000,000 to
develop. The following costs are expected to be incurred on a monthly basis for the normal production level of
1,000,000 pounds of the new product:
1,000,000 lbs.
Direct materials P 300,000
Direct labor 1,250,000
Variable factory overhead 450,000
Fixed factory overhead 2,000,000
Variable selling, general and administrative expenses 900,000
Fixed selling, general and administrative expenses 1,500,000
Total P 6,400,000
If sales price per pound is P 5.90, the sales needed to earn P 3,000,000 profit in the first year would be
C a. 13,017,000 pounds c. 15,000,000 pounds
b. 14,000,000 pounds d. 25,600,000 pounds
21. Mars Company, which is subject to 40% tax, had the following operating data for the period just ended:
Variable cost per unit P 22
Fixed costs P 504,000
Management plans to improve the quality of its only product by way of implementing the following:
(1) Replacing a component that costs P 3.50 with a higher-grade unit that costs P 5.50, and
(2) Acquiring a P 180,000 packaging machine. Mars will depreciate the machine over a 10-year period with no
estimated salvage value by the straight-line method of depreciation.
If the company wants to earn after-tax of P 172,800 in the coming year, how many units must be sold?
C a. 10,300 units c. 22,500 units
b. 21,316 units d. 27,000 units
22. Cost-volume-profit relationships that are curvilinear may be analyzed linearly by considering only
D a. Fixed and semi-variable costs c. Relevant variable costs
b. Relevant fixed costs d. Relevant range of volume
23. Delphi Company has developed a new project that will be marketed for the first time during the next fiscal year.
Although the Marketing Department estimates that 35,000 units could be sold at P 36 per unit, Delphi’s management
has allocated only enough manufacturing capacity to produce a maximum of 25,000 units of the new product annually.
The fixed costs associated with the new product are budgeted at P 450,000 for the year, which includes P 60,000 for
depreciation on new manufacturing equipment. Delphi is subject to a 40% income tax rate. Data associated with
each unit of product are presented on the next page:
Variable Costs
Direct material P 7.00
Direct labor 3.50
Manufacturing overhead 4.00
Total variable manufacturing cost P 14.50
Selling expenses 1.50
Total variable cost P 16.00
Delphi Company’s management has stipulated that it will not approve the continued manufacture of the new product
after the next fiscal year unless the after-tax profit is at least P 75,000 the first year. The unit selling price to achieve
this target profit must be at least
D a. P 34.60 c. P 37.00
b. P 36.60 d. P 39.00
24. The following data pertain to the two products manufactured by Bong, Inc.:
Per Unit
Products Selling Price Variable Cost
A P 240 P 140
B P 1,000 P 400
Fixed cost totals P 600,000 annually. The expected sales mix in units is 60% for Product A and 40% for Product B.
How many units of the two products together must Bong sell to break-even?
C a. 857 c. 2,000
b. 1,111 d. 2,459
25. Dan, Inc. is planning to produce two products, A and B. Dan is planning to sell 100,000 units of A at P 4 a unit and
200,000 units of B at P 3 a unit. Variable cost is 70% of sales for A and 80% of sales for B. In order to realize a total
profit of P 160,000, what must the total fixed cost be?
A a. P 80,000 c. P 240,000
b. P 90,000 d. P 600,000
26. Kris Company sells Products M, T and V. Kris sells three units of M for each unit of V and two units of T for each unit
of M. The contribution margins are P 1 per unit of M, P 1.50 per unit of T, and P 3 per unit of V. Fixed costs are
P600,000. How many units of Product T would Kris sell at the break-even point?
C a. 40,000 units c. 240,000 units
b. 120,000 units d. 400,000 units
27. There are so many assumptions inherent in CVP analysis. Which of the following is not one of these assumptions?
D a. Cost and revenues are predictable and are linear over the relevant range
b. Variable costs fluctuate proportionately with volume
c. Changes in the beginning and ending inventory are insignificant in amount
d. Sales mix will change as fixed costs increase beyond the relevant range
Page 5 of 6
28. If the sales mix shifts toward higher contribution margin products, then over-all break-even point generally
A a. Decreases c. Remains constant
b. Increases d. Is zero
29. Employee, Inc. had the following sales results for 2021:
TV sets CD player Radios
Peso sales component ratio 0.30 0.30 0.40
Contribution margin ratio 0.40 0.40 0.60
Employee, Inc. had fixed costs of P 2,400,000. The break-even sales in pesos for Employee, Inc. are:
TV sets CD player Radios TV sets CD player Radios
C a. P 1.8 M P 1.8 M P 3.6 M c. P 1.5 M P 1.5 M P2M
b. P 1.8 M P 1.8 M P 1.6 M d. P 1,531,915 P 1,531,915 P 2,042,553
30. For a profitable company, the amount by which sales can decline before losses occur is known as the
D a. Sales volume variance c. Variable sales ratio
b. Hurdle rate d. Margin of safety
31. The margin of safety is a key concept of CVP analysis. The margin of safety is
B a. The contribution margin rate
b. The difference between budgeted sales and breakeven sales
c. The difference between the breakeven point in sales and cash flow breakeven
d. The difference between budgeted contribution margin and breakeven contribution margin
32. Dani Company has sales of P 100,000, fixed costs of P 50,000, and a profit of P 10,000. What is Dani Company’s
margin of safety?
B a. P 10,000 c. P 33,333
b. P 16,667 d. P 83,333
33. Operating leverage is greatest in companies that have
B a. Low fixed cost, low unit variable cost c. Low fixed cost, high unit variable cost
b. High fixed cost, low unit variable cost d. High fixed cost, high unit variable cost
34. Vivian Corporation sells sets of encyclopedias. Vivian sold 4,000 sets last year at P 250 a set. If the variable cost per
set was P 175, and the fixed costs for Vivian were P 100,000, what is the Vivian’s degree of operating leverage (DOL)?
C a. 0.67 c. 1.5
b. 0.75 d. 3.0
35. Ube Company’s variable costs are 75% of sales. At a sales level of P 400,000, the company’s degree of operating
leverage is 8. At this level, fixed costs equal
A a. P 87,500 c. P 50,000
b. P 100,000 d. P 75,000
36. A higher degree of operating leverage compared with industry average implies that the firm
B a. Has higher variable costs
b. Has profits that are more sensitive to changes in sales volume
c. Is more profitable
d. Is less risky
37. Candy Company’s variable costs are 70% of sales. At a P 300,000 sales level, the degree of operating leverage is 10.
If sales increase by P 60,000, what will be the degree of operating leverage?
D a. 12 c. 6
b. 10 d. 4
38. If used in cost-volume-profit analysis, sensitivity analysis
C a. Determines the most profitable mix of products to be sold
b. Allows the decision maker to use probabilities in the evaluation of decision alternatives
c. Is done through various possible scenarios and computes the impact on profit of various predictions
of future events
d. Is limited because in cost-volume-profit analysis, costs are not separated into fixed and variable
components
39. The indifference point is the level of volume at which a company
D a. Earns no profit c. Earns large amount of profit
b. Earns its target profit d. Earns the same profit under different schemes
40. Machine XX has fixed costs of P 225,000 and a variable cost of P 20. Machine YY has fixed costs of P 300,000 and a
variable cost of P 14. What is the indifference point in units?
B a. 11,250 c. 21,429
b. 12,500 d. Cannot be determined from given information
41. Bona Motors employs 40 sales personnel to market its line of automobiles. The average car sells for P 1,200,000 and a
6% commission is paid to the salesperson. Bona Motors is considering a change to a scheme that would pay each
salesperson a salary of P 24,000 per month plus a 2% commission of the sales made by that salesperson. What is the
amount of total car sales at which Bona Motors would be indifferent as to which plan to select?
B a. P 30,000,000 c. P 22,500,000
b. P 24,000,000 d. P 12,000,000
42. John Corporation submitted to you the following condensed income statement:
Sales (80% capacity) P 300,000
Variable costs P 180,000
Fixed costs 82,500 262,500
Net income P 37,500
What is the break-even point as a percentage of capacity?
B a. 45% c. 67.85%
b. 55% d. 68.75%
Page 6 of 6
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MANAGEMENT ADVISORY SERVICES C. LEE  E. ARAÑAS  K. MANUEL
MAS-04: ABSORPTION & VARIABLE COSTING WITH PRICING DECISIONS

ABSORPTION COSTING (AC) VARIABLE COSTING (VC)
1. Other Names Full Costing, GAAP Costing Direct Costing, Marginal Costing
2. Treatment of FFOH Product Cost -- Inventory, then Expense Period Cost -- Fully Expensed in the Period Incurred
3. Reason behind Treatment FFOH is necessary to produce units FFOH is incurred with or without production
4. Product Cost Components DM, DL, VFOH & FFOH DM, DL & VFOH
5. Period Cost Items Selling & Administrative Expenses FFOH, Selling & Administrative Expenses
6. Inventory Cost Higher than Variable Costing’s Lower than Absorption Costing’s
7. Matching Principle Compliant Non-Compliant
8. Income Statement Format Functional Presentation (“CGS” Format) Behavioral Classification (“CM” Format)
9. Main Purpose/Function External Financial Reporting Management Decision Aid – for internal use
10. Common Applications Financial Statements, Reporting to BIR & SEC CVP Analysis, Pricing Decision, Relevant Costing
Where: FFOH – Fixed Factory Overhead DM – Direct Materials CGS – Costs of Goods Sold
VFOH – Variable Factory Overhead DL – Direct Labor CM – Contribution Margin
 Under AC, FFOH costs are initially inventoried and expensed (part of CGS) only when related units are sold.
 Under VC, FFOH costs are fully expensed in the period incurred (i.e., outright expense regardless of sales).
 AC Profit vs. VC Profit:
Situation Implication Explanation
Since Ending Inventory = Beginning Inventory:
1 Production = Sales AC Profit = VC Profit
FFOH expensed under AC is equal to FFOH expensed under VC
Since Ending Inventory > Beginning Inventory:
2 Production > Sales AC Profit > VC Profit
FFOH expensed under AC is lower than FFOH expensed under VC
Since Ending Inventory < Beginning Inventory:
3 Production < Sales AC Profit < VC Profit
FFOH expensed under AC is higher than FFOH expensed under VC
∆ Profit = ∆ Inventory x unit FFOH

Where: ∆ Profit = AC Profit – VC Profit
∆ Inventory = Ending Inventory – Beginning Inventory = Production – Sales
Unit FFOH = Total FFOH ÷ Production
 Profit under VC fluctuates with sales (not production); production influences profit under AC (not under VC).
PRICING DECISIONS are the choices businesses make in setting the selling price of their products (or services).
 Major factors that influence pricing decisions [The 3 C’s]:
1. CUSTOMERS - Customers’ preference and willingness to pay is largely affected by the product’s price.
2. COMPETITORS - The price that a company charges for its products is affected by competitor’s pricing for
substitute products.
3. COSTS - Lower production costs allow a company to charge a competitive price for its product.
In general, the price of a product is dependent upon its demand and supply. The value that customers place
on the product and the prices competitors charge for competing products affect DEMAND, while the costs of
producing and delivering the product influence SUPPLY.
[Law of supply and demand shall be thoroughly discussed in MAS-09 (Economics) – Week 9]
 General pricing approaches:
1. VALUE-BASED – prices are based on buyer’s perception of product value instead of on seller’s costs.
2. COMPETITION-BASED – prices are mainly influenced by the price of competing products.
A) Going-rate pricing: price = competitor’s price
B) Target costing: In target costing, selling price is usually known before the product is developed.
➢ Step 1 – Market price is determined based on competition and customer demand.
➢ Step 2 – Target cost is computed based on formula: target cost = market price – desired profit.
➢ Step 3 – Life-cycle costs are reduced to reach the target cost level by doing value engineering.
[Value engineering & life-cycle costs shall be discussed in MAS-10 (Strategic Cost Management) – Week 11]
➢ Step 4 – Product is dropped if cost-cutting measures do not bring costs down to target levels.
C) Bidding (sealed-bid pricing): price = lowest price among bidders
3. COST-BASED – prices shall cover value chain costs and provide the desired return on investment.
A) Cost-plus pricing: price = certain costs + target profit
B) Mark-up pricing: price = full costs + target percentage on costs or selling price
4. Other pricing strategies:
A) Price Skimming – setting an introductory price relatively high to attract non-price-sensitive buyers
so that the firm may recover its research and development costs.
B) Penetration Pricing – setting an introductory price relatively low to gain deep market penetration.
C) Predatory Pricing – an illegal scheme where products are priced below cost to destroy competitors.
• Price adjustment strategies:
1. Cash Discounts – offered to encourage prompt payment of customer dues (e.g., 2/10, n/30).
2. Volume Discounts – offered to customers who purchase in large quantities.
3. Seasonal Discounts – offered to encourage sale and stabilize production of out-of-season products.
4. Functional Discounts – offered to members of trade channel for performing tasks such as selling.
5. Allowances – price reductions that can take the form of a trade-in or promotional allowance.
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Week 3: ABSORPTION & VARIABLE COSTING with PRICING DECISION
EXERCISES: ABSORPTION & VARIABLE COSTING with PRICING DECISIONS

1. ABSORPTION COSTING vs. VARIABLE COSTING
Twice Company makes a single product that sells for P 2,000 each. Data for 2022’s operations follow:
Units: Variable Costs:
Beginning Inventory 5 Direct Materials P 30,000
Production 50 Direct Labor 15,000
Ending Inventory 15 Factory Overhead 5,000
Selling and Administrative 6,000
Fixed Costs:
Factory Overhead P 20,000
Selling and Administrative 3,000
REQUIRED:
1. Determine the inventory cost per unit under:
1A) Absorption costing 1B) Variable costing
2. Determine the total cost of ending inventory under:
2A) Absorption costing 2B) Variable costing
3. Prepare the income statement under:
3A) absorption costing 3B) variable costing.
4. Without knowing the exact amounts of profit under absorption costing & variable costing:
4A) How much is the difference in profit?
4B) Which costing method has the higher profit?
SOLUTION GUIDE to requirement 3
TWICE COMPANY
Income Statement, for the period of 2022
3A) ABSORPTION Costing 3B) VARIABLE Costing
Sales P Sales P
- Costs of Sales ____________ - Variable Costs ____________
Gross Profit P Contribution Margin P
- Expenses ____________ - Fixed Costs ____________
Net Income P Profit P
2. COST-PLUS PRICING (ABSORPTION approach vs. CONTRIBUTION approach)
Blackpink Company has provided the following data for one of its products:
Direct labor 7.00
Variable manufacturing overhead 2.00
Variable SG&A expenses 3.00
The company produces and sells 15,000 units of this product each year. Fixed manufacturing overhead
cost total P 15,000 per year and fixed SG&A expenses total P 30,000 per year.
2A) If company uses the absorption approach to pricing and desires a 50% markup, then what is the
target selling price per unit?
a. P 34.50 c. P 27.00
b. P 31.50 d. P 23.00
2B) If company uses the contribution approach to pricing and desires a 35% markup, then what is the
target selling price per unit?
a. P 29.70 c. P 22.95
b. P 27.00 d. P 20.00
3. MARK-UP PRICING
Red Velvet Company started operations on January 1, 2022 and expected to produce 200,000 units in its
first year of operations. The cost data per unit based on expected production are shown below:
Direct labor P 12.00
Variable overhead P 6.00
Variable selling and admin. expense P 3.50
Fixed overhead P 3.00
Fixed selling and admin. expense P 2.50
Red Velvet Company is trying to decide on what selling price that they will use to project the 2022 sales.
REQUIRED: Determine the unit selling price under each of the following cases:
1. 20% mark-up based on prime costs.
2. 60% mark-up based on conversion costs.
3. 25% mark-up based on variable production costs.
4. 30% mark-up based on variable costs
5. 15% mark-up based on full absorption costs.
6. 10% mark-up based on full costs.
7. Assuming Red Velvet has excess capacity after 200,000 units and an offer to buy 20,000 units by
a local buyer is received, what is the minimum selling price on this offer if no selling and
administrative costs will be incurred, except for P 2 per unit for shipping?

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WRAP-UP EXERCISES
1. Which of the following is a product cost under absorption costing but not under variable costing?
a. Variable marketing costs c. Fixed marketing costs
b. Variable manufacturing costs d. Fixed manufacturing costs
2. Under absorption costing, fixed manufacturing overhead costs are best described as
a. Direct period costs c. Direct product costs
b. Indirect period costs d. Indirect product costs
3. Under variable costing,
a. All period costs are fixed c. All period costs are variable
b. All product costs are fixed d. All product costs are variable
4. As compared to absorption costing inventory cost, inventory cost under variable costing is typically
a. Lower c. The same
b. Higher d. The same or lower in certain cases
Items 5 to 7 are based on the following information
SNSD Company manufactures a single product. Unit variable production costs are P 20 and fixed
production costs are P 150,000. White uses a normal activity of 10,000 units. White began the year with
no inventory, produced 12,000 units, and sold 7,500 units.
5. How much is the unit product cost under variable costing?
a. P 20.00 c. P 35.00
b. P 32.50 d. P 40.00
6. How much is the unit product cost under absorption costing?
a. P 20.00 c. P 35.00
b. P 32.50 d. P 40.00
7. What is the volume or capacity variance under absorption costing?
a. P 24,000 unfavorable c. P 30,000 unfavorable
b. P 24,000 favorable d. P 30,000 favorable
NOTE: volume variance = (actual production – normal production) x unit FFOH
8. If production is higher than sales, then absorption costing profit is expected to be
a. Lower than variable costing profit c. Equal to the variable costing profit
b. Higher than variable costing profit d. Incomparable with variable costing profit
9. 2NE1 Company produced 10,000 units and sold 9,000 units. Fixed manufacturing overhead costs were
P20,000, and variable manufacturing overhead costs were P 3 per unit. Which of the following best
describes the profit under the absorption costing method?
a. P 2,000 less than profit under variable costing method
b. P 5,000 less than profit under variable costing method
c. P 2,000 more than profit under variable costing method
d. P 5,000 more than profit under variable costing method
10. If ending inventory is higher than beginning inventory, then absorption costing profit is expected to be
a. Lower than variable costing profit c. Equal to the variable costing profit
b. Higher than variable costing profit d. Incomparable with variable costing profit
11. Wonder Girls Company has an operating income of P 50,000 under direct costing. Beginning and ending
inventories were 13,000 units and 18,000 units, respectively. If the fixed factory overhead application
rate is P 2 per unit, then what is the operating income under the absorption costing?
a. P 70,000 c. P 50,000
b. P 60,000 d. P 40,000
12. Itzy Company had 16,000 units in its beginning inventory. The company’s variable production costs were
P 6 per unit and its fixed manufacturing overhead costs were P 4 per unit. The company’s net income for
the year was P 24,000 lower under absorption costing than it was under variable costing. How many units
does the company have in its ending inventory?
a. 22,000 units c. 6,000 units
b. 10,000 units d. 4,000 units
13. Aespa Company had a net income of P 90,000 using variable costing and net income of P 85,500 using
absorption costing. Total fixed manufacturing overhead cost was P 150,000, and production was 100,000
units. How did the inventory level change during the year?
a. 3,000 units increase c. 4,500 units increase
b. 3,000 units decrease d. 4,500 units decrease
14. Under a just-in-time (JIT) production environment, profit under absorption costing tends to be
a. Higher than that of variable costing c. Equal to that of variable costing
b. Lower than that of variable costing d. Not equal to that of variable costing
15. Variable costing profit fluctuates with (A) ____ and does not react to changes in (B) ____.
a. (A) sales (B) production c. (A) sales (B) demand
b. (A) production (B) sales d. (A) production (B) supply
16. Product pricing is generally influenced by the following factors, except:
a. Competition c. Seller’s cost structure
b. Consumer demand d. Buyer’s profit objective
17. Which one of the following best represents the steps followed in target costing?
a. Use value engineering and kaizen costing to reduce costs, and determine desired price
b. Use kaizen costing to reduce costs, determine desired mark-up, and set the market price
c. Use value engineering to reduce costs, calculate target costs, and set the desired price
d. Determine market price, calculate target cost, and use value engineering to reduce costs

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18. When using the absorption approach to cost-plus pricing,

a. All costs are included in the cost base.
b. The cost base is made up of the unit manufacturing costs.
c. The “plus” or markup figure contains fixed costs and desired profit.
d. The cost base is made up of the variable costs associated with the product.
19. What price adjustment strategy is usually designed to stabilize production for the selling firm?
a. Cash discounts c. Functional discounts
b. Quantity discounts d. Seasonal discounts
20. Variable costing is unacceptable for
a. Financial reporting c. Cost-volume-profit analysis
b. Transfer pricing d. Short-term decision making
1. Which method of inventory costing treats direct manufacturing costs and manufacturing overhead costs, both variable
and fixed, as inventoriable costs?
B a. Conversion costing c. Variable costing
b. Absorption costing d. Direct costing
2. What is the costing method that treats all fixed costs as period costs?
C a. Absorption costing c. Variable costing
b. Job-order costing d. Process costing
3. A basic tenet of direct costing is that period costs should be currently expensed. What is the rationale behind this
procedure?
D a. Period costs are uncontrollable and should not be charged to a specific product
b. Allocation of period costs is arbitrary at best and could lead to erroneous decisions by management
c. Period costs are generally immaterial in amount and the cost of assigning the amount to specific products
would outweigh the benefits
d. Period costs will occur whether or not production occurs and so it is improper to allocate these costs to
production and defer a current cost of doing business
4. Black Co.’s 2022 fixed manufacturing overhead costs totaled P 100,000 and variable selling costs totaled P 80,000. Under
direct (variable) costing, how should these costs be classified?
Period Costs Product Costs
D a. P0 P 180,000
b. P 80,000 P 100,000
c. P 100,000 P 80,000
d. P 180,000 P0
5. Under variable costing,
B a. Net income will tend to move based on changes in levels of production
b. Inventory costs will always be lower than under absorption costing
c. Net income will always be higher than under absorption costing
d. Net income will tend to vary inversely with production changes
6. White Company had the following costs for 2022:
Raw materials P 700,000 Rent for factory building P 50,000
Direct labor 100,000 Rent for sales office 30,000
Miscellaneous FOH (fixed) 80,000 Depreciation on store equipment 20,000
Depreciation on machines 40,000
How much of these costs should be inventoried under absorption (A) and variable (V) costing methods?
C a. (A) 1,020,000 (V) 880,000 c. (A) 970,000 (V) 800,000
b. (A) 1,000,000 (V) 880,000 d. (A) 930,000 (V) 800,000
7. White Company manufactures a single product and has the following cost structure:
Variable costs per unit:
Direct materials P3
Direct labor 4
Variable manufacturing overhead 1
Variable selling and administrative expense 2
Fixed costs per month:
Fixed manufacturing overhead P 100,000
Fixed selling and administrative 60,000
The company produces 20,000 units each month. The unit product cost under absorption costing
C a. P 10 c. P 13
b. P 12 d. P 15
8. Refer to the data in No. 7, what is the unit product cost under variable costing?
A a. P 8 c. P 11
b. P 10 d. P 13
9. Refer to the data in No. 7, assuming there are no beginning inventories, 20,000 units are produced and 19,000 units are
sold in a month. If the unit selling price is P 20, what is the net income under absorption costing?
B a. P 30,000 c. P 38,000
b. P 35,000 d. P 42,000
10. Refer to the data in No. 7 assuming there are no beginning inventories and 20,000 units are produced and 19,000 units
are sold in a month. If the unit selling price is P 20, what is the net income under variable costing?
A a. P 30,000 c. P 38,000
b. P 35,000 d. P 42,000

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11. The use of variable costing requires knowing

D a. The controllable and non-controllable components of all costs
b. The number of units of each product produced during the period
c. The contribution margin and break-even point for all the units produced
d. The variable and fixed components of production costs
12. Brown Company began its operations on January 1, 2022, and produces a single product that sells for P 10 per unit.
Brown uses an actual (historical) cost system. In 2022, 100,000 units were produced and 80,000 units were sold. There
was no work-in-process inventory at December 31, 2022. Manufacturing costs and selling and administrative expenses
for 2022 were as follows:
Fixed costs Variable costs
Raw materials - P 2.00 per unit produced
Direct labor - P 1.25 per unit produced
Factory overhead P 120,000 P 0.75 per unit produced
Selling and administrative 70,000 P 1.00 per unit sold
What would be Brown’s operating income for 2022 under variable (direct) costing method?
B a. P 114,000 c. P 234,000
b. P 210,000 d. P 330,000
Items 13 and 14 are based on the following information
Pink company manufactures and sells a single product. Planned and actual production in its first year of operation was
100,000 units. Planned and actual costs for that year were as follows:
Manufacturing Non-manufacturing
Variable P 600,000 P 500,000
Fixed 400,000 300,000
The company sold 85,000 units of product at a selling price of P 30 per unit.
13. Using absorption costing, the company’s operating profit was
B a. P 750,000 c. P 975,000
b. P 900,000 d. P 1,020,000
14. Using variable costing, the company’s operating profit was
B a. P 750,000 c. P 915,000
b. P 840,000 d. P 975,000
15. Income under absorption costing may differ from income under variable costing. How is this difference calculated?
A a. Change in the quantity of units in inventory times the fixed factory overhead rate per unit
b. Number of units produced during the period times the fixed factory overhead rate per unit
c. Change in the quantity of units in inventory times the variable manufacturing cost per unit
d. Number of units produced during the period times the variable manufacturing cost per unit
16. Blonde, Inc. manufactured 7,000 units last year. The ending inventory consisted of 100 units. There was no beginning
inventory. Variable manufacturing costs were P 6.00 per unit and fixed manufacturing costs were P 2.00 per unit. What
would be the change in the peso amount of ending inventory if variable costing was used instead of absorption costing?
D a. P 800 decrease c. P 0
b. P 200 increase d. P 200 decrease
17. When production exceeds sales, fixed manufacturing overhead costs
B a. Are released from inventory under absorption costing
b. Are deferred in inventory under absorption costing
c. Are released from inventory under variable costing
d. Are deferred in inventory under variable costing
18. During its first year of operations, a company produced 275,000 units and sold 250,000 units. The following costs were
incurred during the year:
Variable costs per unit
Direct labor 10.00
Manufacturing overhead 12.50
Selling and administrative 2.50
Total fixed cost
Manufacturing overhead P 2,200,000
Selling and administrative P 1,375,000
The difference between absorption costing profit and variable costing profit is that absorption costing profit is:
A a. P 200,000 greater c. P 325,000 greater
b. P 220,000 greater d. P 62,500 less
19. What best accounts for profit difference between absorption costing and variable costing method?
D a. Difference in fixed costs incurred c. Difference in sales revenue
b. Difference in variable costs incurred d. Difference in inventory valuation
20. Lavender Company’s income under absorption costing was P 3,600 lower than its income under variable costing. The
company sold 10,000 units during the year, and its variable costs were P 9 per unit, P 1 of which represents the variable
selling expense. If production cost was P 11 per unit under absorption costing, then how many units did the company
produce during the year?
B a. 8,200 units c. 11,200 units
b. 8,800 units d. 11,800 units
21. Variable costing and absorption costing will show the same incomes when there are no
D a. Beginning inventories c. Variable costs
b. Ending inventories d. Beginning and ending inventories

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22. Absorption costing and variable costing differ in that

C a. Standards can be used with absorption costing, but not with variable costing.
b. Absorption costing inventories are more correctly valued.
c. Production influences income under absorption costing, but not under variable costing.
d. Companies using absorption costing have lower fixed costs.
23. When sales are constant but production fluctuates,
D a. Net income will be erratic under variable costing
b. Absorption costing will always show a net loss
c. Variable costing will always show a positive net income
d. Net income will be erratic under absorption costing
24. Red Co. had the same activity in 2022 as in 2021, except that production was higher in 2022 (vs. 2021). Red will show
C a. Higher income in 2022 than in 2021
b. The same income in both years
c. The same income in both years under variable costing
d. The same income in both years under absorption costing
25. Violet Company manufactures a single product. Unit variable production costs are P 20 & fixed production costs are
P150,000. Violet uses a normal activity of 10,000 units to set its standard costs. Violet began the year with no inventory,
produced 11,000 units, & sold 10,500 units. What is the ending inventory under absorption costing?
C a. P 10,000 c. P 17,500
b. P 15,000 d. P 20,000
26. Purple Company’s production facility has an ideal capacity of 12,500 units, which was used as the basis for the normal
capacity of 10,000 units. The company was able to produce 11,000 units during the period. Fixed manufacturing costs
were P 200,000 while variable manufacturing costs were also P 200,000. What was the volume or capacity variance for
the production?
B a. P 20,000 unfavorable c. P 24,000 favorable
27. Super variable costing treats which of the following costs as the only variable and product costs?
B a. Direct labor c. Straight-line depreciation of factory machine
b. Direct materials d. Supervisory salary of an assembly line manager
28. Super variable costing is sometimes referred to as
D a. Full costing c. Indirect costing
b. GAAP costing d. Throughput costing
29. It is the expected market price for a product or service, considering the consumers’ perception of value and the
competitors’ responses.
B a. Transfer price c. Cost-based price
b. Target price d. Selling price
30. Based on the following information: volume of production – 10,000 units; capital employed – P 60,000; cost to produce
and sell – P 5.00 per unit. The unit selling price that will yield a 20% return on investment is:
B a. P 5.10 c. P 7.00
b. P 6.20 d. P 7.01
31. Magenta Company plans to introduce a new product. To compete effectively, the product could not be priced at more
than P30. The company requires a return on investment of 15% on all new products. The plan is to produce and sell
25,000 units a year. If the product requires a P 500,000 investment, then target cost should be:
A a. P 27.00 c. P 21.50
b. P 23.00 d. P 20.00
32. Based on sales of 500 units per year, a new product has estimated traceable costs of P 990,000. What is the target
price to obtain a 15% profit margin on sales?
A a. P 2,329 c. P 1,980
b. P 2,227 d. P 1,935
33. Cyan Co. signed a government construction contract providing for a formula price of actual cost plus 10%. In addition,
Cyan was to receive one-half of any savings resulting from the formula price being less than the target price of
P2,200,000. Cyan’s actual costs incurred were P 1,920,000. How much should Cyan receive from the contract?
C a. P 2,060,000 c. P 2,156,000
b. P 2,112,000 d. P 2,200,000
34. Fuchsia Company is introducing a new product. It priced the new product low enough to generate excitement. Which
one of the following pricing approaches did management implement?
B a. Price skimming c. Cost-based pricing
b. Penetration pricing d. Market-based pricing
35. A manufacturing firm intentionally priced its product below cost to eliminate competition. It has a reasonable prospect
of recovering the resulting loss through higher prices once competition is eliminated or through a greater share in the
market. The manufacturing firm has engaged in:
B a. Price discrimination c. Collusive pricing
b. Predatory pricing d. Black market pricing
36. Functional discounts are offered to
D a. Encourage large volume purchases {volume discount}
b. Encourage prompt payment, improve cash flows and avoid bad debts {cash discount}
c. Encourage sale and stabilize production of out-of-season products {seasonal discount}
d. Other members of the marketing channel for performing certain services such as sales and marketing

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MAS-06: BUDGETING WITH PROBABILITY ANALYSIS

BUDGET - is a realistic quantitative plan useful for planning and controlling company expenses, cash flows and
earnings for a specific period. The term budgeting refers to the process of coming up with budgets.
BUDGET PERIOD The length of time for which a budget is to be prepared and implemented
BUDGET COMMITTEE Key management personnel responsible for drafting the budget manual, and
coordinating/approving budgets submitted by managers.
BUDGET MANUAL A written description on how to prepare budgets that includes a planning
calendar and distribution instructions for budget schedules.
AUTHORITATIVE BUDGETING A process wherein budgets are prepared by top management with little or no
(Top-Down Budgeting) inputs from operating personnel (i.e., imposed budgeting)
PARTICIPATORY BUDGETING A process wherein budgets are developed through joint decisions by top
(Bottom-Up Budgeting) management and operating personnel (i.e., consensus budgeting)
ZERO-BASED BUDGETING A process of starting over each budget and justifying each budgeted item as if
the programs involved were being proposed for the first time every period
CONTINUOUS BUDGET An incremental budget that adds the current period and drops the older period
(Rolling Budget) to maintain a constant budget period of usually 12 months.
KAIZEN BUDGETING A process that assumes continuous improvement of products and/or processes
so that budgets are not based on existing system but on changes to be made.
ACTIVITY BASED BUDGETING A process that applies mostly Activity-Based Costing (ABC) principles and
procedures to come up with budgets
LIFE-CYCLE BUDGETING A process wherein a product9s revenues and expenses are budgeted over its
entire life cycle from R&D to production to marketing to customer service.
STRATEGIC BUDGET A long-term budget based on the identifications of action plans to achieve
company goals and, ultimately, its mission.
BUDGETARY SLACK A practice of underestimating revenues or overestimating costs to make budget
targets easily achievable in order to project a seemingly <good= performance.
STATIC BUDGET A budget prepared for a single level of activity that does not change even when
(Fixed Budget) actual activity differs from planned activity.
FLEXIBLE BUDGET A budget that adjusts revenues and costs when actual activity differs from the
(Variable Budget) planned activity stated in the fixed budget.
MASTER BUDGET A static budget that is based on the comprehensive plan for the overall activities
(Pro-Forma Budget) of a company. The major components of a master budget are:
(Comprehensive Budget)  OPERATING budget – sales forecast, sales budget, production budget,
inventory budget, CGS budget, selling & administrative expense budget
 FINANCIAL budget – cash budget, working capital budget, capital expenditures
budget*, pro-forma balance sheet, pro-forma statement of cash flows
* The capital expenditures budget, prepared mainly for the acquisition and
maintenance of long-term assets, may be shown as a separate major
component of the master budget, alongside operating and financial budgets.
USES of BUDGETS Forced Planning  Coordination  Communication  Motivation  Efficient Allocation
of Resources  Progress Check  Benchmark for Performance Evaluation
PROBABILITY ANALYSIS
 PROBABILITY is a mathematical expression of doubt or assurance about the occurrence of a chance event.
 The probability of a particular event ranges from 0 (never) to 1 (always).
 A probability of 0 means the event cannot occur; a probability of 1 means the event is certain to occur.
 PROBABILITY ANALYSIS is commonly used in planning to determine the likelihood of a specific event
occurring when several outcomes are possible in order to reduce the level of uncertainty in decision making
 EXPECTED VALUE uses probabilities as weights in computing the average or mean of possible outcomes.
 JOINT PROBABILITY, determined by multiplying the probability of the first event by the conditional probability
of the second event, is the probability of an event occurring given that another event has already occurred.
 Decision-making under CERTAINTY: for each decision alternative, there is only one event with 100% chance.
 Decision-making under conditions of RISK: the probability distribution of possible future events is known.
 Decision-making under conditions of UNCERTAINTY: each decision alternative has several possible outcomes
and the probability distribution of possible future events is not known and must be determined subjectively.
 DECISION TREE is a diagram that shows decision alternatives and the possible outcomes of each decision
along with their associated expected values and probabilities.
 DECISION (Pay-off) TABLE shows the decision, outcomes with their probabilities and the monetary values of
all possible decision-outcome combinations.
 PERFECT INFORMATION is the knowledge that a future event will occur with certainty.
 EXPECTED VALUE (EV) of PERFECT INFORMATION is the difference between expected value with perfect
information (i.e., best results given perfect information) and expected value without perfect information.
EV of Perfect Information = EV with Perfect Information – EV without Perfect Information

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Week No. 6: BUDGETING with PROBABILITY ANALYSIS
EXERCISES: BUDGETING with PROBABILITY ANALYSIS

1. Production & Inventory Budget
DMD Company has budgeted sales at P 100,000 and expects a profit of 10% of the sales. Expenses are
estimated as follows: selling = 10% of sales; administrative = 15% of sales. Labor is expected to be 40%
of the total manufacturing costs. Factory overhead is to be applied at 75% of direct labor costs.
Inventories are to be as follows:
January 1 December 31
Materials P 4,000 P 1,500
Work-in-process 2,500 7,500
Finished goods 5,000 10,000
REQUIRED: Determine the budgeted amount for:
A) Cost of goods sold C) Factory overhead
B) Total manufacturing cost D) Materials purchases
2. Sales & Accounts Receivable Budget

Past collections experienced by BJS Company indicate that 60% of the sales billed in a month are collected
during the month of sales, 30% are collected in the following month, and 10% are collected in the second
following month. The following are the projected sales for next year:
January P 480,000
February P 420,000
March P 500,000
April P 550,000
May P 600,000
A) Budgeted collections during the month of March.
B) Budgeted collections during the month of May.
C) Projected accounts receivable balance on April 1.
D) Projected accounts receivable balance on June 1.
3. Merchandise Purchases Budget
CIT Merchandising has budgeted the following sales for the 2 nd quarter of 2021:
April P 123,500
May 156,000
June 208,000
Other budgeted estimates are:
 All merchandises are to sell at its invoice cost plus 30% mark-up.
 Beginning inventories of each month are budgeted at 40% of that particular month9s projected cost
of goods sold.
REQUIRED: Determine the projected amount for:
A) Merchandise purchases in April. B) Merchandise purchases in May.
4. Pro-forma Statement of Cash Flows
Sugbu Company presents these data to be used as basis for the pro-forma Statement of Cash Flows.
1) Customer sales receipts for P 870,000
2) Purchase of machinery and equipment for P 125,000 cash.
3) Settlement of income taxes of P 110,000
4) Sale of investment securities for P 500,000.
5) Payment of dividends of P 600,000.
6) Receipt of rentals of P 105,000.
7) Issuance of 500 shares of common stock for P 250,000.
8) Payment of P 100,000 due to suppliers and payroll to employees.
9) Purchase of land for plant site for P 550,000 cash that was borrowed from a bank.
10) Payment of P 450,000 for treasury shares.
REQUIRED: Determine the projected amounts of the following:
A) Net cash provided by operating activities C) Net cash used in financing activities
B) Net cash used in investing activities D) Net cash increase or decrease
5. Expected Value
SDA Company prepared the following probability distribution describing the relative likelihood of monthly
sales volume levels and related profit (loss) for its lone product that sells for P 50 per unit:
Sales volume Probability Profit (Loss)
5,000 10% (P 70,000)
12,000 20% 10,000
18,000 40% 60,000
24,000 20% 100,000
30,000 10% 140,000
REQUIRED: Using the expected value approach,
A) How much is the budgeted sales for the month?
B) What is the expected value of the monthly profit?
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6. Indifference Point under Probability Analysis

Eloy Company plans to introduce a new product that requires an initial cash investment of P 440. If the
product becomes successful, the net cash inflow is forecasted at P 800. However, if the product becomes a
failure, net cash inflow is estimated at P 200.
REQUIRED:
A) If the success rate is 70%, what is the value of act <to invest?=
B) What probability-percentages should be assigned to the events 8success9 and 8failure9 to be indifferent
between the two actions <to invest= and <not to invest?=
7. Joint Probability
CGH Company has three sales departments, each contributing the following percentages of total sales:
clothing, 50%; grocery, 30%; and hardware, 20%. Each department has had the following average annual
damaged goods rates: clothing, 2%; grocery, 10%; and hardware, 5%. A random corporate audit has
found a weekly damaged goods rate of sufficient magnitude to alarm CGH9s management.
REQUIRED:
Determine the probability in percentage that the damage occurred in the:
A) Clothing department
B) Grocery department
C) Hardware department
8. Decision Tree
A wine maker must decide whether to harvest grapes now or in four weeks. Harvesting now will yield
100,000 bottles of wine, netting P 2 per bottle. If the wine maker waits for four weeks and weather turns
cold (probability: 20%), the yield will be cut in half but net P 3 per bottle. If the weather does not turn
cold, the yield depends on rain. With rain (probability: 50%), a full yield netting P 4 per bottle will result.
Without rain, there will still be a full 100,000-bottle yield, but the net amount will be P 3 per bottle only.
REQUIRED:
Determine the optimal expected value.
NOW ________________
D COLD ( ): __________________
LATER RAIN ( ): __________________

NOT ( )
(4 weeks)
COLD
NO ( ): _____________________
RAIN
9. Decision (Payoff) Table

ESA Dealers, Inc. is contemplating on how many units of cars to order to meet the customer demands for
the month based on the following projection:
Demand Probability
0 unit 10%
1 unit 50%
2 units 40%
The profit for each unit sold is P 200,000 while the carrying cost for each unit of unsold car is P 50,000.
REQUIRED:
How many units of cars should ESA order and why?
States of Nature (based on demand)

Decision Alternative 0 unit (10%) 1 unit (50%) 2 units (40%) Expected Value
Stock 0 unit
Stock 1 unit
Stock 2 units
10. Perfect Information

Assume that ESA Dealers in No. 9 would maximize profits if the company were able to obtain additional
information that can determine exactly what all potential customers intended to do for this month (i.e.,
ESA has perfect information).
REQUIRED:
A) What is the expected value with perfect information?
B) What is the expected value of perfect information?
C) What maximum amount is ESA willing to pay for the additional information?
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WRAP-UP EXERCISES
1. In a typical planning process, which of the following would be completed last?
a. Vision and mission c. Tactical goals
b. Strategic objectives d. Operational plans
2. In the budgeting process, top management
a. Should only be involved in the approval process
b. Needs to be involved, including using the budget process to communicate goals
c. Lacks the detailed knowledge of the daily operations and should limit their involvement
d. Need to separate the budgeting process and business planning process into two
separate processes
3. Coordinating the preparation of budget is the responsibility assigned to which of the following?
a. Top management c. Accounting department
b. Budget committee d. Lower levels of management
4. Which is an advantage of authoritative budgeting over participative budgeting?
a. Longer time cycle in the budgeting process
b. Stronger commitment from lower level of management
c. Greater flow of information from bottom to top management
d. More emphasis on strategic plans and avoidance of budgetary slacks
5. The master budget usually begins with the
a. Production budget c. Financial budget
b. Operating budget d. Sales forecast
6. The production budget process usually begins with the
a. Sales budget c. Direct materials budget
b. Direct labor budget d. Manufacturing overhead budget
7. Which of these budgets is usually prepared first?
a. Production budget c. Cash disbursements budget
b. Materials purchases budget d. Cash budget
8. All of the following are considered operating budgets, EXCEPT
a. Cash budget c. Purchases budget
b. Sales budget d. Production budget
9. Which of the following budgets is based on many other master budget components?
a. Direct labor budget c. Sales budget
b. Overhead budget d. Cash budget
10. Biden Inc. has projected sales to be P 260,000 in June, P 270,000 in July and P 300,000 in August.
Biden collects 30% of a month9s sales in the month of sale, 50% in the month following the sale, and
20% in the second month following the sale. What is the accounts receivable balance on August 31?
a. P 90,000 c. P 264,000
b. P 210,000 d. Some other number
11. Dems Inc. has projected sales: February, P 10,000; March, P 9,000; April, P 8,000; May, P 10,000;
and June, P 11,000. Dems has 30% cash sales and 70% sales on account. Accounts are collected 40%
in the month following the sale and 55% collected the second month. What would be the total cash
receipts in May?
a. P 3,000 c. P 8,705
b. P 8,150 d. Some other number
12. Donald Company has the following historical pattern on its credit sales:
70% collected in the month of sale
15% collected in the first month after sale
10% collected in the second month after sale
4% collected in the third month after sale
1% uncollectible
The sales on open account have been budgeted for the last six months of 2021 are shown below:
July P 60,000
August 70,000
September 80,000
October 90,000
November 100,000
December 85,000
What would be the estimated total cash collections during the fourth calendar quarter from sales made
on open account within the fourth calendar quarter?
a. P 172,500 c. P 251,400
b. P 230,000 d. P 265,400
13. Nevada Company manufactures a single product. The company keeps inventory of raw materials at
50% of the coming month9s budgeted production. Each unit of product requires 3 pounds of materials.
The production budget is (in units): May, 1,000; June, 1,200; July, 1,300; August, 1,600.
Determine the raw materials purchases in July.
a. 1,450 pounds c. 3,900 pounds
b. 2,400 pounds d. Some other number
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14. Trump Company has budgeted sales of 24,000 finished units for the forthcoming 6-month period. It
takes 4 lbs. of direct materials to make one finished unit. Given the following:
Finished Units Direct Materials (pounds)
Beginning inventory 14,000 44,000
Target ending inventory 12,000 48,000
How many pounds of direct materials should be budgeted for purchase during the 6-month period?
a. 88,000 c. 96,000
b. 92,000 d. 100,000
15. GOP Co. has projected sales to be P 60,000 in January, P 75,000 in February, and P 80,000 in March.
GOP wants to have 25% of next month9s sales needs on hand at the end of a month.
If GOP has an average gross profit of 40%, what are the February purchases?
a. P 30,500 c. P 46,250
b. P 45,750 d. P 76,250
16. Red Co. is preparing its cash budget for the next month based on the following projections:
Sales P 1,500,000
Gross Profit Rate 25%
Decrease in Inventories P 70,000
Decrease in Accounts Payable for Inventories P 120,000
What will be the estimated cash disbursements for inventories?
a. P 935,000 c. P 1,055,000
b. P 1,050,000 d. P 1,175,000
17. Blue Company has prepared the flexible budget formula for production costs: costs = 340,000 + 9X,
where X is the number of units produced. Blue produced 20,000 units at a total cost of P 490,000.
What is the variance of actual costs from budgeted costs (i.e., budget variance)?
a. P 150,000 favorable c. P 30,000 unfavorable
b. P 30,000 favorable d. P 90,000 unfavorable
18. The use of standard costs in the budgeting process signifies that an organization has most likely
implemented a
a. Capital budget c. Zero-based budget
b. Flexible budget d. Static budget

1. Which of the following is NOT an advantage of budgeting?

D a. It requires managers to state their objectives.
b. It facilitates control by permitting comparisons of budgeted and actual results.
c. It facilitates performance evaluation by comparing budgets with actual results.
d. It provides a check-up device that allows managers to keep close tabs on their subordinates.
2. Budgets are a necessary component of financial decision making because they provide a (n)
A a. Efficient allocation of resources c. Means to check managerial discretion
b. Means to use all the firm9s resources d. Automatic corrective mechanism for errors
3. In an organization that plans by using comprehensive budgeting, the master budget is
A a. A compilation of all the separate operational and financial budget schedules of the organization
b. The booklet containing budget guidelines, policies and forms to use in the budgeting process
c. The current budget updated for operations for part of the current year
d. A budget for a non-profit entity after it is approved by the appropriate authoritative body
4. The sales budget is classified as
C a. A financial budget c. An operating budget
b. A flexible budget d. A program budget
5. Using the concept of 8expected value9 in sales forecasting means that the sales forecast to be used is
D a. Developed using the indicator method.
b. The sum of the sales expected by individual
c. Based on expected selling prices of the products
d. Based on probabilities
6. Ohio Company developed the following sales forecasts and associated probabilities.
Sales Forecast Probability
P 600,000 10%
P 650,000 50%
P 700,000 35%
P 800,000 5%
What is the expected value of sales?
B a. P 650,000 c. P 667,500
b. P 670,000 d. P 800,000
7. Which of the following equations can be used to budget purchases? (BI = Beginning inventory, EI = ending inventory
desired, CGS = Budgeted cost of goods sold)
D a. Budgeted purchases = CGS + BI – EI c. Budgeted purchases = CGS + EI + BI
b. Budgeted purchases = CGS + BI d. Budgeted purchases = CGS + EI – BI
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8. Colorado Company desires an ending inventory of P 60,000. It expects sales of P 120,000 and has a beginning
inventory of P 40,000. Cost of sales is 60% of sales. Budgeted purchases are
C a. P 60,000 c. P 92,000
b. P 72,000 d. P 132,000
9. Individual budget schedules are prepared to develop an annual comprehensive or master budget. The budget
schedule that would provide the necessary input data for the direct labor budget would be the
D a. Sales forecast c. Schedule of cash receipts and disbursements
b. Raw materials purchases budget d. Production budget
10. South Dakota Company budgets sales of 22,000 units for January, 30,000 for February. The budgeted beginning
inventory for January 1 was 7,000 units. South Dakota desires an ending inventory equal to one-half of the following
month9s sales needs. What is the budgeted production for January?
B a. 37,000 units c. 26,000 units
b. 30,000 units d. 14,000 units
11. New Mexico Company plans to sell 24,000 units of Product A in July and 30,000 units in August. Sales of Product A
during June were 25,000 units. Past experience has shown that end-of-month inventory must equal 3,000 units plus
30% of the next month9s sales. On June 30, this requirement was met. Based on these data, how many units of
Product A must be produced during the month of July?
D a. 28,800 c. 24,000
b. 22,200 d. 25,800
12. Florida keeps its inventory of finished goods at 75% of the coming month9s budgeted sales and inventory of raw
materials at 50% of the coming month9s budgeted production needs. Each unit of product requires 2 pounds of
materials. The production budget is, in units: May, 1,000; June, 1,200; July, 1,300; August, 1,600. What would be
the raw material purchases in June?
B a. 1,525 pounds c. 2,800 pounds
b. 2,500 pounds d. 3,050 pounds
13. New Jersey Co. is budgeting sales of 53,000 units of product A1 for 2021. The manufacture of one unit of A1 requires
4 kilos of chemical Z5. During 2021, New Jersey plans to reduce the inventory of Z5 by 50,000 kilos and increase the
finished goods inventory of A1 by 6,000 units. There is no work-in-process inventory. How many kilos of Z5 is New
Jersey budgeting to purchase in 2021?
C a. 138,000 c. 186,000
b. 162,000 d. 238,000
14. Washington Company has the following 2021 budget data:
Beginning finished goods inventory 40,000 units
Sales 70,000 units
Ending finished goods inventory 30,000 units
Direct materials P 10 per unit
Direct labor P 20 per unit
Variable factory overhead P 5 per unit
Fixed factory overhead P 80,000
What are the 2021 total budgeted production costs?
B a. P 2,100,000 c. P 2,240,000
b. P 2,180,000 d. P 2,320,000
15. Montana Company9s budget contains the following information:
Units
Beginning finished goods inventory 85
Beginning work-in-process in equivalent units 10
Desired ending finished goods inventory 100
Desired ending work-in-process in equivalent units 40
Projected sales 1,800
How many equivalent units should Montana plan to produce?
D a. 1565 c. 1815
b. 1800 d. 1845
16. The information contained in a cost of goods manufactured budget most directly relates to the
B a. Materials used, direct labor, overhead applied, and ending work-in-process
b. Materials used, direct labor, overhead applied, and work-in-process inventories budgets
c. Materials used, direct labor, overhead applied, and work-in-process inventories, and finished goods
inventories budgets
d. Materials used, direct labor, overhead applied, and finished goods inventories budgets
17. Maine Co. makes payments for purchases 30% during the month of purchase and the remainder the following month.
April purchases are projected to be P 80,000; May purchases will be P 120,000. What will be the cash payments on
account for May?
D a. P 36,000 c. P 84,000
b. P 54,000 d. P 92,000
18. Nebraska Company, a merchandising firm, is preparing its master budget and has gathered the following data to help
budget cash disbursements:
Cost of goods sold P 1,680,000
Desired decrease in inventories 70,000
Desired decrease in accounts payable 150,000
All of the accounts payables are for inventory purchases and all inventories are purchased on account. What are the
estimated cash disbursements for inventories for the budget period?
D a. P 1,460,000 c. P 1,900,000
b. P 1,600,000 d. P 1,760,000
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Operational budgets are used for planning and controlling its business activities. Data regarding a company9s sales for
the last 6 months of the year and its projected collection patterns are shown below:
Forecasted sales
July P 775,000
August 750,000
September 825,000
October 800,000
November 850,000
December 900,000
Types of sales
Cash sales 20%
Credit sales 80%
Collection Pattern for Credit Sales
In the month of sale 40%
In the first month following the sale 57%
Uncollectible 3%
The cost of merchandise averages 40% of its selling price. The company9s policy is to maintain an inventory equal to
25% of the next month9s forecasted sales. The inventory balance at cost is P 80,000 as of June 30.
19. The budgeted cost of the company9s purchases for the month of August would be
C a. P 302,500 c. P 307,500
b. P 305,000 d. P 318,750
20. The company9s total cash receipts from sales and collections on account that would be budgeted for the month of
September would be
B a. P 757,500 c. P 793,800
b. P 771,000 d. P 856,500
21. Alabama Consortium is constructing a corporate planning model. Cash sales are 30% of the company9s sales, with the
remainder subject to the following collection pattern:
One month after sale 60%
Two months after sale 30%
Three months after sale 8%
Uncollectible 2%
If Sn is defined as total sales in month 8n,9 which one of the following expressions correctly describes Alabama9s
collection on account in any given month?
C a. 0.6 S n-1 + 0.3 S n-2 + 0.08 S n-3 c. 0.42 S n-1 + 0.21 S n-2 + 0.056 S n-3
b. 0.42 S n+1 + 0.21 S n+2 + 0.056 S n+3 d. 0.6 S n-1 + 0.3 S n-2 + 0.08 S n-3 - 0.02 S
22. The cash receipts budget includes
D a. Funded depreciation c. Extinguishment of debt
b. Operating supplies d. Loan proceeds
23. The Pennsylvania Company is preparing its cash budget for the month of May. The following information is available
concerning its accounts receivable:
Estimated credit sales for May P 200,000
Actual credit sales for April 150,000
Estimated collections in May for credit sales in May 20%
Estimated collections in May for credit sales in April 70%
Estimated collections in May for credit sales prior to April P 12,000
Estimated write-offs in May for uncollectible credit sales 8,000
Estimated provision for bad debts in May for credit sales in May 7,000
What are the estimated cash receipts from accounts receivable collections in May?
D a. P 142,000 c. P 150,000
b. P 149,000 d. P 157,000
24. Which one of the following budgets is the last item to be prepared under a normal budget preparation process?
C a. Direct labor budget c. Cash budget
b. Cost of goods sold budget d. Manufacturing overhead budget
25. The cash budget should help to ensure
B a. That enough cash is on hand at all times to satisfy maximum cash requirements
b. Sufficient liquidity without an excess amount of idle cash
c. That cash dividends can be paid every quarter
d. That sufficient cash is available to pay salaries, even if it means borrowing the money
26. The cash budget for 2021 would be affected in some way by all of the following, except
B a. A cash dividend declared in 2020 for payment in 2021.
b. A cash dividend declared in 2021 for payment in 2022.
c. Interest expense on loans taken out and repaid during 2021.
d. The sales forecast for the first month in 2022.
27. A company has prepared a cash budget for January through June of 2021. Which of the following, discovered in
February 2021, is LEAST likely to require revising the cash budget?
D a. February sales are lower than budgeted.
b. The interest rate on short-term borrowing is higher than budgeted.
c. The company increased from 10% to 20% the down payment it requires from customers.
d. The company changed inventory methods from LIFO to FIFO.
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28. The last pro forma statement prepared under a typical budgeting process is the
C a. Income statement c. Statement of cash flows
b. Statement of cost of goods sold d. Statement of manufacturing costs
29. In the preparation of a cash budget with clear-cut information on sources and uses of funds, all of the following would
classified as a cash flow under investing activities, EXCEPT:
D a. Collection of a loan from subsidiary c. Sale of plant assets
b. Purchase of a patent from an inventor d. Dividends received on stock investment
30. In the preparation of a cash budget with clear-cut information on sources and uses of funds, all of the following would
classified as a cash flow under financing activities, EXCEPT:
A a. The conversion of the company9s own preferred stock into common stock
b. The declaration and payment of a cash dividend on the company9s own common stock
c. The repayment of principal on a mortgage
d. The sale of the company9s own preferred stock for cash
31. North Carolina projects the following activities related to its financial operations:
a. Issuance of shares of company9s own common stock: P 170,000
b. Dividends to be paid to the company9s own shareholders: P 7,000
c. Dividends to be received from investments in other companies9 shares: P 4,000
d. Interest to be paid on the company9s own bonds: P 11,000
e. Repayment of principal on the company9s own bonds: P 40,000
f. Proceeds from sale of the company9s used equipment: P 23,000
In cash financial budget, the net cash used by financing activities should be projected to be
B a. P 375,000 c. P 112,000
b. P 123,000 d. P 19,000
32. The budget that describes the long-term position, goals, and objectives of an entity is the
D a. Capital budget c. Cash management budget
b. Operating budget d. Strategic budget
33. The budgeting process should be one that motivates managers and employees to work toward organizational goals.
Which one of the following is LEAST likely to motivate managers?
B a. Participation by subordinates in the budgetary process
b. Having top management set budget levels
c. Use of management by exception
d. Holding subordinates accountable for the items they control
34. Comparing actual results with a budget based on achieved (actual) volume is possible with the use of a
D a. Monthly budget c. Rolling budget
b. Master budget d. Flexible budget
35. Which one of the following budgeting methodologies would be most appropriate for a firm facing a significant level of
uncertainty in unit sales volumes next year?
B a. Static budgeting c. Top-down budgeting
b. Flexible budgeting d. Life-cycle budgeting
36. A flexible budget is
B a. One that can be changed whenever a manager so desires.
b. Adjusted to reflect expected costs at the actual level of activity.
c. One that uses the formula 8total cost = cost per unit x units produced9
d. The same as a continuous budget.
37. Which of the following is a difference between a static budget and a flexible budget?
C a. A flexible budget includes only variable costs; a static budget includes only fixed costs.
b. A flexible budget includes all costs; a static budget includes only fixed costs.
c. A flexible budget gives allowances for different levels of activity while a static budget does not.
d. None of the above.
38. A company has developed the budget formula below for estimating its shipping expenses. Shipments have historically
averaged 12 pounds per shipment.
Shipping costs = P 18,000 + (P 0.60 x pounds shipped)
The planned and actual activity regarding orders and shipments for the month are given in the following schedule:
Plan Actual
Sales orders 800 780
Shipments 800 820
Units shipped 8,000 9,000
Sales P 120,000 P 144,000
Total pounds shipped 9,600 12,500
The actual shipping costs for the month amounted to P 21,000. What should be the appropriate monthly flexible
budget allowance for shipping costs for the purpose of performance evaluation?
D a. P 18,000 c. P 23,760
b. P 18,492 d. P 25,500
39. The difference between the actual amounts and the flexible budget amounts for the actual output achieved is the
B a. Production volume variance c. Sales volume variance
b. Flexible budget variance d. Standard cost variance
40. 8Kaizen9 budgeting refers to the budgeting process where
C a. The budget is based on only one level of activity
b. The budget is based on many levels of activity so that budget may be adjusted based on actual activity
c. The budget is based not on the existing system, but on changes or improvements that are to be made
d. A product9s revenues and expenses are estimated over its entire life cycle (i.e., from R&D phase to
customer support phase)
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41. The budget method that maintains a constant twelve month planning horizon by adding a new month on the end as
the current month is completed is called
C a. An operating budget c. A continuous budget
b. A capital budget d. A master budget
42. A company that uses zero-based budgeting has
B a. An expense budget of zero.
b. Zero as the starting point of budgeting the coming year9s expenses.
c. A zero variance between budgeted and actual performance.
d. An assumed sales level of zero.
43. A decision maker is operating in an environment wherein all the facts surrounding a decision are known exactly, &
each alternative is associated only with one possible outcome. The environment is known as:
A a. Certainty c. Uncertainty
b. Risk d. Conflict
A store sells four computer models designated as P100, A200, R300, and T400. The store manager has made random
number assignments to represent customer choices based on past sales data. The assignments are:
Model Random Numbers
P100 0-1
A200 2-6
R300 7-8
T400 9
44. What is the probability that a customer will select model P100?
B a. 10% c. 50%
b. 20% d. Cannot be determined from given information
SOLUTION: 2 {0,1} out of 10 {0,1,2,3,4,5,6,7,8,9} = 20%
45. In running a simulation of the computer demand, the following numbers are drawn in sequence: 2, 8 and 6. The
simulation indicates that the third customer will purchase
B a. Model P100 c. Model R300
b. Model A200 d. Model T400
46. A quantitative technique useful in projecting a firm9s sales and profits is the
A a. Probability distribution theory c. Learning curves
b. Gantt chart d. Queuing theory
47. Expected value in decision analysis is
B a. A standard deviation using the probabilities as weights.
b. An arithmetic mean using the probabilities as weights.
c. A standard deviation divided by the coefficient of variation.
d. A measure of the difference between best possible outcome and outcome of the original decision
48. The term 8expected value9 refers to the
D a. Value which would be assigned to a variable if problem were to be treated in a deterministic manner
b. Most likely single outcome selected from among a number of possible alternatives
c. Tails of a normal probability distribution
d. Mean value of a variable
A group of kids sells sweet candies at a basketball game. The candies are sold for P 1.00 each, and the cost per candy
is P 0.30. Any unsold candies are discarded because they will be stale before the next basketball game. The frequency
distribution of the demand for candies per basketball game is:
Unit sales volume Probability
2,000 candies 0.10
3,000 candies 0.15
4,000 candies 0.20
5,000 candies 0.35
6,000 candies 0.20
49. What is the estimated demand for candies at the next game using an expected value approach?
B a. 4,000 candies c. 5,000 candies
b. 4,400 candies d. 6,000 candies
50. What is the estimated demand for candies at the next game using a deterministic approach (highest probability)?
C a. 4,000 candies c. 5,000 candies
b. 4,400 candies d. 6,000 candies
51. The conditional profit per game of having 4,000 candies available but only selling 3,000 candies is
A a. P 1,800 c. P 2,800
b. P 2,100 d. P 4,000
SOLUTION: 3,000 (1.00) – 4,000 (0.3)
52. Raspberry Enterprises, distributor of compact disks (CDs), is developing its budgeted cost of goods sold for 2021.
Raspberry has developed the following range of sales estimates and associated probabilities:
Sales estimate Probability
P 60,000 25%
85,000 40%
100,000 35%
The cost of goods sold averages 80% of sales. What is 20219s expected value of cost of goods sold?
A a. P 67,200 c. P 84,000
b. P 68,000 d. P 85,000
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53. The Pineapple Company produces its product in batches of 100 units. The units each batch are then tested. The
results from testing the most recent 200 batches are shown below:
Units Failed per Batch Number of Batches
0 50
1 40
2 40
3 30
4 40
Total 200
What is the expected value of the number of failed units per batch?
B a. 0 c. 2.00
b. 1.85 d. 13.33
54. Cherry Distributors has decided to increase its daily muffin purchases of 100 boxes. A box of muffins costs P 2.00 and
sells for P 3.00 through regular stores. Any boxes not sold through regular store are sold through thrift store for P
1.00. Cherry assigns the following probabilities to selling additional boxes:
Additional sales Probability
60 60%
100 40%
What is the expected value of Cherry9s decision to buy 100 additional boxes of muffins?
C a. P 28 c. P 52
b. P 40 d. P 68
SOLUTION: 60 (60%) + 100 (40%) = 76 Expected value of 100 boxes: [76 (3 – 2)] + [24 (1 – 2)]
The probabilities shown in the table represent the estimate of sales for a new product:
Sales (unit) Probability
0 – 200 15%
201 – 400 45%
401 – 600 25%
601 – 800 15%
55. What is the probability of selling between 201 and 600 units of the product?
D a. 0% c. 25%
b. 11.25% d. 70%
56. What is the best estimate of the expected sales of the new product? (Hint: compute average of range)
A a. 380 c. 480
b. 400 d. 800
57. Mango Company uses two major inputs in its production. To prepare its manufacturing operations budget, the
company has to project the cost changes of these material inputs. The cost changes are independent of one another.
The purchasing department provides the following probabilities associated with projected cost changes:
Cost Change Material 1 Material 2
3% increase 30% 50%
5% increase 50% 40%
10% increase 20% 10%
What is the probability of a 3% increase in the cost of both Material 1 and Material 2?
A a. 15% c. 80%
b. 40% d. 20%
58. It is used for situations involving a sequence of events with several possible outcomes associated with each event.
B a. Network analysis c. Queuing theory
b. Decision tree analysis d. Linear programming
59. A contractor has been invited to submit a bid on a large and complicated construction project. The preparation of the
bid proposal will cost about P 20,000. Management feels that if the company bids low, enough to result in a net profit
of P 50,000, there would be a 60% chance of getting the job. If the company bids high, enough to result in a P
100,000 net profit, the chance of getting the contract would be only 20%. What should the company do?
A a. Bid low, enough to allow for P 50,000 profit since the expected value of payoff is P 22,000
b. Bid high, enough to allow for a P 100,000 profit since the expected value of payoff is P 4,000
c. Bid high, enough to allow for a P 100,000 profit since the expected value of payoff is P 20,000
d. Make no bid.
A beverage stand can sell either soft drinks or coffee on any given day. If the stand sells soft drinks and the weather
is hot, it will make P 2,500; if the weather is cold, the profit will be P 1,000. If the stand sells coffee and the weather is
hot, it will make P 1,900; if the weather is cold, the profit will be P 2,000. The probability of cold weather on a given
day at this time is 60%.
60. What is the expected payoff for selling coffee?
B a. P 1,360 c. P 2,200
b. P 1,960 d. P 3,900
61. What is the expected payoff if the vendor has perfect information?
C a. P 1,360 c. P 2,200
b. P 1,960 d. P 3,900
62. Considering only the information given, if the probability of hot weather given a hot weather forecast is 50%, then how
much would the vendor be willing to pay for the forecast?
A a. P 300 c. P 600
b. P 500 d. P 1,000
SOLUTION: 50% (2,500 – 1,900)
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CPA Review Batch 44  October 2022 CPA Licensure Examination
MS-44E
RELEVANT COSTING WITH LINEAR PROGRAMMING

DECISION MAKING – is the process of making choices from at least two alternatives by identifying a problem,
gathering information and evaluating alternative solutions. For business entities,
management usually chooses the option that maximizes company profit.
 FACTORS CONSIDERED IN DECISION MAKING
1. Qualitative Factors – factors that cannot be expressed in money or other numerical units.
Examples: customer satisfaction, suppliers and employee morale
2. Quantitative Factors – factors that can be expressed in money or other numerical units. The two
quantitative approaches to decision making are:
✓ TOTAL approach: Total revenues and costs are determined for each alternative, and the results are
compared to serve as a basis for the decision to make.
✓ DIFFERENTIAL approach (a.k.a. incremental analysis): Only the differences or changes in costs and
revenues are considered.
 TYPES of COSTS COMMONLY ASSOCIATED WITH DECISION MAKING
RELEVANT COSTS Future costs that are different among alternatives.
DIFFERENTIAL COSTS Increases or decreases in total costs resulting from choosing one option over another.
AVOIDABLE COSTS Costs that will be saved or will not be incurred if a certain decision is made.
OPPORTUNITY COSTS Benefit foregone or highest income sacrificed when an option is chosen over another.
OUT-OF-POCKET COSTS Costs required for immediate or near future cash outlays based on a particular decision.
SUNK COSTS Historical or past costs that cannot be avoided regardless of what decision is made.
NOTE: Differential (incremental) costs, avoidable costs, opportunity costs and out-of-pocket costs are
usually considered relevant in decision making while sunk and unavoidable costs are considered irrelevant.
 TYPES of SHORT-TERM NON-ROUTINE DECISIONS
NATURE of ALTERNATIVES DESCRIPTION DECISION-MAKING GUIDELINES
1. MAKE or BUY Should a product or material be internally Choose the option that has the lower cost. In
a product or material manufactured (‘insource’) or bought from most cases, fixed costs are irrelevant. Consider
(Outsourcing Decision) outside supplier (‘outsource’)? if there is any opportunity cost.
2. ACCEPT or REJECT Should a special order that requires a price Accept the order if the additional revenue
a special order lower than the regular selling price be exceeds additional cost. In most cases, fixed
accepted or rejected? costs are irrelevant.
3. CONTINUE or Should a business segment (e.g., product line, Continue if avoidable revenue is greater than its
SHUTDOWN division, department or branch) be continued avoidable costs. Any allocated fixed cost to the
a business segment (‘keep’) or discontinued (‘drop’)? segment is usually considered irrelevant.
4. SELL or PROCESS Should a product, after undergoing the joint Process further if additional revenue from
FURTHER process, be sold at the split-off point or be processing further is greater than further
a product processed further beyond the split-off point? processing costs. Joint costs are considered
sunk costs and irrelevant.
5. SCRAP or REWORK Shall be a substandard or obsolete product Rework if additional revenue after rework is
a product be sold as scrap (‘junk’) or be reworked higher than rework costs. The original cost or
(‘modify’)? carrying value is considered irrelevant.
6. BEST PRODUCT Which product(s) should be given priority in Identify and measure constraint(s). Allocate
COMBINATION production, given limited resources and/or limited resources to products from highest to
(Optimal Use of Scarcity) market limitations? lowest CM per unit of limited resources.
7. CHANGE IN PROFIT Should any of the profit factors such as Change the profit factor if it will cause an
FACTORS selling price, unit sales, variable cost, fixed improvement on the company’s over-all profit
(CVP Analysis in MS-44C) cost and sales mix be manipulated to increase position.
profit?
 OTHER TERMINOLOGIES ASSOCIATED WITH SHORT-TERM NON-ROUTINE DECISIONS
SHUTDOWN COSTS* Costs that will remain to be incurred even if a segment is discontinued. [Irrelevant]
JOINT COSTS** Costs incurred in processing joint products until the split-off point. [Irrelevant]
SPLIT-OFF POINT** The production stage where joint products are split into separate and distinct products.
FURTHER PROCESSING COSTS** Costs incurred in processing separate products beyond the split-off point. [Relevant]
BOTTLENECK RESOURCES*** Any particular operation where the capacity is less than the demand placed upon it.
* connected with No. 3 above ** connected with No. 4 above *** connected with No. 6 above
LINEAR PROGRAMMING (LP) is a quantitative technique used to achieve the best outcome (maximum profit or
lowest cost) in a mathematical model whose requirements are represented by linear relationships.
 LP usually starts by identifying decision variables. Most LP problems are characterized by an objective function
that is to be maximized or minimized subject to multiple constraints.
➢ OBJECTIVE FUNCTION – an equation that deals with maximizing revenue/profit or minimizing costs.
Example: Maximize Z = 5 A + 10 B
➢ CONSTRAINT FUNCTIONS – inequality relationships representing resource limitation and consumption.
Example: 2 A + 4 B  100
NOTE: The non-negativity constraint of the identified decision variables is often assumed even if it is not
specified in linear programming problems (e.g., A, B  0).
 LP models are useful in resource allocation problems with multiple constraints (as opposed to relevant costing
which can typically handle one constraint only). In LP, limited resources are often allocated based on the optimal
product mix that aims to achieve the maximum possible profit.

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY

RELEVANT COSTING with LINEAR PROGRAMMING MS-44E
EXERCISES: RELEVANT COSTING with LINEAR PROGRAMMING
1. TOTAL ANALYSIS vs. DIFFERENTIAL ANALYSIS
ESA Company currently sells 10,000 units of its lone product at a price of P 50 per unit. The product
costs at this level of activity are given below:
Variable Costs: Fixed Costs:
Direct materials P 12 Fixed Overhead P 70,000
Direct labor 8 Fixed Selling Expense 50,000
Variable Overhead 7
Variable Selling Expense 3
REQUIRED:
A) What is the present profit?
B) The company could increase its sales by 25% if it spends P 30,000 for advertisements. Determine
the effect on company profit using: 1) Total approach 2) Differential approach
2. MAKE or BUY (OUTSOURCING DECISION)
Ferrari must decide whether it must continue to produce an engine component or buy it from Sarao-
Philippines for P 25,000 each. The demand for the coming year is 20 units. The costs of producing a
single unit of the engine component are as follows:
Direct labor 6,000
Factory Overhead (80% fixed) 10,000
P 30,000
If Ferrari buys the components, the facility now used to make the components can be rented out to
another firm for P 100,000.
REQUIRED:
A) Should Ferrari make or buy the components?
B) How much is the maximum amount that Ferrari is willing to pay an outside supplier for the
engine component?
3. ACCEPT or REJECT (SPECIAL ORDER DECISION)
Panda Company produces and sells toy cars. Each toy car sells for P 50 and the company sells
approximately 500,000 toy cars each year. Unit cost data for 2022 are given below:
Fixed Variable Fixed Variable
Direct Material - P 15 Factory Overhead P8 P5
Direct Labor - 12 Distribution Costs 2 3
Panda has received an offer from a foreign customer to purchase 15,000 toy cars at P 40. If the offer is
accepted, the company has idle capacity to accommodate the order but the unit variable distribution costs
will increase by P 2 for insurance and import duties.
REQUIRED:
A) What is the relevant unit cost of the special order?
B) Should Panda accept or reject the special order?
4. SPECIAL ORDER PRICING

Bren Company sells “BJS” at a unit price of P 36,000, with the following unit production costs:
Direct labor 8,000
Variable overhead 6,000
Fixed overhead 4,000
A special order for 1,000 units was received from Ely, a well-known BJS distributor based in Makati.
Additional shipping costs for this sale are P 4,000 per unit.
REQUIRED:
What is the minimum selling price per unit for the special order if:
A) Bren is operating at FULL capacity?
B) Bren has EXCESS capacity?
5. CONTINUE or SHUTDOWN (SHUTTING DOWN OPERATIONS)
The combined income statement of Eloy Stores for Bohol and Cebu branches is given below:
Bohol Branch Cebu Branch Total
Sales P 1,200,000 P 800,000 P 2,000,000
Less: Variable expenses (840,000) (360,000) (1,200,000)
Contribution margin P 360,000 P 440,000 P 800,000
Less: Traceable fixed expenses (210,000) (180,000) (390,000)
Segment margin P 150,000 P 260,000 P 410,000
Less: Common fixed expenses (180,000) (120,000) (300,000)
Profit (loss) (P 30,000) P 140,000 P 110,000
If Bohol Branch were eliminated, then its traceable fixed expenses could be avoided. The total common
fixed expenses are merely allocated and would be unaffected.
A) What will be the new company profit (loss) if Bohol Branch is eliminated?
B) What will be the decrease in company profit if Bohol Branch is closed and 20% of its traceable fixed
expense would remain unchanged while Cebu’s sales would decrease by 20%?

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6. PRODUCT ELIMINATION POINT
Salvador Company expects that sales will drop below the current level of 5,000 units per month. An
income statement prepared for the monthly sales of 5,000 units show the following:
Sales (5,000 @ P 3) P 15,000
Less:
Variable costs (5,000 @ P 2) P 10,000
Fixed costs 5,000 15,000
Profit - Nil -
If plant operations are suspended, a shutdown cost (i.e., plant maintenance and taxes) of P 2,000 per
month will remain as incurred. Since there is no immediate possibility of profit under present
conditions, the problem of the company is just how to minimize the loss.
REQUIRED:
A) Determine the shutdown point in units.
B) Should the company continue or shut down operations if sales next month are expected to be:
1) 4,000 units? 2) 2,000 units? 3) 3,000 units?
7. SELL or PROCESS FURTHER

Sardoncillo Company produces products C, I and T for a joint cost of P 200,000. Each product may be
sold at its split-off point or processed further. Additional processing costs are entirely variable. Relevant
data are given below:
Product Sales Value at Split-Off Additional Processing Costs Final Sales Value
C P 100,000 P 80,000 P 250,000
I 200,000 40,000 200,000
T 50,000 . 60,000 . 100,000 .
P 350,000 P 180,000 P 550,000
REQUIRED:
A) Which product(s) should the company sell at split-off point?
B) If the company can only sell all the products at split-off point or process all the products further
beyond the split-off point, then which option is recommended?
8. SCRAP or REWORK
Argao Company has 5,000 obsolete truck parts that are carried in inventory at a cost of P 50,000. The
company is faced with a decision whether to scrap the parts or modify them:
➢ If the parts were junked, the company would realize only 10% of its cost.
➢ Should the company modify the parts, it will spend P 10,000 for materials, P 2,000 for direct labor,
and overhead equal to 40% of prime costs. The new parts will sell for P 25,000 in the market.
REQUIRED:
Should Argao Company modify or scrap the parts?
9. BEST PRODUCT COMBINATION

DMD Company produces products A, B and C. One machine is used to produce the products. The sales
demands, contribution margins and time on the machine (in hours) are as follows:
Market Limit Unit Contribution Margin Hours on Machine

A 100 units P 20 10 per unit
B 80 units P 18 5 per unit
C 150 units P 25 10 per unit
There are 2,400 hours available on the machine during the week. Total fixed cost is P 3,000.
REQUIRED:
A) What is the best product combination that maximizes the weekly contribution?
a. 90 units of A; 0 unit of B; 150 units of C
b. 50 units of A; 80 units of B; 150 units of C
c. 100 units of A; 80 units of B; 100 units of C
d. 100 units of A; 80 units of B; 150 units of C
B) How much is the profit associated with the best product combination?
10. LINEAR PROGRAMMING

A&S Company has an available 120 grams of Material 1 and 80 meters of Material 2 to produce its products
A and B:
Product A Product B
Unit Contribution Margin P3 P4
Required Materials:
Material 1 2 grams 5 grams
Material 2 4 meters 2 meters
REQUIRED:
A) Objective function - involving maximization of the company’s contribution margin.
B) Non-negativity constraint function
C) Constraint function for Material 1
D) Constraint function for Material 2
E) Optimal product mix

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WRAP-UP EXERCISES
1. Identify the best description for relevant costs in decision-making process.
a. Past costs that are expected to be different under each alternative
b. Past costs that are expected to be the same under each alternative
c. Future costs that are expected to be different under each alternative
d. Future costs that are expected to be the same under each alternative
2. A cost incurred in the past and hence irrelevant for current decision making is a:
a. Sunk cost c. Direct cost
b. Fixed cost d. Discretionary cost
3. Which of the following costs is generally considered irrelevant in decision-making process?
a. Direct labor c. Fixed factory overhead
b. Direct materials d. Variable factory overhead
4. Which of the following cost classification schemes is most relevant to decision making?
a. Fixed vs. variable c. Joint vs. common
b. Direct vs. common d. Avoidable vs. unavoidable
5. The salary that you would otherwise earn by working rather than attending the CPA review is a good
example of a (an):
a. Sunk cost c. Opportunity cost
b. Joint cost d. Unavoidable cost
6. An opportunity cost is usually:
a. Relevant and part of traditional accounting records
b. Relevant, but not part of traditional accounting records
c. Irrelevant, but part of traditional accounting records
d. Irrelevant and not part of traditional accounting records
7. In a make-or-buy decision
a. Only variable costs are relevant
b. Only conversion costs are relevant
c. Fixed costs that can be avoided in the future are relevant
d. Fixed costs that will continue regardless of the decision are relevant
8. In a make-or-buy decision, the cost to buy is compared with the
a. Total cost to make c. Variable manufacturing costs
b. Relevant cost to make d. Variable selling & administrative expenses
9. What is the opportunity cost of making a component part in a factory given that there is no alternative
use of the capacity?
a. Zero c. Variable costs of the component
b. Fixed costs of the component d. Total manufacturing costs of the component
10. In an accept-or-reject decision, which cost is usually considered to be irrelevant?
a. Fixed cost of the product c. Direct fixed costs associated with the order
b. Variable cost of the product d. Opportunity costs of the temporary idle capacity
11. If there is an excess capacity, then the minimum acceptable price for a special order must cover
a. Usual fixed manufacturing costs
b. Variable and usual fixed manufacturing costs
c. Variable and incremental fixed costs associated with the special order
d. Variable manufacturing costs plus contribution margin foregone on lost regular units.
12. If a company is operating at maximum or full capacity, the minimum special-order price must cover
a. Variable costs associated with the special order
b. Variable and incremental fixed costs associated with the special order
c. Variable and fixed manufacturing costs associated with the special order
d. Variable costs and incremental fixed costs associated with the special order plus
contribution margin foregone on regular units not produced.
13. If the margin lost by dropping a product line is higher than avoidable fixed costs, then the product line
a. Operates at a loss c. Shall be continued
b. Shall be shutdown d. Has no impact on company profit
14. Assuming there is a material amount of shutdown costs, then the shutdown point must be
a. Nil or zero c. Above its break-even point
b. Below its break-even point d. Equal to its break-even point
15. Which is usually considered irrelevant in ‘sell or process further’ decision making?
a. Joint costs c. Sales value at the split-off point
b. Further processing costs d. Sales value after further processing
16. A company that has a limited number of labor hours and abundant machine hours should produce first
the product that has the highest
a. Demand in units c. Contribution margin per labor hour
b. Contribution margin per unit d. Contribution margin per machine hour
17. In linear programming, the expression “Maximize Z = 50 X + 100 Y” is most likely a (an)
a. Objective function c. Cost function
b. Constraint function d. Restriction function
18. The term ‘constraints’ in a linear programming model generally refers to:
a. Committed costs c. Scarce resources
b. Inefficiencies d. Decision variables

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1. In the development of the accounting data for decision-making purposes, a relevant cost is defined as:
B a. Changes in variable cost under each alternative course of action.
b. Future costs which will differ under each alternative course of action.
c. Historical costs which are the best available basis for estimating future costs.
d. Standard costs which are developed by time-and-motion-study techniques because of their
relevance to managerial control.
2. In a decision analysis situation, which one of the following costs is generally NOT relevant to the decision?
D a. Incremental cost c. Avoidable cost
b. Differential cost d. Historical cost
3. The relevance of a particular cost to a decision is determined by the
C a. Size of the cost c. Potential effects on the decision
b. Risk level of the decision d. Accuracy and verifiability of the cost
4. The kind of cost that can be ignored in short-term decision making is a(n):
C a. Differential cost c. Sunk cost
b. Incremental cost d. Relevant cost
5. In determining whether to manufacture a part or buy it from an outside vendor, a cost that is irrelevant to the short-run
decision is
D a. Prime costs
b. Variable overhead
c. Fixed overhead that will be avoided if the part is bought from an outside vendor
d. Fixed overhead that will continue even if the part is bought from an outside vendor
6. In a make-or-buy decision, the relevant costs include variable manufacturing costs as well as
C a. Factory management costs c. Avoidable fixed costs
b. General office costs d. Depreciation costs
7. Turkey Technology manufactures a particular computer component. Currently, the costs per unit are as follows:
Direct materials, P 50; direct labor, P 500; variable overhead, P 250; fixed overhead, P 400.
Pakistan Inc. has obtained Turkey with an offer to sell 10,000 units of the component for P 1,100 per unit. If Turkey
accepts the proposal, P 2,500,000 of the fixed overhead will be eliminated. Should Turkey make or buy the component?
D a. Make due to savings of P 3,000,000 c. Buy due to savings of P 1,000,000
b. Buy due to savings of P 2,500,000 d. Make due to savings of P 500,000
8. Saudi, Inc. is operating at 70% capacity and considers making Part A5 now being purchased from outside suppliers for
P 110 each, which is projected to increase in the near future. Saudi has the equipment and labor force required to
manufacture Part A5. The design engineer estimates that each part requires P 40 of direct materials and P 30 of direct
labor. The plant overhead is 200% of direct labor peso cost, and 40% of the overhead is fixed cost. A decision to
manufacture Part A5 will result in a gain or (loss) for each component of:
D a. P 26 c. (P 20)
b. P 16 d. P 4
9. The Blade Division of Baghdad Corporation produces hardened steel blades. One-third of the Blade Division’s output is
sold to the Lawn Products Division of Baghdad; the remainder is sold to outside customers. The Blade Division’s
estimated sales and cost data for the fiscal year are as follows:
Lawn Products Outsiders
Sales P 15,000 P 40,000
Variable costs (10,000) (20,000)
Fixed costs (3,000) (6,000)
Profit P2,000 P 14,000
Unit sales 10,000 units 20,000 units
The Lawn Products Division has an opportunity to purchase 10,000 identical quality blades from an outside supplier at a
cost of P 1.25 per unit. Assume that the Blade Division cannot sell any additional products to outside customers. Should
Baghdad allow its Lawn Products Division to purchase the blades from the outside supplier?
D a. Yes, because buying the blades would save Baghdad Company P 500
b. No, because making the blades would save Baghdad Company P 1,500
c. Yes, because buying the blades would save Baghdad Company P 2,500
d. No, because making the blades would save Baghdad Company P 2,500
10. Cairo Manufacturing uses 10 units of Part Number KJ45 each month in the production of radar equipment. The unit cost
to manufacture one unit of KJ45 is presented below.
Materials handling (20% of direct material cost) 200
Direct labor 8,000
Manufacturing overhead (150% of direct labor) 12,000
Materials handling represents the direct variable costs of the Receiving Department that are applied to direct materials
and purchased components on their cost. This is a separate charge in addition to manufacturing overhead. Cairo’s
annual manufacturing overhead budget is one-third variable and two-thirds fixed. Egypt Suppliers, one of Cairo’s
reliable vendors, has offered to supply Part KJ45 at a unit price of P 15,000. If Cairo purchases the KJ45 units from
Scott, the capacity Cairo used to manufacture these parts would be idle. Should Cairo decide to purchase the parts
from Egypt, the unit cost of KJ45 would:
A a. Increase by P 4,800 c. Decrease by P 3,200
b. Decrease by P 6,200 d. Increase by P 1,800
NOTE: The relevant cost to buy must include 20% handling cost. (P 15,000 + P 3,000)

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11. Yemen Company manufactures 20,000 units of a certain component per year. This component is used in the production
of a main product. The following are the costs to make the component per unit:
Direct materials P 11
Direct labor 14
Variable overhead 8
Fixed overhead 9
If Yemen buys the component from outside supplier the company can rent out the released facilities for P 20,000 a year.
The cost of the component per unit as quoted by the supplier is P 36. 60% of the fixed overhead applied in the
manufacture of the component will continue regardless of what decision is made. For all purchases made by the
company, freight and handling costs are applied at 1% of the purchase price. The direct materials cost is exclusive of
the freight and handling cost.
What is the economic advantage or disadvantage of buying the component? (NOTE: the relevant cost to buy both DM
and component must include 1% handling cost based on the purchase price)
B a. P 24,800 advantage c. P 27,000 disadvantage
b. P 27,000 advantage d. P 63,000 advantage
12. Iran Company needs 20,000 of a certain part to use in its production cycle. The following information is available:
Cost to Iran to make the part:
Direct materials P4
Direct labor 16
Variable overhead 18
Fixed overhead applied 10
P 48
Cost to buy the part from the Syria Company P 36
If Iran buys the part from Syria Co., Iran could not use the released facilities in another manufacturing activity. 60% of
the fixed overhead applied will continue regardless of what decision is made. In deciding whether to make or buy the
part, what are the total relevant costs to make the part?
D a. P 560,000 c. P 720,000
b. P 640,000 d. P 840,000
13. Accepting a special order will improve overall net operating income so long as revenue from the order exceeds
D a. The contribution margin on the order c. The variable costs associated with the order
b. The sunk costs associated with the order d. The incremental costs associated with the order
14. In considering a special-order situation that will enable a company to make use of its idle capacity, which of the following
costs would be irrelevant?
B a. Materials c. Direct labor
b. Depreciation d. Variable overhead
15. Given the following target selling price for a unit of product:
Direct labor 7
Overhead (20% variable) 15*
Cost of manufacture 40
Desired markup – 30% 12
Regular selling price P 52
* based on 25,000 units produced each year
A customer has offered to purchase 5,000 units at a special price of P 38 per unit. The company is selling only 20,000
units per year so it has idle capacity. Variable selling costs associated with the special order would be P 2 per unit. If
the special order is accepted, what will be the effect on the company’s overall net income?
A a. Increase by P 40,000 c. Increase by P 50,000
b. Decrease by P 10,000 d. Decrease by P 70,000
16. Iraq, Inc. sells a product for P 30. Variable cost is P 16. Iraq could accept a special order for 1,000 units at P 23. If
Iraq accepted the order, how many units could it lose at the regular price before the decision became unwise?
B a. 1,000 c. 200
b. 500 d. 0
Solution: (30 – 16) X = (23 – 16) 1,000 CM foregone on regular sales = CM earned on special order
17. Abu Company sells Product B at a selling price of P 21 per unit. Abu’s cost per unit based on the full capacity of 200,000
units is as follows:
Direct labor 5.00
Overhead (2/3 fixed) 6.00
P 15.00
A special order offering to buy 20,000 units was received from a foreign distributor. The only selling cost that would be
incurred for this order would be P 3 per unit for shipping. Abu has sufficient existing capacity to manufacture the
additional units. In negotiating the price for the special order, Abu should consider that the minimum selling price per
unit should be:
A a. P 14 c. P 16
b. P 15 d. P 18
18. Delhi Co. operates at full capacity. The minimum selling price to be set for a special order must cover
C a. Fixed cost
b. Variable cost
c. Variable cost plus foregone contribution margin on lost regular sales
d. Fixed cost plus foregone contribution margin on lost regular sales

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19. Mumbai Co. is a manufacturer of industrial components. One of their products used as a subcomponent in manufacturing
is KB-96. This product has the following financial structure per unit:
Selling price P 150
Direct labor 15
Variable manufacturing overhead 12
Fixed manufacturing overhead 30
Shipping and handling 3
Fixed selling and administrative 10
Total costs P 90
Mumbai has received a special, one-time, order for 1,000 KB-96 parts. Assume that Mumbai is operating at full capacity
and that the contribution margin of the output that would be displaced by the special order is P 10,000. The minimum
price that is acceptable, using the original data, for this one-time special order is in excess of
A a. P 60 c. P 87
b. P 70 d. P 100
20. Dhabi Company’s regular selling price for its product is P 10 per unit. Variable costs are P 6 per unit. Fixed costs total
P 1 per unit based on 100,000 units and remain constant within the relevant range of 50,000 units to a total capacity of
200,000 units. After sales of 80,000 units were projected for 2021, a special order was received for an additional 10,000
units. To increase its operating income by a total of P 10,000, what price per unit should Dhabi charge for this special
order?
A a. P 7.00 c. P 10.00
b. P 8.00 d. P 11.00
21. In deciding whether or not to eliminate a branch or division, which of the following is considered relevant?
C a. All variable costs of the branch c. All direct costs of the branch
b. All fixed costs of the branch d. All indirect costs of the branch
22. Lebanon plans to discontinue a division with a P 20,000 contribution margin. Overhead allocated to the division is
P50,000, of which P 5,000 cannot be eliminated. What is the effect on Lebanon’s pretax income by this plan?
C a. P 5,000 decrease c. P 25,000 increase
b. P 20,000 decrease d. P 30,000 increase
23. Baghdad Company produces and sells 8,000 units of Product X each year. Each unit of Product X sells for P 10 and has
a contribution margin of P 6. It is estimated that if Product X is discontinued, P 50,000 of the P 60,000 in fixed costs
charged to Product X could be eliminated. These data indicate that if Product X is discontinued, overall company
operating income should
A a. Increase by P 2,000 per year c. Increase by P 38,000 per year
b. Decrease by P 2,000 per year d. Decrease by P 38,000 per year
24. Arab manages 5 upscale townhouses in Damascus. Shown below are the summary income statements for each unit :
ONE TWO THREE FOUR FIVE
Rent Income P 10,000 P 12,100 P 23,470 P 18,780 P 10,650
Expenses 8,000 13,000 26,000 24,000 13,000
Profit P 2,000 (P 900) (P 2,530) (P 5,220) (P 2,350)
Included in the expenses is P 12,000 of corporate overhead allocated to the townhouses based on rental income. The
townhouse unit(s) that the company should consider selling is (are):
C a. Two, Three, Four and Five c. Four and Five
b. Three, Four and Five d. Four
25. In analyzing whether to build another regional service office, the salary of the Chief Executive Officer (CEO) at the
corporate headquarters is:
D a. Relevant because salaries are always relevant
b. Irrelevant since another imputed cost for the same will be considered
c. Relevant because this will probably change if the regional service office is built
d. Irrelevant because it is a future cost that will not differ between the alternatives under consideration
26. The Uganda Company has two divisions – East and West. The divisions have the following revenues and expenses:
East West
Sales P 720,000 P 350,000
Variable costs 370,000 240,000
Traceable fixed costs 130,000 80,000
Allocated common corporate costs 120,000 50,000
Operating income (loss) P 100,000 (P 20,000)
The management at Uganda is pondering the elimination of the West division since it has shown an operating loss for
the past several years. If the West division were eliminated, its traceable fixed costs could be avoided. The total common
corporate costs would be unaffected by this decision. Given these data, the elimination of the West Division would
result in an overall company operating income of:
D a. P 120,000 c. P 80,000
b. P 100,000 d. P 50,000
27. The income statement of product Pabigat, one of the products being sold by Palugi Company is reproduced below:
Sales P 80,000
Costs and expenses 92,000
Net loss (P 12,000)
P 37,600 of the costs and expenses above are fixed, of which P 21,600 is unavoidable regardless of whether the product
will be dropped or not. What is the product elimination (shutdown) point?
B a. P 16,000 c. P 54,400
b. P 50,000 d. P 70,400

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28. Temple Corporation contemplates the temporary shutdown of its plant facilities in a provincial area which are
economically depressed due to natural disasters. Below are certain manufacturing and selling expenses:
1) Depreciation 5) Sales commissions
2) Property tax 6) Security of premises
3) Interest expense 7) Delivery expenses
4) Insurance of facilities
Which of the above expenses will be considered in the computation of shutdown costs?
B a. All expenses in the list c. Items 1, 2 and 3 only
b. All except items 5 & 7 d. All except item 5
29. The indifference point is the level of volume at which a company
A a. Earns the same profit under different operating schemes.
b. Earns no profit
c. Earns its target profit
d. Any of the above
30. Bible Production, Inc. owns and operates a chain of movie theaters. The theaters in the chain vary from low volume,
small town to high volume, big city/downtown theaters. Management is considering installing machines that will make
popcorn on the premises. This proposed feature would be properly advertised and is intended to increase patronage at
the company’s theaters. These machines are available in two different sizes with the following details:
Economy poppers Regular poppers
Annual capacity 50,000 boxes 120,000 boxes
Costs:
Annual machine rental P 80,000 P 110,000
Popcorn cost per box 1.30 1.30
Cost of each box 0.80 0.80
Other variable costs per box 2.20 1.40
What level of output at which the Economy and Regular Poppers would earn the same profit (loss)?
C a. 50,000 boxes c. 37,500 boxes
b. 65,000 boxes d. 40,000 boxes
31. Desert Company produces three products from a joint process costing P 100,000. The following information is available:
Units Sales Price (Split-Off) Cost to Process Further Sales Price (After Further)
A 10,000 P 35 P 60,000 P 40
B 20,000 P 40 20,000 P 45
C 30,000 P 20 90,000 P 25
Which products should be processed further?
C a. A only c. B and C
b. A and B d. A, B and C
32. Aladdin Company has 100 units of obsolete part. The variable cost to produce them was P 40 per unit. They could now
be sold for P 30 each and it would cost P 60 to make them now. The parts can be reworked for P 80 each and sold for
P 170. What is the monetary advantage of reworking the parts over the next-best action?
C a. P 3,000 c. P 6,000
b. P 5,000 d. P 10,000
33. Middle East Corporation has 1,000 obsolete lanterns that are carried in inventory at a manufacturing cost of P 20,000.
If the lanterns are reworked for P 5,000, they could be sold for P 9,000. If the lanterns are scrapped, they could be sold
for P 1,000. What alternative is more desirable and what are the total relevant costs of the alternative?
A a. Rework, P 5,000 c. Scrap, P 20,000
b. Rework, P 25,000 d. Neither, both options result to losses
34. When a multiproduct plant operates at full capacity, quite often decisions must be made as to which products to
emphasize. These decisions are frequently made with a short-run focus. In making such decisions, managers should
select products with the
D a. Highest sales price per unit
b. Highest sales volume potential
c. Highest individual unit contribution margin
d. Highest contribution margin per unit of the constraining resource
35. Somalia Company produces three products, with costs and selling prices as shown below:
A . B . C .
Selling price per unit P 30 100% P 20 100% P 15 100%
Variable costs per unit 18 60% 15 75% 6 40%
Contribution margin per unit P 12 40% P5 25% 9 60%
A particular machine is a bottleneck. On that machine, 3 machine hours are required to produce each unit of Product A,
1 hour is required to produce each unit of Product B, and 2 hours are required to produce each unit of Product C. In
which order should it produce its products?
C a. C, A, B c. B, C, A
b. A, C, B d. The order of production doesn’t matter
36. Food Co. has a limited number of machine hours that it can use for manufacturing two products, X and Y. Each product
has a selling price of P 160 per unit but product X has 40% contribution margin and product Y has 70% contribution
margin. One unit of Y takes twice as many machine hours to make as a unit of X. Assuming unlimited demand, which
product(s) should the limited machine hours be used for?
A a. X c. Either X and Y
b. Both X and Y d. Y

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37. Data regarding four different products manufactured by an organization are presented below. Direct material and direct
labor are readily available from the respective resource markets. However, the manufacturer is limited to a maximum
of 3,000 machine hours per month:
Product A Product B Product C Product D
Selling price per unit P 15 P 18 P 20 P 25
Variable cost per unit P7 P 11 P 10 P 16
Units produced per machine hour 3 4 2 3
What is the product that is the most profitable for the manufacturer in this situation?
B a. Product A c. Product C
b. Product B d. Product D
38. Sudan Company has three products: A, B and C. Three machines are used to produce the products. The contribution
margins, sales demands, and time on each machine (in minutes) are as follows:
Demand CM Time on Machine 1 Time on Machine 2 Time on Machine 3
A 100 P 30 10 mins 15 mins 12 mins
B 80 P 20 10 mins 5 mins 8 mins
C 60 P 30 5 mins 10 mins 5 mins
Assuming that there are 2,400 minutes available in each machine, which machine is the bottleneck (see page 1 for
definition of “Bottleneck Operations”)?
B a. Machine 1 c. Machine 3
b. Machine 2 d. No bottleneck operation
39. Assuming the same data in No. 38, how many units of A, B and C should be produced during the week?
B a. 93 of A, 60 of B, and 90 of C c. 60 of A, 60 of B, and 90 of C
b. 93 of A, 80 of B, and 60 of C d. 90 of A, 60 of B, and 90 of C
Guava Co. uses the following model to determine its product mix for metal (M) and scrap metal (S):
Max Z = P 30 M + P 70 S If: 3M + 2S  15, 2M + 4S  18, M & S are non-negative values
40. What are the two inequality functions?
D a. Contributions c. Conditions
b. Shadow prices d. Constraints
41. The point at which M = 2 and S = 3 would
C a. Minimize cost c. Be a feasible point
b. Lie in a corner d. Be an infeasible point
Strawberry Company manufactures two models, small and large. Each model is processed as follows:
Machining Polishing
Small model (X) 2 hours 1 hour
Large model (Y) 4 hours 3 hours
The available weekly hours to process the two models: 100 hours in the Machining Department and 90 hours in the
Polishing Department. The contribution margins are P 5 for small model (X) and P 7 for large model (Y).
42. How would the objective function be expressed?
A a. 5 X + 7 Y c. 5 X (3) + 7 Y (7)  190
b. 5 X + 7 Y  190 d. 12 X + 10 Y
43. How would the restriction (constraint) for the Machining Department be expressed?
C a. 2 X + 4 Y c. 2 X + 4 Y  100
b. 2 (5 X) + 4 (7 Y)  100 d. 5 X + 7 Y  100
44. Durian Manufacturing produces two products, X and Y. Product X requires six hours of time on machine 1 and twelve
hours of time on machine 2. Product Y requires 4 hours on machine 1 and no time on machine 2. Both machines are
available for 24 hours. Assuming that the objective function of the total contribution margin is 2X + 1Y, what product
mix will produce the maximum profit?
C a. 0 unit of X, 6 units of Y c. 2 units of X, 3 units of Y
b. 1 unit of X, 4 units of Y d. 4 units of X, 0 unit of Y
45. Lemon Company makes products X and Y, with the following production constraints representing two machines:
Machine 1: 2X + 3Y  18 Machine 2: 2X + Y  10.
If the profit equation is Z = 4 X + 2Y, then what is the maximum possible profit?
B a. P 18 c. P 21
b. P 20 d. P 24
46. A relevant cost is a cost that is
D a. Optimal c. Important
b. Effective d. Pertinent to a decision
47. If a cost has no influence on a decision, it
B a. Is a sunk cost c. Cannot be a future cost
b. Is not a relevant cost d. Is merely a differential cost
48. Which type of cost is a vital part of decision-making process, but omitted from conventional accounting records?
C a. Sunk costs c. Opportunity costs
b. Direct costs d. Out-of-pocket costs
49. Allocated costs are generally
D a. Separable c. Variable
b. Immaterial d. Common
50. The role of sunk costs in decision-making can be summed up in which of the following sayings?
B a. No pain, no gain c. A penny saved is a penny earned
b. Bygones are bygones d. The love of money is the root of all evil

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CPA Review Batch 43  May 2022 CPA Licensure Examination  Weeks 6 - 7
MAS-07: STANDARD COSTING WITH GP VARIANCE ANALYSIS

STANDARDS
 Standard costs are predetermined or targeted costs set by management for various purposes like product
costing, pricing, budgeting, cost control, motivation, and performance measurement.
 Standards are similar to budgeted amounts stated on a per unit basis, but standards differ from budgets in
that they actually appear in general ledger accounts, while budgeted amounts do not.
 Because of the impact of the fixed costs in most businesses, a standard costing system is usually not effective
unless the company uses a flexible budgeting system.
 Standards are developed for each factor of production (materials, labor and overhead) based on accounting,
engineering or statistical quality control studies and usually fit into one of the two (2) broad categories:
(1) IDEAL/THEORETICAL Standards – presume perfect efficiency and 100% capacity and hence not useful for
control purposes as they are not practically attainable.
(2) CURRENTLY ATTAINABLE/PRACTICAL Standards – based on higher-than-average levels of efficiency, but
are clearly achievable and hence typically used for employee motivation, product costing and budgeting.
 Standards based on historical information are not used as this practice may perpetuate past inefficiencies.
 Standards may be used by service and nonprofit organizations as well as manufacturing organizations.
 Standards can be used in both process costing and job-order costing systems.
 In manufacturing companies, standards are broadly classified into two (2) categories:
(1) QUANTITY Standard – usually indicates the quantity of raw materials or labor time required to produce
a unit of product. This is normally expressed per unit of output (e.g., 3 pieces per unit).
(2) COST Standard – usually indicates what the peso amount of the quantity standard should be. This is
normally expressed per unit of input (e.g., P 5.00 per piece).
STANDARD COST VARIANCE
 Standard costs are systematically pre-determined costs established by management to be used as a basis
for comparison with actual cost.
 Variance analysis explains the difference between standard costs and actual costs.
AC < SC: Favorable (credit balance)
VARIANCE = Actual Costs (AC) – Standard Costs (SC)
AC > SC: Unfavorable (debit balance)
 When standard costs are used for inventory valuation, variances are:
➢ If immaterial/insignificant: written-off to cost of goods sold
➢ If material/significant: allocated to ending work-in-process, finished goods, and cost of goods sold
 Under management by exception, managers focus attention on results that materially deviate from
expectations. Results that are close to expectations (e.g., immaterial variances) do not require investigation.
 Standard costing procedures: (1) establish standards, (2) measure actual performance, (3) compare
standards with actual performance, (4) take corrective actions, if needed (5) revise standards, if needed.
VARIANCE ANALYSIS: MATERIAL and LABOR COSTS
 DIRECT MATERIAL (DM) Variance = Actual Costs – Standard Costs = (AQ x AP) – (SQ x SP)
Materials Quantity Variance (MQV) = (AQ – SQ) SP
AQ – Actual Quantity
Materials Price Variance (MPV) = AQ (AP – SP)
AP – Actual Price
AQ x AP
Alternative MPV SQ – Standard Quantity
Solution  AQ x SP
SQ x SP MQV
DM Variance SP – Standard Price
 DIRECT LABOR (DL) Variance = Actual Costs – Standard Costs = (AH x AR) – (SH x SR)
Labor Efficiency Variance (LEV) = (AH – SH) SR
Labor Rate Variance (LRV) = AH (AR – SR) AH – Actual Hours
AR – Actual Rate
AH x AR
Alternative LRV SH – Standard Hours
Solution  AH x SR
SH x SR LEV
DL Variance SR – Standard Rate
 MATERIALS MIX and YIELD variances are normally calculated when production requires combining several
types of materials to produce a unit of product. In which case, over-all DM variance is analyzed as follows:
DIRECT MATERIAL (DM) Variance = Actual Costs – Standard Costs
TAQASP
Materials Price Variance (MPV) = AQ (AP – SP)
Total Actual Quantity at
Materials Mix Variance (MMV) = (AQ x SP) – TAQASP
Average Standard Price
Materials Yield Variance (MYV) = TAQASP – Standard Costs
 Mix and yield variances may also apply to direct labor, specifically in situations where various labor skills are
required to produce units of products.
 IMPORTANT NOTES on MATERIAL and LABOR VARIANCE ANALYSIS:
1. Materials PRICE variance (MPV) is also known as:
Materials spending variance, materials rate variance, materials money variance
2. Materials QUANTITY variance (MQV) is also known as:
Materials usage variance, materials efficiency variance
3. Materials usage variance is a quantity variance while materials price usage variance is a price variance.
4. Labor RATE variance (LRV) is also known as:
Labor price variance, labor spending variance, labor money variance
5. Labor EFFICIENCY variance (LEV) is also known as:
Labor hours variance, labor usage variance, labor quantity variance, labor time variance
6. Labor efficiency variance excludes idle time spent in the production. If any, idle time is separately
explained through the Idle Time Variance, which is regarded as unfavorable.
IDLE TIME variance = Idle Time x Standard Labor Rate

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Weeks 6-7: STANDARD COSTING with GP VARIANCE ANALYSIS
VARIANCE ANALYSIS: FACTORY OVERHEAD (FOH) COSTS

 1-way variance analysis:
FOH Variance = AFOH – SFOH AFOH: Actual FOH
SFOH: Standard FOH = SH x SR
Controllable variance = AFOH – BASH BASH: Budget Adjusted for Standard Hours
Volume variance = BASH – SFOH BASH = Budgeted FFOH + (SH x Variable FOH Rate)
FFOH: Fixed Factory Overhead
Spending variance = AFOH – BAAH BAAH: Budget Adjusted for Actual Hours
Efficiency variance = BAAH – BASH BAAH = Budgeted FFOH + (AH x Variable FOH Rate)
Volume variance = BASH – SFOH
Variable Spending variance = AFOH (V) – BAAH (V) AFOH (V): Actual Variable FOH
Fixed Spending variance = AFOH (F) – BAAH (F) AFOH (F): Actual Fixed FOH
Efficiency variance (variable) = BAAH – BASH BAAH (V): Actual Hours x Variable FOH Rate
Volume variance (fixed) = BASH – SFOH BAAH (F): Budgeted FFOH
 IMPORTANT NOTES on FACTORY OVERHEAD VARIANCE ANALYSIS

1. Standard Factory Overhead (SFOH) = Standard Hours (SH) x Standard FOH Rate (SR).
2. Under standard costing, SFOH is likewise referred to as the Applied Factory Overhead:
➢ AFOH > SFOH (applied FOH): FOH is under-applied, indicating an unfavorable variance
➢ SFOH (applied FOH) > AFOH: FOH is over-applied, indicating a favorable variance.
3. Budget Variance = Actual Cost – Budgeted Cost = Actual FOH (AFOH) – Budgeted FOH (BASH or BAAH)
➢ Under 2-way analysis where BASH is deducted from AFOH, budget variance = controllable variance
➢ Under 3-Way analysis where BAAH is deducted from AFOH, budget variance = spending variance
4. The term capacity variance is also used to mean the volume variance.
5. Volume variance is actually the fixed volume variance; there is no such thing as a variable volume or
variable capacity variance.
6. FOH Efficiency Variance is actually the Variable FOH Efficiency Variance. Other than ‘BAAH – BASH,’
variable overhead efficiency variance may also be computed based on:
Change in hours x variable FOH rate = (AH – SH) VR
7. FOH variances may classified into:
➢ Variable FOH Variances = Variable Spending Variance + (variable) Efficiency Variance
➢ Fixed FOH Variances = Fixed Spending Variance + (fixed) Volume Variance
8. Alternatively, another FOH variance analysis may include the following variances (NOTE: these variances
are not included in the CPA board exam syllabus for both subjects MAS and AFAR):
➢ IDLE capacity variance: BAAH – (AH x SR)
➢ TOTAL efficiency variance: ∆H x SR
➢ FIXED efficiency (effectiveness) variance: ΔH x FR (where: FR is the fixed FOH Rate)
9. The Manufacturing Efficiency Variance incorporates the effect of both FOH Efficiency Variance and Labor
Efficiency Variance. In some cases, the material quantity variance may also be included.
10. DM Variance + DL Variance + FOH Variance = Production or Manufacturing Cost Variance.
GROSS PROFIT VARIANCE ANALYSIS
Gross profit variance analysis is a useful tool in evaluating operational performance as gross profit must be
adequate enough to cover operating and other expenses and generate a desired amount of profit.
Sales = Unit Sales x Unit Selling Price
- Cost of Goods Sold = Unit Sales x Unit Cost
Gross Profit = Unit Sales x (Unit Selling Price – Unit Cost)
Gross Profit (GP) variance = GP (Actual/Current) – GP (Budget/Previous)
Favorable: If actual (current) GP is greater than budgeted (previous) GP.

Unfavorable: If actual (current) GP is less than budgeted (previous) GP.
Analysis:
PRICE Factor = Sales price variance = AQ x Δ SP = AQ (Actual SP – Budgeted SP)
COST Factor = Cost price variance = AQ x Δ CP = AQ (Actual CP – Budgeted CP)
VOLUME Factor = ΔQ x Budgeted Unit GP = (AQ – BQ) x Budgeted Unit GP
Sales volume variance = ΔQ x Budgeted SP
Cost volume variance = ΔQ x Budgeted CP
Alternative analysis:
Sales price variance = Actual Sales – AQ @ Budgeted SP
Sales variance Sales volume variance = AQ @ Budgeted SP – Budgeted Sales
Cost price variance = Actual CGS – AQ @ Budgeted CP
Cost variance Cost volume variance = AQ @ Budgeted CP – Budgeted CGS
Legend
AQ – Actual Quantity SP – Sales Price per unit CGS – Cost of Goods Sold
BQ – Budgeted Quantity CP – Cost Price per unit

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EXERCISES: STANDARD COSTING with GROSS PROFIT VARIANCE ANALYSIS

1. Materials and Labor Variance Analysis
Jollibee Company has established the standard for a single unit of its product, CLICK Camera Tripod:
Inputs Standards
Direct materials 3 metallic bars at P 5 per bar
Direct labor 2 labor hours at P 10 per hour
 At the start of the year, the budget includes a planned production of 100 units of tripod based on
normal capacity.
 At the end of the year, actual production was 120 units of tripod, which resulted to using 400 bars of
metal, purchased at a cost of P 6 per bar.
REQUIRED:
1. Based on the BUDGETED production of 100 units:
A) How many bars must the company plan to use? (Budgeted quantity)
B) How much materials cost is included in the budget? (Budgeted materials cost)
2. Determine the actual cost of materials used.
3. Based on the ACTUAL production of 120 units:
A) How many bars should have been used? (Standard quantity)
B) How much materials cost should have been incurred? (Standard materials cost)
C) How many labor hours should have been spent? (Standard hours)
D) How much labor cost should have been incurred? (Standard labor cost)
A) Materials budget variance
B) Materials standard cost variance
C) Materials quantity variance (MQV)
D) Materials price variance (MPV)
5. In the following year, Jollibee purchased 500 bars at a total cost of P 2,000 and 400 bars of these
were used; the standard quantity allowed for the actual production was 380 bars. Determine:
A) Total materials cost variance
B) Materials quantity variance
C) Materials price usage variance
D) Materials purchase price variance
E) If Jollibee has a favorable MPV and an unfavorable MQV, then this most likely results from
a. Machine efficiency problems
b. Product mix production changes
c. Purchase and use of lower-than-standard quality materials
d. Purchase and use of higher-than-standard quality materials
6. During the year, Jollibee paid a total payroll of P 2,200 to laborers, who rendered 200 labor hours
to produce the 120 units of Tripod. Determine the following:
A) Total labor cost variance
B) Labor efficiency variance (LEV)
C) Labor rate variance (LRV)
D) What is a possible reason Jollibee would experience an unfavorable LRV and favorable LEV?
a. Labor employed was heavily weighted towards higher-paid experienced workers
b. Workers assigned for the job were replaced by workers from other departments
c. Labor employed was heavily weighted towards low-paid unskilled workers
d. Defective materials extended the labor hours required to produce a single unit
2. Materials Price, Mix and Yield Variances

McDo produces the popular “3n1” face powder that has gone viral in various social media. McDo has in
its budget the following standards for one kilo of the “3n1” face powder:
Ingredients Standard Quantity
(Input) (Grams) Standard Unit Cost Standard Cost
Paminta 200 grams (20%) P 3.00 P 600
Gawgaw 700 grams (70%) P 4.00 P 2,800
Atsuete 100 grams (10%) P 5.00 P 500
TOTAL 1,000 grams (100%) P 3,900
McDo reported the following production and cost data for the January 2022 operations:
Ingredients Actual Quantity
(Input) (Grams) Actual Unit Price Actual Cost
Paminta 45,000 P 4.00 P 180,000
Gawgaw 125,000 P 3.00 P 375,000
Atsuete 30,000 P 6.00 P 180,000
TOTAL 200,000 P 735,000
McDo produced 190 kilos of “3n1” face powder in January 2022.
REQUIRED:
1. Total materials cost variance
2. Materials price variance
3. Material mix variance
4. Materials yield variance

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3. Factory Overhead Budget

Mang Inasal Company shows the following data regarding its factory overhead:
Flexible Budget Formula: FOH = 20,000 + 1 X where: X – number of labor hours
• Standard: 1 unit of product requires 4 labor hours
• Normal Capacity: 2,500 units
• Budgeted Hours: A) ________ hours
Fixed Overhead (FFOH) B) _______ Fixed Overhead Rate (FR) E) _____
Variable Overhead (VFOH) C) _______ Variable Overhead Rate (VR) F) _____
Total Budgeted Overhead D) _______ Standard Overhead Rate (SR) G) _____
REQUIRED:
1. Compute for the missing amounts.
2. What is the budgeted FOH if adjusted based on 7,500 actual hours (BAAH)?
3. What is the budgeted FOH if adjusted based on 8,000 standard hours (BASH)?
4. 2-way Factory Overhead Variance Analysis

The normal capacity of Chowking Company is 12,000 labor hours per month. At normal capacity, the
standard factory overhead rate is P 8 per labor hour based on P 72,000 of budgeted fixed cost per month
and a variable cost rate of P 2 per labor hour. During January, Chowking operated at 12,500 labor hours,
with actual factory overhead cost of P 75,000. The number of standard labor hours allowed for the
production actually attained is 10,000.
REQUIRED: 1. Overall FOH variance 2. FOH controllable variance 3. FOH volume variance
5. 2-way, 3-way and 4-way Factory Overhead Variance Analysis

BonChon Company provides the following production data:
Standard factory overhead cost per unit of product: 4 hours at P 3.00 per hour
A) Budgeted fixed factory overhead P 20,000
B) Normal capacity 2,500 units
C) Actual production 2,000 units
D) Actual hours 7,500 hours
E) Actual factory overhead incurred (60% fixed) P 25,000
1. Budgeted factory overhead 6. Volume variance
2. Standard factory overhead 7. Spending variance
3. Budgeted FOH based on actual hours 8. Efficiency variance
4. Budgeted FOH based on standard hours 9. Variable spending variance
5. Controllable variance 10. Fixed spending variance
6. Factory Overhead Variance Analysis - Budget, Variable & Fixed Variances

Assume the same data in item number 5:
One-way Two-way Three-way Four-way
AFOH: P 25,000 Con = S = S (V) =
SFOH: P 24,000 Vol = ________ E = S (F) =
FOH Var: P 1,000 U P 1,000 U Vol = _________ E (V) =
P 1,000 U Vol (F) = _________
P 1,000 U
ADDITIONAL REQUIREMENTS (continued from item number 5):
11. Budget (flexible) variance (2-way) 14. Fixed volume variance
12. Budget (flexible) variance (3-way) 15. Variable FOH variance
13. Variable controllable variance 16. Fixed FOH variance
7. Materials, Labor and Overhead Variances (Comprehensive Problem, Reconstruction)

 Standard variable costs per unit:
A) Materials: 4 pounds @ (1) ______ (2) ______
B) Direct Labor: (3) ______ hours @ P 12.00 P 6.00
C) Variable overhead: P 8 per direct labor hour (4) ______
 Production 8,000 units
 Materials purchases, 32,000 pounds P 62,000
 Materials used at standard prices, 31,200 pounds (5) ________
 Direct labor (actual): (6) _______ hours P 47,200
 Material purchase price variance P 2,000 adverse
 Material use variance (7) ________
 Direct labor rate variance P 2,000 favorable
 Direct labor efficiency variance (8) ________
 Variable overhead spending variance P 1,500 credit
 Variable overhead efficiency variance (9) ________
 Actual variable overhead cost (10) ________
REQUIRED:
Compute for the missing amounts (1) to (10).

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8. GP Variance Analysis with Complete Information

KFC Company prepared the following budgetary information for July 2022:
Sales (12,000 units) P 432,000
Cost of Goods Sold 288,000
Gross Profit P 144,000
In July, actual operations resulted in the production and sale of 13,000 units which were sold for a
selling price of P 34 per unit. The unit cost of goods sold increased by P 3.
REQUIRED:
1. Overall GP variance
2. Sales price variance
3. Sales volume variance
4. Cost price variance
5. Cost volume variance
9. GP Variance Analysis with Incomplete Information
Burger King Company has requested you to determine the cause of the difference between its 2021 and
2022 gross profit based on the following data:
2021 2022
Sales P 200,000 P 252,000
Cost of Goods Sold 120,000 180,000
Gross Profit P 80,000 P 72,000
No additional data was made available except that unit sales increased by 20% in 2022.
REQUIRED:
1. Overall GP variance
2. Price factor
3. Cost factor
4. Volume factor
10. Supplemental Lecture: Strategic Analysis to Operating Income (Oct/Dec 2021 CPALE)
Greenwich Company uses several pounds of materials to produce a single product. 2021 and 2022
operating incomes are shown as follows:
2021 2022
Revenues (2021: 1,000 units x P 26) P 26,000
(2022: 1,100 units x P 25) P 27,500
Expenses:
Materials (2021: 400 lbs. x P 10) 4,000
(2022: 420 lbs. x P 12.50) 5,250
Others (Conversion, Selling, Etc.) 15,000 15,000
Operating Income P 7,000 P 7,250
Aside from materials, other costs (conversion, selling, etc.) remain stable since adequate capacity exists
to support 2022 output and customers.
REQUIRED: Analyze the 2022 increase in operating income of P 250 based on the following:
1. GROWTH component
A) Revenue effect
B) Cost effect
2. PRICE-RECOVERY component
A) Revenue effect
B) Cost effect
3. PRODUCTIVITY component
4. Determine the net effect (change in operating income) due to:
A) Growth component
B) Price-Recovery component
C) Productivity component
2021 GROWTH PRICE-RECOVERY PRODUCTIVITY 2022

Amounts Component Component Component Amounts
Revenues P 26,000 P 27,500
Costs 19,000 20,250
Operating Income P 7,000 P 7,250

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WRAP-UP EXERCISES
1. Determine the FALSE statement about standard costing.
a. Standard costing is compatible with both job order costing and process costing.
b. Standard costs usually appear in the general ledger while budgeted costs do not.
c. A variance that has a debit balance generally indicates an unfavorable performance.
d. Unfavorable variances should be reviewed, but significant favorable variances need not be
reviewed.
2. When used for inventory valuation, standard cost variances with material amounts are closed to the
a. Cost of goods sold only
b. Cost of goods sold and finished goods inventory
c. Cost of goods sold, finished goods inventory and work in process
d. Cost of goods sold, finished goods inventory, work in process and direct materials
3. Which department is usually held responsible for an unfavorable materials price variance?
a. Production c. Engineering
b. Purchasing d. Materials handling
4. In standard costing, materials quantity variances are the responsibility of
a. Purchasing and sales c. Production and industrial engineering
b. Sales and industrial engineering d. Purchasing and industrial engineering
5. Which set of terms describes the same type of variance?
a. Price variance, rate variance, use variance
b. Price variance, rate variance, efficiency variance
c. Use variance, efficiency variance, quantity variance
d. Use variance, efficiency variance, spending variance
The standard for each finished unit of product allows for 3 pounds of plastic at P 0.72 per pound. During
December, 4,500 pounds of plastic were bought at P 0.75 per pound, and used 4,100 pounds in the
production of 1,300 finished units of product.
6. What is the materials quantity variance (MQV) for December?
a. P 144 favorable c. P 432 favorable
b. P 144 unfavorable d. P 432 unfavorable
7. What is the materials price variance (MPV) for December?
a. P 135 favorable c. P 123 favorable
b. P 135 unfavorable d. P 123 unfavorable
8. A debit balance in the labor efficiency variance indicates that
a. Standard hours exceed actual hours c. Actual hours exceed normal hours
b. Actual hours exceed standard hours d. Normal hours exceed actual hours
9. The direct labor costs for the month of January 2022 were as follows:
Actual direct labor hours 20,000
Standard direct labor hours 21,000
Direct labor rate variance, unfavorable P 3,000
Total payroll P 126,000
What was the direct labor efficiency variance?
a. P 6,000 favorable c. P 6,150 unfavorable
10. An unfavorable labor efficiency variance could be caused by a
a. Unfavorable materials usage variance
b. Unfavorable fixed overhead volume variance
c. Favorable variable overhead spending variance
d. Unfavorable variable overhead spending variance
11. Under the two-variance method for analyzing FOH, budget or controllable variance is computed by
subtracting from actual FOH costs incurred the
a. Budgeted FOH based on actual hours c. Budgeted FOH based on standard hours
b. Budgeted FOH based on normal hours d. Budgeted FOH based on budgeted hours
12. Which of the following is considered as a non-controllable FOH variance?
a. Variable spending variance c. Efficiency Variance
b. Fixed spending variance d. Volume Variance
13. The FOH variances were determined as follows:
Variable overhead spending variance P 3,500 F
Variable overhead efficiency variance P 4,000 U
Fixed overhead spending variance P 5,000 F
Fixed overhead volume variance P 6,500 U
What was overhead controllable variance?
a. P 500 U c. P 4,500 F
b. P 1,500 U d. P 5,500 U
14. Assuming the same data in item 13, what is the total overhead variance?
a. P 2,000 over-applied c. P 3,500 under-applied
b. P 2,000 under-applied d. Cannot be determined from given info
15. How do you call the sum of materials variance, labor variance, and overhead variance?
a. Mix variance c. Volume variance
b. Yield variance d. Production cost variance

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1. Which of the following is a purpose of standard costing?
B a. To replace budgets and budgeting
b. To simplify costing procedures and expedite cost reports
c. To eliminate under/over applied factory overhead at the end of period
d. To use them as a basis for product costing for external reporting purposes
2. A primary purpose of using a standard cost system is
B a. To minimize the cost per unit of production
b. To provide a distinct measure of cost control
c. To make things easier for managers in the production facility
d. To minimize recording of certain recurring business transactions
3. Standard costs are LEAST useful for
D a. Measuring production efficiency c. Estimating future costs
b. Simplifying costing procedures d. Determining minimum inventory levels
4. Which of the following is true concerning standard costs?
A a. If properly used, standards can help motivate employees.
b. Standard costs are difficult to use with a process-costing system.
c. Standard costs are estimates of costs attainable only under the most ideal conditions, but rarely
practicable.
d. Unfavorable variances, when material in amount, should be investigated, but favorable variances need
not be investigated.
5. A company using very tight standards in standard cost system should expect that
B a. No incentive bonus will be paid
b. Most variances will be unfavorable
c. Employees will be strongly motivated to attain the standards
d. Costs will be controlled better that if lower standards were used
6. The materials cost variance is composed of
B a. Quantity and efficiency variances c. Price and mix variances
b. Quantity and price variances d. Mix and yield variances
7. What is the variation in the use of materials at actual prices and use of materials at standard prices?
A a. Materials price variance c. Materials mix variance
b. Materials usage variance d. Materials yield variance
8. Lee Company installs solar panels on residential houses. The standard material cost for Type-C house is P 1,250 based
on 1,000 units at a cost of P 1.25 each. During April, Lee Company installed solar panels on 20 Type-C houses, using
22,000 units of materials at a cost of P 1.20 per unit, and a total cost of P 26,400. What is Lee Company’s materials
spending (price) variance?
B a. P 1,000 favorable c. P1,400 unfavorable
b. P 1,100 favorable d. P2,500 unfavorable
9. Information on Beatle Company’s direct materials cost is as follows:
Actual units of direct materials used 20,000
Actual direct materials costs 40,000
Standard price per unit of direct materials P 2.10
Direct material quantity variance, favorable P 3,000
What was Beatle’s materials price variance?
C a. P 1,000 favorable c. P 2,000 favorable
b. P 1,000 unfavorable d. P 2,000 unfavorable
10. Information on Termites Company’s direct-material costs is as follows:
Standard unit price P 3.60
Actual quantity purchased 1,600
Standard quantity allowed for actual production 1,450
Materials purchase price variance, favorable P 240
What was the actual purchase price per unit, rounded to the nearest centavo?
C a. P 3.06 c. P 3.45
b. P 3.11 d. P 3.75
11. If a company follows the practice of isolating variance at the earliest point in time, what would be the appropriate time
to isolate and recognize a direct material price variance?
B a. When material is issued to the requesting department or division
b. When material is purchased
c. When material is used in production
d. When purchase order is originated
12. A credit balance in the materials price variance indicates that
B a. Actual price exceeds standard price c. Actual quantity exceeds standard quantity
b. Standard price exceeds actual price d. Standard quantity exceeds actual quantity
13. Roach Company manufactures tables with glass tops. The standard material cost for the glass used per table is P7.80
based on six square-feet of vinyl at a cost of P 1.30 per square-foot. A production run of 1,000 tables in 2021 resulted
to usage of 6,400 square-feet of vinyl at a cost of P 1.20 per square-foot, a total of P 7,680. What was the materials
usage variance resulting from the above production run?
C a. P 120 favorable c. P 520 unfavorable
b. P 480 unfavorable d. P 640 favorable

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14. The Centipede Company uses standard costing. The following data are available for October:
Actual quantity of direct materials used 23,500 pounds
Standard price of direct materials P 2 per pound
Material quantity variance P 1,000 unfavorable
What is the standard quantity of materials allowed for October production?
A a. 23,000 pounds c. 24,500 pounds
b. 24,000 pounds d. 25,000 pounds
15. A company uses a standard costs system to account for its only product. The materials standard per unit was 4 pounds
at P 5.10 per pound. Operating data for April were as follows:
Materials used 7,800 lbs.
Cost of materials used P 40,950
Number of finished unit 2,000
What was the materials usage variance for April?
A a. P 1,020 favorable c. P 1,170 unfavorable
Caterpillar Co. purchases components from subcontractors for assembly into complete radios. Each radio requires 3
units of Part X at a standard cost of P 2.90 per unit. During June, the following data were made available:
Purchases (P 36,000) 12,000 units
Consumed in manufacturing 10,000 units
Radios manufactured 3,000 units
16. During June, the company incurred a materials purchase-price variance of
C a. P 900 unfavorable c. P 1,200 unfavorable
b. P 900 favorable d. P 1,200 favorable
17. During June, the company incurred a materials efficiency variance of
A a. P 2,900 unfavorable c. P 8,700 unfavorable
18. What is the amount that will be shown on a flexible budget for Part X usage during the month of June?
A a. P 26,100 c. P 29,000
b. P 27,000 d. P 36,000
19. The following data relate to direct labor costs for the current period:
Standard costs 10,000 hours at P 20
Actual costs 9,800 hours at P 19.50
What was the direct labor efficiency variance?
20. Amoeba Corporation’s direct labor information for product C for the month of October is as follows:
Standard rate P 6.10 per hour
Actual rate paid P 6.00 per hour
Standard hours allowed for actual production 1,500 hours
Labor efficiency variance P 600 unfavorable
What is the actual hours worked?
C a. 1,400 c. 1,598
b. 1,402 d. 1,600
21. Worm Corporation’s direct labor costs for the month of March were as follows:
Standard direct labor hours 42,000
Actual direct labor hours 40,000
Direct labor rate variance, favorable P 8,400
Standard direct labor rate per hour P 6.50
What was Worm’s direct labor payroll for the month of March?
C a. P 243,000 c. P 251,600
b. P 244,000 d. P 260,000
22. Leech Company’s operations for April disclosed the following data relating to direct labor:
Actual cost P 10,000
Rate variance (favorable) 1,000
Efficiency variance (unfavorable) 1,500
Standard cost P 9,500
Actual direct labor hours for April amounted to 2,000. What was the standard direct labor hourly rate?
A a. P 5.50 c. P 4.75
b. P 5.00 d. P 4.50
23. The following is a standard cost variance analysis report on direct labor for a manufacturing company:
Actual Hours at Actual Hours at Standard Hours at
Job Actual Wages Standard Wages Standard Wages
213 P 3,243 P 3,700 P 3,100
215 P 15,345 P 15,675 P 15,000
Protex P 6,754 P 7,000 P 6,600
Benz P 19,788 P 18,755 P 19,250
CT-40 P 3,370 P 3,470 P 2,650
Total P 48,500 P 48,600 P 46,600
What is the total (flexible budget) direct labor variance for the division?
B a. P 100 favorable c. P 1,900 favorable

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24. In determining the standard factory overhead rate, which level of capacity is used?
C a. Maximum capacity c. Normal capacity
b. Practical capacity d. Expected actual capacity
25. Which level of capacity if used would result into the lowest fixed overhead application rate?
A a. Theoretical capacity c. Normal capacity
b. Practical capacity d. Expected actual capacity
26. The flexible budget of Spider Company is summarized below:
Percent of normal operating capacity 80% 90% 100% 110%
Variable overhead P 21,000 P 23,000 P 25,000 P 27,000
Fixed overhead 50,000 50,000 50,000 50,000
Total factory overhead P 71,000 P 73,000 75,000 P 77,000
100,000 of units of product are produced when the company operates at its normal capacity. The standard labor time
per unit is 15 minutes. Actual production for the year was 90,000 units of product in 44,000 hours. What is the standard
variable factory overhead rate per hour?
A a. 1.00 c. 4.00
b. 1.25 d. 5.00
NOTE: Based on 100% operating capacity, the variable rate is: P 25,000 ÷ 25,000 hours = P 1
Flexible budget formula: FOH = 50,000 + 1 X, where ‘X’ is based on the number of hours.
27. Using data in No. 26, what is the budgetary factory overhead adjusted to standard hours?
C a. 22,500 c. 72,500
b. 50,000 d. 75,000
28. Information on Caterpillar Company’s overhead costs is as follows:
Standard applied overhead P 80,000
Budgeted overhead based on standard direct-labor hours allowed P 83,000
Budgeted overhead based on actual direct-labor hours allowed P 84,000
Actual overhead P 86,000
What was the total overhead variance?
D a. P 2,000 unfavorable c. P 4,000 favorable
29. Yeast Company has a standard absorption and flexible budgeting system and uses a two-way analysis for overhead
variances. Selected data for the February production activity is as follows:
Actual factory overhead incurred P 230,000
Budgeted fixed factory overhead costs P 64,000
Variable factory overhead rate per direct-labor hour P 5.00
Standard direct-labor hours 32,000
Actual direct-labor hours 33,000
What is the budget (controllable) variance for February?
D a. 1,000 favorable c. 6,000 favorable
b. 1,000 unfavorable d. 6,000 unfavorable
30. Information on Mold Company’s overhead costs for the January production activity is as follows:
Budgeted fixed overhead P 75,000
Standard fixed overhead rate per direct-labor hour P 3.00
Standard variable overhead rate per direct-labor hour P 6.00
Standard direct-labor hours allowed for actual production 24,000
Actual total overhead incurred P 220,000
Mold has a standard absorption and flexible budget system and uses the two-variance method (two-way analysis) for
overhead variances. What is the volume (denominator) variance for January?
Ant Company’s budgeted fixed factory overhead cost is P 50,000 per month plus a variable factory overhead rate of
P 4 per direct labor hour. The standard direct labor hours allowed for October production was 18,000. An analysis of the
factory overhead indicates that in October, Ant had an unfavorable budget (controllable) variance of P 1,000 and an
unfavorable volume variance of P 500. Ant uses a two-way analysis of overhead variance.
31. What is the actual factory overhead measured in October?
D a. P 121,000 c. P 122,300
b. P 122,000 d. P 123,000
32. What is the applied (standard) factory overhead in October?
A a. P 121,500 c. P 122,500
b. P 122,000 d. P 123,000
33. The following information is available from the Honey Company:
Actual factory overhead P 15,000
Fixed overhead expenses, actual P 7,200
Fixed overhead expenses, budgeted P 7,000
Actual hours 3,500
Standard hours 3,800
Variable overhead rate per direct labor hour P 2.50
Assuming that Honey uses a three-way analysis of overhead variance, what is the spending variance?
A a. P 750 favorable c. P 550 favorable
b. P 750 unfavorable d. P 1,500 unfavorable

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34. Queen Company has standard variable costs as follows:

Materials, 3 pounds at P 4.00 per pound P 12.00
Labor, 2 hours at P 10.00 per hour P 20.00
Variable overhead, P 7.50 per labor hour P 15.00
During September, Queen produced 6,000 units using 11,560 labor hours at a total wage of P 113,870 and incurring
P88,600 in variable overhead. What is variable overhead efficiency variance?
B a. P 4,400 U c. P 1,900 U
b. P 3,300 F d. P 1,400 F
35. Bee Company uses a standard cost system in which it applies manufacturing overhead to units of product on the basis
of direct labor hours. The information below pertains to a recent month’s activity:
Denominator (normal) activity 300 hours
Actual activity 350 hours
Standard hours allowed for output 360 hours
Predetermined overhead rate (P 2 variable + P 3 fixed) P 5 per hour
What would be the volume variance?
B a. P 300 favorable c. P 150 favorable
b. P 180 favorable d. P 120 favorable
36. One way of analyzing the variable factory overhead variance is breaking it down into
A a. Spending and efficiency variances c. Efficiency and volume variances
b. Spending and rate variances d. Spending and capacity variances
37. One way of analyzing the fixed factory overhead variance is breaking it down into
A a. Spending and volume variances c. Efficiency and volume variances
b. Spending and budget variances d. Efficiency and capacity variances
38. What is the factory overhead variance that serves as a measure of capacity utilization?
D a. The overhead spending variance c. The overhead budget variance
b. The overhead efficiency variance d. The overhead volume variance
39. Maggot Company has total budgeted fixed overhead costs of P 64,000. Actual production was 15,000 units; normal
capacity is 16,000 units. What was the volume variance?
D a. P 4,000 favorable c. P 4,267 unfavorable
40. An unfavorable volume variance signifies that
D a. Cost control was poor
b. Sales were less than budgeted
c. Production was less than sales
d. Production was less than the level used to set the fixed overhead application rate
41. Mosquito has budgeted fixed overhead of P 150,000. Actual production of 39,000 units resulted in a P 6,000 favorable
volume variance. What normal capacity was used to compute fixed overhead rate?
B a. 33,000 c. 40,560
b. 37,500 d. Undetermined due to lack of information
42. The production volume variance is due to
C a. Inefficient or efficient use of direct labor hours
b. Efficient or inefficient use of variable overhead
c. Difference from planned level of the base used for overhead allocation and actual level achieved
d. Excessive application of direct labor hours over the standard amounts for output level actually achieved
Items 43 to 48 are based on the following information:
Dee Company produces a single product. The standard cost card for the product follows:
Direct materials (4 yards @ P 5 per yard) P 20
Direct labor (1.5 hours @ P 10 per hour) P 15
Variable manufacturing overhead (1.5 hours @ P 4 per hour) P6
During a recent period, the company produced 1,200 units of product. Various costs associated with the production of these
units are given below:
Direct materials purchased (6,000 yards) P 28,500
Direct materials used in production 5,000 yards
Direct labor cost incurred (2,100 hours) P 17,850
Variable manufacturing overhead cost incurred P 10,080
The company records all variances at the earliest possible point in time. Variable manufacturing overhead costs are applied
to products on the basis of direct labor hours.
43. What is the materials price variance for the period?
B a. P 1,250 favorable c. P 1,250 unfavorable
44. What is the materials quantity variance for the period?
B a. P 950 unfavorable c. P 5,000 favorable
b. P 1,000 unfavorable d. P 5,000 favorable
45. What is the labor rate variance for the period?
46. What is the labor efficiency variance for the period?
47. What is the variable overhead spending variance for the period?
D a. P 1,440 favorable c. P 1,680 favorable

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48. What is the variable overhead efficiency variance for the period?
Items 49 and 50 are based on the following information:
The following information relates to a given department of Li Company for the first quarter of 2022:
Actual total overhead (fixed plus variable) P 178,500
Budget formula P 110,000 plus P 0.50 per hour
Total overhead application rate P 1.50 per hour
Spending variance (from three-way analysis) P 8,000 unfavorable
Volume variance (from two-way analysis) P 5,000 favorable
Over-all factory overhead variance P 6,000 unfavorable
49. What were the actual hours worked in this department during the quarter?
B a. 110,000 c. 137,000
b. 121,000 d. 153,000
50. What were the standard hours allowed for good output in this department?
D a. 105,000 c. 110,000
b. 106,667 d. 115,000
51. Information on Lee Company’s manufacturing overhead costs for last period is given below:
Actual direct labor hours worked 40,000 hours
Standard hours allowed for actual production 38,000 hours
Denominator hours used in computing the predetermined overhead rate 35,000 hours
Predetermined overhead rate P 4 per hour
Actual overhead costs incurred P 150,000
Lee Company uses a standard cost system and applies manufacturing overhead cost to units of product on the basis of
direct labor hours. Given these data, the overhead cost for the period would be:
A a. P 2,000 over-applied c. P 10,000 over-applied
b. P 8,000 under-applied d. P 10,000 under-applied
52. Lim Company has a P 20,000 unfavorable fixed overhead budget variance, a P 12,000 unfavorable variable overhead
spending variance, and a P 4,000 favorable volume variance. What was the total overhead?
B a. P 28,000 over-applied c. P 36,000 over-applied
Solution: FOH Variance: AFOH – SFOH (Applied) = VFOH variance + FFOH variance
= (variable spending var + variable efficiency var) + (fixed budget var) + (fixed volume var)
= (12,000 U + 0) + (20,000 U + 4,000 F) = P 28,000 unfavorable (under-applied)
53. Lo Company had a P 18,000 favorable volume variance, a P 15,000 unfavorable variable overhead spending variance,
and P 12,000 total over-applied overhead. The fixed overhead budget variance was
A a. P 9,000 favorable c. P 9,000 unfavorable
b. P 16,000 unfavorable d. P 16,000 favorable
Solution: FOH Variance: 12,000 F = fixed budget variance + 18,000 F + 15,000 U
54. The efficiency variance for either labor or materials can be divided into
D a. Spending variance and yield variance c. Volume variance and mix variance
b. Yield variance and price variance d. Yield variance and mix variance
Lam Company’s standard direct labor rates in effect for the fiscal year ending June 30 and standard hours allowed for
the output in April are:
Standard DL Rate per Hour Standard DL Hours Allowed for Output
Engineering P 8.00 500
Carpentry 7.00 500
Masonry 5.00 500
The wage rates for each labor class increased on January 1 under the terms of a new union contract. The actual direct
labor hours (DLH) and the actual direct labor rates for April were as follows:
Actual Rate Actual DLH
Engineering P 8.50 550
Carpentry 7.50 650
Masonry 5.40 375
55. How much is the labor yield variance?
A a. P 500 c. P 820
b. P 320 d. P 515
56. How much is the labor mix variance?
B a. P 50 c. P 66.67
b. P 325 d. P 500
57. A standard costing system is most often used by a firm in conjunction with
D a. Management by objectives c. Participative management programs
b. Target (hurdle) rates of return d. Flexible budgets
58. A difference between standard costs used for cost control and budgeted costs
B a. Can exist because standard costs must be determined after the budget is completed.
b. Can exist because standard costs represent what costs should be, whereas budgeted costs represent
expected actual costs.
c. Can exist because standard costs are historical, whereas standard costs are based on engineering
studies.
d. Cannot exist because they should be the same amounts.

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59. Setting standards

A a. Has important behavioral implications
b. Is largely a matter of calculating rates and quantities
c. Should be done to make them as tight as possible
d. Is done only for manufacturing activities
60. A major drawback to setting standards based on historical results is that such standards
A a. Can perpetuate inefficiencies
b. Are harder to compute than are engineered standards
c. Are usually too hard to meet because of inflation
d. Are usually not well received by workers.
61. Each finished unit of Product Lui contains 60 pounds of raw material. The manufacturing process must provide for a
20% waste allowance. The raw material can be purchased for a cost of P 2.50 a pound under terms of 2/10, n/30. The
company takes all cash discounts. What is the standard direct material cost of each unit of product Lui?
C a. P 180.00 c. P 183.75
b. P 187.50 d. P 176.40
Solution: 60 lbs. ÷ (100% - 20%) = 75 lbs. (with allowance)
75 bs. (2.50 x 98%) = P 183.75 (net of cash discount)
62. The following direct labor information pertains to the manufacture of product Lu:
Time required to make one unit 2 labor hours
Number of direct workers 50
Number of productive hours per week, per worker 40
Weekly wages per worker P 500
Workers’ benefit treated as direct labor costs 20% of wages
What is the standard direct labor cost per unit of product Lu?
A a. P 30 c. P 15
b. P 24 d. P 12
Solution: (P 500 x 1.2) ÷ 40 hours = P 15 per hour 2 hours x P 15 per hour = P 30 per unit
63. A standard costing system may be used in
C a. Process costing but not job-order costing c. Either job-order costing or process costing
b. Job-order costing but not process costing d. Neither process costing nor job-order costing
64. Which one of the following management practices involves concentrating on areas that deserve attention and placing
less attention on areas operating as expected?
D a. Management by objectives c. Benchmarking
b. Responsibility accounting d. Management by exception
65. Which of the following is best identified with a system of standard costing?
B a. Variable costing c. Contribution margin approach
b. Management by exception d. Standardized accounting system
66. ‘Management by exception,’ in relation to standard costing, means
C a. Only large favorable variance need to be investigated
b. Only large unfavorable variance need to be investigated
c. Only large variances, favorable or unfavorable, need to be investigated
d. Only small variances need to be investigated
67. How should a variance that is significant in amount be treated at the end of an accounting period?
B a. Reported as a deferred charge or credit
b. Allocated among work-in-process inventory, finished goods inventory, and cost of goods sold
c. Charged or credited to cost of goods manufactured
d. Allocated among cost of goods manufactured, finished goods inventory, and cost of goods sold
68. What is the normal year-end treatment of immaterial variances recognized in a standard cost system?
C a. Allocated among cost of goods manufactured and ending work in process inventory
b. Reclassified to deferred charges until all related production is sold
c. Closed to cost of goods sold in the period in which they arose
d. Capitalized as cost of ending finished goods inventory
69. Standard costing will produce the same results as actual costing when variances are distributed to
B a. CGS c. Income Summary
b. CGS and inventories d. WIP and finished goods inventory
70. The sum of material price variance and material use variance always equals the difference between
D a. Actual and standard material purchases
b. Actual material purchases and standard material use
c. Standard material purchases and standard material use
d. Actual cost of material use and standard cost of materials allowed for production
71. Which of the following is NOT a quantity variance?
C a. Material use variance c. Fixed overhead budget variance
b. Labor efficiency variance d. Variable overhead efficiency variance
72. Which variance CANNOT arise under a standard variable costing system?
D a. Variable overhead budget variance c. Fixed overhead budget variance
b. Variable overhead efficiency variance d. Fixed overhead volume variance
73. Which item is NOT used to compute the fixed overhead volume variance?
C a. Standard fixed cost per unit c. Actual fixed overhead
b. Budgeted fixed overhead d. Actual quantity produced
74. Which variance is LEAST likely affected by hiring workers with less skill than those already working?
C a. Labor rate variance c. Material price variance
b. Material use variance d. Variable overhead efficiency variance

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75. Which variance is MOST likely affected by buying a more expensive material that produces less waste and is easier to
handle?
D a. Labor rate variance c. Fixed overhead budget variance
b. Direct labor efficiency variance d. Variable overhead spending variance
76. The purpose of identifying manufacturing variances and assigning responsibility to a person/department should be to:
A a. Use the knowledge about the variances to promote learning and continuous improvement in the
manufacturing operations
b. Trace the variances to finished goods so that the inventory can be properly valued at year-end
c. Determine the proper cost of the products produced so that selling prices can be adjusted accordingly
d. Pinpoint fault for operating problems in the organization
Kim Company produces and sells cellular phone blaster, a gadget which explodes when activated with a remote
commander. This is used by cell phone owners when their unit is snatched from them or is taken by thieves. The static
master budget and the actual results of operations for the month of June are as follows:
Budget (8,000 units) Actual (9,600 units)
Sales P 800,000 P 1,056,000
Cost of goods sold P 480,000 P 556,800
Gross profit P 320,000 P 499,200
Management wants an explanation of the favorable gross profit variance of P 179,200 (actual gross profit of P 499,200 less
budgeted gross profit of P 320,000).
77. Determine the sales price variance.
A a. P 96,000 favorable c. P 19,200 favorable
78. Determine the sales volume variance.
B a. P 96,000 favorable c. P 19,200 favorable
79. Determine the cost price variance.
80. Determine the cost volume variance.
D a. P 96,000 favorable c. P 19,200 favorable
81. What is the percentage change in sales price?
D a. 20% decrease c. 20% increase
b. 3.33% decrease d. 10% increase
82. What is the percentage change in volume?
C a. 20% decrease c. 20% increase
83. What is the percentage change in cost price?
B a. 20% decrease c. 20% increase
The management of Seymour Corporation asks you to prepare an analysis of the gross profit variance based on their
comparative income statements for 2022 and 2021 (Volume increased by 10% from 2021 to 2022):
2022 2021 Variance
Sales P 990,000 P 800,000 P 190,000 F
Cost of goods sold 760,000 640,000 120,000 U
Gross profit P 230,000 P 160,000 P 70,000 F
84. The sales volume variance is
A a. P 80,000 favorable. c. P 110,000 favorable.
b. P 56,000 unfavorable. d. P 64,000 unfavorable.
85. The sales price variance is
C a. P 80,000 favorable. c. P 110,000 favorable.
86. The percentage change in sales price is
A a. 12.5% increase. c. 10% increase.
b. 12.5% decrease. d. 10% decrease.
87. The cost volume variance is
D a. P 80,000 favorable. c. P 110,000 favorable.
88. The cost price variance is
B a. P 80,000 favorable. c. P 110,000 favorable.
89. The percentage change in cost price is
A a. 7.95% increase. c. 12.5% increase.
b. 7.95% decrease. d. 12.5% decrease.
90. The variance in gross profit due to the change in volume is
C a. P 80,000 favorable. c. P 16,000 favorable.
b. P 64,000 unfavorable. d. P 70,000 favorable.

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The management of Marvel Company asked you to submit an analysis of the increase in the gross profit in 2022 based
on the past two-year comparative income statements, which are shown below:
2022 2021
Net Sales P 1,237,500 P 1,000,000
Cost of Sales 950,000 800,000
Gross Profit P 287,500 P 200,000
The selling price increased by 12.5% beginning January 1, 2022.
91. What is the increase in gross profit due to increase in volume? (VOLUME FACTOR)
A a. P 20,000 c. P 50,000
b. P 35,000 d. P 100,000
92. How much is the gross profit decline due to increase in cost? (COST FACTOR)
A a. P 70,000 c. P 88,000
b. P 80,000 d. P 97,500
93. The increase in sales prices caused an increase in gross profit by (PRICE FACTOR)
C a. P 100,000 c. P 137,500
b. P 110,000 d. P 237,500
94. What is the percentage change in volume?
B a. 9% c. 11%
b. 10% d. 12.75%
95. What is the percentage change in cost?
D a. 10.8% c. 8.675%
b. 10% d. 7.95%
Clarifications/Solutions to Selected Self-Test Questions

8. If silent, the Material Price Variance (MPV) is preferably based on Material Purchase Price Variance (MPPV)
since the variance is usually computed at the date of purchase during which the entity has no knowledge of
the actual quantity to use: MPV → MPPV = AQ purchased (AP – SP)
In the final analysis, however, since the production costs are based on the actual quantity of materials used,
the material price usage variance (MPUV) will be eventually closed to the costs of goods sold.
MPUV = AQ used (AP – SP)
Total DM Variance
MQV = (AQ used – SQ) SP
18. Flexible budget for part X usage refers to the standard cost: (3,000 x 3) x P 2.90 = P 26,100
21. LRV = AH x ∆R = 8,400 F = 40,000 (AR – 6.50) AR = 6.29 (AR < SR)
Payroll = Actual direct labor cost = AH x AR = 40,000 (6.29) = P 251,600
35. 3 ways to compute the volume or capacity variance:
 Input-based: BASH – SHSR
 Input-based (fixed): BASH (F) – SHSR (F) = (BH – SH) FR → (300 – 360) 3 = P 180 favorable
 Output-based: (Normal Production – Actual Production) unit FFOH (Refer to MAS-42D, wrap-up item 7)
39. Output-based computation of volume variance (see no. 35):
(15,000 – 16,000) x (64,000/16,000) = P 4,000 unfavorable (AP < NP)
41. Output-based computation of volume variance (see no. 35): 6,000 F = (39,000 – NP) x (150,000/NP)
55. In standard costing, applied FOH is the standard FOH.
➢ If applied FOH (SFOH) >AFOH, then FOH is over-applied (favorable/credit)
➢ If AFOH > applied FOH (SFOH), then FOH is under-applied (unfavorable/debit).
56. Labor yield variance: (AQ – SQ) SP = (1,575 – 1,500) (20/3) = P 500
57. Labor mix variance: (Computation is based on LEV formula, where SH is based on Standard Labor Mix)
(AH - SH) SR Mix Variance
Engineering: (550 - 525) 8 = 200 U
Carpentry: (650 - 525) 7 = 875 U
Masonry: (375 - 525) . 5 =. 750 F .
1,575 1,575 P 325 U
Suggested Answers to Item 7 on Page 3

Materials, Labor and Overhead Variances (Comprehensive Problem, Reconstruction)
 Standard variable costs per unit:
A) Materials: 4 pounds @ (1) P 1.875 (2) P 7.50
B) Direct Labor: (3) 0.5 hours @ P 12.00 P 6.00
C) Variable overhead: P 8 per direct labor hour (4) P 4.00
 Production 8,000 units
 Materials purchases, 32,000 pounds P 62,000
 Materials used at standard prices, 31,200 pounds (5) P 58,500
 Direct labor (actual): (6) 4,100 hours P 47,200
 Material purchase price variance P 2,000 adverse
 Material use variance (7) P 1,500 F
 Direct labor rate variance P 2,000 favorable
 Direct labor efficiency variance (8) P 1,200 U
 Variable overhead spending variance P 1,500 credit
 Variable overhead efficiency variance (9) P 800 U
 Actual variable overhead cost (10) P 31,300

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MAS-08: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING

RESPONSIBILITY ACCOUNTING
 RESPONSIBILITY ACCOUNTING is a performance measurement tool where managers are held responsible for
their performance, actions of subordinates and all activities within their area of authority and control.
 Responsibility accounting is consistent with MANAGEMENT BY OBJECTIVES (MBO) -- the management process
in which managers and subordinates agree on goals as well as the methods to achieve them and subordinates
are subsequently evaluated with reference to the agreed plan.
 Responsibility accounting system functions best under a decentralized form of organization as
DECENTRALIZATION allows the separation of an entity into manageable units wherein each unit is managed
by an individual who is given decision authority and is held accountable for his/her decisions.
 Decentralized organizations must avoid SUB-OPTIMIZATION, which happens when managers decide in favor
of their own unit even at the expense of the entire organization as a whole.
 Most decentralized organizations are divided into responsibility centers (also called STRATEGIC BUSINESS
UNITs) to facilitate improved decision making through the use of more information at the local level.
 A RESPONSIBILITY CENTER is a component of an entity (e.g., product line, department, and division) whose
manager has authority over, and is responsible and accountable for, a particular set of activities.
 The four common types of responsibility centers are:
A) COST CENTER – managers are responsible mainly for the costs incurred by the unit
B) REVENUE CENTER – managers are responsible mainly for the revenues generated by the unit
C) PROFIT CENTER – managers are responsible for both revenues and costs of the unit
D) INVESTMENT CENTER - managers are responsible for revenues, costs and investment of capital.
 The PERFORMANCE REPORT, which is often considered as the end-product of the responsibility accounting,
shows and compares actual results with the intended (budgets or standards) results of a responsibility center,
thereby highlighting material deviations that need corrective actions. The contents would normally depend on
type of responsibility center presenting the performance report:
RESPONSIBILITY CENTER KEY PERFORMANCE MEASURES
Cost Center Variance Analysis: Actual Costs vs. Budgeted/Standard Costs
Revenue Center Variance Analysis: Actual Sales vs. Budgeted/Target Sales
Variance Analysis: Actual Profit vs. Budgeted/Target Profit
Profit Center
Segmented Income Statement
Variance analysis: Actual Profit vs. Budgeted/Target Profit
Investment Center Segmented Income Statement
ROI, Residual Income, EVA
 The SEGMENTED INCOME STATEMENT is a detailed version of the contribution format of income statement.
This income statement presentation highlights controllability of costs by behavioral classification. In addition
to the usual variable costs and fixed costs, a more detailed classification of costs may be made:
Sales ✓ Direct costs are separable costs that are attributable or traceable to
Less: VARIABLE Manufacturing Costs the segment or business unit.
Manufacturing Contribution Margin ✓ CONTROLLABILITY is based on degree of influence a manager can
Less: VARIABLE Non-Manufacturing Costs exercise over an amount with reference to assigned responsibilities.
✓ Most controllable costs are discretionary costs by nature.
Contribution Margin
✓ Non-controllable costs are either committed costs or costs that are
Less: Controllable Direct FIXED Costs controllable by others or by a higher authority.
Controllable or Performance Margin ✓ CONTROLLABLE or PERFORMANCE MARGIN is usually used to evaluate
Less: Non-Controllable Direct FIXED Costs the performance of the manager.
Segment Margin ✓ SEGMENT MARGIN is usually used to evaluate the performance of the
Less: Allocated Common Costs segment or business unit (e.g., continue vs. shutdown).
Profit ✓ Common costs allocated to a segment are usually not controllable by
the manager of the same segment.
 RETURN ON INVESTMENT (ROI):
✓ ROI broken down into margin and turnover is
ROI = Margin x Turnover based on the Du Pont Technique.
✓ ROI is also known as return on assets.
✓ MARGIN - net profit margin, return on sales.
Operating Income Operating Income Sales ✓ TURNOVER - assets turnover, investment
Operating Assets = Sales x Operating Assets turnover, capital turnover.
✓ ‘Operating income’ for most investment centers is based on earnings before interests & taxes (EBIT).
✓ ‘Operating assets’ are preferably based on the average balance for the reporting period and composed of
productive assets used to earn the operating income (i.e., idle assets are excluded).
✓ The term ‘invested capital’ is sometimes used as the denominator for the ROI formula. While the term
means operating assets for most investment centers, invested capital may also mean total assets, owners’
equity or total assets less current liabilities, depending on the situation and application.
 RESIDUAL INCOME (RI):
RI = Operating Income – Required Income ✓ Minimum ROI is also known as desired rate of return,
business quota or minimum required rate of return.
where: Required Income = Operating Assets x Minimum ROI
✓ The ‘Minimum ROI’ under RI is usually based on the imputed interest rate, which is imposed and set by a higher
authority like a head office (for branches) or a holding company (for subsidiaries).
✓

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Week 8: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING
 ECONOMIC-VALUE ADDED (EVA):

✓ WACC is also called hurdle rate, cutoff
EVA = Operating Income after Tax – Required Income rate, target rate, standard rate or
minimum acceptable rate of return.
where: Required Income = (Total Assets – Current Liabilities) x WACC
✓ EVA is a specific form of RI that measures a segment’s economic profit based on residual wealth after
accounting for the costs of capital; EVA is often used for incentive compensation & investor relations.
✓ Unlike RI, EVA uses the Weighted Average Costs of Capital (WACC) as the minimum required rate of
return to determine the amount of required income.
✓ WACC is computed based on the long-term sources of financing -- debt and equity -- hence, the
computation: (total assets – current liabilities) being equal to (long-term liabilities and equity).
[WACC shall be exhaustively discussed in MAS-14 (Capital Structure & Costs of Capital) during Week 15]
✓ Under EVA, ‘operating income after tax’ is based on the formula: EBIT (100% - tax rate)
 ROI vs. RI:
➢ Under ROI method, division managers tend to accept only the investments whose returns exceed the
division’s ROI; under RI method, division managers would accept an investment as long as it earns an
amount in excess of the minimum required return.
➢ RI has the advantage of having a better measure of performance than ROI because it encourages
investment in projects that would otherwise be rejected under ROI.
➢ A major disadvantage of RI is that it cannot be used to compare divisions of different sizes or asset base
-- RI tends to favor larger divisions because of larger peso amount involved.
➢ Consider the following relationship between ROI vs. RI and their corresponding implications:
ROI = Minimum ROI Residual Income = 0 (nil) Indifference point
ROI > Minimum ROI Residual Income > 0 (positive) Performance is generally satisfactory
ROI < Minimum ROI Residual Income < 0 (negative) Performance is generally unsatisfactory
TRANSFER PRICING
 When one division of a manufacturing company supplies components or materials to another division, the
price charged by the selling (producing) division to the buying division is known as the TRANSFER PRICE.
 Transfer prices are usually determined by one of the following methods:
A) MARKET price – regarded as the best transfer price that maximizes the over-all company profit, provided
that: (1) a competitive market price exists, and (2) divisions are independent of each other.
B) COST-BASED price – easy to understand and convenient to use but inefficiencies of the selling division
may be passed on to the buying division – selling division will have little incentive to control costs. Cost-
based price can be based on selling division’s variable cost, full (absorption) cost or cost-plus.
C) NEGOTIATED price – widely used when market prices are subject to rapid fluctuation or when there is no
intermediate market price that exists. In negotiating a transfer price, the usual range shall be based on
the following:
➢ Maximum price (buying division): market price
➢ Minimum price (selling division): outlay cost + opportunity cost
D) ARBITRARY price – normally imposed by the corporate headquarters to promote over-all company goals
with neither the selling division nor the buying division having a control over the price.
 When managers of both selling and buying divisions act in their own individual interests, the entire
organization may suffer from SUB-OPTIMIZATION. Management hence establishes the methodology for
setting transfer prices in such a way to promote GOAL CONGRUENCE, which occurs when division managers
make decisions that are consistent with the goals and objectives of the organization as a whole.
 Aside from goal congruence, other important factors considered in setting the transfer price include cost
structure, capacity constraints, segmental performance, negotiation flexibility and tax implications.
 The following transfer pricing rule helps to ensure goal congruence among divisions and managers:
Transfer price per unit = outlay cost per unit + opportunity cost per unit
➢ OUTLAY COST includes selling division’s variable production costs (e.g., materials, labor and variable
overhead) plus any additional costs incurred (e.g., storage, transportation, administrative).
➢ OPPORTUNITY COST refers to the margin or profit sacrificed by transferring units internally rather than
selling them to external customers. Depending on sales demand and production capacity of the selling
division, there may or may not be an opportunity cost associated with the internal transfer:
✓ Selling division is operating at capacity (FULL Capacity):
 Opportunity cost = contribution margin (given up for sacrificing external sales)
✓ Selling division is operating at less than full capacity (EXCESS/IDLE Capacity):
 Opportunity cost = zero (nothing to sacrifice when there is no need to give up external sales)
➢ When selling division is operating at capacity, market price is the ‘theoretically correct’ transfer price.
➢ When selling division has an excess capacity, transfer price must be based on the variable costs incurred
to produce each unit. In practice, this price usually serves as the MININUM (floor) or lower threshold in
a transfer price negotiation or as the basis for cost-based pricing.
 DUAL PRICING is an attempt to eliminate the internal conflicts associated with transfer prices by giving both
the buying and selling divisions the price that works best for them:
➢ Selling division: uses market price as its transfer-out price to prevent decrease in divisional income
➢ Buying division: uses variable cost as its transfer-in price to minimize divisional costs and avoid ‘profit
sharing’ with selling division by agreeing to a transfer price above cost.
Dual pricing is rarely used nowadays because of the little incentive to control costs -- neither manager from
both buying divisions (assured of a low price) and selling divisions (assured of high price) must exert much
effort to show a profit on segmental performance reports.

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EXERCISES: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING

1. Responsibility Centers
Indicate how each of the business situations below is most likely to be organized: cost center (CC), revenue
center (RC), profit center (PC), or investment center (IC)
A. The assembly department of Toyota Motors Corporation.
B. The Ayala Mall car park ticket outlets.
C. The Magnolia product division of San Miguel Corporation.
D. The accounting department of SM Malls.
E. The Project 8 branch of Starbucks Coffee.
F. The College of Accountancy of the España University.
G. The parts department of Suzuki Motors Corporation.
H. The convenience store (Mini-Stop) that is owned by a chain organization; the head office supplies all
the goods to be sold and determines the selling prices.
2. Controllable vs. Non-Controllable Costs, Direct vs. Indirect Costs

The supervisor of the PAINTING DEPARTMENT of Honda Cars is in-charge of (1) purchasing supplies, (2)
authorizing repairs, and (3) hiring labor for the department. Various costs are given:
1 2 3
A) Sales, salaries and commission A P 60,000 ×
B) Salary, supervisor of Painting department B 50,000 ×
C) Factory heat and light C 40,000 ×
D) General office salaries D 30,000 ×
E) Depreciation, factory E 20,000 ×
F) Supplies, Painting department F 10,000 ✓
G) Repairs and maintenance, Painting department G 20,000 ✓
H) Factory insurance H 30,000 ×
I) Labor costs, Painting department I 40,000 ✓
J) Salary of factory supervisor J 50,000 ×
TOTAL COSTS
1. Total costs controllable by the supervisor of the Painting department.
2. Total costs directly identified with the Painting department.
3. Total costs allocated to the factory departments.
4. On the basis of the answers above, which is a FALSE statement?
a. All controllable costs by the supervisor are direct costs of the Painting department.
b. All direct costs of the Painting department are controllable costs by its supervisor.
c. Painting department costs not controllable by its supervisor may be controlled by others.
d. Common costs allocated to the Painting department are not controllable by its supervisor.
3. Segmented Income Statement

Mr. Rastaman, the QC branch manager of ABZ Company, recently reported annual sales of P 1,000,000 and
presented the following cost information:
Variable manufacturing costs 440,000
Allocated corporate overhead costs 170,000
Variable selling & administrative expenses 220,000
Controllable fixed costs traceable to QC branch 140,000
Uncontrollable fixed costs traceable to QC branch 230,000
REQUIRED:
A) Manufacturing contribution margin
B) Controllable or performance margin
C) Segment margin
2. Identify the appropriate margin that shall be used to evaluate the performance of:
A) Manager (Mr. Rastaman)
B) Business unit (QC Branch of ABZ Corp)
4. Return on Investment, Residual Income & ROI Pricing
For each of the following independent cases, the minimum desired Return on Investment (RoI) is 20%.
Division Lugaw Division LBM
Sales P 400,000 P 700,000 Division Lugaw
Operating Income (1) _____ P 42,000  Unit selling price: P 20
Operating Assets (2) _____ (5) _____  Total fixed costs: P 100,000
Margin 15% (6) _____
Turnover (3) _____ (7) _____ Division LBM
Return on Investments 30% (8) _____  Unit selling price: P 700
Residual Income (4) _____ P 22,000  Total fixed costs: P 258,000
REQUIRED:
1. Compute for each division’s missing items (1) to (8).
2. How many more units shall be sold by Lugaw to achieve a 40% ROI?
3. How much increase in selling price will allow LBM to reach 50% ROI from its current unit sales?

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5. Economic Value Added (EVA)

Fink Company presents the following year-end data:
Book Value Fair Value
Current assets P 800,000
Non-current assets 3,200,000
Current liabilities 400,000
Non-current liabilities (10% interest rate) 1,000,000 P 1,000,000
Stockholders’ equity 2,600,000 3,000,000
Additional data:
 Income before interests and taxes: P 800,000.
 Income tax rate: 20%.
 Cost of equity capital: 12%.
REQUIRED:
1. Weighted Average Costs of Capital (WACC)
2. Economic Value-Added (EVA)
6. Transfer Price Computation

Pakyaw Company is operating with two divisions. Division S is producing a product line that is required as a
component part of the product being manufactured by Division B.
For Division S, the costs of producing the component part per unit are:
Direct labor P8
Variable factory overhead P5
Fixed factory overhead P2
The product of Division S is being sold in a highly competitive market for P 30 per unit.
Division B is currently buying 80% of the production output of Division S at a negotiated price of P 28 per
unit. It is expected that 25,000 units of product will be produced by Division S.
With emphasis on divisional welfare rather than the company’s welfare, a new transfer price must be
developed. It is suggested that a 40% mark-up on cost will be added when transferring the product from
Division S to Division B.
The unit selling price of the product of Division B is P 45 while the additional unit processing cost is P 8.
REQUIRED:
Determine Division B’s gross profit per unit under each of the following independent assumptions:
A) Transfer price is full-cost based.
B) Transfer price is cost-based plus mark-up.
C) Transfer price is based on a negotiated price.
D) Transfer price is market-based.
7. Transfer Pricing
Domagisko Company’s Division ‘S’ (selling division) produces a small tool used by other companies as a key
part in their products. Cost and sales data related to the small tool are given below:

Variable costs per unit P 30
Fixed costs per unit* P 12
* based on capacity of 40,000 tools per year.
The company’s Division ‘B’ (buying division) is introducing a new product that will use the same tool such as
the one produced by Division S. An outside supplier has quoted the Division B a price of P 48 per tool.
Division B would like to purchase the tools from Division S, only if an acceptable transfer price can be
worked out.
REQUIRED: Consider the following independent cases:

1. Division S has ample idle capacity to handle all the Division B’s needs:
A) What is the minimum transfer price for Division S?
B) What is the maximum transfer price for Division B?
2. Division S is presently selling all the tools it can produce to outside customers:
A) What is the minimum transfer price?
B) Shall the Division B purchase the tools from Division or from the outside supplier? Why?
3. Division S is presently selling 36,000 tools per year to outside customers while Division B requires
10,000 tools per year:
A) What is the minimum transfer price for Division S?
B) Shall the company make-and-transfer 10,000 tools or buy the tools from the outside supplier?
Why?

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WRAP-UP EXERCISES (MULTIPLE-CHOICE)

1. Which sequence reflects increasing level of responsibility?
a. Cost center, profit center, investment center
b. Cost center, investment center, profit center
c. Profit center, cost center, investment center
d. Investment center, cost center, profit center
2. “A business within a business” most likely refers to a (an)
a. Investment center c. Profit center
b. Service center d. Cost center
3. A manager of a profit center is responsible for all of the following, except:
a. Sales revenue c. Expanding into new geographic areas
b. Selling and marketing costs d. Cost of merchandise purchase for resale
4. In responsibility accounting, what is the most relevant classification of costs?
a. Fixed and variable c. Controllable and non-controllable
b. Discretionary and committed d. Incremental and non-incremental
5. A controllable cost is any cost that can be ___ by the responsibility center manager for a period of time.
a. Allocated c. Segregated
b. Influenced d. Eliminated
6. Which technique is most appropriate to evaluate the management performance of a cost center?
a. Payback method c. Return on assets ratio
b. Variance analysis d. Return on investment ratio
7. The segment margin of the Division ABZ of ZBN Corporation should NOT include
a. Net sales of ABZ c. Variable selling expenses of ABZ
b. Fixed selling expenses of ABZ d. ABZ’s share of company president’s salary
8. When using a contribution margin format for internal reporting purposes, the major distinction between
segment manager performance and segment performance is:
a. Unallocated fixed cost
b. Direct fixed cost controllable by others
c. Direct variable cost of selling the product
d. Direct fixed cost controllable by the segment manager
9. Which of the following describes the computation of Return on Investment (ROI)?
a. Sales x Investment Turnover c. Income – (Investment x Minimum ROI)
b. Return on Sales x Investment Turnover d. Return on Sales x Investment
10. Residual income (RI) is
a. Contribution margin less the minimum return on average operating assets
b. Contribution margin plus the minimum return on average operating assets
c. Net operating income less the minimum return on average operating assets
d. Net operating income plus the minimum return on average operating assets
11. ROI and RI can be used to evaluate performance of
a. Cost centers c. Profit centers
b. Revenue centers d. Investment centers
12. Economic value added (EVA) is similar to (I) but uses (II) as minimum desired rate of return.
a. (I) RI (II) imputed interest rate
b. (I) ROI (II) imputed interest rate
c. (I) RI (II) weighted-average costs of capital
d. (I) ROI (II) weighted-average costs of capital
13. The objective of a transfer pricing system should be to:
a. Minimize transfer price c. Promote goal congruence
b. Maximize transfer price d. Minimize product outsourcing
14. What is usually considered as the best transfer price to use in intracompany sales given that company
divisions are independent from one another?
a. Cost-based price c. Arbitrary price
b. Market-based price d. Negotiated price
15. Which of these methods is described by a transfer price equal to 120% of a certain base amount?
a. Cost-based transfer price c. Market-based transfer price
b. Negotiated transfer price d. Administered transfer price
16. The minimum transfer price generally is equal to the
a. Opportunity costs plus incremental costs
b. Opportunity costs less additional outlay costs
c. Opportunity costs divided by the additional outlay costs
d. Opportunity costs times 125% plus the additional outlay costs
Division S sells one of its products to division B in the same group. The cost of the said product consists
of P 1,600 for materials, P 600 for direct labor, P 100 for variable overhead and P 1,100 for fixed overhead.
Division S sets its profit margin equal to 40% of the variable cost.
17. What is the appropriate transfer price if Division S is operating at less than full capacity?
a. P 2,300 c. P 4,320
b. P 3,400 d. P 4,760
18. What is the appropriate transfer price if Division S is operating at full capacity?
a. P 2,300 c. P 4,320
b. P 3,400 d. P 4,760

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1. What is the basic purpose of a responsibility accounting system?

B a. Budgeting c. Authority
b. Motivation d. Variance analysis
2. A successful responsibility accounting reporting system is dependent upon
C a. The correct allocation of controllable variable costs
b. Identification of the management level at which all costs are controllable
c. The proper delegation of responsibility and authority
d. A responsible separation of costs into their fixed and variable components since fixed costs are not
controllable and must be eliminated from the performance report
3. What is the LEAST complex segment or area of responsibility for which costs are allocated?
D a. Profit center c. Contribution center
b. Investment center d. Cost center
4. The manager of a revenue center is responsible for all of the following, except:
D a. Product mix and pricing c. Service quality and units sold
b. Sales and promotional activities d. Acquisition cost of products sold
5. Comparing budgeted and actual amounts is important in evaluating the performance of
D a. The manager of a cost center c. The manager of an investment center
b. The manager of a profit center d. Any manager
6. Decentralized firms can delegate authority, retain control and monitor manager’s performance by structuring the
organization into responsibility centers. Which center is almost like an independent business?
D a. Revenue center c. Cost center
b. Profit center d. Investment center
7. A management decision may be beneficial for a given profit center but not for the entire company. From the over-all
company viewpoint, this decision leads to
A a. Sub-optimization c. Goal congruence
b. Centralization d. Maximization
8. In responsibility accounting, a center’s performance is measured by controllable costs. Controllable costs are best
describe as including
D a. Only discretionary costs
b. Direct material and direct labor only
c. Those costs about which the manager is knowledge and informed
d. Only those costs that the manager can influence in the current time period
9. The following is the summarized income statement of Ruby Co.’s profit center for October:
Period Expenses:
Manager’s salary P 20,000
Facility depreciation 8,000
Corporate expense allocated 5,000 (33,000)
Profit center income P 37,000
Which of the following amounts is most likely subject to the control of the profit center’s manager?
A a. P 70,000 c. P 37,000
b. P 50,000 d. P 33,000
10. If a manufacturing company uses responsibility accounting, which one of the following items is least likely to appear in
a performance report for a manager of an assembly line?
D a. Labor payroll c. Repairs and maintenance
b. Materials d. Depreciation on equipment
11. When used for performance evaluation, internal reports based on a responsibility accounting system should not
A a. Include allocated fixed costs.
b. Be related to the organizational chart.
c. Distinguish between controllable and non-controllable costs.
d. Include variances between actual and budgeted controllable costs.
12. In evaluating an investment center, top management should concentrate on
D a. Peso rates c. Profit percentages
b. Net income d. Return on investment
13. The following information pertains to Bronze Co. for the year ended December 31, 2021:
Sales: P 600,000 Income: P 100,000 Capital investment: P 400,000
Which of the following equations should be used to complete Bronze’s return on investment?
B a. (4/6) x (6/1) = ROI c. (4/6) x (1/6) = ROI
b. (6/4) x (1/6) = ROI d. (6/4) x (6/1) = ROI
14. If Division Copper as a 10% return on sales, income of P 5,000, and an investment turnover of 4 times,
divisional investment is
B a. P 5,000 c. P 20,000
b. P 12,500 d. P 50,000
15. If asset turnover increased by 50% and the profit margin increased by 50%, then RoI would increase by
D a. 50% c. 225%
b. 25% d. 125%
16. Compared to a jewelry store, a supermarket has
C a. Higher margin and higher turnover c. Lower margin and higher turnover
b. Higher margin and lower turnover d. Lower margin and lower turnover

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17. The following information pertains to Silver Co.’s Gold Division for the current year:
Sales P 311,000
Variable cost 250,000
Traceable fixed cost 50,000
Average invested capital 40,000
Imputed interest rate 10%
What was Gold’s return on investment?
C a. 10% c. 27.50%
b. 13.33% d. 30%
18. Listed below is selected financial information for Western Division of the Pearl Company for 2022:
Average working capital P 625
General and administrative expenses 75
Net sales 4,000
Average plant and equipment 1,775
Cost of goods sold 3,525
If Pearl treats the Western Division as an investment center, what is the before-tax ROI for 2022?
D a. 34.78% c. 19.79%
b. 22.54% d. 16.67%
19. A firm earning a profit can increase its return on investment by
D a. Increasing sales revenues and operating expenses by the same peso amount
b. Decreasing sales revenues and operating expenses by the same percentage
c. Decreasing sales revenues and operating expenses by the same percentage
d. Increasing sales revenue and operating expenses by the same percentage
20. Mercury Co. plans to sell 200 units using P 20,000 of assets. The company incurs total costs of P 8,000 for these units.
If a return on investment of 10% is targeted, how much should be the selling price?
A a. P 50 c. P 30
b. P 40 d. Cannot be determined from given information
21. The segment margin of an investment center after deducting the imputed interest on the assets used by the investment
center is known as
B a. Return on investment c. Operating income
b. Residual income d. Return on assets
22. If a division’s ROI and the minimum required ROI are the same, what is the division’s residual income?
B a. Positive c. Negative
b. Zero d. None of the above
Jade Co.’s industrial photo finishing division VVV incurred the following costs and expenses in 2022:
Variable Fixed
Direct labor 150,000
Factory overhead 70,000 P 42,000
General, selling and administrative 30,000 48,000
TOTAL P 450,000 P 90,000
During 2022, VVV produced 300,000 units of industrial photo-prints, which were sold for P 2.00 each. Jade’s investment
in VVV was P 500,000 and P 700,000 at January 1, 2022 and December 31, 2022, respectively. Jade normally imputes
interest on investment at 15% of average invested capital.
23. For the year ended December 31, 2022, what was VVV’s return on investment?
B a. 15.0% c. 8.6%
b. 10.0% d. (5.0%)
24. Assume that the net operating income was P 60,000 and that average invested capital was P 600,000. For the year
ended December 31, 2022, what was VVV’s residual income (loss)?
D a. P 150,000 c. (P 45,000)
b. P 60,000 d. (P 30,000)
25. Frank Co. is a computer service center. For the month of May, Frank had the following operating statistics:
Sales P 450,000 Total assets P 500,000
Operating income P 25,000 Shareholder’s equity P 200,000
Net profit after taxes P 8,000 Cost of capital 6%
Based on the above information, which one of the following statements is correct?
B a. Return on investment of 4% c. Return on investment of 1.6%
b. Residual income of (P 5,000) d. Residual income of (P 22,000)
26. Managerial performance can be measured in many different ways, including return on investment (ROI) and residual
income. A good reason for using residual income instead of ROI is that
B a. Residual income can be computed without regard to identifying an investment base.
b. Goal congruence is more likely to be promoted by using residual income.
c. Residual income is well understood and often used in the financial press.
d. ROI does not take into consideration both investment turnover ratio and return-on-sales percentage.
27. Residual income (RI) is a performance evaluation that is used in conjunction with, or instead of, return
on investment (ROI). In many cases, RI is preferred to ROI because
B a. RI is a measure over time, while ROI represents the results for one period
b. RI concentrates on maximizing absolute amount of income rather than a percentage return like ROI
c. The imputed interest rate used in calculating RI is more easily derived than the target rate that is
compared to the calculated ROI
d. Average investment is employed with RI while year-end investment is employed with ROI

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28. Residual income is a better measure for performance evaluation of an investment center manager than return on
investment because
B a. The problems associated with measuring the asset base are eliminated
b. Desirable investment decisions will not be neglected by high-return divisions
c. Only the gross book value of assets needs to be calculated
d. The arguments about the implicit cost of interest are eliminated
29. Mr. Sy is the general manager of the XXX Division, and his performance is measured using the residual income method.
Mr. Sy is reviewing the following forecasts for his division for the next year:
Category Amounts
Working capital P 1,800,000
Revenue 30,000,000
Plant and equipment 17,200,000
If the imputed interest charge is 15% and Mr. Sy wants to achieve a residual income of P 2,000,000, what will costs
have to be in order to achieve the targeted residual income?
C a. P 9,000,000 c. P 25,150,000
b. P 10,800,000 d. P 25,690,000
30. Lead Company presented the following information:
Units to be sold 50,000 units
Total costs of the units P 550,000
Fixed capital investments P 1,000,000
Variable capital on sales 20%
What would be the selling price in order to produce a 20% return on investment?
D a. P 15.652 c. P 16.525
b. P 15.256 d. P 15.625
31. The following information is available for the wholesale products division of Aluminum Company:
Net operating profit before interests and taxes P 30,000,000
Depreciation expense 10,000,000
Change in net working capital 5,000,000
Capital expenditures 4,000,000
Invested capital (total assets – current liabilities) 50,000,000
Weighted-average cost of capital 10%
Tax rate 40%
What is the economic value added (EVA) for the division?
D a. P 25,000,0000 c. P 13,500,000
b. P 18,000,0000 d. P 13,000,000
32. Myrrh Co. reported these data at year-end:
Pre-tax operating income P 4,000,000 Current liabilities P 2,000,000
Current assets 4,000,000 Long-term liabilities 5,000,000
Long-term assets 16,000,000 Tax Rate 25%
Assuming a weighted average cost of capital (WACC) of 9%, what is Myrrh Company’s economic value-added (EVA)?
A a. P 1,380,000 c. P 1,830,000
b. P 1,620,000 d. P 3,000,000
33. In theory, what is the optimal method for establishing a transfer price?
D a. Flexible budget cost c. Budgeted cost with or without a markup
b. Incremental cost d. Market price
34. The most fundamental responsibility center affected by the use of market-based transfer prices is a(n)
D a. Production center c. Cost center
b. Investment center d. Profit center
35. A limitation of transfer prices based on actual cost is that they
B a. Charge inefficiencies to the department that is transferring the goods
b. Can lead to suboptimal decisions for the company as a whole
c. Must be adjusted by some markup
d. Lack clarity and administrative convenience
36. Negotiated price is often employed when
B a. Market prices are stable c. Goal congruence is not a major objective
b. Market prices are volatile d. Market prices change by a constant rate each year
37. The AAA Division of a company, which is operating at capacity, produces and sells 1,000 units of a certain electronic
component in a perfectly competitive market. Revenue and cost data are as follows:
Sales: P 50,000
Fixed costs: P 12,000
Variable costs: P 34,000
What is the minimum transfer price that should be charged to the BBB Division for each component?
D a. P 12.00 c. P 46.00
b. P 34.00 d. P 50.00
38. Division A of company is currently operating at 50% capacity. It produces a single product and sells all its production
to outside customers for P 13 per unit. Variable costs are P 7 per unit, and fixed costs are P 6 per unit at the current
production level. Division B, which currently purchases this product from an outside supplier for P 12 per unit, would
like to purchase the product from Division A. Division A will operate at 80% capacity to meet outside customer’s and
Division B’s demand. What is the minimum price that Division A should charge Division B?
A a. P 7.00 per unit c. P 12.00 per unit
b. P 10.40 per unit d. P 13.00 per unit

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39. An appropriate transfer price between two divisions of the Emerald Co. can be determined from the following data:
Fabricating Division:
Market price of sub-assembly P 50
Variable cost of sub-assembly P 20
Excess capacity 1,000
Assembling Division:
Number of items needed 900
What is the natural bargaining range for the two divisions?
A a. Between P 20 and P 50 c. Any amount less than P 50
b. Between P 50 and P 70 d. P 50 is the only acceptable price
40. The 1st division of Gold Company produces Part I that is to be used by Gold as a key part in its products. Costs and
sales data on Part I are as follows:
Selling price per unit: P 100
Variable cost per unit: P 60
Fixed cost per unit: P 24 (based on 40,000 units capacity per annum)
Gold’s 2nd division is introducing a new product that will use Part I. An outside supplier has quoted 2 nd division a price
of P 96 per unit. This represents the usual P 100 price less a quantity discount due to the large number of 2nd
division’s requirement. If the 2nd division would buy 15,000 units of Part I from the 1st division, the effect on the
corporate-profits would be:
D a. Increase by P 240,000 c. Increase by P 210,000
b. Increase by P 1,500,000 d. Reduce by P 60,000
41. If a transfer price of P 84 is determined using the transfer pricing formula and the lost contribution margin per unit on
outside sales is P 28, then the variable cost per unit must be
B a. P 3 c. P 112
b. P 56 d. P 2,352
42. Division A has the capacity for making 3,000 motors per month and regularly sells 1,950 motors each month on the
intermediate market at a contribution margin of P 62 per motor. Division B, a sister division, would like to obtain 1,400
motors each month from Division A. In computing a transfer price per motor using the transfer pricing formula, the lost
contribution margin per unit portion of the transfer price computation would be
B a. P 26.57 c. P 35.70
b. P 15.50 d. P 62.00
ABC and XYZ are the only two divisions in the Alphabet Company. ABC makes and sells units that can be sold either to
outside customers or to XYZ. The following data are available from last month:
ABC Division:
Unit selling price to outside customers P 45
Unit variable costs when sold to outside customers P 30
Capacity in units 12,000
Units sold to outside customers 6,000
XYZ Division:
Number of units needed per month 4,000
Unit price paid to an outside supplier P 42
If ABC sells the units to XYZ, ABC can avoid P 2 per wheel in sales commissions.
43. What transfer price would be used according to the transfer pricing formula?
A a. P 28 c. P 42
b. P 30 d. P 45
44. What is the maximum price per wheel that XYZ should be willing to pay ABC if a transfer were to take place?
C a. P 28 c. P 42
b. P 30 d. P 45
45. Suppose that ABC sells 9,000 units each month to outside customers and the transfer pricing formula is used to determine
the transfer price, what is the appropriate transfer price per unit?
B a. P 29.50 c. P 39.25
b. P 31.75 d. P 42.00
Clarifications/Solutions to Selected Self-Test Questions
17. ROI = (311,000 – 250,000 – 50,000) ÷ 40,000
18. ROI = (4,000 - 3,525 – 75) ÷ (625 + 1,775)
23. ROI = (600,000 – 450,000 – 90,000) ÷ [(500,000 + 700,000) ÷ 2]
24. RI = 60,000 – 15% (600,000)
29. RI = 2M = (30M – costs) – 15% (1.8M + 17.2M)
30. SP – selling price: Sales – Costs = Profit → 50,000 (SP) – 550,000 = 20% [1M + 20% (50,000 SP)]
31. EVA = 30M (1 – 0.4) – 10% (50 M)
32. EVA = 4M (1 - 0.25) – 9% (4M + 16M – 2M)
35. Minimum transfer price (at capacity): P 50,000 ÷ 1,000 units
41. Transfer price = outlay costs + opportunity costs → 84 = variable costs + 28
42. Excess capacity: 3,000 – 1,950 = 1,050 units Lost CM: (1,400 – 1,050) 62 = 21,700
Lost CM per unit: 21,700 ÷ 1,400 units
43. Transfer price: 30 – 2
44. Maximum transfer price (for buying vision) is based on the purchase price from outside supplier.
45. Excess capacity: 12,000 – 9,000 = 3,000 units Lost CM: (4,000 – 3,000) x (45 – 30) = 15,000
Transfer price: 28 + (15,000 ÷ 4,000)

MAS-11: QUANTITATIVE TECHNIQUES WITH INVENTORY MANAGEMENT

QUANTITATIVE TECHNIQUES
 QUANTITATIVE TECHNIQUES generally refer to the application of mathematics in actual business operations
so that management decisions are made objectively and efficiently.
 Some of the commonly used quantitative techniques or models are:
 Gantt Chart  Learning Curves
 PERT-CPM  Inventory Models
 Regression & Correlation Analysis [covered in MAS-02: Cost Behavior with Regression Analysis]
 Linear Programming [covered in MAS-05: Relevant Costing with Linear Programming]
 Probability Analysis & Decision Tree Diagram [covered in MAS-06: Budgeting with Probability Analysis]
 PROJECT SCHEDULING TECHNIQUES are especially useful for entities involved in building constructions,
book publishing, new product launching, feasibility studies, R&D projects, and audit planning.
 Common project scheduling techniques include Gantt Chart, ‘PERT’ and Critical Path Method:
 GANTT CHART, invented by American engineer Henry Gantt, is a graphic schedule (usually a horizontal
bar graph) used for planning, controlling and recording progress towards completion of a project.
Tasks Present  The entire project is composed of four

50% tasks (i.e., A, B, C, and D).
A  The project started in January and is
B
30% expected to be finished in April.
 At present (February):
0%
C  All tasks are supposed to be performed
100% simultaneously.
D  Task B has the longest time to finish.
 Task C has not been started yet (0%).
Jan Feb Mar Apr  Task D is finished (100%) ahead of time.

 Program Evaluation and Review Technique (PERT) is a project scheduling technique that uses network
models for planning and controlling large-scale projects that have many interrelated activities. A PERT
network is composed of nodes (representing ‘events’) and arrows (representing ‘activities’):
 EVENT is a discrete moment in time representing the start or finish of an activity.
 ACTIVITY is a task (consumes time and resources) that must be accomplished. Two types are:
1) SERIES – an activity that cannot be performed unless its predecessor activity is done.
2) PARALLEL – activities that can be performed simultaneously.
 PATH is series of activities from start to finish.
A 5  4 events: B, A, E, and D
2  4 activities:
 Parallel: B-A & B-E, A-D & E-D
d d
B D  Series: B-A & A-D, B-E & E-D
a a  2 paths:
y y  Longer path (7): B-A-D – critical!
3 E 2  Shorter path (5): B-E-D
 d
CRITICAL PATH d
is the path that takes the longest time to finish through the PERT network.
 EXPECTED aTIME (te) is the average
a time an activity would require if it were repeated several times.
y y
te = (to + 4 tm + tp) ÷ 6 Where: to - optimistic time; tm – most likely time; tp – pessimistic time
 SLACK TIME is the amount of time an activity can be delayed without delaying the entire project.
 CRITICAL PATH METHOD (CPM), which uses deterministic time and cost estimates, may be considered
as a subset of PERT. CPM also includes the concept of crash time and crash costs.
 NORMAL TIME is the maximum time required to complete an activity at normal costs.
 CRASH TIME is the minimum possible time in which an activity can be completed, usually under
rush or urgent condition, using additional resources (e.g., overtime, extra labor, new machine).
 CRASH COSTS are the costs incurred when a project is completed based on its crash time.
 LEARNING CURVE (a.k.a., Experience Curve) is based on the proposition that labor hours decrease in a
definite pattern as labor operations are repeated. Learning curve describes the efficiencies arising from
experience, because with experience comes increased productivity. This productivity increases with
production size, but at a decreasing rate as diagrammed below:
Units  The time required to perform a given task becomes progressively

produced shorter, but this is applicable only to the early stages of production.
per day
 The learning curve is based on statistical findings that as the
cumulative output doubles, the cumulative average labor input time
,,
required per unit will be reduced by some percentage, ranging
between 10% and 40%.
 The learning curve is usually designated by the complement of the
rate of reduction -- if the rate of reduction is 20%, then there is an
Cumulative Production 80% learning curve.
NOTE: The learning curve-associated formula of “Y=aXb” is not used for CPALE purposes since the exponent
‘b’ requires the use of non-basic calculators to solve logarithm functions.
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Week No. 13: QUANTITATIVE TECHNIQUES with INVENTORY MANAGEMENT
INVENTORY MANAGEMENT
 The central issue in inventory management is to maintain an optimum investment in inventories that
considers a risk-reward tradeoff based on the following: overinvesting in inventory to avoid shortages and
incurring excessive costs vs. underinvesting in inventory to save costs, but incurring the risk of shortages.
 Two general approaches to systems of inventory management:
 MATERIALS REQUIREMENT PLANNING (MRP) is suitable for determining the quantity and order timing of
raw materials based on sales forecast and scheduled production of finished goods.
 “JUST-IN-TIME” (JIT) [covered in MAS-10] is a demand-pull system that focuses on real usage, rather
than sales forecast (as opposed to MRP) in order to maximize space, minimize insurance costs,
eliminate waste (non-value-added activities), lower inventory carrying costs, and free-up capital.
MRP is a computer-based system that focuses on meeting requirements of the ‘projected’ usage or demand
while JIT is very much focused on the current, ‘real’ usage or demand while the system runs.
 MRP must be distinguished from MANUFACTURING RESOURCE PLANNING (MRP-II). MRP II evolved from
early MRP systems by including the integration of additional data, such as employee and financial needs.
MRP-II is a closed-loop system that integrates various functional areas of a manufacturing company (e.g.,
inventories, production, sales and cash flows).
 MRP and MRP-II must be distinguished from ENTERPRISE RESOURCE PLANNING (ERP). ERP integrates the
information systems of the whole enterprise where organizational operations are inter-connected while the
organization itself is connected with its customers and suppliers.
 Activity-Based Costing (under MAS-10) must be distinguished from inventory management’s ABC
Classification system. ABC Classification system is an inventory categorization method based on the Pareto
Principle in economics (“In any group, there are significant few and insignificant many”):
 A items – high-value items (relatively few in number) requiring highest possible control
 B items – medium-value items requiring normal or moderate control
 C items – low-value items (relatively many in number) requiring the simplest possible control
 INVENTORY MODEL exists to address two basic inventory management questions:
1) “How many units should be ordered?”
ECONOMIC ORDER QUANTITY (EOQ) refers to the order size (number of units) that minimizes the sum
of ordering costs and carrying costs.
 CARRYING COSTS – increases with order size and units of inventory on hand.
Examples: Storage, insurances, normal spoilage, security, record keeping
 ORDERING COSTS – decreases with order size and units of inventory on hand.
Examples: Delivery, inspection, handling, purchasing, receiving, quantity discount lost
Where: D  Annual Demand or usage in units

2DO
EOQ = O  Costs of placing one Order
C C  Cost of Carrying one unit for one year
Carrying Costs = (EOQ ÷ 2) x C Where: (EOQ ÷ 2)  Average inventory in units
Ordering Costs = (D ÷ EOQ) x O Where: (D ÷ EOQ)  Number of orders per year
NOTE: If safety stock is maintained, then average inventory = (EOQ ÷ 2) + safety stock
Assumptions & limitations of EOQ model:
1. Demand occurs evenly at a constant rate throughout the year.
2. For each order, units are received in a single delivery and lead time is constant or does not vary.
3. The unit cost of the inventory is constant; hence, there can be no quantity discounts.
4. There is no limit as to the order size or the number of units that may be ordered.
2) “When should the unit be reordered?”
REORDER POINT refers to the number of units at which goods should re-ordered to minimize on the
sum of carrying costs and stock-out costs.
 STOCK-OUT COSTS are opportunity costs and other costs incurred when an item is out of stock
(e.g., lost contribution margin on sales)
Reorder Point = Delivery Time Stock + Safety Stock

(Alternative Formula: Reorder Point = Maximum Lead Time x Average Usage per Unit of Time)
Where: Delivery Time Stock = Normal Lead Time x Average Usage per Unit of Time
Safety Stock = (Maximum Lead Time – Normal Lead Time) x Average Usage per Unit of Time
LEAD TIME is period from the time an order is placed until such time the same order is received.
 Normal/Average lead time - this refers to the usual delay in the receipt of ordered goods
 Maximum lead time - this adds to normal lead time a reasonable allowance for further delay
SAFETY STOCK (a.k.a. buffer stock) refers to the extra number of units maintained to protect against
stock-out costs during periods of uncertain lead time and demand. Alternatively, safety stock may be
computed using the demand-based formula: (Maximum Usage – Normal Usage) x Normal Lead Time
 Applications of EOQ:
 When used for production, EOQ becomes the ECONOMIC LOT SIZE (ELS):
Where: P  Annual Production in units
2PS
ELS = S  Setup costs per batch of production
C C  Cost of Carrying one unit for one year
 When used for cash management, EOQ becomes the OPTIMAL CASH BALANCE or the “Baumol Model.”
[The Baumol model shall be thoroughly discussed in MAS-12 (Working Capital Management).]
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EXERCISES: QUANTITATIVE TECHNIQUES with INVENTORY MANAGEMENT

1. PERT network
Paubaya Construction, Inc. will soon begin to work on a building project. The construction firm’s schedule
of activities and related expected completion time are presented in the following time table:
Activity Code Activity Description Estimated Time (in weeks)
A–B Obtain on-site work permits 3
B–E Repair damages done by vandals 7
B–C Inspect construction materials left on site 1
C–E Order and receive construction materials 2
C–D Apply for waiver to add new materials 1
D–E Obtain waiver to add new materials 3
E–F Perform electric work 6
F–G Complete interior partitions 4
REQUIRED:
A) Prepare the PERT network.
B) Determine the critical path and its completion time in weeks.
C) Determine the shortest path and its slack time in weeks.
2. Critical Path Method & Expected Time

E-Why & Co., one of the leading accounting firms, is planning for a certain audit engagement based on the
following PERT network (time in days):
START
A FINISH
L I S T
U
REQUIRED:
A) Determine the expected time (te) for each activity.
B) Identify the critical path(s).
C) What is the shortest time in days to complete the entire project?
3. Crash Time & Crash Costs
Mimiyuuuh Builders uses the critical path method to monitor construction jobs. The company is currently 2
weeks behind schedule on Job #168, which is subject to a P 10,500 per week completion penalty.
Mimiyuuuh desires to reduce the normal completion time of Job #168 and, at the same time, report the
highest possible income. Path A-B-C-F-G-H-I has a normal completion time of 20 weeks, and a critical path
A-D-E-F-G-H-I has a normal completion time of 22 weeks. The following activities can be crashed:
Activities Cost to Crash 1 Week Cost to Crash 2 Weeks
BC P 8,000 P 15,000
DE 10,000 19,600
EF 8,800 19,500
What activity (activities) should Mimiyuuuh crash?
a. Activity EF (2 weeks) c. Activity BC (1 week) & activity EF (1 week)
b. Activity BC (1 week) & activity DE (1 week) d. Activity DE (1 week) & activity EF (1 week)
4. Learning Curve
A particular manufacturing job is subject to an estimated 80% learning or experience curve. The first unit
required 20 labor hours to complete.
REQUIRED:
A) What is the cumulative average time per unit after four (4) units are completed?
B) How many hours are required to produce a total of two (2) units?
C) How many hours are required to produce the second unit?
D) Which of the following unfavorable variances would be directly affected by the relative position of a
production process on the learning curve?
a. Material price c. Labor rate
b. Material usage d. Labor efficiency
5. Economic Order Quantity
Jimin Company requires 40,000 units for its signature product BTS. The units will be used evenly
throughout the year. The cost to place one order is P 20 while the cost to carry the inventory for one year
is P 0.40 per unit.
REQUIRED:
A) Determine the optimal order quantity (EOQ).
B) How many orders should be placed within the year?
C) How often should the units be ordered within a year?
D) Determine the average inventory in units.
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6. Carrying Costs vs. Ordering Costs

Based on an EOQ analysis, the optimal order quantity is 4,000 units. Annual inventory carrying costs equal
30% of the average inventory level. The company pays P 10 per unit to buy the product and P 400 to place
an order. The monthly demand for the product is 5,000 units.
A) Annual inventory carrying costs.
B) Annual inventory ordering costs.
C) Total inventory costs.
7. Reorder Point & Safety Stock

EZ Mil Company purchases 7,500 units of its lone product per annum. The company works 300 days per
year. The normal purchase lead time is 7 working days while maximum lead time is 10 working days.
REQUIRED:
A) How many units should EZ Mil maintain as safety (buffer) stock?
B) What is EZ Mil’s reorder point for the laundry soaps?
8. Stock-Out Costs
Each stock-out of a product sold by Pingleni Company costs P 2,000 per occurrence. The carrying cost per
unit of inventory is P 5 per year and the company orders 1,500 units of product 18 times a year at a cost of
P 200 per order. The probability of a stock-out at various levels of safety stock is:
Units of Safety Stock Probability of a Stock-Out

0 50%
200 30%
400 14%
600 5%
800 1%
What is the optimal level of safety stock for Pingleni?
a. 200 units c. 600 units
b. 400 units d. 800 units
9. Economic Lot Size
SM (Soriano-Manuel) Bookstore publishes a book about RFBT. SM prints 5,000 copies of the book evenly
throughout the year. The set-up cost is P 10 while the optimal production run (economic lot size) is 200.
REQUIRED:
How much is the unit carrying cost of the book per year?
1. Which of the following is heavily weighted in calculating PERT’s expected time?
a. Idealistic time c. Optimistic time
b. Most likely time d. Pessimistic time
2. The critical path through a PERT network is the path that has (the)
a. Zero slack time c. Shortest completion time
b. Highest slack time d. Uncertain completion time
3. An 80% learning curve means that:
a. The incremental time for each unit is 80% of the time of the unit before it
b. The cumulative average time is 80% of the cumulative average time at the previous unit
c. As production doubles, the incremental time for a unit is 80% of the time at the previous
doubling point
d. As production doubles, the cumulative average time is 80% of the time at the previous
doubling point
4. A computerized inventory system that simulates needed materials for the finished product, and then
compares production need to available inventory balance to determine when orders should be placed.
a. EOQ system c. Just-In-Time system
b. Electronic Data Interchange d. Material Requirements Planning System
5. In ABC classification system of inventory control, class “A” inventory consists of
a. Few low-value items c. Many low-value items
b. Few high-value items d. Many high-value items
6. The optimal level of inventory would be affected by all of the following, except the:
a. Cost per unit of inventory
b. Current level of inventory
c. Usage rate of inventory per time period
d. Cost of placing an order for the merchandize
7. The purpose of economic order quantity (EOQ) is to minimize
a. the safety stock
b. the inventory quantities
c. the sum of the demand costs and the back-log costs
d. the sum of the ordering costs and holding (carrying) costs
8. Which of the following is not considered a cost of carrying inventory?
a. Shipping and handling c. Insurance
b. Property tax d. Depreciation and obsolescence
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9. The ordering costs associated with inventory management include

a. Insurance costs, purchasing costs, shipping costs, and spoilage
b. Obsolescence, setup costs, quantity discounts lost, and storage costs
c. Purchasing costs, shipping costs, setup costs, and quantity discounts lost
d. Shipping costs, obsolescence, setup costs, and capital invested
10. In inventory management, the safety stock will tend to increase if the
a. Carrying cost increases c. Variability of the lead time increases
b. Cost of running out of stock decreases d. Variability of the usage rate decreases
SELF-TEST QUESTIONS – with suggested answers to selected items

Answers to some items shall be given during Week 13 discussion
1.PERT and the critical path method (CPM) are used for
B a. Determining product costs
b. Project scheduling and control
c. Determining the optimal product mix
d. Determining the number of servers needed in a fast-food restaurant
2. The Gantt chart used in project management combines which of the following functions?
C a. Planning and leveling c. Planning and scheduling
b. Scheduling and evaluating d. Scheduling and controlling
3. A company is controlling a complex project by focusing on activities that have the greatest influence on the project’s
estimated completion date. What quantitative technique is most relevant to the company?
C a. Cost-volume-profit analysis c. Program evaluation review technique
b. Parametric programming d. Queuing analysis
4. Program evaluation and review technique (PERT) is a system that uses:
D a. Least square method c. Economic Order Quantity (EOQ) formula
b. Linear programming d. Network analysis
5. When using PERT, the expected time for an activity when given an optimistic time (A), a pessimistic time (B), and a
most likely time (m) is calculated by which one of the following formulas?
C a. (b – a) ÷ 2 c. (a + 4m + b) ÷ 6
b. (a + b) ÷ 2 d. (4abm) ÷ 6
6. Orange Firm is considering a research project. The time estimates for completion of the project are:
Optimistic: 2 months Most likely: 4 months Pessimistic: 9 months
Using PERT-CPM approach, what is the expected time for completion of the project?
a. 4 months c. 5 months
b. 4.5 months d. 5.5 months
7. The critical path is the
D a. maximum amount of time an activity may be delayed without delaying the entire project
b. earliest starting time that an activity for a project can begin
c. pessimistic time estimate for an activity of a project
d. longest time path from the first event to the last event for a project
8. Apple Company presents the following PERT-CPM data for a certain project:
Activity Time in Weeks Preceding Activity
A 3 -
B 3 A
C 7 A
D 4 A
E 2 B
F 4 B
G 1 C,E
H 5 D
Determine the project’s (A) completion time of the critical path and (B) slack time of the shortest path.
a. (A) 12 weeks (B) 3 weeks c. (A) 11 weeks (B) 2 weeks
b. (A) 12 weeks (B) 2 weeks d. (A) 10 weeks (B) 1 week
9. The primary difference between PERT and CPM is that
D a. CPM uses probabilities on the activity times and PERT does not
b. PERT considers activity costs and CPM does not
c. PERT can assign probabilities to activity times and CPM does not
d. CPM considers activity costs and PERT does not
10. When doing a cost-time trade-off in PERT analysis, the first activity that should be crashed is the activity
D a. With the largest amount of slack
b. With lowest unit crash cost
c. On the critical path with the maximum possible time reduction
d. On the critical path with the lowest unit crash cost
11. A Gantt chart
D a. Shows the critical path for a project
b. Is used for determining an optimal product mix
c. Shows only the activities along the critical path of a network
d. Does not necessarily show the critical path through a network
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12. If a cost function behaves that the average costs per unit of output decline systematically as cumulative production
doubles, the cost function is referred to as a:
B a. Parabolic curve c. Linear cost curve
b. Learning curve d. Growth curve
13. What is the cost factor that is LEAST likely to be affected by the learning curve?
A a. Materials c. Indirect labor
b. Direct labor d. Variable overhead
14. A particular manufacturing job is subject to an estimated 90% learning curve. The first unit required 50 labor hours to
complete. What is the cumulative average time per unit after four units are completed?
a. 50 hours c. 40.5 hours
b. 45 hours d. 40 hours
15. Orange Company expects a 90% learning curve. The first batch of a new product required 100 hours. The second
batch should take:
a. 100 hours c. 80 hours
b. 90 hours d. 45 hours
16. Mango Company manufactured the first batch of product in 10 hours. The second batch took an additional 6 hours.
What percentage learning occurred?
a. 100% c. 80%
b. 90% d. 60%
17. Kiwi Company used 30 hours to produce the first batch of units. The second batch took an additional 18 hours. How
many hours will the first four batches require?
a. 48 hours c. 96.2 hours
b. 76.8 hours d. 120.0 hours
18. The following information on the utilization of a new software package was collected:
Number of tasks Total time to perform all tasks Average time to perform each task
1 10 minutes 10 minutes
2 18 minutes 9 minutes
4 32.4 minutes 8.1 minutes
If this learning effect continues, what is the average time to perform each of the first eight (8) tasks?
B a. 6.83 minutes c. 7.75 minutes
b. 7.29 minutes d. 8.10 inutes
19. The average labor cost per unit for the first batch produced by a new process is P 120. The cumulative average labor
cost after the second batch is P 72 per product. Using a batch size of 100 and assuming the learning curve continues,
what is the total labor cost of four batches?
D a. P 4,320 c. P 2,592
b. P 10,368 d. P 17,280
20. Fruit Point Manufacturing recently completed and sold an order of 50 units that had the following costs:
Direct labor 8,500
Variable overhead 4,000*
Fixed overhead 1,400**
TOTAL P 15,400
* Applied on the basis of direct labor hours. ** Applied at the rate of 10% of variable cost.
The company has been requested to prepare a bid for 350 units of the same product
If an 80% learning curve is applied, what is the total cost on the bid-order for 350 units?
a. P 26,400 c. P 37,950
b. P 31,790 d. P 54,120
21. The economic order quantity formula indicates that
D a. Annual quantity of inventory to be carried c. Safety stock plus estimated inventory for the year
b. Annual usage of materials during the year d. Quantity of each individual order during the year
22. Which of the following is NOT involved in the computation of the economic order quantity?
A a. Lead-time from order placement until order fulfillment
b. Number of units expected to be sold or used during the year
c. Cost of placing and receiving an order
d. Cost of obtaining capital as carrying costs
23. One of the elements included in the economic order quantity (EOQ) formula is
B a. Safety stock c. Selling price of the item
b. Yearly demand d. Lead time for the delivery
24. The following data refer to various annual costs relating to the inventory of a single-product company:
Unit freight on purchase P 0.20
Storage per unit P 0.12
Insurance per unit P 0.10
Annual interest foregone from alternate investment of funds P 8,000
Annual number of units required 100,000
What is the annual carrying cost per unit?
a. P 0.22 c. P 0.42
b. P 0.30 d. P 0.50
25. Melon Company sells 20,000 radios evenly throughout the year. The cost of carrying one unit in inventory for one year
is P 8, and the purchase order cost per order is P 32. What is the economic order quantity?
B a. 200 units c. 500 units
b. 400 units d. 600 units
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26. Tamarind Company manufactures bookcases. Set up costs are P 2.00. Tamarind manufactures 4,000 bookcases
evenly throughout the year. Using the economic order quantity approach, what is the optimal production run would be
200 when the cost of carrying one bookcase in inventory for one year?
D a. P 0.05 c. P 0.20
b. P 0.10 d. P 0.40
27. Pomelo, Inc. has determined the following for a given year:
Economic order quantity (standard order size) 5,000 units
Total cost to place purchase orders for the year P 10,000
Cost of place one purchase order P 50
Cost carry one unit for one year P4
What is Pomelo’s estimated annual usage in units?
a. 1,000,000 c. 4,000,000
b. 2,000,000 d. 2,250,000
28. Jackfruit Company has computed its EOQ as 500 units. However, management would rather order in quantities of 600
units. How will Jackfruit’s total purchase order cost and total annual carrying cost for an order quantity of 600 units
compared to the respective amounts for an EOQ of 500 units?
D a. Higher purchase order cost and higher carrying cost.
b. Lower purchase order cost and lower carrying cost.
c. Higher purchase order cost and lower carrying cost.
d. Lower purchase order cost and higher carrying cost.
29. Which of the following would tend to increase the holdings of inventory quantity in the future?
B a. Increased computer control c. Standardization of products
b. Increased rate of sales growth d. Limiter variety of products
30. The amount of inventory that a company would tend to hold in stock would increase as the
B a. Variability of sales decreases
b. Cost of carrying inventory decreases
c. Cost of running out of stock decreases
d. Sales level fails to a permanently lower level
31. Which statement best summarizes the factor that affects the level of safety stock that a firm will carry?
D a. The amount of idle cash that management believes it has to invest in safety stock
b. The rapidity with which the inventory position will turn over
c. The level of production the firm’s bank is willing to finance
d. The level of uncertainty with respect to a stock-out condition that management is willing to accept
32. A company has EOQ of 10,000 units and a safety stock of 2,000 units. The cost per unit of inventory is P 5.00 and the
carrying cost is 10% of the average value of inventory. What is the annual inventory carrying cost?
B a. P 3,000 c. P 5,000
b. P 3,500 d. P 6,000
33. The following information relates to Pear Company’s raw materials:
Annual usage in units 7,200 Normal lead time in days 20
Working days per year 240 Maximum lead time in days 45
Assuming even demand for materials during the year, what is the (A) safety stock and (B) order point?
D a. (A) 600 (B) 750 c. (A) 750 (B) 600
b. (A) 600 (B) 1,350 d. (A) 750 (B) 1,350
34. The annual demand for a single product is 4,000 units. The cost to carry one unit is P 0.50 while cost per order
amounts to P 10.00. The average inventory being carried is computed for 225 units. How many units of safety stock
are being maintained?
a. 25 units c. 200 units
b. 50 units d. None
35. Guyabano Company wishes to determine the amount of safety stock they should maintain for Product No. 333 to result
in the lowest cost. Each stock-out costs P 75 and the carrying costs of each unit of safety stock is P 1. Product No.
333 will be ordered five times a year.
Which of the following will produce the lowest cost?
C a. A safety stock of 10 units that is associated with a 40% probability of running out of stock
b. A safety stock of 20 units that is associated with a 20% probability of running out of stock
c. A safety stock of 40 units that is associated with a 10% probability of running out of stock
d. A safety stock of 80 units that is associated with a 5% probability of running out of stock
36. India operates a chain of hardware stores across Manila. The controller wants to determine the optimum safety stock
levels for an air purifier unit. The inventory manager compiled the following data:
 The annual carrying cost of inventory approximates 20% of the investment in inventory.
 The inventory investment per unit averages P 50.
 The stock-out cost is estimated to be P 5 per unit.
 The company orders inventory on the average of 10 times per year.
 The probabilities of a stock-out per order cycle with varying levels of safety stock are as follows:
Safety Stock Stock-out Probability
200 units 0 0%
100 units 100 units 15%
0 100 units 15%
0 200 units 12%
What is the total cost of safety stock on an annual basis with a safety stock level of 100 units?
B a. P 550 c. P 1,950
b. P 1,750 d. P 2,000
This study
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MAS-10: ABC, BALANCED SCORECARD & STRATEGIC COST MANAGEMENT

ACTIVITY-BASED COSTING (ABC)
 ABC is a costing method that uses ‘activities’ as basis to allocate overhead and indirect costs to products.
 ABC provides reliable data for product costing by using multiple cost drivers that are more reflective of the
actual causes of incurred overhead costs.
 ABC is an alternative to the broad-averaging, volume-based conventional practice of Traditional Costing.
 Under the TRADITIONAL COSTING, overhead costs are allocated to products by using a single cost
driver (usually labor hour). This costing is suitable for labor-intensive, low-overhead companies.
Traditional costing (a.k.a. peanut-butter costing) is simple and inexpensive to implement.
 Under ABC, overhead costs are allocated to products using several cost drivers associated with the
identified cost pools. ABC is suitable for capital-intensive, product-diverse and high-overhead
companies. ABC often leads to accurate product costing and elimination of non-value-added activities.
 While ABC is mostly applied on manufacturing costs, ABC may also be used for shared or common period
costs (e.g., customer service, promotion, record keeping and shipping costs).
 ABC is typically a ‘two-stage’ allocation process: First, overhead costs are traced to activities (first cost
object); then, overhead costs are allocated to products (final cost object) on the basis of the activities done.
 ABC implementation usually involves the following steps:
1) Identify activities, cost drivers and cost pools.
 Activities are commonly grouped into four categories:
1) Unit-level activities - performed for each unit of product (e.g., direct materials).
2) Batch-level activities - performed for each batch of production or sales (e.g., setup, inspection).
3) Product-level activities - performed to support product line as a whole (e.g., advertisement)
4) Facility-level activities - performed to sustain an entire facility’s overall process (e.g., security)
 COST DRIVER is the particular activity that causes the incurrence of certain costs.
 COST POOL is a group of mostly homogeneous costs associated with a common cost driver.
2) Calculate predetermined overhead rates for each identified activity.
Predetermined overhead rate = Estimated overhead costs ÷ Estimated activity level
NOTE: Estimated figures are used because actual figures are not yet known at the start of the period.
3) Allocate overhead costs to the products on the basis of predetermined overhead rates.
 ACTIVITY-BASED MANAGEMENT (ABM) refers to the application of ABC and process value analysis
(identifying value-added vs. non value-added activities) in evaluating business activities to improve
strategic and operational decisions in an organization. The main goal of ABM is to maximize customer value
and minimize non-value-added activities/costs.
 VALUE-ADDED activities are necessary activities that incur costs but increase the perceived value of a
particular product to the customer. Example: engineering designs modification.
 NON-VALUE-ADDED activities are operations that are either (1) unnecessary or dispensable, or (2)
necessary, but inefficient and improvable. Example: rework of defective units.
BALANCED SCORECARD
 BALANCED SCORECARD (BSC) is an approach to performance measurement that combines traditional
financial measures with non-financial performance measures.
 BSC was created by David Norton and Robert Kaplan in response to VALUE-BASED MANAGEMENT, which is
a performance evaluation technique that focuses on traditional financial measures.
 BSC translates an organization’s mission and strategy into a comprehensive set of financial (lagging
indicators) and non-financial performance (leading indicators) metrics classified into four (4) perspectives:
1) FINANCIAL (“How do we look to shareholders?”)
Measures: profit, return on investment (RoI), operational cash flows
2) CUSTOMER (“How do customers see us?”)
Measures: rank in customer surveys, repeat order rate, market share, number of complaints
3) INTERNAL BUSINESS PROCESSES (“What must we excel at?”)
Measures: manufacturing cycle efficiency, delivery cycle time, scrap and rework, productivity factor
4) LEARNING & GROWTH (“Can we continue to improve and create value?”)
Measures: employee satisfaction ratings, employee turnover rate, training days for employees
NOTE: Measures in the internal business process, learning and growth perspectives (controllable factors)
are the primary drivers of measures in the customer and financial perspectives (non-controllable factors).
 STRATEGY MAPPING is a process that links the four BSC perspectives with company strategies based on a
cause-and-effect pattern to see where value can be added further. A typical BSC report contains:
 STRATEGIC OBJECTIVES – statements of what strategy must achieve and what is critical to its success.
 STRATEGIC INITIATIVES – key action programs required to achieve strategic objectives.
 PERFORMANCE MEASURES – describe how success in achieving the strategy will be measured.
 BASELINE PERFORMANCE – the current level of performance for the performance measure.
 TARGETS – the level of performance or rate of improvement needed in the performance measure.
NOTE: Strategic objectives focus on WHAT is to be achieved. Strategic initiatives focus on HOW it will be
achieved. Performance measures, baseline performance and targets relate to how it will be MEASURED.
 KEY PERFORMANCE INDICATORS (KPIs) are specific, measureable financial and non-financial elements of a
firm’s performance that are vital to its competitive advantage.
 In summary, BSC provides a framework not only for performance measurement but also for execution of
company strategies by helping management identify what needs to be done and how its achievement can
be measured to determine organizational success.

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Week No. 11: ABC, BALANCED SCORECARD & STRATEGIC COST MANAGEMENT
STRATEGIC COST MANAGEMENT

 STRATEGIC COST MANAGEMENT (SCM) is the process of reducing total costs while improving the strategic
position of a business, accomplished by managing costs and aligning them to the business strategy.
 Three (3) generic strategies in order to achieve sustainable competitive advantage are:
1) COST LEADERSHIP – providing same or better value to customers at a cost lower than competitors’.
2) DIFFERENTIATION – strives to increase customer value by increasing what the customer receives.
3) FOCUS – a firm selects and emphasizes a customer segment in which to compete (i.e., market niche)
 SCM involves recognition of the importance of cost relationships among various activities in the VALUE
CHAIN (a sequence of activities required to design, develop, produce, market and deliver products and
services to customers) in relation to CUSTOMER VALUE (the difference between what is received and given
up by the customer when buying a product or service).
 LIFE-CYCLE COSTING determines the total cost of a product over its life cycle by dividing costs into:
 UPSTREAM or UPWARD costs (examples: R&D, design engineering, target costing, testing)
 Production costs
 DOWNSTREAM or DOWNWARD costs (examples: marketing, distribution, sales, customer service)
WHOLE-LIFE COSTS = LIFE-CYCLE COSTS + after-purchase costs incurred by the customers
Product’s life cycle (marketing viewpoint) is also based on: 1) introduction 2) growth 3) maturity 4) decline
 TARGET COSTING involves the determination of the desired product cost based on a given market price and
given desired profit. In target costing, a company may reduce its cost to reach the target level through
VALUE ENGINEERING, which involves a thorough examination of the value chain aimed at reducing product
costs without sacrificing customer satisfaction. (See MAS-04 for more details on Target Costing)
 TOTAL QUALITY MANAGEMENT (TQM) is a management technique that integrates all organizational
functions (marketing, finance, design, engineering, production, and customer service) to focus on meeting
customer expectation and business objectives.
 TQM requires developing policies to ensure that products and services exceed customer’s expectations
 TQM is a formal effort to ensure and improve quality throughout an entity’s value chain.
 QUALITY COSTS are incurred on quality related processes to prevent defects or incurred as a result of
defects occurring. Quality costs are classified into:
1) CONFORMANCE COSTS are incurred to keep defective products from falling into the hands of customers.
 Prevention Costs (examples: employee training, equipment maintenance, systems development)
 Appraisal Costs (examples: inspection and testing)
2) NON-CONFORMANCE COSTS are incurred because defects are produced despite efforts to avoid them.
 Internal Failure Costs (examples: scrap, spoilage, rework, downtime)
 Externa Failure Costs (examples: warranty repairs, product lawsuits)
 CONTINUOUS IMPROVEMENT is the constant effort to eliminate waste, reduce response time, simplify the
design of both products and processes, and improve quality and customer service. Continuous improvement
can be done in two ways:
1) KAIZEN is the gradual process of reducing costs during the manufacturing phase of an existing product
through small and continual improvements rather than through radical “big-time” changes.
2) BUSINESS PROCESS REENGINEERING (BPR) involves redesigning business process to reduce costs and
eliminate inefficiencies and opportunities for errors. Common features of BPR include:
 Radical, quick, significant and drastic approach to improvement
 Business process is diagrammed in details, analyzed and completely redesigned
 Simplification of business process
 Elimination of non-value-added activities.
 JUST-IN-TIME (JIT) is a “demand-pull” system where inventories are purchased/produced only as needed
for production/sale, reduced to the minimum level and, in some cases, reduced to zero (i.e., elimination of
non-value-added costs). JIT can be classified into two categories:
 JIT Purchasing - raw materials are received just in time for production; goods for sale are received just
in time for delivery or sale.
 JIT Manufacturing – manufactured materials are completed just in time for production; products are
completed just in time for delivery.
JIT NON-JIT (Traditional/Conventional)
Demand-pull system Push-through system
Insignificant inventories Significant inventories
Small supplier base Large supplier base
Long-term supplier contracts Short-term supplier contracts
Cellular structure Departmental structure
Multi-skilled labor Specialized labor
Decentralized services Centralized services
High employee involvement Low employee involvement
Facilitating management style Supervisory management style
Total quality control Acceptable quality level
Value-chain focus Value-added focus
 BENCHMARKING involves the following three (3) steps: 1) Identifying critical success factors 2) Studying
the best practices of other firms based on identified success factors 3) Implementing needed improvements
to match or beat the performance of other firms.
 THEORY OF CONSTRAINTS (TOC) emphasizes the importance of managing a company’s constraints that
hinder progress toward an objective. TOC is a perfect complement to TQM and BPR – it focuses
improvement efforts where they are likely to be most effective.
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EXERCISES: ACTIVITY-BASED COSTING, BALANCED SCORECARD & STRATEGIC COST MANAGEMENT

1. Activity Levels
Determine the appropriate level for each of the following activities or costs. Indicate whether the
activity is unit-level (UL), batch-level (BL), product-level (PL), facility-level (FL):
A) Equipment setups E) Designing, changing and advertising
B) Plant supervision F) Heating, lighting
C) Prime costs G) Research and development
D) Packaging and shipments H) Product order processing
2. Traditional Costing vs. ABC

CPA Company incurs P 800,000 in manufacturing overhead costs. The company has been allocating
overhead to individual product lines based on direct labor hours.
Cost Driver Amount in Cost Pool Amount of Activity
Direct labor hours P 300,000 40,000
Number of batches 300,000
, 1,000
Number of shipments 200,000 500
Total overhead costs P 800,000
Two products have the following characteristics:
Product X Product Y
Direct labor hours 2,000 1,000
Number of batches 24 30
Number of shipments 2 150
REQUIRED:
Determine the overhead costs to be allocated to each product (X and Y) using:
A) Traditional costing (based on direct labor hours)
B) Activity-based costing (ABC)
3. Application of Overhead Costs
3A) CMA Company uses a predetermined overhead rate based on direct labor hours to apply manufacturing
overhead to jobs. Estimated and actual data for direct labor and manufacturing overhead last year are
as follows:
Estimated Actual
Manufacturing overhead P 720,000 P 700,000
Direct labor hours 600,000 550,000
What was the manufacturing overhead for CMA Company for last year?
a. Over-applied by P 20,000 c. Over-applied by P 40,000
b. Under-applied by P 20,000 d. Under-applied by P 40,000
3B) CIA Company uses activity-based costing to compute product costs for external reports. The company
has three activity centers and applies overhead using predetermined overhead rates for each activity
center. Estimated costs and activities for the current year are presented below:
Estimated Overhead Cost Expected Activity
Activity 1 P 18,000 1,200
Activity 2 P 57,600 2,400
Activity 3 P 97,200 3,600
Actual costs and activities for the current year were as follows:
Actual Overhead Cost Actual Activity
Activity 1 P 19,500 1,250
Activity 2 P 65,000 2,500
Activity 3 P 90,000 3,750
What was the amount of overhead applied for Activity 2 during the year?
a. P 5,000 over-applied c. P 4,800 over-applied
4. Manufacturing Cycle Efficiency

CFA Company keeps careful track of the time related to orders and their production. During the most
recent quarter, the following average times were recorded for each unit or order:
Inspection time 2 days
Process time 4 days
Queue time 6 days
Move time 8 days
Wait time 10 days
REQUIRED:
A) How long in days is the manufacturing cycle time or throughput time?
B) What is the manufacturing cycle efficiency ratio?
C) What percentage of the production time is spent on non-value-added activities?
D) How long in days is the delivery cycle time?
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5. Productivity Measures
CISA Company manufactures and sells a single product. The following information was made available:
2020 2021
Unit sales (P 60 per unit) 10,000 15,000
Material usage 4,000 pounds 5,000 pounds
Material cost P 5 per pound P 10 per pound
Labor hours 2,000 hours 2,500 hours
Labor cost P 20 per hour P 25 per hour
5A) Determine the operational partial productivity of DIRECT MATERIAL for (1) 2020 and (2) 2021.
a. (1) 2.50 (2) 3.00 c. (1) 0.25 (2) 0.24
b. (1) 5.00 (2) 6.00 d. (1) 0.50 (2) 0.30
5B) Determine the operational partial productivity of DIRECT LABOR for (1) 2020 and (2) 2021.
a. (1) 2.50 (2) 3.00 c. (1) 0.25 (2) 0.24
b. (1) 5.00 (2) 6.00 d. (1) 0.50 (2) 0.30
5C) Determine the financial partial productivity of DIRECT MATERIAL for (1) 2020 and (2) 2021.
a. (1) 2.50 (2) 3.00 c. (1) 0.25 (2) 0.24
b. (1) 5.00 (2) 6.00 d. (1) 0.50 (2) 0.30
5D) Determine the financial partial productivity of DIRECT LABOR for (1) 2020 and (2) 2021.
a. (1) 2.50 (2) 3.00 c. (1) 0.25 (2) 0.24
b. (1) 5.00 (2) 6.00 d. (1) 0.50 (2) 0.30
5E) Determine the total productivity for 2020 as measured in both (1) units and (2) sales pesos.
a. (1) 0.667 (2) 40.00 c. (1) 1.667 (2) 100.00
b. (1) 0.167 (2) 10.00 d. (2) 6.667 (2) 400.00
WRAP-UP EXERCISES (MULTIPLE-CHOICE QUESTIONS)

1. Activity-based costing (ABC) can be applied to
a. Selling overheads c. Manufacturing overheads
b. Administrative overheads d. All of the choices
2. Which of these situations is most likely to use traditional costing rather than ABC?
a. High-overhead operations c. Labor-intensive production
b. Product-diverse companies d. Capital-intensive production
3. A good example of a unit-level activity is:
a. Machine hours c. TV advertisement
b. Machine setups d. Landscaping
4. A major objective of activity-based management (ABM) is to reduce or eliminate
a. Value-added activities c. Labor-intensive activities
b. Non-value-added activities d. Capital-intensive activities
5. In activity-based costing, which of the following would be considered as a value added activity?
a. Engineering design c. Storage and warehousing
b. Repair of machines d. Bookkeeping and accounting
6. CA Company produces two products in a single factory. The controller has determined total overhead
costs to be P 480,000: P 140,000 of which relates to material moves, P 150,000 relates to testing and
the remainder is related to labor time.
Product D2 Product E1
Production 10,000 2,000
Material moves (total) 100 40
Product tests (total) 250 125
Direct labor hours per unit 1 5
Under activity-based costing (ABC), how much is product D2’s overhead cost per unit?
a. P 40.00 c. P 24.00
b. P 29.50 d. P 12.00
7. The most common treatment of under-applied and over-applied overhead costs is to close it out to
a. Work in process c. Cost of goods sold
b. Retained earnings d. Finished goods
8. It translates an organization’s mission and strategy into a comprehensive set of performance measures
that provide the framework for implementing the company’s strategy.
a. Focus c. Balanced scorecard
b. Cost leadership d. Product differentiation
9. What is the MOST important purpose of a balanced scorecard?
a. Develop strategy c. Develop cause-and-effect linkages
b. Measure performance d. Set priorities
10. The balanced scorecard is said to be “balanced” because it measures
a. Internal and external objectives c. Financial and non-financial objectives
b. Short-term and long-term objectives d. All of the choices
11. Which of the following is NOT one of the four perspectives of the balanced scorecard?
a. Investment in resources perspective c. Customer perspective
b. Learning and growth perspective d. Financial perspective
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12. Which balance scorecard perspective is considered to be a lagging (rather than leading) indicator?
a. Customer c. Learning & growth
b. Financial d. Internal business processes
13. What is the correct order of strategy mapping that links the four balanced scorecard perspectives?
a. Financial, customer, internal business processes, learning & growth
b. Internal business processes, learning & growth, financial, customer
c. Learning & growth, internal business processes, customer, financial
d. Customer, financial, learning & growth, internal business processes
14. Which of the following is NOT a component of a typical balanced scorecard report?
a. Strategic objectives c. Strategy initiatives
b. Targets d. Assessment of human resources
15. Which is NOT among the three (3) generic strategies for a company to achieve competitive advantage?
a. Focus c. Market segmentation
b. Cost leadership d. Product differentiation
16. Process time + inspection time + move time + queue time (during production process) =
a. Wait time c. Throughput time
b. Delivery cycle time d. Lead time
17. What is the correct formula for manufacturing cycle efficiency (MCE) ratio?
a. Value-added time ÷ Throughput time c. Throughput time ÷ Delivery cycle time
b. Value-added time ÷ Lead time d. Non value-added time ÷ Throughput time
18. The unyielding and continuing improving effort by everyone in the organization to understand, meet and
exceed the customer expectations and uses front-line workers to solve problems systematically.
a. Just-in-time manufacturing c. Total quality management
b. Conventional manufacturing d. Total quantity management
19. Total Quality Management (TQM) should be viewed as
a. Goal centered and standard driven c. Customer centered and employee driven
b. Policy centered and procedure driven d. Management centered and technology driven
20. What are the four categories of quality costs?
a. Prevention, appraisal, internal failure, and external failure costs
b. Internal failure, external failure, carrying and ordering costs
c. Product liability, warranty, appraisal, and training costs
d. Training, testing, failure, and conformance costs
21. Identify the two (2) CONFORMANCE costs of quality.
a. Prevention and appraisal costs c. Appraisal and internal failure costs
b. Internal and external failure costs d. Prevention and internal failure costs
22. Identify the two (2) NON-CONFORMANCE costs of quality.
a. Prevention and appraisal costs c. Appraisal and internal failure costs
b. Internal and external failure costs d. Prevention and internal failure costs
23. Quality is achieved more economically if the company focuses on
a. Appraisal costs c. Internal failure costs
b. Prevention costs d. External failure costs
24. A quality cost incurred to detect individual units that do not conform to specifications is an example of
a. Prevention cost c. Internal failure cost
b. Appraisal cost d. External failure cost
25. Determine the false statement regarding failure costs.
a. Internal failure costs result from identification of defects during the appraisal process.
b. Internal failure costs include scrap, rejected products, rework and downtime.
c. It is generally better to incur internal failure costs than to incur external failure costs.
d. External failure costs are generally classified as value-added costs.
26. Following are items included in the quality cost report prepared for the last month:
Employee training costs P 50,000
Product testing P 20,000
Equipment maintenance P 80,000
Rework upon inspection P 25,000
a. Appraisal cost is P 25,000 c. External failure cost is P 20,000
b. Prevention cost is P 130,000 d. Internal failure cost is P 105,000
27. Which of the following is at the core of the definition of total quality management (TQM)?
a. Customer surveys c. Employee satisfaction
b. Continuous improvement d. Supplier inspections
28. A company desiring to achieve radical or drastic improvements in customer relationship management
would most likely undertake:
a. Kaizen c. Total quality management
b. Benchmarking d. Business process reengineering
29. Which of the following quality tools is another term for gradual yet continuous improvement?
a. Theory of constraints c. Six-sigma
b. Kaizen d. Lean manufacturing
30. “Kaizen costing” refers to
a. Radical cost reductions during the design phase of a product
b. Radical cost reductions during the manufacturing phase of a product
c. Small, continual cost reductions during the design phase of a product
d. Small, continual cost reductions during the manufacturing phase of a product
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31. In a product’s life cycle, the first symptom of the decline stage is a decline in
a. Product’s prices c. Product’s production cost
b. Product’s sales d. Firm’s inventory level
32. Determine the correct order of target costing process.
a. Market price, desired profit, target cost, cost reduction thru value engineering
b. Cost reduction thru value engineering, target cost, desired profit, market price
c. Target cost, desired profit, market price, cost reduction thru value engineering
d. Market price, target cost, cost reduction thru value engineering, desired profit
33. Value engineering
a. Is a basis for product costing and pricing
b. Determines the outcome and value added by each activity
c. Is a way of understanding how a company generates its output
d. Is a systematic approach to reaching a targeted cost level during a value chain analysis
without reducing customer satisfaction
34. The just-in-time manufacturing (JIT) system is also called the
a. Job-in-training system c. Zero-cost system
b. Job-in-transit system d. Zero-inventories system
35. JIT is based on notion that ‘work is initiated only in response to customer orders.’ This practice is
described as
a. Demand-pull c. Supply-pull
b. Demand-push d. Supply-push
36. Just-in-time purchasing (demand-pull system) requires
a. Smaller and more frequent purchase orders
b. Larger and more frequent purchase orders
c. Smaller and less frequent purchase orders
d. Larger and less frequent purchase orders
37. Which of the following is among the benefits of adopting a JIT system?
a. Increase in the number of suppliers
b. Reduction in the number of deliveries
c. Performance of non-value added activities
d. Maximization of standard delivery quality
38. Which of the following scenarios is considered as counter-productive?
a. Same outputs, fewer inputs c. More outputs, fewer inputs
b. More outputs, same inputs d. Fewer outputs, same inputs
39. The comparison of a company's practices and performance levels against those of other organizations
(or against the best possible level of performance) is most commonly known as
a. Benchmarking c. Comparative analysis
b. Re-engineering d. Continuous improvement
40. The Theory of Constraints suggests that improvement efforts shall be focused on the company’s
a. Value-added activities c. Constraints
b. Non-value-added activities d. Non-Constraints

1. An objective of activity-based management (ABM) is to
C a. Eliminate the majority of centralized activities in an organization
b. Institute responsibility accounting systems in decentralized organizations
c. Reduce or eliminate non-value-added activities done to make a product or provide a service
d. All of the above
2. What is a non-value-adding cost?
D a. Usually direct to a product c. Unavoidable
b. The same as a discretionary cost d. Not essential to manufacturing a product
3. A tool that focuses on manufacturing processes and seeks to optimize the activities performed within the process is
A a. Process value analysis c. Benchmarking
b. Re-engineering d. None of the above
4. What would be a value-added employee in a construction firm?
C a. An accountant c. A painter
b. A secretary d. All of the above
5. A well-designed Activity-Based Costing (ABC) system helps managers make better decisions because information
derived from an ABC analysis:
C a. Is easy to analyze and interpret
b. Emphasizes how managers can achieve higher sales
c. Can be used to reduce or eliminate non-value-added activities
d. Take the choices and judgment challenges away from the managers
6. Which of the following is least likely classified as a unit-level activity?
a. Peso sales c. Direct labor hours
b. Production volume d. Number of inspections
7. Which level of costs should NOT be included in product costs (mainly because indirect to product line segment) for
internal management reports that are used for decision making?
D a. Unit-level activities c. Product-level activities
b. Batch-level activities d. Facility-level activities
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8. These activities arise because a company does or maintains a particular type of business or product.
C a. Batch-level activities c. Sustaining activities
b. Facility-sustaining activities d. Unit-level activities
9. Property taxes and insurance is an example of a cost that would be considered to be
D a. Unit-level c. Product-level
b. Batch-level d. Organization-sustaining
10. Which of the following is typically regarded as a cost driver in traditional costing practices?
D a. Number of purchase order processed c. Number of transactions processed
b. Number of customers served d. Number of direct labor hours worked
11. Activity-based costing (ABC)
B a. Applied only to discretionary fixed costs
b. Requires the identification of cost drivers
c. Is used only in just-in-time (JIT) operations
d. Does not help to identify activities as value-adding or non-value-adding
12. A company using activity-based costing
A a. Tries to identify cost drivers
b. Is probably using the JIT philosophy
c. Allocates all costs to individual products
d. Looks for the activity with which total costs are most closely associated
13. What is a cost driver?
D a. Any activity that can be used to predict cost changes
b. The attempt to control expenditures at a reasonable level
c. The person who gathers and transfers cost data to the management accountant
d. Any activity that causes costs to be incurred
14. What is a cost pool?
D a. All costs of a production department
b. Over-applied or under-applied overhead costs
c. The material and labor cost used on a particular job
d. A group of overhead costs driven by the same activity
15. In ABC, preliminary cost allocations assign costs to
D a. Departments c. Products
b. Processes d. Activities
16. In ABC, final cost allocations assign costs to
C a. Departments c. Products
b. Processes d. Activities
17. Iran Manufacturing produces three products. Production and cost information show the following:
Model F Model A Model Q
Units produced 1,000 3,000 6,000
Direct labor hours 2,000 1,000 2,000
Number of inspections 20 30 50
Using ABC, what would be the inspection costs of P 50,000 allocated to each unit of Model F?
B a. P 5.00 c. P 20.00
b. P 10.00 d. Some other number
18. The resource utilized by a given product divided by the total amount of the resource available is called
B a. Activity driver c. Cost object
b. Consumption ratio d. Sustaining activity
19. Syria Inc. produces three products. Production and cost information is as follows:
Model Y Model O Model U
Units produced 2,000 6,000 12,000
Direct labor hours 4,000 2,000 4,000
Number of setups 100 150 250
What would be the consumption ratio for the number of setups?
Y O U Y O U
B a. 40% - 20% - 40% c. 10% - 30% - 60%
b. 20% - 30% - 50% d. Some other numbers
Zaire Company is preparing its annual profit plan. The controller estimates the amount of overhead that should be
allocated to the individual product lines from the information given as follows:
Wall Mirrors Specialty Windows
Units produced 25 25
Material moves per product line 5 15
Direct labor hours per unit 200 200
Budgeted materials handling costs P 50,000
20. Under a costing system that allocates overhead on the basis of direct labor hours, what would be the materials
handling costs allocated to one unit of wall mirrors?
B a. P 500 c. P 2,000
b. P 1,000 d. P 5,000
21. Under ABC, what would be the materials handling costs allocated to one unit of wall mirrors?
A a. P 500 c. P 1,500
b. P 1,000 d. P 2,500
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22. Somalia Co. has used a traditional cost accounting system to apply quality control costs uniformly to all products at a
rate of 15% of direct labor cost. Monthly direct labor cost for its main product is P 30,000. In an attempt to distribute
quality control cost more equitably, Somalia is considering ABC. The monthly data shown below have been gathered
for the main product. The three activities are (1) income materials inspection, (2) in-process inspection, and (3)
product certification. Costs are to be allocated to each activity on the basis of cost drivers.
Activity Cost Driver Cost Rate Quantity for Main Product
(1) Number of types of materials P 12 per type 12 types
(2) Number of units P 0.14 per unit 17,500 units
(3) Number of orders P 77 per unit 30 orders
What is the monthly quality control cost assigned to the main product using ABC?
D a. P 150 per order c. P 404 lower than using the traditional system
b. P 4,500 d. P 404 higher than using the traditional system
23. Afghanistan Company uses ABC to compute product costs for external reports. The company has three activity centers
and applies overhead using predetermined overhead rates for each activity center. Estimated costs and activities for
the current year are presented below for the three activity centers:
Estimated overhead cost Expected activity
Activity 1 P 61,387 2,300
Activity 2 P 34,076 2,800
Activity 3 P 69,075 2,500
Actual costs and activities for the current year were as follows:
Actual overhead cost Actual activity
Activity 1 P 61,392 2,290
Activity 2 P 33,941 2,795
Activity 3 P 69,080 1,340
What was the amount of overhead over or under-applied for Activity 1 during the year?
B a. P 271.90 over-applied c. P 5.00 over-applied
b. P 271.90 under-applied d. P 5.00 under-applied
24. A company using activity-based overhead rates
D a. Will usually have higher budget variances than one using a single rate
b. Will usually have higher volume variances than one using a single rate
c. Cannot compute fixed and variable components of overhead cost
d. Should have better information for planning and control than one using a single rate
25. The use of activity-based costing normally results in
A a. Greater unit costs for low-volume products than is reported by traditional product costing
b. Lower unit costs for low-volume products than is reported by traditional product costing
c. Decreased setup costs being charged to volume products
d. Equalizing setup costs for all product lines
26. Predetermined overhead rates are based on activity measured by
D a. Actual overhead cost and actual activity c. Budgeted overhead cost and actual activity
b. Actual overhead cost and budgeted activity d. Budgeted overhead cost and budgeted activity
27. What is the numerator in computing a predetermined overhead rate?
A a. Budgeted manufacturing overhead cost c. Budgeted activity
b. Actual manufacturing overhead cost d. Fixed manufacturing overhead cost
28. What is the denominator in computing a predetermined overhead rate?
C a. Budgeted manufacturing overhead cost c. Budgeted activity
b. Actual manufacturing overhead cost d. Fixed manufacturing overhead cost
29. A predetermined overhead rate cannot be used
A a. If a company does not budget its overhead costs
b. By a company that uses job-order costing
c. In a multi-product company
d. By a highly automated company where labor is a minor part of product cost
30. Assigning overhead to jobs using a predetermined overhead rate is called
A a. Application c. Product costing
b. Budgeting d. Job-order costing
31. Angola applies overhead based on direct labor cost. It had budgeted factory overhead of P 500,000 and budgeted
direct labor of P 250,000. Actual overhead was P 525,000 while actual labor cost was P 270,000. Overhead was:
A a. Over-applied by P 15,000 c. Over-applied by P 25,000
b. Over-applied by P 20,000 d. Under-applied by P 20,000
32. Sudan Company applies overhead at P 4 per machine hour. During March, it worked 10,000 hours and over-applied
overhead by P 3,000. Actual overhead was:
C a. P 43,000 c. P 37,000
b. P 40,000 d. P 35,000
33. Sahara Company applied overhead at P 6 per direct labor hour. In March, Sahara incurred overhead of P 144,000.
Under-applied overhead was P 6,000. How many direct labor hours did Sahara work?
C a. 25,000 c. 23,000
b. 24,000 d. 22,000
34. Machine hours used to set the predetermined overhead rate were 50,000, actual hours were 48,000, and overhead
applied was P 120,000. Budgeted overhead for the year was:
D a. P 115,200 c. P 120,000
b. P 118,000 d. P 125,000
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35. The appropriate method for the disposition of under-applied or over-applied factory overhead
D a. Is to cost of goods sold only
b. Is to finished goods inventory only
c. Is apportioned to cost of goods sold and finished goods inventory
d. Depends on the significance of the amount
36. A report that measures financial and non-financial performance measures for various units in a single report is a(n):
A a. Balanced scorecard c. Imbalanced scorecard
b. Financial report scorecard d. Unbalanced scorecard
37. A balanced scorecard is primarily concerned with
B a. Staff c. Systems
b. Strategy d. Structure
38. Measures of those aspects of the firm’s performance that are crucial to its competitive advantage, and therefore to its
success, are termed:
B a. Cost targets c. Operational controls
b. Critical success factors d. Cost and activity drivers
39. Which one of the following is not one of the perspectives on the business into which critical success factors are
commonly grouped in the balanced scorecard?
B a. Employee innovation and learning c. Internal business processes
b. Competitor business strategies d. Financial performance
40. In balanced scorecard, a survey of employee satisfaction is a potential measure in which of the four perspectives?
D a. Financial c. Internal business processes
b. Customer d. Learning and growth
41. Which is considered to be a performance measurement that is a non-financial rather than a financial measure?
C a. Return on investment c. Customer satisfaction
b. Economic valued-added d. Profit margin
42. Which of the following is an example of an efficiency measure?
C a. The rate of absenteeism
b. The goal of becoming a leader manufacturer
c. The number of insurance claims processed per day
d. The rate of customer complaints
43. Which performance measure would be part of those used for internal business processes perspective?
A a. Cycle time c. Hours of training per employee
b. Employee satisfaction d. Customer retention
44. Which of the following represents value-added time in the manufacturing cycle?
D a. Inspection time. c. Move time.
b. Queue time. d. Process time.
China Manufacturing Corporation has the following information:
Moving time 8 days
Inspection time 2 days
Processing time 10 days
Storage time 30 days
45. What is the total amount of value-added time?

A a. 10 days c. 40 days
b. 30 days d. 50 days
46. What is the product’s cycle time?
D a. 10 days c. 40 days
47. What is the manufacturing cycle efficiency (MCE)?
C a. 25.0% c. 20.0%
b. 80.0% d. 60.0%
48. The primary reason for adopting TQM is to achieve
A a. Greater customer satisfaction c. Reduced delivery charges
b. Greater employee participation d. Reduced delivery time
49. A characteristic of TQM is
C a. Quality by final inspection
b. Management by objectives
c. Education and self-improvement
d. On-the-job training by other workers
50. In which of the following organizations does total quality management (TQM) work best?
D a. Hierarchal
b. Specialists working individually
c. Teams of people from the same specialty
d. Teams of people from different specialties
51. Under a total quality management (TQM) approach
a. A large number of suppliers are used in order to obtain the lowest possible prices
b. Quality control is performed by well-trained inspectors at the end of production process
c. Top management assumes the primary responsibility for the quality of products and services
d. Measurement occurs throughout the process, errors are caught and corrected at the source
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52. What is the ultimate test of a quality product or service?

D a. Whether the product is able to reduce the conformance costs
b. Whether the product is able to reduce the non-conformance costs
c. Whether the product is able to reduce the conformance and non-conformance costs
d. Whether the product meets or exceeds the customers’ expectation
53. These are quality costs incurred to determine whether particular units of product meet quality standards.
A a. Appraisal costs c. Internal failure costs
54. These are quality costs incurred when company determines units that do not meet quality standards.
C a. Appraisal costs c. Internal failure costs
55. These are quality costs incurred when a unit of product fails to perform to customer expectations.
D a. Appraisal costs c. Internal failure costs
56. The cost of disposing defective units would be classified as a(n):
C a. Preventive cost c. Internal failure cost
b. Appraisal cost d. External failure cost
57. The cost of statistical quality control in a product quality cost system is categorized as a(n)
D a. Internal failure cost c. External failure cost
b. Training cost d. Appraisal cost
58. The cost of scrap, rework, and tooling changes in a product quality cost system is categorized as a(n)
C a. Training cost c. Internal failure cost
b. External failure cost d. Prevention cost
59. The cost of processing customer complaints
D a. Appraisal costs c. Internal failure costs
60. As prevention costs increase, other costs of quality generally
C a. Are not affected c. Decrease
b. Increase, but a slower pace d. Change, but the direction cannot be predicted
61. An increase in appraisal costs in a quality improvement program would usually have the following initial effects on (I)
internal failure costs and (II) external failure costs:
B a. (I) Increase (II) Increase c. (I) Decrease (II) Increase
b. (I) Increase (II) Decrease d. (I) Decrease (II) Decrease
62. All of the following would generally be included in a cost-of-quality report, EXCEPT
D a. Warranty claims c. Supplier evaluations
b. Design engineering d. Lost contribution margin
63. Management of a company is attempting to build a reputation as a world-class manufacturer of quality products.
Which of the following measures would NOT be used by the firm to measure quality?
B a. The percentage of shipments returned by customers because of poor quality
b. The number of parts shipped per day
c. The number of defective parts per million
d. The percentage of products passing quality tests the first time
64. Quality cost index is often used to measure and analyze cost of maintaining a given level of quality. One example of a
quality cost index, which uses a direct labor base, is computed as:
Total quality costs
Quality cost index = X 100
Direct labor costs
The following quality cost data were collected for May and June:
May June
Prevention costs P 4,000 5,000
Appraisal costs 6,000 5,000
Internal failure costs 12,000 15,000
External failure costs 14,000 11,000
Direct labor costs 90,000 100,000
Based upon these cost data, the quality cost index
A a. Decreased 4 points from May to June c. Increased 10 points from May to June
b. Was unchanged from May to June d. Decreased 10 points from May to June
65. The value chain is the sequence of business functions in which
D a. Products and services are evaluated with respect to their value to the supply chain
b. Value is proportionately added to the products or services of an organization
c. Value is deducted from the products or services of an organization
d. Usefulness is added to the products or services of an organization
66. R & D, production and customer service are business functions that are all included as part of
A a. Value chain c. Marketing
b. Benchmarking d. Supply chain
67. Which of the following activities would not be considered as adding value?
C a. Redesign of a product c. Rework of defective products
b. Quality assurance activities d. Client support services for product fulfillment
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68. The concept of value added is best described as

A a. Activities that convert resources into products and services consistent with external customer
requirements
b. A series of transactions between employees to deliver an end product to external customers and
external suppliers
c. A series of transactions between employees or between internal customers and internal suppliers to
deliver an end product
d. Activities that can be eliminated with no deterioration in product service, functionality, performance or
quality in the eyes of the end user
69. Which of the following determines the desired cost for a product based upon a given competitive price?
B a. Benchmarking c. Reengineering
b. Target costing d. Life-cycle costing
70. During the growth stage of a product’s life cycle,
B a. The quality of products is poor
b. New product models and features are introduced
c. There is little difference among competing products
d. The quality of the products becomes more variable and products are less differentiated
71. A company’s product has an expected 4-year life cycle from research, development, and design through its withdrawal
from the market. Budgeted costs are:
Upstream costs (R & D, design) P 2,000,000
Manufacturing costs 3,000,000
Downstream costs (marketing, distribution, customer service) 1,200,000
After-purchase costs 1,000,000
The company plans to produce 200,000 units and price the product at 125% of the whole-life unit cost. Thus,
what is the budgeted unit selling price?
D a. P 15 c. P 36
b. P 31 d. P 45
72. In Business Process Reengineering (BPR), the main objectives are to simplify and to possibly eliminate
B a. Value-added activities c. Constraint
b. Non-value-added activities d. Non-constraint
73. Which of the following statements is true regarding BPR?
C a. It requires a change in the company’s products
b. It involves redesigning business processes and eliminating value-added activities
c. It involves completely redesigning business processes and it is often implemented by outside
consultants
d. It empowers front-line workers to solve problems and it focuses attention on solving problems rather
than on finger-pointing
74. BPR
C a. Affects employees in a way that boosts their morale
b. Is less likely to result in employee resistance than total quality management
c. Is more likely to result in employee resistance than total quality management
d. Does not affect employees, hence, no resistance from employees is expected when it is applied
75. JIT purchasing can be used by
D a. Retailers c. Manufacturers
b. Wholesalers d. All of the choices
76. Ideally, the number of units that should be produced in a JIT manufacturing system is equal to the:
B a. Maximum productive capacity
b. Actual demand for the current period
c. Budgeted demand for the current period
d. Budgeted demand for the following period
77. In JIT, the flow of goods is controlled by a “pull” approach. It means that:
A a. Work is initiated only in response to customer orders
b. Customers are pulled to buy more units to reduce the company’s inventory
c. Warehouses should always be full to be sure that customer demands are always met
d. Production officers see to it that there is always something to do to keep everyone busy
78. All of the following are characteristics of a just-in-time manufacturing environment, EXCEPT:
D a. Frequent deliveries of materials c. Little or no inventory of finished product
b. Manufacturing cells d. Longer production cycle
79. A just-in-time manufacturer is more likely than a conventional manufacturer to
A a. Receive more frequent deliveries of materials
b. Hold large inventories to serve as buffers
c. Spend less money on advertising
d. Need workers with fewer skills
80. A conventional manufacturer is more likely than a just-in-time manufacturer to
C a. Have a short production cycle
b. Produce goods in small batches
c. Hold large inventories to serve as buffers
d. Receive more frequent deliveries of materials
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81. Which of the following is a characteristic of just-in-time (JIT) inventory management systems?
D a. JIT users determine the optimal level of safety stocks
b. JIT is applicable only to large companies
c. JIT does not really increase overall economic efficiency because it merely shifts inventory levels further
up the supply chain
d. JIT relies heavily on good-quality materials
82. All of the following are potential financial benefits of JIT, EXCEPT:
A a. Reducing the risk of obsolescence
b. Reducing manufacturing lead time
c. Lower investments in inventories
d. Lower investments in plant space for inventories
83. Which of the following do just-in-time (JIT) operations try to eliminate?
B a. Discretionary fixed costs
b. Non-value-adding costs
c. Avoidable costs
d. Direct costs
84. Well-implemented just-in-time production and purchasing techniques
B a. Result in large stockpiles of inventory to keep production running
b. Strengthen a company’s ability to compete in the marketplace
c. Increase a reliance on long-term customer forecasts
d. Reduce a company’s competitive edge
85. When product demand exceeds production capacity, what is the first step that managers should take?
C a. Change the throughput of the operations
b. Spend money to eliminate the bottleneck
c. Focus their efforts on constraint identification
d. Apply activity-based management to solve the problem
86. Under Theory of Constraints (TOC), improvement efforts should be focused
A a. Work center that is a constraint
b. Work center that has no constraint
c. Cost center that incurs the highest costs
d. Cost center that has least number of constraints
87. The immediate goal of a TOC analysis is to
B a. Minimize direct materials cost
b. Maximize contribution margin through the constraint
c. Maximize the efficiency of the entire production process
d. Smooth production flow to eliminate backup in the system
88. Under TOC,
C a. No company has constraints
b. Improvement efforts should be focused on non-constraints
c. Efforts that would improve output of a workstation shall be focused on the constraints
d. A company that wants to improve its operation shall focus on workstation with the highest productive
capacity
89. An organization will directly gain all of the following benefits from ToC methodology, EXCEPT:
D a. Reduced bottlenecks
b. Increase profitability
c. Improved quality of products and services
d. Assessment of long-term product profitability
90. It refers to the efforts of a company to employ sustainable business practices regarding its employees and
environment.
C a. Value chain analysis
b. Environmental accounting
c. Total quality management
d. Corporate social responsibility
- nothing follows -
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MAS-12: WORKING CAPITAL MANAGEMENT

 WORKING CAPITAL MANAGEMENT (WCM) involves managing the firm’s current assets and current liabilities
to achieve a balance between risks (liquidity) and returns (profitability).
 The term ‘working capital’ generally refers to current assets only. For purposes of WCM, ‘working capital’
refers to the difference between current assets and current liabilities (i.e., net working capital):
 The minimum working capital requirement regardless of the seasonal variations in business operations
is called PERMANENT or FIXED working capital.
 When additional working capital is needed during the more active business season, such working capital
is called SEASONAL or VARIABLE or INCREMENTAL working capital.
 WORKING CAPITAL FINANCING refers to optimal level, mix and use of current assets and current liabilities.
Consider the following working capital financing policies:
1) CONSERVATIVE financing strategy a.k.a. relaxed policy: a company seeks to minimize liquidity risk by
maintaining a relatively high level of working capital. This policy reduces liquidity risk but is considered
as less profitable due to more reliance on long-term financing that incurs higher financing costs.
2) AGGRESSIVE financing strategy a.k.a. restricted policy: operations are conducted with a minimum
amount of working capital. This policy enhances profitability by relying more on short-term debts rather
than long-term debts but is considered risky due to higher chances of short-term insolvency.
3) MODERATE financing strategy a.k.a. balanced or semi-aggressive or semi-conservative policy: working
capital maintained is relatively not too high (conservative) nor too low (aggressive).
4) MATCHING financing strategy a.k.a. self-liquidating or hedging policy: this policy is achieved by
matching the maturity of financing source with an asset’s useful life (i.e., short-term assets are financed
with short-term liabilities; long-term assets are funded by long-term financing sources).
 WCM considers the level, liquidity, activity and structural component of working capital. A sound practice of
WCM would normally involve the following:
 Managing cash and its temporary investment efficiently. (Cash & Marketable Securities Management)
 Drafting and implementing effective credit and collection policies. (Receivable Management)
 Seeking favorable terms from suppliers and other short-term creditors. (Short-Term Credit Financing)
 Ensuring efficient manufacturing operations and sound material procurement. (Inventory Management)
[The topic on ‘Inventory Management’ is well covered in MAS-11 for Week 13]
CASH & MARKETABLE SECURITIES MANAGEMENT
 Four (4) reasons for holding cash: “Why would a firm hold cash when, being idle, it is a non-earning asset?”
1) TRANSACTION motive (Liquidity motive): cash is held to facilitate normal transactions of the business.
2) PRECAUTIONARY motive (Contingent motive): cash is held beyond the normal operating requirement to
provide for buffer against contingencies, such as slow-down in collection and possibilities of strikes.
3) SPECULATIVE motive: cash is held to avail of profit-making opportunities (e.g., sudden price drop).
4) CONTRACTUAL motive: cash is held as required by contract provisions (e.g., compensating balance).
 OPTIMAL CASH BALANCE (OCB), a.k.a. Economic Cash Quantity or Economic Conversion Size, is based on
the following formula under the BAUMOL model (named after the American economist William Baumol):
Where: D  Annual Demand for Cash
2DT
OCB = T  Costs per Transaction
O O  Opportunity Cost of Holding Cash
Opportunity Costs = (OCB ÷ 2) x O Where: (OCB ÷ 2)  average cash balance
Transaction Costs = (D ÷ OCB) x T Where: (D ÷ OCB)  number of transaction per year
 “OCB” is the optimal amount of cash to be raised by selling marketable securities or by borrowing
 “D” is total amount of new cash needed for transactions during the year
 “T” refers to the fixed costs of trading securities or cost of borrowing
 “O” refers to the rate of return foregone on marketable securities or the cost of borrowing
 The Baumol model, like its pattern EOQ [covered in MAS-10 under inventory management], is based on the
assumption that the demand for cash is spread evenly throughout the year. When there is an irregularity of
cash payment, OCB is computed using another formula based on the MILLER-ORR model where OCB or
‘cash return point’ is achieved when the level of cash reaches an upper limit/maximum amount or a lower
limit/minimum amount.
 CASH BREAK-EVEN POINT (BEP) is the sales level at which total cash inflows is equal to total cash outflows.
 Cash BEP in Unit Sales = Fixed Payments ÷ Unit Contribution Margin
 Cash BEP in Peso Sales = Fixed Payments ÷ Contribution Margin Ratio
 CASH CONVERSION CYCLE (CCC) a.k.a. cash flow cycle is the average time from the point cash is used to
pay for raw materials until cash is collected on the accounts receivable associated with the goods produced
with those raw materials. CCC must be distinguished from the NORMAL OPERATING CYCLE (NOC), which is
the length of time within which the firm purchases or produces inventory, sells it and receives cash.
NOC = Average Age of Inventory + Average Age of Receivable
CCC = Average Age of Inventory + Average Age of Receivable – Average Age of Payable
(Alternative: CCC = NOC – Average Age of Payable)
Where: Formula Other Name(s)
Average Age of Inventory Inventory ÷ CGS* per day Inventory Conversion Period, Days Sales in Inventory
Average Age of Receivable Receivables ÷ Sales per day Receivable Collection Period, Days Sales Outstanding
Average Age of Payable Payables ÷ Purchases per day Payable Deferral Period, Days Payables Outstanding
* “Sales per day” may be used in lieu of CGS per day -- the intention is to use an amount in proportion to unit sales.
‘Average age’ may also be computed using TURNOVER ratios [to be covered in MAS-15 on FS Analysis during Week 18].

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Week No. 14: WORKING CAPITAL MANAGEMENT
 CASH MANAGEMENT STRATEGIES that help shorten the CCC:

 Accelerating collections (e.g., prompt billing, cash discounts, online collection, lockbox)
 LOCKBOX SYSTEM requires customers to mail payments to a post office box in a specific city, a local
bank then collects the checks from the box and deposit them promptly in the client’s account.
 Reducing precautionary idle cash (e.g., readily available line of credit, well-thought cash budgeting)
 LINE of CREDIT is a predetermined borrowing limit that an entity can use at any time -- the
borrower can take money out as needed until the limit is reached, and as money is repaid, it can be
borrowed again in the case of an open line of credit.
 Slowing disbursements (e.g., payment thru drafts, zero-balance accounts, playing the float)
 ZERO-BALANCE ACCOUNTS (ZBA) requires checks to be written from special disbursement accounts
having zero peso balance with no minimum maintaining balance required. Funds are automatically
transferred from a master account when a check drawn from a ZBA is presented.
 FLOAT is the difference between cash balance per BANK and cash balance per BOOK as of a certain period,
primarily due to outstanding checks and other similar reasons. Two types of float are:
 POSITIVE or DISBURSEMENT Float: bank balance > book balance
Possible cause: Outstanding checks issued by the firm that have not cleared yet.
 NEGATIVE or COLLECTION Float: book balance > bank balance
1. MAIL Float – amount of customers’ payments that have been mailed by customers but not yet
received by the seller-company
2. PROCESSING Float – amount of customers’ payments that have been received by the seller but not
yet deposited.
3. CLEARING Float – amount of customers’ checks that have been deposited but have not cleared yet.
NOTE: Good cash management suggests that positive float should be maximized while negative float be
minimized or, if possible, eliminated.
 MARKETABLE SECURITIES are short-term money market instruments that can easily be converted to cash.
Some of the common examples where an entity may invest its temporary idle funds:
 CERTIFICATES of DEPOSITS (CD) – savings deposits at financial institutions (e.g., time deposit)
 MONEY MARKET FUNDS – shares in a fund that purchases higher-yielding bank CDs, commercial paper,
and other large-denomination, higher-yielding securities
 GOVERNMENT SECURITIES
 Treasury bills – debt instruments representing obligations of the National Government issued by the
central bank and usually sold at a discount through competitive bidding
 CB Bills or Certificates of Indebtedness (CBCIs) – represent indebtedness by the Central Bank.
 COMMERCIAL PAPERS – short-term, unsecured, material promissory notes issued by private
corporations of very high credit standing.
 REPURCHASE AGREEMENTS (Repos) – investment in loans with a commitment to resell the security at
the original contract price plus an agreed interest income for the holding period.
 BANKERS’ ACCEPTANCES – a draft drawn on a specific bank by a firm that has an account with the
bank, which if accepted by the bank becomes a negotiable instrument and is available for investments.
 Factors considered in choosing marketable securities include:
 RISKS
 Default risk – chances that issuer may not be able to pay interest or principal on time.
 Inflation risk – danger that inflation will reduce the investment’s real value.
 Interest rate risk – fluctuations in prices caused by changes in market interest rates.
 MARKETABILITY – refers to how quickly a security can be sold before maturity date without a significant
price concession.
 RETURNS – an entity is willing to assume more risks given a higher expected return on investment.
 TERM or MATURITY – maturity dates should coincide, whenever possible, with the date at which the firm
needs cash, or when the firm will no longer have cash to invest.
 TAXES – some marketable securities do not require payment of taxes, such as municipal bonds.
RECEIVABLES MANAGEMENT
 Receivable management refers to the set of policies, procedures, and practices employed by a company
with respect to managing sales on account or credit sales.
 Receivable management encompasses the evaluation of customer’s credit worthiness and risk, establishing
sales terms and credit policies, and designing an appropriate receivable collection process.
 CREDIT STANDARD: Which customer will be granted credit? How much is the credit limit? Have we
considered the 5 C’s of Credit?
 Character – customers’ willingness to pay
 Capacity – customers’ ability to generate cash flows
 Capital – customers’ financial sources (i.e., net worth)
 Conditions – current economic or business conditions
 Collateral – customer pledges to secure debt.
 CREDIT TERM refers to the credit period offered to encourage customer sales and discount offered for
customer’s prompt payment. The costs associated with credit terms that must be considered include
cash discounts, credit analysis and collections costs, bad debt losses and financing costs.
 COLLECTION PROGRAM: shortening the average collection period means less investment in receivable
(low opportunity costs) and less chances of delinquency and defaults, but may result to loss of
customers due to less friendly terms.
Meaningful ratios useful in receivable management include receivable turnover, receivable collection period or days
sales outstanding. [These ratios shall be covered in MAS-15 on FS Analysis during Week 18].
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SHORT-TERM CREDIT FINANCING

 Common sources of short-term funds include:
 UNSECURED CREDITS (e.g., accruals, trade credit and commercial papers)
 SECURED LOANS (e.g., receivable financing – pledging and factoring)
(e.g., inventory financing – blanket lien, trust receipts, warehouse receipts)
 BANKING CREDITS (e.g., term loan, line of credit, revolving credit agreement)
 Factors considered in selecting sources of short-term funds:
 COST – the effective costs of various credit sources.
 AVAILABILITY – the readiness of credit as to when needed and how much is needed.
 INFLUENCE – the influence of use of one credit source and availability of other sources of financing.
 REQUIREMENT – additional covenants unique to various sources of financing (e.g., loans).
 Cost of short-term funds:
 Cost of TRADE CREDIT with supplier*:
Discount Rate 360 Days
COST = X
100% - Discount Rate Credit Period - Discount Period
* This type of financing cost is caused by foregoing cash discounts (opportunity cost).
 Cost of BANK LOANS (Effective Annual Rate):
Interest 360 Days
COST = X
Net Proceeds Loan Term
 If loan does not require a compensating balance:
 Non-discounted: net proceeds = face value
 Discounted: net proceeds = face value less interest
 If loan requires a compensating balance (CB):
 Non-discounted: net proceeds = face value less CB
 Discounted: net proceeds = face value less interest less CB
 Cost of COMMERCIAL PAPERS
Interest + Issue Costs 360 Days
COST = X
Face value – Interest – Issue Costs Paper Term
 Cost of FACTORING RECEIVABLES
Interest + Factor’s Fee 360 Days
COST = X
Face value – Interest – Factor’s Fee – Factor’s Holdback Remaining Maturity Period
EXERCISES: WORKING CAPITAL MANAGEMENT
1. Working Capital & Liquidity Ratios

Given the partial balance sheet information of Mental Health Support Group Company:
Cash P 17,000 Accounts Payable P 10,000
Accounts Receivable 13,000 Accrued Payroll 6,000
Inventory 20,000 Current Tax Liability 4,000
Fixed Assets 70,000 Bonds Payable 30,000
NOTE: Bonds will mature in 10 years.
REQUIRED:
A) Determine the: (1) net working capital (2) current ratio (3) quick or acid-test ratio
B) If the entire accounts payable are paid in cash, what is the new current ratio?
C) If a short-term loan of P 10,000 is obtained from a bank, what is the new current ratio?
2. Working Capital Policy: Conservative vs. Aggressive

MHSG Company has P 1,000,000 in current assets, 40% of which are considered permanent current assets.
In addition, the firm has P 600,000 invested in fixed assets. In the current year, the company reported
earnings of P 200,000 before considering the following interests and tax charges:
 Short-term financing: 5%
 Long-term financing: 10%
 Tax rate: 30%
Plan A – MHSG finances all fixed assets and half of its permanent current assets with long-term financing.
Plan B – MHSG finances all fixed assets and permanent assets plus half of its temporary current assets with
long-term financing.
REQUIRED:
A) How much is the difference in earnings after tax between Plan A and Plan B?
B) Which working capital policy between Plan A and Plan B is considered conservative? aggressive?
3. Optimal Cash Balance – Baumol Model

Suju Corporation is expecting to have total payments of P 1,800,000 for one year, cost per transaction
amounted to P 25, and the interest rate of marketable securities is 10%.
A) What is the company’s optimal initial cash balance that minimizes total costs?
B) What is the total number of transactions or cash conversions that will be required per year?
C) How frequent in days shall Suju Corporation do the transaction or cash conversion within the year?
D) What will be the average cash balances for the period?
E) How much is the total cost of maintaining cash balances?
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4. Cash Conversion Cycle

Delight Company is concerned about managing cash efficiently. On the average, inventories have an age of
90 days, and accounts receivable are collected in 60 days. Accounts payable are paid approximately 30
days after they arise. Delight spends P 30 million on operating-cycle investments each year, at a constant
rate.
REQUIRED:
A) How long in days is the normal operating cycle?
B) How long in days is the cash conversion cycle?
C) What is the number of cash conversion cycles in one year (360 days)?
D) How much amount of resources is needed to support the cash conversion cycle?
5. Float & Lockbox System

Smirnoff Company has daily cash receipts of P 120,000. A recent analysis of its collection indicated that
customer’s payments were in the mailing system for an average of 3.5 days. Once received, the payments
are processed in 1.5 days. After payments are deposited, it takes an average of 4 days for these receipts
to clear the banking system. Smirnoff considers adopting a lockbox system that will reduce the collection
float time to 6 days. Rate of return is 10%
REQUIRED:
A) How much is the reduction in collection float associated with implementing the lockbox system?
B) If the lockbox system costs P 2,500 per month, should the system be implemented?
C) What maximum amount is Smirnoff Company willing to pay for the lockbox system for one year?
6. Average Investment in Accounts Receivable

Gin Corporation sells on terms of 2/10, n/30. 70% of customers normally avail of the discounts. Annual
sales are P 900,000, 80% of which is made on credit. Cost is approximately 75% of sales.
REQUIRED:
A) Average balance of accounts receivable B) Average investment in accounts receivable.
7. Collection Policy - Cash Discount

3AM Company presents the following information:
 Annual credit sales: P 30,000,000
 Collection period: 2 months
 Rate of return: 15%
3AM considers changing its credit term from n/30 to 3/10, n/30 to achieve the following results:
(1) 25% of its customers will take advantage of the discount while sales remain constant.
(2) Collection period is expected to decrease from two months to one month.
REQUIRED:
What is the net advantage (disadvantage) of implementing the proposed discount?
8. Credit Policy – Relaxation of Credit Standards & Extension of Credit Period

Red Wristband Corporation reports the following information:
A) Selling price per unit P 10
B) Variable cost per unit P8
C) Total fixed costs P 120,000
D) Annual credit sales 240,000 units
E) Collection period 3 months
F) Rate of return 25%
Red Wristband considers relaxing its credit standards and extending its credit period. The following results
are expected: (1) sales will increase by 25%; (2) collection costs will increase by P 40,000; (3) bad debt
losses are expected to be 5% on the incremental sales; and (4) collection period will increase to 4 months.
REQUIRED:
What is the net advantage (disadvantage) of implementing the relaxation of credit standards and
extension of credit period?
9. SHORT-TERM CREDIT FINANCING

I - COST of TRADE CREDIT
CPL Trading purchases merchandise for P 200,000, 2/10, n/30.
REQUIRED:
A) The annual cost of trade credit.
B) The annual cost of trade credit if term is changed to 1/15, n/20.
II - COST of BANK LOANS
CPL Trading was granted a 180-day P 200,000 bank loan with 12% stated interest.
REQUIRED: The effective annual rate, under the following cases:
A) CPL receives the entire amount of P 200,000.
B) CPL is granted a discounted loan.
C) CPL is required to maintain a compensating balance of P 10,000 under the non-discounted loan.
D) CPL is required to maintain a compensating balance of 10% under a discounted loan.
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III - COST of COMMERCIAL PAPERS

CPL Company plans to sell a 180-day commercial paper amounting to P 100,000,000, which it expects to
pay a discounted interest of 12% per annum. CPL expects to incur P 100,000 in dealer placement fees and
paper issue costs.
REQUIRED:
Determine the effective cost of CPL’s credit.
IV - COST of FACTORING RECEIVABLES
CPL Company has P 200,000 in receivable that carries 30-day credit term, 2% factor’s fee, 6% holdback
reserve and an interest of 12% per annum on advances.
REQUIRED:
A) How much is the cash proceeds from factoring the receivable?
B) What is effective annual rate of financing thru factoring the receivable?
1. Working capital management is concerned about the trade-off between

a. Return and financial risk
b. Default risk and conservatism
c. Current ratio and return on equity
d. Profitability and risk of technical short-term insolvency
2. Which of the following characteristics are generally associated with a CONSERVATIVE financial policy?
a. High current assets relative to sales and high current liabilities relative to total assets
b. High current assets relative to sales and low current liabilities relative to total assets
c. Low current assets relative to sales and high current liabilities relative to total assets
d. Low current assets relative to sales and low current liabilities relative to total assets
3. The PRECAUTIONARY motive for holding cash is for:
a. Daily operating requirements
b. Safety and emergency reasons
c. Compensating balance requirements
d. Buying goods before prices rise to higher levels
4. A working capital technique that increases the payable float and therefore delays the outflow of cash is
a. A draft c. Electronic fund transfer (EFT)
b. A lockbox system d. Electronic data interchange (EDI)
5. A firm has an average age in inventory of 90 days, an average collection period of 40 days, and an
average payment period of 30 days. What is the firm’s cash conversion cycle?
a. 70 days c. 130 days
6. An increase in sales resulting from an increased cash discount for prompt payment would be expected
to cause a(n)
a. Increase in the operating cycle
b. Increase in the average collection period
c. Decrease in the cash conversion cycle
d. Decrease in purchase discounts taken
7. Changing a firm’s credit terms from 2/20, net/60 to 2/10, net/30 will generally
a. Increase the average collection period and increase sales
b. Increase the average collection period and reduce sales
c. Decrease the average collection period and increase sales
d. Decrease the average collection period and reduce sales
8. Which of the following forms of short-term borrowing is a secured credit?
a. Line of credit c. Commercial paper
b. Banker’s acceptances d. Chattel mortgage
9. Using a 360-day year, what is the opportunity cost to a buyer of not accepting terms 3/10, n/45?
a. 22.27% c. 55.67%
b. 31.81% d. 101.73%
10. Sydney Corp. is considering borrowing P 100,000 from a bank for one year at a stated interest rate of
9%. What is the effective interest rate to Sydney if this borrowing is in the form of a discount note?
a. 8.10% c. 9.81%
b. 9.00% d. 9.89%
SELF-TEST QUESTIONS – with suggested answers

1. If current assets go up by P 120,000, current liabilities go down by P 50,000, then net working capital
C a. Did not change c. Increased by P 170,000
b. Increased by P 70,000 d. Decreased by P 170,000
2. Which of the following is strictly not a use of working capital?
B a. Repurchase of common stock c. Purchase of equipment on account
b. Purchase of inventory on account d. Repayment of long-term debt
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3. The net working capital of Philippines Company at December 31, 2020 was P 10,000,000. Selected information for the
year 2021 for Philippines Company is as follows:
Working capital provided from operations P 1,700,000
Capital expenditures 3,000,000
Proceeds from short-term borrowings 1,000,000
Proceeds from long-term borrowings 2,000,000
Payments on short-term borrowings 500,000
Payments on long-term borrowings 600,000
Proceeds from issuance of common stock 1,400,000
Dividends paid on common stock 800,000
What is the net working capital at December 31, 2021?
A a. P 10,700,000 c. P 11,500,000
b. P 11,200,000 d. P 12,000,000
4. China Corporation had income before taxes of P 60,000 for the year. Included in this amount was depreciation of P
5,000, a charge of P 6,000 for the amortization of bond discounts, and P 4,000 for interest expense. What is the
estimated cash flow for the period?
D a. P 49,000 c. P 66,000
b. P 60,000 d. P 71,000
5. USA Co. has an acid test ratio of 1.5 to 1.0. Which of the following will cause this ratio to deteriorate?
B a. Payment of cash dividends previously declared
b. Borrowing short-term loan from a bank
c. Sale of inventory on account
d. Sale of equipment at a loss
6. It is the policy of a company that the current ratio cannot fall below 1.5 to 1.0. Its current liabilities are P 400,000 and
the present current ratio is 2 to 1. How much is the maximum level of new short-term loans it can secure without
violating the policy?
A a. P 400,000 c. P 266,667
b. P 300,000 d. P 800,000
7. A firm's current ratio is currently 2.2 to 1. Management knows it cannot violate a working capital restriction contained
in its bond indenture. If the firm's current ratio falls below 2 to 1, technically it will have defaulted. If current liabilities
are P 200,000,000, what is the maximum new commercial paper that can be issued to finance inventory expansion?
B a. P 20 million c. P 180 million
b. P 40 million d. P 240 million
8. Which one of the following transactions would increase the current ratio and decrease net profit?
D a. An income tax payment due from the previous year is paid
b. A stock dividend is declared
c. Uncollectible accounts receivable are written off against the allowance account
d. Vacant land is sold for less than the net book value
9. Which of the following transactions does not change the current ratio and total current assets?
A a. A cash advance is made to a divisional office
b. A cash dividend is declared
c. Short-term notes payable are retired with cash
d. A fully depreciated asset is sold for cash
10. Australia Corporation has 100,000 shares of stock outstanding. Below is part of Australia’s Statement of Financial
Position for the last fiscal year.
Statement of Financial Position as of December 31 – Selected items
Cash P 455,000
Accounts receivable 900,000
Inventory 650,000
Prepaid assets 45,000
Accrued liabilities 285,000
Accounts payable 550,000
Current portion, long-term notes payable 65,000
What is the maximum amount Australia can pay in cash dividends per share and maintain current ratio of 2 to 1?
Assume that all accounts other than cash remain unchanged.
B a. P 2.05 c. P 3.35
b. P 2.50 d. P 3.80
11. As a company becomes more conservative in working capital policy, it would tend to have a (an)
C a. Decrease in acid test ratio
b. Increase in the ratio of current liabilities to non-current liabilities
c. Increase in the ratio of current assets to units of output
d. Increase in funds invested in common stock and a decrease in funds invested in securities
12. The firm’s financing requirement can be separated into
A a. Seasonal and permanent c. Current liabilities and long-term funds
b. Current assets and fixed assets d. Current liabilities and long-term debts
13. The working capital financing policy that subjects the firm to the greatest risk of being unable to meet the firm’s
maturing obligations is the policy that finances (where: CA = current assets)
D a. Temporary CA with long-term debts c. Permanent CA with long-term debts
b. Fluctuating CA with short-term debts d. Permanent CA with short-term debts
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14. Which of the following actions would not be consistent with good working capital management?
B a. Increased synchronization of cash flows
b. Minimize the use of float
c. Maintaining an average cash balance equal to that which minimizes total cost
d. Use of checks and drafts in disbursing funds
15. Determining the appropriate level of working capital for a firm requires
D a. Evaluating the risks associated with various levels of fixed assets and the types of debt used to
finance these assets
b. Changing the capital structure and dividend policy of the firm
c. Maintaining short-term debt at the lowest possible level because it is generally more expensive than
long-term debt
d. Offsetting the benefit of working capital against the probability of technical insolvency
16. The most direct way to prepare a cash budget for a manufacturing firm is to include
D a. Projected sales, credit terms, and net income
b. Projected net income, depreciation and goodwill amortization
c. Projected purchases, percentages of purchases paid, and net income
d. Projected sales and purchases, percentages of collections, and terms of payments
17. Shown below is a forecast of sales for Europe Inc. for the first 4 months of the year (amounts in thousands of pesos).
January February March April
Cash sales P 15 P 24 P 18 P 14
Sales on credit 100 120 90 70
On average, 50% of credit sales are paid for in the month of sale, 30% in the month following the sale, and the
remainder is paid 2 months after the month of sale. Assuming there are no bad debts, what is the expected cash
inflow for Europe in March?
C a. P 138,000 c. P 119,000
b. P 122,000 d. P 108,000
18. Asia Inc. has a pool of cash that it uses to pay bills. When the cash is exhausted, it replenishes its pool by selling T-
bills. The firm disburses P 600,000 in cash every year, and every sale of T-bills costs P 60. The current risk-free rate
is 8%. What is the optimal cash balance for Asia?
C a. P 27,932 c. P 30,000
b. P 48,530 d. P 37,546
19. A firm needs a total of P 30,000,000 in new cash for transaction purposes. The annual interest rate on marketable
securities is 10% and the brokerage fee cost per transaction of selling securities to replenish cash is P 1,000. Which of
the following is closest to the firm’s optimal average cash balance?
B a. P 353,432 c. P 774,597
b. P 387,298 d. P 790,213
20. Africa, Inc. has P 2 million invested in T-bills yielding 8% per annum. This investment will satisfy the firm’s need for
funds during the coming year. It costs P 50 to sell these bills. If Africa needs P 166,667 a month, how frequently
should the company sell off T-bills?
B a. About every 3 days c. About every 15 days
b. About every 9 days d. About every 18 days
21. A firm has an average age in inventory of 60 days, an average collection period of 45 days, and an average payment
period of 30 days. What is the number of days in the cash flow cycle?
22. The company’s cash flow cycle extends up to 50 days. Receivables age is for 20 days. Average age in inventory is
twice as long as days’ receivable. For how long is the company’s payable deferral period?
23. Assume that each day a company writes and receives checks totaling P 10,000. If it takes 5 days for the checks to
clear and be deducted from the company’s account, and only 4 days for the deposits to clear, what is the float?
C a. (P 10,000) c. P 10,000
b. P 0 d. P 50,000
24. Arctic is a retail mail order firm that currently uses a central collection system. An average of 6 days is required for
mailed checks to be received, 3 days for Arctic to process them, and 2 days for the checks to clear through its bank. A
proposed lockbox system would reduce the mailing and processing time to 2 days and the check-clearing time to 1
day. Arctic has an average daily collection of P 150,000. If Arctic adopts the lockbox system, its average cash balance
will increase by
A a. P 1,200,000 c. P 600,000
b. P 750,000 d. P 450,000
25. America Company is considering implementing a lockbox system at a cost of P 20,000 per quarter. Annual sales are P
90,000,000, and the lockbox system will reduce collection time by 3 days. If America can invest funds at 8%, should it
implement lockbox system? (Assume a 360-day year)
C a. Yes, savings of P 140,000 per year c. No, loss of P 20,000 per year
b. Yes, savings of P 60,000 per year d. No, loss of P 60,000 per year
26. A method of delaying the disbursement of cash by a corporation with a liquidity problem would be to:
D a. Install a lockbox system
b. Utilize a concentration banking program
c. Take as many cash discounts as possible
d. Pay its bills through the use of bank drafts
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27. A firm has daily cash receipts of P 100,000 and collection time of 2 days. A bank has offered to reduce the collection
time on the firm’s deposit by 2 days for a monthly fee of P 500. If money market rates are expected to average 6%
during the year, the net annual benefit (loss) from having this service is
C a. P 0 c. P 6,000
b. P 3,000 d. P 12,000
28. Peru Company is a newly established firm and the owner is deciding what type of checking account to open. Peru is
planning to keep a P 500 minimum balance in the account for emergencies and plans to write roughly 80 checks per
month. The bank charges P 10 per month and P 0.10 per check charge for a standard business checking account with
no minimum balance. Peru also has the option of a premium business balance that requires a P 2,500 minimum
balance but has no monthly fees or per check charges. If cost of funds is 10%, which account should Peru choose?
D a. Standard account, because the savings is P 34 per year
b. Premium account, because the savings is P 34 per year
c. Standard account, because the savings is P 16 per year
d. Premium account, because the savings is P 16 per year
29. When managing cash and short-term investments, a corporate treasurer is primarily concerned with
D a. Maximizing rate of return
b. Minimizing taxes
c. Investing in treasury bonds since they have no default risk
d. Liquidity and safety
30. Investment instruments used to invest temporarily idle cash balances should have the following characteristics:
C a. High expected return, readily marketable, and no maturity date
b. Low default risk, low marketability, and a short term to maturity
c. Low default risk, readily marketable, and a short term to maturity
d. High expected return, low marketability, and a short term to maturity
31. China Inc. has a majority of its customers located in Metro Manila. Tibetan, a major retail bank, has agreed to provide
a lockbox system to China at a fixed fee of P 50,000 per year and a variable fee of P0.50 for each payment processed
by the bank. On average, China receives 50 payments per day, each averaging P 20,000. With the lockbox system,
the company’s collection float will decrease by 2 days. The annual interest rate on money market securities is 6%. If
China makes use of the lockbox system, what would be the net benefit to the company? (Use 365 days per year)
C a. P 50,000 c. P 60,875
b. P 59,125 d. P 120,000
32. The primary objective in management of accounts receivable is
A a. To achieve that combination of sales volume, bad debt experience, and receivables turnover that
maximizes the profits of the firm
b. To coordinate the activities of manufacturing, marketing, and financing so that the firm can
maximize its profits
c. To provide the treasurer of the corporation with sufficient cash to pay for the bills on time
d. To realize no bad debts because of the opportunity costs involved
33. The average collection period for a firm measures the number of days
A a. After a typical credit sale is made until the firm receives the payment
b. For a typical check to ‘clear’ through the banking system
c. Beyond the end of the credit period before a typical customer payment is received
d. Before a typical account becomes delinquent
34. Russia, Inc. sells with terms 3/10, net 30 days. Gross sales for the year are P 2,400,000 and the collections
department estimates that 30% of the customers pay on the tenth day and take discounts; 40% pay on the thirtieth
day; and the remaining 30% pay, on the average, 40 days after the purchase. Assuming 360 days per year, what is
the average collection period?
B a. 40 days c. 20 days
35. England Company has an inventory conversion period of 60 days, a receivable conversion period of 35 days, and a
permanent cycle of 26 days. If its sales for the period just ended amounted to P 972,000, what is investment in
accounts receivable? (Assume 360 days in a year)
D a. P 72,450 c. P 85,200
b. P 79,600 d. P 94,500
36. Italy sells to retail stores on credit terms of 2/10, n/30. Daily sales average 150 units at a price of P 300 each.
Assuming that all sales are on credit and 60% of its customers take the discount and pay on day 10 while the rest of
the customers pay on day 30, what is the amount of Italy’s accounts receivable?
D a. P 1,350,000 c. P 900,000
b. P 990,000 d. P 810,000
37. Mexico Company has the opportunity to increase annual sales by P 1 million by selling to new riskier customers. It has
been estimated that uncollectible expenses would be 15% and collection costs, 5%. The manufacturing and other
selling costs are 70% of sales and corporate tax rate is 35%. What will be effect on the after-tax profit?
C a. Increase by P 35,000 c. Increase by P 65,000
b. Increase by P 97,500 d. Remain the same
38. A company’s budgeted sales for the coming year are P 96 million, of which 80% are expected to be credit sales at
terms of n/30. The company estimates that a proposed relaxation of credit standards would increase credit sales by
30% and increase the average collection period from 30 to 45 days. Based on a 360-day year, the proposed relaxation
of credit standards would result to an increase in AR balance by
B a. P 6,880,000 c. P 2,880,000
b. P 6,080,000 d. P 1,920,000
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39. Singapore Corporation plans to tighten its credit policy. Below is the summary of changes:
OLD policy NEW policy
Average number of days collection 75 50
Ratio of credit sales to total sales 70% 60%
Projected sales for the coming year are P 50 million and it is estimated that the company’s credit sales to be 5% less if
the new policy is implemented. Assuming a 360-day year, what is the effect of the new policy on accounts receivable?
A a. P 3,333,333 decrease c. P 6,500,000 decrease
b. P 3,817,445 decrease d. P 18,749,778 increase
40. Iran Computers believes that is collection costs could be reduced through modification of collection procedures. This
action is expected to result in a lengthening of the average collection period from 28 days to 34 days; however, there
will be no change in uncollectible accounts. The company’s budgeted credit sales for the coming year are P
27,000,000, and short-term interest rates are expected to average 8%. To make the changes in collection procedures
cost beneficial, what would be the minimum savings in collection costs (using a 360-day year) for the coming year?
B a. P 30,000 c. P 180,000
b. P 36,000 d. P 360,000
41. A company with P 4.8 million in credit sales per year plans to relax its credit standards, projecting that this will increase
credit sales by P 720,000. The company’s average collection period for new customers is expected to be 75 days, and
the payment behavior of the existing customers is not expected to change. Variable costs are 80% of sales. The
firm’s opportunity cost is 20% before taxes. Assuming a 360-day year, what is the company’s benefit (loss) on the
planned change in credit terms?
C a. P 0 c. P 120,000
b. P 28,800 d. P 144,000
42. Based on a 360-day year, what is the current price of P 100 Treasury bill in 180 days on a 6% discount basis?
B a. P 100.00 c. P 94.00
b. P 97.00 d. P 93.00
43. The forms of short-term borrowing that are unsecured credit are
D a. Floating lien, revolving credit, chattel mortgage, and commercial paper
b. Factoring, chattel mortgage, bankers’ acceptances, and line of credit
c. Floating lien, chattel mortgage, bankers’ acceptances, and line of credit
d. Revolving credit, bankers’ acceptances, line of credit, and commercial paper
44. Sweden Company, a retail store, is considering foregoing sales discounts in order to delay using its cash. Supplier
credit terms are 2/10, n/30. Assuming a 360-day year, what is the annual cost of credit if the cash discount is not
taken and Sweden pays net 30?
D a. 24.0% c. 36.0%
b. 24.5% d. 36.7%
45. Norway buys on terms of 2/10, net/30, but generally does not pay until 40 days after the invoice date. Its purchases
total P 1,080,000 per year. How much non-free trade credit does the firm use each year?
B a. P 120,000 c. P 60,000
b. P 90,000 d. P 30,000
46. Finland plans to acquire an equipment costing P 2,400,000. A bank loan can finance the acquisition with a 10%
discounted interest. Alternatively, the company may delay payment to its suppliers. Presently, the company buys
under terms of 2/10, net 40, but it believes payment could be delayed 30 additional days, without penalty (i.e.,
payment could be made in 70 days). What should the company do?
A a. Borrow since it is cheaper by 1.13% than delaying payment to suppliers.
b. Borrow since it is cheaper by 2.5% than delaying payment to suppliers.
c. Delay payments to suppliers since it would cost 12% as against bank loan of 10%.
d. Delay payments to suppliers since it does not cost anything.
47. A compensating balance
A a. Compensates a financial institution for services rendered by providing it with fund deposits
b. Is used to compensate for possible losses on a marketable securities portfolio
c. Is a level of inventory held to compensate for variations in usage rate and lead time
d. Is the amount of prepaid interest on a loan
48. Romania Company’s bank requires a compensating balance of 20% on a P 100,000 loan. If the stated interest on the
loan is 7%, what is the effective cost of the loan?
D a. 5.83% c. 8.40%
b. 7.00% d. 8.75%
49. Belgium Company got a recent quote on a commercial bank loan of 16% discounted rate with a 20% compensating
balance. The term of the loan is one year. What is the effective cost of borrowing?
D a. 19.05% c. 22.85%
b. 20.00% d. 25.00%
50. A bank loans P 1,000,000 to Ireland for 180 days, with interest of P 60,000 to be paid. The bank also requires a
P200,000 compensating balance for the loan period. What is the effective annual rate?
B a. 16.22% c. 14.00%
b. 15.00% d. 13.00%
51. Assume that a bank has lent a firm a P 200,000 for 60 days at 10% interest. The loan is discounted, and the bank
requires a 20% compensating balance. What is the effective annual rate?
B a. 14.60% c. 10.17%
b. 12.76% d. 10.00%
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54. The Brunei Bank and Lugina Corp. signed a loan agreement subject to the following terms:
 Stated interest rate of 18% on one-year discounted loan
 15% compensating non-interest bearing checking account balance to be maintained by Lugina with Brunei Bank.
The net proceeds of the loan totaled P 1,000,000. What was the principal amount of the loan?
A a. P 1,492,537 c. P 1,176,471
b. P 1,219,512 d. P 1,000,000
55. Chile Co. obtained a short-term bank loan for P 250,000 at an annual interest of 6%. Under the loan, the company is
required to maintain a compensating balance of P 50,000 in its savings account that earns interest at an annual rate of
2%. The company would otherwise maintain only P 25,000 in the savings account for transaction purposes. What is
the effective interest rate of the loan?
B a. 5.80% c. 6.66%
b. 6.44% d. 7.00%
56. A company has accounts payable of P 5 million with terms of 2% discount within 15 days, net 30 days (2/15, n/30). It
can borrow funds from a bank at an annual rate of 12%, or it can wait until the 30th day when it will receive revenues
to cover the payment. If it borrows funds on the last day of the discount period in order to obtain the discount, what
will be its total cost?
C a. P 24,500 more c. P 75,500 less
b. P 51,000 less d. P 100,000 less
57. Brazil Co. can issue 3-month commercial paper with a face value of P 1,000,000 for P 980,000. The transaction costs
would be P 1,200. What would be the annualized percentage cost of financing?
D a. 2.17% c. 8.48%
b. 8.00% d. 8.66%
58. A company enters into an agreement with a firm that will factor the company’s accounts receivable. The factor agrees
to buy the receivables, which average P 100,000 per month and have an average collection period of 30 days. The
factor will advance up to 80% of the face value of the receivables at an annual rate of 10% and charge a fee of 2% on
all receivables purchased. The company controller estimates that the company would save P 18,000 in collection
expenses over the year. Fees and interest are not deducted in advance. Based on a 360-day year, what is the annual
cost of financing?
D a. 10.0% c. 14.0%
b. 12.0% d. 17.5%
59. A firm often factors its accounts receivable. Its finance company requires a 6% reserve and charges a 1.4%
commission on the amount of the receivables. The remaining amount to be advanced is further reduced by an annual
interest charge of 15%. What proceeds will the firm receive from the finance company at the time a P 100,000
account due in 60 days is factored?
B a. P 85,000 c. P 92,600
b. P 90,285 d. P 96,135
60. Greece, Inc. plans to factor its receivable and has collected data on the following finance companies:
Required reserves Commissions Annual interest charge
Company A 6% 1.4% 15%
Company B 7% 1.2% 12%
Company C 5% 1.7% 20%
Company D 8% 1.0% 5%
Which company will give Greece the highest proceeds from a P 100,000 account due in 60 days?
A a. Company A c. Company C
b. Company B d. Company D
Solutions and clarifications to selected items
20. Square root of: 2 (2,000,000) 50 ÷ 0.08 = P 50,000 2M ÷ 50,000 = 40 transactions

Frequency of transactions: 360 days ÷ 40 transactions = every 9 days
25. 8% [(90,000,000/360)3] – 20,000 (4) = P 20,000 loss
28. Standard: 500(10%) + 12[10+0.1(80)] = P 266 Premium: 2,500(10%) = P 250
36. Age of AR: 60% (10) + 40% (30) = 18 days AR = 150 (300) x 18 = P 810,000
39. Old AR balance: 76.8M x (30/360) New AR balance: (76.8M x 1.3) x (45/360)
40. (27M ÷ 360) x 6 days x 8%
41. Benefit: 720,000 x 20% = P 144,000 Cost: (720,000/360) x 75 days x 80% x 20% = P 24,000
45. Non-free trade credit: (1,080,000 ÷ 360) x (40-10) = P 90,000
46. Loan: 10/90 = 11.1% Credit: 2/98 x 360/60 = 12.24%
50. 60,000 ÷ (1,000,000 - 200,000) = 7.5% 7.5% (360 ÷ 180) = 15%
Assuming interest is compounded, the effective annual rate (EAR) would have been:
(1 + 7.5%) 360/180 - 1 = 15.56%
NOTE: Unless indicated otherwise, interest is assumed to be non-compounded.
51. Interest = 200,000 x 10% x 60/360 = 3,333
[3,333 ÷ (200,000 – 40,000 – 3,333)] x 360/60 = 12.76%
54. (100% - 18% - 15%) Principal = P 1,000,000
55. [6% (250,000) – 2% (50,000 - 25,000)] ÷ [250,000 - (50,000 - 25,000)] = 6.44%
56. (5M x 98%) x 12% x 15/360 = P 24,500 vs. P 100,000 = 5M x 2 %
58. Interest: 80,000 x 10% x (30/360) = 666.7 Charges: 100,000 x 2% = 2,000
Cost of financing (factoring): {[666.7 + 2,000 - (18,000/12)] ÷ 80,000} x (360 ÷ 30)
59. (100% - 6% - 1.4%) 100,000 – [92,600 (15%) X (60 ÷ 360)]
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MAS-13: COSTS OF CAPITAL, LEVERAGE & CAPITAL STRUCTURE

COSTS of CAPITAL
 COST of CAPITAL is the rate of return necessary to maintain market value of a firm or firm’s stock price.
 Cost of capital is used for: (1) capital budgeting decisions, (2) helping establish the optimal capital
structure, and (3) making decisions such as leasing and working capital management. It is often called by a
variety of names: minimum required rate of return, hurdle rate, desired rate, standard rate, cut-off rate.
 The cost of capital is computed as a weighted average of the various capital sources or components, which
are items mostly found on the right-hand side of the balance sheet such as LONG-TERM DEBT, PREFERRED
STOCK, COMMON STOCK and RETAINED EARNINGS:
CAPITAL COST
Long-Term Debt Yield Rate (100% - Tax Rate)
Preferred Stock Yield Rate
Common Stock Yield Rate + Growth Rate
Retained Earnings Yield Rate + Growth Rate
 Cost of Long-Term Debt  “KD”
 Yield rate is based on a debt instrument’s EFFECTIVE interest rate, rather than its nominal interest rate.
 In lieu of doing the interpolation process to determine effective interest rate, the following formula may
be used to approximate the YIELD-TO-MATURITY (YTM) rate on a debt instrument like bonds:
Interest + [(Face Value – Net Proceeds) ÷ Life]
YTM =
(Net Proceeds + Face Value) ÷ 2
 Another way to compute YTM, although rarely used nowadays, is to express the denominator as a
weighted average (“60-40”) of the net proceeds and face value, rather than as a simple average.
 YTM must be distinguished from CURRENT YIELD (CY). CY = Annual Interest ÷ Current Market Price
 Cost of long-term debt is expressed as “after-tax” since interest charges are tax-deductible expenses.
 Cost of Preferred Stock(PS)  “KP”
 Yield rate that must be used is actually the DIVIDEND YIELD.
Dividend per share
Dividend Yield =
Market price per share
 Dividend per share = preferred dividend rate x par value per share
 Market price per share should be net of any flotation or issue costs.
 FLOTATION COST is the cost of issuing or ‘floating’ securities in the market, normally incurred by
issuing Initial Public Offering (IPO) shares in the exchange market. The typical costs of selling stock
include underwriter’s spread, direct expenses, indirect expenses, abnormal returns, underpricing.
 Growth rate is not considered since preferred dividends are relatively fixed every year.
 Tax is not considered since dividends paid are not deductible for tax purposes (i.e., no tax shield).
 Cost of Common Stock (CS) & Retained Earnings (RE)  “KE”
 Yield rate, like the cost of preferred stock, is also the DIVIDEND YIELD.
 Dividend per share must be based on the next dividend to be paid (i.e., expected dividend).
 Expected dividend per share = past/present dividend per share x (100% + Growth Rate)
 In computing cost of CS & PS, market price per share should be net of any flotation or issue costs.
 In computing cost of RE, flotation cost should be ignored as RE is neither being sold nor issued.
 The formula “KE = Yield Rate + Growth Rate” is actually based on the GORDON’s GROWTH MODEL,
named after the American economist Myron Gordon who invented the model along with Eli Shapiro.
 Under the Gordon model, the growth rate of dividends is assumed to be constant throughout perpetuity.
 Tax is not considered since dividends paid are not deductible for tax purposes (i.e., no tax shield).
 Alternatively, the cost of equity capital may be computed using the CAPITAL ASSET PRICING MODEL.
CAPITAL ASSET PRICING MODEL (CAPM): A RISK-BASED APPROACH
 A security risk consists of two components: 1) diversifiable risks and 2) non-diversifiable risks.
1) DIVERSIFIABLE RISK, a.k.a. controllable risk or unsystematic risk or company-specific risk, represents
the portion of a security’s risk that can be controlled through diversification. This type of risk is unique
to a given security. Business, liquidity, and default risks fall into this category.
 BUSINESS RISK is caused by fluctuations of earnings before interest and taxes (operating income).
It depends on variability in demand, sales price, input prices, and amount of operating leverage.
 LIQUIDITY RISK is the possibility that an asset may not be sold on short notice for its market value.
If an asset is sold at a high discount, then it is said to have a high level of liquidity risk.
 DEFAULT RISK is the risk that a borrower will be unable to make interest payments or principal
repayments on debt.
2) NON-DIVERSIFIABLE RISK, a.k.a. noncontrollable risk or systematic risk or market-related risk, results
from forces outside of the firm’s control and is therefore not unique to the given security. Purchasing
power, interest rate, and market risks fall into this category.
 MARKET RISK is the risk that a stock’s price will change due to changes in stock market as a whole
since prices of all stocks are correlated to some degree with broad swings in the stock market.
 INTEREST RATE RISK is the risk resulting from fluctuations in the value of an asset as interest rates
change. For example, if interest rates rise (fall), bond prices fall (rise).
 PURCHASING POWER RISK is the risk that a rise in price will reduce the quantity of goods that can
be purchased with a fixed sum of money.
 CAPM, a model developed by American economist William Sharpe, deals with the relationship between (1)
non-diversifiable/systematic risk and (2) expected return for assets, particularly stocks.

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Week No. 15: COSTS of CAPITAL, LEVERAGE & CAPITAL STRUCTURE
 Using the CAPM approach in computing cost of common equity and retained earnings, the formula is:
KE = KRF + β (KM - KRF)
 “KE” is the EXPECTED or REQUIRED RATE OF RETURN used as cost of equity capital
 “KRF” is the RISK-FREE RATE that is usually based on treasury bill (T-bill) rate
 “β” is the BETA COEFFICIENT is a measure of the volatility (sensitivity) or systematic risk of a security
compared to the market as a whole (i.e. how much stock price changes compared with how much the
entire stock market changes). Consider the following interpretations based on different values of β:
Aβ > 1 Stock price is more volatile than stock market If market rises by 10%, stock price rises above 10%
β=1 Stock price is as volatile as stock market If market rises by 10%, stock price rises also by 10%
nβ < 1 Stock price is less volatile than stock market If market rises by 10%, stock price rises below 10%
A negative value for β signifies that stock price moves in opposite direction with the stock market.
 “KM” is the MARKET RETURN while “(KM - KRF)” is the MARKET RISK PREMIUM
 “β (KM - KRF)” is the RISK PREMIUM, the additional return required to compensate for assumed risks
 CAPM is graphically represented by drawing the SECURITY MARKET LINE, which shows the amount of
returns an investor can expect from the market with regard to the different levels of systematic risk (β).
 The fundamental idea behind the CAPM is that investors expect a reward for both waiting and worrying:
 If you invest in a risk-free T-bill, you just receive the rate of interest. That’s the reward for waiting.
 When you invest in risky stocks, you can expect an extra return or risk premium for worrying.
LEVERAGE
 LEVERAGE is that portion of the fixed costs which represents a risk to the firm
 OPERATING LEVERAGE, a measure of operating or business risk, refers to the degree to which a firm uses
and incurs fixed costs in its operations.
CM  % in EBIT
DEGREE OF OPERATING LEVERAGE (DOL) = OR DOL =
EBIT  % in Sales
Where: CM (Contribution Margin) = Sales – Variable Costs
EBIT (Earnings before Interests and Taxes) = CM – Fixed Operating Costs
 FINANCIAL LEVERAGE, a measure of financial risk, refers to financing a portion of the firm’s assets, bearing
fixed financing charges in hopes of increasing the return to the common stockholders.
EBIT  % in EPS
DEGREE OF FINANCIAL LEVERAGE (DFL) = OR DFL =
EBIT – FFC  % in EBIT
Where: EPS – Earnings per Share [This shall be taken up under MAS-15: FS Analysis during Week 18]
FFC (Fixed Financing Charges) = Interest Charges + Pre-Tax Preferred Dividends
NOTE: The higher the financial leverage, the higher the financial risk, and the higher the cost of capital
since it costs more to raise funds for a risky business.
 TOTAL LEVERAGE, a measure of total risk, determines how EPS is affected by a change in sales.
CM  % in EPS
DEGREE OF TOTAL LEVERAGE (DTL) = OR DTL =
EBIT – FFC*  % in Sales
NOTE: DTL may be also be computed based on: DTL = DOL x DFL
CAPITAL STRUCTURE
 CAPITAL STRUCTURE refers to the mix of the LONG-TERM FINANCING that comprises the sources of funds
used by a firm that do not mature with one year, such as long-term debt, preferred and common equity.
 Capital structure must be distinguished from FINANCIAL STRUCTURE, which refers to the mix of all firm’s
assets. Hence, Capital Structure = Financial Structure – Current Liabilities
 OPTIMAL CAPITAL STRUCTURE refers to the mix of debt and equity financing that maximizes a firm’s
market value while minimizing its overall or weighted average cost of capital (WACC).
 WACC is a calculation of a firm’s capital in which each category of capital is proportionately weighted on the
basis of each category’s market value rather than book value.
 WACC must be distinguished from MARGINAL COST of CAPITAL (MCC), which is the cost to the firm of the
next peso of new capital raised after exhausting internal source of financing (e.g., retained earnings). MCC
is the rate of return that shareholders and debt holders expect before making an investment in a company.
 DEBT FINANCING offers the lowest cost of capital due to its tax deductibility. However, too much debt
increases financial risk to shareholders and return on equity that they require.
 Providers of equity capital are exposed to more risk than are creditors because (1) the firm is not legally
obligated to pay them a return and (2) in case of liquidation, equity investors trail creditors in priority.
 To compensate for the higher level of risk, equity investors demand a higher return, making equity
financing more expensive then debt.
 The TRADITIONAL theory of capital structure states that when WACC is minimized and the market value of
assets is maximized, an optimal capital structure exists.
 Value of the firm = Market value of debt + Market value of common equity = EBIT ÷ WACC
Where: Market value of debt = Interest ÷ Cost of Debt
Market value of common equity = (EBIT – Interest) ÷ Cost of Common Equity
 Firm’s value increase to certain level of debt capital. However, a firm’s value after the debt tipping point
eventually decreases because of overleveraging (too much borrowing).
 An unlevered (i.e., no debt) company will have a WACC equal to its cost of equity financing and can
reduce WACC by adding debt up to the point where marginal cost of debt equals marginal cost of equity.
 According to economists MODIGLIANI and MILLER (authors of “MM” theory), in perfect markets where there
are no taxes and transaction costs, the value of a firm depends on present value of future earnings and is
NOT affected by the capital structure or the choice of financing adopted to finance the assets.
 According to the PECKING ORDER theory, firms prioritize financing strategy based on the order: (1st)
Internal financing thru retained earnings (2nd) Debt (3rd) New issue of equity shares – as last resort.
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EXERCISES: COSTS of CAPITAL, LEVERAGE & CAPITAL STRUCTURE
1. Weighted Average Cost of Capital

Sinovac Company wants to determine the weighted average cost of capital that it can use to evaluate
capital investment proposals. The company’s capital structure with corresponding market values follows:
8% Term Bonds P 600,000
5% Preferred stock (P 100 par) 200,000
Common stock (no par, 10,000 shares outstanding) 400,000
Retained earnings 800,000
TOTAL P 2,000,000
Additional data:
1) Current market price per share: 2) Expected common dividend: P 2 per share
 Preferred stock: P 100 3) Dividend growth rate: 4%
 Common stock: P 40 4) Income tax rate: 30%
REQUIRED:
A) Cost of bonds
B) Cost of preferred stock
C) Cost of common stock and retained earnings
D) Weighted average cost of capital
2. Cost of Debt: Current Yield vs. Approximate Yield-to-Maturity

Astra Company has an outstanding P 1,000 par value bond with 20 years to maturity. The bond carries an
annual interest payment of P 110 and is currently selling for P 1,080.

A) Current Yield
B) Approximate Yield-to-Maturity (using simple average)
C) Approximate Yield-to-Maturity (using weighted average)
3. Cost of Preferred Stock

Pfizer Company pays an annual dividend of P 15 per share for its preferred stock with a P 100 par value.
Pfizer can sell each share of preferred stock for a price of P 125.

A) Cost of preferred stock (assuming a tax rate of 30%)
B) Cost of preferred stock (assuming a flotation cost of P 10 per share)
4. Cost of Common Equity: Gordon Growth Model (GGM)

Zeneca Company’s common stock is selling for P 50 per share with 20% flotation cost and a dividend of P 2
per share. Both earnings and dividends are expected to grow by 10%. Tax rate is 25%.

A) Cost of common stock (assuming the P 2 dividend is not yet paid)
B) Cost of retained earnings (assuming the P 2 dividend is not yet paid)
C) Cost of common stock (assuming the P 2 dividend was just paid recently)
D) Cost of retained earnings (assuming the P 2 dividend was just paid recently)
5. Cost of Common Equity: Capital Assets Pricing Model (CAPM)

Use the Security Market Line equation for CAPM in each of the following independent cases.
REQUIRED:
A) Determine the required rate of return for an asset with a beta of 0.90 when the risk-free rate and
market return are 8% and 12%, respectively.
B) Determine the risk-free rate for a firm with a required rate of return of 15% and a beta of 1.25
when the market return is 14%.
C) Determine the market return for an asset with a required rate of return of 16% and a beta of 1.10
when the risk-free rate is 9%
D) Determine the beta for an asset with a required rate of return of 15% when the risk-free rate and
market return are 10% and 12.5%, respectively.
6. Leverage
Moderna Company sells 50,000 units of a product at P 12 each. The unit variable cost is P 10 while the fixed
operating costs amounted to P 50,000. The company has current interest charges of P 6,000 and preferred
dividends of P 2,400. The corporate tax rate is 40%.

A) Degree of operating leverage (DOL)
B) Degree of financial leverage (DFL)
C) Degree of total leverage (DTL)
D) What happens to DOL, DFL and DTL if sales increase by 50%?
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1. The theory underlying the cost of capital is primarily concerned with the cost of
a. Long-term funds and old funds c. Short-term funds and old funds
b. Long-term funds and new funds d. Short-term funds and new funds
2. Which one of a firm’s sources of new capital usually has the lowest after-tax cost?
a. Bonds c. Preferred stock
b. Common stock d. Retained earnings
3. The dividend growth rate is relevant to which of the following costs of capital?
a. Cost of debt and equity
b. Cost of common and preferred equity
c. Cost of common equity and retained earnings
d. Cost of debt, common equity and retained earnings
4. When calculating the cost of capital, the cost assigned to retained earnings should be
a. Zero
b. Equal to the cost of external common equity
c. Lower than the cost of external common equity
d. Higher than the cost of external common equity
5. Using the Capital Asset Pricing Model (CAPM) approach of computing the cost of common equity and
retained earnings, which among the following formulas is correctly stated?
a. KRF - (KM + KRF) β c. KRF + (KM - KRF) β
b. (KRF + KM) β d. (KM - KRF) β
6. According to the Capital Asset Pricing Model (CAPM), the relevant risk of a security is its
a. Company-specific risk c. Systematic risk
b. Diversifiable risk d. Total risk
7. What is the difference between the required rate of return on a given risky investment and that on a
risk-free investment with the same expected return?
a. Risk premium c. Standard deviation
b. Coefficient of variation d. Beta coefficient
8. The use of debt in the capital structure of a firm
a. Increases its financial leverage c. Decreases its financial leverage
b. Increases its operating leverage d. Decreases its operating leverage
9. Operating leverage x financial leverage =
a. Total leverage c. Margin of safety
b. Business leverage d. No meaningful amount
10. Capital structure decisions involve determining the proportions of financing from
a. Debt or equity c. Short-term or long-term assets
b. Short-term or long-term debt d. Retained earnings or common stock
11. Equity in a firm with no debt is called
a. Levered equity c. Riskless equity
b. Unlevered equity d. Risky equity
12. It is generally more expensive for a firm to finance with equity capital than with debt capital because
a. Long-term bonds have a maturity date and must therefore be repaid in the future
b. Investors are exposed to greater risk with equity capital
c. Equity capital is in greater demand than debt capital
d. Dividends fluctuate to a greater extent than interest rates
13. One reason that a financial manager may prefer to issue preferred stock rather than debt is because:
a. Payments to preferred stockholders are not considered fixed payments.
b. The preferred dividend is cumulative, whereas interest payments are not.
c. In a legal sense, preferred stock is equity; dividend payments are hence not legal obligations
d. The cost of fixed debt is less expensive since it is tax-deductible even if a sinking fund is
required to retire debt
14. A company has announced that it plans to finance future investments so that the firm will achieve an
optimum capital structure. Which corporate objective is consistent with this announcement?
a. Maximize earnings per share c. Maximize the net worth of the firm
b. Minimize the cost of debt d. Minimize the cost of equity
15. A firm’s target or optimal capital structure is consistent with which one of the following?
a. Minimum risk c. Maximum earnings per share
b. Minimum cost of debt d. Minimum weighted-average cost of capital
16. Which of the following is not a relevant theory concerning capital structure and value of the firm?
a. Classic or Traditional Theory c. MM Theory
b. Pecking Order Theory d. Big Bang Theory
17. The overall or weighted average cost of capital is equal to the
a. Average rate of return a firm earns on its assets
b. Minimum rate a firm must earn on high-risk projects
c. Rate of return on assets that covers the costs associated with the funds employed
d. Cost of equity capital at which the market value of the firm will remain unchanged
18. What is the weighted average cost of capital for a firm with equal amounts of debt and equity financing,
a 15% before-tax company cost of equity capital, a 35% tax rate and a 12% coupon rate on its debt
that is selling at par value?
a. 8.78% c. 11.40%
b. 9.60% d. 13.50%
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1. Cost of capital is
C a. The amount the company must pay for its plant assets
b. The dividends a company must pay on its equity securities.
c. The cost the company must incur to obtain its capital resources.
d. The cost the company is charged by investment bankers who handle the issuance of equity or long-
term debt securities.
2. In an investment in plant asset, the return that keeps the market price of the firm stock unchanged is
B a. Net present value c. Adjusted rate of return
b. Cost of capital d. Unadjusted rate of return
3. A company with cost of capital of 15% plans to finance an investment with debt that bears 10% interest. The rate it
should use to discount the cash flows is
B a. 10% c. 25%
b. 15% d. 150%
4. If bonds are currently yielding 8% in the marketplace, why is the firm’s cost of debt lower?
D a. Market interest rates have increased
b. Additional debt can be issued more cheaply than the original debt
c. There should be no difference; cost of debt is the same as the bonds’ market yield
d. Interest is deductible for tax purposes
5. Tabaco Co. has 5% preferred stock with a par value of P 100. Selling price is P 123.50 per share and flotation costs
are P 0.50 per share. If tax rate is 20%, then what is the cost of preferred stock?
B a. 4.03% c. 4.7%
b. 4.07% d. 5%
6. Malaysia Company’s 10% preferred stock that has a par value of P 100 per share is sold for P 101, gross of
underwriting fees of P 5 per share. If the tax rate is 40%, what is the cost of funds for preferred stock?
D a. 4.2% c. 10.0%
b. 6.2% d. 10.4%
7. The term “underwriting spread” as an example of flotation costs refers to the
C a. Commission percentage an investment banker receives for underwriting a security issue
b. Discount investment bankers receive on securities they purchase from the issuing company
c. Difference between the price the investment banker pays for a new security issue and the price at
which the securities are resold
d. Commission a broker receives for either buying or selling a security on behalf of an investor.
8. The three elements needed to estimate the cost of equity capital for use in determining a firm’s weighted average cost
of capital are
D a. Current dividends per share, expected growth rate in dividends per share, and current book value
per share of common stock
b. Expected earnings per share, expected growth rate in dividends per share, and current market price
c. Current earnings per share, expected growth rate in earnings per share, and current book value per
share of common stock
d. Expected dividends per share, expected growth rate in dividends per share, the current market price
9. Pili Company is attempting to compute the cost of internal and external equity. The company’s common stock is
currently selling at P 62.50 per share with flotation cost of P 5 per share. The next dividend per share is P 5.42.
Earnings and dividends are expected to grow at a constant rate of 5%. What is the cost of new common stock (C/S)
and retained earnings (R/E)?
B a. C/S: 13.67%; R/E: 13.67% c. C/S: 13.67%; R/E: 14.43%
b. C/S: 14.43%; R/E: 13.67% d. C/S: 14.43%; R/E: 14.43%
10. The investment-banking firm of Syria & Associates will use a dividend valuation model to appraise the shares of the
Lebanon Corporation. Dividends (D1) at the end of the current year will be P 1.20. The growth rate (g) is 9 percent
and the discount rate (K) is 13 per cent. What should be the price of the stock to the public?
C a. P 28.75 c. P 30.00
b. P 29.00 d. P 31.50
11. Ceteris paribus, the market value of a firm’s outstanding common shares will be higher if
A a. Investors have a lower required return on equity
b. Investors expect lower dividend growth
c. Investors have longer expected holding periods
d. Investors have shorter expected holding periods
12. With everything else held constant, if investors expect high growth in dividends, then:
D a. Price and dividend yield will be low
b. Price and dividend yield will be high
c. Price will be low and dividend yield will be high
d. Price will be high and dividend yield will be low
13. France Co. paid cash dividends to its common stockholders over the past 12 months at P 2.20 per share. The current
market value of the common stocks is P 40 per share, and investors are anticipating the common dividends to grow at
a rate of 6% annually. The cost to issue new common stocks will be 5% of the market value. What will be the cost of
the new common stock issue?
D a. 11.50% c. 11.83%
b. 11.79% d. 12.14%
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14. The weighted average cost of capital approach to decision making is not directly affected by the
C a. Value of common stock
b. Cost of debt outstanding
c. Current budget for expansion
d. Proposed mix of debt, equity, and existing funds used to implement the project
15. The market value of Bato Company’s common stock (book value: P 65M) is estimated at P 60 M and the market value
of its interest bearing debt (book value: P 35M) is estimated at P 40M. The average before tax yield on these liabilities
is 15% per year. Income taxes are 40%. The company is expected to pay a dividend of P 10 per share and the stock
is selling at a price of P 100 per share. The growth rate of dividend is projected to be 2.5% per year. What is the
weighted average cost of capital (WACC) of the company as a whole?
B a. 9% c. 21.5%
b. 11.1% d. 25%
16. Which of the following are acceptable criteria for determining the weights in WACC?
C a. Book value and target capital structure c. Market value and target capital structure
b. Book value and historical capital structure d. Market value and historical capital structure
17. A company has P 1,000,000 in shareholders’ equity and P 2,000,000 in debt (8% bonds). Its after-tax weighted
average cost of capital is 12%, but it uses 15% as the hurdle rate in capital budgeting decisions. During the past year,
its operating income before tax and interest was P 500,000. Its tax rate is 40%. What is the company’s cost of equity
capital?
D a. 8% c. 15%
b. 12% d. 26.4%
18. A single, overall cost of capital is often used to evaluate projects because:
A a. It avoids the problem of computing the required rate of return for each investment proposal.
b. It acknowledges that most new investment projects offer about the same expected return.
c. It acknowledges that most new investment projects have about the same degree of risk.
d. It is the only way to measure a firm's required return.
England Corporation is preparing to evaluate capital expenditure proposals for the coming year. Because the firm
employs discounted cash flow methods, the cost of capital for the firm must be estimated. The following information
for England Corporation is provided:
 The market price of common stock is 60 per share.
 The dividend next year is expected to be P 3 per share.
 Expected growth in dividends is a constant 10%.
 New bonds can be issued at face value with a 10% coupon rate.
 The current capital structure of 40% long-term debt and 60% equity is considered to be optimal.
 Anticipated earnings to be retained in the coming year are P 3 million
 The firm has a 40% marginal tax rate.
19. What is the after-tax cost of the new bond issue?
B a. 4% c. 10%
b. 6% d. 14%
20. What is the cost of using retained earnings for financing?
D a. 5% c. 10%
b. 9% d. 15%
21. If the company must assume a 20% flotation cost on new stock issuances, what is the cost of new common stock?
D a. 6.25% c. 15%
b. 10% d. 16.25%
22. What is the maximum capital expansion that can be supported in the coming year without resorting to external equity
financing?
C a. P 2 million c. P 5 million
b. P 3 million d. Cannot be determined from information given
23. Assume that the after-tax cost of debt financing is 10%, the cost of retained earnings is 14%, and the cost of new
common stock is 16%. If capital expansion needs to be P 7 million for the coming year, what is the after-tax
weighted-average cost of capital?
B a. 11.14% c. 13.60%
b. 12.74% d. 16.00%
24. Assume that after-tax cost of debt is 10%, the cost of retained earnings is 14%, and the cost of new common stock is
16%. What is the marginal cost of capital for a projected capital expansion in excess of P 7 million?
C a. 10.00% c. 13.60%
b. 12.74% d. 16.00%
25. Which model explicitly recognizes a firm’s risk when determining the estimated cost of equity?
A a. Capital asset pricing model c. Bond-yield-plus model
b. Dividend-yield-plus-growth model d. Return on equity model
26. Under CAPM, the required rate of return on a security is the sum of a risk premium and
A a. Risk-free rate c. Operating risk
b. Financial risk d. Diversifiable risk
27. Using Capital Asset Pricing Model (CAPM), what is the required rate of return for a firm with a beta of 1.25 when the
market rate is 14% and the risk-free rate is 6%?
D a. 6% c. 14%
b. 7.5% d. 16%
28. If an individual stock’s beta is higher than 1.0, that stock is:
A a. Riskier than the market c. Less risky than the market
b. Exactly as risky as the market d. The exact opposite of market directions
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29. Tibet plans to use retained earnings to finance capital expenditures. The beta coefficient for Tibet stocks is 1.15, the
risk-free rate of interest is 8.5%, and the market return is 12.4%. The flotation costs for the issue of new common
would be 7%. Under CAPM, what is the cost of using retained earnings to finance the capital expenditures?
B a. 12.40% c. 13.96%
b. 12.99% d. 14.26%
30. Based on the following information about stock increases and decreases, make an estimate of the stock’s beta: Month
1: stock +1.5%, market, +1.1%; Month 2: stock +2%, market, +1.4%, Month 3: stock -2.5%, market -2%
A a. Beta is greater than 1.0 c. Beta is less than 1.0
b. Beta equals 1.0 d. There is no consistent pattern of returns
31. A measure that describes the risk of an investment project relative to other investments in general is the
B a. Coefficient of variation c. Standard deviation
b. Beta coefficient d. Expected return
32. The market risk premium is equal to the return on market portfolio minus the:
A a. Risk-free rate of interest c. Expected rate of inflation
b. Return on average stocks d. Return on average corporate bonds
33. The type of investment risk that can be avoided through proper diversification is called
B a. Systematic risk c. Market risk
b. Unsystematic risk d. Non-controllable risk
34. The risk to which all investment securities are subject is known as
D a. Credit risk c. Unsystematic risk
b. Diversifiable risk d. Systematic risk
35. All of the following are diversifiable (unsystematic) risks, except:
A a. Market risk c. Business risk
b. Default risk d. Liquidity risk
36. All of the following are non-diversifiable (systematic) risks, except:
B a. Market risk c. Interest rate risk
b. Business risk d. Purchasing power risk
37. The risk that securities cannot be sold at a reasonable price of short notice is called
B a. Default risk c. Interest-rate risk
b. Liquidity risk d. Purchasing-power risk
Spain, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms
described below, the company can sell unlimited amounts of all instruments.
 Spain can raise cash by selling P 1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an
average premium of P 30 per bond would be received, and the firm must pay flotation costs of P 30 per bond.
The after-tax cost of funds is estimated to be 4.8%.
 Spain can sell 8% preferred stock at P 105 per share. The cost of issuing and selling the preferred stock is
expected to be P 5 per share.
 Spain’s common stock is currently selling for P 100 per share. The firm expects to pay next year cash dividends of
P 7 per share, and the dividends are expected to remain constant. The stock will have to be underpriced by P 3
per share, and flotation costs are expected to amount to P 5 per share.
 Spain expects to have available P 100,000 of retained earnings in the coming year, once these retained earnings
are exhausted, the firm will use new common stock as the form of common stock equity financing.
 Spain’s preferred capital structure is: Long-term debt 30%, Preferred stock 20%, and Common stock 50%.
38. What is the cost of funds from sale of common stock for Spain?
C a. 7.0% c. 7.6%
b. 7.4% d. 8.1%
39. What is the cost of funds from retained earnings for Spain?
A a. 7.0% c. 7.6%
b. 7.4% d. 8.1%
40. If Spain needs a total of P 200,000, what would be the firm’s weighted average cost of capital?
B a. 4.8% c. 6.8%
b. 6.5% d. 19.80%
41. If Spain needs a total of P 1,000,000, what would be the firm’s weighted average cost of capital?
C a. 4.8% c. 6.8%
b. 6.5% d. 27.4%
42. A company has P 1,000,000 in shareholders’ equity and P 2,000,000 in debt equity (8% bonds). Its after-tax weighted
average cost of capital is 12%, but it uses 15% as the hurdle rate in capital budgeting decisions. During the past year,
its operating income before tax and interest was P 500,000. Its tax rate is 40%. What is the company’s cost of equity
capital?
D a. 8% c. 15%
b. 12% d. 26.4%
43. A firm with a higher degree of operating leverage when compared to industry average implies that the
D a. Firm is less risky
b. Firm is more profitable
c. Firm has higher variable costs
d. Firm’s profits are more sensitive to changes in sales volume
44. For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will
C a. Increase pre-tax profits by 3.5% c. Increase pre-tax profits by 21%
b. Decrease pre-tax profits by 3.5% d. Increase pre-tax profits by 1.71%
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45. Securing of funds for investment at a fixed rate of return to fund suppliers, to enhance the well-being of the common
stockholders is known as:
A a. Financial leverage c. Prudent borrowing
b. Fund management d. Financial arbitrage
46. In 2021, Thailand Corporation increased earnings before interest and taxes by 17%. During the same period, net
income after tax increased by 42%. What is the degree of financial leverage for 2021?
C a. 1.70 c. 2.47
b. 4.20 d. 5.90
Vatican Company currently sells 400,000 bottles of perfume each year. Each bottle costs P 0.84 to produce and sells
for P 1.00. Fixed costs are P 28,000 per year. The firm has annual interest expense of P 6,000, preferred stock
dividends of P 2,000 per year, and a 40% tax rate.
47. What is the degree of operating leverage for Vatican Company?
B a. 2.4 c. 1.35
b. 1.78 d. 1.2
48. What is the degree of financial leverage for Vatican Company?
C a. 2.4 c. 1.35
b. 1.78 d. 1.2
49. If Vatican Company did not have preferred stock, the degree of total leverage would
A a. Decrease in proportion to a decrease in financial leverage
b. Increase in proportion to an increase in financial leverage
c. Remain the same
d. Decrease but not be proportional to the decrease in financial leverage
50. Financial leverage is concerned with the relationship between
A a. Changes in EBIT and changes in EPS
b. Changes in EBIT and changes in operating income
c. Changes in volume and changes in EPS
d. Changes in volume and changes in EBIT
51. A company has unit sales of 300,000, unit variable cost of P 1.50, unit sales price of P 2.00 and annual fixed costs of P
50,000. Furthermore, the annual interest expense is P 20,000, and the company has no preferred stock. Accordingly,
what is the degree of combined leverage?
A a. 1.875 c. 1.25
b. 1.50 d. 1.20
52. Combined leverage is concerned with the relationship between
C a. Changes in EBIT and changes in EPS c. Changes in volume and changes in EPS
b. Changes in EBIT and changes in net income d. Changes in volume and changes in EBIT
53. Assume that Company A and Company B are alike in all respects except that Company A utilizes more debt financing
and less equity financing that does Company B. Which of the following statements is true?
A a. Company A has more net earnings variability than Company B
b. Company A has more operating earnings variability than Company B
c. Company A has less operating earnings variability than Company B
d. Company A has less financial leverage than Company B
54. Ideally, a firm’s capital structure is one that balances the cost of debt and equity capital and their associated risk
levels. The optimal capital structure that minimizes the firm’s
D a. Cost of debt c. Earnings per share
b. Cost of equity d. Weighted average cost of capital
55. Which of the following factors generally does not impact management’s capital structure strategy?
D a. Business risk c. Management’s aggressiveness
b. Tax position d. Expected return on assets
56. Which of the following is not a source of long-term financing?
D a. Common stock c. Bonds
b. Preferred stock d. Line of credit
57. Which of the following is considered as a hybrid financing that has features of both debt and equity, requires a fixed
charge and increases leverage, but dividend payment is not a legal obligation?
B a. Common stock c. Bonds
b. Preferred stock d. Floating Lien
58. Generally speaking, the most expensive source of financing is:
D a. Debt c. Retained earnings
b. Preferred stock d. New common stock
59. Which of the following is an advantage of equity financing in comparison to debt financing?
C a. Issuance costs are greater than for debt
b. Ownership is given up with respect to the issuance of common stock
c. The company has no firm obligation to pay dividends to common shareholders
d. Dividends are not tax deductible by the corporation whereas interest is tax deductible
60. All of the following are advantages of debt financing, EXCEPT
B a. Interest is tax deductible
b. The acquisition of debt decreases stockholders’ risk
c. The use of debt will assist in lowering the firm’s cost of capital
d. In periods of inflation, debt is paid back with pesos that are worth less than the ones borrowed
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CPA Review Batch 41  May 2021 CPA Licensure Examination  Weeks 16-17
MAS-14: CAPITAL BUDGETING WITH INVESTMENT RISKS & RETURNS

CAPITAL BUDGETING
 CAPITAL INVESTMENT is the long-term commitment of significant funds to meet certain objectives such as
acquiring additional plant assets to expand company operations. Its typical characteristics include:
 As to COST: requires a large sum of money and resources
 As to COMMITMENT: ties up invested funds for a long period of time
 As to FLEXIBILITY: more difficult to reverse than short-term decisions
 As to RISK: involves so much risks and uncertainties mainly due to estimates and forecasts being
assumed over an extended period of time
 INDEPENDENT capital investment projects (meant for SCREENING decisions) are projects that are evaluated
individually against predetermined corporate standard of acceptability resulting in an accept-or-reject
decision. Common examples: investment in long-term assets such as purchase of property, plant or
equipment, new product development, large-scale advertising campaign.
 MUTUALLY EXCLUSIVE capital investment projects (meant for PREFERENCE decisions) are projects that
require choosing from among alternatives and, once chosen, usually preclude the company from choosing
other competing projects. Common examples: replacement vs. renovation of equipment, lease vs. buy of
facilities, manual bookkeeping vs. computerized system, preventive maintenance vs periodic overhaul.
 CAPITAL BUDGETING is the process of measuring, evaluating, and selecting capital investments.
 Six formal stages of capital budgeting: 1) Identification and definition stage 2) Search stage 3) Information-
acquisition stage – both qualitative and quantitative information is considered 4) Selection stage – choosing projects
after cost-benefit evaluation 5) Financing stage 6) Implementation and Control stage – conduct of post-audit.
 An over-simplified capital budgeting process involves the following steps:
Step 1: Step 2: Step 3:
Identification Evaluation Decision
Nature of Capital Investments FACTORS OF CONSIDERATION

Replacement (Equipment)
Improvement (Products)
Expansion (Facilities) Net Investments Net Returns Costs of Capital
Addition (Technology)
Reduction (Costs)
Capital budgeting, after the selection Non-discounted methods Discounted methods

of the capital investment project, Payback period Net present value (NPV)
typically extends up to the financing, Bail-out payback Profitability index
implementation, monitoring and Accounting rate of return (ARR) Internal rate of return (IRR)
review of the project. Payback reciprocal Discounted payback
 NET INVESTMENTS, primarily computed for decision-making purposes, refer to COSTS (cash outflows) less
SAVINGS (cash inflows) incidental to the acquisition of the capital investment projects.
 COSTS (Cash outflows) include:
 Purchase price of the asset, net of any related cash discount
 Incidental project-related expenses such as freight, insurance, handling, installation, test-runs
 Additional working capital needed to support the operation of the project at the desired level.
(NOTE: At the end of the project’s life, additional working capital shall be recaptured as part of the
project’s terminal cash flow, along with any salvage value of the project)
 Market value of existing idle assets to be used in the operation of the proposed capital project.
 Training cost, net of related tax
 SAVINGS (Cash inflows) include:
 Proceeds from sale of an old asset disposed, net of related tax
 Trade-in value of the old asset (in case of replacement)
 Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax
 NET RETURNS refers to either net income (under accrual basis) or net cash flows (under cash basis), the
latter may be computed under direct or indirect method:
 Direct method: Net cash inflows = cash inflows – cash outflows
 Indirect method: Net cash inflows = Net income + noncash expenses (e.g., depreciation)
 COST of CAPITAL, a.k.a. hurdle rate, minimum required/acceptable rate of return, desired rate, cut-off rate,
standard rate, is used as a discount rate in discounted capital budgeting techniques like NPV and
profitability index. [Cost of Capital was discussed in MAS-13 during Week 15]
 PAYBACK PERIOD measures the length of time required to recover the amount of initial investment.
Net Investment
PAYBACK PERIOD =
Net Cash Inflows
RULE: the shorter the payback period, the less risky the project and the greater the liquidity
PROS: simple to compute, easy to understand, useful in evaluating liquidity of the project, a good surrogate
for risk -- a quick or short payback period indicates a less risky project.
CONS: ignores time value of money, ignores salvage value and cash flows after payback period, more
emphasis on return OF investment instead of ROI, maximum payback period may be arbitrary
 BAIL-OUT PAYBACK PERIOD is payback method wherein cash recoveries include not only the annual net
cash inflows but also the estimated salvage value realizable at the end of each year of the project life.

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Weeks 16-17: CAPITAL BUDGETING with INVESTMENT RISKS & RETURNS
 ACCOUNTING RATE of RETURN, a.k.a. book rate of return, simple rate of return, unadjusted rate of return,
financial statement rate of return, measures the profitability from accounting standpoint by relating the
required investment to the future annual net income.
Average Annual Net income
ACCOUNTING RATE of RETURN (ARR) =
Original or Average Investment*
RULE: choose the project with higher ARR vs. the cost of capital.
PROS: emphasize project9s profitability, considers entire life and project results, consistent with FS values
CONS: ignores time value of money, ignores inflationary effects, uses accrual values rather than cash flows
 PAYBACK RECIPROCAL provides a reasonable estimate of the internal rate of return (IRR) provided that the
following two conditions are met:
Condition No. 1: Payback period is at most half of the economic life of the project
Condition No. 2: Net cash inflows are uniform throughout the life of the project.
Net Cash Inflows 1
PAYBACK RECIPROCAL = =
Net Investment Payback period
NOTE: Payback reciprocal is a non-discounted technique used to estimate a discounted technique (IRR).
 NET PRESENT VALUE measures the excess of the present value of cash inflows generated by the project
over the amount of initial investment.
Net Present Value (NPV) = Present Value of Cash Inflows – Present Value of Cash Outflows
 CASH INFLOWS include annual net cash inflows infused by the capital investment project and any cash
realizable at the end of the project life (e.g., salvage value, return of working capital requirements).
 CASH OUTFLOWS is usually based on the net investment cost required at the inception of the project.
RULE: choose the project that has positive NPV.
PROS: emphasizes cash flows, considers time value of money, assumes cost of capital as reinvestment rate
CONS: costs of capital is not always available, may be incomparable if projects have different lives or sizes.
 PROFITABILITY INDEX, a.k.a. benefit-cost ratio, desirability index, present value index, expresses the
present value of cash benefits as to an amount per peso of investment in a capital project and is used as a
measure of ranking projects in a descending order of desirability.
Present Value of Cash Inflows
PROFITABILITY INDEX =
Present Value of Cash Outflows
RULE: choose the project that has a profitability index of more than 1.0.
 INTERNAL RATE of RETURN (IRR), a.k.a. time-adjusted rate of return, discounted cash flow rate of return,
sophisticated rate of return, break-even cash flow rate or return, is the rate of return that equates the
present value of cash inflows to present value of cash outflows. IRR is the discount rate at which the net
present value is zero.
RULE: choose the project with higher IRR vs. the cost of capital.
PROS: emphasizes cash flows, considers time value of money, computes the true return of the project
CONS: difficult to compute for uneven cash flows, requires estimation of cash flows over a long period of
time, assumes IRR as reinvestment rate, may not be meaningful if a project has negative earnings.
NOTE: Determination of a project9s exact IRR may require an interpolation process. Trial and error
technique and the payback reciprocal method may also be used to approximate the IRR.
 IRR must be distinguished from CROSSOVER RATE (a.k.a. NPV Point of Indifference, Fisher Rate*), which is
the discount rate at which the NPV of two capital investment projects are equal.
 DISCOUNTED PAYBACK, a.k.a. break-even time, is the length of time required to equalize the discounted
cash flows (using the cost of capital as a discount rate) and initial investment of a capital project.
 EQUIVALENT ANNUAL ANNUITY (EAA), a.k.a. annualized NPV, is a NPV-based technique that is used to
compare capital investment projects with unequal lives.
 CAPITAL RATIONING is, given a constraint on capital budget, the selection of investment proposals that
would maximize the over-all NPV of the firm. The profitability index, which is considered as a project
ranking method rather than a project screening method, is proven to be more useful than NPV and IRR
when the projects being evaluated involve different investment sizes, earnings pattern and project lives.
 REAL OPTIONS are alternatives or choices that become available over the life of a capital investment.
Common examples include: (1) option to delay, (2) option to expand, (3) option to abandon, (4) option to
scale back, (5) option to vary inputs/output (6) option to enter new market (7) new product option. In
capital investment projects, real options provide management the opportunity to limit possible losses by
taking advantage of future positive events that may improve investment outcomes.
 RISK ANALYSIS attempts to measure the likelihood of the variability of future returns from the proposed
investment. The following approaches are used to assess risk in capital investments:
 RISK-ADJUSTED DISCOUNT RATE is a technique that adjusts the discount rate upward as investment
becomes riskier. By increasing the discount rate, the expected flow from the investment must be
relatively larger or a negative NPV will be generated and the proposed investment would be rejected.
 TIME-ADJUSTED DISCOUNT RATE assumes a higher discount rate in later years of a project9s life due to
uncertainties (e.g., inflation) involved in making projection of cash flows over a long period of time.
 SCENARIO ANALYSIS considers multiple possible outcomes or scenarios and associated probabilities to
determine the overall expected outcome based on the weighted average of all possible outcomes.
 SENSITIVITY ANALYSIS uses an iterative process that uses forecasts of many NPVs under various
<what-if= assumptions to see how sensitive NPV is to changing conditions.
 MONTE CARLO SIMULATION is a sophisticated computer analysis that considers uncertainties and
probability distributions for inputs and uses random number inputs to map range of possible outcomes.
 DECISION TREE is a probability-based technique used when management needs to decide through a
series of <if-then= scenarios that describe how the firm might react based on future events.
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INVESTMENT RISKS & RETURNS

 INVESTMENT RISK, a.k.a. security risk, speculative risk, is possibility that actual investment returns will
differ from expected returns, which could result in either a gain or a loss.
 An investment risk consists of two components: (1) Diversifiable risk (2) Non-diversifiable risk
1) DIVERSIFIABLE risk (a.k.a. UNSYSTEMATIC or controllable risk) represents portion of a security9s risk
that can be controlled through proper diversification. This type of risk is unique to a given security.
Default risk, business risk, liquidity risk normally fall under this category.
2) NON-DIVERSIFIABLE risk (a.k.a. SYSTEMATIC or non-controllable risk) results from forces outside the
firm9s control and is therefore not unique to a given security. Marker risk, political risk, purchasing
power risk, foreign exchange risk normally fall under this category.
[Various investment risks and corresponding definitions are covered in MAS-13 under Costs of Capital]
 STANDARD DEVIATION (SD), a measure of dispersion of potential returns from average returns, is
commonly used to quantify risk of investment. The smaller the SD, the lower the risk of the investment.
 Using SD to compare investment risks is only an absolute measure of dispersion (risk) and does not
consider the dispersion of outcomes in term of EXPECTED RETURN, which is the weighted average of
possible returns using the probabilities as weights.
 <68-95-99= Normal Rule in statistics: given a normal probability distribution, 68% of the returns will lie
within  1 SD of the expected return, 95% of all observations will lie within  2 SDs of the expected return
and 99% of all observations will lie within  3 SDs of the expected return.
 SD must be distinguished from STANDARD ERROR of the MEAN (always smaller than SD), which measures
how far a sample mean (e.g., expected return) deviates from the actual mean of a population.
 When comparing investments that have different expected returns, the more appropriate measure of
investment9s relative risk is the COEFFICIENT of VARIATION, a measure of risk per unit of return.
Standard Deviation (ơ)
Coefficient of Variation =
Expected Return (µ)
The higher the coefficient of variation is, the riskier the investment is relative to its expected return.
 An investor may be willing to take additional risks in order to attempt greater returns. The ultimate decision
largely depends on management9s profile and appetite for risks and returns – whether a firm9s management
is risk-taker, risk-neutral or risk-averse.
EXERCISES: CAPITAL BUDGETING with INVESTMENT RISKS & RETURNS
1. Net Investment for Decision-Making

Zilong Company plans to replace an old unit of equipment with a new one:
I) The old unit was acquired three years ago; the old unit9s carrying value is now at P 50,000 while it
can be sold for P 60,000. Tax rate is 25%.
II) The new unit can be acquired at a list price of P 300,000. A 10% cash discount is available if the
equipment is paid for within 30 days from acquisition date. Shipping, installation and testing
charges to be paid are estimated at P 16,000.
III) Other assets with a book value of P 12,000 that are to be retired as a result of the acquisition of the
new machine can be salvaged and sold for P 10,000.
IV) Additional working capital of P 32,000 will be needed to support operations planned with the new
equipment.
V) The annual cash flow from the use of the new equipment is P 50,000. At the end of its useful life of
5 years, the new equipment must be disposed of with a zero book value but with an expected
salvage value of P 4,000.
REQUIRED:
A) What is the initial cost of net investments for decision-making purposes?
B) What is the terminal cash flow expected at the end of life of the project?
2. Net Returns - Increase in Revenues

Bruno Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee are
estimated to be 10,000 cups to be sold for P 15 per cup. Variable costs are estimated at P 6 per cup, while
incremental fixed cash costs, excluding depreciation, at P 20,000 per year. The machines are expected to
have a service life of 5 years, with no salvage value. Depreciation will be computed on a straight-line basis.
The company9s income tax rate is 20%.
A) The increase in annual net income.
B) The annual cash inflows that will be generated by the project.
3. Net Returns - Cost Savings

Gord, Inc. is planning to buy a high-tech machine that can reduce cash expenses by an average of P 70,000
per year. The new machine will cost P 100,000 and will be depreciated for 5 years on a straight-line basis.
No salvage value is expected at the end of the machine9s life. Income tax rate is 30%.
REQUIRED:
Determine the net cash inflows that will be generated by the project.
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4. Payback Period & ARR (Even Cash Flows)

Nana Company plans to replace its old equipment. The cost of the new equipment is P 90,000, with a
useful life estimate of 8 years and a salvage value of P 10,000. The annual pre-tax cash savings from the
use of the new equipment is P 40,000. The old equipment has zero market value and is fully depreciated.
The company uses a cost of capital of 25%.
REQUIRED: Assuming that the income tax rate is 40%, determine:

A) Payback period
B) Accounting rate of return on original investment
C) Accounting rate of return on average investment
5. Payback Period & ARR (Uneven Cash Flows)

Pharsa Company has an investment opportunity costing P 90,000 that is expected to yield the following
cash flows over the next five years:
Year Amount
1 P 40,000
2 35,000
3 30,000
4 20,000
5 10,000
P 135,000
REQUIRED: Assuming a hurdle rate of 30%, determine:
A) Payback period in months
B) Book rate of return
6. Bail-Out Payback Period

A project costing P 180,000 will produce the following annual cash flows and year-end salvage values:
Year Cash flows Salvage value
1 P 50,000 P 60,000
2 P 50,000 P 55,000
3 P 40,000 P 50,000
4 P 40,000 P 45,000
REQUIRED:
Bail-out payback period.
7. Net Present Value (Even Cash Flows)

Hanabi Company plans to buy a new machine costing P 28,000. The new machine is expected to have a
salvage value of P 4,000 at the end of its economic life of 4 years. The annual cash inflows before income
tax from this machine are estimated at P 11,000. The tax rate is 20%. The company desires a minimum
return of 25% on invested capital.
REQUIRED: Rounding-off present value factors to three decimal places, determine the net present value.
Solution Guide
Year 0 PV factor Year 1 Year 2 Year 3 Year 4

Year 0 ________
Year 1 ________
Year 2 ________
Year 3 ________
Year 4 ________
Year 4 ________
NPV = _________
Cash inflows before tax PV, Cash IN

- Depreciation ____________ 10,000 (_____)
Earnings before tax 4,000 (_____)
- Tax (20%) ____________
Earnings after tax PV, Cash OUT
+ Depreciation ____________ 28,000 (_____)
Cash inflows after tax NPV =
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8. NPV, Profitability Index & IRR (Even & Uneven Cash Flows)
Vale Corporation gathered the following data on two capital investment opportunities:
Project 1 Project 2
Cost of investment P 195,200 P 150,000
Cost of capital 10% 10%
Expected useful life 3 years 3 years
Net cash inflows P 100,000 P 100,000*
* This amount is to decline by P 20,000 annually thereafter.
REQUIRED: Round-off present value factors to three decimal places.
Project 1 Project 2
NPV: A) _____________ B) _____________
P. Index: C) _____________ D) _____________
E) What is project 19s internal rate of return?
a. 23% c. 25%
b. 27% d. 29%
F) What is project 29s internal rate of return?
a. Below 30% c. Between 31% and 32%
b. Between 30% and 31% d. Above 32%
9. Capital Budgeting Techniques

Silvanna Company is considering buying a new machine, requiring an immediate P 400,000 cash outlay.
The new machine is expected to increase annual net after-tax cash receipts by P 160,000 in each of the
next five years of its economic life. No salvage value is expected at the end of 5 years. The company
desires a minimum return of 14% on invested capital.
REQUIRED: Round-off factors to three decimal places in all cases.

A) Payback period D) Profitability index
B) ARR (based on original investment) E) Internal rate of return
C) Net present value
10. Equivalent Annual Annuity: Project with Unequal Lives

Project Cost Life Annual Cash Inflow
Guinevere P 50,000 10 years P 9,000
Lancelot P 50,000 15 years P 7,500
REQUIRED: Assuming a cost of capital of 10% (round-off factors to four decimal places):
On the basis of equivalent annual annuity, which project is more attractive?
11. Crossover Rate - NPV Point of Indifference

Mythical Glory Corporation has a weighted average cost of capital of 12% and is evaluating two mutually
exclusive projects (Fighter and Tank), which have the following projections:
Project Fighter Project Tank
Investment P 1,000 P 800
After-tax cash inflow P 400 P 400
Asset life 4 years 3 years
The crossover rate for the two projects is closest to:
a. 20% c. 18%
b. 19% d. 10%
12. Payback Reciprocal
Gatotkaca Company is planning to buy an equipment costing P 640,000 with an estimated life of 30 years
and is expected to produce after-tax net cash inflows of P 128,000 per year.
REQUIRED:
Without using present value factors, what is the best estimate of the IRR?
Answer and solution
Payback period: 640,000 ÷ 128,000 = 5 years Payback reciprocal: 1 ÷ 5 years = 20%
Based on page 2, PAYBACK RECIPROCAL is a reasonable estimate of the internal rate of return (IRR)
provided that the following conditions are met:
 Payback period is at most half of the economic life of the project [i.e., 5 years ≤ (30 ÷ 2)]
 Net cash inflows are uniform throughout the life of the project.
13. Relationships: Discounted Techniques

Fill in the blanks for each of the following independent cases. In all cases, the investment has a useful
life of ten (10) years and no salvage value. Round off factors to three decimal places.
Project Annual Cash Flow Investment Cost of Capital IRR NPV
1 P 45,000 P 188,640 14% (A) _______ (B) ________
2 P 75,000 (C) ________ 12% 18% (D) ________
3 (E) __________ P 300,000 (F) _______ 16% P 81,440
4 (G) __________ P 450,000 12% (H) _______ P 115,000
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14. Capital Rationing - Ranking Projects

Leslie Corporation is considering five investment opportunities. The cost of capital is 12%.
Project Investment PV - Cash Flow NPV IRR (%) P. Index
1 P 35,000 P 39,325 P 4,325 16 1.12
2 20,000 22,930 2,930 15 1.15
3 25,000 27,453 2,543 14 1.10
4 10,000 10,854 854 18 1.09
5 9,000 8,749 (251) 11 0.97
REQUIRED:
A) Rank the projects in descending order of preference according to NPV, IRR and profitability index.
B) If only a budget of P 55,000 is available, which projects should be chosen?
15. Capital Budgeting under Risk: Coefficient of Variation

ML is considering whether to invest in one of two mutually exclusive projects: Project <MM= vs. Project
<Mage=. Depending on the state of the economy, the projects would provide the following cash inflows in
each of the next 5 years. Consider the following probability distribution:
State of Economy Probability Project <MM= Project <Mage=
Recession 30% P 1,000 P 500
Normal 40% P 2,000 P 2,000
Prosperity 30% P 3,000 P 5,000
REQUIRED: Assuming probability distribution is normal when determining confidence internal, determine:
Project MM Project Mage
Expected Return A) _____________ E) _____________
Standard Deviation (rounded, whole amount) B) _____________ F) _____________
Confidence Interval (with 68% probability) C) _____________ G) _____________
Coefficient of Variation D) _____________ H) _____________
I) Which project is likely to be chosen assuming ML is a conservative, risk-averse type of investor?

1. Capital budgeting is the process
a. Used in make-or-buy decision making
b. Of eliminating unprofitable product line
c. Of making capital expenditure decisions
d. Of determining how much capital stock is issued
2. Which of the following is considered in computing the net investment for the decision to replace an old
machine with a new one?
I) Purchase price of the old machine III) Salvage value of the old machine
II) Purchase price of the new machine IV) Salvage value of the new machine
a. I and II c. I and IV
b. II and III d. II and IV
3. Which of the following is not a typical cash inflow in capital investment decisions?
a. Salvage value c. Incremental revenues
b. Cost reductions d. Additional working capital
4. Annual cash inflows from the capital projects are measured in terms of
a. Income after depreciation and taxes c. Income before depreciation but after taxes
b. Income before depreciation and taxes d. Income after depreciation but before taxes
5. A depreciation tax shield is
a. An after-tax cash outflow c. The expense caused by depreciation
b. A reduction in income taxes d. The cash provided by recording depreciation
6. When computing for the accounting rate of return (ARR), which of the following is used?
a. Income after depreciation and taxes c. Income before depreciation but after taxes
b. Income before depreciation and taxes d. Income after depreciation but before taxes
7. The payback method measures
a. Cash flows of an investment c. Economic life of an investment
b. Profitability of an investment d. How quickly investment may be recovered
8. The payback period considers (I) income over the entire project life and (II) time value of money.
a. (I) Yes (II) Yes c. (I) No (II) Yes
b. (I) Yes (II) No d. (I) No (II) No
9. Which of the following is a TRUE statement regarding non-discounted capital budgeting techniques?
a. Payback period (liquidity of project); ARR (liquidity of project)
b. Payback period (liquidity of project); ARR (profitability of project)
c. Payback period (profitability of project); ARR (liquidity of project)
d. Payback period (profitability of project); ARR (profitability of project)
10. All of the following capital budgeting analysis techniques use cash flows as the primary basis for the
calculation, except for the:
a. Payback period c. Accounting Rate of Return (ARR)
b. Net Present Value (NPV) d. Internal Rate of Return (IRR)
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11. Which of the following groups of capital budgeting techniques considers the time value of money?
a. ARR, IRR and payback period c. ARR, NPV and profitability index
b. IRR, NPV and profitability index d. ARR, IRR and profitability index
12. Cost of capital is 8%; economic life in years = 4 years; what is the simple PV factor for year 4?
a. 0.095 c. 0.735
b. 0.171 d. 0.794
13. Discount rate is 12%; economic life in years = 3 years; what is the PV annuity factor for 3 years?
a. 0.712 c. 2.402
b. 1.690 d. 3.157
14. What is the PV factor of any amount at year zero or zero percent?
a. Zero c. 0.50
b. 1.00 d. 1.50
15. The discount rate (hurdle rate of return) must be determined in advance for the
a. ARR c. Payback period
b. IRR d. Net present value
16. When using the net present value method for capital budgeting analysis, the required rate of return is
called all of the following, except
a. Risk-free rate c. Discount rate
b. Cutoff rate d. Cost of capital
17. A capital project with a positive NPV also has
a. A profitability index of one c. A profitability index less than one
b. A positive profitability index d. A profitability index greater than one
18. A capital project that has a positive NPV based on a discount rate of 12% also has an IRR of
a. Zero c. Less than 12%
b. 12% d. Greater than 12%
19. Which of the following combinations is possible?
Profitability Index NPV IRR
a. Greater than 1 Positive Equals cost of capital
b. Greater than 1 Negative Less than cost of capital
c. Less than 1 Negative Less than cost of capital
d. Less than 1 Positive Less than cost of capital
20. The net present value method assumes that the project9s cash flows are reinvested at the
a. Internal rate of return c. Cost of capital
b. Simple rate of return d. Payback period
21. The internal rate of return method assumes that the project9s cash flows are reinvested at the
a. Required rate of return c. Simple rate of return
b. Internal rate of return d. Payback period
22. Mutually exclusive projects are those that:
a. If accepted, preclude the acceptance of competing projects
b. If accepted, can have a negative effect on the company9s profit
c. If accepted, can also lead to the acceptance of a competing project
d. Require all managers to consider and make decision on the capital investment project
23. In choosing from among mutually exclusive investments, an entity shall normally select the one with
the highest
a. Net present value c. Book rate of return
b. Profitability index d. Internal rate of return
24. Which capital budgeting method is a project-ranking method rather than a project-screening method?
a. Net present value c. Simple rate of return
b. Profitability index d. Sophisticated rate of return
25. Which of the following capital budgeting techniques would allow management to justify investing in a
project that could not be justified currently by using techniques that focus on expected cash flows?
a. Real options c. Internal rate of return
b. Net present value d. Accounting rate of return
26. Which of the following is not a technique for considering risks of an investment in capital budgeting?
a. Probability analysis c. Simulation techniques
b. Risk-adjusted discount rate d. Internal rate of return
27. Which of the following expresses the relationship between risk and return?
a. Direct relationship c. Spurious relationship
b. Inverse relationship d. Non-existing relationship
28. The expected return of an investment or a portfolio is measured by the
a. Beta c. Weighted average
b. Variance d. Standard deviation
29. Standard deviation divided by expected return is used to calculate
a. Coefficient of variation c. Coefficient of determination
b. Coefficient of correlation d. Co-variance of a portfolio
30. The expected rate of return for ABC stock is 20%, with a standard deviation of 15%. The expected rate
of return for XYZ stock is 10%, with a standard deviation of 9%. The riskier stock is:
a. ABC because its return is higher
b. XYZ because its standard deviation is lower
c. ABC because its standard deviation is higher
d. XYZ because its coefficient of variation is higher
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1. Capital budgeting is concerned with
C a. Decisions affecting only capital intensive industries
b. Analysis of short-range decisions
c. Analysis of long-range decisions
d. Scheduling office personnel in office buildings
2. Of the following decisions, capital budgeting techniques would least likely be used in evaluating the
D a. Acquisition of new aircraft by a cargo company
b. Trade for a star quarterback by a football team
c. Design and implementation of a major advertising program
d. Adoption of a new method of allocating non-traceable costs to product lines
3. The capital budgeting process contains several stages. At which stage are financial and nonfinancial factors addressed?
D a. Search stage c. Identification and definition stage
b. Selection stage d. Information-acquisition stage
4. At what stage of the capital budgeting process would management most likely apply present value techniques?
B a. Search stage c. Financing stage
b. Selection stage d. Identification stage
5. The stage of the capital budgeting process that has the most risk is
A a. Forecasting cash flow c. Identifying alternative possible projects
b. Evaluating performance and learning d. Raising funds to initially support the project
6. In equipment-replacement decisions, which one of the following does not affect the decision-making process?
C a. Current disposal price of old equipment c. Original fair market value of the old equipment
b. Operating costs of the old equipment d. Cost of the new equipment
7. In deciding whether to replace a machine, which of the following is NOT a sunk cost?
A a. The expected resale price of the existing machine
b. The book value of the existing machine
c. The original cost of the existing machine
d. The depreciated cost of the existing machine
8. Naga Company is considering the sale of a machine with a book value of P 80,000 and 3 years remaining in its useful
life. Straight-line depreciation of P 25,000 annually is available. The machine has a current market value of P
100,000. What is the cash flow from selling the machine if the tax rate is 40%?
C a. P 80,000 c. P 92,000
b. P 88,000 d. P 100,000
9. A company is considering replacing a machine with one that will save P 50,000 per year in cash operating costs and
has P 20,000 more depreciation expense per year than the existing machine. The tax rate is 40%. Buying the new
machine will increase annual net cash flows of the company by
A a. P 38,000 c. P 20,000
b. P 30,000 d. P 12,000
10. Legaspi Company is considering replacing a machine with a book value of P 400,000, a remaining useful life of 5 years,
and annual straight-line depreciation of P 80,000. The existing machine has a current market value of P 400,000. The
replacement machine would cost P 550,000, have a 5-year life, and save P 75,000 per year in cash operating costs. If
the replacement machine would be depreciated using the straight-line method and the tax rate is 40%, what would be
the net investment required to replace the existing machine?
B a. P 90,000 c. P 330,000
b. P 150,000 d. P 550,00
11. Old equipment with a book value of P 15,000 will be replaced by new equipment with a purchase price of P 50,000,
exclusive of freight charges of P 2,000. The market value of the old equipment is P 11,000. Repair costs of P 2,000
can be avoided if the new equipment is acquired. Assume a tax rate of 35%, what is the net investment of the project?
B a. P 33,800 c. P 39,700
b. P 38,300 d. P 52,000
Costs (Cash outflows): 50,000 + 2,000 = P 52,000
Savings (Cash inflows): 11,000 + 0.35 (15,000 – 11,000) + 2,000 (1 – 0.35) = P 13,700
12. A company is considering a project that requires a P 50,000 working capital investment. The company’s tax rate is
40%. In a capital budgeting analysis, the initial investment in working capital should be:
C a. Multiplied by (1-0.40) and shown as a net P 30,000 cash outflow
b. Multiplied by the rate (0.40) and shown as a net P 20,000 cash outflow
c. Shown as a cash outflow of P 50,000
d. Ignored
13. Sipocot Company owns a building that originally cost P 400,000 and has a current book value of P 250,000. The
building was financed by a loan that has one payment of P 20,000 outstanding, which must be paid off upon the sale
of the building. Sipocot would like to purchase a new building for P 600,000. If the new building is purchased, the
existing building would be sold for P 380,000. Sipocot Company’s income tax rate is 40%. If the new building is
purchased, the relevant initial cash flows would total
B a. P 272,000 c. P 372,000
b. P 292,000 d. P 392,000
14. In computing the initial investment for decision-making, taxes would be relevant for all of the following, EXCEPT:
C a. Avoidable repairs of old asset
b. Profit on sale of old asset replaced by a new one
c. Increase in working capital required to support new capital investment
d. Loss on write-off of other assets disposed because of new capital investment
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15. Which one of these statements concerning cash flow determination for capital budgeting purposes is not correct?
B a. Tax depreciation must be considered because it affects cash payments for taxes.
b. Book depreciation is relevant because it affects net income.
c. Sunk costs are not incremental flows and should not be included.
d. Net working capital changes should be included in cash flow forecasts.
16. Ragay is expanding its manufacturing plant, which requires an investment of P 4 million in new equipment and plant
modifications. Ragay’s sales are expected to increase by P 3 million per year as a result of the expansion. Cash
investment in current assets averages 30% of sales; accounts payable and other current liabilities are 10% of sales.
What is the estimated total investment for this expansion?
C a. P 3.4 million c. P 4.6 million
b. P 4.3 million d. P 5.2 million
17. Daet Inc.’s depreciation deduction last year was P 50,000 and its tax rate was 30%. The company’s tax savings from
the depreciation tax shield for the year was
A a. P 15,000 c. P 50,000
b. P 35,000 d. P 30,000
18. A project costing P 180,000 will produce the following annual cash benefits and salvage value:
OLD equipment NEW equipment
Revenue P 150,000 P 180,000
Cash operating costs 70,000 60,000
Annual depreciation 30,000 50,000
Income tax, 46%
What is the incremental annual cash income after taxes?
B a. P 30,000 c. P 40,000
b. P 30,800 d. P 38,000
19. Nabua Company is considering replacing a machine with a book value of P 200,000, a remaining useful life of 5 years,
and annual straight-line depreciation of P 40,000. The existing machine has a current market value of P 200,000. The
replacement machine would cost P 300,000, have a 5-year life, and save P 100,000 per year in cash operating costs.
The replacement machine would be depreciated using the straight-line method and the tax rate is 40%. What would
be the increase in annual net cash flow if the company replaces the machine?
B a. P 60,000 c. P 76,000
b. P 68,000 d. P 84,000
20. Which statement describes the relevance of depreciation in calculating cash flows?
A a. Depreciation is relevant only when income taxes exist
b. Depreciation is always relevant
c. Depreciation is never relevant
d. Depreciation is relevant only with discounted cash flow methods
21. Ligao Company is analyzing a capital investment proposal for a new machinery to produce a new product over the next
10 years. At the end of ten years, the machinery must be disposed of with a zero net book value but with a scrap
salvage value of P 20,000. It will require some P 30,000 to remove the machinery. The applicable tax rate is 35%.
What is the approximate <end-of-life= (terminal) cash flow based on the foregoing information?
B a. Inflow of P 30,000 c. Outflow of P 10,000
b. Outflow of P 6,500 d. Outflow of P 17,000
Misibis Corporation is considering the acquisition of a new machine. The machine can be purchased for P 90,000; it will
cost P 6,000 to transport to Misibis plant and P 9,000 to install. It is estimated that the machine will last 10 years, and
it is expected to have an estimated salvage value of P 5,000. Over its 10-year life, the machine is expected to produce
2,000 units per year, each with a selling price of P 500 and combined material and labor costs of P 450 per unit. Tax
regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no
estimated salvage value. Misibis has a marginal tax rate of 40%.
22. What is the net cash flow for the third year of the project that Misibis should use in a capital budgeting analysis?
C a. P 64,200 c. P 68,400
b. P 68,000 d. P 79,000
23. What is the net cash flow for the tenth year of the project that Misibis should use in a capital budgeting analysis?
D a. P 100,000 c. P 68,400
b. P 91,000 d. P 63,000
24. Which of the following is irrelevant in projecting the cash flows of the final year of a capital project?
D a. Cash devoted to use in project.
b. Disposal value of equipment purchased specifically for project.
c. Deprecation tax shield generated by equipment purchased specifically for project.
d. Historical cost of equipment disposed of in the project’s first year.
25. The length of time required to recover the initial cash outlay for a project is determined by using the:
B a. Discounted cash flow method c. Net present value method
b. Payback method d. Simple rate of return method
26. An advantage of using the payback method is that the method is:
A a. Simple to compute c. Precise in estimates of profitability
b. Not based on cash flow data d. Insensitive to the life of the project
27. Iriga Company is considering a certain project with the following projected cash income after taxes for 4 years, the life
of the project: year 1, P 11,000; year 2, P 9,000; year 3, P 8,000; year 4, P 7,000. If the project requires an
investment of P 25,000 with a salvage value of P 5,000, what is the payback period?
D a. 2.265 years c. 2.526 years
b. 2.562 years d. 2.625 years
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28. Albay, Inc. recently acquired a machine at a cost of P 64,000. It will be depreciated on a straight-line basis over 8
years, with no salvage value. Albay expects that this machine will produce P 18,000 annual net cash flow before
income tax. Assuming an income tax rate of 50%, the appropriate payback period on this investment is: (Hint:
compute cash flow after tax)
B a. 3.6 years c. 7.1 years
29. A company is planning to buy a machine that costs P 12,000 and has an annual depreciation for tax purposes of
P2,400 for 5 years. The machine is expected to result in cash savings from operations of P 4,000 per year. If the tax
rate is 50%, then what is the payback period for the new machine?
B a. 3 years c. 5 years
b. 3.75 years d. 6 years
30. Bulan Company is planning to purchase a new machine. The payback period is estimated to be 6 years. The project’s
after tax cash flow is estimated to be P 2,000 yearly for the first three years and P 3,000 yearly for the next three
years of the payback period. Annual depreciation of P 1,300 will be charged to income for each of the 6 years of the
payback period. The machine will cost:
A a. P 15,000 c. P 9,000
b. P 12,000 d. P 6,000
31. Oas Company is planning to purchase a new machine for P 30,000. The payback period is expected to be five years.
The new machine is expected to produce cash flows from operations, net of income taxes, of P 7,000 per year in each
of the next three years and P 5,500 in the fourth year. Depreciation of P 5,000 a year will be charged to income for
each of the five years of the payback period. What is the amount of cash flow from operations, net of income taxes,
that the new machine is expected to produce in the last (fifth) year of the payback period?
B a. P 1,000 c. P 5,000
b. P 3,500 d. P 8,500
32. The payback period considers depreciation expense (DE) and time value of money (TMV) as follows:
B a. DE, relevant and TVM, relevant c. DE, irrelevant and TVM, relevant
b. DE, irrelevant and TVM, irrelevant d. DE, relevant and TVM, irrelevant
33. The payback method assumes that all cash inflows are reinvested to yield a return equal to
D a. The discount rate c. The internal rate of return
b. The hurdle rate d. Zero
34. Buhi Company is studying a project that has a 10-year life and requires a P 800,000 investment in equipment that has
no salvage value. The project would provide net operating income each year as follows for the life of the project:
Sales P 500,000
Less: cash variable expenses 100,000
Contribution margin 400,000
Less: fixed expenses
Fixed cash expenses P 200,000
Depreciation expenses 80,000 280,000
Net operating income P 120,000
The company’s required rate of return is 8%. What is the payback period for this project?
D a. 3 years c. 2 years
b. 6.67 years d. 4 years
35. Sabang Company purchased a new machine on January 1 of this year for P 90,000, with an estimated useful life of 5
years and a salvage value of P 10,000. The machine will be depreciated using the straight-line method. The machine
is expected to produce cash flow from operations, net of tax, of P 36,000 a year in each of the next 5 years. The new
machine’s salvage value is P 20,000 in years 1 and 2, and P 15,000 in years 3 and 4. What will be the bailout payback
period for this machine?
C a. 1.4 years c. 1.9 years
36. Tigaon Co. is considering the purchase of a P 100,000 machine that is expected to reduce operating cash expenses by
P 25,000 per year. This machine, which has no salvage value, has a useful life of 10 years and will be depreciated on a
straight-line basis. What would be the simple rate of return on original investment?
B a. 10% c. 25%
b. 15% d. 35%
37. San Jose Company is considering the acquisition of a personal computer that costs P 120,000 with an economic life of
12 years and a terminal salvage value of P 12,000. It is estimated that the increase in net income before taxes as a
result from this investment will amount to P 7,000 annually. Income taxes are 35%. The company uses the straight-
line method of depreciation. What is the accounting rate of return on the average cost of investment?
C a. 3.79% c. 6.89%
b. 5.83% d. 6.98%
38. Lagonoy Inc. purchased a new machine for P 60,000 on January 1. The machine is being depreciated on the straight-
line basis over five years with no salvage value. The simple rate of return is expected to be 15% on the initial
investment. Assuming a uniform cash flow, this investment is expected to provide annual cash flow from operations of:
D a. P 7,200 c. P 12,000
b. P 13,800 d. P 21,000
39. Camalig Company has invested in a machine that cost P 70,000, that has a useful life of seven years, and that has no
salvage value at the end of its useful life. If the machine has a payback period of four years, then the simple rate of
return on the machine is closest to:
C a. 7.1% c. 10.7%
b. 8.2% d. 39.3%
Solution: Net income: cash flow – depreciation: (70,000 ÷ 4) – 10,000 = 7,500
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40. Which of the following methods is a discounted cash flow method for evaluating capital investment?
C a. Payback c. PV payback
b. Bail-out payback d. Payback reciprocal
41. A project costing P 28,715 will produce the following cash benefits after taxes:
End of year After-tax cash benefits
1 P 11,000
2 15,000
3 18,000
The company’s cost of capital is 16%. The PV of P 1 for one year at 16% is 0.862; for two years is 0.743; for three
years is 0.641. What is the break-even time or discounted (PV) payback period?
D a. 1.7 years c. 2.3 years
b. 2 years d. 2.7 years
42. Which capital budgeting method assumes that the funds are reinvested at the company’s cost of capital?
C a. Payback c. Net present value
b. Accounting rate of return d. Time adjusted rate of return
43. You have been consulted to advise Polangui Corp. on the projected acquisition of another production line costing P 1
million. The line has an expected useful life of five (5) years without any salvage value. The following additional
information was made available:
Year Estimated Annual Cash Inflow Present Value of P 1
1 P 600,000 0.91
2 300,000 0.76
3 200,000 0.63
4 200,000 0.53
5 200,000 . 0.44
TOTAL P 1,500,000 3.27
Assuming that the cash flow is to be discounted, your advice is
B a. To invest due to net present value of P 541,280
b. To invest due to net present value of P 94,000
c. To invest due to net advantage of P 500,000
d. To invest due to net present value of P 635,000
44. Labo Company purchased a machine with an estimated useful life of seven years and no salvage value. The machine
is expected to generate cash flows from operations, net of income taxes of P 80,000 in each of the seven years.
Labo’s expected rate of return is 12%. Information on present value factors is as follows:
Present value of P 1 at 12% for seven periods: 0.452
Present value of an ordinary annuity of P 1 at 12% for 7 periods: 4.564
Assuming a positive net present value of P 12,720, what is the cost of the machine?
C a. P 240,400 c. P 352,400
b. P 253,120 d. P 377,840
45. An investment opportunity costing P 110,000 is expected to yield net cash flows of P 28,000 annually for six years. The
NPV of the investment at a cutoff rate of 12% would be: (Round off PV factors based on three decimal places)
B a. (P 5,108) c. P 110,000
b. P 5,108 d. P 115,108
46. The effectiveness of the present value method has been appropriately questioned as a capital expenditure evaluation
technique because:
A a. Predicting future cash flows is often difficult and often associated with uncertainties
b. The average return on investment method is more accurate and useful
c. The payback method is theoretically more reliable
d. The computation involves difficult mathematical applications most accountants cannot perform
47. On January 1, a company invested in an asset with a useful life of 3 years. The company’s expected rate of return is
10%. The cash flow and present and future value factors for the 3 years are as follows:
Year Cash inflows Present value of P 1 @ 10% Future value of P 1 @ 10%
1 P 8,000 0.91 1.10
2 P 9,000 0.83 1.21
3 P 10,000 0.75 1.33
All cash inflows are assumed to occur at year-end. If the asset generates a positive net present value of P 2,000, what
was the amount of the original investment?
A a. P 20,250 c. P 30,991
b. P 22,250 d. P 33,991
48. Ignoring taxes, how are the following used in the calculation of the NPV of a proposed project?
Depreciation Expense Salvage Value Depreciation Expense Salvage Value
C a. Include Include c. Exclude Include
b. Include Exclude d. Exclude Exclude
49. Pilar acquired a machine that has a useful life of 10 years with no salvage value. The incremental annual net income
before taxes is P 8,500. Income taxes are 25%. The PV of an annuity of P 1 for 10 years at 18% is 4.494. The annual
depreciation is P 5,000. The NPV is positive P 1,119.25. How much is the amount of investment?
C a. P 30,000 c. P 50,000
b. P 40,000 d. P 60,000
50. A decrease in the discount rate:
A a. Will increase present values of future cash flows
b. Is one way to compensate for greater risk in a project
c. Will reduce present values of future cash flows
d. Responses a and b are both correct
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51. The calculation of the NPV of an investment project requires that the depreciation tax shield be included at:
C a. The amount of the depreciation with no adjustment taxes
b. The amount of the depreciation times one minus the tax rate
c. The amount of the depreciation times the tax rate
d. Zero, since depreciation is not relevant to the calculation of net present value
52. A disadvantage of the net present value method of capital expenditure evaluation is that it
C a. Computes the true interest rate
b. Is calculated using sensitivity analysis
c. Does not provide the true rate of return on investment
d. Is difficult to apply because it uses a trial-and-error approach
53. A project requires an investment of P 40,000 and has a net present value of P 10,000. The profitability index is:
B a. 0.80 c. 4.0
b. 1.25 d. 1.0
54. Consider an investment with the following cash flows:
Year Cash flows PV of P 1 at 14%
0 (P 31,000) 1.000
1 10,000 0.877
2 20,000 0.770
3 10,000 0.675
4 10,000 0.592
Salvage Value: P 5,000
What is the profitability index?
B a. 1.824 c. 1.482
b. 1.284 d. 1.842
55. An investment in a new piece of equipment costing P 50,000 is expected to yield the following over its 5-year useful
life: Revenues (cash), P 40,000; operating costs (cash), P 18,000; depreciation, P 10,000. The present value of P 1
received annually for 5 years and discounted at the cost of capital is 4.10 assuming that all cash flows occur at year-
end. Ignoring tax effect, what is the benefit/cost ratio (profitability index) for this piece of equipment?
C a. 0.984 c. 1.804
b. 1.200 d. 2.200
56. Which of these methods measure cash flows and outflows of a project as if they occurred at a single point in time?
C a. Payback and bail-out payback period c. Net present value and internal rate of return
b. Accounting and internal rate of return d. Return on original and average investment
57. The present value and discounted cash flow rate of return methods of evaluating capital expenditure proposals are
superior to the payback method in that they:
C a. Requires less input c. Consider the time value of money
b. Are easier to implement d. Reflects the effects of depreciation and income tax
58. The internal rate of return (IRR) is the
D a. Hurdle rate
b. Rate of interest at which the net present value is greater than 1.0
c. Rate of return generated from the operational cash flows
d. Rate of interest at which the net present value is equal to zero
59. The discount rate that equates the PV of expected cash flows with the cost of investments is the
B a. Net present value c. Accounting rate of return
b. Internal rate of return d. Payback period
60. Which of the following is a basic difference between IRR and ARR criteria for evaluating investments?
D a. IRR emphasizes expenses; ARR emphasizes expenditures
b. IRR emphasizes revenues; ARR emphasizes receipts
c. IRR is used for internal investments; ARR is used for external investments
d. IRR concentrates on receipts & payments; ARR concentrates on revenues & expenses.
61. Virac, Inc. is planning to invest P 120,000 in a 10-year project. Virac estimates that the annual cash inflow, net of
income taxes, from this project will be P 20,000. Virac’s desired rate for return on investments of this type is 10%.
Information on present value factors is as follows:
@ 10% @12%
Present value of P 1 for 10 periods 0.386 0.322
Present value of an annuity of P 1 for 10 periods 6.145 5.650
What is Virac’s internal rate of return on this investment?
C a. Less than 10%, but more than 0% c. Less than 12%, but more than 10%
b. 10% d. 12%
62. Bula Corporation is planning to invest P 80,000 in a three-year project. Bula’s expected rate of return is 10%. The
present value of P1 at 10% for 1 year is 0.909, for two years is 0.826 and for the three years is 0.751. The cash flows,
net of income taxes, will be P 30,000 for the first year (present value: P 27,270) and P 36,000 for the second year
(present value: P 29,736). Assuming the rate of return is exactly 10%, what will be the net cash flow, net of income
taxes, for the third year?
D a. P 17,260 c. P 22,904
b. P 22,000 d. P 30,618
63. Libon Company is planning to invest in a machine with a useful life of five years and no salvage value. The machine is
expected to produce cash flow from operations of P 20,000 in each of the five years. Libon’s required rate of return is
10%. What would be the maximum price that the company would pay for the machine?
C a. P 32,220 c. P 75, 820
b. P 62,100 d. P 122,100
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64. If an investment of P 14,760 now is to yield P 18,000 at the end of one year, then what is the internal rate of return
for this investment to the nearest whole percentage?
C a. 14% c. 22%
b. 18% d. 28%
65. A company is considering a capital investment for which the initial cash outlay is P 20,000. Net cash flows from
operations, net of income taxes, are predicted to be P 4,000 for 10 years. Assume a cost of capital of 12%. The
present value of an annuity of P 1 for 10 years at various rates are as follows:
Discount Rate PV Factor
14% 5.216
15% 5.018
16% 4.833
17% 4.658
What is the company’s internal rate of return? (choose the best answer)
A a. 15.1% c. 15.3%
b. 15.2% d. 15.4%
66. What is the approximate IRR for a project that costs P 50,000 and provides cash inflows of P 20,000 for 3 years?
A a. 10% c. 22%
b. 12% d. 27%
67. A weakness of the internal rate of return (IRR) approach for determining the acceptability of investments is that it
D a. Does not consider the time value of money.
b. Is not a straightforward decision criterion.
c. Implicitly assumes that the firm is able to reinvest project cash flows at the firms cost of capital.
d. Implicitly assumes that the firm is able to reinvest project cash flows at the projects internal rate of
return.
68. One disadvantage of using internal rate of return (IRR) is that it
B a. Provides a result that cannot be compared to other projects.
b. May not be used when cash flows vary from positive to negative in different years.
c. Is difficult for managers to understand the results of the calculation.
d. Can only use a limited number of years in calculating the result.
69. The payback reciprocal can be used to approximate a project’s
D a. Profitability index
b. Net present value
c. Accounting rate of return if the cash flow pattern is relatively stable
d. Internal rate of return if the cash flow pattern is relatively stable
70. If a company has computed the profitability index of an investment project as 1.15, then:
B a. The project’s internal rate of return is less than the discount rate
b. The project’s internal rate of return is greater than the discount rate
c. The project’s internal rate of return is equal to the discount rate
d. The relationship of rate of return and discount rate is impossible to determine from the data given
71. Del Gallego Company is considering several investment proposals, as shown below:
A B C D
Investment required 90,000 110,000 80,000 140,000
Present value of future cash inflows 105,000 120,000 100,000 170,000
Using the profitability index, what would be the ranking?
C a. D, B, A, C c. C, D, A, B
b. D, C, A, B d. C, A, D, B
72. Labo Co. uses a 12% hurdle rate for all capital expenditures. It has lined up four projects:
In Thousand Pesos
Project 1 Project 2
Project 3 Project 4
Initial cash outflow 400 496 596 544
Annual net cash inflows
Year 1 130 200 160 190
Year 2 140 270 190 250
Year 3 160 180 180 180
Year 4 80 130 160 160
Net present value (7,596) 8,552 28,128 29,324
Profitability index (%) 98% 101% 106% 105%
Internal rate of return 11% 13% 14% 15%
If the company has no budgetary limitations, which projects should be pursued?
C a. Projects 3 and 4 c. Projects 2, 3 and 4
b. Project 4 d. All the four projects
73. Sta. Elena Co. is considering two projects, A and B. The following information has been gathered on these projects:
Project A Project B
Initial investment needed P 40,000 P 60,000
Present value of future cash flows 60,000 85,000
Useful life 4 years 4 years
Based on this information, which of the following statements is (are) true?
I. Project A has the higher ranking according to the profitability index criterion.
II. Project B has the higher ranking according to the net present value criterion.
C a. Only I c. Both I and II
b. Only II d. Neither I nor II
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74. The NPV and IRR methods give

A a. The same decision (i.e., accept or reject) for any single investment project
b. The same choice from among mutually exclusive investments
c. The same rankings of projects with unequal lives
d. The same rankings of projects with different required investments
75. The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the net
present value method (NPV) may be different when
D a. The lives of the multiple projects are equal and the required investment sizes are equal.
b. The required rate of return equals the IRR of each project.
c. The required rate of return is higher than the IRR of each project.
d. Multiple projects have unequal lives and the size of the investment for each project is different.
76. Milaor Corporation is contemplating four projects, L, M, N, and O. The capital costs for the initiation of each project
and its estimated after-tax, net cash flows are listed below. The company’s desired after-tax opportunity costs is 12%.
It has P 900,000 capital budget for the year. Idle funds cannot be reinvested at greater than 12%.
In Thousand Pesos
L M N O
Initial cash outflow 400 470 380 420
Annual net cash inflows:
Year 1 113 180 90 80
Year 2 113 170 110 100
Year 3 113 150 130 120
Year 4 113 110 140 130
Year 5 113 100 150 150
Net present value P 7,540 P 59,654 P 54,666 (P 15,708)
Profitability index 1.02 1.13 1.14 0.96
Internal rate of return 12.7% 17.6% 17.2% 10.6%
The company will choose:
B a. Projects, M, N, and O c. Projects L and N
b. Projects M and N d. Projects L and M
77. In evaluating a capital budget project, the use of the net present value (NPV) model is generally not affected by the
C a. Projected salvage value
b. Initial cost of the project
c. Method of funding the project
d. Amount of added working capital needed for operations during the term of the project
78. A profitability index greater than one for a project indicates that:
A a. The discount rate is less than the internal rate of return
b. There has been a calculation error
c. The project is unattractive and should not be pursued
d. The company should reevaluate its cost of capital
79. Which is a basic difference between the IRR and book rate of return (BRR) criteria for evaluating investments?
D a. IRR emphasizes expenses and BRR emphasizes expenditures
b. IRR emphasizes revenues and BRR emphasizes receipts
c. IRR is used for internal investments and BRR is used for external investments
d. IRR concentrates on receipts and expenditures and BRR concentrates on revenues and expenses
80. If the IRR on an investment is zero,
D a. Its NPV is positive
b. It is generally a wise investment
c. Its cash flows decrease over its life
d. Its annual cash flows equal its required investment
81. The relationship between payback period and IRR is that
B a. A payback period of less than one-half the life of a project will yield an IRR lower than the target rate
b. The payback period is the present value factor for the IRR
c. A project whose payback period does not meet the company’s cutoff rate for payback will not meet the
company’s criterion for IRR
d. Both methods are discounted techniques
82. The internal rate of return on an investment
C a. Usually coincides with the company’s hurdle rate.
b. Disregards discounted cash flows.
c. May produce different rankings from the net present value method on mutually exclusive projects.
d. Would tend to be reduced if a company used an accelerated method of depreciation for tax purposes
rather than the straight-line method.
83. A company has unlimited capital funds to invest. The decision rule for the company to follow in order to maximize
shareholders wealth is to invest in all projects having
B a. Present value greater than zero.
b. Net present value greater than zero.
c. Internal rate of return greater than zero.
d. Accounting rate of return greater than the hurdle rate used in capital budgeting analyses.
84. A project that when accepted or rejected will not affect the cash flows of another project refers to:
B a. Dependent projects c. Mutually inclusive projects
b. Independent projects d. Mutually exclusive projects
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85. Deciding whether or not an investment meets a predetermined company standard is called
B a. Payback decision c. Preference decision
b. Screening decision d. Profitability decision
86. A thorough evaluation of how well a project’s actual performance matches the projections made when the project was
proposed is called a
B a. Pre-audit c. Risk analysis
b. Post-audit d. Sensitivity analysis
87. Which procedure would most likely help managers identify errors in their capital budgeting decisions?
A a. Post-audits c. Value engineering
b. Scenario analysis d. Monte Carlo simulations
88. In capital budgeting, sensitivity analysis is used to:
D a. Evaluate mutually exclusive investments
b. Test the relationship of the IRR and NPV
c. Determine whether an investment is profitable
d. See how decision would be affected by changes in variables
89. How should the following projects be listed in the order of increasing risk?
C a. New venture, replacement, expansion c. Replacement, expansion, new venture
b. Replacement, new venture, expansion d. Expansion, replacement, new venture
90. A company wants to use discounted cash flow techniques when analyzing its capital investment projects. The company
is aware of the uncertainty involved in estimating future cash flows. A simple method some companies employ to
adjust for the uncertainty inherent in their estimates is to
C a. Prepare a direct analysis of the probability of outcomes
b. Increase the estimates of the cash flows
c. Adjust the minimum desired rate of return
d. Use accelerated depreciation
91. Assume that an investment projects assume cash flows are not changed but the assumed weighted-average cost of
capital is reduced. What impact would this have on the NPV and IRR of this project?
D a. Both NPV and IRR will increase c. Both NPV and IRR will not change
b. NPV decreases while IRR increases d. NPV increase while IRR will not change
Isarog Company has gathered the following data on a proposed investment project:
Investment required in equipment P 142,500
Annual cash inflows 30,000
Life of the investment 8 years
Required rate of return 10%
92. The payback period for the investment is closest to:
C a. 8.00 years c. 4.75 years
93. The simple rate of return on the investment is closest to:
A a. 8.55% c. 21.05%
b. 10.00% d. 33.55%
94. The net present value on this investment is closest to:
D a. P 300,000 c. P 58,800
b. P76,024 d. P 17,550
95. The internal rate of return on the investment is closest to:
A a. 13% c. 14%
b. 15% d. 12%
Bee-Cool, Inc. plans to introduce a new product. Returns largely depend on the degree of market acceptance:
Market Acceptance Probability Returns
Very weak 10% 0%
Weak 20% 10%
Moderate 40% 20%
Strong 20% 30%
Very Strong 10% 40%
96. Determine the expected value of the returns.
D a. 4% c. 16%
b. 10% d. 20%
97. Determine the standard deviation of the returns.
B a. 4.5% c. 20.99%
b. 10.95% d. 40%
98. Determine the coefficient of variation of the returns.
D a. 0.12 c. 0.40
b. 0.14 d. 0.55
99. Oragon has a weighted average cost of capital of 12% and is evaluating two mutually exclusive projects (AM and PM):
Project AM Project PM
Investment P 48,000 P 83,225
After-tax cash inflow 12,000 15,200
Asset life 6 years 10 years
What is the indifference point for the two projects?
B a. 12.00% c. 16.01%
b. 12.64% d. 19.33%
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Solutions and Clarifications to Selected Items
13. Cash OUT (Costs): 600,000 + 20,000 = 620,000

Cash IN (Savings): 380,000 - 40% (380,000 – 250,000) = 328,000
18. Cash flow after tax = Net income after tax + Depreciation
OLD Equipment: 54% (150,000 – 100,000) + 30,000 = 57,000
NEW Equipment: 54% (180,000 – 110,000) + 50,000 = 87,800
19. NEW MACHINE OLD MACHINE

Savings (before tax) P 100,000 Depreciation P 40,000
Less: depreciation (60,000) Tax rate X 40%
Income before tax P 40,000 Tax on Depreciation P 16,000
Less: tax (40%) (16,000)
Net income P 24,000 New Machine P 84,000
Add: depreciation 60,000 Old Machine (16,000)
Net cash flows (after tax) P 84,000 Net cash flows P 68,000
NOTE: The tax on 8lost9 depreciation (P 16,000) is a cash flow deduction since the old machine is to
be replaced (i.e., the tax shield on depreciation of the old machine will be foregone).
Alternative solution: (100,000 – 20,000*) 60% + 20,000* = P 68,000
* Increase in depreciation: 60,000 (new) – 40,000 (old)
37. ARR (based on average investment):

7,000 (1 – 0.35) ÷ (120,000 + 12,000)/2
62. (80,000 – 27,270 – 29,736) ÷ 0.751
96. Expected value: 10% (0) + 20% (10%) + 40% (20%) + 20% (30%) + 10% (40%) = 20%
97. Standard Deviation: Square root of variance = √ 120% = 10.95% (rounded)

(A) (B) (C) (D) (E) (F)
Market Acceptance Returns Expected Value A–B C2 Probability DxE
Very weak 0% 20% -20% 400% 10% 40%
Weak 10% 20% -10% 100% 20% 20%
Moderate 20% 20% 0 0 40% 0
Strong 30% 20% +10% 100% 20% 20%
Very Strong 40% 20% +20% 400% 10% 40% .
Variance: 120%
98. Coefficient of variation: 10.95% ÷ 20%
99. Trial and error: NPV is the same for both projects at @ 12.64%
Project AM: 12,000 (4.038) – 48,000 = P 455 Project PM: 15,200 (5.505) – 83,225 = P 455
Answers and Solutions to Problem No. 9 (Page 5)

A) Payback period: 400,000 ÷ 160,000 = 2.5 years
B) Accounting rate of return (based on original investment): 80,000 ÷ 400,000 = 20%
C) Net present value: 160,000 (3.433) – 400,000 = P 149,280
D) Profitability index: 549,280 ÷ 400,000 = 1.37 times
E) Internal rate of return: 28.65% (approximation through trial and error or interpolation)
Answers to Problem No. 13 (Page 5)

(NOTE: some amounts and percentages are rounded-off)
Project Annual Cash Flow Investment Cost of Capital IRR NPV

1 P 45,000 P 188,640 14% (1) 20% (2) P 46,080
2 P 75,000 (3) P 337,050 12% 18% (4) P 86,700
3 (5) P 62,073 P 300,000 (6) 10% 16% P 81,440
4 (7) P 100,000 P 450,000 12% (8) 18% P 115,000
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CPA Review Batch 42  October 2021 CPA Licensure Exam  Week No. 16
MANAGEMENT ADVISORY SERVICES C. Lee  E. Arañas  K. Manuel
MAS-42O: FINANCIAL STATEMENT ANALYSIS

 FINANCIAL STATEMENT (FS) ANALYSIS involves the evaluation of an entity’s past performance, present
condition, and business potentials by way of analyzing the financial statements to obtain information about,
among others, profitability of the business firm, ability to meet company obligations, safety of investment in
the business, and effectiveness of management in running the firm
 HORIZONTAL ANALYSIS shows changes of corresponding FS items over a period of time. Changes in the
value of a particular FS item can be analyzed in terms of amount or in percentage. The percentage change of
the amounts is calculated using the earlier period as the base period.
Percentage Change (Δ %) = Most Recent Value – Base Period Value

Base Period Value
Comparisons can be made between an actual amount and a budgeted amount, with the latter serving as basis
or pattern of performance. However, if a zero or negative amount appears in the base year, percentage
change cannot be computed. TREND or INDEX ANALYSIS, a subset of horizontal analysis, uses an index
number of 1.00 for the base period and converts all FS items in the subsequent period as percentage of the
base in order to facilitate better understanding of performance over multiple periods.
 VERTICAL ANALYSIS is the process of comparing figures in the FS of a single period. This is accomplished
by expressing all figures in the FS as percentages of a common base such as total assets (in the balance
sheet) or net sales (in the income statement). These converted statements are called common-size
statements or percentage composition FS, often used for comparing multiple years of data from the same
firm, companies of different size, and company-to-industry averages.
 CASH FLOW ANALYSIS is a detailed study in the net change in cash and cash equivalents as a result of
operating, investing and financing activities during the period.
➢ OPERATING ACTIVITIES are principal revenue-producing activities of the entity and generally relate to
changes in current assets and current liabilities involved in company’s normal operations.
➢ INVESTING ACTIVITIES are acquisition and disposal of long-term assets and investments not included in
cash equivalents and generally relate to changes in a company’s non-current assets.
➢ FINANCING ACTIVITIES are result in changes in the size and composition of the contributed equity and
borrowings of the entity and generally relate to changes in long-term liabilities and equity accounts.
 FINANCIAL RATIOS are relationships among accounts found in the FS that provide information about the
firm’s liquidity, solvency, stability, profitability and other aspects of financial situation and potential. Major
categories of financial ratios are: (NOTE: Specific ratios and formulas are found on pages 2 and 3)
➢ LIQUIDITY RATIOS measure an entity’s ability to meet short-term obligations and provide insights on
present cash solvency. Common examples include net working capital, current ratio and quick ratio.
➢ SOLVENCY RATIOS, a.k.a. leverage ratios, measure an entity’s long-term financial viability. Common
examples included debt ratio, debt-equity ratio and times interest earned ratio.
➢ ACTIVITY RATIOS, a.k.a. asset utilization ratios or efficiency ratios, measure an entity’s ability to use its
assets and manage its liabilities effectively in the current period -- how quickly various accounts are
converted into sales or cash. Common examples include turnover ratios and conversions periods.
➢ PROFITABILITY RATIOS, a.k.a. performance ratios, are used to determine how well an entity can generate
profits from its operations. Common examples include margin ratios and return ratios.
➢ MARKET VALUE RATIOS, a.k.a. market prospect ratios, are used to help potential investors make equity
investment decisions through the use of trends in earnings, dividends and stock prices. Common examples
include dividend payout ratio, dividend yield and price-earnings ratio.
 The Basic rules in calculating financial ratios include:
✓ When calculating a ratio using balance sheet (BS) amounts only, the numerator and denominator should
be based on amounts as of the same BS date. The same is true for ratios using only income statement
(IS) numbers. Exception: calculation of growth ratios.
✓ If an IS amount and a BS amount are used at the same time to calculate a ratio, the BS amount should
be expressed as an average for the time period represented by the IS amount.
✓ If the beginning balance of a BS account is not available and cannot be computed from the given data,
the ending balance of the account is used to represent the average balance.
✓ If sales and/or purchases are given without making distinction as to whether made in cash or on credit,
assumptions are made depending on the ratio being calculated:
➢ Turnover ratios: Sales and purchases are made on credit.
➢ Cash flow ratios: Sales and purchases are made in cash.
✓ As a rule, an operating year is assumed to have 360 days, unless specified otherwise.
➢ A 360-day year is preferred as this is consistent with a 12-month year and a 30-day month;
➢ Alternatively, a year may be comprised of 365 calendar days, 300 working days or 270 productive
days, or any appropriate number of days (NOTE: exact number shall be specified in problems).
• FS analysis helps in making FINANCIAL FORECASTS, particularly the required ADDITIONAL FUNDS
NEEDED (AFN), determined based on entity’s capital requirements and from a variety of financial ratios.
Required increase in assets →  in Sales x (Assets ÷ Sales)
- Spontaneous increase in liabilities →  in Sales x (Liabilities ÷ Sales)
- Increase in retained earnings* → Earnings after tax – Dividend payment
ADDITIONAL FUNDS NEEDED from external sources (e.g., creditors, investors)
AFN, a.k.a. External Funds Needed (EFN), may alternatively be computed using the following formulas:
AFN = total changes in equity – internal financing
= (Assets – Liabilities) (% ∆ sales) – (projected sales x profit margin x plowback ratio)

ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-42O
Week 16: FINANCIAL STATEMENT ANALYSIS
 LIQUIDITY RATIOS
RATIO FORMULA RATIO FORMULA
Current Assets – Quick Ratio Quick Assets
Net Working Capital
Current Liabilities (Acid Test Ratio) Current Liabilities
NOTE: Quick assets are cash items and other current
Current Ratio Current Assets
assets that can be quickly converted into cash (i.e.,
(Working Capital Ratio) Current Liabilities
cash, receivables, marketable securities)
 ACTIVITY RATIOS / EFFICIENCY RATIOS / ASSET UTILIZATIO RATIOS

Inventory Turnover Cost of Goods Sold Age of Inventory 360 days .
(for merchandisers) Average Inventory (Inventory Conversion Period) Inventory Turnover
Net Credit Sales Age of Receivable 360 days .
Receivable Turnover
Average Receivables (Receivable Collection Period) Receivables Turnover
Net Credit Purchases Age of Payable 360 days .
Payable Turnover
Average Payables (Payable Deferral Period) Payables Turnover
Finished Good Turnover Cost of Goods Sold Sales .
Asset Turnover
(for manufacturers) Ave. FG Inventory Average Total Assets
Work-in-Process Turnover Cost of Goods Manu. Sales .
Fixed Asset Turnover
(for manufacturers) Ave. WIP Inventory Average Fixed Assets
Raw Material Turnover Cost of Materials Used Age of Inventory +
Normal Operating Cycle
(for manufacturers) Ave. RM Inventory Age of Receivables
Inventory Turnover FG Turnover + WIP Normal Operating Cycle
Turnover + RM Turnover
Cash Conversion Cycle
(for manufacturers) – Age of Payables
NOTE: ‘Age of Receivable’ is also known as Days Sales Outstanding, Number of Days Sales in Receivable, or
Days Receivable.
 SOLVENCY RATIOS / LEVERAGE RATIOS

Total Liabilities 1 .
Debt Ratio Equity Multiplier
Total Assets Equity Ratio
Total Equity Times Interest Earned EBIT .
Equity Ratio
Total Assets (Interest Coverage Ratio) Interest Payments
Total Liabilities NOTE: Equity multiplier, a.k.a. equity ratio reciprocal,
Debt-Equity Ratio
Total Equity can be computed based on formula: Assets ÷ Equity
 PROFITABILITY RATIOS / PERFORMANCE RATIOS

Gross Profit Income .
Gross Profit Margin Return on Sales
Sales Sales
EBIT Income .
Operating Profit Margin Return on Assets
Sales Average Assets
Profit Income .
(Net) Profit Margin Return on Equity
Sales Average Equity
What INCOME figure to use?
 If the intention is to measure operational performance, income is expressed as before interest and tax;
alternatively, income before ‘after-tax’ interest may be used to exclude the effect of capital structure.
 If the intention is to evaluate total managerial effort, income is expressed after interest and tax.
 Expressing income after interest but before tax is now rarely applied in business practice.
 Income should include dividends and interest earned if the said investments are included in asset base.
 If used in the context of “Du Pont” technique, income must be expressed after interests, taxes and
preferred stock dividends. The Du Pont model is based on the following formula:
Return on Equity = Return on Sales x Assets Turnover x Equity Multiplier
 MARKET VALUE RATIOS / MARKET PROSPECT RATIOS

Market value ratios are anchored on Earnings per Share (EPS), which is also considered a profitability ratio.
Net Income – Preferred Dividends .
EPS =
Weighted Average Common Shares Outstanding
EPS must be distinguished from common shareholder’s Book Value per Share, which is based on the formula:
Common Shareholders’ Equity ÷ Number of Common Shares Outstanding
Market Price per Share Dividend Per Share
Price-Earnings Ratio Dividend Payout
EPS EPS
Dividend Per Share Retention Ratio
Dividends Yield 100% - Dividend Payout
Market Price per Share (Plowback Ratio)

 OTHER FINANCIAL RATIOS

Cash_+ Marketable Securities Times Preferred Net Income After Tax
Cash Ratio
Current Liabilities Dividends Earned Preferred Dividends
Quick Assets . Capital Intensity Total Assets
Defensive Interval
Average Capital Expenditures Ratio Net Sales
Operating Cash Flow (CF) . Operating CF + After-Tax
Cash Flow Margin Free Cash Flow
Net Sales Interest – Capital Expenditures
EXERCISES: FINANCIAL STATEMENT ANALYSIS

1. Vertical & Horizontal Analysis
Following are the financial statements of BTS Company:
BTS COMPANY
Condensed Statement of Financial Position
December 31, 2021 (In thousands)
ASSETS LIABILITIES AND EQUITY
Cash P 1,200 Current Liabilities P 500
Non-Cash Current 1,800 Long-term Debts 1,000
Fixed Assets 2,000 Capital Stock 1,500
Retained Earnings 2,000
TOTAL ASSETS P 5,000 TOTAL LIAB. & SHE P 5,000
For 2020: Net sales, P 1,600; CGS, P 1,000; Operating Expenses, P 300; Interests and tax charges, P 200.
For 2021: Net sales, P 2,000; CGS, P 1,300; Operating Expenses, P 300; Interests and tax charges, P 220.
REQUIRED:
1. Prepare 2021 common-size balance sheet and determine:
A) Current ratio B) Debt ratio C) Equity ratio
2. Prepare 2021 common-size income statement and determine:
A) Gross profit margin B) Operating profit margin C) Net profit margin
3. Compute trend percentages for the following:
A) Net sales B) EBIT C) Net income
2. Cash Flow Analysis

The following information is taken from Blackpink Corporation’s accounting records for the recent year.
A) Customer sales receipts for P 890,000
B) Purchased machinery and equipment for P 110,000 cash.
C) Settled income taxes of P 125,000
D) Sold investment securities for P 450,000.
E) Paid dividends of P 250,000.
F) Received rentals of P 275,000.
G) Issued 500 shares of common stock for P 180,000.
H) Paid a sum of P 150,000 due to suppliers and payroll to employees.
I) Purchased delivery van for P 690,000 cash that was borrowed from a bank in the same year.
J) Paid P 360,000 for treasury shares.
REQUIRED:
1. Net cash provided by operating activities 3. Net cash provided by financing activities
2. Net cash used in investing activities 4. Net cash increase or decrease
3. Liquidity Ratios
Twice Company has a current ratio is 2.5 to 1 and an acid-test ratio is 1.2 to 1. Its current assets are composed
of cash, receivables, and inventory with cash and receivables combined amounting to P 360,000.
REQUIRED:
1. Determine the amount of: A) current liabilities B) inventory.
2. Assuming both the current ratio and the acid-test ratio are currently greater than 1, indicate the
effects of each transaction below by using (+) for increase, (-) for decrease, and (0) for no effect.
Current Ratio Acid-test Ratio
Example: Sell merchandise for cash + +
A) Buy inventory on account _______ ________
B) Pay an account payable _______ ________
C) Borrow cash on a short-term loan _______ ________
D) Issue long-term bonds payable _______ ________
E) Collect an account receivable _______ ________
F) Sell a plant asset for cash at a loss _______ ________
G) Buy marketable securities for cash _______ ________
H) Sell merchandise on credit _______ ________

4. Activity Ratios/Efficiency Ratios

The receivable collection period is 45 days on the average. Annual sales of P 900,000 are spread evenly
throughout the year. Inventory turnover is 6 times. Cash conversion cycle extends up to 80 days.
REQUIRED: Assuming a 360-day year, determine:

1. Average accounts receivable
2. Operating cycle
3. Payable deferral period
5. Solvency & Profitability Ratios

Net sales total P 100,000. Net profit margin is 12%. Interest charges are earned 6 times. Tax rate is 40%.
REQUIRED:
1. How much is the earnings before interests and taxes?
2. Assuming that inventory age is 30 days and average annual amount of inventory is P 5,000, how
much is the company’s operating expenses?
6. Du Pont Technique
➢ Return on sales is 5%.
➢ Return on assets is 10%.
➢ Return on equity is 25%.
➢ There is no preferred stock.
REQUIRED: Using Du Pont technique, determine:
1. Asset turnover
2. Equity ratio
3. Equity multiplier
4. Debt-equity ratio
7. EPS, Dividend & IPO Shares

Red Velvet Company decided to go public when its net income available to common shareholders amounted
to P 300,000 while the number of common shares issued and outstanding is 125,000.
REQUIRED:
1. Assume that the pay-out ratio is 75%, how much of the total dividends shall a shareholder owning
15,000 common shares receive?
2. Assume that the pay-out ratio is 60% and the price per share is P 15, what is the dividend yield?
3. Assume that the price-earnings ratio will be set 12 times and 25,000 new shares will be issued:
A) How much is the initial public offering (IPO) per share of the 25,000 new shares?
B) How much is the net proceeds from issuance if underwriter spread is 2%?
8. Additional Funds Needed

EXO Corporation’s sales are expected to increase from P 5,000,000 in 2020 to P 6,000,000 in 2021. Its
assets totaled P 3,000,000 at the end of 2020. Exo has full capacity, so its assets must grow in proportion
to projected sales. At the end of 2020, current liabilities are P 1,000,000 (of which P 300,000 are accounts
payable, P 200,000 accruals and P 500,000 notes payable). The after-tax profit margin is projected to be
10%. The forecasted pay-out ratio is 75%.
REQUIRED:
Determine the additional funds needed from external sources.
9. Financial Ratios
ITZY Merchandising has 1,000,000 common shares outstanding, with each share priced at P 8.00. In 2021,
the company declared dividends of P 0.10 per share. The balance sheet at the end of 2021 showed
approximately the same amounts as that at the end of 2020. The financial statements for Long
Merchandising are as follows:
ITZY Merchandising, Income Statement for 2021 (in thousands)______
Sales P 4,700
Cost of goods sold 2,300
Gross profit P 2,400
Operating expenses:
Depreciation P 320
Other 1,230 1,550
Income before interest and taxes P 850
Interest expense 150
Income before taxes P 700
Income taxes 280
Net income P 420

ITZY Merchandising, Balance Sheet at December 31, 2021 (in thousands)

Assets Liabilities and SHE
Cash P 220 Accounts payable P 190
Accounts receivable 440 Accrued expenses 180
Inventory 410 Total current liabilities P 370
Total current assets P 1,070 Long-term debt 1,960
Plant and equipment 5,600 Common stock 1,810
Accumulated depreciation (2,100) Retained earnings 430
Total Assets P 4,570 Total liabilities and SHE P 4,570
REQUIRED: (round-off answers to two decimal places)

1. Current ratio (2.89:1) 11. EPS (0.42)
2. Acid-test ratio (1.78:1) 12. P/E ratio (19.05)
3. Accounts receivable turnover (10.68 times) 13. Dividend yield (1.25%)
4. Inventory turnover (5.61 times) 14. Payout ratio (23.81%)
5. Gross profit margin (51.06%) 15. Debt ratio (50.98%)
6. Operating profit margin (18.09%) 16. Debt-equity ratio (1.04:1)
7. Return on sales (RoS) (8.94%) 17. Times interest earned (5.67 times)
8. RoA – operational performance (18.60%) 18. Cash flow to total debt (31.76%)
9. RoA – total management effort (9.19%) 19. Cash flow margin (15.74%)
10. Return on equity (RoE) (18.75%) 20. Cash ratio (0.59:1)
10. Construction of Financial Statements

The following information is available concerning IU Company’s expected results in 2021 (in thousands
of pesos). Turnovers are based on year-end values.
REQUIRED: Fill in the blanks.
1) Return on sales 6%
2) Gross profit percentage 40%
3) Receivables turnover 5 times
4) Inventory turnover 4 times
5) Current ratio 3:1
6) Ratio of total debt to total assets 40%
Condensed Income Statement
Sales P 900
Cost of sales (A) _____
Gross profit (B) _____
Operating expenses (C) _____
Net income (D) _____
Condensed Balance Sheet
Cash P 30 Current liabilities (H) ____
Receivables (E) ____ Long-term debt (I) ____
Inventory (F) ____ Shareholders’ equity (J) ____
Plant and equipment 670
Total (G) ____ Total (K) ____

,
1. When preparing common-size statements, balance sheet items are generally stated as a percentage of
(1) ______ while income statement items are generally stated as a percentage of (2) ______.
a. (1) total assets (2) net income c. (1) total liabilities (2) net sales
b. (1) total equity (2) net income d. (1) total assets (2) net sales
2. Which type of analysis best facilitates observation of year-to-year trends within a company?
a. Ratio c. Horizontal
b. Vertical d. Intercompany
3. Which one of the following would not be considered a liquidity ratio?
a. Quick ratio c. Return on assets
b. Current ratio d. Inventory turnover
4. How are trade receivables used in the calculations of (1) acid-test ratio and (2) receivable turnover?
a. (1) Denominator (2) Denominator c. (1) Numerator (2) Numerator
b. (1) Numerator (2) Denominator d. (1) Not used (2) Numerator
5. Which ratio is most helpful in appraising profitability?
a. Debt ratio c. Dividend payout
b. Acid-test ratio d. Return on assets
6. Which of the following ratios is most relevant to evaluating solvency?
a. Debt ratio c. Return on assets
b. Dividend yield d. Days’ purchase in accounts payable
7. Return on sales x assets turnover = __________________
a. Return on equity c. Equity multiplier
b. Return on assets d. Equity ratio

8. Dividend yield x price-earnings ratio = ________________

a. Dividend per share c. Earnings per share
b. Market price per share d. Dividend payout ratio
9. When a balance sheet amount is related to an income statement amount in computing a financial ratio
(e.g., turnover),
a. The income statement amount should be converted to an average for the year
b. The balance sheet amount should be converted to an average for the year
c. Comparisons with industry ratios are not meaningful
d. Both amounts should be converted to market value
10. Which one of the following provides a spontaneous source of financing for a firm?
a. Debentures c. Mortgage payable
b. Accounts payable d. Accounts receivable

1. Horizontal and vertical analyses are techniques used by analysts in understanding the financial statements of companies.
Which of the following is an example of a vertical, common-size analysis?
D a. Commission expense in 2021 is 10% greater than it was in 2020 which serves as base year
b. A comparison in financial ratio between two or more firms in the same industry
c. A comparison in financial ratio between two or more firms in different industries
d. Commission expense in 2021 is 5% of sales
2. The statement of cash flows
D a. Reports the revenues earned and expenses incurred by the firm during the period
b. Shows the company’s total assets, broken down into current and non-current assets
c. Shows the company’s capital structure for a period of time
d. Reports the periodic cash inflows and outflows in operating, investing and financing activities
3. Under the direct method of determining net cash provided by operating activities on the statement of cash flows, a gain
on the sale of plant assets would be:
D a. Added to the amount of operating expenses reported under the accrual basis
b. Deducted from the amount of operating expenses reported under the accrual basis
c. Deducted from the amount of sales reported under the accrual basis
d. Totally ignored since the gain is not a part of sales, cost of goods sold, or operating expenses
4. Jollibee incurred operating expenses amounting to P 265. The following information is also available:
Prepaid expenses, 1/1 P 14
Accrued expenses, 1/1 40
Prepaid expenses, 12/31 21
Accrued expenses, 12/31 36
How much was the cash paid for operating expenses?
D a. P 224 c. P 268
b. P 262 d. P 276
5. Chowking has provided the following 2021 balances for the preparation of the statement of cash flows:
January 1 December 31
Accounts receivable P 11,500 P 14,500
Allowance for uncollectible accounts 400 500
Prepaid rent expense 6,200 4,100
Accounts payable 9,700 11,200
Chowking’s 2021 net income is P 75,000. How much is net cash provided by operating activities?
D a. P 72,700 c. P 74,300
b. P 73,500 d. P 75,700
6. Using the indirect method of computing operating cash flows, decrease in trade receivable is treated as
C a. A cash inflow c. An addition to income
b. A cash outflow d. A deduction from income
7. Which of the following account changes would be classified as a use of funds?
C a. An increase in accounts payable c. A decrease in bonds payable
b. An increase in retained earnings d. A decrease in accounts receivable
8. Short-term solvency is another term for
A a. Liquidity c. Profitability
b. Stability d. Marketability
9. Which of the following ratios best measures short-term solvency?
A a. Quick ratio c. Creditors’ equity to total assets
b. Earnings per share d. Return on inventories
10. Mc Donald Company has current assets of P 400,000 and current liabilities of P 500,000. Mc Donald Company’s current
ratio would be increased by
A a. The purchase of P 100,000 of inventory on account
b. The payment of P 100,000 of accounts payable
c. The collection of P 100,000 of accounts receivable
d. Refinancing a P 100,000 long-term loan with short-term debt
11. Shakey’s Corp. has an acid test ratio of 1.5. Which of the following will cause this ratio to deteriorate?
C a. Sale of equipment at a loss. c. Borrowing short-term loan from a bank.
b. Sale of inventory on account. d. Payment of cash dividends previously declared.

12. A company has a current ratio greater than 1:1 and a quick ratio less than 1:1. If all cash was used to reduce accounts
payable, how would these cash payments affect (1) current ratio (2) quick ratio?
C a. (1) Decreased (2) Decreased c. (1) Increased (2) Decreased
b. (1) Decreased (2) Increased d. (1) Increased (2) Increased
13. The issuance of serial bonds in exchange for a building, with the first installment of the bonds due late this year:
D a. Decreases net working capital c. Decreases the quick ratio
b. Decreases the current issue d. Affects all of the answers as indicated
14. If Jonas Co. decides to change from FIFO to LIFO inventory method during a period of rising prices, its
A a. Current ratio would be reduced c. Inventory turnover would be reduced
b. Debt-to-equity ratio would be reduced d. Cash flow would be reduced
15. Which cost flow assumption will result in a higher inventory turnover ratio in an inflationary economy?
B a. FIFO c. Weighted average
b. LIFO d. Specific identification
16. A quick ratio of 2.0, current assets of P 5,000 and inventory of P 2,000 has current liabilities of _____.
A a. P 1,500 c. P 3,500
b. P 2,500 d. P 6,000
17. How is the average inventory balance used in the calculation of each of the following?
Acid-test ratio Inventory Turnover
C a. Numerator Numerator
b. Numerator Denominator
c. Not used Denominator
d. Not used Numerator
18. Selected data from Starbucks are presented below. The difference between average and ending inventories is
immaterial. Current assets are comprised mainly of cash, receivables and inventories.
Current ratio 2.0
Quick ratio 1.5
Current liabilities P 600,000
Inventory turnover (based on cost of sales) 8 times
Gross profit margin 40%
What were Starbuck's net sales for the year?

B a. P 2.4 million c. P 1.2 million
b. P 4.0 million d. P 6.0 million
SOLUTION: Inventory: (2 – 1.5) 600,000 = P 300,000 Cost of goods sold: 300,000 (8) = P 2.4 M
19. Based on the data presented below, what is Goldilock Corporation’s cost of sales for the year?
Current ratio 3.5
Acid test ratio 3.0
Year-end current liabilities P 600,000
Beginning inventory P 500,000
Inventory turnover 8.0
C a. P 1,600,000 c. P 3,200,000
b. P 2,400,000 d. P 6,400,000
SOLUTION: Ending inventory: (3.5 – 3) 600,000 = P 300,000 Average Inventory: P 400,000
Items 20-22 are based on the following information
2019 2020 2021
Accounts receivable, net P 40,000 P 42,500 P 45,000
Inventory 40,000 50,000 45,000
Current assets 120,000 140,000 130,000
Total assets, net 700,000 750,000 725,000
Current liabilities 70,000 80,000 50,000
Cash sales 400,000 420,000 450,000
Credit sales 120,000 125,000 131,250
Costs of sales 310,000 324,000 345,000
20. What should be the age of receivables in 2021?

B a. 110 days c. 130 days
b. 120 days d. None of these
SOLUTION: Receivable turnover: 131,250 ÷ [(45,000 + 42,500)/2] = 3 Age, AR: 360 ÷ 3
21. Determine the number of days in inventory for 2020.
b. 60 days d. None of these
SOLUTION: Inventory turnover: 324,000 ÷ [(40,000 + 50,000)/2] = 7.2 Age, Inventory: 360 ÷ 7.2
22. What is the net working capital turnover for 2021?
B a. 9.9 c. 7.15
b. 8.3 d. None of these
SOLUTION: (450,000 + 131,250) ÷ {[(140,000 – 80,000) + (130,000 – 50,000)] ÷ 2}
23. The ratio of sales to working capital is a measure of
C a. Collectibility c. Liquidity
b. Financial leverage d. Profitability

24. A high sales-to-working-capital ratio could indicate

C a. Unprofitable use of working capital
b. Sales are not adequate relative to available working capital
c. The firm is undercapitalized
d. The firm is not susceptible to liquidity problems
25. The number of days’ sales in receivable is a measure of
D a. Asset value c. Profitability
b. Sales performance d. Liquidity
26. Accounts receivable turnover ratio will normally decrease as a result of
D a. The write-off of an uncollectible account (assume the use of the allowance for doubtful accounts
method)
b. A significant sales volume decrease near the end of the accounting period
c. An increase in cash sales in proportion to credit sales
d. A change in credit policy to lengthen the period for cash discounts
27. To determine the operating cycle for a department store, which one of these pairs of items is needed?
C a. Days’ sales in accounts receivable and average merchandise inventory
b. Cash turnover and net sales
c. Accounts receivable turnover and inventory turnover
d. Asset turnover and return on sales
28. Selected information for 2021 for Tokyo Company is as follows:
Cost of goods sold P 5,400,000
Average inventory 1,800,000
Net sales 7,200,000
Average receivables 960,000
Net income 720,000
Assuming 360 days in a year, what was the average number of days in operating cycle for 2020?
SOLUTION: Age, Inventory: 360 ÷ (5.4M/1.8M) Age, Receivables: 360 ÷ (7.2M ÷ 960,000)
29. Return on investment may be calculated by multiplying total asset turnover by
B a. Average collection period c. Debt ratio
b. Profit margin d. Fixed-charge coverage
30. The following ratios were computed from Dads Company’s financial statements for 2020:
Return on asset 24%
Asset turnover 1.6 times
What was the company’s profit margin ratio?
C a. 38.4% c. 15%
b. 24% d. 6%
31. Return on investment (RoI) is a term often used to express income earned on capital invested in a business unit. A
company’s RoI is increases if
B a. Sales increase by the same peso amount as expenses and total assets
b. Sales remain the same and expenses are reduced by the same peso amount that total assets increase
c. Sales decrease by the same dollar amount that expenses increase
d. Net profit margin on sales increases by the same percentage as total assets
32. If a company is profitable by effectively using leverage, which one of the following ratios is likely to be the largest?
C a. Return on total assets c. Return on common equity
b. Return on operating assets d. Return on total equity
33. RoA and RoE are measures of ______.
C a. Solvency c. Profitability
b. Liquidity d. Current asset activity
34. National Company’s return on equity is 12% and debt ratio is 0.40. Determine the return on assets.
D a. 5.35% c. 6.60%
b. 8.4% d. 7.20%
SOLUTION: Based on DuPont technique: RoE = RoA ÷ equity ratio = 12% = RoA ÷ 0.60
35. Selected information for Saisaki Company is as follows:
2019 2020
Preferred stock * P 125,000 P 125,000
Common stock 300,000 400,000
Retained earnings 75,000 185,000
Dividends paid on preferred stock for the year ended 10,000 10,000
Net income for the year ended 60,000 120,000
* 8%, P 100 par non-cumulative, non-convertible
What is Saisaki Company’s return on common stockholders’ equity for 2020?
C a. 17% c. 23%
b. 19% d. 25%
SOLUTION: Return on Common SHE: (120,000 – 10,000) ÷ (375,000 + 585,000)/2
36. It refers to the practice of financing assets with borrowed capital. Its extensive use may impact on the return on common
stockholders’ equity to be above or below the rate of return on total asset.
C a. Discounting c. Leverage
b. Mortgage d. Arbitrage

37. If the return on total assets is 10% and if the return on common stockholders' equity is 12% then
D a. The after-tax cost of long-term debt is probably greater than 10%.
b. The after-tax cost of long-term debt is 12%.
c. Leverage is negative.
d. The after-tax cost of long-term debt is probably less than 10%.
38. Which would be considered as the most favorable for the common stockholders?
D a. Book value per share of common stock is substantially higher than market value per share; return on
common stockholder's equity is less than the rate of interest paid to creditors.
b. Equity ratio is high; return on assets exceeds the cost of borrowing.
c. The company stops paying dividends on its cumulative preferred stock: the price earnings ratio of
common stock is low.
d. Equity ratio is low; return on assets exceeds the cost of borrowing.
39. If the ratio of total liabilities to stockholders equity increases, a ratio that must also increase is the
C a. Times interest earned c. Debt ratio
b. Current ratio d. Return on shareholders’ equity
40. The set of ratios that is most useful in evaluating solvency is
D a. Debt ratio, current ratio, and TIE c. Debt ratio, quick ratio, and TIE
b. Debt ratio, TIE, and RoA d. Debt ratio, TIE, and cash flow to debt
41. A debt equity ratio is
B a. About the same as the debt to assets ratio. c. Lower than the debt to assets ratio.
b. Higher than the debt to assets ratio. d. Not correlated with the debt to assets ratio.
42. In 2020, Kenny had total assets of P 375,000 and equity for P 206,250. For 2021, its budget for capital investments is
P 62,500. The company may borrow from a bank provided that the 2021’s debt-to-equity ratio should be the same as
the debt-to-equity ratio in 2020. How much debt should be incurred to satisfy the bank’s condition?
A a. P 28,125 c. P 51,138
b. P 34,375 d. P 62,500
SOLUTION: Equity ratio: 206,250 ÷ 375,000 = 55% Debt ratio: 45% Debt: 62,500 x 45%
43. A measure of long-term debt-paying ability is a company’s
D a. Length of the operating cycle c. Inventory turnover ratio
b. Return on assets d. Times-interest-earned ratio
44. A company has interest expense of P4 million, sales revenue of P50 million, earnings before interest and taxes of P20
million, and an income tax rate of 35%. This company has a times-interest-earned ratio of
C a. 12.5 c. 5.0
b. 7.5 d. 0.2
Items 45-47 are based on the following data
Operating income P 900,000
Interest expense 100,000
Income before 40% income tax 800,000
Net income 480,000
Preferred stock dividends 200,000
Net income available to common shareholders 280,000
Common shares outstanding 120,000
45. What is the “times interest earned” (TIE) ratio?
D a. 2.8 c. 8.0
b. 4.8 d. 9.0
46. What is the “times preferred dividend earned” (TPDE) ratio?
C a. 1.4 c. 2.4
b. 1.7 d. 4.0
47. What is the basic Earnings Per Share (EPS)?
A a. 2.3 c. 3.0
b. 2.6 d. 4.1
48. Which would likely cause a firm to increase its use of debt financing as measured by the debt to total capital ratio?
D a. Increased economic uncertainty.
b. An increase in the degree of operating leverage.
c. An increase in the price-earnings ratio.
d. An increase in the corporate income tax rate.
49. What type of ratio is Earnings Per Share (EPS)?
A a. Profitability ratio c. Liquidity ratio
b. Activity ratio d. Leverage ratio
50. The book value per share a corporation is usually different from the market value of the stocks due to the
C a. Use of accrual accounting in preparing financial statements
b. Omission of the number of preferred shares outstanding at year-end in the calculation
c. Use of historical costs in preparing financial statements
d. Omission of total assets from the numerator in the calculation
51. Book value per common share represents the amount of equity assigned to each outstanding share of common stock.
Which one of the following statements about book value per common share is correct?
B a. Market price per common share usually approximates book value per common share
b. Book value per common can be misleading because it is based on historical cost
c. A market price per common share that is greater than book value per common share is an indication
of an overvalued stock
d. Book value per common share is the amount that would be paid to shareholders if the company were
sold to another company

52. KFC Company’s equity balances as of the end of 2021 are as follows:
6% cumulative preferred stocks, 2,000 shares outstanding
P 200 par value, with liquidation value of P 220 P 400,000
Common stocks, 20,000 shares issued and outstanding 800,000
Retained earnings 1,024,000
Preferred dividends in arrears amount to P 24,000.
What is KFC Company’s book value per share of common stock?
D a. P 111.20 c. P 89.20
b. P 91.20 d. P 88.00
SOLUTION: [800,000 + 1,024,000 – 24,000 - 2,000 (220 – 200)] ÷ 20,000
53. The issuance of new shares in a five-for-one split of common stock
A a. Decreases the book value per share of common stock
b. Increases the book value per share of common stock
c. Increases total stockholders’ equity
d. Decreases total stockholders’ equity
54. A company has net income of P 250,000 and dividends of P 50,000 on its convertible preferred stock. There were
400,000 shares of common stock outstanding and the preferred is convertible into 125,000 shares of common stock.
Basic earnings per share were (rounded):
B a. P 0.48 c. P 0.60
b. P 0.50 d. P 2.50
55. A company has net income of P 250,000 and dividends of P 50,000 on its convertible preferred stock. There were
400,000 shares of common stock outstanding and the preferred is convertible into 125,000 shares of common stock.
Diluted earnings per share were (rounded):
A a. P 0.48 c. P 0.60
b. P 0.50 d. P 2.50
56. Financial ratios, which assess the profitability of a company, include all of the following, except
A a. Dividend yield c. Earnings per share
b. Gross profit percentage d. Return on sales
57. A drop in the market price of a firm’s common stock will immediately increase its
D a. Return on equity c. Market-to-book ratio
b. Dividend payout ratio d. Dividend yield
58. Which of the following statements about the price-earnings (P-E) ratio is correct?
A a. A company with high growth opportunities ordinarily has a high P-E ratio
b. P-E ratio has more meaning when a firm has losses than when it has profits
c. P-E ratio has more meaning when a firm has abnormally low profits in relation to its assets
d. P-E ratio expresses the relationship between a firm’s market price and its net sales
59. The following information is provided about the common stock of Karate Kid Inc. at the end of the year:
Par value per share P 10.00
Dividends paid per share (last 12 months) 12.00
Market price per share 108.00
Basic earnings per share 36.00
Diluted earnings per share 24.00
What is the price earnings ratio for Karate Kid’s common stock?
B a. 3.0 times c. 9.0 times
b. 4.5 times d. 10.8 times
NOTE: Price-earnings ratio is preferably based on diluted earnings per share.
60. Aristocrat paid out half of last year’s earnings in dividends. Aristocrat’s earnings increased by 20% and the amount of
dividends increased by 15% in the current year. What was Aristocrat’s dividend payout ratio for the year?
C a. 50.0% c. 47.9%
b. 57.5% d. 78.0%
SOLUTION: Payout ratio: 1.00 (1.15) ÷ 2.00 (1.20)
61. Watson Corporation computed the following items from its financial records for the year:
Price-earnings ratio: 12 Payout ratio: 0.6 Assets turnover ratio: 0.9
What is the dividend yield on Watson’s common stock?
A a. 5.0% c. 7.2%
b. 7.5% d. 10.8%
NOTE: Yield x P/E = payout = (dividends/price) x (price/earnings) = dividends/earnings
62. Dividend yield is 10%, price-earnings ratio is 4 times, what is the plowback ratio?
C a. 2.5% c. 60%
b. 40% d. Cannot be determined from given information
NOTE: Plowback ratio = Retention ratio = 100% - payout ratio
63. ABC Corporation is a closely held corporation owned by the siblings Antoinette, Bonna & Connie. It currently earns a
profit after tax of P 6,000,000 and has 300,000 shares outstanding. Next year, ABC will go public for the first time. Its
initial public offering of 100,000 shares will be priced at P 60 per share, with a 5% underwriter’s spread on the price
offering. In addition, ABC will incur P 200,000 in out-of-pocket costs. If all the shares will be issued, how much will be
the net proceeds?
A a. P 5,500,000 c. P 5,800,000
b. P 5,700,000 d. P 6,000,000
SOLUTION: [100,000 (60) x 95%] – 200,000
64. Which of the following is not a potential source of financial leverage?
B a. Long-term debt c. Preferred stock
b. Common stock d. Current liabilities

65. A company’s cash ratio will decrease if the company

B a. Purchases commercial paper.
b. Purchases materials on account.
c. Sells goods for cash at a selling price lower than cost.
d. Receives cash by issuing a short-term note payable.
66. A company had P 500,000 of sales for the year just ended and is projecting sales of P 600,000 for the coming year. For
every P 1 increase in sales, 38% of additional financing is required for the purchase of additional assets. The projected
profit margin is 20%, and 60% of profits will be retained for reinvestment in the company. What is the amount of
additional external financing needed by the company in the coming year?
A a. P 0 c. P 86,000
b. P 38,000 d. P 110,000
67. Given the following items that vary directly with P 2,000,000 sales for the year 2020:
Assets: 65% Liabilities: 20%
Net profit margin is expected to be 12% and while payout ratio is constant at 60%.
If sales are expected to increase by 25% in 2021, how much is the additional financing needed?
B a. P 225,000 c. P 45,000
b. P 105,000 d. Some other amount
68. Which of the following is not a limitation of ratio analysis affecting comparability among firms?
D a. Different source of information
b. Different accounting periods
c. Different accounting policies
d. Provision of useful information regarding stability of financial conditions
69. Which of the following is not a problem or limitation associated with financial statement analysis?
A a. Financial statements are based on current market value of the firm’s assets, therefore do not reflect
historical costs
b. There may be some differences in the accounting methods and estimates used by companies so that
comparison of their ratios may not be advisable
c. The timing of transactions and use averages in applying the various techniques in FS analysis affect the
results to be obtained
d. A ratio that is acceptable to one company may not be acceptable to another when some other factors are
considered
70. Financial statement analysis is least associated with
D a. Common-size income statement c. Liquidity and profitability
b. Gross profit variance d. Productivity
Solutions to Exercise No. 9 (Pages 4 & 5)

1. Current ratio (1,070/370) 11. EPS (420/1,000)
2. Acid-test ratio (660/370) 12. P/E ratio (8/0.42)
3. Accounts receivable turnover (4,700/440) 13. Dividend yield (0.1/8)
4. Inventory turnover (2,300/410) 14. Payout ratio (0.1/0.42)
5. Gross profit margin (2,400/4,700) 15. Debt ratio (2,330/4,570)
6. Operating profit margin (850/4,700) 16. Debt-equity ratio (2,330/2,240)
7. Return on sales (RoS) (420/4,700) 17. Times interest earned (850/150)
8. RoA – operational performance (850/4,570) 18. Cash flow to total debt (740*/2,330)
9. RoA – total management effort (420/4,570) 19. Cash flow margin (740*/4,700)
10. Return on equity (RoE) (420/2,240) 20. Cash ratio (220/370)
*Cash Flow (Operations): Net Income + Depreciation = 420 + 320 = 740
Answers to Exercise No. 10 (Page 5)

Condensed Income Statement
Sales P 900
Cost of sales (A) 540
Gross profit (B) 360
Operating (C) 306
expenses (D) 54
Net income
Condensed Balance Sheet
Cash P 30 Current liabilities (H) 115
Receivables (E) 180 Long-term debt (I) 291
Inventory (F) 135 Shareholders’ equity (J) 609
Plant and equipment 670
Total (G) 1,015 Total (K) 1,015

MAS-02: Cost Behavior Regression Analysis: - T R S A

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

MANAGEMENT ADVISORY SERVICES A. Lee  E. Ara–as  K. Manuel

MAS-02: COST BEHAVIOR WITH REGRESSION ANALYSIS

COST BEHAVIOR ASSUMPTIONS and LIMITATIONS

COST ESTIMATION: SEGREGATING VARIABLE & FIXED COSTS

ReSA Ð THE REVIEW SCHOOL OF ACCOUNTANCY MAS-02

EXERCISES: COST BEHAVIOR with REGRESSION ANALYSIS

REQUIRED: Using the high-low method, determine the admission departmentÕs:

ReSA Ð THE REVIEW SCHOOL OF ACCOUNTANCY MAS-02

4. Least-Squares Regression Method

Month X (Hours) Y (Total Costs) XY X2

ReSA Ð THE REVIEW SCHOOL OF ACCOUNTANCY MAS-02

SELF-TEST QUESTIONS (with suggested answers)

ReSA Ð THE REVIEW SCHOOL OF ACCOUNTANCY MAS-02

ReSA Ð THE REVIEW SCHOOL OF ACCOUNTANCY MAS-02

MANAGEMENT ADVISORY SERVICES C.P. Lee  E.S Arañas  K.L. Manuel

MAS-03: COST-VOLUME-PROFIT (CVP) ANALYSIS

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REQUIRED: Determine the following:

SELF-TEST QUESTIONS - with suggested answers

ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

MANAGEMENT ADVISORY SERVICES C. LEE  E. ARAÑAS  K. MANUEL

MAS-04: ABSORPTION & VARIABLE COSTING WITH PRICING DECISIONS

∆ Profit = ∆ Inventory x unit FFOH

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EXERCISES: ABSORPTION & VARIABLE COSTING with PRICING DECISIONS

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-04

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-04

18. When using the absorption approach to cost-plus pricing,

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-04

11. The use of variable costing requires knowing

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22. Absorption costing and variable costing differ in that

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

MANAGEMENT ADVISORY SERVICES C.P. Lee  E.S Arañas  K.L. Manuel

MAS-06: BUDGETING WITH PROBABILITY ANALYSIS

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EXERCISES: BUDGETING with PROBABILITY ANALYSIS

2. Sales & Accounts Receivable Budget

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-06

6. Indifference Point under Probability Analysis

LATER RAIN ( ): __________________

9. Decision (Payoff) Table

States of Nature (based on demand)

10. Perfect Information

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-06

MANAGEMENT ADVISORY SERVICES A. Lee E. Ara–as K. Manuel

Month X (Hours) Y (Total Costs) XY X2