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2010 CMA Part 1 Section B Performance Management

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2010 CMA Part 1 Section B
Performance Management
2010 CMA Part 1 Section B Performance Management
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Performance Management
This section is 25% of the Part 1 Exam
The main topics within Section B are:
Introduction to Variance Analysis and Standard Costs
Variance Analysis Concepts
Manufacturing Input Variances
Sales Variances
Market Variances
Variance Analysis for a Service Company
Responsibility Centers and Reporting Segments
Performance Measures
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Introduction to Variance Analysis and
Standard Costs

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Variance Analysis
Variance analysis is the comparison between the
actual results for the period and the budgeted
results.
Variance analysis is an attempt to determine why
the actual results were different from the budgeted
results.
Either the quantity sold (or purchased), or the price
received (or paid), was different than expected, or both.
Variances enable management to focus its
attention on areas where something was wrong.
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Standard Costs
A standard cost is an estimate of the cost the
company expects to incur in the production
process. It is the standard against which to
measure the actual performance.
Standard costs are calculated at the beginning of
each year and are based on the estimated costs
and the expected level of activity or production.
Standard costs are determined through the use of
accounting and production estimates.
Standard costs are used to control costs. A large
variance between actual cost and standard cost is
an alert to management.
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Standard Costs Contd
A standard cost is not the same thing as a standard
cost system.
A standard cost prescribes expected performance in
terms of cost.
A standard cost system is an accounting system that
uses standard costs and standard cost variances in the
formal accounting system.
There are other types of accounting systems, and
standard costs can be used with those accounting
systems as well. In these other systems the
standard costs are used for control purposes
outside the formal accounting system.
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Standard Costs Contd
A standard cost system can be used with either a
job order costing system or a process costing
system.
A process costing system is used to assign costs to
individual products when the products are all relatively
similar and are mass-produced, as on an assembly line.
A job-order costing system is a method in which all of the
costs associated with a specific job (or client) are
accumulated and charged to that job (or client).
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Standard Costs Contd
Standard costs are used with a flexible budgeting
system.
A flexible budget enables the company to identify
differences from the budget that are not simply due
to the actual quantity sold or produced being
different from the budgeted or standard quantity to
be sold or produced.
A flexible budget is a budget prepared using standard
per-unit amounts and the actual level of activity.
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Determining the Level of Activity
Costs are the result of activities that create
products or render services. Standards should be
established for the cost drivers underlying the
costs.
An expected, or budgeted, level of activity for
production must be determined in order to calculate
standard costs.
It is important to use the correct level of activity
when developing standards.
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Determining the Level of Activity Contd
Choices of levels of activity to use:
Ideal, perfect, or theoretical level of output assumes
no breakdowns, no waste and no time lost and that
workers are working at maximum efficiency.
Practical, or currently attainable, level of output the
level achieved given the normal amount of time lost,
waste, and a normal learning curve for employees.
Attainable, but difficult to attain.
Normal level of output an average expected level of
production within a period of several years, given
effective and efficient production and customer demand.
Master budget capacity the planned output for the next
budget period.
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Reviewing the Established Standard Cost
The established standard costs need to be
reviewed periodically, because costs of the inputs
into the manufacturing process will change over
time.
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Sources of Standards
Standards can be set using several sources:
Activity analysis:
Identifying, delineating or outlining, and evaluating all the
activities necessary to complete a job, a project or an operation
Considers everything required to complete the task efficiently and
involves personnel from several areas including engineers,
management accountants and production workers
Time consuming and expensive.
If properly executed, it is the most precise way to determine
standard costs.
Use of historical data
less costly way since historical data for a similar product can be a
good source if reliable information is available.
Advantage: using historical data is that it is based on the way the
particular firm has operated in the past.





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Sources of Standards Contd
Standards can be set using several sources:
Benchmarking:
based on current practices of similar operations in other firms.
Associations of manufacturers often collect industry information
and have data available. The firm can use this data as guidelines
By using benchmarking to set standard costs, a firm can have
access to the best performance anywhere and this can help
sustain its competitive edge.
A disadvantage of using benchmark data is that it might not be
completely applicable to the firms own situation.



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Sources of Standards Contd
Standards can be set using several sources:
Use of target costing:
Use of target costing to set standard costs puts the focus on the
market and on the price the product can be sold for
A target price is the price the firm can sell its product for, and the
target cost is the cost that must be attained for the firm to realize
its desired profit margin for the product.
Once the target cost has been determined, detailed standards
are then set to attain the desired cost.
Strategic decisions:
Strategic decisions may affect a products standard cost. For
instance, a decision to replace an obsolete machine with a new,
computer-controlled machine would require an adjustment to the
standard cost for the process.





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Management by Exception
Variance reporting enables management by
exception which permits management to focus on
areas where there are problems, as identified by
the variance from the standard.
Disadvantages of management by exception:
Negative trends may be overlooked at earlier stages,
before they show up as variances.
If too many deviations from the standards occur, it
becomes a very confusing and involved process because
management is trying to fix all of the problems at once.
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Variance Analysis Concepts

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Variance Analysis Concepts
Variances are a comparison between the actual
results and the budgeted, or standard, results.
More detailed levels of variance analysis determine
the cause for the difference:
whether the actual quantity was different or
whether the actual price per unit was different, or
whether both quantity and price differences caused the
variance.
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Static Budget Vs Flexible Budget Variances

Variances can be looked at from a variety of levels
and perspectives.
The total static budget variance is the difference
between the actual results and the static (or
master) budget.
This is the broadest variance, and not very useful
because much of it may be explained by the fact that
actual sales were different than expected.
This variance may be broken down into two sub-
variances:
1. The flexible budget variance is the difference
between actual results and the flexible budget amount.
2. The sales volume variance is the difference between
the flexible budget and the static budget amount.
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Variances: Favorable or Unfavorable
When calculating variances for incomes or
expenses, always subtract the Budget amount
from the Actual amount.
Actual Budget = Variance
A positive variance for an income item is a
Favorable variance
A negative variance for an income item is an
Unfavorable variance
A positive variance for an expense item is an
Unfavorable variance
A negative variance for an expense item is a
Favorable variance
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Types of Variances
Manufacturing Input Variances
Direct Materials Variances
Price Variance
Quantity or Efficiency Variance
Mix Variance
Yield Variance
Direct Labor Variances
Rate (Price) Variance
Efficiency (Quantity) Variance
Mix Variance
Yield Variance

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Types of Variances Contd
Factory Overhead Variances
Total Variable Overhead Variance
Variable Overhead Spending Variance
Variable Overhead Efficiency Variance
Total Fixed Overhead Variance
Fixed Overhead Spending or Budget Variance
Fixed Overhead Production-Volume Variance
Sales Variances
Sales Price Variance
Sales Volume Variance
Quantity Variance
Mix Variance
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Variance Abbreviations
The formulas for the different variances all have
common elements to them. The following
abbreviations are used:
AQ Actual Quantity
SQ Standard Quantity for the actual level of output
AP Actual Price
SP Standard Price
WASPAM The weighted average standard price of the
actual mix
WASPSM The weighted average standard price of the
standard mix
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Manufacturing Input Variances

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Manufacturing Input Variances
Concerned with inputs to the manufacturing process
Whether the amount of inputs used per unit
manufactured was over or under the standard
Whether the cost of inputs used per unit manufactured
was over or under the standard
Standard (expected, budgeted) costs are determined
using an estimated cost and estimated level of usage.
If the company either pays a different price per unit of
the input purchased than planned or uses a different
amount of inputs than planned, the actual cost will be
different from the budgeted cost.
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Manufacturing Input Variances Contd
Input cost variances are subdivided into
A price variance reflecting the difference between actual
and budgeted input prices, and
A quantity variance, also called an efficiency variance,
reflecting the difference between actual and budgeted
input quantities.
Variance analysis enables management to identify
the specific reasons for variances and then to focus
its efforts on the variances that are unfavorable.
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Intro to Direct Materials Variances
The total materials variance is the difference
between the actual direct material costs and the
expected direct material costs in the flexible
budget.
Note that these variances are not caused by
manufacturing more units than were planned.
Variances are caused by either using more inputs per
unit manufactured than the standard per unit, or by
paying more per unit used than the standard per unit,
or both.
These differences need to be further examined to
identify what caused the difference.
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Direct Materials Variances
The total materials variance may be broken down
into two smaller variances:
1. The quantity variance, and
2. The price variance.
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The Quantity Variance
The quantity variance is also called the efficiency
variance, or the usage variance.
It measures the effect on the total variance that was
caused by the actual quantity used being different
from the expected quantity to be used for the actual
level of output that was produced.
The formula for the quantity variance is:
(AQ SQ) SP
If the result is positive, actual cost was greater
than planned because the company used more
inputs per unit manufactured than it had planned.
Since this is a cost, the variance is Unfavorable.
If the result is negative, actual cost was lower than
planned, and the variance is Favorable.
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The Price Variance
The price variance measures the effect on the total
variance that was caused by the actual price being
different from the expected price.
The formula for the price variance is:
(AP SP) AQ
If the result is positive, actual cost was greater
than planned because the he company paid more
than it expected to for each unit that was
purchased. Since this is a cost, the variance is
Unfavorable.
If the result is negative, actual cost was lower than
planned, and the variance is Favorable.
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The Variance Formulas and Using Them
In addition to being able to solve for the amount of
the variance, you also need to be able to use these
formulas to solve for any of the variables.
In a question, it is possible that you will be given what the
variance is and will need to calculate what the standard
price, or the actual quantity, or another variable was.
This is not difficult as it is simply an algebraic equation in
which you need to solve for the missing variable. This is
easy after you have identified the equation that must be
used.
You also need to be able to understand what may
cause a variance or a combination of variances.
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Accounting for Direct Materials Variances
Standard costing systems use actual variance
accounts to record the variances from the standard
costs as they occur.
The following accounting is performed at the time of
purchase:
Purchases of direct materials are recorded as debits to
the materials inventory account at their standard cost
If the company recognizes price variances at the time of
purchase, any difference in price from the standard is
recorded in a direct materials purchase price variance
account (a debit if the price is higher than the standard
and a credit if the price is lower than the standard)
The credit is booked to accounts payable


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Accounting for Direct Materials Variances Contd
The following accounting is performed at the time of
material requisition to production:
When direct materials are requisitioned from the
materials inventory for use in production, the debit to
Work-in-Process inventory is for the standard quantity
of materials that should have been used for
manufacturing the units manufactured at their standard
cost.
The credit to the materials inventory account is for the
total amount of the material actually used at their
standard cost
The difference is the direct materials quantity variance,
and it is recorded in the direct materials quantity variance
account
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Accounting for Direct Materials Variances Contd
These entries isolate the variances in special
accounts so they can be analyzed. It also maintains
standard costs in the Work-in-Process inventory
accounts during the production process.
At the end of the period, the variances are closed
out to cost of goods sold or, if material, prorated
among cost of goods sold, Work-In-Process
inventory, and Finished Goods inventory.
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Intro to Direct Labor Variances
The direct labor variances are almost exactly the
same as the direct material variances.
The formulas are the same, but the names given to
the variances are a little bit different.
The total labor variance is the difference between
the actual labor costs and the expected labor costs
in the flexible budget.
Variances result either by using more direct labor per
unit manufactured than the standard per unit, or by
paying more per unit used than the standard per unit,
or both.
This difference needs to be further examined to identify
what caused the difference.
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The Direct Labor Variances
The total labor variance may be broken down into
two smaller variances:
1. The labor rate (or price) variance, and
2. The labor efficiency (or quantity) variance.
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The Labor Rate Variance
The labor rate variance measures the effect on the
total variance that was caused by the actual labor
rate being different from the expected labor rate.
The formula for the price variance is:
(AP SP) AQ

If the result is positive, the variance is Unfavorable.
This means that the company paid more than it
expected to for each unit of labor that was used.
If the result is negative, the variance is Favorable.
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The Labor Efficiency Variance
The efficiency variance measures the effect on the
total variance that was caused by the actual
quantity used being different from the expected
quantity to be used for the actual level of output that
was produced.
The formula for the labor efficiency variance is:
(AQ SQ) SP
If the result is positive, the variance is Unfavorable
because the company used more labor than it
expected to for the level of output actually
produced.
If the result is negative, the variance is Favorable.
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Accounting for Direct Labor Variances
Standard costing systems use actual variance
accounts to record the variances from the standard
costs as they occur.
The following accounting is performed at the time of
production for direct labor:
The production payroll is recorded by debiting Work-in-
Process inventory for the total number of standard
hours for the units manufactured at the standard
hourly rate.
The credit is accrued payroll at the total number of
hours actually spent and at the actual rate.
The difference is recorded in the direct labor variance
accounts depending upon the type of variance.
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Accounting for Direct Labor Variances Contd
At the end of the period, the variances are closed
out to cost of goods sold or, if material, prorated
among cost of goods sold, Work-In-Process
inventory, and Finished Goods inventory.
Note: the company must also choose how the costs
of employee related costs such as employee
benefits and payroll taxes are treated. They may be
included in the cost of direct labor or treated as an
overhead and allocated to the units produced. In
some cases they may be treated as a period cost.
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More than One Material or Labor Input
The variances already discussed are used when
there is only one type (or class) of labor or material.
When there is more than one input (either labor or
material), the total price (or rate) variance, is
calculated as follows:
1. The price (or rate) variance is calculated for each
individual input separately, and
2. These individual variances are added together.
When there is more than one input, the total
quantity (or efficiency) variance is calculated in
the same manner as the total price (or rate)
variance.
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More than One Material or Labor Input Contd
When there is more than one type of labor (as in
skilled and unskilled) or materials (as in different
ingredients), the materials quantity variance and
the labor efficiency variance may be broken down
into two sub-variances:
Mix Variance and
Yield Variance
These sub-variances determine whether the quantity
variance was caused by the mix of the inputs being
different from the standard or by the actual total volume of
usage being different from the standard, or both.
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The Mix Variance (Materials or Labor)
The mix variance is the part of the quantity variance
that is caused by the mix of materials (ingredients)
actually used being different from the mix that
should have been used.
Needed (calculate):
Weighted Average Standard Price of the Actual Mix
(WASPAM)
Weighted Average Standard Price of the Standard Mix
(WASPSM)
The formula for the mix variance is:
(WASPAM WASPSM) AQ
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The Yield Variance (Materials or Labor)
The yield variance results from a difference
between the total quantity of the inputs that were
actually used to produce the actual output and the
total standard quantity that should have been used
to produce the actual output.
Needed (calculate):
Weighted Average Standard Price of the Standard Mix
(WASPSM)
The formula for the yield variance is:
(AQ SQ) WASPSM
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Factory Overhead Variances
In addition to calculating variances for materials
and labor, variances may also be calculated for
manufacturing (factory) overhead. These variances
are:

Total Variable Overhead Variance
Variable Overhead Spending Variance
Variable Overhead Efficiency Variance

Total Fixed Overhead Variance
Fixed Overhead Spending (or Budget) Variance
Fixed Overhead Production-Volume Variance
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Total Variable Overhead Variance
This is also called the flexible budget variance.
It is equal to the difference between the actual
variable overhead incurred and the standard
variable overhead applied, based on the standard
usage of the allocation base.
The total variable overhead variance is calculated
as:
Actual Total Variable Overhead Incurred
Flexible Budget Amount of Variable Overhead
= Total Variable Overhead Variance
The total variable overhead variance can be
broken down into spending and efficiency
variances.
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Variable Overhead Spending Variance
This is essentially the same as a price variance and
determines how much of the total variance was
caused by the actual variable overhead cost per
unit of the allocation base actually used being
different from the standard overhead application
rate per unit of the allocation base actually used.
The formula is:
(AP SP) AQ
Remember that it is not a price in this case, but
rather the overhead application rate. We have left
the variables the same to indicate how similar this
is to the materials and labor variances.
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Variable Overhead Spending Variance Contd
This variance is also the difference between the
actual amount of variable overhead incurred and
the standard amount of variable overhead allowed
for the actual quantity used of the variable
overhead allocation base for the actual output
produced.
Actual Variable Overhead Incurred
Standard amount of variable overhead allowed
for the actual quantity used of the variable
overhead allocation base for the actual output
= Variable Overhead Spending Variance
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Variable Overhead Efficiency Variance
This is essentially the same as the quantity
variance and determines how much of the total
variance was caused by the actual number of the
allocation base (direct labor hours, number of
parts) used being different than the expected
number of the allocation base to be used.
The formula is:
(SQ AQ) SP

Again, remember that it is not a price in this case,
but rather the overhead application rate. We have
left the variables the same to indicate how similar
this is to the materials and labor variances.
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Example: Variable Overhead Variances
Variable overhead is applied based on machine
hours.
Total budgeted production: 200,000 units
Standard quantity of machine hours allowed per
unit: 2.
Standard variable overhead cost per machine hour:
$1.50.
Actual production: 180,000 units
Actual machine hours used: 450,000 hours
Actual variable overhead incurred: $603,000
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Example: Total Variable OH Variance
The Total Variable Overhead Variance is:




1
U

1
180,000 units produced 2 MH standard per unit $1.50
standard variable overhead cost/MH = $540,000
Actual Variable Overhead Incurred $603,000
Less: Flexible Budget Amount of VOH 540,000
Total Variable Overhead Variance $ 63,000
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Example 1: VOH Spending Variance
The Variable Overhead Spending Variance is:





1
F

1
450,000 machine hours actually used $1.50/hr. = $675,000
Actual Variable Overhead Incurred $603,000
Less: Standard Amount of VOH $
Allowed for the Actual Quantity of the
VOH Allocation Base Used for the
Actual Output

675,000
Total Variable Overhead Variance $ (72,000)
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Example 2: VOH Spending Variance
Using the variance formula (AP SP) AQ:
The Variable Overhead Spending Variance is:
($1.34
1
$1.50) 450,000 = (72,000) F

1
$603,000 VOH actually incurred 450,000 machine hours
actually used = $1.34 actual variable overhead cost per
unit of the allocation base actually used.
The Variable OH Spending Variance was $72,000 Favorable
because the actual variable overhead incurred per machine
hour used was lower than the standard: $1.34 actual variable
overhead cost per machine hour, compared with the standard
of $1.50 per machine hour.
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Example: VOH Efficiency Variance
The Variable Overhead Efficiency Variance, using
the variance formula (AQ SQ) SP is:

(450,000 360,000
1
) $1.50 = $135,000 U


1
2.0 machine hrs. standard/unit 180,000 units
produced = standard quantity of 360,000 MH
The Variable OH Efficiency Variance was $135,000
Unfavorable because instead of the 2.0 machine hours
planned to be used for each unit produced, 2.5 machine hours
were used (450,000 total actual hours used 180,000 units
produced).
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Example: Total Variable OH Variance
Here are the individual variable overhead variances
combined, and their total is the Total Variable
Overhead Variance:

F

U

U
Variable Overhead Spending Variance $(72,000)
Variable Overhead Efficiency Variance 135,000
Total Variable Overhead Variance $ 63,000
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Example: Interpretation of Variable OH Variances
Calculating variances is only the beginning. The
next step is to interpret them.
The Total Variable Overhead Variance was
$63,000 Unfavorable, because the actual amount
of variable overhead incurred was $63,000 greater
than the flexible budget amount. Why?
Investigation should be performed into why more
machine hours were used per unit than planned
and why the actual variable overhead incurred per
machine hour was lower than the expected amount.
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The Fixed Overhead Variances
The fixed overhead variances are different from all
of the previous variances we have looked at. This is
because fixed factory overhead (rent, for example)
is not dependent on quantity produced, or sales, or
anything.
Also, because of the nature of these expenses,
much less control can be maintained or effected
over these costs. If the production is less than
expected, there will be an unfavorable variance, but
there is little that can be done to change, or control,
the fixed overhead costs.
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Total Fixed Overhead Variance
The total fixed overhead variance analysis is the
difference between the actual fixed overhead
incurred and the amount that was applied using the
standard rate and the standard usage for the actual
level of output.
Actual Fixed Overhead Incurred
Applied Fixed Overheads
1

= Total Fixed Overhead Variance

1
Standard rate per unit of application base Standard amt.
of application base for actual output
Note that this amount is the same as the over- or
under-applied fixed factory overhead.
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Fixed Overhead Spending (Budget) Variance
The Fixed Overhead Spending (also called the
Fixed Overhead Budget) Variance is simply the
difference between the actual fixed overhead costs
and the budgeted fixed overhead amount.

Actual Fixed Overhead Incurred
Budgeted Fixed Overhead (Static Budget Amt.)
= Fixed Overhead Budget/Spending Variance
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Fixed Overhead Production-Volume Variance
The Fixed Overhead Production-Volume Variance is the
difference between the budgeted amount of fixed over-
head and the amount of fixed overhead applied. It is
caused by the actual production level being different
from the production level used to calculate the
budgeted fixed overhead rate.
Budgeted Fixed Overhead (Static Budget Amt.)
Applied Fixed Overheads
1

= Fixed overhead production-volume variance

1
Standard rate per unit of application base Standard amt. of
application base for actual output
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Example: Fixed Overhead Variances
Fixed overhead is applied based on machine hours.
Total budgeted fixed overhead: $1,000,000
Total budgeted production: 200,000 units
Standard quantity of machine hours allowed per unit:
2.
Standard fixed overhead cost per machine hour:
$1,000,000 200,000 units 2 MH/unit =
$2.50/MH. (Also, $5 per unit)
Actual production: 180,000 units
Actual machine hours used: 450,000 hours
Actual fixed overhead incurred: $1,200,000
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Example: Total Fixed Overhead Variance
The Total Fixed Overhead Variance is:


1
U


1
$2.50/MH 2 MH/unit 180,000 units produced
The variance is Unfavorable because the actual fixed
overhead incurred was greater than the amount of fixed
overhead applied.
Actual Fixed Overhead Incurred $1,200,000
Less: Fixed Overhead Applied 900,000
Total Fixed Overhead Variance $ 300,000
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Example: Fixed Overhead Spending Variance
The Fixed Overhead Spending (Budget) Variance
is:




U
The variance is Unfavorable, meaning the actual fixed
overhead incurred was greater than the fixed overhead
budgeted.
Actual Fixed Overhead Incurred $1,200,000
Less: Static Budget Fixed Overhead

1,000,000
Fixed Overhead Spending Variance $ 200,000
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Example: FOH Production-Volume Variance
The Fixed Overhead Production-Volume Variance
is:



1

U


1
$2.50/MH 2 MH/unit 180,000 units produced
The variance is Unfavorable because the actual output was
lower than planned. The facilities were under-used, and so less
overhead was applied to units produced than anticipated.
Static Budget Fixed Overhead $1,000,000
Less: Fixed Overhead Applied 900,000
Fixed Overhead Production-
Volume Variance
$ 100,000
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Example: Total FOH Variance
Here are the individual fixed overhead variances
combined, and their total is the Total Fixed
Overhead Variance:
U
U
U
Fixed Overhead Spending Variance $200,000
Fixed Overhead Production-
Volume Variance
100,000
Total Fixed Overhead Variance $300,000
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Example: Interpreting the FOH Variances
The $200,000 Unfavorable Fixed Overhead
Spending Variance needs to be investigated to find
out why fixed costs were higher than planned, to
identify the source of the variance.
The $100,000 Unfavorable Fixed Overhead
Production-Volume Variance measures the amount
of excess fixed costs that the company incurred for
fixed manufacturing capacity that it planned to use
but did not use. By their very nature, fixed costs do
not decrease if usage is lower than anticipated.
The interpretation of this variance depends upon the
reason for the lower production, which should be
investigated.
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2-way, 3-way and 4-way Analysis
The Overhead Variances may be combined in
different ways and measured as either 2-way, 3-
way or 4-way variance.
In 4-way variance analysis, each of the 4
subvariances are looked at and measured
individually.
In 3-way variance analysis, the variable and fixed
overhead spending variances are combined into
one spending variance.
In 2-way variance analysis, the spending variance
is combined with the variable overhead efficiency
variance in what is called the controllable
variance.
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2, 3 and 4-way OH Variance Summary
In table format, this is the presentation of 2-way, 3-
way and 4-way variance analysis, with our variances:

Variable Overhead Variances Fixed Overhead Variances
Efficiency
Variance
$135,000 U
Spending
Variance
($72,000) F
Spending
Variance
$200,000 U
Prod.-Volume
Variance
$100,000 U
Efficiency
Variance
$135,000 U
Spending Variance (Var &
Fixed)

$128,000 U
Prod.-Volume
Variance
$100,000 U
Controllable Variance

$263,000 U
Prod.-Volume
Variance
$100,000 U
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OH Variance Summary Contd
The Controllable Variance of $263,000 is equal to
the difference between the total actual overhead
incurred (variable and fixed) and the total flexible
budget overhead (variable and fixed).
1





1
Note: For fixed overhead, the flexible budget and the static budget
amounts are the same, because fixed overhead does not change with
changing activity levels.
Variable Fixed Total
Total Actual Overhead $603,000 $1,200,000 $1,803,000
Less: Total Flexible
Budget Overhead

540,000 1,000,000 1,540,000
Total Variances $ 63,000 $ 200,000 $ 263,000
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Sales Variances

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Sales Variances
Variance analysis can be used to assess the selling
department as well as the production department.
Sales variances are used to explain the differences
between actual and budgeted amounts of revenue,
variable costs, and contribution margin caused
by differences between actual sales results and
planned or budgeted sales results.
These variances can be caused by differences in
sales prices charged, differences in sales volume,
differences in variable cost per unit, and by
differences in the mix of products sold.
They are called Sales Variances to differentiate
them from manufacturing input variances.
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Sales Price Variance for a Single Product Firm
The Sales Price Variance is the same as the
Flexible Budget Variance.
Since the Flexible Budget is adjusted to the actual
sales volume, the only cause for a variance
between the actual and the flexible budget amounts
is sales price charged (for revenue) or variable
costs of sales (for costs) i.e., price variances.
The Sales Price Variance for a single product firm
is calculated as:
(AP SP) AQ
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Sales Volume Variance for a Single Product Firm
The Sales Volume Variances measures the impact
of the difference in sales volume between the
actual results and the STATIC budget.
The Sales Volume Variance for a single product
firm is calculated as:
(AQ SQ) SP

If only a Flexible Budget is used to make
comparisons to actual results, the Sales Volume
Variance will be zero, because the actual quantity
sold will be the same as the budgeted (i.e.,
standard) quantity.
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Single Product Firm Variances Contd
The Sales Price Variance and the Sales Volume
Variance can be calculated for the Revenue,
Variable Costs, and Contribution Margin lines.
For Revenue and Contribution Margin, a positive
variance amount is Favorable (revenue or
contribution margin were higher than planned); and
a negative variance amount is Unfavorable (they
were less than planned).
For Variable Costs, a positive variance amount is
Unfavorable (costs were higher than planned); and
a negative variance amount is Favorable (they
were less than planned).
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Summary of Single Product Variances
For a single product firm, Flexible Budget Variances are
due to differences in prices, and Sales Volume
Variances are due to differences in quantity.
When comparing actual results to the static budget,
the Flexible Budget Variances are due to price while
the Sales Volume Variances are due to quantity.
When comparing actual results to the flexible budget,
there will be no Sales Volume/Quantity Variance (i.e.,
the variance will be zero). This is because the quantity
in the flexible budget is the same as the actual quantity.
The Flexible Budget Variance plus the Sales Volume
Variance equals the Static Budget Variance.
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Sales Variances When More Than One Product Is Sold
When more than one product is sold, the Sales Price
Variance is calculated differently from the way it is
calculated for a single product firm.
The Sales Volume Variance (or Sales Quantity
Variance) is also calculated differently, although it is
also true that when the actual results are compared
with the Flexible Budget, the Sales Volume Variance
will be zero.
The Sales Volume Variance is subdivided into a
Sales Mix Variance and a Sales Quantity Variance.
This breakdown of the Sales Volume Variance is similar
to the way manufacturing quantity variances are
subdivided when there is more than one input.
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Sales Price Variance for a Multi-Product Firm
This is also the Flexible Budget Variance.
Calculate each products individual sales price
variance and sum the variances:
The Sales Price Variance for a multi-product firm is:
(AP SP) AQ

This variance can be calculated for revenue,
variable costs, or contribution margin.
It is the portion of the total variance caused by the
fact that the sales prices received for the units sold
were different from the budgeted sales prices.
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Sales Volume Variance for a Multi-Product Firm
The total Sales Volume Variance for a multi-product
firm is the total of the Sales Volume Variances for each
individual product.
The Sales Volume Variance for a multi-product firm,
calculated for revenue, variable cost, or contribution
margin, is:
(AQ SQ) SP
The detail by product for this variance tells us the effect
on income and expense of the differences between the
actual units sold and budgeted amounts for each
product. The sum is the net effect.
The total Sales Price Variance and the total Sales
Volume Variance together make up the total Static
Budget Variance.
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Sales Volume Variance for a Multi-Product Firm Contd
For a multi-product firm, the total Sales Volume
Variance is sub-divided into
the Sales Quantity Variance and
the Sales Mix Variance.
The Sales Quantity Variance tells us how much of the
Sales Volume Variance was caused by the fact that, in
total, the number of units sold was different from
what was budgeted.
The Sales Mix Variance tells us how much of the
Sales Volume Variance was caused by the fact that the
mix of products sold was different from the budgeted
mix.
These variances can be calculated for revenue,
variable costs, and contribution margin.
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Sales Quantity Variance for a Multi-Product Firm
To calculate the Sales Quantity Variance, we use
our quantity variance formula, but we use the
weighted average standard price for the
standard mix (WASPSM) in the formula as the
standard price. The Quantity figures are the total
actual and budgeted units sold.
The formula is:
(AQ SQ) WASPSM
For a multi-product firm, the Sales Quantity
Variance analyzes only the effect of differences
between actual and budget in terms of total units
sold, regardless of what products were sold.
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Sales Mix Variance for a Multi-Product Firm
The Sales Mix Variance incorporates the impact of
the differences between the actual product mix sold
and the budgeted product mix and its effect on
whichever line is being analyzed (revenue, variable
cost, or contribution margin).
It works in much the same manner as the mix
variance for labor or material, using the weighted
average standard price for the actual mix
WASPAM) and the weighted average standard
price for the standard mix (WASPSM).
The formula is:
(WASPAM WASPSM) AQ
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Market Variances

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Market Variances
The Sales Quantity Variance can also be analyzed
as to why it occurred.
The difference between actual and expected sales
units may be connected to two potential areas
related to the market.
1. The actual market was bigger or smaller than was
expected,
2. The companys market share was bigger or smaller
than expected.
The market variances measure how much of the
difference was a result of these two potential
factors.
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Market Size Variance
This measures how much of the Sales Quantity
Variance for the contribution margin was caused by
the market itself being bigger or smaller than was
expected.
The formula for the Market Size Variance is:
(Actual Market Size in
Units Expected Market
Size in Units) Expected
Market Share %

Standard Weighted
Average Contribution
Margin per Unit
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Market Share Variance
This variance measures the difference in the
budgeted contribution margin caused by the actual
market share being different from the expected
market share.
The formula for the Market Size Variance is:
(Actual Market Share
Expected Market Share)
Actual Market Size in
Units

Standard Weighted
Average Contribution
Margin per Unit
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Variance Analysis for a Service Company
A service companys product is the service it
provides. An example of a pure service company is
a public accounting firm. The public accounting firm
has no cost of goods sold because its sole product
is the service it provides.
Service companies can have the following
variances: price, volume (quantity), mix (related to
the services they provide) and overhead
If a service company provides service only, then it can
calculate price, quantity and mix variances for the
revenue line.
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Variance Analysis for a Service Company Contd
If the company provides both a service and a
product such as replacement parts, the company
should segregate its service revenue from its parts
revenue in its accounting system.
It can then analyze its service revenue in isolation while
analyzing the parts sales variances the same way a
reseller would analyze its sales variances: revenue,
variable costs, and contribution margin.

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Variance Analysis for a Service Company Contd
Variance analysis can also be done by any
company on its selling, and general and
administrative overhead costs.
Variable overhead can be a large component of a service
companys costs, and it needs to be used in
A service organization may have high fixed
overhead costs. If revenue declines, the fixed
overhead costs remain, and the company can
quickly find itself in financial trouble.
Fixed overhead variance reporting can detect this early
and may enable the company to make changes in its
fixed cost structure to respond to the decreased sales.
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Variance Analysis for a Service Company Contd
A company that manufactures a product or resells
a product will have both fixed and variable
overhead costs for its non-manufacturing functions.
These costs need to be included in pricing and
product mix decisions. Variance analysis provides
a way of doing that.

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Responsibility Centers and Reporting
Segments^^

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Responsibility Centers
A responsibility center is any part of an organiza-
tion. It may be a product line, a geographical area,
or any other meaningful unit.
The main classifications of centers, from the most
fundamental (basic) to the least fundamental, are:
A cost center is responsible only for the incurrence of
costs (any revenue it may earn is immaterial).
Cost centers are measured on their efficiency (obtaining
the most with the least use of resources).
Training and maintenance are examples of cost centers.
A service center is a type of cost center that provides
services to other departments.
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Responsibility Centers Contd
Classifications of responsibility centers continued:
A revenue center is responsible only for generating
revenues and is not measured by its expenses.
A sales department is a revenue center.
It is measured on its effectiveness (how much did it sell).
A profit center is responsible for both the incurrence of
costs and generating revenue.
It is measured in respect to both efficiency and
effectiveness.
An example is a department within a larger store, such as
linens.
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Responsibility Centers Contd
An investment center is responsible not only for the
incurrence of costs and generating revenues, but also for
providing a return on an investment.
An investment center is most like a complete business in
and of itself. However, it is part of the larger organization.
A branch office in a different location would be an example.
It is measured using return-on-investment.
Return on investment emphasizes that the department
must provide a return to the larger company.
A company wants to have as many of its units be
investment centers as possible.
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Evaluating Managers and Departments
Whenever an evaluation of a manager is made, it is
important that the manager be evaluated only on
things that they are able to control.
For example, a line manager may be evaluated based on
the cost of production as they have control over that, but
should not be evaluated by the effectiveness of the
marketing campaign as they have no control over that.
Similarly, departments should not be evaluated on
things that they cannot control.
Local departments cannot control the amount of central
costs that are charged to them, so these costs should
generally not be included when evaluating the
department.
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Allocation of Common Costs
Common costs are costs that are shared by two or
more responsibility centers.
Common costs are non-manufacturing overhead costs
such as IT, human resources, or accounting.
These are service departments. Their costs need to be
allocated between or among the responsibility centers
that benefit from them in order to properly evaluate
people and departments.
The method of allocation should:
Provide accurate departmental and product costs
Motivate managers to make their best effort
Provide a fair evaluation of managers performance
Provide incentives for managers to make decisions that are
consistent with the companys goals,
Justify costs for transfer prices or cost based contracts
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Systems for Cost Allocation
Cost allocations can be done based on various
systems:
Cause and effect: activities that cause resources to be
consumed are identified, and cost allocations are based
upon each responsibility centers usage of the resources
Benefits received: based upon the benefit received by
each responsibility center
Fairness or equity: allocation should be reasonable or
fair. It is a matter of judgment. This approach is often a
requirement for government contracts when a price to the
government is based on costs and cost allocations.
Ability to bear: costs are allocated based upon the
ability of the responsibility center to bear the cost
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Systems for Allocating Common Costs Contd
An alternative: allocate some percentage of each
departments contribution to covering the common
costs, rather than actually allocating common costs
to each department.
This will enable managers to see themselves as
contributing to the overall success of the company rather
than paying for a central administration cost that they
may not perceive as adding value to their operations.
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Ways of Allocating Common Costs
There are two main ways in which common costs
may be allocated:
Stand alone cost allocation, and
Incremental cost allocation.
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Stand-Alone Cost Allocation
The stand-alone cost allocation method allocates
costs proportionately among all users on some
basis that relates to each users proportion of the
entire organization.
This could be based on each responsibility centers
other costs as a proportion of the companys total
costs; or it could be the proportion of each
responsibility centers sales in relation to total sales
of the entire company.
The cost allocation methods discussed in Section C
of this text (i.e., direct method, step method,
reciprocal method) are all stand-alone cost allocation
methods.
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Incremental Cost Allocation
The incremental cost-allocation method ranks
users of a cost object according to their total usage or
on some other basis.
The first-ranked user of the activity is called the
primary user. The primary user is charged for costs
up to what its cost would be if it were the only user.
Then, the next-ranked user(s) are called the
incremental users and are allocated the additional
cost, proportionately if there is more than one
incremental user.
This is advantageous for a new responsibility centers such
as a new branch office just building its business, if it can be
charged as an incremental user ,as its costs can be lower.
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The Contribution Income Statement
One way to be able to more easily identify the
performance of different managers or departments
in the organization is to use a contribution income
statement.
In short, this classifies costs according to who
controls them.
We will look at the different lines of the contribution
income statement.
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Manufacturing Contribution Margin
Net Revenue
Variable manufacturing costs
= Manufacturing contribution margin
The manufacturing contribution margin is the amount
available after all variable manufacturing costs are
covered to cover nonmanufacturing variable costs,
all fixed costs, and leave some for profit.
Variable manufacturing costs are the variable costs
of production labor, materials, and variable
overhead incurred in the production of the units sold

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Contribution Margin
Manufacturing contribution margin
Variable nonmanufacturing costs
= Contribution margin
This is the amount that is available to cover fixed
costs after all variable costs are covered, and leave
some for profit.
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Controllable Margin
This is also called short-term segment manager
performance.
Contribution margin
Controllable fixed costs
= Controllable margin
Controllable fixed costs are the costs the segment
manager can control.
This is important because it is a measurement of all the
revenues and expenses (variable and fixed) that are
controllable by the individual managers on a short-term
(less than one year) basis.
The controllable margin is a good measure of a
managers short-term performance.
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Segment Margin
This is also called contribution by strategic business
unit.
Controllable margin
Noncontrollable, traceable fixed costs
= Segment Margin
Noncontrollable, traceable fixed costs are costs the
segment manager cannot control over the short term,
such as depreciation, but they can be traced to that
department.
The segment margin is a measure of the performance of
each business unit. It may also be used as a measure of
the long-term performance of the manager, if the
manager can control the noncontrollable traceable fixed
costs over a long-term period.
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Net Income
Segment margin
Noncontrollable, untraceable fixed costs
= Net income
Noncontrollable, untraceable fixed costs are the
costs that are incurred at the company level and
would continue even if the individual segment were
discontinued.
Because they would continue if any individual segment
was discontinued, these costs should not be allocated
to the individual departments or segments.
Rather, they are subtracted from the sum of the
segment margins to calculate the companys net
income.
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Transfer Pricing
The transfer price is the price charged by one unit of
the company to another unit of the same company
for the services or goods produced by the first unit
and sold to the second unit.
Profit and investment centers use transfer pricing
to calculate the costs of services received from
service departments and revenues when selling a
product that has an outside market to another
department.
Transfer pricing is most common in firms that are
vertically integrated, i.e., they are engaged in several
different value-creating operations for a product.
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Goals of a Transfer Pricing System
A transfer system must accomplish the following:
It must give senior management the information it needs
to evaluate the performance of the profit centers
It must motivate the profit center managers to pursue
their own profit goals while also working towards the
success of the company as a whole
It must encourage the cost center managers efficiency
while maintaining their autonomy as managers of profit
centers
It must be equitable, permitting each unit of a company to
earn a fair profit for the functions it performs
It must meet legal and external reporting requirements
It should be easy to apply
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Transfer Pricing Decisions
Ultimately, the method used to calculate the
transfer price is determined by top management.
They must identify a method that will motivate managers
to make the best decisions for the entire company.
The methods used for transfer pricing include:
Market price (this is often the best method)
Cost of production plus opportunity cost
Variable cost
Full cost
Cost plus
Negotiation
Arbitrary pricing
Dual-Rate pricing
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Transfer Pricing Methods
Market price the transfer price is set as the
current price of the selling divisions product in an
arms-length transaction (a transaction made
under the same terms as with an unrelated 3
rd

party).
When there is an external market for the product, this is
usually the best transfer price to use.
However, sometimes there is no external market and
thus a market price is not available.
Cost of production plus opportunity cost
includes not only the cost of production, but also
the contribution that the selling department gives
up by selling internally rather than externally.
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Transfer Pricing Methods Contd
Variable cost the variable costs of the selling
division only.
Advantage: Works well when the seller has excess
capacity and when the objective is just to satisfy the
internal demand for goods.
Disadvantage: Not appropriate if the seller is a profit or
investment center because it decreases their profitability.
Full cost the full cost of production including all
materials, labor, and a full allocation of overhead.
Advantages: Well understood and cost information is
easily available. No need to eliminate intracompany
profits in consolidated statements; easy comparison
between actual and budgeted costs.
Disadvantage: Because it includes fixed costs, it can be
misleading and cause poor decision-making.
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Transfer Pricing Methods Contd
Cost plus A fixed dollar amount or percentage of
costs is added to the cost of production (the cost of
production is defined in the contract). Can be used
when a market price is not available. May use
either standard costs or actual costs.
If standard costs are used, there is an opportunity to
separate out the variances.
If actual costs are used, the manager of the selling
department has no motivation to control the costs,
because whatever the actual costs are will be passed on
to the purchasing department.
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Transfer Pricing Methods Contd
Negotiation the selling and buying departments
agree on a price.
Each department must have the ability to determine the
amount of materials it buys or the amount of its output it
sells.
Enables both parties to operate as if they were dealing
with an unrelated party and can lead to good long-term
decisions.
Most useful when the products in the market are rapidly
changing and companies need to react quickly to the
changes.
Also helpful when the units are having a conflict and
negotiation can bring about a resolution.
It can negatively impact the units autonomy.
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Transfer Pricing Methods Contd
Arbitrary Pricing central management decides
on a price to achieve some overall objective such
as tax minimization
Advantage of this approach is that it achieves the
objectives that central management considers most
important
Disadvantages far outweigh the advantages because it
defeats the goal of making divisional managers profit
conscious. It hampers their autonomy as well as their
profit incentive

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Transfer Pricing Methods Contd
Dual-Rate pricing the selling and purchasing
departments each record the transaction at
different prices.
Advantage of this method is that the selling division has
an incentive to expand sales and production; while, at the
same time, the buying division gets to book the product
at its actual cost to the firm. No artificial profit exists for
the selling division. Variable cost is used for decision
making but market price is used for evaluation
Disadvantage of this method is the complexity because
divisional profits are determined using different bases.

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Transfer Pricing Contd
Any cost-based method does not provide any
motivation for the producing department to control
costs.
However, cost-based transfer pricing is perhaps the
best method if the buying department is not
required to buy from another internal department.
If the buying department is unable to choose its supplier,
the manager of the supplying department will not be
motivated to control costs.
In deciding which method to use, management
considers:
The goals of the company
The capacity of the producing department
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Transfer Pricing and Capacity
If the producing department has excess capacity
and can produce what is required by the other
department, the minimum price that they will charge
is the variable cost of production.
Any transfer price between the variable cost of
production and the market price will be beneficial to both
departments.
If the producing department does not have excess
capacity, they will need to charge a transfer price
that:
Covers the variable costs of production, and
Recovers any lost contribution from the units that they
are not able to produce because of this order.
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Performance Measures

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Performance Measures
Performance needs to be measured and rewarded
in a way that motivates managers to achieve the
companys strategic objectives and operational
goals.
Goal congruence Individuals and organization
segments are all working toward achieving the
organizations goals. Managers should be evaluated on
their achievement of goals that benefit the company, not
on their achievement of goals that benefit their own
department or division.
Short-term versus long-term focus Emphasis on
short-term profits endangers long-term success because
managers will eliminate or postpone activities that are
vital for the firms long-term success.
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Performance Measures Contd
Timing of feedback is important. Feedback not
received in a timely manner is not useful.
The proper timing of feedback depends on who the
information is going to, how critical the information
is, and what the information is.
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Performance Measurement
In addition to the contribution income statement,
there are other tools for financial and performance
measurement that you need to be familiar with:
Return on Investment (ROI), and
Residual Income (RI).

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Return on Investment
ROI is the key performance measure for an
investment center.
It provides the measure of the percentage of return
that was provided on the dollar amount of the
investment (i.e., assets).
The formula is:
Net income of the Investment Center
Average Total Assets (Investment Base) of the Investment Center
Several different measurements of investment are
used.
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Return on Investment Contd
The different bases of investment (the
denominator) that may be used are:
Working capital plus fixed assets (if this information is
provided in the problem, use this)
Total assets
Long-term assets
Total assets employed
Average invested capital
Note: Shareholders equity should not be used as
the base because this includes decisions that are
made only at the corporate level, so they are
probably outside the control of the manager.
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Return on Investment Contd
One problem with ROI is that it measures return as a
percentage rather than as a dollar amount. While it is
good to have a higher rate of return, the company is
ultimately interested in the amount of the return.
As a result of this shortcoming, ROI is often used
together with other measurement tools.
Also, when a manager is evaluated using ROI, the
manager may make decisions that are good for short-
term ROI, but bad for the company in the long-term.
A profitable project may be rejected because its ROI is
lower than the segments current ROI and would bring it
down; even though the project would increase profits for
the company.
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Residual Income
Residual Income provides a $ based measure
instead of a % measure. It measures the amount of
income the company achieved in excess of a
determined target income.
Two terms that are involved in RI are:
The targeted amount of return is usually some
percentage of the total assets of the division or the
invested capital in the division, and
The percentage used in the calculation is the target
rate that management has set.
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Residual Income Contd
The residual income formula is:
Net income before taxes
Target return in dollars
1

= Residual Income
Residual income may be a negative amount. This
occurs when the profits that the division or project
actually achieved are less than the target income
that was set for the division or project.

1
a percentage of assets or invested capital.
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Residual Income Contd
Because it measures a dollar amount, RI is not
useful in comparing projects or departments of
different sizes.
RI is useful when different projects (or
departments) have different risks or operating
environments, because a different target rate can
be used for each segment to take these into
account.
RI is useful for evaluating managers, because it
motivates them to maximize an absolute amount
(dollars) instead of a percentage.
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Accounting Methods and Performance Measurement
When items such as inventory and fixed assets are
used in calculating performance measures, their
values are influenced by the chosen accounting
methods.
When comparing two business units, both units should
use the same inventory valuation, depreciation, revenue
recognition and expense recognition methods in order to
be comparable.
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Performance Measurement in Multinationals
When a company operates in different countries, it
creates additional difficulties in comparing
performance of its operating divisions.
Government controls on selling prices
Varying tax rates
Tariffs and customs duties
Availability and costs of labor, materials and
infrastructure vary
Economic, legal, political, social and cultural
environments vary
Different currencies, exchange rate fluctuations and
differences in inflation rates
Expropriation risk
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Performance Measurement in Multinationals Contd
Foreign currency calculation of ROI used to
compare two divisions:
Both divisions incomes should be restated into U.S.
dollars at the average exchange rate in effect during the
year.
Both divisions assets should be restated into U.S. dollars
at the exchange rate that was in effect when the
assets were acquired.

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The Balanced Scorecard
More companies are using a more encompassing
method of evaluation that includes financial and
nonfinancial measures - called a balanced
scorecard.
The common categories (perspectives) measured are
Financial perspective - profitability
Customer perspective - identifying the market
segment(s) to target and then measuring success in
those segments.
Internal business process perspective - products and
services, operations and customer service/support
Innovation and learning a culture that supports
employee innovation, growth and development
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Balanced Scorecard Contd
The scorecard used by an individual business
should depend upon its strategy.
The business should select just a few measures
critical success factors that are most relevant
to its business strategy and track those measures
rigorously.
Managements attention needs to be focused on
these few key measures and not be distracted by
measures that are not critical.
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Balanced Scorecard Contd
A strategy map links the four perspectives
together and provides a way for all employees to
see how their work is linked to the corporations
goals.
Beginning at the bottom, innovation and learning
contributes to the goals of the internal business process
perspective.
Operational improvements made in operations support
(business process perspective) contribute to the
companys ability to fulfill the goals of customer
satisfaction (customer perspective).
Customer satisfaction brings about increased business,
increased profits and improved financial performance
(financial perspective).
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The Balanced Scorecard Contd
The balanced scorecard is a tremendous evaluation
tool when it is used correctly.
However, there are several problems with using the
balanced scorecard approach to performance
evaluation:
It is difficult to use scorecards to make comparisons
across business units, because each business unit has
its own scorecard.
In order to implement balanced scorecard performance
measurement, it is necessary for a firm to have extensive
enterprise resource planning systems to capture the
detailed information required.
Nonfinancial data is not subject to control or audit and
thus its reliability could be questionable.
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Customer Profitability Analysis
80% of profits usually come from the top 20% of a
firms customers.
To maintain competitive advantage, a firm needs to
work to attract and keep profitable customers while
discouraging unprofitable customers from dragging
down profits.
Customer profitability analysis can be used to
determine the profitability of individual customers or
groups of customers.
Profitability information can be used for targeted
marketing, as well.
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Product Profitability Analysis
Product profitability analysis can identify products
and services that are unprofitable so those
products and services can be either repriced or
discontinued.
Accurate allocations of common costs are critical
when customers and products are being evaluated
for their profitability.