Cost Accounting and Budgeting

Lisaura Goossens
IBS202

Cost Accounting and Budgeting

Table of Contents
Introduction............................................................................................................................3
Chapter 8: Managerial Accounting and Cost Concepts.............................................................4
LO1: Distinguish managerial accounting from financial accounting....................................................4
LO2: Concepts Underlying Costs.........................................................................................................5
LO3: Inventory Accounts in Manufacturing Organizations.................................................................6
Chapter 9: Costing Systems: Job Order Costing.......................................................................8
LO1: Concepts Underlying Product Costing Systems...........................................................................8
LO2: Job Order Costing in a Manufacturing Company........................................................................8
iLO3: A Job Order Cost Card and the Computation of Unit Costs......................................................11
LO4: Cost Allocation.........................................................................................................................11
Activity Based Costing (ABC) / Activity Based Management (ABM).......................................12
LO1: ABC History..............................................................................................................................12
LO2: Cost refinement.......................................................................................................................12
LO3: A specific approach towards cost refinement: ABC (Activity Based Costing)............................13
LO4: Activity Based Management....................................................................................................13
LO5: Exercises different systems............................................................................................14
Chapter 10: Cost-Volume-Profit analysis................................................................................15
LO1: Define cost behavior, and identify variable, fixed and mixed costs..........................................15
LO2: Mixed Costs and the Contribution Margin Income Statement..................................................17
LO3: Cost-Volume-Profit Analysis.....................................................................................................19
LO4: Breakeven Analysis..................................................................................................................19
Chapter 11: The Budgeting Process........................................................................................22
LO1: Define budgeting and describe how it relates to the concepts of comparability and
understandability.............................................................................................................................22
LO2: Preparation of a Master Budget...............................................................................................23
LO3 Operating Budgets....................................................................................................................24
LO 4: Financial Budgets....................................................................................................................25
LO5: Budgeting and the Management Process.................................................................................26

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Cost Accounting and Budgeting
Lisaura Goossens
IBS202
Management Control Function of Budgets............................................................................27
Chapter 12: Capital Investment Analysis................................................................................30
LO1: Introduction.............................................................................................................................30
LO2: Time Value of Money...............................................................................................................30
LO3: Multiple Cash Flows.................................................................................................................32
LO4: Annuities..................................................................................................................................32
LO5: Net Present Value and Other Investment Criteria....................................................................33

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IBS202

Introduction
Accounting is an information system that measures, processes and communicates (financial) information
about a business (the provision of information for decision-making).
- This information is used by a wide range of stakeholders enabling them to make informed
decisions.
o These stakeholders can be inside the company (management, employees) or external
(lenders, shareholders, suppliers, customers etc.)
The 4 important financial statements used when making the balance at the end of a period:
- Income statement
Income Statement
Revenues
- Cost of Goods Sold
Gross Profit
- Operating expenses
Operating Profit

COGS: relationship to production – product costs

Operating: no relationship to production – period costs

- Balance sheet
- Cash Flow Statement
- Statement of changes in Equity

Internal VS External Stakeholders

Internal:
- Employees
- Manager
- Owners (not the same as shareholder, depending on legal form of company)
External:
- Suppliers
- Society
- Government (e.g. for tax purposes)
- Creditors (those who lend money to the company)
- Shareholder (owners) (limited corporations; stock listed; division of management)
- Customer

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Cost Accounting and Budgeting
Lisaura Goossens
IBS202

Chapter 8: Managerial Accounting and Cost Concepts

LO1: Distinguish managerial accounting from financial accounting
Accounting is divided into 2 separate branches: managerial accounting and financial accounting.
- Managerial accounting is the accounting done to inform the internal stakeholders
- Financial accounting is the accounting done to inform the external stakeholders

DEF: Managerial Accounting

Management accounting is a profession that involves partnering in management decision

making, devising planning and performance management systems, and providing expertise in
financial reporting and control to assist management in the formulation and implementation of
an organization’s strategy.

A comparison between financial and managerial accounting

Financial accounting
 External reporting
 Periodic
 Based on Rules and Regulations (GAAP  US)
IAS  IFRS (only for large companies – small companies follow national rules)
 Information is historical (reflection of transactions that happened in the past)
Managerial Accounting
 Internal reporting
 Continues
 Based upon specifications users, flexible formats
 Future related
Planning and control cycle
In every stage of the cycle (long run, controlling, etc.) decisions need to be made. Goal of
managerial accounting: provide information for decision makers.

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LO2: Concepts Underlying Costs

Costs
In managerial accounting decisions more often than not we will work with different cost
concepts.

DEF: A Cost
A cost is a resource sacrificed (normally expressed as a monetary amount) to achieve a specific
objective of an organization.
Cost object: anything costs can be accumulated for

1. Cost measurements / traceability

- Direct costs: costs that can be measured (conveniently) by tracing them to a cost object
- Indirect costs: costs that cannot be measured (conveniently) by tracing them to a cost
object.
 The indirect costs still need to be allocated to a cost object.
2. Financial reporting
- Period costs: costs of resources that are not assigned to products (operating expenses)
- Product costs: direct materials, labor and overhead costs of 1 product.
o Direct materials
o Prime costs
o Direct labor
o Conversion costs
1
o Overhead costs

3. Cost behavior
- Variable cost: costs that ae in direct proportion to a change in productive output
- Fixed cost: a cost that remains constant within a defined range of activity.

1
[Overhead costs are the costs that are indirect; indirect labor, indirect materials…]

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[E.g. PPT 1 – Slide 14 – Tesla]

Fixed: Variable
 Depreciation equipment  Most labor costs (production etc.)
 Rent  Most materials
 Insurance

4. Value adding / non-value adding costs

- Value-adding cost: cost of activity that increases the market value of product
- Non-value -adding cost: cost of activity that does not increase the market value of the
product
LO3: Inventory Accounts in Manufacturing Organizations
The Manufacturing Cost Flow

Calculating Costs of Goods Sold: direct materials, direct labor and overhead.

1st: Calculate how many materials are being used; direct used materials:

Materials Inventory

Beginning materials inventory – Cost of materials used in production

+ Total cost of materials purchased

= Balance END

Work in Progress Inventory (WIP)

Beginning Work-in-Process Inventory - Cost of goods manufactured

+ Costs of materials used

+ Costs of direct labor

+ Costs of overhead

= Balance END
[In between step: Cost of materials used + Costs of direct labor + Overhead cost = total manufacturing costs]

Finished goods inventory

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IBS202
Beginning finished goods inventory - Cost of goods sold

+ Cost of goods manufactured

= Balance END

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IBS202
Statement of Cost of Goods Manufactured

Direct materials used:

Beginning materials inventory $$$$$$$
Direct materials purchased $$$$$$$
------------
Cost of direct materials available for use $$$$$$$
(Ending materials inventory) $$$$$$$
------------
Cost of direct materials used $$$$$$$$$$$$
Direct Labor $$$$$$$$$$$$
Overhead Cost $$$$$$$$$$$$
--------------------
Total manufacturing costs $$$$$$$$$$$$
Beginning work in process inventory $$$$$$$$$$$$
--------------------
Total cost of WIP during the year $$$$$$$$$$$$
(Ending WIP inventory) $$$$$$$$$$$$
--------------------
Cost of goods manufactured $$$$$$$$$$$$

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IBS202

Chapter 9: Costing Systems: Job Order Costing

LO1: Concepts Underlying Product Costing Systems
A product costing system is used to account for an organization’s product costs and to provide
timely and accurate unit cost information for pricing, cost planning and control, inventory
valuation and financial statement preparation.
 It enables manages to measure and recognize costs throughout the management
process.
 It provides a measurement and recognition structure for matching the revenues to their
costs.

2 basic types of product costing systems

Process Costing the cost object is masses of identical or similar units of a product or service. In
this type of system, we divide the total cost of producing an identical or similar product or
service by the total number of units produced to obtain a per-unit cost.

Job Costing the cost object is a unit or multiple units of a distinct product or service which we
call a job. Each job generally uses different amounts of resources.
 Accumulate the cost of an individual unit (job) (often used w/ services)
There are different types of job costing systems
e.g. Normal costing, Actual costing…

(There is also a hybrid system using both systems: Accumulate the process costs + the costs for
the individual adjustments).

LO2: Job Order Costing in a Manufacturing Company

Normal Costing
In assigning costs to a cost object under a job costing system, we normally use a normal costing
system.
- Direct costs are traced to the job by multiplying actual direct cost rats with actual
quantities of direct cost inputs
- Indirect costs are allocated to the job by budgeted indirect cost rates with actual
quantities of the cost allocation bases.
bugeted manufacturing overhead cost
Budgeted manufacturing overhead rate=
bugeted total quantity of cost allocation base

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7 step approach to Job Costing
1. Identify the cost object
2. Identify the direct costs of the job
3. Identify the indirect costs and group these in indirect cost pools
4. Select a cost allocation base for every indirect cost pool to use for allocating indirect
costs to the job
5. Compute the rate per unit of each cost allocation base to use to allocate indirect costs
to the job
6. Compute the indirect costs allocated to the job
7. Compute the total cost of the job by adding all the direct and indirect costs assigned to
the job.

The journal entries for:

Materials

Purchase of materials (direct or indirect).

DATE ACCOUNTS DEBIT CREDIT
XX/XX Materials inventory $$$$$$$
@ Accounts Payable $$$$$$$
Purchase of (in)direct materials on account

Transfer of direct materials to production

DATE ACCOUNTS DEBIT CREDIT
XX/XX WIP Inventory $$$$$$$
@Materials Inventory $$$$$$$
Transfer of direct materials to production

Transfer of indirect materials to production

DATE ACCOUNTS DEBIT CREDIT
XX/XX Overhead $$$$$$$
@Materials Inventory $$$$$$$
Transfer of indirect materials to production

Labor

Payroll (/Salary) Costs Incurred for Production Labor

DATE ACCOUNTS DEBIT CREDIT
XX/XX WIP Inventory $$$$$$$
@Payroll Payable $$$$$$$
Labor costs

Indirect labor Incurred for Production Labor

DATE ACCOUNTS DEBIT CREDIT
XX/XX Overhead (ID Labor) $$$$$$$
@Payroll Payable $$$$$$$
Indirect labor costs

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IBS202
Overhead

Other overhead costs paid which were incurred for Production

DATE ACCOUNTS DEBIT CREDIT
XX/XX Overhead $$$$$$$
@Cash $$$$$$$
@Accumulated Depreciation
Payed overhead costs

Apply of Overhead costs

DATE ACCOUNTS DEBIT CREDIT
XX/XX WIP $$$$$$$
@Overhead $$$$$$$
Apply overhead

Completed Units

Transfer of completed Production to Finished Goods

DATE ACCOUNTS DEBIT CREDIT
XX/XX Finished Goods Inventory $$$$$$$
@WIP Inventory $$$$$$$

Sold Units

Sales
DATE ACCOUNTS DEBIT CREDIT
XX/XX Accounts Receivable $$$$$$$
@Sales Revenue $$$$$$$
sales

Transfer of Production Costs to COGS

DATE ACCOUNTS DEBIT CREDIT
XX/XX COGS $$$$$$$
@Finished inventory $$$$$$$
Cost of goods sold

Under or Over allocation of Overhead

Overhead
DEBIT CREDIT
$$$$$$$$ $$$$$$$$

 If Actual (D) > Estimated (C) = UNDERALLOCATION

 If Actual (D) < Estimated (C) = OVERALLOCATION

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IBS202
LO3: A Job Order Cost Card and the Computation of Unit Costs
When using a managerial approach, we try to allocate the costs based on different allocation
bases.

1 COST POOL
BEGINNING OF THE YEAR
Overhead rate=expected costs/(cost poolbase )

DURING THE YEAR

Multiply your rate with the jobs

END OF YEAR
Total allocated overhead – actual overhead = over/ under allocation

MULTIPLE COST POOLS

Calculated in the same way.

Overhead rate per department=Overhead dep x /cost pool x

LO4: Cost Allocation

Resources: items used to create a cost object.
Factory costs: direct materials / direct labor / overhead (product expenses)
Non-factory costs: selling, general, admin… (period expenses)

Direct costs are easily traced to its product. However, there are many indirect costs that are
harder to allocate within a company. How these are allocated, is harder to determine.

Allocation of indirect costs

Creating a cost pool: a grouping of individual indirect cost items, to allocate the indirect costs.
1 pool is convenient but not very accurate – separate pools for every item is very
accurate but not convenient

Cost allocation base: a systematic way to link an indirect cost or group of indirect costs to cost
objects.  Finding the appropriate cost allocation base is often not easy, you will have to find
out what drives the indirect costs (look for a cause-and-effect relationship).
E.g. Energy: vs energy use / nr of machine hours  will help you allocate this cost. (rate
per machine hour)

Under-allocated or overallocated indirect costs

Given that we work with a budgeted indirect cost  actual indirect costs will be different
The under-allocation or overallocation will be written off on the cost of goods sold.
! Financial Statements should always state actual numbers.
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Activity Based Costing (ABC) / Activity Based Management (ABM)
LO1: ABC History
Activity Based Costing (ABC): a way to create multiple cost pools and multiple allocation bases.

Historically
Businesses were only producing a limited variety of products thus most costs were direct.
Indirect costs were only a small part of the total costs.

Traditional Approach towards allocating indirect costs

Peanut-butter costing: costs of resources are uniformly spread to cost objects when, in fact, the
various cost objects use those resources in a nonuniform way.

E.g. Restaurant bill Emma Jame Jessica Matthew Total Average

By just taking the average, there are s
people who had to pay more than Entree $ 11 $ 20 $ 15 $ 14
they actually consumed (and other Dessert 0 8 4 4
way around). This is an easy way to Drinks 4 14 8 6
split costs but is not accurate. Total $ 15 $ 42 $ 27 $ 24 $ 108 $ 27

Broad averaging results in under costing and over costing

Product-cost cross-subsidization will result (under costed products are being subsidized by over
costed products).
Can result in serious strategic consequences, since cost information is e.g. used for pricing
decisions. (Mistakes can have a large impact on business)

LO2: Cost refinement

 Goal: achieve a better measurement of the cost of indirect resources used by different cost
objects.
The increasing importance of cost refinement has three causes:
- Increase in product diversity
- Increase in indirect costs
- Increase in competition in product / service markets

Refining a costing system

1. Identify as many direct costs as economically feasible.
o Sometimes, companies will calculate direct costs as indirect costs, by eliminating
this, you can lessen the indirect cost amounts.
2. Expand the number of indirect cost pools until each pool is more homogeneous (the
costs in every pool should have a clear cause-effect relationship with a cost allocation
base).
o Instead of having 1 cost pool > have multiple cost pools.
3. Find an appropriate cost allocation base for every indirect cost pool

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LO3: A specific approach towards cost refinement: ABC (Activity Based Costing)
(grouping indirect costs according to activities)

E.g. Supermarket
Biggest costs: COGS
But also, Wages?
 How do we allocate these to the products?
- you can calculate them all together (Peanut Butter Method)
- you can calculate them into groups of activities (ABC)
- Cashiers / Bakers / Re-stockers …
- Fresh baked bread will need to have more costs than a can of soup because it requires
more work.

(Indirect) Costs are first allocated to activities, subsequently the costs of the activities are
assigned to cost objects.

Defining the activities to be used in the ABC-system is extremely difficult!

[It can be useful to look into the cost hierarchy of a company to define the activities and cost allocation bases:
o Output unit-level costs: cost of activities is related to # of units produced (e.g. energy, machine
depreciation, packaging).
o Batch level costs: cost of activities is related to a group of units (e.g. setup costs)
o Product/service sustaining costs: cost of activities undertaken to support products/services (e.g.
design costs).
o Facility sustaining costs: cost of activities that support the organization as a whole (e.g. cleaning,
rent)  these are the most difficult costs to allocate]

LO4: Activity Based Management

The use of Activity Based Costing information in order to improve customer satisfaction and
profitability.
- It enables managers to make the right decisions for pricing and product-mix decisions
- By better understanding the cost structure, companies can achieve cost reductions.

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LO5: Exercises different systems

Simple Costing System
 there is only 1 allocation base for all costs.
 Overhead Costs:
o Allocation Rate = total overhead costs/ total amount allocation base
 E.g. total overhead costs / total machine hours = allocation rate
 CUST 1/ PROD 1: allocation rate x nr machine h
 CUST 2/ PROD 2: allocation rate x nr machine h
 Direct Labor:
o Direct manufacturing labor cost per hour x nr of hours per unit x nr of units
 Direct Material:
o Direct material cost per unit x nr of units
Total Overhead +Total Direct Labor +Total Direct Materials=Total Cost
---------------------------------------------------
Total Cost
Total cost per unit =
Nr of units
ABC-system
 there are multiple allocation bases for each cost
 Overhead:
o For each activity define what your cost driver will be
 E.g. Activity  Activity cost driver
 Production Scheduling ($190 000)  Nr of Production Runs
 Machine Set Up ($50 000)  Machine Set Ups
o Calculate the Rate for each cost base
 E.g. Activity Total cost / Total h or nr = specific rate
 Production Scheduling rate = $190 000 / 125 (production runs) = $1 520
o Calculate the total cost per customer or product for each cost base
 E.g. Specific Rate x nr or h = total cost per customer or product
 Production Scheduling rate
o $1 520 x 40 = $60 800
o $1 520 x 85 = $129 200
 Direct Labor:
o Direct manufacturing labor cost per hour x nr of hours per unit x nr of units
 Direct Material:
o Direct material cost per unit x nr of units

Total Overhead ¿
---------------------------------------------------
Total Cost
Total cost per unit =
Nr of units

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IBS202
Chapter 10: Cost-Volume-Profit analysis
LO1: Define cost behavior, and identify variable, fixed and mixed costs
Cost behavior: the way costs respond to changes in volume or activity – is a factor in almost
every decision management will make.

Two underlying concepts support the cost-volume-profit analysis (CVP-analysis).

- Understandability: knowing how costs behave improves comprehension of the meaning
of the information they receive.
- Comparability: knowledge of cost behavior patterns enables managers to identify cost
similarities and differences, so comparisons of alternatives are possible.

Variable costs
Variable cost: the costs that change in direct proportion to changes in productive output (or any
other measure of volume).

Variable costs can be computed using the variable cost formula:

Total Variable Cost =Variable rate x Units Produced

Variable costs change in direct proportion to changes in activity; that is, they increase in total
with an increase in volume and decrease in total with a decrease in volume, but they remain
the same on a per unit basis.

Operating Capacity: is the upper limit of an organization’s productive output capability given its
existing recourses.
 Theoretical capacity (ideal capacity): maximum productive output for a given period in
which all machinery and equipment are operating at optimum speed without
interruption.
 Practical capacity (engineering capacity): theoretical capacity reduced by normal and
expected work stoppages, this is primarily used as a planning goal of what could be
produce if all goes well
 Normal capacity: is the annual average of operating capacity needed to meet expected
sales demand. = realistic measure of what a company is likely to produce.

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Fixed costs
Fixed cost: are costs that remain constant within a relevant range of volume or activity.
(Relevant range is the span of activity in which a company expects to operate).
In the long term, all fixed costs will become variable, a change in plant capacity, labor needs or
other production factors causes fixed costs to increase or decrease.

Fixed costs can be computed by using the fixed cost formula.

Totl ¿ Costs=¿Costs∈ Relevant Range

Fixed costs remain the same within a relevant range, it’s curve thus is linear. However, the cost
per unit will behave in a downward slope, as we produce more, the cost per unit will decrease
(economies of scale).

Total Costs
The total cost: is the sum of all fixed and variable costs.
Total cost=total ¿ costs+ total variable costs

The total cost curve is a linear increasing line starting at the point fixed costs of no units
produced.

Total Revenue
Total revenue: is the sales price multiplied by the number of units sold, depending on the price,
the slope of the curve will be different.

Total Revenue=sales price x units sold

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LO2: Mixed Costs and the Contribution Margin Income Statement
Mixed Costs
Mixed cost: is a cost which has characteristics of both variable and fixed costs. Part of the mixed
cost changes with the volume or usage, and part is fixed over a particular period.
E.g. Electricity bill
- the flat fee is a fixed cost
- the usage is a variable cost

High-Low method
The high-low method is an approach to determine the variable and fixed components of a
mixed cost, which is based on the premise that only two data points are necessary to define a
linear cost-volume relationship.

STEP 1: Find the variable rate

- Select the periods of highest and lowest activity within the accounting period.
o Dec 6450 h and Aug 6050 h
- Find the difference between both the machine hours and their related costs
o $24700-$23600= $1100
o 6450-6050= 400h
- Compute the variable cost per machine hour by dividing the difference in cost by the
difference in machine hours.
o Variable cost / machine h= $1100 / 400h = $2.75 per machine h

STEP 2: Find the total fixed costs

- Compute the total fixed costs for a moth by pitting the known variable rate and the
information from the month with the highest volume into the cost formula and solve
for the total fixed costs
o Total Fixed cost = total costs – variable costs
o Total fixed costs Dec = $24700 – (6450h x $2.75) = $6962.50
STEP 3: Express the cost formula to estimate the total costs within the relevant range
- Total Mixed Costs = (Variable Rate x Volume Level) + Fixed Costs
o Total electricity cost per month = ($2.75xMachine h) + $6962.50

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Contribution Margin Statement
In Financial Reporting: Traditional income statement
Sales
– COGS
-----------------------------------------
= Gross Profit (Product costs)
– operating expenses
-----------------------------------------
= Operating Expenses (Period Costs)

In managerial Reporting (CVP-analysis): contribution margin income statement

A contribution margin income statement emphasizes cost behavior rather than organizational
functions.
CM (Contribution Margin) is the amount that remains after all variable costs are subtracted
from the sales. The fixed costs are subtracted from the total contribution margin to determine
operating income.

The Contribution Margin Income Statement

Unit contribution margin=selling price – variable costs per unit

Contribution margin percentage =contribution margin/sales

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LO3: Cost-Volume-Profit Analysis
CVP- analysis is an examination of the relationships among cost, volume of output and profit. It
usually applies to a single product, product line or division of a company. For that reason, profit
is the term used in the CVP analysis. However, profit and operating income mean the same
thing.
Sales Revenue−Variable costs−¿ Costs=Profit

LO4: Breakeven Analysis

 At the breakeven point, a firm has no profit or loss at the given sales level. Breakeven is
where:
o Sales – Variable Costs – Fixed Costs = 0
o Calculation of breakeven number of units
o Before BE = loss
o Above BE = profit

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BE= TOT REV = TOT COST
BE  TOT REV = TOT VAR COST + TOT FIX COST
BE  SELLING P x SALES VOL(Q) = TOT VAR COST + TOTFIX COST
BE  SELLING P x SALES VOL (Q) = VAR COST per Unit x Q + TOT FIX COST
BE  SELLING P x SALES VOL (Q) - VAR COST per Unit x Q = TOT FIX COST
BE  SALES VOL (Q) x (SELLING P – VAR COST per Unit = TOT FIX COST

total fix cost

Break EvenQuantity (Point)=
(Selling P – Variable Cost per Unit )

 The breakeven point formula can be modified to become a profit planning tool by
adding Target Operating Income to fixed costs in the numerator.

¿ costs+Target Income
Target sales volume=
Selling price−variable cost per unit

E.g. Selling Hotdogs at Groenplaats

You see a business opportunity in selling hotdogs at Groenplaats;
Your fixed costs (permit, depreciation equipment + booth) amount to app. 300 euros per day;
Variable costs per hotdog are on average 1 euro;
Average selling price per hotdog is euro 2.50.
1. How many hotdogs do you need to sell in order to break even?
Unit contribution margin = 2.5 – 1 = 1.5
(300/ (2.5 - 1) = 200 units

2. How many hotdogs do you need to sell in order to achieve a daily income (before taxation) of
200 euros?
(300 + 200) / (250 – 1) = 333 unit.

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Determining breakeven point with sales mix (multiple products)
STEP 1: Calculate a weighted average unit contribution margin
Selling Price – Variable Costs = CM x Percentage of Sales Mix = Weighted Average CM
STEP 2: Determining percentages of sales mix
In the text look for the sales mix (e.g. 1:2:2)  1+2+2 = 5
A  1/5 // B  2/5 // C 2/5
STEP 3: Calculate the weighted-average breakeven point
Weighted-average BE point Units = Total Fixed Costs / Weighted Average Contribution Margin
STEP 4: Determine how many units of every product need to be sold in order to break even.
Weighted Average Breakeven point x Sales Mix % = Breakeven Point.

STEP 5: Multiple BEP with percentage

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Chapter 11: The Budgeting Process

LO1: Define budgeting and describe how it relates to the concepts of comparability and
understandability
Definition Budget
Budgeting is the quantitative expression of a proposed plan of action by management for a
specified future period.
- Budgeting enhances understandability (know their roles, plans and objectives)
- Budgeting enhances comparability (budget-to-actual comparisons)

Master Budget
A master budget consists of a set of operating budgets and a set of financial budgets that detail
an organization’s financial plans for a specific period. (Usually 1 year).
Operating budgets:
- Sales, Production, Direct Materials Purchases, Direct Labor, Overhead, Selling and Admin
Expenses and Cost of Goods Manufactured budgets
Financial budgets:
- Budgeted income statement, Capital expenditures budget, Cash budget and a budgeted
balance sheet.

Planning and control cycle of an organization

A continuous process that never ends.
- Identifying goals and objectives
o Mission, vision…
- Develop LT strategy and ST plans
o Operational o Technical o Strategic
1y 1-3 y 3-5y
- Develop master budget
o Difference between budget and a plan is that a budget has specific numbers in
them.
- Measure performance against the budget
o Compare forecast w/ actual results
- Reevaluate objectives, goals, strategy and plan
o Feedback on the variances
o Adjust where needed
 We analyze it in a managerial accounting manner (How do we quantify plans)
Why is it difficult to come up with a budget?
There is a lot of assumptions and forecasts to be made.
 What drives the budgeted amounts?
- E.g. Subscription Fee (known amount) x people who buy it (start from last y  more or
less this y?).
- There are also many links between costs and revenues
 It is very time consuming and complex.
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LO2: Preparation of a Master Budget
Master Budget
A master budget is a comprehensive overview of all individual budgets being employed by an
organization.
[A preparation of a master budget for a Manufacturing Organization].

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LO3 Operating Budgets
The sales budget (Revenue budgets)
Sales in units
x Selling price per unit
= Total Sales (Revenues)
The Production Budget
[need to take into consideration a certain amount as safety stock].
Q1 Q2
Sales in Units 10 000 30 000
+ targeted ending inventory 3 000 1 000
- beginning inventory 1 000 3 000
= Total production units 12 000 28 000

Direct Materials Purchases Budget

Q1 Q2
Total production Units 12 000 28 000
x Amount needed per Unit x 10 x 10
Total production units needed 120 000 280 000
+ targeted ending inventory 56 000 26 000
- beginning inventory 24 000 56 000
= Total amount of DM to be purchased 152 000 250 000
x Cost per amount x $0.05 x $0.05
= Total Cost if direct materials purchases $7 600 $12 500
Direct Labor Budget
Q1 Q2
Total production units 12 000 28 000
x Direct Labor hours per unit x 0.10 x 0.10
Total Direct Labor Hours 1 200 2 800
x Direct Labor cost per hour x $6 x $6
= Total Direct Labor Cost $7 200 $16 800

Overhead (depending on exercise – allocate the overhead)

= Budgeted production x OH-rate
Cost of Goods Manufactured Budget
Direct Materials
+ Direct Labor Cost
+ Overhead
= Cost of Goods Manufactured

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LO 4: Financial Budgets
Gross Margin Budget
Sales Budget (Revenues)
- Cost of Goods Sold
Finished Goods Inventory beginning
+ Cost of goods manufactured
- Finished Goods Inventory ending
= Gross Margin

Cash Budget
Total Estimated Cash Receipts
- Total Estimated Cash Payments
+ Estimated Beginning Cash Balance
= Estimated ending Cash Balance

Elements of a Cash Budget

Activities Cash Receipts From Cash Payments From
Operating  Cash Sales  Purchase of Materials
 Cash Collections  Direct Labor
(credit sales)  Overhead Expenses
 Interest Income  Selling and Admin
(investments) Expenses
 Cash Dividends  Interest Expense
(investments)  Income Taxes
Investing  Sale of investments  Purchase of
 Sale of LT assets investments
 Purchases of LT assets
Financing  Proceeds from loans  Loan Payments
 Proceeds from issue  Cash dividends to
of stock stockholders
 Proceeds from issue  Retirement of bonds
of bonds  Purchases of treasury
stock

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LO5: Budgeting and the Management Process
The use of budgets in organizations
Enhance communication and coordination within a company
 Different departments are responsible for different parts of the master budget. There
needs to be a clear communication. If it is implemented correctly, it will improve
communication and coordination.
Encourage forward thinking; in this way opportunities and threats may be anticipated in time
 We look to the future, what can happen and how do we deal w/ it?

Provides a framework for monitoring, control and learning

 Set certain limits to the budget.

Motivation for managers and employees

 Only works if targets are set at a realistic level.
Budgets
- Normally developed for a set period (most commonly  1 Y).
- Increasingly budgeting is done on a continuous/rolling basis
o Always have a 12m budget ready
- Managers are only responsible for certain tasks (revenues, costs, rev &costs,
investments, profits…)
o Use a budget to define responsibility centers
- Differences between actual and budgeted figures  variances
- Be aware of budgetary slack (underestimating revenues or overestimating costs)
- Kaizen budgeting: incorporating continuous improvement in the budgets
o Reduce expenses on yearly basis (originated in Japan)

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Management Control Function of Budgets

Variance Analysis
The difference between the budgeted amounts and the
actuals and look at what the difference is between both.
(What are the variances).
 It’s not about blaming, but about better
understanding
the differences.

Static Budget VS. Actual Budget VS. Flexed Budget

Static Budget is a budget based upon the level of output planned at the start of the budget
period. This budget should be based upon carefully predetermined standards (standard
costing).

Actual Budget is the real results after the budget period has taken place. This budget should be
accurate and represent actual figures.

Flexed Budget is a budget based upon the static budget parameters for costs and sales price but
the actual amount of output.

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The Analysis
On the exam, you will have to calculate a part of a full budget analysis!!!
STEP 1: Static Budget Variances
- We start comparing the original budget (static budget) with the actual results.
o Compare revenues / costs and income

 Sales Revenues variance: $6000  unfavorable, because income is lower than expected
 Costs variances:
DM variances: $1600  favorable, costs are lower than expected
DL variances: $400  favorable, costs are lower than expected
OH variances: $220  favorable, costs are lower than expected
 Operating Income variances: $ 3 780  unfavorable, income is lower than expected

! We are however comparing a budget based upon 1200 units with actuals based upon 1000
units.  We solve this by calculating a flexed budget based upon 1000 units.

STEP 2: Retrieve items from the static budget

Budgeted selling price: Sales revenue/ units
24000/1200 = 20 $ per unit
KG’s per unit: total DM/ units
3600/1200= 3KG
Budgeted price per KG: DM cost/KG used
9000/3600 = 2.50 $
Labor h / unit= total H / units produced
600/1200 = 0.5H
Budgeted rate / h = DL cost/ nr of h
2700/60= 4.50
Budgeted fixed overhead should stay the same

STEP 3: Flexed budget based upon actual amount of output

Output: 1000
Sales Revenue: 1000 x 20= 20 000 $
DM: 3KG x 1000 = 3000 KG x 2.5 $ = 7500 $
DL: 0.5H x 1000 = 500H x 4.5$ = 2250 $
OH: 4320 $
-------------------------------------------------
Operating Income = 5 930 $

The only difference between static and flexed budget is that they are calculated based on a
different amount of output.

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STEP 4: Sales volume variances
- We start comparing the original budget (static budget) with the flexed budget.
o Compare revenues / costs and income

Sales Revenues: $4000  unfavorable

Costs:
DM: $1500  favorable
DL: $450  favorable
OH: $0  ///
Operating Income: $2050  unfavorable

STEP 5: Flexible budget variances.

- We start comparing the flexed budget with the actual results.
o Compare revenues / costs and income

Sales Revenue: $ 2000  unfavorable – because selling price variance of 2$

Costs
DM: $100  favorable
DL: $50  unfavorable
OH: $220  favorable
Operating Income: $ 1730 unfavorable

REASONING:
- 4000$ less because less is sold & 2000$ less because the difference in selling price (2$/unit)
 the sum of the difference between sales volume variance and flexible budget variances is the
same as the variance in the static budget variances.
- Flexible budget variance in direct materials $100 FAV
o Efficiency variance: 200KG
 200KG x 2.50$ = 500$ favorable (less used than thought)
o Price variance: 2.65 $ (actual) – 2.5 $ (budget) x 2800 KG
 400 $  unfavorable
- Flexible budget variance in direct labor $50 UNFAV
o Efficiency variance: 10H
 10H x 4.5$ = 45$  UNFAV
o Price variance: 4.51$ - $4.50 x 510H  5 UNFAV

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Chapter 12: Capital Investment Analysis

LO1: Introduction
Capital Budgeting

 It is about investments that companies undertake.

(normally about fixed costs  big costs)
It is important to figure out which to undertake and to
have a good system in place.

Central Question
 What real assets should the firm invest in?
Real assets can be tangible or intangible
Tangible: Machinery, Buildings…
Intangible: Trademarks, patents, copyrights …
(We do not consider the financial investments: shares, bonds…)

GOAL
Find real assets that are worth more than they cost over their lifetime.
 Capital Outflow – Capital Inflow = Revenue from investment ( Is it worth it?)

Basic Problem Capital Budgeting

A huge investment will have an immediate outflow but will take a long time to get a cash
inflow.

How do we value cash flows to be received and paid at different moments in time?
- Investments often imply a huge cash outflow now and multiple cash inflows in the
future.

LO2: Time Value of Money

Assume you have the option to choose between receiving $10,000 now versus $10,000 in two
years.

Which option would a rational investor prefer and why?

 You can make a return on your investment, so always prefer at least a part now.
(A $ today is more worth than the same $ at some future date since the $ today can be invested
and thereby earning a return = potential earning capacity of money).

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Future Value
FV: How much is the value in the future of an amount paid today.
Suppose you invest $1000 for 1 year at 5% per year. What is the future value in 1 year?
 Interest = 1000 x (0.05) = 50
 Value in one year = principal + interest = 1000 + 50 = 1050
 Future Value (FV)= 1000(1+.05) = 1050
Suppose you leave the money in for another year, how much will you have two years from
now?
 FV= 1000(1.05)(1.05) = 1000(1.05)^2 = 1102.50

General Formula for FV:

FV =PV (1 + r) ^ t

Effects of Compounding
Simple interest:
Compound interest:
 Simple interest is always lower than compounding interest (if the % is positive)
Compounding is very interesting. The difference between both calculations grows exponentially
over time.

EX: 1000 (1.05) ^ 5 = 1276.28

 The impact of compounding becomes more significant over time.

EX: 10$ at 5.5% over 200 y

 10(1.055) ^ 200 = 447 149.84 $ (compounding)
 120 $ (simple)

Present Value
PV: How much is the value today of an amount to be received or paid in the future.
General Formula for PV:
PV= FV / (1+r) ^ t

When we talk about discounting, we mean finding the present value of some future amount.

EX: Suppose you need $10 000 in 1 year for the down payment on a car. If you can earn 7%
annually how much do you need to invest today?
 PV = 10 000 / (1.07)^1 = 9345.79

You are saving for college education, estimating the cost around $150 000 due in 17 years. You
believe to earn 8% each year, how much do you need to invest today?
 PV=150 000/ (1.08)^17= 40 540.34

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LO3: Multiple Cash Flows
Valuing multiple cash flows FV
More often than not, an investment will involve multiple cash flows. The amount to be saved
now, is still a large amount at times, so you will put in cash at regular periods overtime.

EX: 4000$ at the end of the next 3y  paying 8% interest, & currently 7000$ in bank acc.
FV
7000 4000 4000 4000

7000(1.08)^3 4000(1.08)^2 4000(1.08) 4000 = 21,803.58 (FV)

Valuing multiple cash flows PV

EX:
Interest rate 12%
PV 200 400 600 800
200/(1.12) 400/(1.12)^2 600/(1.12)^3 800/(1.12)^4
PV= 1432.93

[With multiple still the same formula, just each year is to a different power]

LO4: Annuities
Annuity: finite series of equal payments that occur at regular intervals
 if the cash flow is the same each year, you can just use 1 equation:

Formula for annuities: (given on exam)

C∗( 1− (1+r )t )
PV =
r

EX:
Over a period of 5 years, you pay 100$ each year at a rate of 12%.
PV= 100/(1.12) + 100/(1.12)^2 + 100/(1.12)^3 +100/(1.12)^4 +100/(1.12)^5
OR
PV = C x ((1-(1/(1+r)^t))/r)
PV= 100 x (1-(1/(1.12)^5))/0.12

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LO5: Net Present Value and Other Investment Criteria
Capital Budgeting Process
(focus on steps 2 and 3 within our course)

Capital Budgeting Techniques.

There are many different types of techniques (traditional and modern).
Each company must decide for themselves which technique they will use.
MOST IMPORTANT: Payback Period + Average Rate of Return + NPV

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The Average Rate of Return
Estimated average annual income generated by investment / average amount of investment

Estimated average annual income generated by investment

Average amount of investment

How to decide what is a decent investment?

- The outcome is always a %.
- The company must decide for themselves the % above which it is acceptable.
- When you are deciding between 2 different investments you should take the highest %.
- The higher the % the better the investment.
 The method is not favorable – but simple because information needed is always available

EX:
 Average rate of return = 24 000 */ 300 000* * = 0.08 = 8%
* 120 000/5
* * (500 000 + 100 000) /2

Cash Payback Period

How long does it take to get the initial cost back in a nominal sense?  The method isn’t
favorable because you don’t consider the wealth that the investment creates.
Computation:
- Estimate the cash flows
- Subtract future cash flows from the initial cost until the initial investment has been
covered
 Decision Rule: Accept if the payback period is less than some preset limit

Investment
Cash Payback Period=
Annual Net Cash Flow

EX:
Cash payback period = 500 000/ 40 000 * = 12.5 Y
* Annual net cash flow = Cash rev – Cash expenses = 100 000 – 60 000

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Net Present Value
NPV compares the amount invested in a project/asset with the present value of the cash flows
this project/asset generates.

How much value is created from undertaking an investment?

- Estimate expected future cash flows
- Estimate the required return for project of the risk
- Find the present value of the cash flows and subtract the initial investment

(If the NPV is positive, accept the project: A positive NPV means the project is expected to add
value to the firm and will therefore increase the wealth of the owners. Since our goal is to
increase owner wealth, NPV is a direct measure of how well this project will meet our goal.)

CashFlow CashFlow
NPV = + ( 1+% )k +…
( 1+ % ) k

K = depending on which year it is in

If all years are the same amount of cashflow:

C∗( 1− (1+r )t )
PV =
r

EX:
70 000/(1.1) + 60 000/(1.1)^2 … = 202 946 – 200 000 = 2 946 (NPV)
If it is > than 200 000  good investment

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