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FINANCIAL MANAGEMENT IN VALUE CHAIN

(ABVM322)

LT 4: COST AND MANAGEMENT


ACCOUNTING
(5 ECTS)

Prepared by:
DerejeUrgecha (MSc)
Mesfin Mala (MSc)

JULY 2012
Financial Management in Value Chain: Cost and Management Accounting

Table of Content

3.4.3.1. Section I: Cost and Management Accounting:


An Overview 1
3.4.3.2. Section II: Cost Terminology and Classification 8
3.4.3.3. Section III: Product Costing and Cost Flow 15
3.4.3.4. Section IV: Cost-Volume-Profit (CVP) Analysis and its implications 24
3.4.3.5. Section V: Master Budget 36
3.4.3.6. Section VI: Flexible Budget and Variance Analysis 56
3.4.3.7. Section VII: Relevant Information for Decisions in Value Chain
Development 70
Major references 82

Section I: Cost and Management Accounting: An overview

Cost Accounting

Cost is an amount that has to be paid or given up in order to acquire goods or services. In
business, cost is usually a monetary valuation of effort, material, resources, risks incurred,
and opportunity forgone in production and delivery of a good or service.

Accounting is the process of identifying, measuring, recording and communicating financial


information to interested users so that they can make the best possible decisions. Thus, cost
accounting is the process of identifying, measuring, recording and communicating cost
information which will be used for determination of cost of a products or services on the
basis of historical data. This was the emphasis of cost of accounting for many years, however
in the course of time, the determination of cost of product or service has become equally
important with cost control due to competitive nature of the market and because of
technological developments in all areas. Thus, now a day’s cost control and reduction has
also come within the scope of cost accounting.

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Modern cost accounting is, thus, concerned with recording, classifying and reporting cost
information for:
 Determination of costs of products or services,
 Planning, controlling and reducing costs and
 Furnishing of information to management for decision making.
Definitions
According to T. Horngren “Cost accounting measures and reports financial and other
information related to the acquisition or consumption of an organization’s resources. Cost
accounting provides information to both management accounting and financial accounting.
The Chartered Institute of Management Accountants (CIMA) defines it as,” The
establishment of budgets, standard costs and actual cost of operations, processes, activities or
products and the analysis of variances, profitability or the social use of funds”.

Wilmot has summarized the nature of cost accounting as, “the analyzing, recording,
standardizing, forecasting, comparing, reporting and recommending” and the role of cost
accountant as that of “a historian, news agent and prophet”. As a historian he must be
meticulously accurate and sedulously impartial. As a newsagent be must be up to date,
selective and pithy. As a prophet he must combine” knowledge and experience with foresight
and courage”.
Role of Cost Accounting in Decision Making
Many factors are considered while fixing the price of a product/item such as competitors’
price etc. One of the basic factors is the cost of its production. Cost is essential not only to fix
price but also to ascertain the margin of profit.
Knowledge of the cost determination is also necessary to keep a check on the cost of
product/control on wastages, etc. The accounting used to study the various aspects of cost is
known as cost accounting.

The main areas of decision making where cost accounting is very much helpful can be
summarized as follows:
 Ascertaining product unit cost
 Controlling cost
 Stimulating cost consciousness
 Determining selling price
 Determining profit and loss for various products and services and inventory
valuation and
 Providing basis for formulating operating policies.

Management accounting
Management accounting is the process of identification, measurement, accumulation,
analysis, preparation, interpretation, and communication of financial (and non financial)

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information used by management to plan, evaluate, and control the organization and to assure
appropriate use and accountability for its resources. The management accountant is expected
to provide timely, accurate information including budgets, standard costs, and variance
analyzes, support for so that planning, organizing, directing and controlling of business
operations can be done in an orderly manner.

Management accounting information helps organization make better decisions. Such


decisions make all organizations become more cost effective and help manufacturing, retail
and service organizations becomes more profitable. The major objectives of managerial
accounting activity are:
o Providing managers with information for decision making and planning
o Assisting managers in directing and controlling operational activities
o Motivating managers and other employees toward the organizational goals
o Measuring the performance of subunits, managers and other employees with in
the organization.

Managerial accountants supply all kinds of information to management and act as strategic
business partners in support of management’s role in decision making and managing the
organization’s activities. Measuring managing and continuously improving operational
activities is critical to be organization’s success.

Management accounting provides valuable services to management in all of its function as


summarized below:

Planning: Management accounting makes an important contribution in performance of the


planning function. It makes available the relevant data after pruning and analyzing them
suitably for effective planning and decision-making.

Controlling: It involves evaluation of performance keeping in view that the actual


performance coincides with the planned one and remedial measures are taken in the event of
variation between the two.

Coordinating: It involves interlinking of different divisions of the business enterprise in a


way so as to achieve the objectives of the organization as a whole.

Organizing: A sound system of internal control and internal audit for each of the cost or
profit centers helps in organizing and establishment of a sound business structure.
Motivating: It involves maintenance of a high degree of morale in the organization. The
superiors should be in a position to find out whom to demote or promote and to reward or
penalize.

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Communicating: Communicating involves transmission of data, results etc. both to the


insiders as well as outsiders. The management owes a duty to the creditors, prospective
investors, shareholders etc to communicate to them about the progress, financial position etc
of the enterprise. Management accounting helps the management in performance of their
function by developing a suitable system of reporting.

Management Accounting Guidelines


Three important guidelines help management accountants provide the most value in
performing their functions. They are: -
 Cost-benefit approach
 Behavioral and technical considerations and
 Different costs for different purposes.

Cost benefit approach: Management accountants continually face resource allocation


decisions. A cost benefit approach should be used in these decisions-resources should be
spent if they promote decision making that better attains organizational goals in relation to
the costs of those resources. The expected benefits from spending those resources should
exceed their expected costs.

Behavioral and Technical considerations: A management accounting system should have


two simultaneous missions for providing information:
 To help managers make wise economic decisions, and
 To motivate managers and other employees to aim and strive for goals of the
organization.

Both accountants and managers should always remember that management system are not
confined exclusively to technical matters such as the type of computer software systems used
and the frequency with which reports are prepared. Management is primarily a human
activity that focus on how to help individuals do their jobs better. For example it is often
better for managers to personally discuss how to improve performance with under
performing workers rather than just sending these workers a report highlighting their
underperformance.

Different costs for different purposes. The different costs for different purposes theme is
the management accountant’s version of the “one shoe does not fit all size” nation. A cost
concept used for the external reporting purpose may not be an appropriate concept for
internal routine reporting to managers. Consider the advertising costs associated with
launching a major new product. For external reporting to shareholders, television-advertising
costs are fully expensed in the income statement in the year they are incurred. In contrast, for

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evaluating management performance (internal reporting purpose), the television


advertisement costs could be capitalized and then written off as expenses one several years.
There are multiple external parties and multiple internal parties for which financial reports
are prepared. Any specific accounting method is unlikely to be the preferred method for all
external parties or all internal parties. Indeed, even an individual manager may prefer
accounting method A for one decision and accounting method B for another decision.

Cost accounting and Management accounting


Cost accounting refers to the accounting procedures relating to recording of all incomes and
expenditure and the preparation of periodical statements and reports with the object of
ascertaining and controlling costs. It is thus the formal mechanism by means of which the
cost of products or services are ascertained and controlled.

On the other hand Management accounting involves collecting, analyzing, interpreting and
presenting all accounting information, which is useful to the management. It is closely
associated with management control, which comprises planning, executing, measuring and
evaluating, the performances of an organization. Thus, Management accounting depends
heavily on cost data and other information derived from Cost accounting.

Management accounting has a wider scope as compared to cost accounting. Cost accounting
primarily deals with cost data while management accounting involves the considerations of
both cost and revenue. Management accounting is an all-inclusive accounting information
system, which covers financial accounting, Cost accounting and all aspects of Financial
Management. But it is not substitute for other accounting functions. The main thrust in
Management Accounting is towards determining policy and formulating plans to achieve
desired objective of management. Management accountancy makes corporate planning and
strategy effective and meaningful.

Cost Accounting and Financial Accounting


Financial accounting: is primarily concerned with the preparation of financial statement,
which summarizes the results of operation for selected period of time and show the financial
position of the corporation at a particular date.

Cost accounting: is primarily concerned with determination of cost of something, which


may be a product, service, a process or an operation. A cost accountant is primarily charged
with the responsibility of providing cost data for whatever purposes they may be required.

Management Accounting and Financial Accounting


Management accounting and financial accounting are linked by their responsibilities for
summarizing and reporting information for interested parties, yet the two differ in some
ways.
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Financial accounting includes all the principles that regulate the accounting and reporting of
financial information that must be disclosed to outside users, such as shareholder, creditors
etc. On the other hand, management accounting exists primarily for the benefit of managers
inside a company, the people who are responsible for day-to-day operations of the firm.
However, financial accounting and management accounting are part of and use data from a
company’s management information system. Much of the financial data generated by a
company’s events activities and actions are used for both financial and management
accounting purposes.

Cost accounting integrates with financial accounting by providing product costing


information for financial statements and with management accounting by providing some of
the quantitative, cost-based information managers need to perform their tasks.

Section II: Cost Terminology and Classification

Costs and Cost Terminology


According to Carl .S. Warren, the term cost refers to all payments of cash for the purpose of
generating revenues. Costs can be either expensed or capitalized. Expensed costs are treated
as expresses in the period cash is paid. Capitalized costs are treated as assets in the period
cash is paid and expensed in future periods when it is consumed.

According to J. Horngren, cost refers as resource scarified or foregone to achieve a specific


objective. It is usually measured as the monetary amount that must be paid to acquire goods
and services.

Cost object:is any thing for which a separate measurement of costs is desired. To guide their
decisions, managers want to know how much a particular thing (such as a product, machine,
service, or process) costs.Thus, Product, machine, service, project, customer, brand category,
activity department are cost object.

Cost accumulation: is the collection of cost data in some organized way by means of an
accounting system. For example, organizations that manufacture consumer goods accumulate
the costs incurred in producing the commodities.

Cost assignment: is a general term that encompasses both tracing accumulated costs to a
cost object, and allocating accumulated costs to a cost object. Example, cost may be assigned
to a department to facilitate decisions about departmental efficiency and again cost may be
assigned to a product or a customer to facilitate product-profitability analysis
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Cost driver: isany activity that causes costs to be incurred. A cost Driver is characteristics of
an activity or event that causes that activity or event to incur costs. The cost driver of variable
costs is the level of activity or volume whose change causes the (variable) costs to change
proportionately. For example the number of vehicles assembled is a cost driver of the cost of
steering wheels, Fuel cost at Transport Corporation is derived by number of tons of cargo
transported or distance travelled.

Classification of Costs

Direct Costs and Indirect Costs


For the purpose of assigning costs to cost objects, costs are classifiedas direct cost and
indirect costs.

Direct costs: are costs that can be conveniently or economically traced to a cost object. For
example, the cost of bottles is a direct cost of a Pepsi soft drink, because it can be
conveniently and economically traced to the Pepsi soft drink. The other example, the wages
of production line workers can be conveniently traced to the product because the time
worked and the related hourly wages can be easily found by looking at time cards and payroll
records.

Indirect costs: are costs that cannot be conveniently or economically traced to a cost object.
Example, the cost of quality control personnel who taste and content tests on multiple soft
drink products bottled at a Pepsi plant is an indirect cost of a Pepsi soft drink. Unlike cost of
bottles, it is difficult to trace quality control personnel costs to a specific Pepsi soft drink.

Behavioral classification of costs


Managers are also interested in the way costs respond or behave to changes in volume or
level of activity. By analyzing those patterns of behavior, managers gain information about
how changes in selling prices or operating costs affect the net income of the organization.
Thus, based on their behavior cost can classified as variable, fixed and mixed costs

Variable cost: are costs that vary in total, in direct proportion to changes in the level of
activity or cost driver i.e. if activity increase by n%, total variable cost also increase by n%,
but the per unit cost remains constant. E.g. direct material cost, direct labor cost, commission
paid to sales personnel, wages paid to employees will increase as level of out put increases.
Graphically, total variable cost can be explained as follows:

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TVC= unit variable costX Q


Cost

Activity/level of out put (Q)

Fixed Cost: are costs that remain unchanged in totalregardless of variation in the level of
activity or cost driver in a given relevant range. If activity increases or decreases by n%
within the given relevant range, total fixed cost remains the same; but the per unit fixed cost
changes. Example, monthly rental cost of equipment and /or house, depreciation of machines
used to produce furniture’s is fixed in total per year regardless of the level of production, but
in unit, fixed costs are variable i.e. fixed cost per unit increases as level of production
decrease and it decreases as level of out put increases. Graphically, fixed cost can be
summarized as follows:

Cost

Total fixed cost

Activity (or cost driver)

Mixed costs: are costs that have both variable and fixed characteristics. These costs are often
called mixed costs or semi-variable or semi-fixed costs. Mixed costs have an element that is
constant regardless of change in level of activity and an element that is variable as level of
activity changes. For example, utility costs like telephone, electric and water charges are
composed of monthly fixed charge plus some other variable costs which depends on the level
of usage.

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Cost Total mixed cost

Variable cost

Fixed cost

Level of out put (Q)

Product cost and period costs


For financial reporting purposes, costs are often classified as either product costs or period
cost.
Product costs: are cost producing goods that are sold to customers. They are also called
manufacturing cost and are composed of Direct Material, Direct Labor and Factory overhead.

Direct Material Costs: - All manufactured products are made from basic direct
materials. Direct materials are the acquisition costs of materials that can be
conveniently and economically traced to specific unit of product. Acquisition cost of
direct materials includes freight –in charges, sales taxes and customs duties. Some
examples of direct materials are iron ore for steel, sheet steel for automobiles and
sugar for candy.

Direct Labor Costs: are the costs of labor to complete production activities that can
be conveniently and economically traced to specific units of product. The wages of
machine operators and other workers involved in actually shaping the product are
direct labor costs.

Manufacturing Overhead Costs: The third elements of product cost include all
manufacturing costs that cannot be classified as direct materials or direct labor costs.
Manufacturing overhead costs are production related costs that can’t be practically or
conveniently traced directly to an end product. This assortment of costs is also called
factory overhead, or indirect manufacturing costs. Two common components of
manufacturing overhead costs are indirect material costs, indirect labor costs and
other manufacturing overhead costs.

Indirect material costs: are the costs of materials that cannot be conveniently
or economically traced to a unit of product e.g. cost of nails, reverts,
lubricants and small tools.

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Indirect labor costs: are labor costs for production related activities that
cannot be conveniently or economically traced to a unit of product. E.g. cost
of labor for maintenance, inspection, engineering design, supervision,
materials handling and machine handling.

Other indirect manufacturing costs: Cost of building and machine


maintenance, property taxes, property insurance and depreciation on plant and
equipment used in production.

These costs are treated as assets until the product is sold as raw material inventory, work in
process inventory and finished goods inventory and later expensed in the form of cost of
goods sold when the product is sold.

Period (non manufacturing) costs: Period costs are all goods in the income statement other
than cost of goods sold. These costs are treated as expenses of the period in which they are
incurred because they are assumed not to benefit future periods. Expensing these costs
immediately best matches to revenues.

For manufacturing sector companies, period costs include all non-manufacturing costs for
example, selling cost, administration cost and Research and Development costs. For
merchandising-sector companies, period costs include all costs not related to the cost of
goods purchased for resale in the same form (for example, labor cost of sales floor personnel
and marketing costs). For service sector companies, since there are no inventorable costs, all
their costs are period costs.

Prime cost and conversion costs:


In manufacturing companies, the costs can again be classified as Prime Cost and conversion
costs.
Prime costs: are all direct manufacturing costs i.e. direct material costs and direct
manufacturing labor cost.

Conversion Costs: are all manufacturing costs other than direct material costs.
Manufacturers typically use people and machines to convert raw material to output that has
substance. Thus, conversion costs are the costs incurred to convert direct material into the
final product, namely, costs for direct labor and manufacturing overhead.

Controllable and uncontrollable costs


Controllable costs are those costs, which can be influenced by the action of a specified
member of the undertaking. If a manager can control or heavily influence the level of cost,

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then that cost is classified as a controllable cost. Costs that a manager cannot influence
significantly are classified as uncontrollable cost of that manager.
Many costs are not completely under the control of any individual. In classifying costs as
controllable or uncontrollable, managerial accountants generally focus on a manager’s ability
to influence costs.

Economic Characteristics of Costs


In addition to accounting cost classifications, such as product costs and period costs,
managerial accountants also employ economic concepts in classifying costs. Such concepts
are often useful in helping accountants decide what cost information is relevant to the
decisions faced by the organization’s managers. Some of the most important economic cost
concepts are:
 Opportunity costs
 Out-of- pocket costs
 Sunk costs
 Differential costs
 Marginal costs and Average costs

Opportunity cost: is defined as the benefit that is scarified when the choice of one action
precludes taking an alternative course of action. If goat meat and fish are the available
choices for dinner, the opportunity cost of eating goat meat is the foregone pleasure
associated with eating fish.

Sunk Costs: Such costs are past or historical cost. These are costs, which have been created
by a decision that was made in the past that cannot be changed by any decision that will be
made in the future. Investments in plant and machinery, buildings, etc., are important
examples of such costs. Since later decisions can’t alter sunk costs, they are irrelevant for
decision-making.

Differential Cost: The difference in total cost between two alternatives is known as
differential cost. In case the choice of an alternative results in increase in total cost, such
increased costs are known as incremental costs. While assessing the profitability of a
proposed change, the incremental costs are matched with incremental revenue.

Differential cost is a technique used in the preparation of adhoc information in which only
cost and income differences between alternative courses of action are taken into
consideration. Thus, in case of differential costing a comparison is made between the cost
differential and income differential between two or more situations and decisions regarding
adopting a particular cause of action is taken if it is on the whole profitable.

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Marginal costs and Average costs- marginal cost is the extra cost incurred when one
additional unit is produced. The average cost per unit is the total cost of quantity
manufactured divided by the number of units manufactured.

Section III: Product Costing and Cost Flow

Product Costing

Product costs in manufacturing firm are the sum of direct material, direct labor and overhead
cost of producing a given product. Thus, production cost per unit is the sum of direct material
cost per unit, direct labor cost per unit and overheads cost per unit.

There are two main types of cost accounting systems for product costing: Job order and
process costing systems.
Job order costing system: is a product costing system used by both manufacturing
companies and service organizations that make large, unique, or special order
products such as customized publications, specially built cabinets, custom printing
business etc. Under such a system, the costs of direct materials, direct labor, and
manufacturing overhead is traced to a specific job order or a batch of products. A job
order is a customer order for a specific number of specially designed, made to order
products. Job order costing measures the cost of each complete unit. It uses one work
in process inventory account to summarize the cost of all jobs. This account is
supported by job order cost cards or a subsidiary ledger of accounts for each job.

Process costing system: is a product costing system used by companies that produce
large amounts of similar products or liquids, or that have a continuous production
flow. Makers of paint, soft drinks, bricks, milk or paper would use a process costing
system. Under such a system, the cost of direct materials, direct labor and
manufacturing overhead are first traced to processes, departments, or work cells and
then assigned to the products manufactured by those processes, departments or work
cells. A process costing system uses several works in process inventory accounts, one
for each process, department or work cell.

Job costing
Job order costing is an accumulation of costs by specific jobs, contracts, or orders. It keeps
track of costs as follows: direct material and direct labor are traced to a particular job and
costs not directly traceable-factory overhead-are applied (allocated) to individual jobs, using
a predetermined overhead rate. The overhead rate is equal to the budgeted annual overhead

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divided by the budgeted annual activity units (direct labor-hours, machine-hours, etc.). At the
end of the year, the difference between actual overhead and overhead applied is closed to
cost of goods sold, if there is an immaterial difference. On the other hand, if a material
difference exists, work-in-process, finished goods, and cost of goods sold are adjusted on a
proportionate basis based on units or dollars at year-end for the deviation between actual and
applied overhead.

As products are manufactured, the costs of direct materials and direct labor are transferred to
the work in process inventory account and are recorded on the job’s job order cost card.
Manufacturing overhead costs are applied and charged to the work in process inventory
account using a predetermined overhead rate. Those charges are used to reduce the balance in
the manufacturing overhead account. They two are recorded on the job’s job order cost card.
When products and jobs are completed, the costs assigned to them are transferred to the
finished goods inventory account. When the products are sold and shipped; their costs are
transferred to the cost of goods sold account. The summarized journal entries are illustrated
as follows:

When the materials are purchased:


Materials control Debited
Accounts payable control Credited.

When materials are sent to manufacturing plant:


Work in Program Control (for direct material) Debited
Manufacturing overhead control (for indirect material) Debited
Materials control Credited

When labor costs are assigned:


Work in process control (direct labor) Debited
Manufacturing overhead control (indirect labor) Debited
Wages payable control Credited
When payment of total manufacturing payroll:
Wages payable control Debited
Cash control Credited.

When manufacturing overhead costs are incurred:


Manufacturing Overhead control Debited
Various Accounts Credited

When manufacturing overheads is allocated:


Work in process control Debited
Manufacturing overhead control Credited

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When jobs are completed and transferred to finished goods account:


Finished goods control Debited
Work in process control Credited

When transferring finished goods to cost of goods sold:


Cost of goods sold Debited
Finished goods control Credited

When marketing and customer service payable and advertising costs accrued:
Marketing and Advertising costs Debited
Customer – service costs Debited
Salaries payable control Credited
Accounts payable control Credited
When sales are made on account:
Accounts receivable control Debited
Sales or Revenues Credited

Job Costing Procedures


The starting point of the job costing system is the production order. Once an order has been
accepted, the production department will make out a production and manufacturing.
Production order is the starting point for the cost accountant to prepare a job cost card/sheet.
Job cost sheet is the basic record form for a job order costing system. In fact, it is a cost
sheet on which the cost accountant records the costs incurred as the job passes through the
factory. When job cost sheet is complete, it shows the total cost of the completed job which
is composed of three elements (direct material cost, direct labor cost and over head cost) as
shown at the end of this section.

Accounting for materials in job order costing system


The term “materials” refers to such commodities which are supplied to the manufacturing
industry in original forms. They are raw in nature and have to be processed further to be sold
to customers.

In manufacturing enterprises, materials are recorded using a control account called materials.
Cost accounting for materials involves; the purchase of materials and the issuance of
materials for production use
Cost accounting techniques for the purchase of materials are similar to those studied in
general accounting for a perpetual inventory method. As materials are purchased and
received, the amount is debited to materials or materials inventory account as follows:

Materials -------------------------------xxxx

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Accounts payable -------------------------xxxx

When a job is orders is started, the necessary material are issued to the factory i.e. materials
are transferred from the store room to the factory in response to material requisitions, which
may be issued by the manufacturing department concerned or by a central scheduling
department. .

A summary of the materials requisitions completed during the month serves as the basis for
transferring the cost of the materials from the controlling account in the general ledger
account to the controlling account for work in process and factory overhead. The flow of
materials into production is illustrated by the following entry:

Work in process ( direct material) …………….xxxx


Factory overhead ( indirect material)…………..xxxx
Materials ……………………..………………. xxxx

Accounting for Labor in Job Costing System


In manufacturing process, the raw materials are converted into completed finished goods
using labor and manufacturing facilities. Accounting for labor is critical to determine the
proper cost of a job or a product. Just as it necessary to know the cost of material input in
each product or job the organization produces, it is also necessary to know the amount or cost
of the labor and time spent on each product or job as this is part of the cost of the job or
product.

For direct workers, job cards may also be maintained to record the time spent on particular
orders as a basis for cost accounting. A job card is a record of time spent on a job.At regular
intervals usually daily or weekly, the direct labor time and cost for each job are entered on
the job order cost sheets. For each payroll period-weekly, biweekly, or monthly-the
summary of employees’ earnings and the liabilities for payments are journalized and posted
to the general ledger.

Journal Entry:
Work-In process (direct labor) -----------------------------xx
Factory overhead (Indirect labor) -------------------------xx
Wages payable ------------------------------------------------xxx

Accounting for Manufacturing Overheads in Job Costing System

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Factory overhead includes all manufacturing costs except direct materials and direct labor.
Examples of factory over head costs, in addition to indirect materials and indirect labor, are
depreciation, electricity, fuel, insurance, and property taxes on factory plants.

Budgeted rate in Applying overhead


Management wants to know the overhead cost of producing different products. This will help
management in product pricing, income determination and inventory valuation; they must be
timely as well as accurate.

The actual overhead cost or rate can be determined only at the end of the year, after actual
results are determined. However, this timing would be too late as managers want product cost
information throughout the year for decision making. To meet these needs, accountants
usually budget overhead application rates i.e. they estimate or compute a rate in advance of
production and adjustment is made at year for the difference between actual over head cost
and the one allocated to products or jobs based on estimated rate.

To allocate over head cost to specific job, budgeted factory overhead rate is first computed
by dividing the total budgeted overhead cost by budgeted application base (cost driver) and
the application is made by multiplying the budgeted rate by actual cost driver for each job.

The following entry is made to record manufacturing over head cost applied:
Work in process………..xxxx
Manufacturing overhead…………….xxxx

The actual over head costs are recorded as follows as they are incurred over the year:

Manufacturing overhead………..xxx
Accumulated Depreciation……………..xxxx
Cash…………………………………….xxxx
Prepaid assets…………………………... xxxx

At the end of the year, adjustment is made for any differences between the amount of
overhead actually incurred and the amount of overhead applied (allocated) to products. The
amount by which actual overhead exceeds the applied overhead is called under applied
overhead. If actual overhead had been less than applied overhead, the difference would have
been called over applied overhead.

Journal entries for adjustment of over or under application of overhead costs


For under applied:
Cost of goods sold Debited
Manufacturing overhead Credited
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For over applied:


Manufacturing overhead Debited
Cost of goods sold Credited

Bilisuma Company Job order No 5574


Shager Street Date ordered: 1/10
For: Finfinne Construction Company Date started: 1/14
PRODUCT:# Maple Drain Boards Date Wanted: 1/22
SPECIFICATION: 12’x 20” x1” clear Finishes Date completed: 1/18
Quantity: 10
Direct Material
Date REQ.NO Amount
1/14 516 Br. 1,420.00
1/17 531 780.00
1/18 544 310.00
Br. 2,510.00
Direct Labor
Date Hours Cost
1/14 40 Br. 320.00
1/15 32 256.00
1/16 36 288.00
1/17 40 320.00
1/18 48 384.00
196 Br. 1568.00
Factory overhead Applied
Date Rate of application cost
1/14 16.20 Br. 684.00
1/16 10.00 400.00
1/17 3.20 128.00
29.40 Br. 1,176.00
Total manufacturing Cost Income statement
Direct materials Br 2,510.00 Selling price Br. 7860.00
Direct labor 1,568.00 Production cost (5254.00)
Factory overhead applied 1,176.00 Admin. Expense (420.00)
Total production Cost Br. 5,254.00 Marketing Expense (776.00)
Cost to make and sell (6,450.00)
Profit Br. 1,410.00
Example of job card/sheet after the job is completed

Manufacturing cost flow and financial statements


Raw materials purchases are recorded in the Raw Materials inventory account. When raw
materials are used in production, their costs are transferred to the Work in Process inventory
account as direct materials. Direct labor costs are added directly to Work in Process
inventory they do not flow through Raw Materials inventory.
Manufacturing overhead costs are applied to Work in Process by multiplying the
predetermined overhead rate by the actual quantity of the allocation base consumed by each
product or job. When goods are completed, their costs are transferred from Work in Process
to Finished Goods.

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The amount transferred from Work in Process to Finished Goods is referred to as the cost of
goods manufactured. As goods are sold, their costs are transferred from Finished Goods to
Cost of Goods Sold.
Period costs (or selling and administrative expenses) do not flow through inventories on the
balance sheet. They are recorded as expenses on the income statement in the period incurred.
These are further summarized by the following cost flow chart:

unused

Manufacturing costs Direct Materials Inventory


usedDirect Material costs (Balance sheet)

Direct labor cost Work in process


Manufacturing Inventory(Balance sheet)
process

Factory overhead
costs Finished and unsold
Finished goods Inventory
(Balance sheet)

Finished and sold


Cost of goods sold
(Income statement)

Non manufacturing Selling and administration


or period costs expense
(Income statement)

Section IV:Cost-Volume-Profit (CVP) Analysis and its implications

Definition of cost-volume-profit (CVP) analysis


Cost-volume-profit (CVP) analysis: is a study of the relationship between cost, volume, and
profit. It examines the behavior of total revenues, total costs, and operating income as
changes occur in the output level (volume), selling price, variable costs per unit, or fixed
costs. Managers commonly use CVP analysis as a tool to answer questionslike how will
revenues and costs be affected:
 If we sell 1,000 more units?
 If we raise or lower our selling prices?

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 If we expand business into overseas market?


These questions have a common “what-if” theme. By examining various possibilities and
alternatives, CVP analysis illustrates various decision outcomes and thus serves as an
invaluable aid in the planning process.

Assumptions of Cost-Volume-Profit Analysis

Cost-volume-profit analysis is based on several assumptions. These are:


1. Changes in the level of revenues and costs arise only because of changes in the
number of product (or service) units produced and sold. The number of output units is
the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a
revenue driver is any factor that affects revenues.
2. Total costs can be divided into a fixed component and a component that is variable
with respect to the level of output. Variable costs include both direct variable costs
and indirect variable costs of the product. Similarly, fixed costs include both direct
fixed costs and indirect fixed costs of the product.
3. When graphed, the behavior of total revenues and total costs is linear (straight line) in
relation to output units within the relevant range (and time period).
4. The unit selling price, unit variable costs, and fixed costs are known and constant.
5. The analysis either covers a single product or assumes that the sales mix when
multiple products are sold will remain constant as the level of total units sold
changes.
6. All revenues and costs can be added and compared without taking into account the
time value of money.
7. Units manufactured equal to units sold

Essential terminology of CVP analysis


 Operating income (OI) = Total revenues from operations – Costs of goods sold and
operating cost (excluding income taxes)
 Net income: is operating income plus non-operating revenues (such as interest revenue)
minus non-operating costs (such as interest cost) minus income taxes. For simplicity,
throughout this chapter we assume non-operating revenues and non-operating costs are
zero. Thus, net income is computed as:
Net income = Operating income – Income taxes
 Contribution margin (CM) :is the difference between total revenues and total variable
costs. Contribution margin is an effective summary of the reasons that operating income
changes as the number of units sold changes.Contribution margin is a key concept in
CVP analysis. It represents the amount of revenues minus variable costs that contribute to
recovering fixed costs. Once fixed costs are fully recovered, contribution margin
contributes to operating income.

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Total Contribution Margin = Total Revenues – Total Variable Costs

 Contribution margin per unit (CMU): is a useful tool for calculating contribution
margin. The contribution margin per unit is the difference between the selling price and
the variable cost per unit.
Contribution Margin per Unit = Selling Price per Unit – Variable Cost per Unit

Instead of expressing the contribution margin as a per unit amount, we can also express it as
a percentage. Contribution margin percentage (also called contribution margin ratio) is the
contribution margin per unit divided by the selling price. The contribution margin percentage
is the contribution margin achieved per dollar of revenues.

CM% = CMU/SPU or CM% = TCM/TR

In other words, contribution margin ratio is the proportion of each sales dollar available to
cover fixed costs and provide for profit.

Contribution Margin % = 1-Variable Cost %


Variable cost ratio: is the proportion of each sales dollar that must be used to cover
variable costs.
VC% = VCU/SPU

The Breakeven Point (BEP)


Breakeven point (BEP) is that quantity of output sold at which total revenues equal total
costs−that is, the quantity of output sold at which the operating income is zero ($0).Why
would managers be interested in the breakeven point? Managers are interested in the
breakeven point mainly because they want to avoid operating losses, and the breakeven point
tells them how much output they must sell to avoid a loss. The breakeven is often stated in
terms of units or sales dollar required to breakeven.

The following abbreviations are useful in the subsequent analysis:


 SPU = Selling price per unit
 VCU = Variable cost per unit
 CMU = Contribution margin per unit (SPU-VCU)
 CM % = Contribution Margin Percentage (CMU/SPU)
 FCs = Fixed costs
 Q = Quantity of output units sold (and manufactured)
 OI = Operating income
 TOI = Target operating income
 TNI = Target net income
Methods to Express CVP Relationships
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Three methods to express CVP relationships are the equation method, the contribution
margin method, and the graph method. The first two methods are most useful for analyzing
operating income at a few specific levels of sales. The graph method is useful for visualizing
the effect of sales on operating income over a wide range of quantities sold.

1. Equation Method
Under the equation method, the income statement can be expressed using the preceding
terminology in the form of the following equation:
Total Revenues - Total Variable Costs – Total Fixed Costs = Operating Income
(SPU x Q) - (VCU x Q) – TFC = OI
This equation provides the most general and easy-to-remember approaches to any CVP
situations.

2. Contribution Margin Method


The contribution margin method simply uses the concept of the contribution margin to
rework the equation method.

TR-TVC-TFC = OI
(SPU X Q) – (VCU X Q) – TFC = OI
Q (SPU-VCU) = FC + OI
Q (CMU) = FC + OI
Q (CMU)/CMU = (FC + OI)/CMU
Q = (FC + OI)/CMU
At the breakeven point, operating income, is by definition, zero. Setting OI = 0, we obtain

Q (CMU)/CMU = (FC + 0)/CMU


Q= TFC/CMU

Breakeven Number of Units = Fixed costs divided Contribution margin per unit
We can also algebraically manipulate the above equation to calculate breakeven revenues
using the contribution margin percentage. Multiplying both sides of the above equation by
the SPU gives:
Breakeven in Revenues Dollars = Breakeven Number of Units X SPU
= (FC/CMU) x SPU….by dividing both numerator and denominator by SPU
Breakeven in Revenues Dollars = FC/CM%

3. Graph Method

Total revenue line


Sales (in dollars)
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Loss area Total cost line


BEP
Profit area

---------------------------------------------------- FC Line

Sales (in quantity)

The total cost line is the sum of fixed costs and variable. The slope of the total costs line is
the variable cost per unit. For total revenues Line, one convenient starting point is $0
revenues at 0 units sold. Slope of total revenues line is selling price.

i. Units Needed to Breakeven for a Single Product


We can derive the breakeven equation by starting with the fact that total revenue equal total
cost at the breakeven point. Then the equation is restated in terms of unit sales, unit prices
and unit cost and then rearranged into the more convenient format presented in equation 1.
Total Revenues = Total Costs

Q (SPU) = Q (VCU) + TFC


Q (SPU – VCU) = TFC
Q (CMU) = TFC
TCM = TFC
Q = TFC/CMU --------------------------------- (1)

Equation 1 shows that the breakeven point is where total contribution margin [Q (SPU –
VCU)] is equal to total fixed costs, i.e., this level of production and sales provides just
enough revenue to cover all the cost.

ii. Breakeven Point in Dollars for a Single Product


The equation for the breakeven point in sales dollars may also be derived by equating total
revenue and total cost.
Total Revenues = Total Costs
Total Revenues = Total Variable Costs + Total Fixed Costs
Since the variable cost ration (VCU÷SPU) multiplied by total revenues equals’ total variable
cost, we can substitute (VCU÷SPU) TR for variable cost in the equation above as follows:

Total Revenues = (VCU/SPU) TR + Total Fixed Costs

Then subtracting variable cost from both sides of the equation provides the basic breakeven
point equation in sales dollars.

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TR - (VCU/SPU) TR = TFC

Stated in words, the equation indicates that total revenue, less total variable costs, equal total
contribution margin and the breakeven point is where contribution margin total is equal to
total fixed cost. Since the contribution margin percentage (CM % = 1-VCU/SPU) multiplied
by total revenue equals total contribution margin, it is more convenient for computational
purposes to state the equation in the following manner.

TR – (VCU/SPU) TR = TFC
TR – (1-VCU/SPU) = TFC
TR – TR (VCU/SPU) = TFC
TR (1-VCU/SPU) = TFC
TR (CM %) = TFC
TR = TFC/CM %

Target Operating Income (Net Income before Taxes)


The breakeven point tells managers how much they must sell to avoid a loss. But managers
are equally interested in how they will achieve the operating income targets underlying their
strategies and plans.
1. Units Needed for Target Operating Income for a Single Product
This equation can be derived from scratch in the same manner used to develop equation 1.
Notice however that equation 2 may be obtained by simply adding the target operating
income to the right hand side of the equation.

TR = TVC +TFC + Target OI


Q (SPU) = Q (VCU) +TFC + Target OI
Q (SPU – VCU) = TFC + TOI
Q (CMU) = TFC + TOI
Q = (TFC + TOI)/CMU ----------------------- (2)

2. Units Needed for Target Operating Income when Target Operating Income is
stated as a Percentage of Sales $ for a Single Product

If we use ROR to define target rate of return on sale; ROR = Target OI/ Total Revenues i.e.,
Target OI = ROR (TRs); then we can substitute ROR (SPU x Q) for the target operating
income in equation 2. This provides equation 3.

Q (SPU – VCU) = TFC + TOI


Q (SPU – VCU) = TFC + ROR (SPU x Q)
Q (SPU – VCU)/ (SPU - VCU) = TFC + ROR (SPU x Q)/ (SPU - VCU)
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Q = TFC + ROR (SPU x Q)/SPU – VCU)

Q= TFC + ROR (SPU x Q) …………..(3)


CMU

Since (SPU x Q) equals sales dollars, then ROR multiplied by (SPU x Q) will provide target
OI. Although the desired profit is often stated as a percentage, ROR is proportion, i.e., it
ranges from 0 to 1.

3. Total Revenue Needed for Target Operating Income


Although we could derive this equation from scratch, the fact that total contribution margin
must be equal to the total fixed costs plus target operating income allows us to develop
equation 2 by simply adding the target operating income to equation 1.

Total Contribution Margin = Total Fixed Costs + target OI


TR (CM %) = TFC + Target OI

TR = TFC + Target OI
CM%

4. Total Revenue needed when Target Operating Income is Stated as a Percentage of


Sales $
To solve a problem in sales dollars, when the target operating income is stated as a
percentage of sales dollars, substitute (Total revenue x ROR) in equation 2 for target
operating income as follows:

Total Revenue (CM %) = TFC +Target Operating Income


TR (CM %) = TFC + TR (ROR)
TR = (TFC + TR (ROR))/CM%

Target Net Income (or Net Income after Taxes) and Income Taxes
Objective 4: Understand how income taxes affect CVP analysis. Thus far, we have ignored
the effect of income taxes in our CVP analysis. At times, managers want to know the effect
of their decisions on income after taxes. Net income is operating income minus income taxes.
CVP calculations for target income must then be stated in terms of target net income instead
of target operating income.

1) Units needed for Target Net Income


If TR = the tax rate, and TNI = Target Net Income, then
Target NI = Target OI – (Target OI x Tax Rate)
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Target NI = Target OI (1- Tax Rate)


Target OI = Target NI / (1-Tax Rate)

Substituting Target NI / (1-Tax Rate) for target OI in equation 2, provides equation 3, which
allows us to solve for units needed to generate a target NI.

Q (SPU – VCU) = TFC + (Target NI/(1-Tax Rate))


Q= [TFC + (Target NI/(1-Tax Rate))]/(SPU – VCU)
Q= [TFC + (Target NI/(1-Tax Rate))]/CMU

2) Units needed for Target Net Income When Target NI is stated as a Percentage of
Sales $
If the target rate of return is stated as an after tax rate, i.e., ROR =Target NI/Total Revenue,
then the following approach is used.Substituting ROR (SPU x Q)/(1-Tax Rate) for ROR
(SPU x Q) in equation 4 provides equation 5.

Q (SPU – VCU) = TFC + [ROR (SPU x Q)/(1-Tax Rate)]


Q= TFC + [ROR (SPU x Q)/(1-Tax Rate)]/(SPU–VCU)

3) Total Revenue needed for Target Net Income


Solving for total revenue needed to generate a target net income involves substituting Target
NI /(1-Tax Rate) for target operating income in the equation for sales dollars needed for
target OI (i.e., equation 2). This provides equation 3.

Total Revenues (CM %) = TFC + (Target NI/ (1-Tax Rate))


Total Revenues = TFC + [(Target NI/ (1-Tax Rate))]/CM%

4) Total Revenue needed when Target NI is stated as a Percentage of Sale $


When the target net income is stated as an after tax rate (ROR), the equation needed is
developed by simply dividing ROR (Total Revenue) in equation 3 by (1-Tax Rate)

TR (CM %) = TFC + [ROR (TRs) / 1-Tax Rate]


Total Revenue = [TFC + ROR (TR)/(1-Tax Rate)]/CM %

Note that no income taxes are paid at the breakeven point (BEP), income taxes do not affect
the BEP. An increase in income tax rates, however, would increase the number of units that
must be sold to generate a given net income (NI).

Effects of Sales Mix on Income

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CVP analysis can be applied to a company producing multiple products by assuming the
sales mix of products sold remains constant as the total quantity of units sold changes. In
other words, we must assume a stable sales mix. Sales mix is the quantities of various
products (or services) that constitute total unit sales of a company. There is no unique
breakeven number of units for a company producing multiple products. Few companies
produce or sell only one product. CVP analysis techniques can be utilized by managers to
determine the impact of proposed changes to the current product mix. Multiplying
contribution margin per product by the percentage of total sales for each product yields a
single weighted-average contribution margin per unit which is then plugged into the CVP
analysis to determine breakeven point and target-income activity levels. Managers calculate
the weighted-average contribution margin for each different proposed product mix and then
compare the CVP analysis results for each proposed product mix to determine which product
mix should be produced or sold.

i) Units Needed for Break-even for Multiple Products


TR-TVC-TFC = 0
(WASPU x Q) – (WAVCU x Q) = TFC
Q (WASPU – WAVCU) = TFC
Q (WACMU) = TFC
Q = TFC/ WACMU

ii) Total Revenues needed for Breakeven point for a Multiple Products
TR-TVC-TFC = 0
TR – TR (VC %) = TFC
TR (1- VC %) = TFC
TR (CM %) = TFC
TR = TFC/ CM %

iii) Units needed for Target Net Income for Multiple Products

The equation for mixed units needed to generate a desired after tax profit is developed by
substituting Target NI/ (1-Tax Rate) for Target Operating income in equation 2.

Total Contribution Margin = Total Fixed Cost + Target OI


Q (WACMU) = TFC + Target NI/ (1-Tax Rate)

TFC + Target Net Income


Q= 1-Tax Rate
WACMU
iv) Units needed for Target Net Income when Target NI is stated as a Percentage
of Sales $ for Multiple Products
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The appropriate equation for after tax net income is found by dividing the term [(ROR) (Q x
WAP)], in equation 4, by 1-Tax Rate.

Total Contribution Margin = Total Fixed Cost + Target OI


Q (WACMU) = TFC + Target NI/ (1-Tax Rate)
Q (WACMU) = TFC + ((ROR) (WAP x Q))/ (1-Tax Rate)
TFC + (ROR) (WAP x Q)
Q= 1-Tax Rate
WACMU
Where WAP = Weighted Average Price=∑ [SPUi) (Mi)]
WACMU = ∑ [CMUi) (Mi)]

Remember that it is usually best for computational purposes to leave the amount represented
by WACMU on the left hand side in equations until the expression on the right hand side has
been simplified. Also remember that the units for individual products (Q i) are always found
by multiplying the total mixed units (Q) by the mix ratios (Mi) for each product.

v) Total Revenue Needed for Target NI for Multiple Products

Revising the previous equation to indicate after tax profit we have:


Total Contribution Margin = Total Fixed Cost + Target OI
Total Contribution Margin = TFC + Target NI/ (1-Tax Rate)
TR (WACMR) = Total Fixed Cost + Target NI
1-Tax Rate

TR = Total Fixed Cost + Target NI


1-Tax Rate
WACMR
vi) Total Revenue Needed for Target NI when Target NI is stated as a Percentage of
Sales $ for Multiple Products

If ROR is used as the after tax target rate of return on sales, i.e., Target NI ÷ Total Revenue,
the equation becomes,

Total Contribution Margin = Total Fixed Cost + Target OI


Total Contribution Margin = TFC + Target NI/ (1-Tax Rate)
TR (WACMR) = Total Fixed Cost + (ROR) (Total Revenue)
1-Tax Rate

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TR = Total Fixed Cost + (ROR) (Total Revenue)


1-Tax Rate
WACMR

Sensitivity Analysis (or What-if Analysis) and Uncertainty


Before choosing strategies and plans about how to implement strategies, managers frequently
analyze the sensitivity of their decisions to changes in underlying assumptions.

Sensitivity analysis- is a “what-if” technique that managers use to examine how a result will
change if the original predicted data are not achieved or if an underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answer such questions as,
What will operating income be if the quantity of units sold decreases by 5% from the
original prediction?
What will operating income be if variable cost per unit increases by 10 percent?

The sensitivity of operating income to various possible outcomes broadens managers`


perspectives about what might actually occur before they make cost commitments.Another
aspect of sensitivity analysis is margin of safety, which is the amount of budgeted revenues
over and above breakeven revenues. Expressed in units, margin of safety is the sales quantity
minus the breakeven quantity.

The margin of safety answers the ‘what-if” question: If budgeted revenues are above
breakeven and drop, how far they can fall below budget before the breakeven point is
reached? Such a fall could be due to a competitor introducing a better product, to poorly
executed marketing programs, and so on.

The margin of safety (MOS) for any sales level represents the amount of sales dollars above
or below the breakeven point. Mathematically, the margin of safety is:

Margin of Safety (MOS) = Budgeted Revenues – Breakeven Revenues


Margin of Safety (in units) = Budgeted Sales (units) – Breakeven Sales (units)
 When sales are above the breakeven point, the margin of safety is positive.
 When sales are below the breakeven point, the margin of safety is negative.

Contribution Margin and Gross Margin


Gross Margin = Revenues – Cost of Goods Sold
Contribution Margin = Revenues – All Variable Costs

Cost of goods sold in the merchandising sector is made up of goods purchased and then sold.
Cost of goods sold in the manufacturing sector consists entirely of manufacturing costs

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(including fixed manufacturing costs). The phrase “all variable costs” refers to variable costs
in all of the business functions of the value chain.

Service sector companies can compute a contribution margin but not gross margin. That`s
because service-sector companies do not have a cost of goods sold line item in their income
statement.

Section V: Master Budget

Definition of budget
Budget: is the quantitative expression of a proposed plan of actionby management for a
specified period. It also aids in coordinating what needs to be done to implement that plan.A
budget can cover both financial and non-financial aspects of the plan and serves as a
blueprint for the company to follow in an upcoming period.

A budget that covers financial aspects quantifies management’s expectations regarding


income, cash flows, and financial position. For example, a budgeted income statement, a
budgeted statement of cash flows, and a budgeted balance sheet.

Budgets can also be non-financial budgets, for, say, units manufactured or sold, number of
employees, and number of new products being introduced to the market place.

Budgeting Cycle and Master Budget

Well-managed organizations usually have the following budgeting cycle:


1) Planning the performance of the organization as a whole, as well as its sub-units
(such as departments and divisions). Management at all levels agrees on what is
expected.
2) Providing a frame of reference, a set of specific expectations against which
actual results can be compared.
3) Investigating variations from plans. If necessary, corrective action follows
investigation.
4) Planning again, in light of (considering)feedback and changed conditions.

The preceding four steps describe the ongoing budget process. The working document at the
core of this process is called the master budget. The master budget expresses management`s
operating and financial plans for a specified period (usually a fiscal year), and it includes a
set of budgeted financial statements. The master budget is the initial plan of what the
company intends to accomplish in the budget period. The master budget evolves from both
operating and financial decisions made by managers.

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 Operating decisions: deal with how to best use the limited resources of an
organization.
 Financial decisions: deal with how to obtain the funds to acquire those resources.

Types of Budgets
[A]. Master Budget (Financial Plan) is:
 A comprehensive expression of management’s operating and financial plans for a
future time period (usually a year) that is summarized in a set of budgeted
financial statements.
 It is a comprehensive budget that expresses the overall business plan for the
whole organization for a period of one year or less. It is essentially a more
extensive analysis of the first year of the long-range plan. It summarizes the
planned activities of all sub units of an organization-sales, production,
distribution, and finance.
 The master budget is a summary of all phases of a company’s plans and goals for
the future. It quantifies targets for sales, cost driver activity, purchase, production,
net income, cash position and other objectives that management specifies. It
expresses these amounts in the form of forecasted financial statements and
supporting operating schedules. These supporting schedules provide the
information that is to highly detailed to appear in the actual financial statements.
Thus, a master budget is a periodic business plan that includes a coordinated set
of detailed operating schedules and financial statements. It includes forecast of
sales, expense, cash receipts and disbursements, and balance sheet. A master
budget is also called pro forma statements, the term used for forecasted financial
statements.

[B]. Continuous/Perpetual/Rolling Budget: is budget that covers a 12-month period but


which is constantly adding a new month on the end as the current month’s completed.
It is a common form of master budget. It makes the budgeting an ongoing process
rather than a periodic process. Advocates of continuous budgets states that this
approach to budgeting is superior to other approaches in that it keeps management
thinking andplanning a full 12 months ahead and thus maintains a stable planning
horizon. Thus, continuous budget stabilizes the planning horizon. As managers add a
new 12th month to a continuous budget, they may update the other 11 months as well.
Then they can compare actual monthly results with both the original plan and the
most recently revised plan. Under other budget approaches, the planning horizon
becomes shorter as the year progresses.

Advantages of Budgets

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A budget is a formal business plan. All managers do some kind of planning. Sometimes plans
are unwritten. Such plans might work in a small organization, but as an organization grows,
informal planning is not enough. A more formal plan- budgetary system- becomes a
necessity. Since budgets forces managers to think ahead to anticipate and prepare for
changing conditions, it allows systematic rather than chaotic reaction to change. It helps to
adjust the firm’s plan to changing conditions.

Budgets are an integral part of management control systems. When administered thoughtfully
by managers, budgets:

Formalize planning
Promote coordination and communication among subunits within the company
Provide a framework for judging performance
Motivate managers and other employees

Formalization of planning
Budgets formalize plans, it compels (forces) managers to think ahead, to anticipate and
prepare for changing conditions. The budgeting process makes planning an explicit
management responsibility. In such conditions, managers are forced to react to current events
rather than planning for future. To prepare a budget, a manager should set goals and
objectives and establish policies to aid their achievement. The objectives are the destination
points, and budgets are the road maps guiding to those destination. Without goals and
objectives, company operations lack directions, problems are not foreseen, and results are
difficult to interpret afterwards.

Framework for Judging Performance

Plans enable a company`s manager`s to measure actual performance against budgets.


Budgets can overcome two limitations of using past performance as a basis for judging actual
results. One limitation is that past results often incorporate past miscues (mistakes) and
substandard performance. The other limitation of using past performance is that future
conditions can be expected to differ from the past. However, it is important to remember that
a company`s budget should not be the only benchmark used to evaluate performance. Many
companies also consider performance relative to peers as well as improvement over prior
years.

The problem with evaluating performance relative only to a budget is it creates an incentive
for subordinates to set a target that is relatively easy to achieve. Of course, managers at all
levels recognize this incentive, and therefore they work to make the budget more challenging
to achieve for the individuals who report to them. Negotiations occur among managers at

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each of these levels to understand what is possible and what is not. The budget is the end
product of these negotiations.

Communication and Coordination

Budgets tell employees what is expected of them. Nobody likes to drift along, not knowing
what the boss expects or hopes to achieve. A good budget process communicates both from
the top down and from the bottom up. Top management makes clear the goals and objectives
of the organization in its budgetary directives. Employees and lower level managers then
inform higher level managers how they plan to achieve the goals and objectives. Budgets
also help managers in coordinating their efforts, so that the objectives of the organization as a
whole match the objectives of its parts. Once the organization’s overall goals have been
communicated to each department’s budget and for coordinating it with the budgets of other
department’s. For example, a budget forces purchasing department to integrate (incorporate)
its plan with plan of the production department, it forces production department to consider
the delivery schedule set by sales department. Similarly, financial officers use the sales
budget, purchasing requirements, and so forth to anticipate the company’s need for cash.
Therefore, the budgetary process enhances communication and coordination among
departments. Coordination is meshing and balancing all aspects of production or service and
all departments in a company in the best way for the company to meet its goals.
Communication is making sure those goals are understood and accepted by all employees.
Coordination forces executives to think of relationships among individual departments and
the company as a whole, and across companies.

Motivating Managers and Other Employees


Research shows that challenging budgets improve employee performance. That`s because
falling short of budgeted numbers is viewed by employees as a failure. Most employees are
motivated to work more intensively to avoid failure than to achieve success. As employees
get closer to a goal, they work harder to achieve it. Therefore, many executives like to set
demanding but achievable goals for their subordinate managers and employees. Creating a
little anxiety improves performance, but overly ambitious and unachievable budgets increase
anxiety without motivationthat`s because employees see little chance of avoiding failure.

Limitations of Budgets
There are several limitations and problems associated with the master budget that need to be
considered by management. These problems involve uncertainty, behavioral bias and costs.

 Uncertainty: Budgeting includes a considerable amount of forecasting and this activity


involves a considerable amount of uncertainty.

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 Behavioral Bias: A second problem involves a variety of behavioral conflicts that are
created when the budget is used as a control device. To be effective, the budget must be
used by the managers it is designed to help. Thus, it must be acceptable to all levels of
management. The behavioral literature on budgeting supports the view that the budget
should reflectwhat is most likely to occur under efficient operating conditions. If a budget
is to be used as an effective planning and monitoring device, it should encourage a high
level of performance and efficiency, but at the same time, it should be fair and obtainable.
If the budget is viewed by managers as unfair, (too optimistic) it may intimidate
(frighten) rather than motivate. One way to gain acceptance is referred to as participative
(rather than imposed) budgeting. The idea is to include all levels of management in the
budget preparation process.

 Costs: A third problem or limitation is thatbudgeting requires a considerable amount of


time and effort. Many companies maintain a twelve month budget on a continuous basis
by adding a future month as the current month expires. While this does not create a major
expenditure for large or medium sized organizations, smaller companies may find it
difficult to justify the costs involved. Many small, potentially profitable firms do not plan
effectively and eventually fail as a result. Cash flow problems are common, e.g., not
having enough cash available (or accessible through a line of credit with a bank) to pay
for merchandise or raw materials or to meet the payroll. Many of these problems can be
avoided by preparing a cash budget on a regular basis.

The Assumptions of the Master Budget

Typically, the following simplifying assumptions are made when preparing a master budget:
1. Sales prices are constant during the budget period,
2. Variable costs per unit of output are constant during the budget period,
3. Fixed costs are constant in total and
4. Sales mix is constant when the company sells more than one product. These
assumptions facilitate the planning process by removing many of the economic
complexities.

Types of Master Budget


The master budget comprises the financial projections of all the individual budgets for a
company for a specified period, usually a fiscal year. Master budget can be classified into
two: operating and financial budget.
 Operating budget: budgeted income statement and its supporting budget schedules.
 Financial budget: part of the master budget that focuses on how operations and
planned capital outlays affect cash. It is made up of the capital expenditures budget,
the cash budget, the budgeted balance sheet, and the budgeted statement of cash
flows.
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1) The Operating Budget


Preparing an operating budget is a sequential process of developing nine sub-budgets. Except
for one or two exceptions the sub-budgets must be prepared in the following order: sales,
production, direct materials, direct labor, and factory overhead, ending inventory, cost of
goods sold, selling and administrative and income statement.

[A]. Step 1: Revenues or Sales Budget


A revenue (sales) budget is the usual starting point for budgeting. That’s because the
production level and the inventory leveland hence manufacturing costsas well as non-
manufacturing costs, generally depend on the forecasted level of sales or revenues.

Many factors influence the sales forecast, including the sales volume in recent periods,
general economic and industry conditions, market research studies, productive capacity,
pricing policies, advertising and sales promotions, backlog of unfilled sales orders,
competition, and regulatory policies.Developing a sales budget involves the following
calculations:

Budgeted Sales $ = Budgeted Unit Sales x Budgeted Sales Prices

The revenue budget is often the outcome of elaborate information gathering and discussions
among sales managers and sales representatives who have a detailed understanding of
customer needs, market potential, and competitors` product. Statistical approaches such as
regression and trend analysis can also help in sales forecasting. These techniques use
indicators of economic activity and past sales data to forecast future sales. Managers should
use statistical analysis only as one input to forecast sales. In the final analysis, the sales
forecast should represent the collective experience and judgment of managers.

The usual starting point for step 1 is to base revenues on expected demand. Occasionally, a
factor other than demand limits budgeted revenues. For example, when demand is greater
than available production capacity or a manufacturing input is in short supply, the revenues
budget would be based on the maximum units that could be produced. Why? Because sales
would be limited by the amount produced.Sales budget is accompanied by cash collection
budget.

Current Period Cash Collections = (Current Period Cash Sales + Current Period Credit
Sales Collected in Current Period + Prior Period Credit Sales Collected in Current Period)

These calculations are relatively simple, but where does the budget director obtain this
information? Well, sales forecasting is a marketing function. Sales estimates are frequently
generated by the company's sales representatives who discuss future needs with customers
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(wholesalers and retailers). Statistical forecasting techniques can also be used to make
estimates of expected future sales, considering the company's previous sales performance and
various assumptions about the future economic climate, and the actions of competitors and
consumers. Pricing is also a marketing function, but many prices are based on costs plus a
markup (the supply function) and consideration of what consumers are willing and able to
pay for the product (the demand function). Thus, the budgeted sales price is usually
determined after the budgeted unit cost has been calculated.

The information needed to develop an equation for collections is provided by the finance
departmentand is normally based on past experience. These calculations are somewhat more
involved than they appear to be in the equation above because of the effects of cash discounts
and the time lags between credit sales and collections. Cash discounts are frequently used to
speed up cash inflows. This puts the funds back to work sooner and reduces the need for
short term loans. However, even with a generous cash discount for prompt payment,
collections for credit sales are typically spread out over several months.

[B]. Step 2: Production Budget (In units)


After the revenues are budgeted, the manufacturing manager prepares the production budget.
The total finished goods units to be produced depend on budgeted sales and expected
changes in inventory levels.
Preparing a production budget includes consideration of the desired inventory change as
follows:
Units to be Produced = (Budgeted Unit Sales + Target (Desired) Ending Finished
Goods Inventory in units − Beginning Finished Goods Inventory in units)

The desired ending inventory is usually based on the next period’s sales budget.
Considerations involve the time required to produce the product, (i.e., cycle time or lead
time) as well as setup costs and carrying costs, the costs that arise while holding an inventory
of goods for sale. Carrying costs include the opportunity cost of the investment tied up in
inventories and the costs associated with storage, such as insurance, obsolesce, spoilage, and
shrinkage resulting from theft). In a just-in-time environment the desired ending inventory is
relatively small, or theoretically zeros in a perfect situation.

The nature of the product makes it difficult for some companies to synchronize production
levels with expected sales. When inputs are available only seasonally, production occurs “in
season.” For example, a manufacturer of jellies makes the year`s supply of strawberry jelly
during strawberry harvest season.

[C]. Step 3: Direct Materials Usage and Direct Materials Purchase Budget

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 Once we determine the number of units to be produced from the production budget,
we can budget for the manufacturing inputsdirect materials, direct labor, and
overhead.
 Thenumber of units to be produced is the key to computing the usage of direct
materials in quantities and in dollars. The direct material quantities used depend on
the efficiency with which materials are consumed to produce a
product.Manufacturing managers are constantly seeking ways to make process
improvements that increase quality and reduce waste, which reduces direct material
usage and costs.

The direct materials budget includes five separate calculations

Quantity of MaterialNeeded for Production (Direct Materials Used in Production) =


(Units to be Produced X Quantity of MaterialBudget per Unit)

The quantity of material required per unit of product is determined by the industrial
engineers who designed the product. Materials requirements are frequently described in an
engineering document referred to as a "bill of materials".

Quantity of Material to be Purchased (Or Purchases of Direct Materials) = (Quantity of


Material Needed for Production + Target Ending Inventory of Direct Materials ─
Beginning Inventoryof Direct Materials)

The purchasing manager prepares the budget for direct material purchases. The desired
ending materials quantity is normally based on the next period's (month's) materials needed
for production and this amount depends on the third period's budgeted unit sales. Of course
inventories of raw materials (just like finished goods) are kept to a minimum in a JIT
environment. Factors that influence the desired inventory levels include the reliability of the
company's suppliers, as well as ordering and carrying costs.

Budgeted Costof Material Purchases = Quantity of Direct Material to be Purchased


X Budgeted Material Prices

This amount is needed to determine cash payments. Once the quantity to be purchased
has been determined, the cost of purchases is easily calculated. Budgeted material prices
are provided by the purchasing department.

Cost of Material Used = Quantity of Material Needed for Production X Budgeted


Material Prices

The cost of materials used is needed in the cost of goods sold budget below.
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Cash Payments for Direct Material Purchases = Current Period Purchases Paid in
Current Period + Prior Period Purchases Paid in Current Period

The information needed to determine budgeted cash payments is provided by accounting,


(accounts payable) and is usually based on past experience. Normally the budget should
reflect a situation where the company pays promptly to take advantage of all cash discounts
allowed, thus cash payments for direct materials purchases may be equal to budgeted cost of
material purchases.

[D]. Step 4: Direct Manufacturing Labor Cost Budget


These costs depend on wage rates, production methods, and hiring plans. The manufacturing
manager prepares the budget for direct manufacturing labor. Fewer calculations are needed
for direct labor than for direct materials because labor hours cannot be stored in the inventory
for future use. Time can be wasted, but not postponed.

Direct Labor Hours Needed for Production = Units to be Produced X Direct Labor
Hours Budgeted per Unit

The amount of direct labor time needed per unit of product is determined by industrial
engineers. Estimates are frequently made using a technique referred to as motion and time
study. This involves measuring each movement required to perform a task and then assigning
a precise amount of time allowed for these movements. The cumulative time measurements
for the various tasks required to produce a product provide the estimate of a standard time per
unit. There are alternative techniques that are less expensive, but motion and time study
provides estimates that are very precise. Learning curves provide another quantitative
technique that is helpful in establishing labor standards.

Budgeted Direct Labor Cost = (Direct Labor Hours Needed for Production X Budgeted
Rates per Hour)

The budgeted rates per hour for direct labor are provided by the human resource department.
Frequently the labor (union) contract provides the source for this information. Many different
types of labor may be required with different levels of expertise and experience.

[E]. Step 5: Manufacturing Overhead Costs Budget


The total of these costs depends on how individual overhead costs vary with respect to the
cost driver,which is a variable, such as level of activity or volume that casually affects costs
over a given time span.

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Budgeted Factory Overhead Costs = ((Budgeted Fixed Overhead Cost + (Budgeted Variable
Overhead Rate x Direct Labor Hours Needed for Production))

This is a cumulative equation that combines the equations for the company's various types of
indirect resources. Keep in mind however, that although many companies are still using a
single production volume based measurement for overhead allocations, most companies use
departmental rates and many companies are now using activity based rates.
The calculation for cash payments reflects one of the differences between cash flows and
accrual accounting. Since some costs, like depreciation, do not involve cash payments in the
current period, these costs must be subtracted from the total overhead costs to determine the
appropriate amount.

Cash Payments for Overhead = Budgeted Factory Overhead Cost − Depreciation and Other
Costs that do not require cash payments

[F]. Step 6: The Ending Inventories Budget


The management accountant prepares the ending inventories budget. The dollar amount for
the ending inventory of finished goods is needed below to determine cost of goods sold. The
dollar amounts for ending direct materials and finished goods are needed for the balance
sheet.
Ending Direct Materials = Desired Ending Materials X Budgeted Prices

Budgeted or Standard Unit Cost = (Quantity of D.M. Required per Unit x Budgeted
Prices) + (D.L. Hours Required per Unit x Budgeted Rate) + (Total Overhead Rate x
D.L. Hours Required per Unit)

The budgeted or standard unit cost can be calculated at any time after the budgeted quantities
per unit and input prices are obtained. The calculation is placed here because it is needed for
determining finished goods.

Ending Finished Goods = Desired Ending Finished Goods x Budgeted Unit Cost

[G]. Step 7: Cost of Goods Sold Budget

Cost of goods sold is needed for the income statement. One method of determining budgeted
COGS involves accumulating the amounts from the previous sub-budgets as follows.

 Budgeted Total Manufacturing Cost (Cost of Goods Manufactured) = Cost of Direct


Material Used + Cost of Direct Labor Used + Total Factory Overhead Costs

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 Cost of Goods Available for Sale = Beginning Finished Goods Inventory + Budgeted
Total Manufacturing Cost

 Budgeted Cost of Goods Sold = (Budgeted Total Manufacturing Cost + Beginning


Finished Goods ─ Ending Finished Goods)

This is the same approach used in determining cost of goods sold, but when developing a
budget we typically assume no change in Work in Process. Therefore, budgeted cost of
goods manufactured is equal to budgeted cost of goods sold.

[H]. Step 8: Selling and Administrative Expense Budget (Nonmanufacturing Costs


Budget)
The preparation of the selling and administrative expense budgets is very similar to the
approach used for factory overhead.

Budgeted Selling and Administrative Expenses = Budgeted Fixed Selling & Administrative
Expenses + (Budgeted Variable Rate as a Proportion of Sales $ x Budgeted Sales $)

Cash Payments for Selling & Administrative Expenses = Budgeted Selling & Administrative
Expenses − Depreciation and other cost which do not require cash payments

[I]. Step 9: Budgeted Income Statement

Preparing the budgeted income statement involves combining the relevant amounts from the
sales, cost of goods sold and selling and administrative expense budgets and then subtracting
interest, bad debts and income taxes to obtain budgeted net income. These amounts are
provided by the finance department.
a. Budgeted Sales $ - Budgeted Cost of Goods Sold = Budgeted Gross Profit
b. Budgeted Gross Profit - Budgeted Selling & Administrative Expenses = Operating
Income
c. Operating Income - Interest Expense - Bad Debts Expense = Net Income Before
Taxes
d. Net Income before Taxes – Income Taxes = Net Income after Taxes

2) The Financial Budget


The financial budget includes the cash budget, the capital expenditure budget, which
summarizes plans for acquiring fixed assets), the budgeted balance sheet and budgeted
statement of cash flows. The cash budget and budgeted balance sheet are discussed below.

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[A]. Cash Budget


The cash budget is a statement (schedule) of expected (planned) cash receipts and
disbursements (payments). It predicts the effects on the cash position at the given level of
operations. It is highly affected by the level of operations summarized in budgeted income
statement. Cash budgets are very helpful for cash planning and control. Cash budgets
helpavoid unnecessary idle cash and unexpected cash deficiencies. They thus keep cash
balance in line with needs.The cash budget has the following four major sections:

I. The Receipts Sections: It consists of operating cash balance added to whatever is


expected in the way to cash receipts during the budget period. The beginning cash
balance plus cash receipts equals the total cash available before financing.
Budgeted Cash Available = Beginning Cash Balance + Budgeted Cash Collections
Cash receipts depend on the collections of accounts receivable, cash sales, and
miscellaneous recurring sources, such as rental and royalty receipts. Information on the
expected collectability of accounts receivable is needed for accurate predictions. Key-
factors include bad-debt (uncollectible accounts) experience and average time lag
between sales and collections.
II. The Cash Disbursements (Requirements Section): It consists of all cashrequirements
that are planned for the budget period. Cash disbursements include payments for:
o Direct materials purchases
o Direct labor and other wages and salary outlays
o Interest on long term borrowings
o Income tax payments
o Dividend payments
o Outlays for property, plant, equipment and other long-term investments
o Desired cash balance
III. The Excess or Deficiency Section: It consist the difference between cash receipts
section and cash disbursements section.

Budgeted Cash Excess or Deficiency = Budgeted Cash Available - Budgeted Cash


Payments

IV. The Financing section


Short term financing requirements depend on how the total cash available for needs
compares with the total cash disbursements plus the minimum ending cash balance desired.
The financing plans will depend on the relationship between total cash available for needs
and total needed.
 If there is a deficiency of cash, loans will be taken (obtained).
 If there is excess cash, any outstanding loans will be repaid.

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Ending Cash Balance = Cash Excess or Deficiency + Borrowings - Repayments including


Interest

[B]. Budgeted Balance Sheet


Preparing the budgeted balance sheet involves accumulating information from the previous
period’s balance sheet, the various operating sub-budgets, the cash budget and other
accounting records.
Assets
a. Current Assets:
 Cash (from the cash budget)
 Accounts Receivable (from the sales budget and previous balance sheet)
 Direct materials (from the ending inventory budget)
 Finished goods (from the ending inventory budget)
b. Long Term Assets:
 Land (from previous balance sheet and budgeted activity)
 Buildings (from previous balance sheet and budgeted activity)
 Equipment (from previous balance sheet and budgeted activity)
 Accumulated depreciation (from the accounting records)
Liabilities
Liabilities includes current liabilities (such as accounts payable (from various operating sub-
budgets), taxes payable (from income statement)) and long term liabilities
Shareholders’ equity includes both common stock (from previous balance sheet and budgeted
activity) and retained earnings (from previous balance sheet and income statement)

Illustration

The Expando Company produces entertainment centers from a type of pressed wood referred
to as particle board. Other materials, such as glue and screws are viewed as insignificant and
are charged to overhead as indirect materials. Budgeted or standard quantities allowed per
unit along with the budgeted prices and rates are as follows:

Type of input Inputs per output Cost per input Cost per output
Direct materials 2 particle board sheets* $10 $20

Direct labor 0.4 hours 15 6


Factory overhead:
Variable 0.4 hours 30 12
Fixed 0.4 hours 50 20
$58
* Particle board is purchased in sheets that are 3/4" by 4' by 8'.

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Overhead rates are based on 4,800 standard direct labor hours per month, or average monthly
production of 12,000 units, i.e., (0.4) (12,000) = 4,800 hours. Desired ending inventories are
10% of next period’s material needs for direct material and 5% of next period’s sales for
finished goods. Unit Sales are budgeted as follows for the first six months of the year.
January February March April May June

9,000 10,000 11,000 12,000 14,000 14,500

The budgeted sales price is $100 per unit. Sales are budgeted as 50% cash and 50% credit
sales. Past experience indicates that 80% of the credit sales are collected during the month of
sale, 18% are collected in the following month, and 2% are uncollectible. A 1% cash
discount is allowed to customers who pay within the month the sale takes place including
cash sales.

Variable selling and administrative expenses are budgeted at 10% of sales dollars. The
budget for fixed selling and administrative expenses is $50,000 per month. Cash payments
are made for all expenditures made during the month except for depreciation of $100,000 in
manufacturing and $25,000 in the selling and administrative area. The budgeted beginning
cash balance for March is $100,000 and the tax rate is 40%. Budgeted income taxes from
January and February are $200,000. This amount is to be paid at the end of March along with
the current months taxes. A three month note for $50,000 is to be repaid at the end of March.
The interest rate on the note is 12 percent.

Some additional account balances budgeted for the end of February include: Land
$5,000,000, buildings and equipment $15,000,000, accumulated depreciation $6,000,000,
other current liabilities 0, long term liabilities 0, common stock $5,000,000 and retained
earnings $8,993,000.

Required: Prepare
1. Sales budget for March, including net sales dollars.
2. Calculate collections for March.
3. Production Budget, i.e., units to be produced for March.
4. Direct Material quantity needed for production for March.
5. Direct Material quantity to be purchased for March.
6. Budgeted cost of direct material purchases for March.
7. Budgeted cost of direct material used for March.
8. Direct labor needed for production for March.
9. Budgeted cost of direct labor used for March.
10. Budgeted factory overhead costs for March.

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11. Budgeted cost of goods sold for March.


12. Prepare a simple Budgeted Income Statement for March.
13. Prepare a cash budget for March.
14. Budgeted Balance Sheet for March

Solution for the Illustration

Expando Company
Sales Budget for March
Budgeted Unit Sales Budgeted Sales Price Total
50%cash sales 5,500 $100 $550,000
50%credit sales 5,500100 550,000
Total sales 11,000 100 $1,100,000
Less: Sales discounts 9,900
[(550,000 x 0.01) + (550,000 x 0.08) x 0.01] ________
Net sales $1,090,100

Expando Company
Cash Collection Budget for March
Collections for March:
Current period cash sales (50% x $1,100,000) – (0.01 x $550,000) $544,500
Add: Current period credit sales collected in current period 435,600
(80% x 0.5 x 1,100,000) – (440,000 x 0.01)
Prior period credit sales collected in current period (10,000 x $100 x 0.5 x 0.18) 90,000
Current period cash collection $1,070,100

Expando Company
Production Budget for March
March April
Units to be produced:
Budgeted unit sales 11,000 12,000
Add: Desired ending inventory of finished goods (5% x 12,000) 600 700
Total requirements 11,600 12,700
Less: Beginning inventory of finished goods 550 600
Units to be produced 11,05012,100

Expando Company
Direct Materials Budget for March
Physical unit budget:
Quantity of DM needed for production:
Units to be produced 11,050
Times: Quantity of DM budgeted per unit 2
Quantity of DM needed for production 22,100 sheets
Quantity of DM to be purchased:

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Quantity of DM needed for production 22,100


Add: Desired ending inventory of DM (10% x 24,200) 2,420
Total requirements 24,520
Less: Beginning inventory of DM (10% x 22,100) 2,210
Quantity of DM to be purchased 22,310 PBs
Cost budget:
Budgeted cost of DM used:
Quantity of DM needed for production 22,100
Times: Budgeted material prices $10
Budgeted cost of direct materials used $221,000
Budgeted cost of DM to be purchased:
Quantity of DM to be purchased 22,310
Times: Budgeted prices $10
Budgeted cost of DM purchases $223,100

Therefore, cash payments for DM purchases = $223,100


Note: April units to be produced = 12,000 + (0.05 x 14,000) – (0.05 x 12,000) = 12,100
April DM needed for production = (12,100 x 2) = 24,200 sheets

Expando Company
Direct Labor Budget for March
DLHs needed for production:
Units to be produced 11,050
Times: DLHs budgeted per unit 0.4
DLHs needed for production 4,420
Budgeted DL cost:
DLHs needed for production 4,420
Times: Budgeted rates per hour $15
Budgeted DL costs $66,300
Cash payments for DL costs = $66,300

Expando Company
Budgeted Factory Overhead Costs Budget for March
Budgeted variable overhead costs:
DLHs needed for production 4,420
Times: Budgeted variable OH rate $30
Budgeted variable overhead cost $132,000
Add: Budgeted fixed overhead ($50 per hour x 4,800 denominator hours given) 240,000
Total budgeted factory overhead costs $372,600
Cash payments for OH costs = $372,600 – $100,000 = $272,600

Expando Company
Ending Inventory Budget for March
Ending Direct Materials:
Desired Ending Inventory of Direct Materials (0.10 x 24,200) 2,420 PBs

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Times: Budgeted prices $10/PBs


Ending Direct Materials $24,200

Ending Finished Goods:


Desired Ending Inventory of Finished Goods (0.05 x 12,000 April budgeted unit sales)
600Times: Budgeted cost per unit* $58
Ending Inventory of Finished Goods
$34,800

*Budgeted or Standard Unit Cost = (Quantity of DM required per Unit x Budgeted Prices)
+ (DLHs required per Unit x Budgeted Rate) + (Total Overhead Rate x DLHs required per
Unit)
= (2 x $10) + (0.4 x $15) + (0.4 x $80) = 20 + 6 + 32 = $58

Expando Company
Budgeted Cost of Goods Sold for March
Budgeted Cost of Goods Sold:
Beginning inventory of finished goods (0.05 x 11,000 x $58) $31,900
Add: Cost of Goods Manufactured:
Budgeted cost of DM used 221,000
Budgeted cost of DL 66,300
Total FOH cost 372,600
Cost of goods manufactured 659,900
Cost of goods available for sale $691,800
Less: Ending inventory of finished goods (0.05 x 12,000 x $58) (34,800)
Budgeted cost of goods sold $657,000

Expando Company
Selling and Administrative Expense Budget for March
Budgeted selling and administrative expense:
Variable selling and administrative expense (0.10 x $1,100,000) $110,000
Fixed selling and administrative expense 50,000
Total selling and administrative expense $160,000
Cash payments for selling and administrative expense = $160,000 − $25,000 = $135,000

Expando Company
Budgeted Income Statement for March
Sales $1,100,000
Less: Cash discounts 9,900
Net sales $1,090,100
Less: Cost of goods sold 657,000
Gross profit $433,100
Less: Selling and administrative expenses 160,000
Bad debts expense [($1,100,000 x 0.5 x 0.02)] 11,000
Interest expense ($50,000 x 0.12 x 1/12) 500

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Net income before taxes $261,600


Less: Income taxes (0.40 x $261,600) 104,640
Net income after taxes $156,960

Notice that bad debts are 2% of credit sales and credit sales are 50% of total sales. The
interest expense is for one month`s interest on the three month note.

Expando Company
Cash Budget for March
Cash receipts:
Beginning cash balance $100,000
Cash collection 1,070,100
Total cash available for needs $1,170,100
Less: cash requirements (payments):
Direct materials $223,100
Direct labors 66,300
Factory overhead ($372,600-$100,000 depreciation) 272,600
Selling and administrative expense ($160,000-$25,000) 135,000
Income taxes ($200,000+$104,640) 304,640
Total cash needed $1,001,640
Excess (deficiency):
Total cash available − total cash needed $168, 460
Financing:
Borrowings 0
Repayments [$50,000 + ($50,000*0.12*3/12)] 51,500
Total cash increase (decrease) from financing (51,500)
Ending cash balance $116,960

Human Aspects of Budgeting


Too often, budgeting is thought of as a mechanical tool as the budgeting techniques
themselves are free of emotion. However, the administration of budgeting requires education,
persuasion, and intelligent interpretation.

Learning activity
Student will visit to one of the business firmsnearby them and indentify how budget is being
prepared by the firm and relate it with the theoretical knowledge they have.

Continuous assessment
Quiz, test,report /presentation

Summary
A budget is the quantitative expression of a proposed plan of action by management for a
specified period and aid to coordinating what needs to be done to implement that plan.

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Budget can be classified in to two: master and continuous. When administered thoughtfully
by managers, budgets formalize planning; promote coordination and communication among
subunits within the company; provide a framework for judging performance and motivate
managers and other employees.There are several limitations and problems associated with
the master budget that need to be considered by management. These problems involve
uncertainty, behavioral bias and costs.

3.4.3.6. Section VI: Flexible Budget and Variance Analysis


Pre-test
What is the relationship between management by exception and variance analysis?
…………………………………………………………………………………………………
………………………………………………………………………………………………….
What are two possible sources of information a company might use to compute the budgeted
amount in variance analysis?
…………………………………………………………………………………………………
…………………………………………………………………………………………………

Section content
 The use of variances
 Static budget and flexible budgets
 Steps in developing flexible budget
 Application of standard costing in variance analysis
 Definition of standard costing
 Advantages of standard costing
 Limitations of standard costing

The Use of Variances


Variance represents the difference between an amount based on an actual result and the
corresponding budgeted amount. Each variance wecompute is the difference between an
actual result and the corresponding budgeted amount. The budgeted amount is a benchmark,
a point of reference from which comparisons may be made.

Variances assist managers in their planning and control decisions. In other words, variances
are where the planning and control functions come together to assist managers in
implementing their strategies. Management by exception is the practice of concentrating on
areas not operating as anticipated or expected (such as a cost overrun on a defense project or
a large shortfall in sales of a product) and giving less attention to areas operating as
anticipated or expected. In other words, managers usually pay more attention to areas with
large variances. Sometimes large positive variances may occur, such as a significant decrease

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in manufacturing costs of a product. Managers will try to understand the reasons for this
decrease, for example; better operator training or changes in manufacturing methodsso
these practices can be appropriately continued. Managers use information from variances
when planning how to allocate their efforts. Areas with sizable variances receive more
attention by managers on an ongoing basis than do areas with minimal variances. Variances
are also used in performance evaluation and to motivate managers. Sometimes variances
suggest a change in strategy. Excessive defect rates for a new product may suggest a flawed
product design. Managers may then want to reevaluate their product strategies.

Static Budget and Flexible Budgets


The master budget or static budget is based on the level of output planned at the start of
the budget period.
Based on Planned level of output at start of
Static budget the budget period

In other words, the static budget is the “original” budget. It’s static in the sense that the
budget is developed for a single (static) planned output level. A static budget is prepared at
the beginning of the budgeting period and is valid for only the planned level of activity. It is
suitable for planning, but it is inadequate for evaluating how well costs are controlled
because the actual level of activity is unlikely to equal the planned level of activity, thus
resulting in “apples-to-oranges” cost comparisons. When variances are computed from a
static budget at the end of the period, adjustments are not made to the budgeted amounts for
the actual output level in the budget period.
A flexible budget (variable budget)calculates budgeted revenues and budgeted costs
based on the actual output level in the budget period.

Based on Budgeted revenues and cost


Flexible based on actual level of
budget output.

A flexiblebudget is calculated at the end of the period when the actual output is known; a
static budget is developed at the start of the budget period based on the planned output level
for the period. A flexible budget is dynamic rather than static; it can be tailored for any level
of activity within the relevant range. A relevant range is the band of normal activity level or
volume in which there is a specific relationship between the level of activity or volume and
the cost in question. For example, a fixed cost is fixed only in relation to a given wide range

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of total activity or volume (at which the company is expected to operate) and only for a given
time span (usually a particular budget period). A flexible budget provides estimates of what
costs should be for any level of activity within a specified range. A flexible budget is a
performance evaluation tool. When used for performance evaluation purposes, actual cost are
compared to what the costs should have been for the actual level of activity during the
period. This enables “apples-to-apples” cost comparisons. A flexible budget enables
managers to compute variances that provide more information than the information from
variances in a static budget. A flexible budget can be prepared for various levels of output
whereas a static budget is based on one specific level of output. A flexible budget adjusts the
static budget for the actual level of output. It cannot be prepared before the end of the period.

A flexible budget asks the question: “If I had known at the beginning of the period what my
output volume (units produced or units sold) would be, what would my budget have looked
like?”

Question: If the flexible budget (FB) is based on the level of output, which isn’t known
until the end of the period, how can it be a budget?

Answer: The flexible budget (FB) shows the costs that should have been incurred (the
budgeted costs) to achieve the actual output level. The FB is the budget we would have made
at the beginning of the period if we had perfectly predicted the actual output level (i.e., the
FB is the budget managers would have prepared at the beginning of the period if they had
perfectly predicted the actual output level).

Budgets, both static and flexible, can differ in the level of detail they report. Companies
present budgets with broad summary figures that can then be broken down into progressively
more detailed figures via computer software programs. The level of detail increases in the
number of line items examined in the income statement and the number of variances
computed. “Level” followed by a number denotes the amount of detail shown by a variance
analysis.
Level 0 reports the least detail.
Level 1 offers more information, and so on.

Assume for example that Webb manufactures and sells jackets. The jackets require tailoring
and many hand operations. Webb sells exclusively to distributors, who in turn sell to
independent clothing stores and retail chains. For simplicity, we assume that Webb’s only
costs are manufacturing costs; it incurs no costs in other value-chain functions such as
marketing and distribution. We assume that all units manufactured in April 2006 are sold in
April 2006. Therefore, all direct materials are purchased and used in the same budget period,
and there is no direct materials inventory at either the beginning or the end of the period.

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There are also no work-in-process or finished goods inventories at either the beginning or the
end of the period. Webb has three variable-cost categories. The budgeted variable cost per
jacket for each category is:

Cost category Variable-cost per jacket


Direct material costs $60
Direct manufacturing labor costs 16
Variable manufacturing overhead costs 12
Total variable costs $88

Actual April 2006 results are as follows:


Units sold 10,000
Revenues $1,250,000
Variable costs:
Direct materials $621,600
Direct manufacturing labor 198,000
Variable manufacturing overhead 130,500
Fixed Costs 285,000

The number of units manufactured is the cost driver for direct materials, direct manufacturing
labor, and variable manufacturing overhead. The relevant range for the cost driver is from 0
to 12,000 jackets. The budgeted fixed manufacturing costs are $276,000 for production
between 0 and 12,000 jackets.

The budgeted selling price is $120 per jacket. This selling price is the same for all
distributors. The static budget for April 2006 is based on selling 12,000 jackets. Actual sales
for April 2006 were 10,000 jackets.

Static Budget Variances


The static budget variance is the difference between the actual result and the
corresponding budgeted amount in the static budget.
 A Favorable Variance (denoted by F) has the effect of increasing operating
income relative to the budgeted amount.
 For revenue items, F means actual revenue exceeds budgeted revenues.
 For cost items, F means actual costs are less than budgeted costs.
 An Unfavorable Variance (denoted by U) – has the effect of decreasing
operating income relative to the budgeted amount. Unfavorable variances are also
called adverse variances in some countries, for example, the United Kingdom.

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Favorable versus Unfavorable Variances


Profit Revenue Costs
Actual > Expected F F U
Actual < Expected U U F

Static Budget Variances = Actual Results – Static Budget Amount

Static budget based variances analysis for Webb Company for April 2006.

Level 0 Analysis:
Actual operating income $14,900
Budgeted operating income 108,000
Static budget variance for operating income $93,100U

Note:Level 0 Analysis gives the least detailed comparison of the actual and budgeted
operating income. It compares the actual operating income with the budgeted operating
income.

Level 1 analysis:
Actual Static-Budget
Results Variances Static-Budget
(1) (2)=(1)-(3)(3)
Units sold 10,000 2,000U 12,000
Revenues $1,250,000 $190,000U $1,440,000
Variable costs:
Direct materials 621,600 98,400F 720,000
Direct manufacturing labor 198,000 6,000U 192,000
Variable Mfg. Overhead 130,500 13,500F 144,000
Total Variable costs $950,100 $105,900F$1,056,000
Contribution margin 299,900 84,100U 384,000
Fixed costs 285,000 9,000U 276,000
Operating income $14,900$93,100 U $108,000
$93,100U

Static-budget variance

Level 1 Analysis: Provides managers with more detailed information on the operating
income. It also compares actual operating income items with line (each) operating income
items.

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Steps in Developing Flexible Budget

The following steps are used to prepare a flexible budget:


Step1. Identify the actual quantity of output.
Step2. Calculate the flexible budget for revenues based on budgeted selling price and
actual quantity of output.
Step3. Calculate the flexible budget for costs based on budgeted variable cost per
output unit, actual quantity of output, and budgeted fixed costs. The only
difference between the static budget and the flexible budget is that the static
budget is prepared for the planned output level, where as the flexible budget is
based on the actual output level.

Webb develops its flexible budget in three steps:


Step1: Identify the actual quantity of output.
In April 2006, Webb produced and sold 10,000 jackets.
Step2: Calculate the flexible budget for revenues based on budgeted selling price and
actual quantity of output.
Flexible-budget revenues = $120 per jacket x 10,000 jackets = $1,200,000
Step3: Calculate the flexible budget for costs based on budgeted variable cost per
output unit, actual quantity of output, and budgeted fixed costs.

Flexible budget variable costs:


Direct materials, ($60 per jacket x 10,000 jackets) $600,000
Direct manufacturing labor ($16 per jacket x 10,000 jackets) 160,000
Variable Mfg. overhead ($12 per jacket x 10,000 jackets) 120,000
Total flexible budget variable costs 880,000
Plus: Flexible budget fixed costs 276,000
Flexible-budget total costs $1,156,000

Static-budget variance can be classified into two:


i) Flexible-budget variance (or cost variance) (or total variance)
ii) Sales-volume variance

Flexible-Budget Variances: The flexible budget variance is the difference between the
actual results and the flexible- budget amount based on the level of output actually achieved
in the budget period.

Flexible Budget Variance = Actual Results - Flexible Budget Amounts


Or Flexible Budget Variance = Price Variance + Efficiency Variance

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The flexible –budget variance pertaining to revenues is often called a selling- price variance
because it arises solely from differences between the actual selling price and the budgeted
selling price.

Selling price variance = (Actualselling price – Budgetedselling price) x Actual units sold
= ($125 per jacket - $120 per jacket) x 10,000 jackets = $50,000 F

Webb has a favorable selling-price variance because the $125 actual selling price exceeds the
$120 budgeted amount, which increases operating income. Marketing managers are generally
in the best position to understand and explain the reason for this selling price difference. For
example, was it because of better quality? Or was it because of an overall increase in market
prices? Webb`s managers concluded it was because of a general increase in prices.

Flexible-budget variancecan be classified into two:


1. Price (or rate) variance
2. Efficiency (or usage) variance

Sales-Volume Variances: The sales-volume variance is the difference between a flexible-


budget amount and the corresponding static-budget amount. It’s called the sales-volume
variance because it represents the difference caused solely by the actual quantity of units sold
and the quantity of units expected to be sold in the static budget.

Sales-Volume Variance = Flexible-Budget Amount – Static-Budget Amount

The sales-volume variances arises solely from the differences between the budgeted output
level used to develop the static budget and the actual output level used to develop the flexible
budget. Note particularly that any budgeted selling prices or unit variable costs are always
held constant when sales-volume variances are computed.Hence:

Sales-volume variance = (Budgeted selling price - Budgeted variable cost per unit) x
(Actual units sold – Static budget units sold)

Sales-volume variance = Budgeted contribution margin per unit x (Actual units sold -
Static- budget units sold)

Level 2 analysis:
Actual Flexible-budget Flexible Sales-volume Static
Results Variance Budget Variance Budget
(1) (2)=(1)-(3) (3) (4)=(3)-(5) (5)

Units sold 10,000 0 10,000 2,000U 12,000


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Revenues $1,250,000 $50,000F $1,200,000 $240,000U $1,440,000


Variable costs:
Direct materials 621,600 21,600U 600,000 120,000F 720,000
Direct mfg. labor 198,000 38,000U 160,000 32,000F 192,000
Variable mfg. OH 130,100 10,500U 120,000 24,000F 144,000
Total variable costs 950,100 70,100U 880,000 176,000F 1,056,000
Contribution margin 299,900 20,100U 320,000 64,000U 384,000
Fixed costs 285,000 9,000U 276,0000 276,000
Operating income $14,900 $29,100U $44,000 $64,000U $108,000

$29,100U $64,000U
Flexible budget variance Sales-volume variances
$93,100U

Static-budget variances

Static-budget variance = Flexible-budget variance + Sales-volume variance

The flexible-budget variance for total variable costs is unfavorable ($70,100 U) for the actual
output of 10,000 jackets. It`s unfavorable because of one or both of the following:

 Webb used greater quantities of inputs (such as direct manufacturing labor-hours)


relative to the budgeted quantities of inputs.
 Webb incurred higher price per unit for the inputs (such as the wage rate per direct
manufacturing labor-hour) relative to the budgeted prices per unit of the inputs.

Higher input quantities relative to the budget and/or higher input prices relative to the budget
could be the result of Webb deciding to produce a better product than what was planned in
the budget or the result of inefficiencies in Webb’s manufacturing and purchasing, or both.
You should always think of variance analysis as providing suggestions for further
investigation rather than as establishing conclusive evidence of good or bad performance.

The sales-volume variance in operating income for Webb measures change in budgeted
contribution margin because Webb sold only 10,000 jackets rather than the budgeted 12,000.

Sales-volume variance for operating income = (Budgeted contribution margin per


unit) x (Actual units sold – static-budget units sold)

= (Budgeted selling price – Budgeted variable cost per unit) x (Actual units sold –
static-budget units sold)
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= ($120 per jacket − $88 per jacket) x (10,000 jackets – 12,000 jackets)
= $32 per jacket x (-2,000 jackets)
= $64,000 U

Webb`s managers determine that the unfavorable sales-volume variance could be because of
one or more of the following reasons:
1. The overall demand for jackets is not growing at the rate that was anticipated
2. Competitors are taking away market share from Webb
3. Webb did not adapt quickly to changes in customer preferences and tastes
4. Budgeted sales targets were set without careful analysis of market conditions
5. Quality problems developed that led to customer dissatisfaction with Webb`s jacket

Application of standard costing in variance analysis


Standard costing is a very important technique of cost control. Every organization wants to
minimize the cost of production and maximize the profits. Standard costing is such a system
which seeks to control the cost of each unit or batch or product through price determination
beforehand of what should be the cost and then its comparison with actual cost.

Definition of standard costing


1. According to J. Batty, “standard costing is a system of cost accounting which is
designed to show in detail how much each product should cost to produce and sell
when a business is operating at a stated level of efficiency and for a given volume of
output.”
2. According to W.B. Lawrence, “A standard cost system is a method of cost accounting
in which standard costs are used in recording certain transactions and the actual costs
are compared with the standard costs to learn the amount and reason for any
variations from the standard.”

Application of Standard Costing


The application of standard costing requires the following conditions to be fulfilled:
1. A sufficient volume of standard products or components should be produced
2. Methods, procedures and materials should be capable of being standardized.
3. A sufficient number of costs should be capable of being controlled.

Advantages of standard costing


The various advantages of standard costing are as follows:
1) Simplification of cost bookkeeping: it is very simple in comparison to historical
costing. Once the standards are fixed for the product, the records can be simplified
through uniformity which saves the time and money.

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2) Basis for measuring operating performance: standards work as yardsticks for


measuring the operating efficiency or inefficiency. For it, the comparisons are made
between standard cost and actual cost.
3) Cost reduction and control: standard costing is very useful in cost reduction and
control by eliminating or limiting lost time, idle time, spoilage, material wastage and
lost machine hours.
4) Management by exception: standard costing is helpful in applying the principle of
management by exception. Variance analysis brings the inefficient operations in light
and management can focus its attention towards those matters only.
5) Formulation of production and price policies: Standard costs represent long-term
estimates, cost and prices. It helps the management in the formulation of ideal
production policy.
6) Implementing incentive schemes: standard costing promotes the implementation of
incentive schemes in the organization because every incentive scheme is based on
certain standards which are determined under this system.
7) Facilitates comparison: Cost comparison between different products and department
can be done under standard costing. It also makes possible the comparison of costs of
one period with another.
8) Promotes cost consciousness and efficiency: It also promotes cost consciousness as
the employees know that their performance shall be in assessing manufacturing
inefficiencies and fixing responsibilities. This improves the efficiency of the
organization.

Limitations of standard costing


1. Not appropriate for small concerns: it is not appropriate for small concerns as the
installation of standard costing requires high degree of skill and the small concerns may
not have expert staff for handling or operating the system
2. Not suitable for certain industries: this system is not suitable for industries which
produce non-standardized products and for job works which change according to
customers` requirements

Why standard costs are often used in variance analysis?Because, standard costs exclude past
inefficiencies and take into account future changes.

A standard is a carefully predetermined price, cost or quantity amount. It is usually expressed


on a per unit basis.The advantages of using standard amounts for variance analysis are:
 They can exclude past inefficiencies
 They can take into account changes expected to occur in the budgeted period

Webb has developed standard inputs and standard costs for each of its variable cost items. A
standard input is a carefully predetermined quantity of inputs (such as pounds of materials or
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manufacturing labor-hours) required for one unit of output. A standard price is a carefully
determined price that a company expects to pay for a unit of input. A standardcost is a
carefully predetermined cost. Standard costs can relate to units of inputs or units of outputs.

The standard direct materials input allowed for one output is 2.00 square yards of cloth
(jacket), at $30 standard cost per square yard and standard manufacturing labor time allowed
is 0.80 hours per output unit, at $20 standard cost per hour.
Webb’s budgeted cost for each variable direct-cost item is computed as follows:
Standard cost per output unit for each variable direct-cost input = Standard input allowed for
one output unit x Standard price per input unit

Direct Materials:
2.00 square yards of cloth input allowed per output unit (jacket) manufactured, at $30
standard cost per square yard.
Standard cost = 2.00 x $30 = $60.00 per output unit manufactured
Direct manufacturing labor:
0.80 manufacturing labor hour of input allowed per output unit manufactured, at $20
standard cost per hour.
Standard cost= 0.80 x $20 = $16.00 per output unit manufactured

Price Variances and Efficiency Variances for Direct Cost Inputs


Consider Webb’s two direct cost categories. The actual cost for each of these categories in
April 2006 is:

Direct materials purchased and used


1) Square yards of cloth input purchased and used22,200
2) Actual price paid per square yard$28
3) Cost of direct materials (1x2) $621,600

Direct manufacturing labor:


1) Manufacturing labor-hour9,000
2) Actual price paid per direct manufacturing labor hour$22
3) Direct manufacturing labor costs (1x 2) $198,000

We assume here that the quantity of direct materials used is equal to the quantity of direct
materials purchased.

Price Variance
A price variance is the difference between the actual price and the budgeted price multiplied
by the actual quantity of input in question (such as direct materials purchased or used). A

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price variance is sometimes called input-price varianceor rate variance, especially when
referring to a price variance for direct labor.

The formula for computing the price variance is:


Price Variance = (Actual Price of Input – Budgeted Price of Input) x Actual Quantity of
Input

Price variances for each of Webb’s two direct-cost categories are:

Direct materials ($28-$30) x 22,200 = $44,400F

Direct manufacturing labor ($22-$20) x 9,000 = 18,000U


$26,400F

The direct materials price variance is favorable because actual price of cloth is less than the
budgeted price, resulting in an increase in operating income. The direct manufacturing labor
price variance is unfavorable because actual wage rate paid to labor is more than the
budgeted rate, resulting in a decrease in operating income.

Always consider a broad range of possible causes for a price variance. For example, Webb`s
favorable direct materials price variance could be because of one or more of the following:
 Webb`s purchasing officer/manager negotiated the direct materials prices more
skillfully than was planned for in the budget
 The purchasing manager changed to a lower-price supplier
 The purchasing manager bought in larger lot sizes than budgeted, thus obtaining
quantity discounts (i.e., Webb`s purchasing manager ordered larger quantities than
the quantities budgeted, thereby obtaining quantity discounts).
 Materials prices decreased unexpectedly due to, say, industry oversupply
 Budgeted purchase prices were set without careful analysis of the market, and
 Purchasing manager received unfavorable terms on nonpurchase price factors (such
as lower quality materials)

Efficiency Variance
 An efficiency variance is the difference between the actual quantity of input used (such as
yards of cloth of the direct materials) and the budgeted quantity of input that should have
been used, multiplied by the budgeted price.
 Efficiency variances are sometimes called usage variance. Computation of an efficiency
variance requires measurement of inputs for a given level of output. For any level of
output, the efficiency variance is the difference between the input that was actually used

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and the input that should have been used to achieve that actual output, holding input price
constant at the budgeted price.

Efficiency Variance = (Actual quantity of input used − Budgeted quantity of input


allowed for actual output) x Budgeted Price of Input

The idea here is that an organization is inefficient if it uses more inputs than budgeted for the
actual output units achieved, and it is efficient if it uses fewer inputs than budgeted for the
actual output units achieved.

The efficiency variances for each of the Webb’s direct cost categories are:

Direct Material = [22,200 yards-(10,000 units x 2 yards)] x $30


= (22,200 yards – 20,000 yards) x $30 ………………..$66,000U
Direct Mfg. labor = [9,000 hours-(10,000 units X 0.80 hour)] X $20
= (9,000 hours – 8,000 hours) x $20 ………………..20,000 U
$86,000U
The two manufacturing efficiency variances are direct materials efficiency variance and
direct manufacturing labor efficiency varianceare each unfavorable because more input was
used than was budgeted, resulting in a decrease in operating income.

As with price variances, there is a broad range of possible causes for these efficiency
variances. For example, Webb`sunfavorable efficiency variance for direct manufacturing
labor could be because of one or more of the following:
 Webb`s personnel manager hired under-skilled workers
 Webb`s production scheduler inefficiently scheduled work, resulting in more
manufacturing labor time than budgeted being used per jacket
 Webb`s maintenance department did not properly maintain machines, resulting in
more manufacturing labor time than budgeted being used per jacket.
 Budgeted time standards were set too tight without careful analysis of the operating
conditions and the employee`s skills.

Note that managers generally have more control over efficiency variances than price
variances. That`s because the quantity of inputs used is primarily affected by factors inside
the company, but price changes are primarily due to market forces outside the company.

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