BAC312 - Management Accounting Module

Mulungushi University
Institute of Distance Education
Management Accounting
BAC312
MULUNGUSHI UNIVERSITY
INSTITUTE OF DSTANCE EDUCATION
Mulungushi University SBS Page 1 of 129

Content
CHAPTER I. MASTER BUDGET: AN OVERALL PLAN .........................................................................4

1.1 INTRODUCTION...................................................................................................................................4
1.2 THE FUNDAMENTALS OF BUDGETING ...........................................................................................4
1.3 PRINCIPAL ADVANTAGES OF BUDGETING ...................................................................................7
1.4 COMPONENTS OF MASTER BUDGET .............................................................................................10
1.5 OPERATING BUDGET .........................................................................................................................11
1.6 FINANCIAL BUDGET .........................................................................................................................15
1.7Preparing THE MASTER Budget ...........................................................................................................17
PREPARATION OF MASTER BUDGET (Manufacturing Company) ..................................................22
Chapter II. FLEXIBLE BUDGETS ..................................................................................................................31

2.1 Master Budget Vs Flexible Budget ......................................................................................................31
2.2 Flexible Budget (Dynamic Budget)......................................................................................................32
2.2.1 Distinguishing Features of Flexible Budget ....................................................................................33
2.2.2 Flexible Budgeting Process..............................................................................................................33
Flexible Budgets For Various Activity Levels .............................................................................................34
Chapter III. Standard Cost and Variance Analysis ...................................................................................37

3.1 Introduction ...........................................................................................................................................37
3.2 Purpose of Standard Costs ...................................................................................................................39
3.3.1 Setting the Standards........................................................................................................................41
Chapter IV. Measuring Mix, Yield and Productivity Variances................................................................55

4.1 Introduction ...........................................................................................................................................55
Chapter V. Cost Volume Profit (CVP) Analysis ..........................................................................................66
5.1 Introduction ...........................................................................................................................................66

5.2 The Basic of CVP Analysis ...................................................................................................................66
5.3 break even Analysis ..............................................................................................................................70
5.4 Applying CVP Analysis ........................................................................................................................75
5.4.1 Sensitivity “What If” Analysis.........................................................................................................75
5.4.2 Target Net Profit Analysis ...............................................................................................................78
5.4.3 The Margin of Safety .......................................................................................................................81
5.5 The Impact of Income Tax CVP Analysis ..........................................................................................82
5.6 CVP Analysis with Multiple Products ................................................................................................84
5.6.1 Definition of Sales Mix ....................................................................................................................84
5.6.2 Sales Mix and CVP Analysis ...........................................................................................................84
5.7 Underlying Assumptions in CVP Analysis .........................................................................................93
5.8 Cost Structure and Operating Leverage.............................................................................................93
5.8.1 Cost Structure and Profitability .......................................................................................................94
5.8.2 Operating Leverage ..........................................................................................................................96

Chapter VI: Relevant Information & Decision Making .............................................................................99
6.1 The Concept of Relevance ..................................................................................................................100
6.2 Alternative Choice Decisions .............................................................................................................101
6.2.1 Marketing Decisions ......................................................................................................................102
6.2.1.1 Special Order Decisions ..............................................................................................................102
6.2.1.2 Deletion or Addition of Products or Departments ......................................................................109
6.2.1.3 Optimal Use of Limited Resources .............................................................................................111
6.2.2 Production Decisions ....................................................................................................................113
6.2.2.1 Make or Buy Decisions ...............................................................................................................114
6.2.2.2 Joint Product Decisions: Sell or Process Further ........................................................................119
6.2.2.3 Keep or Replace Equipment Decisions.....................................................................................122

d
CHAPTER I. MASTER BUDGET: AN OVERALL PLAN
LEARNIING OBJECTIVES
Upon a successful completion of this chapter, you should be able to:

 Explain the fundamental elements of budget
 Enumerate the principal advantages of budgeting
 Understand the difficulty of sales forecasting
 Diagram and explain the master budget interrelationships
 Follow the principal steps in preparing a maser budget
 Prepare the operating budget and the supporting schedules
 Prepare the financial budget
1.1 INTRODUCTION
ike many accounting terms, budgeting is used commonly in our everyday language. The
L news media discuss budgets of federal and state governments, and many people
describe a variety of resource allocation decisions, ranging from vacation planning to
the purchase of food and clothing, as budgeting. The purpose of this chapter is to introduce
the framework for the budgeting process, define budgeting terms, enumerate the principal
advantages of budgeting, explain the concepts of responsibility accounting and participatory
budgeting and provide a clear understanding of the concepts of budgeting. Although the
primary emphasis in this chapter is on business budgeting, most of the concepts are also
applicable to non-business activities.
1.2 THE FUNDAMENTALS OF BUDGETING
A budget is a comprehensive formal management plans expressed in quantitative terms,

describing the expected operations of an organization over some future time period. A budget

deals with a specific entity, covers a specific future time period and is expressed in
quantitative terms.
Budget entity .The entity concept, so important in financial accounting, is essential to

budgeting also. A specific budget must apply to a clearly defined accounting entity. For
budgeting purpose the entity may consist of a small part of a business, a single activity, or a
specific project. The concept of a budget entity applies to individuals as well. For example, a
student interested in budgeting the cost of a first year’s college education should not include
in the budget the cost of three weeks vacation or the purchase of a $ 5800 guitar. Although
these two expenditures may be cost of the period, they are not college education expenses.
A budget entity can be as a specific as a single project such as a trip or it can be a broad
activity, such as the budget for an entire manufacturing firm, or for the Zambian government.
Future time period .Many financial figures are meaningless unless they are couched in some
time references. For example, income statements are annual, quarterly, or monthly. A job
offer of $ 40,000 is of little value without knowing if the figure represents pay for a month, a
year, a lifetime, or some other time period. We might assume the $ 40,000 is annual salary.
In accounting, however, time reference should be clearly stated.
Budgets should express the expected financial consequences of programs and activities
planned for a specific period of time. Annual budget are widespread. In addition to annual
budgets, budgets for many other time periods are prepared. The planning horizon for
budgeting may vary from one day to many years. For example, master budget usually cover 1
month to 1year where as long-range plan are prepared for 2 to 10 years.

In planning for profits, managers must consider two time horizons: the short term and the
long term.
Short-term planning is the process of deciding what objectives to pursue during a short,
near-future period, usually one year, and what to do to achieve those objectives. The typical
short-term budget covers one year and is $oken down into monthly or quarterly units.
Another method frequently used to prepare a short-term budget is the continuous budget.
This kind of budget starts with an annual budget $oken down into 12 monthly units. As each
month arrives, it is dropped from the plan and replaced by a new month so that at any given
time, the next 12 months are always shown. Thus, in a budgetary period covering January
through December 20X4, when January 20x4 arrives, it would be dropped from the plan and
replaced by January 20x5, thus creating a new budgetary period covering February 20x4
through January 20x5. Using this technique, a firm always has guidance for the full following
year. When a continuous budget is not used, a firm will have guidance for only a month or
two as it approaches the end of its budgetary period.
Long-term planning, also known as strategic planning, is the process of setting long-term
goals and determining the means to attain them. Short-term planning is concerned with
operating details for the next accounting period, but long-term planning addresses broad
issues, such as new product development, plant and equipment replacement, and other
matters that require years of advance planning. For example, short-term planning in the
automotive industry would be concerned with which and how many of the current year’s
models to manufacture, while long-range planning would focus on new model development
and major changes, as well as equipment replacements and modifications. The time frame for
long-range planning may extend as far as 20 years in the future, but its usual range is from 2
to 10 years. An important part of long-term planning is the preparation of the capital budget,

which details plans for the acquisition and replacement of major portions of property, plant,
and equipment.
Quantitative plan. Often budgets contain materials describing the various programs and
activities planned by the company. This chapter focuses primarily in the way that cost and
revenue estimates of the activities are expressed by the budget. All planned projects or
activities for the organization are reduced to the common denominator of money and other
quantitative measures, such as units of input or output.
1.3 PRINCIPAL ADVANTAGES OF BUDGETING
As noted earlier, a budget is a detailed plan expressed in quantitative terms that specifies
how resources will be acquired and used during a specific period of time. The act of
preparing a budget is known as budgeting. The use of budgets to control a firm’s activities is
called budgetary control.
Companies realize many benefits from a budgeting program. Among these benefits are the
following:
 Requires periodic planning.
 Fosters coordination, cooperation, and communication.
 Provides a framework for performance evaluation.
 Means of allocating resources.
 Satisfies legal and contractual requirements.
 Created an awareness of business costs.
Periodic Planning (Formalization of Planning). The most obvious purpose of a budget is to

quantify a plan of action. The development of a quarterly budget for a Sheraton Hotel, for
example, forces the hotel manager, the reservation manager, and the food and beverage

manager to plan for the staffing and supplies needed to meet anticipated demand for the
hotel’s services.
To sum up, budgets forces managers to think a head to anticipate and prepare for the
changing conditions. The budgeting process makes planning an explicit management
responsibility.
Coordination, Cooperation and Communication. Planning by individual managers does not

ensure an optimum plan for the entire organization. Therefore, any organization to be
effective, each manager throughout the organization must be aware of the plans made by
other managers. In order to plan reservations and ticket sales effectively, the reservation
manager for Zambezi Air Lines must know the flight schedules developed by the airline’s
route manager. The budget process pulls together the plans of each manager in an
organization.
In a nutshell, 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 to middle and lower level managers, and also to all employees.
Employees and lower level managers inform top-level managers how they can plan to
achieve the objectives.
Performance Evaluation or Framework for Judging Performance .Budgets are estimates

of future events, and as such they serve as estimates of acceptable performance. Comparing
actual result against budgeted results helps managers to evaluate the performance of
individuals, departments, or entire companies.

Budgets are generally a better basis for judging actual results than is past performance. The
major drawback of using historical results for judging current performance is that
inefficiencies may be concealed in the past performance.
Means of Allocating Resources. Because we live in a world of limited resources, virtually all
individuals and organizations must ration their resources. The rationing process is easier for
some than for other. Each person and each organization must compare the costs and benefits
of each potential project or activity and choose those that result in the most appropriate
resource allocation decision.
Generally, organizations resources are limited, and budgets provide one means of allocating
resources among competing uses. The city of Addis Ababa, for example, must allocate its
revenue among basic life services (such as police and fire protection), maintenance of
property and equipment (such as city streets, parks and vehicles) and other community
services (such as programs to prevent alcohol and drug abuse).
Legal and Contractual Requirements. Some organizations are required to budget because of
legal requirements. Others commit themselves to budgeting requirement when signing loan
agreements or other operating agreements. For example, a bank may require a firm to submit
an annual operating budget and monthly cash budget throughout the life of a bank loan.
Local police department, for example, would be out of funds if the department decided not to
submit a budget this year.
Cost Awareness. Accountants and financial managers are concerned daily about the cost
implications of decisions and activities, but many other managers are not. Production
managers focus on input, marketing manager’s focuses on sales, and so forth. It is easy for
people to overlook costs and cost-benefit relationships. At budgeting time, however, all

managers with budget responsibility must convert their plans for projects and activities to
costs and benefits. This cost awareness provides a common ground for communication
among the various functional areas of the organization.
1.4 COMPONENTS OF MASTER BUDGET
The master budget is the total budget package for an organization; it is the end product that
consists of all the individual budgets for each part of the organization aggregated into one
overall budget for the entire organization.
The two major components of master budget are the operating budget and the financial
budget.
Operating budget. It focuses on income statement and its supporting schedules. It is also
called profit plan. However, such budget may show a budgeted loss, or can be used to budget
expenses in an organization or agency with no sales revenues.
Financial budget. It focuses on the effects that the operating budget and other plans will
have on cash.
The usual master budget for a non-manufacturing company has the following components.
1. Operating budget includes: 2. Financial budget include:
a. Sales budget a. Capital budget
b. Purchases budget b. Cash budget
c. Cost of goods sold budget c. Budgeted balance sheets
d. Operating expense budget d. Budgeted statement of cash flows
In addition to the master budget there are countless forms of special budgets and related
reports. For example, a report might detail goals and objectives for improvements in quality
or customer satisfaction during the budget period.
Figure 1-1 Preparation of Master Budget (Non manufacturing Company)

Sales
Budget
Ending –inventory Purchase

Budget Budget
Operating Cost of Goods

Budget Sold Budget
Operating
Expenses Budget
Budgeted Statement
of Income
Financial
Budget
Capital Cash Budgeted
Budget Budget Balance Sheet
Exhibit 1-1 above show graphically the follow of process in development of the master
budget for a non-manufacturing firm. The master budget example that follows should clarify
the steps required to prepare the budget package. After studying the entire example, return to
Exhibit 1-1 and follow the example through the flow diagram.
1.5 OPERATING BUDGET
The operating budget is composed of the income statement elements. A manufacturing

business budgets both manufacturing and non-manufacturing activities. Below the various
elements of the operating budget of a manufacturing firm have been discussed.

Sales Budget: The sales budget is the first budget to be prepared. It is usually the most
important budget because so many other budgets are directly related to sales and are therefore
largely derived from the sales budget. Inventory budgets, purchases budgets, personnel budgets,
marketing budgets, administrative budgets, and other budget areas are all affected significantly
by the amount of revenue that is expected from sales.
Sales budgets are influenced by a wide variety of factors, including general economic
conditions, pricing decisions, competitor actions, industry conditions, and marketing programs.
In an effort to develop an accurate sales budget, firms employ many experts to assist in sales
forecasting.
The sales budget is usually based on a sales forecast. A sales forecast is a prediction of sales
under a given conditions. The objective in forecasting sales is to estimate the volume of sales for
the period based on all the factors, both internal and external to the business that could potentially
affect the level of sales. The projected level of sales is then combined with estimated of selling
prices to form the sales budget.
Sales forecasts are usually prepared under the direction of the top sales executive. Important
factors considered by sales forecasters include:
a) Past patterns of sales: Past experience combined with detailed past sales by product line,
geographical region, and type of customer can help predict future sales.
b) Estimates made by the sales force: A company’s sales force is often the best source of
information about the desires and plans of customers.

c) General economic conditions: Predictions for many economic indicators, such as gross
domestic product and industrial production indexes (local and foreign), are published regularly.
Knowledge of how sales relate to these indicators can aid sales forecasting.
d) Competitive actions: Sales depend on the strength and actions of competitors. To forecast
sales, a company should consider the likely strategies and reactions of competitors, such as
changes in their prices, products, or services.
f) Changes in the firm’s prices: Sales can be increased by decreasing prices and vice versa.
Planned changes in prices should consider effects on customer demand.
f) Changes in product mix: Changing the mix of products often can affect not only sales levels
but also overall contribution margin. Identifying the most profitable products and devising
methods to increases sales is a key part of successful management.
g) Market research studies: Some companies hire market experts to gather information about
market conditions and customer preferences. Such information is useful to managers making
sales forecasts and product mix decisions.
h) Advertising and sales promotion plans: Advertising and other promotional costs affect sales
levels. A sales forecast should be based on anticipated effects of promotional activities.
Purchases Budget: After sales are budgeted, prepare the purchases budget. The total
merchandise needed will be the sum of the desired ending inventory plus the amount needed to
fulfill budgeted sales demand. The total need will be partially met by the beginning inventory; the
remainder must come from planned purchases.

These purchases are computed as follows:
Budgeted Desired Cost of Beginning

Purchases = Ending inventory + Goods Sold - Inventory
Budgeted cost of goods sold: For a manufacturing firm cost of goods sold is the production cost
of products that are sold. Consequently, the cost of goods sold budget follows directly from the
production budget. However, a merchandising firm has no production budget. The cost of goods
sold budget comes directly from merchandise inventory and the merchandise purchases budget.
Operating Expense Budget: The budgeting of operating expenses depends on various

factors. Month – to – month fluctuation in sales volume and other cost-drivers activities
directly influence many operating expenses. Examples of expenses driven by sales volume
include sales commissions and many delivery expenses. Other expenses are not influenced by
sales or other cost-driver activity (such as rent, insurance, depreciation, and salaries) within
appropriate relevant ranges and are regarded as fixed.
Budgeted Income Statement: The budgeted income statement is the combination of all of
the preceding budgets. This budget shows the expected revenues and expenses from
operations during the budget period.
A firm may have budgeted non-operating items such as interest on investments or gain or
loss on the sale of fixed assets. Usually they are relatively small, although in large firms the
Dollar amounts can be sizable. If non-operating items are expected, they should be included
in the firm’s budgeted income statement. Income taxes are levied on actual, not budgeted, net
income, but the budget plan should include expected taxes; therefore, the last figure in the
budgeted income statement is budgeted after tax net income.

1.6 FINANCIAL BUDGET
The second major part of the master budget is the financial budget, which consists of the
capital budget, cash budget, ending balance sheet and the statement of changes in financial
position. Although there are some differences in operating budgets of manufacturing,
merchandising and service firms, very little difference exists among financial budgets of
these entities.
Capital expenditure budget: Capital budgeting is the planning of investments in major

resources like plant and equipment, and other types of long-term projects, such as employee
education programs. The capital expenditure budget or capital budget describes the capital
investment plans for an organization for the budget period. It contains some of the most
critical budgeting decisions of the organizations.
Cash budget: The cash budget is a statement of planned cash receipts and disbursements.
The cash budget is composed of four major sections:
i. The receipts section: It consists of a listing of all of the cash inflows, except for
financing, expected during the budget period. Generally the major source of
receipts will be from sales.
ii. The disbursement section: It consists of all cash payments that are planned for
the budget period. These payments will include inventory purchases, wages and
salary payments and so on. In addition, other cash disbursements such as
equipment purchases, dividends, and other cash withdrawals by owners are
listed.
iii. The cash excess or deficiency section: The cash excess or deficiency
section is computed as follows:

Cash balance, beginning xxx
Add receipts xxx
Total cash available before financing xxx
Less disbursements xxx
Excess (deficiency) of cash available over disbursements xxx
If there is a cash deficiency during any budget period, the company will need
to borrow funds. If there is cash excess during any budget period, funds
borrowed in previous periods can be repaid or the idle funds can be placed in
short-term or other investments.
iv. The financing section: This section provides a detail account of the
borrowing and repayments projected to take place during the budget
period. It also includes a detail of interest payments that will be due on
money borrowed.
Budgeted Balance Sheet: The budgeted balance sheet, sometimes called the budgeted
statement of financial position, is derived from the budgeted balance sheet at the beginning
of the budget period and the expected changes in the account balance reflected in the
operating budget, capital budget, and cash budget.
Budgeted Statement of Changes in Financial Position: The final element of the master
budget package is the statement of changes in financial position. It has emerged as a useful
tool for managers in the financial planning process. This statement is usually prepared from
data in the budgeted income statement and changes between the estimated balance sheet at

the beginning of the budget period and the budgeted balance sheet at the end of the budget
period.
1.7Preparing THE MASTER Budget
The master budget is a network consisting of many separate but interdependent budgets. This
network is illustrated in Exhibit 1-1. The master budget can be a large document even for a
small organization. The simple example that follows on the next page for Blue Nile
Company’s give some indication of the potential size and complexity of the master budget of
a business. The example illustrates a fixed or static budget prepared for a single expected
level of activity. Flexible budgeting that involves various activity levels will be discussed
later in the next unit.
PREPARATION OF MASTER BUDGET (Merchandising Company)

Example 1: Blue Nile Company’s newly hired accountant has persuaded management to prepare a master budget to aid financial
and operating decisions. The planning horizon is only three months, January to March. Sales in December (20x3) were $ 40, 000.
Monthly sales for the first four months of the next year (20x4) are forecasted as follows:
January $ 50, 000
February 80, 000
March 60, 000
April 50, 000
Normally 60% of sales are on cash and the remainders are credit sales. All credit sales are collected in the month following the
sales. Uncollectible accounts are negligible and are to be ignored.
Because deliveries from suppliers and customer demand are uncertain, at the end of any month Blue Nile wants to have a basic
inventory of $ 20, 000 plus 80% of the expected cost of goods to be sold in the following month. The cost of merchandise sold
averages 70%of sales. The purchase terms available to the company are net 30 days. Each month’s purchase are paid as follows:
50% during the month of purchase and,
50% during the month following the purchases.
Monthly expenses are:
Wages and commissions……………………………$ 2, 500 + 15%of sales, paid as incurred.
Rent expense………………………………………..$ 2, 000 paid as incurred.
Insurance expense…………………………………..$200 expiration per month.
Depreciation including truck……………………….$500 per month

Miscellaneous expense…………………………….5% of sales, paid as incurred.
In January, a used truck will be purchased for $ 3, 000 cash. The company wants a minimum cash balance of $ 10, 000 at the end
of each month. Blue Nile can borrow cash or repay loans in multiples of $ 1, 000. Management plans to borrow cash more than
necessary and to repay as promptly as possible. Assume that the borrowing takes place at the beginning, and repayment at the end
of the months in question. Interest is paid when the related loan is repaid. The interest rate is 18% per annum. The closing balance
sheet for the fiscal year just ended at December 31, 20x3,is:
Blue Nile Company
Balance Sheet
December 31, 20x3
ASSETS
Current assets:
Cash $ 10, 000
Account receivable 16,000
Merchandise inventory 48, 000
Unexpired insurance 1, 800 $75, 800
Plant assets:
Equipment, fixture and other $37, 000
Accumulated depreciation 12, 800 $24, 200
Total assets $100,000
LIABILITIES AND OWNERS’ EQUITY
Liabilities:
Accounts payable $16, 800
Accrued wages and commissions payable 4, 250 $21, 050
Capital:
Owners’ equity 78, 950
Total liabilities and owners’ equity $100, 000
Instructions:
1) Using the data given above, prepare the following detailed schedules for the first quarter of the year:
a) Sales budget
b) Cash collection budget
c) Purchase budget
d) Disbursement for purchases
e) Operating expenses budget
f) Disbursement for operating expenses
2) Using the budget data given above and the schedules you have prepared, construct the following pro forma financial statements
a. Income statement for the first quarter of the year.
b. Cash budget including receipts, payments, and effect of financing
c. Balance sheet at March 31, 20x3.

STEPS IN PREPARATION OF MASTER BUDGET
1. a) Sales budget
December* January February March Jan.-Mar.

Total
Cash sales (40%) $24, 000 $30, 000 $48, 000 $36, 000 $114, 000
Credit sales (60%) 16, 000 20, 000 32, 000 24,000 76, 000
Totals $40, 000 $50, 000 $80, 000 $60, 000 $190, 000
*December sales are included in the schedule (a) because they affect cash collected in January.
b) Cash collection budget
January February March

Cash sales of the month $30, 000 $48, 000 $36, 000
Credit sales of last month 16, 000 20, 000 32, 000
Total cash collected $46, 000 $68, 000 $68, 000
c) Purchase budget
January February March Jan.-Mar

Required ending inventory $64, 800 $53, 600 $48, 000
Cost of gods sold 35, 000 56, 000 42, 000 $133, 000
Total needed $99, 800 $109, 600 $90, 000
Beginning inventory 48, 000 64, 800 53, 600
Purchases budget $51, 800 $44, 800 $36, 400
d) Disbursement for purchases

50% of last month’s purchase $16, 800 $25, 900 $22, 400
50% of current month’s purchase 25, 900 22, 400 18, 200
Total disbursement for purchase $42, 700 $48, 300 $40, 600
e) Operating expense budget
January February March Jan.-Mar.

Wages and commissions $10, 000 $14, 500 $11, 500 $36, 000
Rent expense 2, 000 2, 000 2, 000 6, 000
Insurance expense 200 200 200 600
Depreciation expense 500 500 500 1, 500
Miscellaneous expense 2, 500 4, 000 3, 000 9, 500
Total $15, 200 $21, 200 $17, 200 $53, 600

f) Disbursement for operating expenses budget

Wages and commissions $14, 250 $14, 500 $11, 500
Rent expense 2, 000 2, 000 2, 000
Miscellaneous expense 2, 500 4, 000 3, 000
Total $18, 750 $20, 500 $16, 500
2. a) Budget income statement
Blue Nile Company

Budget Income Statement
For the Quarter Ended, March 31, 20x4
Sales (schedule 1(a)) $190, 000

Cost of goods sold (schedule 1(c)) 133, 000
Gross profit 57, 000
Operating expenses
Wages and commissions $36, 000
Rent expense 6, 000
Insurance expense 1, 500
Depreciation expense 600
Miscellaneous expense 9, 500 53, 600
Operating income 3, 400
Interest expense* 885
Net income $ 2, 515
*Interest expense computation

Paid interest = 11, 0000.183/12= 495
Accrued amount:
On the first batch borrowing:
8, 0000.183/12= 360
On the second batch borrowing:
1, 0000.182/12= 30
Total interest expense incurred $885

b) Cash budget including receipts, payments and effects of financing

Beginning balance $10, 000 $10, 550 $10, 750
Collections (Schedule1 (b)) 46, 000 68, 000 68, 000
Cash available for the use (x) $56, 000 $78, 550 $78, 750
Cash disbursements for:
Purchases (Schedule 1(d)) 42, 700 48, 300 40, 600
Operating expenses (Schedule1 (f)) 18, 750 20, 500 16, 500
Truck purchases 3, 000 - -
Total disbursement (y) $64, 450 $68, 800 $57, 100
Minimum cash balance required 10, 000 10, 000 10, 000
Total cash needed $74, 450 $78, 800 $67, 100
Cash excess (deficiency) $(18, 450) $( 250) $11, 650
Effects of financing
Borrowing 19, 000 1, 000 -
Payment of the principal - - (11, 000)
Payment of interest - - (495)
Net effect of financing (z) $19, 000 $1, 000 $(11, 495)
End cash balance (x+z-y) $10, 550 $10, 750 $10, 155
c) Budgeted balance sheet
Blue Nile Company

Budgeted Balance Sheet
March 31, 20x4
ASSETS
Current assets
Cash $ 10, 155
Accounts receivable 24, 000
Merchandise inventory 48, 000
Unexpired insurance 1, 200 $ 83, 355
Plant assets
Equipment, Fixture and others 40, 000
Accumulated depreciation 14, 300 25, 700
Total assets $ 109, 055
LIABILITIES AND OWNER’S EQUITY
Liabilities
Accounts payable $18, 200
Loan payable 9, 000
Interest payable 390
Total liabilities $27, 590
Capital
Beginning owners’ equity $78, 950
Net income 2, 515
Ending capital balance 81, 465
Total equities $109, 055

PREPARATION OF MASTER BUDGET (Manufacturing Company)
Example (2) Great Company manufactures and sells a product whose peak sales occur in the third quarter. Management is now
preparing detailed budgets for 20x4- the coming year and has assembled the following information to assist in the budget
preparation:
1) The company’s product selling price is $ 20 per unit. The marketing department has estimated sales as follows for the
next six quarters.
20x4 Quarters 20x5 Quarters
1 2 3 4 1 2
Budgeted sales in units 10, 000 30,000 40, 000 20, 000 15, 000 15, 000
2) Sales are collected in the following pattern: 70% of sales are collected in the quarter in which the sales are made and
the remaining 30% are collected in the following quarter. On January1, 20x4, the company’s balance sheet showed
$90, 000 in account receivable, all of which will be collected in the first quarter of the year. Bad debts are negligible
and can be ignored.
3) The company maintains an ending inventory of finished units equal to 20% of the next quarter’s sales. The
requirement was met on December 31, 20x3, in that the company had 2, 000 units on hand to start the new year.
4) Fifteen pounds of raw materials are needed to complete one unit of product. The company requires an ending
inventory of raw materials on hand at the end of each quarter equal to 10% of the following quarter’s production
needs of raw materials. This requirement was met on December 31, 20x3 in that the company had 21, 000 pounds of
raw materials to start the new year.
5) The raw material costs $0.20 per pound. Raw material purchases are paid for in the following pattern: 50% paid in
the quarter the purchases are made, and the remainder is paid in the following quarter. On January 1,20x4, the
company’s balance sheet showed $25, 800 in accounts payable for raw material purchases, all of which be paid for in
the first quarter of the year.
6) Each unit of Great’s product requires 0.8 hour of labor time. Estimated direct labor cost per hour is $7.50.
7) Variable overhead is allocated to production using labor hours as the allocation base as follows:
Indirect materials $0.40
Indirect labor 0.75
Fringe benefits 0.25
Payroll taxes 0.10

Utilities 0.15
Maintenance 0.35
Fixed overhead for each quarter was budgeted at $ 60, 600. Of the fixed overhead amount,
$ 15, 000 each quarter is depreciation. Overhead expenses are paid as incurred.
8) The company’s quarterly budgeted fixed selling and administrative expenses are as follows:
20X4 Quarters
1 2 3 4
Advertising $20, 000 $20, 000 $20, 000 $20, 000
Executive salaries 55, 000 55, 000 55, 000 55, 000
Insurance - 1, 900 37,750 -
Property taxes - - - 18, 150
Depreciation 10, 000 10, 000 10, 000 10, 000
The only variable selling and administrative expense, sales commission, is budgeted at $1.80 per unit of the budgeted
sales. All selling and administrative expenses are paid during the quarter, in cash, with exception of depreciation. New
equipment purchases will be made during each quarter of the budget year for $ 50, 000, $ 40, 000, & $20, 000 each for
the last two quarter in cash, respectively. The company declares and pays dividends of $8, 000 cash each quarter. The
company’s balance sheet at December 31, 20x3 is presented below:

ASSETS
Current assets:
Cash $ 42, 500
Accounts Receivable 90, 000
Raw Materials Inventory (21, 000 pounds) 4, 200
Finished Goods Inventory (2, 000 units) 26, 000
Total current assets $162, 7 00
Plant and Equipment:
Land $80, 000
Building and Equipment 700, 000
Accumulated Depreciation (292, 000)
Plant and Equipment, net 488, 000
Total assets $650, 700
LIABILTIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable (raw materials) $25, 800
Stockholders’ equity:
Common stock, no par $175, 000
Retained earnings 449, 900
Total stockholders’ equity 624, 900
Total liabilities and stockholders’ equity $650, 700
The company can borrow money from its bank at 10% annual interest. All borrowing must be done at the beginning of a
quarter, and repayments must be made at the end of a quarter. All borrowings and all repayments are in multiples of $ 1,000.
The company requires a minimum cash balance of $40, 000 at the end of each quarter. Interest is computed and paid on the
principal being repaid only at the time of repayment of principal. The company whishes to use any excess cash to pay loans
off as rapidly as possible.
Instructions: Prepare a master budget for the four-quarter period ending December 31. Include the following detailed budget and
schedules:
1. a) A sales budget, by quarter and in total
b) A schedule of budgeted cash collections, by quarter and in total
c) A production budget
d) A direct materials purchase budget
e) A schedule of budgeted cash payments for purchases by quarter and in total

f) A direct labor budget
g) A manufacturing overhead budget
h) Ending finished goods inventory budget
i) A selling and administrative budget
2. A cash budget, by quarter and in total
3. A budgeted income statement for the four- quarter ending December 31, 20x4
4. A budgeted balance sheet as of December 31, 20x4.
1. a) Sales Budget
Quarter
1 2 3 4
Expected sales in units 10, 000 30, 000 40, 000 20, 000
Selling price per unit x $ 20 x $ 20 x $20 x $20
Total sales $200, 000 $600, 000 $800, 000 $400, 000
b) Schedule of Expected Cash Collections
Quarter
1 2 3 4 Total
30% of the previous quarter sales $ 90, 000 $60, 000 $180, 000 $240, 000 $570, 000
70% of the current quarter sales 140, 000 420, 000 560, 000 280, 000 1, 400, 000
Total collections $230, 000 $480, 000 $740, 000 $ 520, 000 $1, 970, 000
c) Production Budget
After the sales budget has been prepared, the production requirements for the forth-coming budget period can be determined and
organized in the form of a production budget. Sufficient goods will have to be available to meet sales and provide for the desired
ending inventory. A portion of these goods will already exist in the form of a beginning inventory. The remainder will have to be
produced. Therefore, production needs can be determined as follows:
Budgeted sales in units ………………………………………… xxxx
Add desired ending inventory……………….…………………. xxxx
Total needs……………………………………………………… xxxx
Less beginning inventory……………………………………….. xxxx
Required production……………………………………………. .xxxx

The schedule given below shows the production budget for Great Company. Note that the desired level of the ending
inventory influences production requirements for a quarter. Inventories should be carefully planned. Excessive inventories tie
up funds and create storage problems. Insufficient inventories can lead to lost sales or crash production efforts in the following
period
Quarter Total
Expected sales(units) 10, 000 30, 000 40, 000 20, 000 100, 000
Add: Desired Ending Inventory 6, 000 8, 000 4, 000 3, 000 3, 000
Total needs 16, 000 38, 000 44, 000 23, 000 103, 000
Lees: Beginning Inventory 2, 000 6, 000 8, 000 4, 000 2, 000
Units to be produced 14, 000 32,000 36, 000 19, 000 101, 000
1 2 3 4
d) Direct Materials Budget

Returning to Great Company’s budget data, after the production requirements have been computed, a direct materials budget can be
prepared. The direct materials budget details the raw materials that must be purchased to fulfill the production budget and to provide for
adequate inventories. The required purchases of raw materials are computed as follows:
Raw materials needed to meet the production schedule…………………………….xxxx

Add desired ending inventory of raw materials……………….……………………..xxxx
Total raw materials needs…………………………………………………… .xxxx
Less beginning inventory of raw materials………………………….………… xxxx
Raw materials to be purchased………………………………………………………. .xxxx
Quarter Total
1 2 3 4
Production needs(pounds) 210, 000 480, 000 540, 000 285, 000 1, 515, 000
Add: Desired ending inventory 48, 000 54, 000 28, 500 22, 500 22, 500
Total needs 258, 000 534, 000 568, 500 307, 500 1, 537, 500
Less: Beginning inventory 21, 000 48, 000 54, 000 28, 500 21, 000
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516,500
purchased(pounds)
Raw Materials to be purchased (in Dollars)

1 2 3 4 Total
Raw materials to be purchased 237, 000 486, 000 514, 500 279, 000 1, 516, 500
Raw materials cost per pound x $0.20 x $0.20 x $0.20 x $0.20 x $0.20
Total $47, 400 $97, 200 $102, 900 $55, 800 $303, 300

e) Schedule of Expected Cash Disbursements (for Materials Purchase)
Quarter Total
1 2 3 4
50% of the previous quarter $ 25, 800 $23, 700 $48, 600 $51, 450 $149, 550
50% of the current quarter 23, 700 48, 600 51, 450 27, 900 151, 650
Total cash disbursement $49, 500 $72, 300 $101, 050 $79, 350 $301, 200
f) Direct Labor Budget

The direct labor budget is also developed from the production budget. Direct labor requirements must be computed so that the company
will know whether sufficient labor time is available to meet production needs. By knowing in advance just what will be needed in the
way of labor time throughout the budget year, the company can develop plans to adjust the labor force as the situation may require.
Firms that neglect to budget run the risk of facing labor shortage or having to hire and lay off at awkward times. Erratic labor policies
lead to insecurity and inefficiencies on the part of employees.
To compute direct labor requirements, the number of units of finished product to be produced each produced each period (month,
quarter, and so on) is multiplied by the number of direct labor-hours required to produced a single unit. Many different types of labor
may be involved. If so, then the computation should be by type of labor needed. The labor requirements can then be translated into
expected direct labor costs. How this is done will depend on the labor policy of the firm. In schedule given below, the management of
Great Company has assumed that the direct labor force will be adjusted as the work requirement change from quarter to quarter (for
example as units produced changes from l4, 000 units in quarter 1 to 32, 000 units in quarter 2 for Great Company, the direct labor
work force will be fully adjusted to the workload, i.e., total hours of direct labor time needed) . In that case, the total direct labor cost is
computed by simply multiplying the direct labor-hour required by the direct labor rate hour as was done in the schedule here under.
Quarter Total
1 2 3 4
Direct labor time needed 11, 200 25, 600 28, 800 15, 200 80, 800
Direct labor cost per hour x $7.50 x $7.50 x $7.50 x $7.50 x $7.50
Total direct labor cost $84, 000 $192, 000 $216, 000 $114, 000 $606, 000
g) Manufacturing Overhead (MOH) Budget

The manufacturing overhead budget provides a schedule of all costs of production other than direct materials and direct labor.
These costs should be $oken down by cost behavior for budgeting purposes and a predetermined overhead rate developed.
This rate will be used to apply manufacturing overhead to units of product throughout the budget period.

A computation showing budgeted cash disbursement for manufacturing overhead should be made for use in developing the cash
budget. Since some of the overhead costs do not represents cash outflows, the total budgeted manufacturing overhead costs
must be adjusted the determine the cash disbursement for manufacturing overhead. At Great Company, the only significant
noncash manufacturing overhead cost is depreciation. Any depreciation charges included in manufacturing overhead must be
deducted from the total in computing expected cash payments, since depreciation is a noncash charge.
Quarter Total
1 2 3 4
Variable overhead $22, 400 $51, 200 $57, 600 $30, 400 $161,600
Fixed overhead 60, 600 60, 600 60, 600 60, 600 242,400
Total MOH $83, 000 $111, 800 $118, 200 $91, 000 $404,000
Less: Depreciation 15, 000 15, 000 15, 000 15, 000 60, 000
Cash disbursements for MOH $68, 000 $96, 800 $103, 200 $76, 000 $344, 000
h) Ending Finished Goods Inventory Budget

After completing schedules (a) to (g), the company had all of the data needed to compute unit product costs. This computation
was needed for two reasons: first, to know how much to charge as cost of goods sold on the budgeted income statement; and
second, to know what amount to put on the balance sheet inventory account for unsold units. The carrying cost of the unsold
units is computed on the ending finished goods inventory budget
Budgeted Finished Goods Inventory 3, 000
Unit product cost $13
Ending Finished Goods Inventory in Dollars $39, 000
Production cost per unit

Quantity (unit) Cost Total
Direct materials 15 pounds $0.20 per pound $3
Direct labor 0.8 hours 7.50 per hour 6
Manufacturing overhead 0.8 hours 5.00 per hour 4
Unit product cost $13
MOH rate= Total MOH = 404, 000 = $5.00
Direct labor hours 80, 800

i) Selling and Administrative Expenses Budget
Quarter Total
1 2 3 4
Variable selling expenses $18, 000 $54, 000 $72, 000 $36, 000 $180, 000
Fixed selling & administrative
expenses
Advertising 20, 000 20, 000 20, 000 20, 000 80, 000
Executive salaries 55, 000 55, 000 55, 000 55, 000 220, 000
Insurance - 1, 900 37, 750 - 39, 650
Property taxes - - - 18,150 18,150
Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total budgeted selling & $103, 000 $140, 900 $194, 750 $139, 150 $577, 800
administrative expenses
Disbursement for Selling & Administrative Expenses

Quarter Total
1 2 3 4
Budgeted Selling & Administrative $103, 000 $140, 900 $194, 750 $139, 150 $577, 800
Less: Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total Cash Disbursements $93, 000 $130, 900 $184, 750 $129, 150 $537, 800
2. a) Cash Budget
Quarter Total
1 2 3 4
Cash balance, beginning $42, 500 $40, 000 $40, 000 $40, 500 $42, 500
Add : Collection from customers 230, 000 480, 000 740, 000 520, 000 1, 970, 000
Total cash available before financing 272, 500 520, 000 780, 000 560, 500 2, 012, 500
Less: Disbursements for
Direct materials 49, 500 72, 300 100,050 79, 350 301,200
Direct labor 84, 000 192, 000 216,000 114, 000 606,000
Manufacturing overhead 68, 000 96, 800 103,200 76, 000 344,000
Selling & Administrative 93, 000 130, 900 184,750 129, 150 537,800
Equipment purchases 50, 000 40, 000 20,000 20,000 130,000
Dividend 8, 000 8, 000 8, 000 8, 000 32,000
Total disbursements 352, 500 540,000 632,000 426,500 1,951,000
Minimum cash balance 40, 000 40, 000 40, 000 40, 000 40, 000
Total need 392, 500 580, 000 672, 000 466, 500 1, 991,000
Excess (deficiency) of cash available (120, 000) (60, 000) 108, 000 94, 000 21, 500
over total need
Financing:
Borrowing(at beginning) 120,000 60, 000 - - 180, 000
Repayments( at ending) - - (100, 000) (80,000) (180,000)
Interest(at 10% per annum) - - (7,500) (6,500) (14,000)
Total financing 120, 000 60, 000 (107,500) (86,500) (14,000)
Cash balance, ending $40,000 $40, 000 $40, 500 $47, 500 $47, 500

b) Budgeted Income Statement
Great Company
Budgeted Income Statement
For the Year Ended December31, 20x4
Sales [100, 000units at $20 Schedule 1(a)] $2, 000, 000

Cost of Goods Sold [100, 000 units at $13 Schedule1 (h)] 1, 300, 000
Gross Margin 700, 000
Selling & Administrative Expenses [Schedule 1 (i)] 577, 800
Net Operating Income 122, 200
Interest Expense [Schedule 2(a)] 14, 000
Net Income $ 108, 200
c) Budgeted Balance Sheet

Great Company
Budgeted Balance Sheet
December31, 20x4
ASSETS
Current assets:
Cash [ Schedule 2(a)] $ 47, 500
Accounts Receivable 120, 000
Raw Materials Inventory 4, 500
Finished Goods Inventory 39, 000
Total current assets $211, 000
Plant and Equipment:

Land $80, 000
Building and Equipment 830, 000
Accumulated Depreciation (392, 000)
Plant and Equipment, net 518, 000
Total assets $729, 000
LIABILTIES AND STOCKHOLDERS’ EQUITY

Current liabilities:
Accounts payable (raw materials) $27, 900
Stockholders’ equity:
Common stock, no par $175, 000
Retained earnings 526, 100
Total stockholders’ equity 701, 100
Total liabilities and stockholders’ equity $729, 000

Chapter II. FLEXIBLE BUDGETS
Learning Objectives:
 distinguish between flexible budgets and master (static) budget
 understand the performance evaluation relationship between master (static) budgets and flexible
budgets
 compute flexible-budget variance and sales activity variance.
As we have seen in Chapter I, formal budgeting procedures result in comprehensive operational and financial
plans for future periods. These budgets guide managers and employees as they make their daily decisions
and as they try to anticipate future problems and opportunities.
2.1 Master Budget Vs Flexible Budget
All master budgets discussed in the previous chapter are static or inflexible because they assume fixed level
of activity. A master budget or static budget is prepared for only one activity level (for example one volume
of sales activity).
This chapter introduces flexible budgets, which are budgets designed to direct management to areas of
actual financial performance that desire attention. Managers can apply this same basic process to control
important areas of performance such as quality or customer service.
Example (1): Evergreen Company prepares a budget based on detailed expectation for the forthcoming
month. Evergreen Company’s plan tailored to a single sales level, i.e., 9,000 units. However, sales volume
units turned out to be only 7, 000 units instead of the original 9, 000 units. Compute the master budget
variance for each item given below. Exhibit 2-1 Evergreen Company Performance Report
Master Budget
Particulars Actual Master Budget
Variances
Units 7,000 units 9,000 units 2,000 units U
Sales $ 217,000 $ 279,000 $ 62,000 U
Variable Expenses
* Manufacturing $ 151,270 $ 189,000 $ 37,730 F
* Selling 5,000 5,400 400 F
* Administrative 2,000 1,800 200 U
Total Variable Expense $ 158,270 $ 196,200 $ 37,930 F
Contribution Margin $ 58,730 $ 82,800 $ 24,070 U
Fixed Expenses
* Manufacturing $ 37,300 $ 37,000 300 U
*Selling & Administrative 33,000 33,000 ---
Total Fixed Expenses $ 70,300 $ 70,000 300 U
Operating Income (Loss) $ (11,570) $ 12,800 $ 24,370 U

N.B. Master budget variance (static budget variance) is the variance of actual result from the master
budget.
It is customary to label variances favorable (F) or unfavorable (U). The label indicates whether the target or
the actual figure is larger. The way in which labels are applied depends on the item for which a variance is
computed. If the item for which the variance is computed is a revenue or profit item, favorable variances are
those for which actual is greater than the target; unfavorable variances are those for which actual is less than
the target (or the budget).
If the item for which the variance is computed is a cost or expense item, favorable variances are those for
which actual is less than the target. Therefore, if actual cost is greater than target cost, the variance will be
labeled unfavorable.
2.2 Flexible Budget (Dynamic Budget)
Actual activity may differ significantly from budgeted activity because of an unexpected labor strike,
cancellation of an order, an unexpected large new production contract, and other factors. When actual results
differ considerably from plans, a fixed or static budget may not be particularly effective in supporting
managers. In such cases several budgets prepared for a variety of activity levels may be more useful.
In contrast to the performance report based only on comparing the master budget to the actual results, a more
useful benchmark for analysis is the flexible budget. A flexible budget (sometimes called a variable budget)
is budget that can easily be adjusted for differences in the level of activity. It provides managers more useful
information for planning and better basis for comparing performance than, a static or fixed budget.
In performance evaluation, a master budget is kept fixed or static to serve as a benchmark for evaluating
performance. It shows revenues and costs at only the originally planned levels of activity. However, a
flexible budget will be prepared at the actual activity level.
The flexible budget is identical to the master budget in format, but managers may prepare it for any level of
activity.

2.2.1 Distinguishing Features of Flexible Budget
Flexible budgets have several desirable characteristics. They:
i. Cover a range of activity
ii. Are dynamic
iii. Facilitate performance measurement.
Flexible Budget Cover a Range of Activity. Accurate predictions of activity levels are sometimes hard to
make, and many managers find they make more effective decisions with the aid of flexible budgets. In
developing a flexible budget one activity level at each extreme of the relevant range is selected, with one or
more in between.
Flexible Budget Are Dynamic. Flexible budgets allow managers to adjust plans easily when activity level
differs from the expected level. Such budgets address “what is” rather than “what was” or “what was
expected”. This dynamic nature of flexible budget makes them a very useful decision making tool for
management.
Flexible Budget Facilitate Performance Measurement. Measuring efficiency is an important role of

performance report. Fixed budgets are useful for measuring effectiveness, i.e., achievement of goal. In some
cases, however, fixed budgets do not identify the question, “what should the result be, given the actual level
of activity”. In other words, the flexible-budget approach says, “Give me any activity level you choose, and
I’ll provide a budget tailored to that particular level.” To summarize, whenever actual and budgeted activity
are significantly different, a flexible budget variance report provides a better measure of efficiency than a
report based on a fixed budget.
2.2.2 Flexible Budgeting Process

The following steps are needed to develop a flexible budget.
i. Determine the range of activity the budget should cover (because cost behavior patterns may
be different in different ranges of activity)
ii. Determine the cost behavior pattern for each cost included in the budget.
iii. Select the activity levels for which budgets will be prepared.
iv. Prepared a flexible budget using the cost behavior data and the selected activity level.

Example (2): Evergreen Company is planning to use a flexible budgeting system to plan and control its
operations. Evergreen made the following cost estimates for budgeting purposes:
Budget Formula Per Unit
Sales $ 31.00
Variable Costs
* Manufacturing $ 21.00
* Selling 0.60
* Administrative 0.20
Total Variable Costs $ 21.80
Contribution Margin $ 9.20
Budget Formula Per Month
Fixed Costs
* Manufacturing $ 37,000
* Selling and administrative 33,000

Total fixed costs $ 70,000
Instruction: Prepared a flexible budget for the next month using 7,000, 8,000, and 9,000 units as activity
level. Evergreen Company’s cost functions or flexible budget formulas are believed to be valid
within the range of 7,000 to 9,000 units. At what level of activity does the company breakeven?
Exhibit 2.2 Evergreen Co. Flexible Budget
Flexible Budgets For Various Activity Levels
7,000 units 8,000 units 9,000 units
Sales $ 217,000 $ 248,000 $ 279,000
Variable Costs
* Manufacturing $ 147,000 $ 168,000 $ 189,000
* Selling 4,200 4,800 5,400
* Administrative 1,400 1,600 1,800
Total Variable Costs $ 152,600 $ 174,400 $ 196,200
Contribution margin $ 64,400 $ 73,600 $ 82,800
Fixed costs
* Manufacturing $ 37,000 $ 37,000 $ 37,000
* Selling and administrative 33,000 33,000 33,000
Total fixed costs $ 70,000 $ 70,000 $ 70,000
Operating income (loss) $ (5,600) $ 3,600 B. 12,800
BEP (in units) = Total fixed costs = $70, 000

Unit Contribution Margin 31-21.8
= 7609 units(approximation)
BEP (in Dollars) = Total fixed costs =$70, 000 =$235,873(approximation)

CM-ratio 9.2/31

Comparing the flexible budget to actual results accomplishes an important performance evaluation purpose.
There are basically two reasons why actual results might not have conformed to the master budget:
i. Sales and other cost-driver activities were not the same as originally forecasted.
ii. Revenues or variable costs per unit and fixed costs per period were not as expected.
Flexible Budget Variances: Any variances between the flexible budget and actual results can not b due to
activity levels. These variances between the flexible budget and actual results are called flexible budget
variances and must be due to departure of actual costs or revenues from flexible-budget formula amounts.
Activity level variances: Any differences or variances between the master budget and the flexible budget
are due to activity levels. These differences are called activity-level variances.
The sum of the activity level variances and the flexible budget variances equal the total of the master
budget variances.
Example (3): Refer the data given in example (1) and (2). Prepare a condensed table showing the static
(master) budget variance, the sales activity variance, and the flexible-budget variance.
Exhibit 2.3 Evergreen Co. Summary of Performance
Flexible Sales
Actual Flexible Master
Budget Activity
Results Budget Budget
Variance Variances
Units 7,000 7,000 9,000 - 2,000 U
Sales $ 217,000 $ 217,000 $ 279,000 - $ 62,000 U
Variable costs 158,270 152,600 196,200 $ 5,670 U 43,600 F
Contribution margin $ 58,730 $ 64,400 $ 82,800 $ 5,670 U $ 18,400 U
Fixed Costs 70,300 70,000 70,000 300 U -
Operating Income (loss) $ (11,570) $ (5,600) $ 12,800 $ 5,970 U $ 18,400 U
*U or F indicates whether the variances are unfavorable or favorable, respectively.

Total master budget variance (TMBV) = ALF + FBV
where TMBV = Total Master Budget Variance
ALF = Activity Level Variance
FBV = Flexible Budget Variance
Thus, the total master budget variance for Evergreen Co. amounts to $ 24,370 unfavorable ($ 5970 U + $
18400 U). The sum of the activity-level variances here equals sales-activity variances because sales are the
only activity used as a cost driver.
Managers use comparisons between actual results, master budgets, and flexible budgets to evaluate
organizational performance. When evaluating performance, it is useful to distinguish between effectiveness-

the degrees to which a goal, objective, or target is met- and efficiency-the degree to which inputs are used in
relation to a given level of outputs.
Performance may be effective, efficient, both, or neither. For example, Evergreen Co. set a master budget
objective of manufacturing and selling 9,000 units. Only 7,000 units were actually made and sold, however.
Performance, as measured by sales-activity variances, was ineffective because the sales objective was not
met.
Was Evergreen’s performance efficient? Managers judge the degree of efficiency by comparing actual
outputs achieved (7,000 units) with actual inputs (such as the cost of direct materials and direct labor). The
less input used to produce a given output, the more efficient the operation. Evergreen was in efficient in its
use of a number of inputs. Later in this Chapter, direct material, direct labor and variable and fixed overhead
flexible-budget variances will be discussed in detail.
Flexible-budget variances measure the efficiency of operations at the actual level of activity. The flexible-
budget variances shown in column (4) of Exhibit 2.3 total $ 5,970 unfavorable. The total flexible-budget
variance arises from sales prices received and the variable and fixed costs incurred. Evergreen Co. had no
difference between actual sales price and the flexible-budgeted sales price, so the focus is on the differences
between actual costs and flexible-budgeted costs at actual 7,000-unit level of activity.
Sales-activity variances measure how effective managers have been in meeting the planned sales objective.
In Evergreen Co., sales activity fell 2,000 units short of the planned level. The sales-activity variances
(totaling $ 18,400 U) are unaffected by any changes in unit prices or variable costs. Why? Because the same
budgeted unit prices and variable costs are used in constructing both the flexible and master budgets.
Therefore, all unit prices and variable costs are held constant in columns (2) and (3) of Exhibit 2.3

Chapter III. Standard Cost and Variance Analysis
 explain the nature of standard costs.
 describe the types and purposes of standard costs.
 compute the direct materials price and quantity variances and explain their significance.
 compute the direct labor rate and efficiency variances and explain their significance.
 compute the manufacturing overhead variances.
3.1 Introduction
Many companies for planning and controlling operations use standard cost accounting systems. Standards
are useful in detailed planning, cost control, performance measurement, and pricing decisions.
Standard Costs Defined. Standard costs are carefully predetermined costs created by management and used
as a basis for comparison with actual costs. Like all standards, standard costs are measure of achievement.
Consequently, managers must use care to ensure that the standards are appropriate measures of performance
that encourage attainment of organizational goals.
Types of standards. Different firms may fix different standards and the same firm may adopt different
standards at different points of time. This difference in standards arises due to the variation in circumstances
or conditions under which standards are fixed. On the basis of circumstances, the standards may be
classified as under:
Ideal standard: A standard is said to be an ideal if it is based on ideal conditions of work. It reflects the
most optimistic expectations of management. Ideal standards (also called perfection standards) can be
achieved only with perfect operating conditions. It pre-supposes most favorable conditions of work and
rules out any possibility of loss arising out of abnormal conditions such as break-down of machines, failure
of power, employee error, labor strikes, changes in government policy, defective raw material, inventory
shortage, etc. In $ief, it assumes no production problems of any sort. Some managers believe that perfection
(or ideal) standards motivate employees to achieve the lowest cost possible. They claim that since the

standard is theoretically attainable, employees will have an incentive to come as close as possible to
achieving it.
Other managers and many behavioral scientists disagree. They feel that ideal standards discourage
employees, since they are so unlikely to be attained. Moreover, setting unrealistically difficult standards
may encourage employees to sacrifice product quality to achieve lower cost.
Basic standard: It is a fixed standard that provide a framework for comparing performance over a period of
years. They are sometimes called long-range standards because once created, they are used for several years
or longer. Since a basic standard remains unchanged, it does not suggest, “what the cost for the year ought to
be?” Therefore, it cannot be used for valid comparisons as rapidly rising resource costs and charging
production technology often make basic standards difficult to use. As a result, not many firms use basic
standards.
Normal standard: Normal standards can also be termed as historical standards as it is based on the average
performance in the past years. It can be fairly a satisfactory standard if the performance in the past has been
fairly stable. In case of constantly improving efficiency or erratic performance, the normal standards will
fail to serve the purpose. It suffers from all the defects of an arithmetic average based on a series of items
that include few extreme items.
Attainable standard: It is one that can be attained under the conditions and circumstances prevailing within
the organization. Currently attainable standards are the most commonly used standards. They represent
benchmarks for efficient production in the current environment. Currently attainable standards are not as
stringent as ideal standards because they allow for normal production problems, such as equipment
maintenance, downtime, random employee errors, and occasional inventory shortages. Still, currently
attainable standards represent desirable information. Currently attainable standards are also called practical
standards.
Are Standards the Same As Budgets?
Standards and budgets are very similar. The major distinction between the two terms is that a standard is a
unit amount, whereas a budget is a total amount. Suppose that the standard cost for materials is $ 12 per unit
and 1,000 units are to be manufactured during a budget period, then the budgeted cost of materials would be
$ 12,000 ($ 12 x 1,000). In effect, a standard can be viewed as the budgeted cost for one unit of product.

3.2 Purpose of Standard Costs
Cost information may be used for many different purposes. It should be noted that cost information that
serves one purpose might not be appropriate for another. Therefore, the purpose for which cost information
is to be used should be clearly defined before procedures are developed to accumulate cost data. Standard
costs may be used for the following purposes:
Cost control: Monitoring and controlling the cost of production, marketing, and administrative activities are
among the primary functions of managers. Cost control is not merely the minimization of costs; it is
identifying costs with their benefits and ensuring that the costs are justified, given the benefits derived.
Standard costs provide a useful framework for cost control.
Typically, standards are expressed in terms of one unit of output. When standards are expressed in terms of
a single unit of output, they can be used to measure cost with standard costs as frequently as desired –
monthly, weekly, daily, or for each work shift. As long as production output can be measured and actual
cost accumulated, cost performance can be measured.
Product pricing: The selling price of a unit and the cost per unit are usually closely related. The cost data
are readily available under standard costing system and the price can be quoted on the basis of standard costs
without fear of under or over pricing. Standard cost is the predetermined normal cost of normal output and
as such forms basis for price fixation.
Estimating budgets: Standard costs and budgets are similar, because they both represent planned costs for a
specific period. Standard costs are very useful when developing a budget, since they form the building
blocks of a total cost goal (or budget). Budgets, in effect, are standard costs multiplied by the volume or
activity level expected.
Performance appraisal: Employee performance evaluation is a difficult task involving many different
variables, some of which are subjective and therefore difficult to use in comparing employees. When
standards are established for performance evaluation, they provide tangible measures that can be applied
uniformly to all personnel. For example, the standard labor time for performing various production activities
may be used to evaluate the efficiency of employees. Similarly, production department supervisors may be
evaluated on how close their department came to achieving standards. Standards can be effective in

performance evaluation if employees have a clear understanding of the standards and the way they are used.
In addition, employees must be given timely reports evaluating their performance. The timely reports are
possible because the standards are readily available for quick comparison and reporting.
Simplify performance reports. The performance reports presented in the form of variance analysis are
simple to understand as they clearly distinguish between favorable and unfavorable variances. The busy top
management can concentrate on significance variances and take appropriate action in the matter.
Record Keeping: Detailed record keeping may be reduced when standard costs are used in conjunction
with actual costs. For example, when materials are kept at standard cost, the materials ledgers need only
keep tack of quantities.
Cost awareness: Accountants and financial managers are aware of the costs associated with the activities of
the business, because they deal with them daily. Many other employees, however, have little or no
awareness of costs. They may be concerned with increasing daily production, improving employee morale,
and improving production efficiency, all of which have an impact on costs, but many employees do not
understand the cost consequences of these activities. Standard costs and standard cost performance reports
inform employees about the cost implications of their actions. Such cost awareness may result in better
employee efforts at cost control.
3.3 The Standard Cost System
Three fundamental activities in a standard cost system are:
 Standard setting.
 Accumulation of actual costs.
 Variance analysis.
Standard setting: The first step in a standard cost system is the creation of the standards to be used as a
basis for measuring performance. Standard setting is an important activity because poorly conceived
standards result in inappropriate measures of performance. Standard setting is not a one – time activity. As
resource costs and production methods change, revision of the standard is necessary. In many firms
standards are evaluated on a regular basis, such as annually or every 6 months.
Management accountants typically use two methods for setting standards: analysis of historical data and task
analysis.

Historical data: Often the immediate past is the best indicator of the near future. Firms that have been
producing the same product using the same production technology for a number of years may base their
standards on their historical experience. They may use various cost estimation techniques to determine the
past relationship between in put usage and output produced or between input purchases and input prices.
The past relationships and prices are then used as standards. However, the management accountant often will
need to adjust these predictions to reflect movements in price levels or technological changes in the
production process.
Task analysis: Another way to set cost standards is to analyze the process of manufacturing a product to
determine what it should cost. The emphasis shifts from what the product did cost in the past to what it
should cost in the future. In using task analysis, the management accountant typically works with engineers
who are intimately familiar with the production process. Together they conduct studies to determine how
much direct material should be required and how machinery should be used in the production process. Time
and motion studies are conducted to determine how long each step performed by direct laborers should take.
Accumulation of actual costs: A standard cost system does not eliminate the need for accumulating actual
production costs. Actual costs are compared with standard costs to determine variances. In manufacturing,
actual costs are accumulated in a job order or a process costing system. With nonmanufacturing activities,
actual costs are also accumulated and compared with standards established for nonmanufacturing activities.
Variance analysis: A variance occurs when actual costs differ from standard costs. Variances are expressed
in total Dollar amounts and separated into specific classifications to facilitate cost analysis and control.
Variance analysis is a systematic process of identifying variances and reporting them to management.
3.3.1 Setting the Standards

As discussed earlier, an integral part of any standard cost system is the setting of standards. Establishment of
standards for direct materials and direct labor will be presented here under, along with variance analysis to
these two basic cost elements of manufacturing.
DIRECT MATERIALS STANDARDS
Direct materials cost standards may be divided into:
1. Quantity (usage) standards.
2. Price standards.
Quantity (usage) standards: It refers to predetermined specifications of the quantity of direct materials that
should go into the production of one finished unit under normal conditions. If more than one direct material
is required to complete a unit, individual standards must be computed for each direct material. The number
of direct materials required to complete one unit can be developed from engineering studies, analyses of past
experiences, and /or tests runs under controlled conditions.
The engineering department is normally responsible for setting quantity standards because it is generally
responsible for designing production processes for making a product. Many manufacturing companies have
separated departments that are assigned the responsibility for setting standards.
Price standards: It refers to prices at which direct materials should be purchased. The cost accounting
department and /or the purchasing department are normally responsible for setting materials price standards
because they have ready access to price data and should have knowledge of market conditions. If more than
one direct material is used in a production process, a standard unit price must be computed for each one.
DIRECT LABOR STANDARDS

Direct labor cost standards may be divided into:
1. Efficiency (time or usage) standards.
2. Rate (wage) standards.
Efficiency standards: These are predetermined performance standards of the cost of direct labor that should
go into production, under normal conditions, of one finished unit. Time – and – motion studies is very
helpful in developing direct labor efficiency standards. In these studies, an analysis is made of procedures to
be followed by workers, and the conditions (space, temperature, equipment, tools, lighting, etc.) under which
the worker must perform assigned tasks. Procedures and conditions are closely related; and therefore, a
change in one is usually accompanied by a change in the other. For example, the introduction of an
additional piece of equipment to an assembly line would require a change in the procedures followed by

workers. When either the situations or procedures are changed, a new standard should be developed. Time –
and – motion studies must be performed for all steps in the production process.
Staff specialists are usually given the responsibility for setting direct labor efficiency standards. Staff
specialists should have a thorough knowledge of the production process used by the factory in addition to
knowledge of the techniques of time – and – motion studies. Many companies have departments devoted
solely to the establishment of direct labor efficiency standards.
Rate standards: These are predetermined wage rates for a period. The cost accounting, engineering, or
personnel departments are normally responsible for setting direct labor rate standards, because they usually
have access to the data required to set standards.
3.3.2 Standard Cost Variance Analysis
Variances are the differences arising when actual results do not equal the standard because of either external
or internal factors. Management has little control over internal factors. Therefore, external factors
(uncontrollable variances) should be separated form internal factors (controllable variances). Variance
analysis is a valuable technique for separating the two. It is defined as the systematic evaluations of
variances to provide managers with useful information for measuring efficiency and improving performance.
Variance analysis is performed in order to answer two general questions:
1. What is the amount of difference between actual and standard cost?

2. Why did the difference occur?
The first question deals with the measurement of the variance, which is basically a computation process.
Accountants accumulate actual cost data and compare them with the standards to find the variances.
The second question addresses the cause of the variance. Often the question of why the variance occurred is
the more difficult of the two questions to answer. Sometimes variances result from a complex interaction of
human and physical variables.
In this section, the discussion emphasis primarily on the computation of several specific variances. The
more complex issue of explaining their cause is beyond the scope of this course.
Variances can be computed for all three of the basic cost elements – direct materials, direct labor, and
manufacturing overhead. The computation for materials and labor is quite similar. Manufacturing overhead
variances require different and somewhat more complex situations.
DIRECT MATERIAL VARIANCES
Direct materials variances may be divided into:

Quantity (usage) variance.
Price variance.
Material Quantity Variance: The material quantity variance measures the amount of variance caused by
using more or less materials than standard. Direct materials quantity variance is favorable when the actual
quantity used is less than the standard quantity allowed and is unfavorable when more materials are used
than standard. The formula for the variance can be expressed as follows:
MQV = (AQ – SQ) x SP
Where MQV = direct materials quantity variance
AQ = actual quantity used
SQ = standard quantity allowed
SP = standard unit price
Standard quantity allowed is the amount of direct materials that should have been used to produce the actual
unit out put of the period. And it is equal to the predetermined quantity of direct materials that should go
into one finished unit multiplied by the number of units produced.
Standard quantity of = Actual out put x materials allowed
Materials allowed Achieved per unit of out put
Material quantity variance highlights deviations between the quantity of material actually used and the
standard quantity allowed. Thus, it makes sense to compute this variance at the time the material is used in
production.
The production department or cost center that controls the input of direct materials into the production
process is usually assigned the responsibility for this variance.
Material Price Variance: The material price variance measures the amount of variances from standard that
occurs because the price paid for raw materials is different from the standard cost. If the actual materials
cost is greater than standard, the price variance is unfavorable. A favorable variance occurs if the cost of
materials is less than standard. The equation of the material price variance is
MPV = (AP – SP) x AQ
Where MPV = direct materials price variance
AP = actual price or unit cost
SP = standard price
AQ = actual quantity purchase.

As stated above, the direct material price variance is based on the actual quantity purchased because
deviations between the actual and standard price relate to the purchasing function in the firm.
Management has little control over price variances, especially when they result from rising prices. However,
the purchasing department may have some control over prices by ordering in economical quantities, and /or
finding suppliers who offer the same quality of goods at lower prices.
Note that: The sum of the direct material usage and price variances equals the total direct material flexible
budget variance (MFBV).
MFBV = MQV + MPV
Example (4) National Company produces a single product. For the first quarter of the year, the following
data were collected:
Units produced (finished products) 10,000 units
Direct materials quantity standard 4 units of direct materials per unit of finished product
Direct materials used in production 39,000 units

Direct materials purchased 50,000 units
Direct materials standard cost $ 2.00 each
Actual direct materials cost $ 2.10 each.
Instruction: For materials used in the production, compute the following variances for the quarter:
a. Direct materials quantity and price variances.
b. Direct materials flexible budget variance.
Identify each variance as favorable (F) and unfavorable (U).
Solutions:
i) Direct materials quantity variance
Standard materials allowed (SQ) = Actual x Materials allowed
Out put per unit.
= 10,000 x 4 = 40,000 units
= (39,000 – 40,000) x 2.00
= $( 2,000) F
A favorable (F) variance indicates that direct materials quantity used was less than the
standard quantity allowed.
ii) Direct materials price variance

= (2.10 – 2.00) x 50,000
= $ 5,000 U
An unfavorable (U) direct materials price variance resulted because the actual unit cost was
greater than the standard unit cost.
Direct materials flexible budget variance (MFBV)
MFBV = MQV + MPV
= $ (2,000) F + $ 5,000 U
= $ 3,000 U
DIRECT LABOR VARIANCES
The computation of direct labor variances is very similar to that of direct materials variances. However,
there are some differences between labor and materials in setting variances, in the controllability of the
variances, and in the timing of the variance reports. Consequently, labor and materials variances are treated
separately.
Direct labor variances may be divided into
i. Efficiency variance.
ii. Rate variance.
Labor Efficiency Variance: The labor efficiency variance identifies the amount of total labor variance
caused by using more or less than the standard quantity. The term efficiency expresses the idea that the labor
is used favorably if fewer hours than standard are used to make a product. Conversely, labor is used
inefficiently if more labor hours than standard are used. The equation for the direct labor efficiency is
LEV = (AH – SH) x SR
Where LEV = direct labor efficiency variance
AH = actual hours worked
SH = standard hours allowed
SR = standard wage rate.
Standard hours allowed is equal to the number of direct labor hours that should be worked in the production
of one finished unit multiplied by the number of units production.
The supervisor of the department or cost center in which the work performed is usually held responsible for
direct labor efficiency variances if procedures and conditions remain constant (for example, if no new
procedures or equipment were introduced).

Labor Rate Variance: It isolates the portion of the total labor variance that is caused by the actual labor
rate’s being different from the expected (standard) labor rate. It is computed in the same way as the material
price variance. The formula is:
LRV = (AR – SR) x AH
Where LRV = direct labor rate variances
AR = actual wage rate
SR = standard wage rate
AH = actual hours worked
As in the case of the direct materials price variances, management has very little control over rate variances.
However, some companies hold the supervisor of the department or cost center where the work is performed
responsible if, for example, workers with a high rate were used in a particular process and as a result, the
greatest worker loss efficiency was achieved.
Note that the sum of the direct labor usage and rate variances equals the direct labor flexible – budget
variances (LFBV).
LFBV = LEV + LRV

Exhibit 3– 1 presents the analysis of direct material and direct labor variances in a format that deserves close
study.
DIRECT MATERIALS
Actual quantity Actual quantity Standard quantity X

X Actual price X Standard price Standard price
Difference = Difference =
+
Material price variance Material quantity variance
Sum =
Materials Flexible
Budget variance
DIRECT LABOR
Actual labor hours Actual labor hours Standard labor hours
X actual labor rate X standard labor rate X standard labor rate
Difference = + Difference =
Labor rate variance Labor efficiency variance
Sum =
Labor Flexible
Budget Variance
Exhibit 3.1 Analysis of Direct Labor and Direct Material Variances
Example (1) Beza Mills, Inc., a large producer of men’s and women’s clothing, began production on April
1. The company uses standard costs for all of its products. The standard costs and actual costs for April are
given below for one of the company’s product lines.

STANDARDS
Standard inputs Standard price expected Standard cost expected
expected per unit of per unit of input per unit of output
output
Direct material 5 pounds $2 $ 10
Direct labor ½ hour 16 8
During April, the company produced 7,000 units of product. However, 9,000 units were scheduled for
production. The following activity was recorded relative to the product line during this period:
Direct material: 36,800 pounds of material were purchased and used at an actual unit price of $ 1.90.
Direct labor: 3,750 hours of labor were used at an actual hourly rate (price) of $ 16.40.
There was no inventory of materials on hand to start the period.
Instructions:
a. Compute the direct material price and quantity variances for April.
b. Compute the direct labor rate and usage variances for April.
c. Compute the sales activity and master budget variances for both direct materials and direct labor.
Indicate whether each variance is favorable (F) or unfavorable (U).
Solutions:
a. i) Direct material price variances
= (1.90 – 2) x 36,800
= $( 3,680 )F
ii. Direct material quantity variances
Standard material allowed (SQ) = Actual x Materials allowed
Output per unit of output.
= 7,000 x 5
= 35,000 pounds

= (36,800 – 35,000) x 2
= $ 3,600 U
iii. Materials flexible budget variances (MFBV)

MFBV = MPV + MQV
= (3680) F + 36000U
=(80)F
i) Labor rate variances
LRV = (AR – SR) x AH
= (16.40 – 16) x 3,750
= $ 1500 U
ii) Labor efficiency variances
Standard hours allowed (SH) = Actual x hours allowed
Output per unit of output
= 7,000 x ½
= 3500 hours
= (3,750 – 3,500) x 16
= $ 4,000 U
a. Labor flexible budget variances (LFBV)
LFBV = LRV + LEV
= 1500 U + 4000 U
= $ 5,500 U
Flexible Budget = Actual output x Input allowed per x Standard unit price
Achieved unit of output of input
Master Budget = Original x Input allowed x standard unit
Planned per unit of price of input
Output output
MBV = FBV + ALV
Where: MBV = master budget variance
FBV = flexible budget variance
ALV = activity level variance.
Refresh your memory of MBV, FBV and ALV from the previous discussion.

Exhibit 2.5 Actual and Budgeted Costs for Direct Materials and Direct Labor.
Actual cost Static Flexible FBV ALV MBV
budget Budget
Direct materials $ 69,920 $ 90,000 $ 70,000 $ 80 F $ 20,000 F $ 20,080 F
Direct labor 61,500 72,000 56,000 5,500 U 16,000 F 11,500 F
MBV = Actual cost – Static budget

FBV = Actual cost – Flexible Budget
ALV = Master Budget – Flexible Budget
Supporting computations:
Actual costs:
Direct materials = $ 1.90 x 36,800 = $ 69.920
Direct labor = $ 16.40 x 3,750 = $ 61,500
Static budgets
Direct materials = 9,000 x 5 x 2 = $ 90,000
Direct labor = 9,000 x ½ x 16 = $ 72,000
Flexible budget (budgets for the actual activity levels)
Direct materials = 7,000 x 5 x 2 = $ 70,000
Direct labor = 7,000 x ½ x 16 = $ 56,000
Example (2) Summarized manufacturing cost data from the records of Kariba Products Company are given
below:
Direct materials: Purchased, 130,000 units at an actual cost of $ 546,000. Standard cost of 130,000 units, $
520,000. Used 98,000 units of direct materials in production. Only 95,000 units should have been used.
Direct labor: The standard labor rate is $ 2 per hour. The company operated at 40,000 direct labor hours
but produced a quantity of product that should have been produced in 35,000 direct labor hours. All but
2,000 of the direct labor hours were paid for at the standard rate and the 2,000 hours were paid for at the rate
of $ 3.25 per hour.
Instructions: Compute the following
a. Direct material price variance
b. Direct material usage variance
c. Direct labor rate variance
d. Direct labor efficiency variance.

Solution:
a. Direct material price variance
AP = $ 546,000 = $ 4.20
130,000units
SP = $ 520,000 = $ 4.00
130,000 units
= (4.20 – 4.00) x 98,000
= $ 19,600U
b. Direct materials usage variance
MQV =(AQ-SQ) x SP
=(98,000-95, 000) x 4.00
=$12, 000 U
c. Direct labor rate variance

LRV = (AR-SR) x AH
The actual labor hour used totaled 40, 000 hours. Of which 38, 000 hours are paid at the
standard rate. Therefore, AH, in the formula here above, can be taken as 2, 000 hours i.e., the
excess of 38, 000 over 40, 000.
LRV = (3.25 –2.00) x 2, 000
=$2, 500 U
Or computed alternatively
LRV =3.25 – 2.00) x 2, 000 +(2.00 –2.00) x 38,000
=2, 500 U + 0
=$2, 500 U
d. Direct labor efficiency variance
= (40,000 – 35,000) x 2
= $ 10,000 U

Example (3) Lucy Company produces a single product. The company has set standards as follows for
materials and labor:
Direct Direct
Materials Labor
Standard quantity or hours per unit ? Pounds 2.5 hours
Standard price or rate ? Per pound $ 9 per hour
Standard cost per unit ? $ 22.50
During the past month, the company purchased 6,000 pounds of direct materials at a cost of $ 16,500. All of
these materials were used in the production of 1,400 units of product. Direct labor cost totaled $ 28,545 for
the month. The following variances have been computed:
Material quantity variance $ 1,200 U
Total materials variance 300 F
Labor efficiency variance 4,500 F
F and U denote favorable and unfavorable variances, respectively.
Instructions:
a. For direct materials used in production, compute the following
i. The standard price per pound.
ii. The standard quantity allowed for materials for the month’s production.
iii. The standard quantity of materials allowed per unit of product.
b. For labor employed in production,
i. Compute the actual direct labor cost per hour for the month
ii. Compute the labor rate variance.
Solutions:
i. Total material variance (TMV) =Material flexible budget variance (MFBV)
MFBV=MQV+MPV
(300) F=1200U + MPV
MPV=$1,500F
Actual material purchase price=$16, 500 =$2.75 / lb*
6, 000 pounds
*lb= pound

MPV = (AP – SP) X AQ
(1, 500) F= (2.75 – SP) X 6, 000
(1, 500) =2.75 -SP
6, 000
(0.25) =2.75 - SP
SP = $3.00 / lb
ii. MQV = (AQ-SQ) X SP
1, 200 U = (6, 000 –SQ) X 3
1, 200 =6, 000 –SQ
3
SQ =6, 000 –400

SQ =5, 600 pounds
iii. Standard quantity of materials allowed per unit of product =5, 600 = 4 pounds
1, 400
i.) LEV =(AH –SH) X SR
(4, 500) =[AH –(1, 400 X2.5)] X9
(4, 500) =[AH –(1, 400 X2.5)]
9
(500) =AH –3, 500

AH= 3, 000 hours
Actual labor cost =AH X AR
$28, 545 =3, 000 X AR
AR= $28, 545
3, 000
= $9.515
ii) LRV =(AR-SR) X AH

=(9.515 –9) X 3, 000
=$154.5 U

Chapter IV. Measuring Mix, Yield and Productivity Variances
 Prepare a factory overhead variance analyses using a standard cost system.
 Explain what the overhead variances are measuring.
 Illustrate the close similarity between applied overhead rates in an actual cost system and overhead
standards in a standard cost system.
 Compute the material and price yield and mix variances.
 Define and apply the new terms introduced.
4.1 Introduction
Standard Costs and Variances

Calculation of a standard cost is based on physical standards, two types of which are often
discussed: basic and current. A basic standard is a yard stick against which both expected
and actual performances arte compared. It is similar to an index number against which all
later results are measured. Current standards are of three types: expected actual standard,
normal standard and theoretical standard. (For a more detailed discussion refer Chapter III.)
 The expected actual standard is a standard set for an expected level of operation and
efficiency. It is a reasonably close estimate of actual results.
 The normal standard is a standard set for a normal level of operation and efficiency,
intended to represent challenging yet attainable results.
 The theoretical standard is a standard set for an ideal or maximum level of operation
and efficiency.
Materials and labor costs are generally based on normal, current conditions, allowing for
alterations of prices and rates and tempered by the desired efficiency level. Factory overhead
is based on normal conditions of efficiency and volume.

Example (1) Chekun Company uses a standard cost system. The standard product and cost
specification for 1, 000 pounds (lbs) of chewing gum are as follows:
Material Quantity Unit Cost
A 800 lbs $0.25 per lb
B 200 lbs 0.40
C 200 lbs 0.10
Materials records indicate:
Material Beginning Inventory Purchases in January Ending Inventory
A 10, 000 lbs 162, 000 lbs @ $0.24 15, 000 lbs
B 12, 000 30, 000 0.42 4, 000 lbs
C 15, 000 32, 000 0.11 11, 000 lbs
To convert 1, 200 lbs of raw materials into 1, 000 lbs of finished product requires 20 direct
labor hours at $9 per hour, or $0.18 per lb of finished product. Actual direct labor hours and
cost for January are 3, 800 hours at $34, 656.
Actual production for January is 200, 000 lbs of chewing gum. Expected production for this
month totaled 192, 500 pounds.
Factory overhead is applied on a direct labor hour basis at a rate of $5 per hour ($3 fixed, $2
variable), or $0.10 per pound of finished product. Normal overhead is $20, 000, with 4, 000
direct labor hours. Actual overhead for the month is $22, 000.
The standard cost per pound of finished chewing gum is:
Materials $0.30 per lb
Labor 0.18
Factory overhead 0.10
Total $0.58
Instructions:
a. Compute the materials purchase price, mix, and yield variances and the materials
quantity variances for each material.

b. Compute the labor rate, efficiency, and yield variance.
c. Compute the factory overhead variances using the two, three and four variance
method.
Solution:
Material Variances
Material purchase price variances for each material
Material Purchased Unit Cost Price
Quantity Variation Variance
A 162, 000 $(0.01) $1, 620 F
B 30, 000 0.02 600U
C 32, 000 0.01 320U
Net materials purchase price variance $700 F
Material Mix Variance

It is common for more than one material to be required in a production process. In a cotton
fabric, for example, cotton from many parts of the world with the hope that the new mix and
its costs will contribute to improved profits. The proportion or ratio of one material to
another material is called the mix. In many cases, the new mix is accompanied by either a
favorable or unfavorable yield of the final product.
A mix variance shows the change in cost that results from changing the proportions of
materials added to the production mix. It measures the effect of using a different combination
of materials.
Material mix variance is calculated by measuring the difference in cost, at standard prices,
between the actual mix of quantities used and the standard mix of the total quantity used.
Weighted average of standard materials cost of input:

Material Quantity X Unit Cost = Total
A 800 $0.25 $200
B 200 0.40 80
C 200 0.10 20
Input 1, 200 lbs $300
Weighted average per unit of input= 300 = $0.25 per lb

1, 200
Weighted average per unit of output= 300 = $ 0.30 per lb

1, 000
Actual quantities at individual standard materials costs:
Material Quantity Used x Stdcost

A 157, 000 X 0.25 $39, 250
B 38, 000 X 0.40 15, 200
C 36, 000 X 0.10 3, 600 $58, 050
231, 000 lbs
Actual quantity at weighted average of std materials cost of input
(231, 000 lbs x 0.25) 57, 750
Materials mix variance $300 U
The influence of individual raw materials on the total materials mix variance can be
computed in the following manner:
Material Actual Actual Qty Qty Std Material
Quantity Using Std Variation Cost Mix
Formula Variance
A 157, 000 lbs 154, 000 lbs 3, 000 0 750

.
2
5
B 38, 000 38, 500 (500) 0.40 200F

C 36, 000 38, 500 (2, 500) 0.10 250F
231,000 231, 000 -0- 300 U
Actual quantity using standard formula for each material

Actual Qty = Std x Total
Using Std Formula Formula Actual Qty
Material A= 800 X 231, 000= 154, 000 lbs
1, 200
Material B = 200 X 231, 000 = 38, 500 lbs
1, 200
Material C = 200 X 231, 000 = 38, 500 lbs

1, 200
Material Yield Variance
Yield can be defined as the amount of prime product manufactured from a given amount of
materials. The yield variance is the result of obtaining a yield different from the one expected
on the basis of input.
A yield variance measures whether a change in mix affected the yield and shows the
difference in cost that result if the actual yield (out put) varies from the standard quantity of
yield determined for a given input of materials.

The material yield variance is computed as follows:
Actual quantity (input) at weighted averaged of standard material cost 57, 750
Actual output quantity at weighted average of standard material cost
(200, 000 lbs x $0.30) 60, 000*
Materials yield variance $ 2, 250F
*Alternatively computed:
60, 000 = Input needed to produce the actual output x 0.25
= 240, 000 X 0.25
= $60, 000
N.B. The total of the mix and yield variance for material equal the quantity variance. Thus, the
material quantity variance will be $1, 950 F, i.e. 300 U + 2, 250 F.
The influence of individual raw materials on the total materials quantity variance (MQV) can
be computed in the following manner:
MQV=(AQ-SQ) X SP
Where AQ= actual quantity of material used
SQ= standard quantity of materials allowed for the actual output.
SP= standard price per unit of material
MQV (material A) = (157, 000-160, 000) X 0.25 =$ 750 F
MQV (material B) = (38, 000-40, 000) X 0.40 = 800 F
MQV (material C) = (36, 000-40, 000) X 0.10 = 400F
Total material quantity variance $ 1, 950 F
Standard quantity of materials allowed for the actual output:

Material A=200, 000 X 800 =160, 000 lbs
1, 000

Material B=200, 000 X 200=40, 000 lbs
1, 000
Material C=200, 000 X 200=40, 000 lbs
1, 000
Labor Variance
The labor variances are the
i. Rate variances
ii. Efficiency variances, and
iii. Yield variances
The computations of these variances for January are as follows:

1. Computation of labor rate variance variances:
LRV= (AR-SR) X AH = (AR X AH) – (SR X AH)
Actual labor costs $34, 656
Actual hr x SR = 3, 800 X 9 34, 200
Labor rate variance $456 U
2. Computation of labor efficiency variance variances:
LRV= (AR-SR) X AH = (9.12* -9) X 3, 800 = $456 U
*9.12 = 34, 656
3, 800
AH X SR = 3, 800 X 9= $34, 200
SH for expected output x SR= 3, 850* X 9 = 34, 650
Labor efficiency variance $ 450 F
*SH for expected output = 192, 500 X 20 = 3, 850 hrs
1,000
3. Computation of labor yield variance variances:
SH for expected output x SR = 3, 850 X 9 = $34, 650

SH for actual output X SR = 4, 000 X 9 = 36, 000
Labor yield variance $ 1, 350F
The labor yield variance identifies the portion of the labor efficiency variance attributable to
obtaining an unfavorable or favorable yield. The favorable labor efficiency of $450 is the
portion of the traditional labor efficiency variance that is attributable to factors other than
yield.
The traditional labor efficiency variance (LEV) is given by:

LEV = (AH-SH) X SR
= (3, 800 – 4, 000) X 9
= $ 1, 800 F
Factory Overhead Variances
The overall overhead variance needs further analysis to reveal detailed causes for the
variance and to guide management toward remedial action. This analysis may be made by
using (1) the two- variance method, (2) the three-variance method, or (3) the four -variance
method.
Two Variance Method

A yield variance can also be computed for factory overhead. When the two variance method
is used, the overhead variances are the
i. Controllable variance
ii. Volume variance
iii. Yield variance
1. Computation of controllable variances:
Actual FOH $22, 000

Budgeted allowance based on Std hours for expected output
Fixed OH budgeted $12, 000
Variable OH (3, 850 X 2) 7, 700 19, 700
Controllable variance $2,300 U
Part of the controllable variance consists of variable overhead, and part consists of any
difference between budgeted and actual fixed overhead.
2. Computation of volume variances:

Budgeted allowance based on Std hours for expected output $19, 700
Std hours for expected output x Std OH rate= 3, 850 x 5 19, 250
Volume Variance $450 U
3. Computation of yield variance
Std hours for expected output x Std OH rate= 3, 850 x 5 $ 19, 250
SH for actual output x Std OH rate = 4,000 X 5 20, 000
Yield variance $750F
N.B. The controllable variance equals the sum of spending variance and the variable efficiency
variance.
Variable efficiency variance = (3, 800 – 3, 850) x 2 = $100 F
Controllable Variance =Spending variance + variable Efficiency Variance
=2, 400 U + 100 F =$2, 300U
Three Variance Method

When the three variance method is used, the overhead variances consist of the
i. Spending variance
ii. Idle capacity variance
iii. Efficiency variance
iv. Yield variance

1.Computation of overhead spending variances:
Actual FOH $22, 000
Budgeted allowance based on actual hours
Fixed OH $12, 000
Variable OH (3, 800 X 2) 7, 600 19, 600
Spending variances $2, 400 U
2. Computation of overhead idle capacity variances:
Budgeted allowance based on actual hours $19, 600
Actual hrs x Std OH rate= 3, 800 x 5 19, 000
Idle Capacity Variance $600 U
3. Computation of overhead efficiency variances:
Actual hrs x Std OH rate= 3, 800 x 5 $ 19, 000
SH for expected output X Std OH rate = 3,850 X 5 19,250
Efficiency variances $ 250 F
4. Computation of overhead yield variances:
SH for expected output x Std OH rate= 3, 850 x 5 $ 19, 250
SH for actual output X Std OH rate = 4,000 X 5 20, 000
Yield variances $ 750 F
Overhead yield variance measures that portion of the total overhead variance resulting from a
favorable or unfavorable yield.
Four- Variance Method

The four variances are (1) spending variance, (2) variable efficiency variance, (3) fixed
efficiency variance, (4) idle capacity variance and (5) yield variance. This variance divides
the efficiency variance in three-variance method into its variable and fixed portion. Here in
four –variance method, the spending, idle capacity and yield variances are identical to the
three-variance method.
Variable Efficiency Variance. The variable efficiency variance is computed is as follows:
Budgeted allowance based on actual hours worked (3,800 x 2) $7, 600
SH for expected output X Std OH rate (3,850 X 2) 7, 700
Variable efficiency variance $ 100F
Fixed Efficiency Variance. The fixed efficiency variance is computed is as follows:
Actual hrs x Std OH rate= 3, 800 x 3 11, 400
SH for expected output X Std OH rate = 3,850 X 3 11, 550
Efficiency variances $ 150F
The $2, 300 unfavorable controllable variance equals the unfavorable spending variance, $2,
400, combined with the $100 variable part of the favorable overhead efficiency variance. The
$450 unfavorable overhead volume variance equals the unfavorable idle capacity variance,
$600, combined with the $150 fixed part of the favorable overhead efficiency variance.

Chapter V. Cost Volume Profit (CVP) Analysis
5.1 Introduction
Cost-volume-profit (CVP) analysis is one of the most powerful tool that help managers as they make
decisions by facilitating quick estimation of net income at different levels of activity. In other words, it helps
them to understand the interrelationship between cost, volume, and profit in an organization by focusing on
interactions between the following five elements: prices of products, volume or level of activity, per unit
variable costs, total fixed costs, and mix of products sold.
Because CVP analysis helps managers understand the interrelationship between cost, volume, and profit, it is
a vital tool in many business decisions. These decisions include, for example, what products to manufacture
or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive
facilities to acquire.
5.2 The Basic of CVP Analysis
Contribution Margin Vs Gross Margin
The form of income statement used in CVP analysis is shown in Exhibit 5.1, i.e., the projected income
statement of Sample Merchandising Company for the month ended January 31, 20x3. This income statement
is called contribution approach to income statement. The contribution income statement emphasizes the
behavior of the costs and there fore is extremely helpful to manager in judging the impact on profits of
changes in selling price, cost, or volume.

Exhibit 5.1
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31,20x3
Total Unit
Sales (10, 000 units) $ 150, 000 $15.00
Variable Expenses 120, 000 12.00
Contribution Margin $ 30, 000 $3.00
Fixed Expenses 24, 000
Net Income $ 6, 0000
In the income statement here above, sales, variable expenses, and contribution margin are expressed on a per
unit basis as well as in total. This is commonly done on income statements prepared for management’s own
use since it facilitates profitability analysis.
The contribution margin represents the amount remaining from sales revenue after variable expenses have
been deducted. Thus, it is the amount available to cover fixed expenses and then to provide profit for the
period. Notice the sequence here- contribution margin is used first to cover the fixed expenses, and then
whatever remains goes toward profit. In the Sample Merchandising Company income statement shown
above, the company has a contribution margin of $ 30, 000. In this case, the first $24, 000 covers fixed
expenses; the remaining $ 6, 000 represents profit.
The per unit contribution margin indicates by how much Dollars the contribution margin is increased for
each unit sold. Sample Merchandising Company’s contribution margin of $3.00 per unit indicates that each
unit sold contributes $3.00 to covering fixed expenses and providing for a profit. If the firm had sold 5, 000
units, this would cover only $15, 000 of their fixed expenses (5, 000 units x $3.00 per unit). Therefore, the
firm would have a net loss of $9, 000.
Contribution margin $15, 000
Fixed expenses 24, 000
Net loss $(9, 000)

If enough units can be sold to generate $24, 000 in contribution margin, then all of the fixed costs will be
covered and the company will have managed to show neither profit nor loss but just cover all of its cost. To
reach this point (called breakeven point), the company will have to sell 8, 000 units in a month, since each
unit sold yield $ 3.00 in contribution margin.
Total Per Unit

Sales (8, 000 units) 120, 000 $15.00
Variable expenses 96, 000 12.00
Contribution margin $24, 000 $3.00
Fixed expenses 24,000
Net income $ 0
Computations of the break-even point are discussed in detail later in this unit. For the moment, note that the
break even point can be defined as the point where total sales revenue equals total expenses (variable plus
fixed) or as the point where total contribution equals total fixed expenses.
Too often people confuse the terms contribution margin and gross margin. Gross margin (which is also
called gross profit) is the excess of sales over the cost of goods sold (that is, the cost of the merchandise that
is acquired or manufactured and then sold). It is a widely used concept, particularly in the retailing industry.
Contribution Margin Ratio (CM-Ratio)
In addition to being expressed on a per unit basis, revenue, variable expenses, and contribution margin for
Sample Merchandising Company can also be expressed on a percentage basis:
Total Per Unit Percentage

Sales (8, 000 units) $150, 000 $15.00 100%
Variable expenses 120, 000 12.00 80%
Contribution margin $30, 000 $3.00 20%

Net income $ 6, 000
The percentage of the contribution margin to total sales is referred to as the contribution margin ratio (CM-
ratio). This ratio is computed as follows:
CM-ratio= Contribution Margin
Sales
Contribution margin ratio = 1 – variable cost ratio. The variable-cost ratio or variable-cost percentage is
defined as all variable costs divided by sales. Thus, a contribution margin of 30% means that the variable-
cost ratio is 80%.
In the example here below, the contribution margin percent or contribution margin ratio, also called
profit/volume ratio (p/v ratio) is 20%. This means that for each Dollar increase in sales, total contribution
margin will increase by 20 cents ($1 sales x CM ratio of 40%). Net income will also increase by 20 cents,
assuming that there are no changes in fixed costs.
At this illustration suggests, the impact on net income of any given Dollar change in total sales cad be
computed in seconds by simply applying the contribution margin ratio to Dollar change.
Once the break-even point has been reached, net income will increase by the unit contribution margin for
each additional unit sales. If 8001 units are sold in a month, for example, then we can expect that the Sample
Merchandising Company’s net income for the month will be $ 3, since the company will have sold 1 unit
more than the number needed to break even:
Total Per Unit

Sales (8, 000 units) $120, 015 $15.00
Variable expenses 96, 012 12.00
Contribution margin $24, 003 $3.00
Net income $3
If 8002 units are sold (2 units above the break even point). Then we can expect that the net income for the
month will be $9, and so forth.

5.3 break even Analysis
The study of cost-volume-profit analysis is usually referred as break-even analysis. This term is misleading,
because finding break-even point is often just the first step in planning decision. CVP analysis can be used to
examine how various alternatives that a decision maker is considering affect operating income. The break-
even point is frequently one point of interest in this analysis
break-even point can be defined as the point where total sales revenue equals total expenses, i.e., total
variable cost plus total fixed costs. It is a point where the total contribution margin equals total fixed
expenses. Stated differently, it is a point where the operating income is zero.
Equation Technique. It is the most general form of break-even analysis that may be adapted to any
conceivable cost-volume-profit situation. This approach is based on the profit equation. Income (or profit) is
equal to sales revenue minus expenses. If expenses are separated into variable and fixed expenses, the
essence of the income statement is captured by the following equation.
Profit= Sales revenue-Variable expenses-Fixed expenses
Profit (net income) is the 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 unit non-
operating revenues and non-operating cost are assumed to be zero. Thus, the above formula can be restated
as follows
Profit (Net income) =(P XQ)-(VxQ)-F
NI=(P XQ)-(VxQ)-F
where P=sales price
Q=break-even unit sales
V= variable expenses per unit
F=fixed expenses per period
NI= net income
At break-even point, net income=0 because total revenue equal total expenses.
That is, NI=PQ-VQ-F
0= PQ-VQ-F……………………………………equation (1)

Contribution-Margin Technique. The contribution margin technique is merely a short version of the
equation technique. The approach centers on the idea that each unit sold provides a certain amount of fixed
costs. When enough units have been sold to generate a total contribution margin equal to the total fixed
expenses, break-even point (BEP) will be reached. Thus, one must divide the total fixed costs by the
contribution margin being generated by each unit sold to find units sold to break-even.
BEP= Fixed expenses

Unit contribution margin
Given the equation for net income, you can arrive at the above short cut formula for computing break-even
sales in units as follows:
NI=PQ-VQ-F
0=Q (P-V)-F because at BEP net income equals zero.
Q (P-V)=F…divide both sides by (p-v)
Q= F ………………….…. equation (2)

P-V
There is a variation of this method that uses the CM ratio of the unit contribution margin. The result is the
break-even point in total sales Dollars rather than in total units sold.
BEP (in sales Dollars)= Fixed expenses = F

CM ratio P-V
P
This approach to break-even analysis is particularly useful in those situations where a company has multiple
product lines and wishes to compute a single break-even point for the company as a whole. More is said on
this point in later section titled Sales Mix and CVP Analysis.
The contribution- margin and equation approaches are two equivalent techniques for finding the break-even
point. Both methods reach the same conclusion, and so personal preference dictates which approach should
be used.
Graphical Method: In the graphical method we plot the total costs and revenue lines to obtain their point of
intersection, which is the breakeven point.

Total costs line. This line is the sum of the fixed costs and the variable costs. To plot fixed costs, draw a line
parallel to the volume axis. To plot the total cost line, choose some volume of sale and plot the point
representing total expenses (fixed and variable) at the activity level you have selected. After the point has
been plotted, draw a line through it back to the point where the fixed expense line intersects the Dollars axis
(the vertical axis).
Total Revenue Line. Again choose some volume of sales to construct the revenue line and plot the point
representing total sales Dollars at the activity you have selected. Then draw a line through this point back to
the origin.
The break-even point is where the total revenues line and the total costs line intersect. This is where total
revenues just equal total costs.
Example (1) Zoom Company manufactures and sells a telephone answering machine. The company’s
income statement for the most recent year is given below:
Total Per Unit Percent
Sales (20,000 units) $ 1,200,000 $ 60 100
Variable expenses 900,000 45 ?
Contribution Margin $ 300,000 $ 15 ?
Fixed Expenses 240,000
Net Income $60,000
Based on the above data, answer the following questions.

Instructions:
a. Compute the company’s CM ratio and variable expense ratio.
b. Compute the company’s break-even point in both units and sales Dollars. Use the above three
approaches to compute the break-even.
c. Assume that sales increase by $ 400,000 next year. If cost behavior patterns remain unchanged,
by how much will the company’s net income increase?
Solution:
a. CM – ratio = 60-45 = 0.25 (25%)
60
Variable expense ratio = 1 – CM-ratio = P-V
P
= 1-0.25 = 60 – 15 = 0.75 (75%)

60
b. Method 1: Equation Method
i) Net Income (NI) = PQ – VQ – FC
0 = Q (60-45) – 240,000
15Q = 240,000
Q = 240,000
15
Q = 16,000 units, at $ 60 per unit, $ 960,000
ii) Let “X” be sales volume in Dollars to breakeven

CM- ratio = 0.25
Variable expense ratio = 0.75
Net Income = Total revenue – Total variable expense – total fixed cost
0 = X – 0.75X-240, 000
0.25X = 240,000
X = 240,000
0.25
X = $ 960,000
Method 2. Contribution Margin Method

i) BEP (in units) = Fixed expenses
CM per unit
= $ 240,000
$ 60 – $ 45
= 16,000 units
ii) BEP (in Dollars) = Fixed expenses

CM – ratio
= $ 240,000
0.25
= $ 960,000
Method 3. Graphical Method: To plot fixed costs, measure $ 240,000 on the vertical axis and extend a line
horizontally. Select a point (say, 20,000 units) and determine the total costs (the total of fixed and variable)

at the selected activity level. The total costs at this output level are $ 1,140,000= $ 240,000 + (20,000 X $
45). Then, starting from the selected point draw a line back to the origin where the fixed cost line touches the
vertical axis. The break-even point (BEP) is where the total revenues line and the total costs line intersect. At
this point, total revenues equal total costs. Refer Exhibit 5.2.
TR
TC
$1,500,00
$ 750,000
$ 500,000 TR= Total revenues line

TC = Total costs line
$ 250,000
X
0
10,000 20,000 30,000 40,000
Exhibit 5.2 Cost-Volume-Profit Chart
c)
Increase in sales $ 400,000
Multiply by the CM ratio X 25%
Expected increase in contribution margin $ 100.000

Since the fixed expenses are not expected to change, net income will increase by the entire $ 100,000
increase in contribution margin.
5.4 Applying CVP Analysis
5.4.1 Sensitivity “What If” Analysis
Sensitivity analysis is a “what if” technique that 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, sensitivity analysis
answers such questions as, what will operating income be if the output level decreases by a given percentage
from the original reduction? And what will be operating income if variable costs per unit increase? The
sensitivity analysis to various possible outcomes broadens managers’ perspectives as to what might actually
occur despite their well-laid plans.
Example (1) ZZZ Concepts, Inc., was founded by MR Z, a graduate student in engineering, to market a
radical new speaker he had designed for automobiles sound system. The company’s income statement for the
most recent month is given below:
Total Per Unit
Sales (6400 speakers) $100, 000 $250
Variable expenses 60, 000 150
Contribution margin 40, 000 $100
Fixed expenses 35, 000
Net income $5, 000
MR X, the senior accountant at ZZZ Concepts, wants to demonstrate the company’s president how the
concepts developed on the preceding pages can be used in planning and decision-making. To this end, MR X
will use the above data to show the effects of changes in variable costs, fixed costs, sales, and sales volume
on the company’s profitability.
Changes in Fixed Costs and Sales Volume: ZZZ Concepts is currently selling 400 speakers per month
(monthly sales of $100, 000). The sales manager feels that a $10, 000 increase in the monthly advertising
budget would increase monthly sales by $30, 000. Should the advertising budget be increased?

Expected contribution margin ($130, 000 x 40% CM ratio)………..… $52, 000
Present contribution margin ($100, 000 x 40% CM ratio)………….… 40, 000
Incremental contribution margin………………………………………… 12, 000
Change in fixed costs (incremental advertising expense)………………… 10, 000
Increased net income…………………………………………………….. $ 2, 000
Yes, based on the information above and assuming that other factors in the company don’t change, the
advertising budget should be increased.
Changes in Variable Costs and Sales Volume. Refer to the original data. Management is contemplating the
use of high- quality components, which would increase variable costs by $10 per speaker. However, the sales
manager predicts that the higher overall quality would increase sales to 480 speakers per month. Should the
higher quality component be used?
The $10 increase in variable costs will cause the unit contribution margin to decrease from $100 to $90.
Expected total contribution margin (480 speakers x$90)…………… $43, 200
Present total contribution margin (400 speakers x$100)……………. 40, 000
Increase in total contribution margin………………………………… $3, 200
Yes, based on the information above, the high-quality component should be used. Since the fixed will not
change, net income will increase by the $3, 200 increase in contribution margin shown above.
Change in Fixed Cost, Sales Price, and Sales Volume. Refer to the original data and recall that the
company is currently selling 400 speakers per month. To increase sales, the sales manager would like to cut
selling price by $ 20 per speaker and increase the advertising budget by $ 15, 000 per month. The sales
manager argues that if these two steps are taken, unit sales will increase by 50%. Should the change be
made?
A decrease of $ 20 per speaker in the selling price will cause the unit contribution margin to decrease from
$100 to $ 80.
Expected total contribution margin:(400-speakersx150%x$80)…………………..$80, 000
Present total contribution margin (400 speakers x $ 100)……………………………40,000

Incremental contribution margin………………………………………….…………… 8, 000
Change in fixed costs:
Incremental advertising expenses………………………...………….. 15, 000
Reduction in net income…………………………………………………………… $ (7, 000)
No, based on the information above, the changes should not be made.
Changes in Variable Cost, Fixed Cost, and Sales Volume. Refer to the original data. The sales manager
would like to replace the sales staff on a commission basis of $ 15 per speaker sold, rather than on flat
salaries that now total $ 6, 000 per month. The sales manager is confident that the change will increase
monthly sales by 15%. Should the change be made?
Changing the sales staff from a salaried basis to a commission basis will affect both fixed and variable costs.
Fixed costs will decrease by $ 6, 00, from $ 35, 000 to $ 29, 000. Variable costs will increase by $ 15, from $
150 to $ 165, and the unit contribution margin will decrease from $ 100 to $ 80.
Expected total contribution margin (400speakers x 115% x $85)………………. $39, 100
Present total contribution margin (400 speakers x $ 100)……………………… 40, 000
Decrease in total contribution margin…………………………………………….. (900)
Change in fixed costs:
Salaries avoided if a commission is paid [to be added on $(900)]……………… 6, 000
Increase in net income……………………………………………………………… $5, 100
Yes based on the information above, the changes should be made. Again, the same answer can be obtained
by preparing comparative income statements:
Present 400 Expected 460*

Speakers per month speakers per month
Total Per unit Total Per unit
Sales …………………..…. $100, 000 $250 $ 115, 000 $ 250
Variable costs…………… 60, 000 150 75, 900 165
Contribution margin 40, 000 $100 39, 100 $ 85

Fixed expenses 35, 000 29, 000
Net income $ 5, 000 $ 10, 100
*400 speakers x 115%= 460 speakers
Changes in Regular Sales Price. Refer the original data. The company has an opportunity to make bulk
sales of 150 speakers to wholesalers if an acceptable price can be worked out. This sale would not disturb the
company’s regular sales. What price per speaker should be quoted to the wholesaler if ZZZ Concepts wants
to increase its monthly profits by $ 3, 000?
Variable cost per speaker…………………………………. $ 150
Desired profit per speaker ($3, 000÷150 speakers)……… 20
Quoted price per speaker………………………………..… $ 170
Notice that no element of fixed cost is included in the computation. This is because fixed costs are not
affected by the bulk sale, so all of the additional revenue that is in excess of variable costs goes to increasing
the profits of the company.
5.4.2 Target Net Profit Analysis
Managers can also use CVP analysis to determine the total sales in units and Dollars needed to reach a target
profit.
The method used for computing desired or targeted sales volume in units to meet the desired or targeted net
income is the same as was used in our earlier breakeven computation.
Example (1) Tantu Company manufactures and sales a single product. During the year just ended the
company produced and sold 60,000 units at an average price of $20 per unit. Variable manufacturing costs
were $ 8 per unit, and variable marketing costs were $ 4 per unit sold. Fixed costs amounted to $ 180,000 for
manufacturing and $72, 000 for marketing. There was no year-end work-in-progress inventory. Ignore
income taxes.
Instructions:
a) Compute Tantu’s breakeven point (BEP) in sales Dollars for the year.
b) Compute the number of sales units required to earn a net income of $ 180,000 during the year

c) Tantu’s variable manufacturing costs are expected to increase 10 % in the coming year. Compute the
firm’s breakeven point in sales Dollars for the coming year.
d) If Tantu’s variable manufacturing costs do increase 10 %, compute the selling price that would yield
the same CM-ratio in the coming year.
Solution:
i- The BEP using contribution margin technique can be calculated as:
BEP (in Dollars) = Fixed Expenses
Cost –ratio
BEP (in Dollars) = $ 180,000 + 72,000 = $ 252,000

20-(8+4) 0.4
20
= $ 630,000
ii- Target – net profit analysis can be approached using either of these two methods
a. Equation method
b. Contribution margin method
Equation Method. Managers use a targeted income as the starting point in decision which marketing and
pricing strategies to use. The formula to determine a specific targeted income is an extension of the break-
even formula. Here, instead of solving sales volume where profits are zero, you instead solve sales where
profit equals some targeted amount. The equation for target income is:
TI = Total sales – Variable expenses – Fixed expenses
TI = PQ – VQ – FC
Where P= sales price
Q= sales unit to achieve the targeted income
V= unit variable costs
FC = fixed costs
For Tantu Company, the targeted sales volume in units would be determined as given below
TI = PQ – VQ – FC
180, 000 = 20Q – 12Q – 252, 000
8Q= 180, 000 + 252, 000

Thus, Q= $432, 000 = 54, 000 units
8
Target sales (in Dollars) = $20 x 54,000=$ 1, 080, 000

Alternatively computed,
Target income=PQ –VQ – FC
= Total CM* - FC
= CM-RATIO X S – FC
where S= Dollar sales to achieve the target income
Target income= 0.4S – $252, 000
$ 180, 000=0.4S- $252, 000
0.4S= $432, 000
S= $ 432, 000 = $1, 080, 000
0.4
Contribution Margin Approach. A second approach would be expanding the contribution margin formula
to include the target income requirements. Thus, we can modify the formula given earlier for BEP
computations as follows:
Target sales (in units) = Fixed expenses + Target Profit
Unit CM
This approach is simpler and more direct than using the CVP equation. In addition, it shows clearly that once
the fixed costs are covered, the unit contribution is fully available for meeting profit requirements.
Target sales in units (for Tantu Co.) = Fixed expenses + Target Profit
Unit CM
= $252, 000+180, 000

$8
=54, 000 units
Target sales in Dollars (for Tantu) = $20 x 54, 000 = $1, 080, 000
The total Dollar sales required to earn a target net profit is found by
Target sales (in Dollars) = Fixed expenses + Target Profit
CM-ratio
Target sales in Dollars (for Tantu) = $252, 000 + $ 180, 000

0.4
= $ 1, 080, 000
5.4.3 The Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales over the breakeven volume of sales. It states
the amount by which sales can drop before losses begin to be incurred. In other words, it is the amount of
sales revenue that could be lost before the company’s profit would be reduced to zero. The formula for its
calculations follows:
Total sales - break even Sales = Margin of safety
The margin of safety can also be expressed in percentage form. This percentage is obtained by dividing the
margin of safety in Dollar terms by total sales:
Margin of safety in Dollars = Margin of safety ratio

Total sales
Example (1): Consider the cost structure for ABC Company and XYZ in Exhibit 5-2
ABC Co. and XYZ Co.

Comparative Cost Structures
ABC Co. XYZ Co.
Amount Percent Amount Percent
Sales $ 500,000 100 $ 500,000 100
Variable costs 100,000 20 300,000 60
Contribution Margin 400,000 80 200,000 40
Fixed costs 300,000 100,000
Net income $ 100,000 $ 100,000
The break even sales for each company may be computed as follows:
BEP (in Dollars) = Fixed Costs
CM ratio
BEP (ABC Co.) = $300, 000 = $375, 000

0.8
BEP (XYZ Co.) = $100, 000 = $250, 000

0.4
The margin of safety for each company may be computed as:
Total sales - break even Sales = Margin of safety
ABC Co.’s: $500, 000- $375, 000 = $125, 000

XYZ Co.’s: $500, 000- 250,000 = $ 250,000
Note that the companies’ sales revenues are the same ($ 500,000) and their net incomes are the same ($
100,000) their individual margins of safety are different. This is because they have different cost structures,
and consequently different breakeven. A higher breakeven sales amount for ABC Co. produces a lower
margin of safety. For ABC Co., the $125, 000 margin of safety means that sales would have to diminish by
more than this amount before the company suffers a loss. In effect the margin of safety is a buffer before
losses are incurred. The same analysis applies to XYZ Co., except its buffer is $ 250,000. At this point,
neither company is experiencing losses; thus it is difficult to say which company is better off. Because they
are in different businesses the amounts computed as buffers may mean the companies’ operating results are
fine. A comparison within each company on a year-by-year basis may shed light on the possibility of
impending difficulties.
The margin of safety may also be expressed as a percentage. The calculation is done by dividing the margin
of safety (in Dollars) by the total sales (in Dollars). This, the calculation of the margins of safety percentage
is:
Margin of safety percentage = Margin of safety in Dollars
Total sales in Dollars
ABC Co.’s: $ 125,000 = 25 %
$500, 000
XYZ Co.’s: $ 250,000 = 50 %

$500, 000
5.5 The Impact of Income Tax CVP Analysis

Thus far we have ignored income taxes. However, profit-seeking enterprises must pay income taxes on their
profits. A firm’s net income after tax, the amount of income remaining after subtracting the firm’s income-
tax expense, is less than its before- tax income. This fact is expressed in the following formula:
NIAT = NIBT (1 – tax rate)
Where NIAT = net income after taxes
NIBT=net income before taxes
The requirement that companies pay income taxes affects their CVP relationships. To earn a particular after-
tax net income will require greater before-tax income than if there were no tax.
Example (1) Hydro System Engineering Associates, Inc. provides consulting services to city water
authorities. The consulting firm’s contribution margin ratio is 20%, and its annual fixed expenses are $ 120,
000. The firm’s income-tax rate is 40%.
Instructions:
a. Calculate the firm’s break-even volume of service revenue.
b. How much before-tax income must the firm earn to make an after-tax net income of $ 48, 000?
c. What level of revenue for consulting services must the firm generate to earn an after-tax income of
$48, 000?
d. Suppose the firm’s income-tax rate rises to 45 percent. What will happen to break-even level of
consulting service revenue?
Solutions:
a. break-even sales= Fixed expenses
CM-ratio
= $120, 000
0.2
= $ 600, 000
b. NIBT = NIAT = $80, 000

1- tax rate
c. Target sales (in Dollars)= FC + NIBT = $120, 000+ $80, 000

CM-ratio 0.2
= $1, 000, 000

N.B. In the formula that we have seen previously for target sales volume computations, the target profit
refers to the before-tax income.
d. BEP (in units) = Fixed expenses = FC

Unit CM P-V
BEP (in Dollars) = Fixed expenses = FC

CM-ratio P-V
P
Thus, the change in income-tax rate has no effect on break-even sales.
5.6 CVP Analysis with Multiple Products
5.6.1 Definition of Sales Mix
The term sales mix (also called revenue mix) is defined as the relative proportions or combinations of
quantities of products that comprise total sales. If the proportions of the mix change, the CVP
relationships also change. Thus, managers try to achieve the combination, or mix, that will yield the
greatest amount of profit.
A shift in sales-mix from high-margin items to low-margin items can cause total profits to decrease even
though total sales may increase. Conversely, a shift in the sales mix from low margin items to high-margin
items can cause the reverse effect-total profit may increase even though total sales decrease.
5.6.2 Sales Mix and CVP Analysis
To this point the discussion on CVP analysis focused on a firm that sells a single product; such a firm is
generally unrealistic, existing only in the minds of textbook writers. This section of the unit examines the
usefulness of the CVP technique for firms that deal in several products. In the general case the CVP equation
could be presented as:
P1Q1 + P2Q2+...+PnQn – V1Q1 – V2Q2-...VnQn-FC = NI
where Pi = Selling price per unit of product i
Qi = Number units of i produced and sold
Vi = Unit variable cost of product i
FC = Fixed Cost Per Period

NC = Net Income
In a multi product firm, break-even analysis is somewhat more complex. The reason is that different products
will have different selling prices, different costs, and different contribution margins.
Using contribution margin approach, the computation of the break-even point (BEP) in multi product firm
follows:
BEP (in units) = Total fixed expenses
Weighted average CM
BEP (in Dollars) = Total Fixed Expenses
CM – ratio
Weighted average unit contribution margin is the average of the several products’ unit contribution margins,
weighted by the relative sales proportion of each product.
For a company manufacturing and selling three products (X, Y and Z), with sales of mix of n1,n2 and n3,
respectively, the break-even point may be given by the following short cut formula:
BEP (in units) = Total fixed costs
cm1n1 + cm2n2 + cm3n3
n1 + n2 + n3
where cmi = Unit contribution margin for product i.
To prove the above formula, let us begin with general CVP equation for a company producing three
products.
NI = P1Q1 + P2Q2 + P3Q3 - V1Q1 – V2Q2 – V3Q3 – FC
where NI = income
Pi = Unit sales price for product i
Qi = Sales volume for product
Vi = Unit variable cost for product i
FC = Fixed cost per period
The difference between total sales and total variable costs for each product, i.e. PiQi – ViQi, equals their
total contribution margin (TCM). The above general formula can be restated as follows:
NI = TCM1 + TCM2 + TCM3 – FC
0 = TCM1 + TCM2 + TCM3 – FC (NI equals at BEP)
0 = CM1Q1 + CM2Q2 + CM3Q3 – FC
where CMi =contribution margin per unit for product i
Qi = sales volume for product i to break even

Given the sales mix X: Y: Z = n1: n2 : n3, and assuming that the company break-even at “Q” units, then
0 = CMn1 Q + CM2n2 Q + CM3n3 Q – FC
n1 + n2 + n3 n1 + n2 + n3 n1 + n2 + n3
0= Q (Cm1n1 + Cm2n2 + Cm3n3) – FC

n1 + n2 + n3
FC= Q (Cm1n1 + Cm2n2 + Cm3n3)

n1 + n2 + n3
Q (Cm1n1 + Cm2n2 + Cm3n3) = FC (n1 + n2 + n3)
Q= FC (n1 + n2 + n3)
Cm1n1 + Cm2n2 + Cm3n3
Q= FC …………….. equation (1)

n1 + n2 + n3
Here in equation (1), the denominator, Cm1n1 + Cm2n2 + Cm3n3 , is the weighted average
n1 + n2 + n3
contribution margin.
Similarly, the company’s break-even sales in Dollars would be calculated as

BEP (in Dollars) = Fixed expenses
CM – ratio
= Fixed expenses
Average CM
Average Sales Price
= Fixed expenses
n1 + n2 + n3
P1n1 + P2n2 + P3n3
n1 + n2 + n3
BEP (in Dollars) = Fixed expenses …………….. equation (2)

p1n1 + p2 n2 + p3n3

Here in equation (2), the denominator represents the contribution margin ratio.
Example (1) Topper Sports, Inc., produces high-quality sports equipment. The
company’s Racket Division Manufactures three tennis rackets – the
Standard, the Deluxe, and the Pro- that are widely used in amateur play.
Selected information on the rackets are given below:
Standard Deluxe Pro
Selling price per racket $ 40.00 $ 60.00 $ 75.00
Variable expenses per racket:
Production 22.00 27.00 40.45
Selling (5% of selling price) 2.00 3.00 3.75
All sales are made thorough the company’s own retail outlets. The Racket Division has the following fixed
costs:
Per Month
Fixed production costs………………………….$ 120, 000
Advertising expenses…………………………… 100, 000
Administrative salaries…………………………. 50, 000
Total $270, 000
Sales, in units, for the month of May have been as follows:
Standard Deluxe Pro Total
Sales in units………… 2, 000 1, 000 5, 000 8, 000
Instructions:
a. Compute the weighted- average unit contribution margin, assuming the above sales mix is
maintained.
b. Compute the Racket Division’s break-even point in Dollars for May.
c. How many units of each product should the company sale in order to earn a $162, 000
incomes? Ignore income taxes.
Solution:
Method I: Equation method

Sales – variable expenses – fixed expenses = Net income (at BEP net income equals zero)
Sales – variable expenses – fixed expenses = zero
As given here above, for every unit of sales in made Deluxe we expect 5 units and 2 units of Pro
and Standard, respectively. Therefore, let K=number of units of Deluxe to break-even, the break
even sales for Standard and Pro will be 2K and 5K, respectively.
Sales – variable expenses – fixed expenses = zero
Total contribution margin - fixed expenses= zero
For three products, the formula for the net income would be:
(TCM1 + TCM2 + TCM3) – fixed expenses = zero
Where TCM = total contribution margin
16(2K) + 30(K) + 30.8(5K) – 270,000 = 0
216K =270, 000
K = 270, 000 = 1, 250 units
216
Thus, the breakeven sales for each product line would be:
Standard racket =2K=2 x 1, 250= 2, 500 units
Deluxe racket = K = 1, 250 units
Pro racket =5K =5 x 1, 250 = 6, 250 units
Topper Sports Inc., breakeven at 10, 000 units, i.e., 2, 500 + 1, 250 +6, 250
Multiply unit sales to break even by the selling price of each product in order to determine break-even sales
volume in total Dollars
Racket BEP in Dollars

Standard 2, 500 x $ 40 = $100, 000
Deluxe 1, 250 x $ 60 = $75, 000
Pro 6, 250 x $ 75 = $468, 750
Total…………………………………………….$643, 750
Method II. Contribution Margin Method
Sales mix, given above, for the three rackets Standard: Deluxe: Pro = 2: 1: 5
BEP (in units for Topper Sports)= Fixed Costs = $270, 000
Cm1n1 + Cm2n2 + Cm3n3 16(2)+30(1)+30.8(5)

n1 + n2 + n3 2 +1+5
=10, 000 units

Racket BEP in units
Standard 10, 000 x 2/8 = 2, 500 units
Deluxe 10, 000 x 1/8 = 1, 250 units
Pro 10, 000 x 5/8 = 6, 250 units
Total 10, 000 units
At this it is possible to multiply break-even sales for each product by their corresponding sales price to a
break-even sales of $643, 750 for the company as a whole. Or this break –even sales can be computed with
the following short cut formula:
BEP (in Dollars for Topper Sports) = Fixed expenses
p1n1 + p2 n2 + p3n3
= $270, 000
16(2)+30(1)+30.8(5)
40(2)+60(1)+75(5)
= $ 270, 000
216
515
= $ 270, 000 x 515
216
= $ 643, 750
Example (2) Addis Marine Products Inc. plans to manufacture and sell accessories for recreational fishing
craft and pleasure boats. Three of the principal product lines are manufactured at the Kariba plant. Operating
data for the coming year is estimated as follows:
Product Lines
Kariba-01 Kariba-02 Kariba-03

Sales price $150 $80 $40
Variable costs 100 60 10
Units sales 3, 200 units 1, 600 units 4, 800 units
The total annual fixed cost on the three-product lines amount to $ 840,000
Instructions:
a) Assuming the above sales mix, determine the BEP (break-even point) for Addis Company during the
coming year. Also determine the number of units of each product that should be sold to break even in
units and in Dollars.
b) What volume of sales in Dollars for each product must Addis Marine Products Inc. achieve to earn a
net income of $ 73,500 after taxes in the coming year? Assume the company is subject to a 30%
income tax rate.
c) Calculate the total sales volume in units and in Dollars for each product so that Addis Company
achieves 8.4% return on sales.
d) Suggest any other alternative sales mix that can lower the Company’s BEP in units holding the unit
selling price, the unit variable cost and the total annual fixed costs constant.
Solutions:
a. BEP (in units for Addis)= Fixed Costs = $840, 000
Cm1n1 + Cm2n2 + Cm3n3 50(2)+20(1)+30(3)
n1 + n2 + n3 2 +1+3
= $840, 000
210
6
= 24, 000 units
Product Lines BEP in units BEP in Dollars

Kariba-01 24, 000 x 2/6 = 8, 000 units 8, 000 x 150 =$1, 200,000
Kariba-02 24, 000 x 1/6 = 4, 000 4, 000 x 80 = 320, 000
Kariba-03 24, 000 x 3/6 = 12, 000 12, 000 x 40= 480, 000
Total 24 , 000 units $2, 000, 000

Or computed alternatively:
Fixed expenses
BEP (in Dollars for Addis) = Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3
= $840, 000
50(2)+20(1)+30 (3)
150(2)+80(1)+40(3)
= $2, 000, 000
b. NIAT = $73, 500. This implies that NIBT= $10, 500
Target sales (in units)= FC + NIBT = 840, 000 +105, 000 = 27, 000 units
Average CM 50(2)+20(1)+30(3)
2 +1+3
Product Lines Target sales in units Target sales in Dollars

Kariba-01 27, 000 x 2/6 = 9, 000 units 9, 000 x150 =$1, 350,000
Kariba-02 27, 000 x 1/6 = 4, 500 4, 500 x 80 = 360, 000
Kariba-03 27, 000 x 3/6 = 13, 500 13, 500 x 40= 540, 000
Total 27 , 000 units $ 2, 250, 000
Target Sales (in Dollars for Addis) = Fixed expenses +NIBT = $ 840, 000 +105, 000
Cm1n1 + Cm2n2 + Cm3n3 50(2)+20(1)+30(3)
p1n1 + p2 n2 + p3n3 150(2)+80(1)+40(3)
= $ 945, 000 = $2, 250, 000

210
500
c. Total sales to achieve a target profit = Average P (Q)

Where P =sales price
Q= target sales in units
Average P= 150(2)+80(1)+40(3) =$500
2+1+3 6
Total sales = Average P (Q)=500(Q)

6
Net income =Total sales x Return on sales
=500(Q) x 8.4%
6
=7Q
Target sales (in units)= FC + NIBT = 840, 000 +7Q
Average CM 50(2)+20(1)+30(3)
2 +1+3
Thus, Q = 840, 000 +7Q

50(2)+20(1)+30(3)
2 +1+3
Q = 840, 000 + 7Q
210
6
210 Q =840, 000+7Q

6
210Q=6(840, 000+7Q
210Q=5, 040, 000 + 42Q
168Q=5, 040, 000
Q= 5, 040, 000
168
Q=30, 000 units
d. In a multiproduct company, a switch or movement from less profitable product to more profitable
product lowers break-even point in units keeping other things, i.e., sales prices, variable costs and
fixed cost per period constant. The original sales mix was 2: 1:3 for Kariba-01, Kariba-02 and
Kariba-03, respectively. Suggested sales mix here below reduces the company’s break-even:
Kariba-01: Kariba-02: Kariba-03=3:1:2
Kariba-01: Kariba-02: Kariba-03=4:1:1
Check:
a) BEP with Kariba-01: Kariba-02: Kariba-03=3:1:2
BEP= $840, 000

50(3)+20(1)+30(2)
2 +1+3
=21, 913 units
b) BEP with Kariba-01: Kariba-02: Kariba-03=4:1:1
BEP= $840, 000
50(4)+20(1)+30(1)
2 +1+3
=20, 160 units
5.7 Underlying Assumptions in CVP Analysis
For any CVP analysis to be valid, the following important assumptions must be reasonably satisfied within
the relevant range.
1. Costs are linear (straight-line) through the entire relevant range, and they can be accurately
divided into two variable and fixed elements. This implies the following more specific assumptions.
a. Total fixed expenses remain constant as activity changes, and the unit variable
expense remains unchanged as activity varies.
b. The efficiency and productivity of production process and workers remain constant.
2. The behavior of total revenue is linear (straight-line). This implies that the price of the
product or service will not change as sales volume varies within the relevant range.
3. In multiproduct companies, the sales mix remains constant over the relevant range.
4. In manufacturing firms, inventories do not change, i.e., the inventory levels at the beginning
and end of the period are the same. This implies that the number units produced during the period
equals the number of units sold.
5. The value of a Dollar received today is the same as the value of a Dollar received in any
future year.
5.8 Cost Structure and Operating Leverage

5.8.1 Cost Structure and Profitability
Cost structure refers to the relative proportion of fixed and variable costs in an organization. Highly
leveraged companies are characterized by high fixed cost and low variable costs. In the contrary, low
leveraged companies are characterized by lower fixed costs and higher variable costs, which cost structure is
better-high variable costs and low fixed costs, or the opposite? No categorical answer to this question is
possible: we can simply note that there may be advantages either way, depending on the specific
circumstances involved.
Example (1) Revenue and cost behavior relationships at two firms, A and B, follow:
Firm A Firm B
Sales …………………… $100, 000 100 $100, 000 100
Less variable expenses …. 60,000 60 30,000 30
Contribution margin …… 40,000 40 70,000 70
Less fixed expenses …… 30,000 60,000
Net income ……………. $ 10,000 $ 10,000
Firm A has higher variable costs because it is labor-intensive while Firm B has higher fixed costs as a result
of its investment in machines. The question as to which firm has the better cost structure depends on many,
factors including the long run trend in sales, year-to-year fluctuations in the level of sales and the attitude of
the owners toward risk. If sales are expected to trend above $ 100, 000 in the future, then Firm B has the
better-cost structure. The reason is that its CM ratio is higher, and its profits will therefore increase more
rapidly as sales increase. To illustrate, assume that each firm experiences a 10% increase in sales. The new
income statement will be as follows:
Firm A Firm B

Sales …………………… $110,000 100 $110,000 100
Less variable expenses …. 66,000 60 33,000 30
Contribution margin …… 44,000 40 77,000 70
Less fixed expenses …… 30,000 60,000
Net income …………… $ 14,000 $ 17,000
As we would expect, for the same Dollar increase in sales, Firm B has experienced a greater increase in net
income due to its higher CM ratio.
What if sales can be expected to drop below $100, 000 from time to time? What are the break-even points of
the two firms? What are their margins of safety? The computations needed to answer these questions are
carried out below using the contribution margin method.
Firm A Firm B
Fixed expenses ……………………………….. $30, 000 $60, 000
Contribution margin ratio ………………  40% 70%
breakeven in total sales Dollars . ……… $75,000 $85,714
Total current sales (a) …………………………. $100, 000 $100, 000

break-even sales ………………………………. 75,000 85,714
Margin of safety in sales Dollars (b) ……… $ 25,000 $ 14,286
Margin of safety as a percentage of sales (b)  (a) … 25.0% 14.3%
This analysis makes it clear that Firm A is less vulnerable to downturns than Firm B. We can identify two
reasons why it is less vulnerable. First, due to its lower fixed expenses, Firm A has a lower break-even point
and a higher margin of safety, as shown by the computations above. Therefore, it will not incur losses as
quickly as Firm B in periods of sharply declining sales. Second, due to its lower CM ratio, Firm A will not
lose contribution margin as rapidly as Firm B when sales fall off. Thus, Firm A’s income will be less
volatile. We saw earlier that this is a drawback when sales increase, but it provides more protection when
sales drop.
To summarize, without knowing the future, it is not obvious which cost structure is better. Both have
advantages and disadvantages. Firm B, with its higher fixed costs and lower variable costs, will experience

wider swing in net income as changes take place in sales, with greater profits in good years and greater
losses in bad years. Firm A, with its lower fixed costs and higher variable costs, will enjoy greater stability in
net income and will be more protected from losses during bad years, but at the cost of lower net income in
good years.
5.8.2 Operating Leverage
To the scientist, leverage explains how one is able to move a large object with a small force. To the manager,
leverage explains how one is able to achieve a large increase in profits with only a small increase in sales
and/or assets. One type of leverage that the manager uses to do this is known as operating leverage.
Operating leverage is a measure of the extent to which fixed costs are being used in an organization. It is
greatest in companies that have a high proportion of fixed cost in relation to variable costs. Conversely,
operating leverage is lowest in companies that have a low proportion of fixed costs in relation to variable
costs. If a company has high operating leverage (that is, a high proportion of fixed costs in relation to
variable costs), then profits will be very sensitive to changes in sales. Just a small percentage increase (or
decrease) in sales can yield a large percentage increase (or decrease) in profits.
Operating leverage can be illustrated by returning to the data given above for the two firms, A and B. Firm B
has a higher proportion of fixed costs in relation to its variable costs than does Firm A, although total costs
are the same in the two firms at a $100,000 sales level. We previously showed that with a 10% increase in
sales (from $100,000 to $ 110,000 in each firm), the net income of Firm B increases by 70% (from $10,000
to $17,000), whereas the net income of Firm A increases by only 40% (from $10,000 to $14,000). Thus, for a
10% increase in sales, Firm B experiences a much greater percentage increase in profits than does Firm A.
The reason is that Firm B has greater operating leverage as a result of the greater amount of fixed cost in its
cost structure.
The degree of operating leverage at a given level of sales is computed by the following formula.
Contribution margin = Degree of operating leverage (DOL)
Net income
The degree of operating leverage is a measure, at a given level of sales, of how a percentage change in sales
volume will affect profits. To illustrate, the degree of operating leverage for the two firms at a $ 100, 000
sales would be as follows:

Firm A: $40, 000=4
$10, 000
Firm B: $70, 000=7
$10, 000
These figures tell us that for a given percentage change in sales we can expect a change four times as great in
the net income of Firm A and a change seven times as great in the net income of Firm B. Thus, if sales
increase by 10% then we can expect the net income of Firm A to increase by four times this amount, or by
40%, and the net income of Firm B to increase by seven times this amount, or by 70%.
The degree of operating leverage is greater at sales levels near the break-even point and decreases as sales
and profits rise. This can be seen from the tabulation below, which shows the degree of operating leverage
for Firm A at various sales levels. [Data used earlier for Firm A are shown under column (3)]
Sales ……… $75, 000 $80, 000 $100, 000 $150, 000 $225, 000
Less variable expenses …. 45, 000 48, 000 60, 000 90, 000 135, 000
Contribution margin(a) …… 30, 000 32, 000 40, 000 60, 000 90, 000
Less fixed expenses …… 30,000 30, 000 30, 000 30, 000 30, 000
Net income (b) … $ –0- $2, 000 $ 10, 000 $30, 000 $60, 000
Degree of Operating
leverage (a)÷(b) ∞ 16 4 2 1.5
Thus, a 10% increase in sales would increase profits by only 15%(10% x 1.5) if the company were operating
at a $ 225, 000 sales level, as computed to the 40% increase we computed earlier at the $100, 000 sales level.
The degree of operating leverage will continue to decrease the father the company moves from its break-
even point. At the break-even point, the degree of operating leverage will be infinitely large ($30, 000
contribution margin÷$0 net income=∞)
A manager can use the degree of operating leverage to quickly estimate what impact various percentage
changes in sales will have on profits, without the necessity of preparing detailed income statements. As
shown by our examples, the effect of operating leverage can be dramatic. If a company is fairly near its
break-even point, then even small increase in sales can yield large increase in profits. This explains why
management often works very hard for only a small increase in sales volume. If the degree of operating
leverage is 5, then a 6% increase in sales would translate into a 30% increase in profits.

Chapter VI: Relevant Information & Decision Making
Upon on completing this chapter, you should be able to:
 Discriminate between relevant ad irrelevant information for making decisions.
 Analyze data by the contribution approach to support a decision for accepting or rejecting special
sales order.
 Analyze data by the relevant-information approach to support a decision for adding or deleting a
product line.
 Compute a measure of product profitability when production is constrained by a scare resource.
 Prepare an analysis to support a decision to make or buy certain parts or products.
 Distinguish between joint products and by-products.
 Prepare an analysis showing whether joint products should be sold at the split-off point or process
further.
 Identify sunk costs and explain why they are not relevant in decision whether to keep or replace
equipment.
Decision-making is a fundamental part of management. Managers are constantly faced with problems of
deciding what product to sell, what production method to use, whether to make or buy component parts,
what prices to charge, what channels of distribution to use, whether to accept special orders at special prices,
and so forth. This chapter covers the role of management accounting information in a variety of marketing
and production decisions.

6.1 The Concept of Relevance
Accountants have an important role in the decision-making process, not as a decision maker but as collectors
and reporters of relevant information. What makes information relevant to a decision problem? Relevant
information is the predicted future costs and revenues that will differ among the alternatives. These two
criteria are discussed here under:
Bearing on the Future: To be relevant to a decision, cost or benefit information must involve a future event.
Relevant information is a prediction of the future, not a summary of the past. Historical (past) data have no
bearing on a decision. Such data can have an indirect bearing on a decision because they may help in
predicting the future. But past figures, in themselves, are irrelevant to the decision itself. Why? Because
decision-making affect future, but not past. Nothing can alter what has already happened.
Different under Competing Alternatives: Relevant information must involve future costs or benefits that
differ among the alternatives. Costs or benefits that are the same across all the available alternatives have no
bearing on the decision. For example, if management is evaluating the purchase of either a manual or an
automated drill press, both of which require skilled labor costing $ 10 per hour, the labor rate is not relevant
because it is the same for both alternatives.
Why Isolate Relevant Information?
Why is it important for the management accountant to isolate the relevant costs and benefits in a decision
analysis? The reasons are twofold.
First, generating information is a costly process. The management accountant can simplify and shorten the
data gathering process by focusing on only relevant information.
Second, people can effectively use only a limited amount of information. If a manager is provided with
irrelevant revenues and costs, these figures can cause information overload, and decision-making
effectiveness of the manager declines.
Example (1) Marina Company, a manufacturer of a line of ashtrays, is thinking of using aluminum instead
of copper in the manufacture of its product. Historical direct material costs were $ 0.30 per unit. The

company expected future costs for aluminum is $ 0.20 and it is unchanged for copper. Direct labor cost was
$ 0.70 per unit and will not be affected by the switch in materials. The analysis in a nutshell is as follows.
Copper Aluminum Difference

Direct material $ 0.30 $ 0.20 $ 0.10
Direct labor 0.70 0.70 -
Required: Given the above-summarized data identify the relevant data for the decision on hand.
Solution:
The cost of copper and direct labor costs used for this comparison probably came from historical cost records
on the amount paid most recently for copper and direct laborers, respectively. Past or historical costs are
relevant to the decision only if they are expected to continue in the future, or are used as the basis for
predicting the future costs.
In the foregoing analysis, the material cost (the expected future cost of copper compared with the expected
future cost of aluminum) is the only relevant cost. The material cost met both criteria for relevant
information.
That is, bearing on the future and an element of difference between the alternatives. However, the direct –
labor cost will continue to be $ 0.70 per unit regardless of the material used. It is irrelevant because the
second criterion – an element of difference between the alternatives – is not met.
Therefore we can safely exclude direct labor. There is no harm in including irrelevant items in a formal
analysis, provided that they are included properly. However, confining the reports to the relevant items
provides greater clarity and time savings for busy managers.
6.2 Alternative Choice Decisions
Many of the decisions described in this chapter are frequently referred to as alternative choice decision.
Alternative choice decisions are situations with two or more courses of action from which the decision maker
must select the best alternative.
The variety of alternative choice decisions is limitless. Some business example follows:
 Should we accept a special order for a product below our normal selling price?
 Should we raise the price of a product or maintain the current price?

 Should we make or buy a component part?
 Should we sell a joint product at the split off point or process it further?
 Should we keep our copying machine or acquire a faster one?
The analyses of these and other types of alternative choice decisions are aided by relevant cost and benefit
data.
6.2.1 Marketing Decisions
The discussions that follow illustrate a variety marketing and production decisions. The marketing decisions
for which we examine relevant information include special order decisions, addition or deletion, and optimal
use of limited resources.
6.2.1.1 Special Order Decisions
A special order is a one-time order that is not considered part of the company’s normal on going business.
For example, a discount department store chain planning a big spring sale offers to make a large one-time
purchase of a firm’s product but wants a reduced price. In general, a special order is profitable as long as the
incremental revenue from the special order exceeds the incremental costs of the order. The incremental
revenue in this decision will be the price per unit offered by the potential customer times the number of units
to be purchased. The incremental costs will be the amount of the expected cost increase if the offer is
accepted. The incremental cost usually includes variable manufacturing costs of producing the units. Since
the units being sold in the special order are not being sold through the firm normal distribution channel, the
firm may or may not incur variable selling and administrative expenses in conjunction with the special order.
The incremental costs usually do not include fixed manufacturing costs. Although the fixed costs must be
incurred to permit production, the amount of fixed costs incurred by the firm usually will not increase if the
special order offer is accepted. For the same reason, other fixed expenses, such as fixed selling and
administrative expenses, are usually not relevant in the special order price.
However, management must also be assured that it has sufficient capacity to produce the special order
without affecting normal sales. When there is no excess capacity, the opportunity cost of using the firm’s
facilities for the special order are also relevant to the decision. The opportunity cost would be the
contribution margin forgone on regular sales that have to be reduced to accommodate the special order. The
relevant costs to accept the special order, therefore, would include a forgone contribution margin on regular

sales that could not be made in addition to the incremental costs associated with the special order that have
already been discussed.
Example (1) Consider the following details of the income statement of Samson Company for the year just
ended December 31, 20 x 3.
Sales (1,000,000 units) $ 20,000,000
Manufacturing cost of goods sold 15,000,000
Gross margin $ 5,000,000
Selling and administrative expenses 4,000,000
Operating income $ 1,000,000
Samson’s fixed manufacturing costs were $ 3 million and its fixed selling and administrative costs were $
2.9 million.
Near the end of the year, Kariba Company offered Samson $ 13 per unit for 100,000 unit special order. The
special order would not affect Samson’s regular business in any way. Furthermore, the special sales order
would not affect total fixed costs and would not require any additional variable selling and administrative
expenses.
Instruction: Should Samson accept or reject the special order? By what percentage the operating income
decreases or increases if the order had been accepted? Assume that the company would utilize its idle
manufacturing capacity to accept the special order.
Solution:
There are two approaches to costs on income statement.
1. Absorption/financial approach
2. Contribution approach
An absorption approach is a costing technique that considers all factory overheads (both variable and fixed)
to be product costs that become an expense in the form of manufacturing cost of goods sold as sales occur.
A contribution approach is a method of internal reporting (management accounting) that emphasizes the
distinction between variable and fixed costs for the purpose of better decision.
Financial Approach Contribution Approach

Sales xxx Sa l e s xxx
Cost of goods sold xxx Variable costs xxx
Gross profit xxx Contribution margin xxx
Selling and Administrative expenses xxx Fixed costs xxx
Operating income xxx Operating income xxx
Exhibit 6-1 Approaches to costs on income statement
The correct analysis to the above problem employs the contribution approach to income statement, not the
financial approach. The fallacy in the case of the later approach is that it treats a fixed cost, i.e., fixed
manufacturing cost as if it were variable.
Exhibit 6-2 The correct analysis

Without special Effectof special With special
order order order
1,000,000 units 100,000 units 1,100,000units
Sales $ 20,000,000 $ 1,300,000 $ 21,300,000
Variable expenses
Manufacturing $ 12,000,000 $ 1,200,000 $ 13,200,000
Selling and Administrative 1,100,000 - 1,100,000
Total variable expenses $ 13,100,000 $ 1,200,000 $ 14,300,000
Contribution Margin $ 6,900,000 $ 100,000 $ 7,000,000
Fixed expenses
Manufacturing $ 3,000,000 - $ 3,000,000
Selling and administrative 2,900,000 - 2,900,000
Total fixed expenses $ 5,900,000 - $ 5,900,000
Operating income $ 1,000,000 $ 100,000 $ 1,100,000
The accountant’s role in decision making is primarily that of a technical expert on cost analysis, i.e.,
collecting and reporting relevant information. However, many managers want the accountant to recommend
the proper decision; the final choice always rests with the operating executives.
Recommendation: Based on the relevant data, Samson Company should accept the special order because it
$ings an additional income of $ 100,000 for company and as a result the operating income increase by 10%
if the order had been accepted.
Income with special order $ 1,100,000

Income without special order 1,000,000
Additional income if the order had been accepted $ 100,000
%NI = NI
NIo
Where : %NI = Percentage change in income.
NI = Change in income.
NIo = Income if the special order had not been accepted.
%NI = NI = $ 100,000 = 0.1 or 10%
NIo $ 1,000,000
Exhibit 6-3. The Incorrect Analysis

Without Special Incorrect effect of With special
order special order order
1,000,000 units 100,000 units 1,100,000 units
Sales $ 20,000,000 $ 1,300,000 $ 21,300,000
Manufacturing COGs* 15,000,000 1,500,000 16,500,000
Gross margin $ 5,000,000 $ (200,000) $ 4,800,000
Selling&administrative expenses 4,000,000 - 4,000,000
Operating income $ 1,000,000 $ (200,000) $ 800,000
*COGs denote cost of goods sold.
Here above, the analysis treats the fixed manufacturing COGs as if it were variable. Refer the effect of the
special order on manufacturing COGs; it amounted to $ 1,500,000 that include $ 300,000 fixed cost.
However, the special sales order would not affect the total fixed costs.
Example (2) Lucy Company has the capacity to produce 15,000 units per month. Current regular production
and sales are 10,000 units per month at a selling price of $ 15 each. Based on the current production level,
the following costs are to be incurred per unit:
Direct materials $ 5.00
Direct labor 3.00
Variable factory overhead (FOH) 0.75
Fixed FOH 1.50
Variable selling expense 0.25
Fixed administrative expense 1.00

Lucy Company has received special order from a customer that wants to purchase 4,000 units at $ 10 each.
There would be no selling expense in connection with this special order.
Instructions:
a. Should Lucy Company accepts or rejects the special order? Why or Why not? Assume that the special
order should not disturb regular business.
b. Suppose that the special order was for 8,000 units instead of 4,000 units. Thus, regular business would be
reduced by 3,000 units to accept the special order because production capacity cannot be expanded in the
short run. What would be the overall profit of the firm if it accepts this order?
c. Refer the data given in requirement (b) above. At what selling price per unit from the customer would the
Lucy Company be economically indifferent between accepting and rejecting the offer?
Solutions:
a. Here, the incremental costs (variable manufacturing costs) are the only relevant costs. The special order
would have no effect on the company’s variable selling expenses. Since the existing fixed costs would not be
affected by the order, they are not incremental costs and are therefore not relevant. The incremental net
operating income from accepting the special order can be computed as follows:
Per unit Total

Incremental revenue $ 10.00 $ 40,000
Incremental costs:
Variable costs
Direct material 5.00 20,000
Direct labor 3.00 12,000
Factory overhead 0.75 3,000
Total variable costs $ 8.75 $ 35,000
Fixed costs 0
Total incremental costs $ 35,000
Incremental net operating income $ 5,000
Accepting the special order will increase costs by $ 8.75 per unit produced. The offered price of $ 10 per
unit exceeds the $8.75 incremental variable costs, implying that the special order will provide a positive
contribution to profits. The contribution margin earned on the order will be $ 1.25 per unit, so for the 4,000
units special order, the firm should be $ 5,000 ($ 1.25 x 4,000) better off by accepting the special order.

Unit variable cost = 5 + 3 + 0.75 + 0.25 = $ 9.00
Unit fixed costs = 1.50 + 1.00 = $ 2.50
Total fixed costs = 2.50 x 10,000 = $ 25,000
Income = Total sales – Total variable cost – Total fixed costs
Income (for 10,000 units of regular sale) = [10,000(15-9)] -25,000 = $ 35, 000
Income with special order (for 14, 000unit) = 35,000 + 5,000 = $ 40,000
Income without special order = 35,000
Advantage of accepting the special order $ 5,000
b. In this case, the company has no sufficient capacity to produce the special order without affecting normal
sales. Therefore, the relevant costs to use in evaluating the special order include an opportunity cost. The
opportunity cost is the contribution margin forgone on regular sales. The net relevant costs to accept the
special order would now be the total of $ 70,000 variable manufacturing costs and a forgone contribution
margin of $ 18,000. The total cost of accepting the special order, $ 88,000, exceed the offered selling price
of $ 80,000.
Incremental revenue $ 80,000
Incremental cost
 Variable costs * $ 70,000
 Opportunity costs 18,000 88,000
Decremental net operating income $ (8,000)
Incremental revenue = 10 x 8,000 = $ 80,000

Variable costs = 8,000 (5 + 3 + 0.75) = $ 70,000
Opportunity cost = 3,000 [15 – (5 + 3 + 0.75 + 0.25)] = $ 18,000
Note that special order would not require the $ 0.25 variable selling expenses. The normal sales however,
require the $ 0.25 variable selling expense
Recommendation. Lucy Company should not accept the special order because it has a net $ 8,000
disadvantage.
The above analysis may be presented as tabulated here below:

WITHOUT EFFECT OF EFFECT OF WITH
SPECIAL SPECIAL ORDER SPECIAL SPECIAL
ORDER ON REGULAR ORDER 8,000 ORDER
10,000 units SALES 3,000 units units 15,000 units
Sales $ 150,000 $ 45,000 $ 80,000 $ 185,000
Variable expenses
Direct material $ 50,000 $ 15,000 $ 40,000 B4. 75,000
Direct labor 30,000 9,000 24,000 45,000
Factory overhead 7,500 2,250 6,000 11,250
Selling 2,500 750 - 1,750
Total variable costs $ 90,000 $ 27,000 $ 70,000 $ 133,000
Contribution margin $ 60,000 $ 18,000 $ 10,000 52,000
Fixed expenses
Factory overhead $ 15,000 - - $ 15,000
Administrative 10,000 - - 10,000
Total fixed expenses $ 25,0 00 - - $ 25,000
Operating income (loss) $ 35,000 $ 18,000 $ 10,000 $ 27,000
Income with special order = $ 27,000

Income without special order = 35,000
Disadvantage of accepting the special order $ (8,000)
c. In requirement (b) above the company will be economically indifferent between accepting and rejecting
the special sales order if the contribution to profit from the special order equals a contribution margin
forgone from regular sales. Therefore, the offer “p” will make Lucy Company equally attractive between
two alternatives as computed here under:
P (8,000) – 8,000 (8.75) = 18,000
P (8,000) = 18,000 + 70,000
P (8,000) = 88,000
P = 88,000
8,000
P = $ 11
Thus, assuming an offer of $ 11 instead of $ 10, the company will be indifferent between accepting and
rejecting the special order in requirement (b) above.

6.2.1.2 Deletion or Addition of Products or Departments
Decisions relating to whether old product lines or other segments of a company should be dropped and new
ones added are among the most difficult that managers have to make. In such decisions, many factors must
be considered that are both qualitative and quantitative in nature. Ultimately, however, any final decision to
drop an old segment or to add a new one is going to hinge primarily on the impact the decision will have on
net operating income. To assess this impact, it is necessary to make a careful analysis of the costs involved.
To this end, let us try to distinguish the difference between avoidable and unavoidable fixed expenses.
Fixed costs are divided into two categories, avoidable and unavoidable. Avoidable costs are costs that will
not continue if an ongoing operation is changed, deleted or eliminated. These costs are relevant costs in
decision-making. Examples of avoidable costs include departmental salaries and other costs that could be
avoided by not operating the specific department. Unavoidable costs are costs that continue even if a
subunit or an activity is eliminated and are not relevant for decision. The reason for this is that such costs are
not affected by a decision to delete a particular activity. Unavoidable costs include many common costs,
which are defined as those costs of facilities and services that are shared by users. Examples are store
depreciation, heating, air conditioning, and general management expenses.
Example (1) Eyoha Department Store has three major departments: groceries, general merchandise, and
drugs. Management is considering dropping groceries, which have consistently shown a net loss. The
following table reports the present annual net income (in thousands).
DEPARTMENTS
Groceries General merchandise Drugs Total
Sales $ 1,000 $ 800 $ 100 1,900
Variable COGS* & Expenses 800 560 60 1,420
Contribution margin $ 200 $ 240 $ 40 $ 480
Fixed expenses
Avoidable $ 150 $ 100 $ 15 $ 265
Unavoidable 60 100 20 180
Trial fixed expenses $ 210 $ 200 $ 35 $ 445
Operating income (loss) $ (10) $ 40 $5 $ 35
*COGS denote cost of goods sold.

Instructions:
a. Which alternative would you recommend if the only alternatives to be considered are dropping or
continuing the grocery department? Assume that the total assets would be unaffected by the decision
and the space made available by dropping groceries would remain idle.
b. Refer the income statement presented above. However, assume that the space made available by
dropping groceries could be used to expand the general merchandise department. The space would
be occupied by merchandise that would increase sales by $ 500,000, generate a 30% contribution
margin percentage and have additional avoidable fixed costs of $ 70,000. Should Eyoha discontinue
grocery and expand merchandise department?
a)
A B A–B
Total before Effect of dropping Total after change
change grocery
Sales $ 1,900 $ 1,000 $ 900
Variable COGS and Expenses 1,420 800 620
Contribution margin $ 480 $ 200 $ 280
Fixed expenses
Avoidable $ 265 $ 150 $ 115
Unavoidable 180 - 180
Total fixed expenses $ 445 $ 150 $ 295
Operating income (loss) $ 35 $ 50 $ (15)
Income with grocery department = $ 35,000

Loss assuming grocery is eliminated = (15,000)
Disadvantage of discontinuing grocery = $ (50,000)
Notice that all of the grocery’s variable expenses are avoidable. If the grocery department is discontinued,
the $ 60,000 of the fixed expenses will continue. Eyoha Department Store will incur these expenses
regardless of its decision about that particular department.
Recommendation: Dropping grocery and leaving the vacated facilities idle would be worse. Groceries $ing
in contribution margin of $ 200,000, which is $ 50,000 more than the $ 150,000 fixed expenses that would be
saved by closing the grocery department.
b)
A B C (A – B ) + C
Total before Effect of Effect of Total

change Dropping Expanding after
Groceries General Change
Merchandise
Sales $ 1,900 $ 1000 $ 500 $ 1,400
Variable COGS and Expense 1 ,4 2 0 800 350 970
Contribution margin $ 480 $ 200 $ 150 $ 430
Fixed expenses
Avoidable $ 265 $ 150 $ 70 $ 185
Unavoidable 180 - 180
-
Total fixed expenses $ 445 $ 150 $ 70 $ 365
Operating income (loss) $ 35 $ 50 $ 80 $ 65
Effect of expanding general merchandise:

Incremental revenue = $ 500,000
Incremental cost
Variable cost = (1-0.30) x 500,000 = (350,000)
Fixed cost = (70,000)…..(420, 000)
Incremental income $ 80,000
N.B. All Dollars in the exhibit above are in thousands.
Recommendation: The conclusion in (a) will be correct if and only if the space made available by dropping
grocery would be idle. As the above analysis shows, dropping grocery and using the vacated space to
expand general merchandise is recommendable. The $ 80,000 increase in operating income of general
merchandise more than offset the $ 50,000 decline fro eliminating groceries, providing an overall increase in
operating income of $ 30,000, i.e., $ 65,000 less $ 35,000.
6.2.1.3 Optimal Use of Limited Resources

Managers are routinely faced with the problem of deciding how scarce resources are going to be utilized. A
scarce resource or a limiting factor refers to any factor that restrict or constraint the production or sale of a
product or service. It include the following, among others, labor hours, machine hours, square feet of floor
space, cubic meters of display space .A department store, for example, has a limited amount of floor space
and therefore cannot stock every product that may be available. A manufacturing firm has a limited number

of machine- hours and a limited number of direct labor-hours at its disposal. When capacity becomes pressed
because of scarce resource, the firm is said to have a constraint.
When a plant that makes more than one product is operating at capacity, managers often must decide which
orders to accept. The contribution margin technique also applies here, because the product to be emphasized
or the order to be accepted is the one that makes the biggest total profit contribution per unit of the limiting
factor. Fixed cost are usually unaffected by such choices.
In such kind of decision, the contribution margin technique must be used wisely. Managers sometimes
mistakenly favor those products with the biggest contribution margin or gross margin per sales Dollar,
without regard to scarce resources.
Example (1): Wajo Company has two products: a plain cellular phone and a fancier cellular phone with
many special features. Unit data follow:
Plain Phone Fancy Phone

Selling price $80 $120
Variable costs 64 84
Contribution margin $16 $36
Contribution margin ratio 20% 30%
Instructions:
a. Which product is more profitable? On which should the firm spend its resources? Assume that sales
are restricted by demand for only a limited number of phones.
b. Now suppose that annual demand for phones of both types is more than the company can produce in
the next year and the major constraint is the availability of time on a processing machine. Plain Phone
requires one hour of processing on the machine, Fancy Phone requires three hours of processing.
Which product is more profitable? Assume that only 10, 000 machine hours of capacity are available.
Solution:
a. Under this circumstance, the limiting factor is units of sale. Thus, the more profitable product is the one
with the higher contribution margin per unit. The fancier cellular phone appears to be more profitable than
the plain phone. It has $36 per unit contribution margin as compared to $16 per unit for the plain model,
and it has a 30% CM ratio as compared to 20% for the plain model.

To maximize total contribution margin, a firm should not necessarily promote those products that have
the highest contribution margins. Rather, total contribution margin will be maximized by promoting
those products or accepting those that provide the highest unit contribution margin in relation to scarce
resources of the firm.
b. In requirement (b) above, for instance, the productive capacity is the limiting factor because only 10,
000hours of capacity is available. To answer this question, the manager should look at the
contribution per unit of the scarce resource. This figure is computed by dividing the contribution
margin for a unit of product by the amount of the scarce resource it requires. These calculations are
carried out below for the plain and fancy phones.
Model
Plain Phone Fancy Phone
Contribution margin (CM) per unit (a) $16 $36
Machine hours required per unit (b) 1 hour 3 hours
CM per unit of the scarce resource (a÷b) $16 per machine $ 12 per machine hour
hour
With this data in hand, it is easy to decide which product is less profitable and should be de-emphasized.
Each hours of processing time on the machine that is devoted to the plain phone results in an increase of $16
in contribution margin and profits. The comparable figure for the fancier phone is only $12 per hour.
Therefore, the plain model should be emphasized in this situation. Even though the fancier model has the
larger per unit contribution margin and the larger CM ratio, the plain model provides the larger contribution
margin in relation to scarce resource.
6.2.2 Production Decisions
This part and the preceding one illustrate relevant costs for many types of decisions. Does this mean that
each decision requires a different approach to identifying relevant costs? No. The fundamental principle in
all decision situations is that relevant costs are future costs that differ among alternatives. The principle is
simple, but its application is not always straightforward.

Managers must have tools at their disposal to assist them in distinguishing relevant and irrelevant costs so
that the latter can be eliminated from the decisions framework.
What costs are relevant in decision-making? The answer is easy. Any future cost that makes a difference
between decisions alternative is relevant for decision purpose. All costs are considered relevant, except
a) Sunk costs. A sunk cost is a cost that has already been incurred and that cannot be avoided
regardless of which course of action a manager may decide to take. As such, sunk costs have no
relevance to future events and must be ignored in decision-making.
b) Future costs that do not differ between the alternatives at hand.
Relevant costs are avoidable costs. An avoidable cost can be defined as cost that can be eliminated as a result
of choosing one alternative over another in a decision-making situation.
In management accounting, the term avoidable is synonymous with differential cost. These terms are
frequently used interchangeably. To identify the costs that are avoidable (differential) in a particular decision
situation, the manager’s approach to cost analysis should include the following steps:
 Assemble all of the costs associated with each alternative being considered.
 Eliminate those costs that are sunk.
 Eliminate those that do not differ between alternatives.
 Make a decision based on the remaining costs. These costs will be the differential or avoidable costs,
and hence the costs relevant to the decision to be made.
6.2.2.1 Make or Buy Decisions

Managers in manufacturing companies are often faced with the problem whether to manufacture a
component used in manufacturing a product or to purchase from the outside. Production of such basic
materials as screws, nails, washers, sheet metal and so on is not usually economical owing to specialization
and returns to scale. These materials can almost always be acquired more cheaply from outside suppliers.
But for many materials, such as subassemblies and special parts, it is not always clear which is least costly
means of acquisition. The cost and management accounting system assist managers in arriving at a correct
decision by presenting suitable analysis of the cost of production and comparing it with the purchase price of
the product.

In make or buy decisions, the appropriate means of analysis is to compare the relevant cost of buying the part
with the relevant costs of making the part. Here relevant cost of buying the component is typically the
amount paid to supplier. It may also include transportation costs incurred to get the component to the
company’s plant and costs incurred to process the part upon receipt.
The relevant cost of making the component is often the variable costs incurred to produce the component. In
some cases, however, the company will need to acquire special equipment to produce the product or will hire
additional supervisory personnel to assist with making the product. These incremental fixed costs will be part
of the relevant cost of making the part. The alternative chosen make or buy, is typically the one with the
lowest cost.
In the final decision regarding make or buy qualitative factors, besides the quantitative data, should be
considered as part of the decision.
In make or buy decision, the following qualitative factors, besides the quantitative considerations may favor
the decision to “buy”:
 Advantage of long-term relationship with suppliers.
 Possibility of shortage of material or labor for making the component.
 Uninterrupted supply of requisite quality from reliable suppliers.
 The internal demand for the product under consideration is small and, as such, it is no use to set up
manufacturing facilities for it and so forth.
On the contrary, the following qualitative factors may favor the decision “to make”:
 The quality of the product is decided to be controlled.
 If the purchase price is likely to rise due to increased demand in the market, it becomes uneconomical
to buy.
 Where the technical know-how is to be kept secret and not to be passed on to the suppliers and so on.
Example (1) Great Company manufactures 60, 000 units of part XL-40 each year for use on its production
line. The following are the costs of making part XL-40:
Total Costs Cost per

60, 000 units unit
Direct material $ 480, 000 $8
Direct labor 360, 000 6
Variable factory overhead (FOH) 180, 000 3
Fixed FOH 360, 000 6

Total manufacturing costs $ 1, 380, 000 $23
Another manufacturer has offered to sell the same part to Great for $21 each. The fixed overhead consists of
depreciation, property taxes, insurance, and supervisory salaries. The entire fixed overhead would continue if
the Great Company bought the component except that the cost of $ 120, 000 pertaining to some supervisory
and custodial personnel could be avoided.
Instructions:
a) Should the parts be made or bought? Assume that the capacity now used to make parts internally will
become idle if the pats are purchased?
b) Assume that the capacity now used to make parts will be either (i) be rented to near by manufacturer
for $ 60, 000 for the year or (ii) be used to make another product that will yield a profit contribution
of $ 250,000 per year. Should the company purchase them from the outside supplier?
Solutions:
a) To approach the decision from a financial point of view, the manager must focus on the relevant or
differential costs. The differential cost can be obtained by eliminating from the cost data those costs that
are not avoidable –that is, by eliminating the sunk costs and the future costs that will continue regardless
of whether the parts XL-40 are produced internally or purchased from outside.
Thus, the relevant cost computation follows:

COST TO MAKE COST TO BUY
Per Unit Total Per Unit Total
Direct materials $8.00 $480, 000
Direct labor 6.00 360, 000
Variable FOH 3.00 180, 000
Fixed FOH, avoidable 2.00 120, 000 _______ ___________
Total cost $ 19.00 $ 1, 140, 000 $21.00 $1, 260, 000
Here above, the analysis shows that the variable costs of producing the part XL-40 (materials, labor, and
variable overhead) are differential costs. All these variable costs, therefore, can be avoided or eliminated by
buying the part from the outside supplier.

Again, are only the variable costs relevant? No. Perhaps $ 120, 000 of the total fixed factory overhead cost is
avoidable by purchasing the component part from outside, then it too will be a differential cost and relevant
to the decision. Therefore, the decision should be made by comparing the total of all variable costs and the
avoidable fixed factory overhead against the total purchase price- that is, cost to buy.
Recommendation: Great Company should reject the outside supplier’s offer because it costs $2 less per unit
to continue to make the part XL-40. This is a total of $120, 000 net advantages.
Relevant Costs Per Unit
Cost to buy $21.00
Cost to make 19.00
Advantage of making the part internally $ 2.00
Total advantage = $ 2.00 x 60, 000 units=$ 120, 000
b) If the space now being used to produce the part would otherwise be idle, then Great should continue to
produce its own XL-40and the supplier’s offer should be rejected, as stated above. Idle space that has
no alternative use has an opportunity cost of zero.
But what if the space now being used to produce the part would not sit idle rather could be used for some
other purpose? In that case, the space would have an opportunity cost that would have to be considered in
assessing the desirability of the supplier’s offer. What would this opportunity cost be? It would be the
segment margin that could be derived from the best alternative use of the space. Therefore, the use of the idle
facilities may change our previous decision in requirement (a) above.
Assuming the space now being used to produce part XL-40 would be
i) Rented to a nearby manufacture for $ 60, 000 per annum or
ii) Used to produce other product that contributes a profit of $ 250, 000 per year, the relevant cost
computation follows:
Make Buy and Buy and Buy and

Leave Facility Rent out Produce Other
Idle Product
Cost to obtain parts $ 1, 140,000 $ 1, 260, 000 $1, 260, 000 $ 1, 260, 0000
Contribution from other products - - (250, 000)
Rent revenue - - (60, 000) -
Net relevant costs $ 1, 140, 000 $ 1, 260, 000 $1, 200, 000 $1, 010, 000

Great company would be better off through accepting the supplier’s offer and to using the available facility
to produce the new product line. This move has the least net relevant cost of $ 1,010,000.
Example (2) Assume that a division of Leranso Company makes an electric component for its speakers. The
management is trying to decide whether the division of the company should manufacture this component part
or purchase it from another manufacturer.
The following are production costs for 100,000 units of the component for the forth-coming year.
Direct material $500, 000
Direct labor 200,000
Factory overhead
Indirect labor $ 32,000
Supplies 90,000
Allocated occupancy costs 50,000 172,000
Total cost $872, 000
A small local company has offered to supply the components at a price of $7.80 each. If the division
discontinued the production of its components it would save two thirds of the supplies cost and $22, 000 of
indirect labor cost. All other overhead costs would continue regardless of the decision made.
Instruction: Should the parts be made or bought? Assume that the capacity now used to make the parts will
become idle if they are purchased from outside.
Solution:
In this case $10, 000 of indirect labor cost and the $50, 000 allocated occupancy costs are unavoidable costs.
That is, a total of $ 60,000 fixed overhead costs cannot be eliminated irrespective of the decision made.
Therefore, these costs are irrelevant for the decision making at hand. The relevant costs can be computed as
follows.
COST TO MAKE COST TO BUY
Unit Total Unit Total
Direct material $ 5.00 $ 500,000
Direct labor 2.00 200,000
Factory overhead
Indirect labor 0.22 22,000
Supplies 0.60 60,000
Occupancy costs - - ______ _________
Total cost $7.82 $782, 000 $7.80 $780,000
Leranso should purchase the component from the supplier because the form saves $ 2,000 by purchasing the
component.

Net relevant cost to make $ 782,000
Net relevant cost to buy 780,000
Advantage of purchasing the part from outside $ 2,000
6.2.2.2 Joint Product Decisions: Sell or Process Further
Often a firm manufactures several different products from a common input and a common production
process. In some cases of such multiple product processing, only one product is of major importance. The
other products are incidental to production. For example, processing of log in a wood industry produces
lumber and saw dust where the latter is produced incidentally. In other cases, several products of comparable
value or importance emerge from a single process. For example, gasoline, jet fuel, and lubricants all result
from petroleum refining. The accountant classifies multiple products according to their relative importance.
The principal product is called the main product. Incidental products of lesser value are usually called by –
products. Products of nearly equal value are usually called joint products, or co-products.
When two or more manufactured products have relatively significant sales values and are not separately
identifiable as individual products until their split off, they are called joint products.
 Split –off point- is the juncture in manufacturing where the joint products become individually
identifiable.
 The costs of manufacturing joint products before the split – off are called joint costs. The costs of
further processing beyond the split-off are separable costs.
Firms that produce several end products from a common input are faced with the problem of deciding
whether it is more advantageous to sell the products at split- off point or process them further. When such a
choice is available, managers must be familiar with the relevant cost and revenue data to reach a correct
decision.
Here, the decision whether to sell or process further will be taken by comparing the additional cost of
processing with the incremental revenue obtainable from the product processed further. This decision will
not be influenced either by the size of the joint cost or the portion of the joint cost allocated to the product
which is to be processed further. Thus, joint product costs are irrelevant in decision regarding what to do

with a product from the split-off point forward, the joint product costs have already been incurred and
therefore are sunk costs. However, allocation of joint product costs is need for some purposes, such as
balance sheet inventory valuation. In case joint products are on hand at the end of an accounting period,
some value must be assigned to them. To do so, joint product costs must be allocated to specific units of
inventory.
 As a general rule, it will always be profitable to continue processing a joint product after the split –off
point so long as the incremental revenue from such processing exceeds the incremental costs.
Example (1) GREAT Co. uses a common direct material R that has a joint product cost of $ 16,000 and
yields 6,000 pounds of product X selling for $ 3 per pound and 4,000 pounds of product Y selling for $ 3.50
per pound. Product X can be processed further into XP at an additional cost of $ 8,000, and product Y can be
processed further into YP at an additional cost of $ 6,000. The new products, XP and YP, can then be sold
for $ 4 and $ 6 per pound, respectively.
Instruction: Which product (s) should be sold at split off and which should be sold after processed further?
Why? Assume no loss of input in further processing.
Solution:
Product XP
Sales revenue (6,000 x $ 4) $ 24, 000
Less: Sales value at split- off (6,000 x $ 3) 18, 000
Additional sales revenue $ 6, 000
Less: separable costs 8, 000
Disadvantage (loss) of processing further $ (2, 000)
Product YP
Sales revenue (4,000 x $ 6) $ 24, 000
Less: Sales value at split- off (4,000 x $ 3.50) 14, 000
Additional sales revenue $ 10, 000
Less: separable costs 6, 000
Advantage of processing further $ 4, 000
Comment: From this analysis, a manager would correctly conclude that product X should be sold at the split
–off and product Y should be processed into product YP. The joint product cost of $ 16,000 should not be
used to reach this decision. Rather, the analysis should be limited to the difference between the incremental
revenue and the incremental (separable) cost.
Example (2) UNITED Chemical Company produces three chemical products, x, y and z, as a result of a
particular joint process. The joint process cost is $ 105,000. This includes raw material costs and the cost of

processing to the point where these joint products go their separate ways. These products were processed
further and sold as follows:
CHEMICAL ADDITIONAL PROCESSING

PRODUCTS SALES COSTS
X $ 260,000 $ 220,000
Y 330,000 300,000
Z 175,000 100,000
The company has had an opportunity to sell at split-off directly to other processors. If that alternative had
been selected, sales would have been: X, $ 56,000, Y, $ 28,000 and Z, $ 54,000.
The company expects to operate at the same level of production and sales in the forth-coming year.
Consider all the available information, and assume that all costs incurred
after split-off are variable.
Instruction:
a. Which products should be processed further and which should be sold at split-off?
a. Could the company increase operating income by altering its processing decisions? If so, what would
be the expected overall operating income?
Solutions:
a.
Products Sales At Sales After Incremental Incremental Difference
split-off Further Revenue Cost Separable
Process cost
X $ 56,000 $ 260,000 $ 204,000 $ 220,000 $, (16,000)
Y 28,000 330,000 302,000 300,000 2,000
Z 54,000 175,000 121,000 100,000 21,000
Comment: The above analysis shows that X should be sold at Split-off and Y and Z should be sold after
processed further. Further processing Y and Z have an advantage of $ 2,000 and $ 21,000, respectively. On
the other hand, processing X beyond split-off point has a net $ 16,000 disadvantage.
b. (i) Operating income (OI) with the current processing decision

OI= Total sales - (Joint Cost + Separable costs)
Operating income = (260,000+330,000+175,000)-(105,000+220,000+300,000+100,000)
= $ 40,000

(ii) Operating income (OI) with the recommended processing decision.
OI = (56,000+330,000+175,000)-(105,000+300,000+100,000)
= $ 56,000
Increase in operating income = $ 56,000-$ 40,000
= $ 16,000
This analysis also shows that the recommended processing decision has a net $ 16,000 advantage, which
equals the disadvantage of processing X further.
6.2.2.3 Keep or Replace Equipment Decisions
Care must be taken to select only the data that are relevant for a decision whether to replace or keep the old
equipment. In such kind of decision, the book value of the old equipment is not a relevant consideration, for
instance.
In deciding whether to replace or keep existing equipment, four commonly encountered items differ in
relevance:
(i) Book value of old equipment: Irrelevant, because it is a past (historical) Cost. Therefore,
depreciation on old equipments irrelevant.
(ii) Disposal value of old equipment: Relevant, because it is an expected future inflow that usually
differs among alternatives.
(iii) Gain or loss on disposal: This is the alge$aic difference between book value and disposal value. It
is therefore, a meaningless combination of irrelevant and relevant items. Consequently, it is best to
think of each separately.
(iv) Cost of new equipment: Relevant, because it is an expected future outflow that will differ among
alternatives. Therefore depreciation on new equipment is relevant.

Example (1) Consider these data regarding Success co. photocopying requirements:
Old Proposed
Equipment Replacement
Equipment
Useful life, in years 5 3
Current age, in years 2 0
Useful life remaining, in years 3 3
Original cost $ 25,000 $ 15,000
Accumulated depreciation 10,000 0
Book value 15,000 Not acquired yet
Disposal value (in cash) now 3,000 Not acquired yet
Disposal value in 2 years 0 0
Annual cash operating costs for power,
maintenance, toner and supplies $ 14,000 $7, 500
The administrator is trying to decide whether to replace the old equipment. Because of rapid changes in
technology, he expects the replacement equipment to have only a three-year useful life. Ignore the effects of
taxes.
Instruction: Should SUCCESS keep or replace the old equipment? Compute the difference in total cost over
the next 3-years under both alternatives, that is, keeping the original or replacing it with the new machine.
Solution:
THREE YEARS TAKEN TOGETHER
OLD EQUIPMENT NEW EQUIPMENT
Cost of new equipment - $ 15,000
Disposal Value - (3,000)
Cash operating costs $ 42,000 22,500
Net relevant costs $ 42,000 $ 34,500
Recommendation: Replacing the old equipment has a net $ 7,500 advantage
($42, 000 less $ 34,500)
Example (2) Zambezi Co. has just today paid for and installed a special machine for polishing cars at one of
its several outlets. It is the first day of the company's fiscal year.
The machine cost, $ 20,000. Its annual cash operating costs total $ 15,000, exclusive of depreciation. The
machine will have a 4-year useful life and a zero terminal disposal price.

After the machine has been used for a day, a machine salesperson offers a different machine that promises to
do the same job at a yearly cash operating cost of $ 9,000, exclusive of depreciation. The new machine will
cost $ 24,000 cash, installed. The "old" machine is unique and can be sold outright for only $ 10,000 minus $
2000 removal cost. The new machine, like the old one, will have a 4-year useful life and zero terminal
disposal prices.
Sales, all in cash, will be $ 150,000 annually, and other cash costs will be $ 110,000 annually, regardless
of this decision.
Instructions:
(a) Prepare a summary income statement covering the next four years under both alternatives (when the
new machine is not purchased and when the new machine is purchased). What is the cumulative
difference in operating income for the 4 years taken together?
(b) Determine the desirability of purchasing the new machine using only relevant costs in your analysis?
Solutions:
Two different approaches may be used to solve such kinds of problems for decision-making purposes.
(i) Comparative income approach. This approach includes both relevant and irrelevant costs. When
the comparative income approach is used, the net operating income for reach alternative is
computed and compared. All revenues and costs are considered-even those that are the same for
each alternative.
(ii) Differential analysis. In this approach, only revenues and costs that differ among the alternatives
are considered.
N.B. The end-result- a correct decision - will be the same regardless of which method is used.
a) Comparative income approach.
ZAMBEZI Company
comparative INCOME STATEMENT
for the next 4 years together
OLD MACHINE NEW MACHINE
Sales $ 600,000 $ 600,000
Cash operating costs (60,000) (36,000)
Other cash costs (440,000) (440,000)
Depreciation (20,000) (24,000)
Loss on disposal _______- (12,000)
Income $ 80,000 $ 88,000

Comment: The above analysis (which includes both relevant and irrelevant items) shows $ 8000 cumulative
difference in operating income for the 4 years taken together. Ignoring income taxes and the time value of
money, the purchase of the new machine appears to be a favorable.
b) Differential analysis
Four years taken together
Old machine New machine
Cost of new equipment - $ 24,000
Disposal value - (8,000)
Cash operating costs $ 60,000 36,000
Net relevant costs $ 60,000 $ 52,000
When differential analysis is used, the focus is on cash flows. The investment decision is based on the
difference between the net cash inflows and the net cash outflows. Regardless of which method is used; the
net cash advantage will always be the same. Net cash advantage in favor of replacing old machine is $
8,000 as shown above using differential analysis.

Review Questions
1. Tyson's Hardware uses a flexible budget to develop planning information for its
warehouse operations. For 20X5, the company anticipated that it would have 96,000
sales units for 664 customer shipments. Average storage bin usage for various
inventories was estimated to be 200 per day. The costs and cost drivers were
determined to be as follows:
Item Fixed Variable Cost driver

Product handling $10,000 $1.25 per 100 units
Storage 3.00 per storage bin
Utilities 1,000 1.50 per 100 units
Shipping clerks 1,000 1.00 per shipment
Supplies 0.50 per shipment
During the year, the warehouse processed 90,000 units for 600 customer shipments. The
workers used 225 storage bins on average each day to sort, store, and process goods for
shipment. The actual costs for 20X5 were:
Item Actual costs

Product handling $10,900
Storage 465
Utilities 2,020
Shipping clerks 1,400
Supplies 340
Required:
a. Prepare a static budget for 20X5 with static-budget variances.
b. Prepare a flexible budget for 20X5 with flexible-budget variances.
Answer
A. Tyson's Hardware Static Budget with Variances 20X5
Static
Actual Budget Variances
Product handling $10,900 $11,200 $300 F
Storage 465 600 135 F
Utilities 2,020 2,440 420 F
Shipping clerks 1,400 1,664 264 F
Supplies 340 332 8 U
Total $15,125 $16,236 $1,111 F

B. Tyson's Hardware Flexible Budget with Variances 20X5
Flexible
Actual Budget Variances
Product handling $10,900 $11,125 $225 F
Storage 465 675 210 F
Utilities 2,020 2,350 330 F
Shipping clerks 1,400 1,600 200 F
Supplies 340 300 40 U
Total $15,125 $16,050 $925 F
2. Casey Corporation produces a special line of basketball hoops. Casey Corporation
produces the hoops in batches. To manufacture a batch of the basketball hoops,
Casey Corporation must set up the machines and molds. Setup costs are batch-level
costs because they are associated with batches rather than individual units of
products. A separate Setup Department is responsible for setting up machines and
molds for different styles of basketball hoops.
Setup overhead costs consist of some costs that are variable and some costs that are
fixed with respect to the number of setup-hours. The following information pertains
to January 2005.
Static-budget Actual
Amounts Amounts
Basketball hoops produced and sold 30,000 28,000
Batch size (number of units per batch) 200 250
Setup-hours per batch 5 4
Variable overhead cost per setup hour $10 $9
Total fixed setup overhead costs $22,500 $21,000
Required
a. Calculate the efficiency variance for variable setup overhead costs.
b. Calculate the spending variance for variable setup overhead costs.
c. Calculate the flexible-budget variance for variable setup overhead costs.
d. Calculate the spending variance for fixed setup overhead costs.
e. Calculate the production-volume variance for fixed setup overhead costs
Answer: a. ((28,000 / 250) × 4 × $10) - (28,000 / 200) × 5 × $10) = $2,520 (F)
b. (28,000 / 250) × 4 × ($9 - $10) = $448 (F)
c. $2,520 (F) + $448 (F) = $2,968 (F)
d. $22,500 - $21,000 = $1,500 (F)

e. Normal setup-hours = (30,000 / 200) × 5 = 750 hours
OH rate = $22,500 / 750 = $30 per setup-hour
$22,500 - ((28,000 / 200) × 5 × $30) = $1,500 (U)

3. Pat, a Pizzeria manager, replaced the convection oven just six months ago. Today, Turbo
Ovens Manufacturing announced the availability of a new convection oven that cooks more
quickly with lower operating expenses. Pat is considering the purchase of this faster, lower-
operating cost convection oven to replace the existing one they recently purchased. Selected
information about the two ovens is given below:
Existing New Turbo Oven

Original cost $60,000 $50,000
Accumulated depreciation $ 5,000
Current salvage value $40,000
Remaining life 5 years 5 years
Annual operating expenses $10,000 $ 7,500
Disposal value in 5 years $0 $0
Required:
a. What costs are sunk?
b. What costs are relevant?
c. What are the net cash flows over the next 5 years assuming the Pizzeria purchases the new convection oven?
d. What other items should Pat, as manager of the Pizzeria, consider when making this decision?
Answer
a. Sunk costs include the original cost of the existing convection oven and the accompanying accumulated
depreciation.
b. Relevant costs include:

Acquisition cost of the new Turbo oven
Current disposal value of the existing convection oven
Annual operating expenses for the existing and the new Turbo oven
c. Net cash flows over 5 years with the new Turbo oven:
Cash inflow:
Decrease in annual operating expenses ($2,500 × 5) $ 12,500
Sale of the existing oven 40,000
Cash outflow:
Acquisition of the new Turbo oven (50,000)
Net cash inflow (outflow) $ 2,500
d. Other items the manager should consider when making this decision include:
∙ The Turbo oven's reliability and efficiency is still unknown since it is a brand-new product.
∙ If the Turbo oven bakes faster as it claims, the Pizzeria may be able to increase sales due to the quicker baking
time.
∙ After purchasing another oven just six months prior, top management should consider the Turbo oven option,
but instead may question the decision-making ability of Pat, the current manager

4. Atlanta Radio Supply sells only two products, Product X and Product Y.
Product X Product Y Total

Selling price $25 $45
Variable cost per unit $20 $35
Total fixed costs $350,000
Atlanta Radio Supply sells three units of Product X for each two units it sells of Product Y.
Atlanta Radio Supply has a tax rate of 25%.
Required
a. What is the breakeven point in units for each product, assuming the sales mix is 3 units of Product X for each
two units of Product Y?
b. How many units of each product would be sold if Atlanta Radio Supply desired an after-tax net income of
$210,000, using its tax rate of 25%?
Answer
a. 3N = breakeven in product X 2N = breakeven in product Y
($25 - $20) × 3N + ($45 - $35) x 2N - $350,000 = 0

$15N + $20N- $350,000 = 0
$35N - $350,000 = 0
N = $350,000 / $35 = 10,000
Therefore, to break even, 30,000 (10,000 x 3) units of Product X and 20,000 (10,000 x2) units of Product Y need to be
sold.
b. 3N = number of units of product X 2N = number of units of product Y
($25 - $20) × 3N + ($45 - $35) x 2N - $350,000 = $210,000 / (1 - .25)

$15N + $20N- $350,000 = $280,000
$35N- $350,000 = $280,000
$35N - $630,000 = 0
N = $630000 / $35 = 18,000
Therefore, to meet the profit goal, 3 × N = 54,000 units of Product X and 2 x N = 36,000 units of Product Y need
to be sold

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Mulungushi University

Institute of Distance Education

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CHAPTER I. MASTER BUDGET: AN OVERALL PLAN .........................................................................4

Chapter II. FLEXIBLE BUDGETS ..................................................................................................................31

Chapter III. Standard Cost and Variance Analysis ...................................................................................37

Chapter IV. Measuring Mix, Yield and Productivity Variances................................................................55

Chapter V. Cost Volume Profit (CVP) Analysis ..........................................................................................66

5.1 Introduction ...........................................................................................................................................66

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Upon a successful completion of this chapter, you should be able to:

A budget is a comprehensive formal management plans expressed in quantitative terms,

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Budget entity .The entity concept, so important in financial accounting, is essential to

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1.3 PRINCIPAL ADVANTAGES OF BUDGETING

Periodic Planning (Formalization of Planning). The most obvious purpose of a budget is to

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Coordination, Cooperation and Communication. Planning by individual managers does not

Performance Evaluation or Framework for Judging Performance .Budgets are estimates

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Figure 1-1 Preparation of Master Budget (Non manufacturing Company)

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Ending –inventory Purchase

Operating Cost of Goods

1.5 OPERATING BUDGET

The operating budget is composed of the income statement elements. A manufacturing

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Budgeted Desired Cost of Beginning

Operating Expense Budget: The budgeting of operating expenses depends on various

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Capital expenditure budget: Capital budgeting is the planning of investments in major

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1.7Preparing THE MASTER Budget

PREPARATION OF MASTER BUDGET (Merchandising Company)

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December* January February March Jan.-Mar.

b) Cash collection budget

January February March

January February March Jan.-Mar

d) Disbursement for purchases

January February March

e) Operating expense budget

January February March Jan.-Mar.

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January February March

2. a) Budget income statement

Blue Nile Company

Sales (schedule 1(a)) $190, 000

*Interest expense computation

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