CHAPTER 1

INTRODUCTION: THE ROLE, HISTORY, AND

DIRECTION OF MANAGEMENT ACCOUNTING
Learning Objectives:
After studying this chapter, you should be able to:
1. Discuss the need for management accounting information.
2. Differentiate between management accounting and financial accounting.
3. Provide a brief historical description of management accounting.
4. Identify the current focus of management accounting.
5. Describe the role of management accountants in an organization.
6. Explain the importance of ethical behavior for managers and management
accountants.
7. List three forms of certification available to management accountants.
Management Accounting Information System
The managerial accounting system has three broad objectives:
1. To provide information for costing out services, products, and other objects of
interest to management.
2. To provide information for planning, controlling, evaluating, and continuous
improvement.
3. To provide information for decision making.

Information Needs of Managers and Other Users

1 -6

Management Accounting
Information System
Collecting Special Reports
Measuring Product Costs
Storing Customer Costs
Analyzing Budgets
Reporting Performance Reports
Economic Events Managing Personal Communication

Inputs Processes Outputs

Users

Managerial accounting is directed towards providing information to managers

inside the organization.

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The Management Process
Planning:
1. Identify objectives the company wants to accomplish which will add value to the
company and increase profits.
2. Discuss ways to accomplish the objectives
3. Prepare budgets to accomplish the profit objective

Directing/Motivating:
1. Coordinating the activities to produce a smooth running operation.
2. Oversee day to day activities and keep the organization functioning smoothly
3. Assign jobs/tasks – answer questions – solve problems
Controlling:

1. Make sure the plans are being followed and objectives are accomplished
2. Performance reporting – compare actual results to the budget
3. Implement changes when objectives and goals are not being accomplished
Decision Making:
Use all information provided to make good business decisions.

Examples of activities performed by managerial accountants are:

1. Determining the cost of providing a service or making a product
2. Assist management in profit planning and formalizing the plans into budgets
3. Determine the behavior of costs and how profit will change as sales and
production volumes change
4. Compare actual costs and financial results with budgeted costs and results
5. Providing cost and sales information necessary for management to use to
make a decision.

Managerial accountants prepare reports and analyze data.

Reporting and analysis is often related to parts/departments/functions of the
company rather than reporting on the entire organization as a whole.

There are no required specific formats for reporting the management accountant
provides the report that gives the most useful information.

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Comparison of Financial Accounting and Managerial Accounting:
FINANCIAL ACCOUNTING:
1. Reports are provided outside the organization – external reports
2. Reports past activities – based on a historical perspective
3. Reliability of data is emphasized – reports take more time to provide
4. Focus on precise information since they are used outside the company
5. Summarized data for entire company as a whole
6. Must follow GAAP which has specific required external reports

MANAGERIAL ACCOUNTING:
1. Does not follow GAAP and there are no reporting regulations
2. Prepares reports only for management’s internal use
3. Provides information to make decisions regarding the future
4. Relevance of data is emphasized over reliability
5. Focuses on timeliness of information
6. Nothing is required to be reported, reports what management needs to see
7. Reporting is focused on parts of the organization such as departments or
divisions and not on the organization as a whole.

The Institute of Management Accountants:

Goal is to assist those working in managerial accounting positions to develop
professionally. Provide general guidelines and assistance for managerial accountants
Sponsors the Certified Managerial Accountant certification. Developed the Standards for
Ethical Conduct for Practitioners of The 4 components of this ethical standard are:
Competence
maintain competence by ongoing development of knowledge and skill perform duties in
accordance with relevant laws,regulations and technical standards prepare complete
and clear reports and recommendations after appropriate analysis of relevant and
reliable information

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Confidentiality
refrain from disclosing confidential information except where authorized to do so
Integrity
avoid actual or apparent conflicts of interest and always advise of any conflicts of
interest that arise refuse any gift or favor that would appear to influence your actions
recognize and communicate any professional limitations that would preclude you from
doing an adequate job
Objectivity
communicate information fairly and objectively disclose all relevant information that
could influence the decision maker communicate unfavorable as well as favorable
information and do not be biased towards one outcome or another
Resolving an ethical delimna:
1st – follow the established procedures within your organization
2nd – if the issue is not resolved to your satisfaction,
– present problems to the next higher management level
– if you are not clear on the issues, discuss with an objective advisor to clarify
your alternatives and solutions
3rd – if the issue can not be resolved, resign from your position
Curent Focus of Management Accounting
These other issues are often mentioned in the first chapter of a managerial accounting
text book. Please check your notes to make sure you are not overlooking the following
things that your professor may have discussed in class which are not noted on this
review sheet. These items are not often discussed:
1. Just in time inventory
2. Total quality management
3. Enterprise resource planning
4. Supply chain management
5. Benchmarking
6. The accounting organizational structure – Chief financial officer, controller,
7. managerial accountant, general ledger accountant
8. Cost Accounting Standards Board

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Exercise:
1. Explain the role of financial reporting in development of management
accounting. Why has this changes in recent years?
2. Firms with higher ethical standard will experience a higher level of economic
performance than firms with lower or poor ethical standards. Do you agree?
Why?

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 Chapter 2
Basic Management Accounting Concepts

After studying this chapter, you should be able to:

1. Describe the cost assignment process.
2. Define tangible and intangible products and explain why there are different
product cost definitions.
3. Prepare income statements for manufacturing and service organizations.
4. Outline the differences between functional-based and activity-based
management accounting systems.
Cost Assignment

The term cost has wide and different applications. The initial treatment of costs is
centred on the function of product or service costing for financial accounting purposes.
Manufactured products contain three elements:
Direct materials
Direct labour
Manufacturing overhead
Conversion costs are direct labour and manufacturing overhead. Prime costs are
direct labour and direct material.
Note: Conversion costs plus prime costs do not equal total costs since direct labour is
included in both.
Costs that cannot be easily traced to individual products are treated as
manufacturing overhead. Examples of overhead are oil for machines, salary for a
supervisor, and amortization of equipment and buildings. In the case of oil, the cost to
trace and the benefit of doing so make it impractical to consider it a direct cost.
Amortization for the period on the factory building cannot be traced to individual
products or services in any logical way, so it is considered overhead. Consider idle time
and overtime in terms of whether these two costs should be treated as part of direct
labour or overhead. For example, should the overtime premium (the extra wage rate
over and above the regular wage rate) be charged to the job in progress, or to all jobs? If
the overtime were spent to finish a specific job, then the overtime premium could
legitimately be a cost of that job. But, overtime on one job is usually the result of

6
scheduling of all jobs, and therefore should be an overhead charge. The same applies to
idle time.
The textbook refers to nonmanufacturing costs that include selling costs and
general and administrative costs. In addition, service organizations such as banks are
now using cost concepts to analyze their costs for the purpose of more accurately
pricing consumer products and services offered to banking customers. In classifying
various cost items, it often helps to think about what is assigned to inventory for
financial accounting purposes. Selling and administrative expenses have nothing to do
with the manufacture of a product. For this reason, these costs are not treated as
product costs but as period costs. Period costs arecharged directly to expenses as they
are incurred.
Cost classifications on financial statements
Refer to Exhibit 2-2 and note the similarities and differences between the financial
statement presentation of inventory in a merchandising situation and the financial
statement presentation of the three types of inventory (raw material, work in process,
and finished goods) in a manufacturing setting. The cost of goods manufactured of
$850,000 on the manufacturing income statement.
3. Review the format and headings for this schedule.
Costs for planning, costing, and decision making
This topic deals with three major classes of costs:
a. Variable and fixed costs are classifications of costs based on how the cost behaves
as volume changes. Cost behaviour is important knowledge for planning and
forecasting. Note the definitions and the distinction between unit cost and total cost.
b. Direct and indirect costs are classifications based on how easily the costs can be
traced to a cost object. Direct costs, su ch as direct materials and direct labour, are
easily traced to a cost object such as an individual product or department. Indirect
costs, such as the janitor's salary or utilities expense, are less cost-effective to trace
so are included in overhead. It should be noted that given unlimited resources, any
cost can be traced. However, in business, resources are limited so the cost-benefit
must always be considered. You will encounter this concept again in Module 6 when
you study segment analysis.
c. Differential, opportunity, and sunk costs are terms used in problem solving and
decision analysis.

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Exercise:
1. How do the income statement of a manufacturing firm and a service firm differ?
2. Give three examples of product cost definitions. Why do we need different
product cost definition?

8
 Chapter 3
Activity Cost Behavior
Learning objective:
1. Define cost behavior for fixed, variable, and mixed costs.
2. Explain the role of the resource usage model in understanding cost behavior.
3. Separate mixed costs into their fixed and variable components using the high-low
method, the scatterplot method, and the method of least squares.
4. Evaluate the reliability of a cost equation.
5. Discuss the role of multiple regression in assessing cost behavior.
6. Describe the use of managerial judgment in determining cost behavior.

Introduction:

The most important building block of both microeconomic analysis and cost accounting
is the characterization of how costs change as output volume changes. Output volume
can refer to production, sales, or any other principle activity that is appropriate for the
organization under consideration (e.g.: for a school, number of students enrolled; for a
health clinic, number of patient visits; for an airline, number of passenger miles). The
following discussion examines the volume of production in a factory, but the same
principles apply regardless of the type of organization and the appropriate measure of
activity.

Costs can be variable, fixed, or mixed.

 Variable Costs:

Variable costs vary in a linear fashion with the production level. However, when stated
on a per unit basis, variable costs remain constant across all production levels within
the relevant range. The following two charts depict this relationship between variable
costs and output volume.

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.

A good example of a variable cost is materials. If one pair of pants requires $10 of fabric,
then every pair of pants requires $10 of fabric, no matter how many pairs are made. The
fabric cost is $10 per unit at every level of production. If one pair is made, the total
fabric cost is $10; if two pairs are made, the total fabric cost is $20; and if 1,000 pairs are
made, the total fabric cost is $10,000. Hence, the total cost is increasing and linear in the
production level.

Fixed Costs:

Fixed costs do not vary with the production level. Total fixed costs remain the same,
within the relevant range. However, the fixed cost per unit decreases as production
increases, because the same fixed costs are spread over more units. The following two
charts depict this relationship between fixed costs and output volume.

10
In this example, fixed costs are $50,000. The first chart shows that fixed costs remain
$50,000 at all production levels from 100 units to 1,000 units. The second chart shows
that the fixed cost per unit decreases as production increases. Hence, when 100 units
are manufactured, the fixed cost per unit is $500 ($50,000 ÷ 100). When 500 units are
manufactured, the fixed cost per unit is $100 ($50,000 ÷ 500).

Relevant Range:

The relevant range is the range of activity (e.g., production or sales) over which these
relationships are valid. For example, if the factory is operating at capacity, increasing
production requires additional investment in fixed costs to expand the facility or to
lease or build another factory. Alternatively, production might be reduced below a
threshold at which point one of the company’s factories is no longer needed, and the
fixed costs associated with that factory can be avoided. With respect to variable costs,
the company might qualify for a volume discount on fabric purchases above some

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production level. The relevant range for characterizing fabric as a variable cost ends at
that production level, because the fabric cost per unit of output is different when the
factory produces above that threshold than when the factory produces below that
threshold.

Mixed Costs:

If, within a relevant range, a cost is neither fixed nor variable, it is called semi-variable
or mixed. Following are two common examples of mixed costs.

 In this example, although the total cost line increases in production, it does not pass
through the origin because there is a fixed cost component. An example of a cost that fits
this description is electricity. A fixed amount of electricity is required to run the factory
air conditioning, computers and lights. There is also a variable cost component related
to running the machines on the factory floor. The fixed component in this example is
$3,000 per month. The variable cost component is $10 per unit of output. Hence, at a
production level of 500 units, the total electric cost is $8,000 [$3,000 + ($10 x 500)].

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The mixed cost illustrated in the above chart is called a step function. An example of
such cost behavior would be the total salary expense for shift supervisors. If the factory
runs one shift, only one shift supervisor is required. In order for the factory to produce
above the maximum capacity of a single shift, the factory must add a second shift and
hire a second shift supervisor, so that total shift supervisor salary expense doubles. If
the factory runs three shifts, three shift supervisors are required.

Cost Behavior Assumptions in Management Accounting Versus Microeconomics:

Microeconomic analysis usually assumes decreasing marginal costs of production,

sometimes followed by increasing marginal costs of production beyond a certain
production level. Hence, economists’ graphs of the total cost of production and the
average per-unit cost of production show smooth, curved functions. Management
accountants usually assume the linear relationships depicted in the previous graphs.
Linearity is a more accurate description of many situations encountered by
management accountants than the economists’ curves, and even when linearity
constitutes a simplifying assumption it is almost always sufficiently descriptive for the
task at hand.  

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Exercise

A particular cost is $10,000 in total when 50 units are made.

 
A)        Complete the following table, indicating what the cost would be if production is
increased to 200 units:
 
  Cost per Unit Cost in total
If this cost is a   
variable cost
If this cost is a fixed   
cost
 

B)        Complete the following table, indicating what the cost would be if production is
reduced to 20 units:
 
  Cost per Unit Cost in total
If this cost is a   
variable cost
If this cost is a fixed   
cost

3. If a company makes 100 units of product, the fixed cost per unit is $5 and the
variable cost per unit is $6. How much will the company have to spend in total to
make 200 units?

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 Chapter 4
Activity-Based Costing

Learning Objectives:
1. Discuss the importance of unit costs.
2. Describe functional-based costing approaches.
3. Explain why functional-based costing approaches may produce distorted costs.
4. Explain how an activity-based costing system works for product costing.

Activity-based costing (ABC)

Activity-based costing (ABC) is a better, more accurate way of allocating overhead.
 
Recall the steps to product costing:
1.   Identify the cost object;
2.   Identify the direct costs associated with the cost object;
3.   Identify overhead costs;
4.   Select the cost allocation base for assigning overhead costs to the cost object;
5.   Develop the overhead rate per unit for allocating overhead to the cost object.

Activity-based costing refines steps #3 and #4 by dividing large heterogeneous

cost pools into multiple smaller, homogeneous cost pools. ABC then attempts to select,
as the cost allocation base for each overhead cost pool, a cost driver that best captures
the cause and effect relationship between the cost object and the incurrence of
overhead costs. Often, the best cost driver is a nonfinancial variable.  
ABC can become quite elaborate. For example, it is often beneficial to employ a
two-stage allocation process whereby overhead costs are allocated to intermediate cost
pools in the first stage, and then allocated from these intermediate cost pools to
products in the second stage. Why is this intermediate step useful? Because it allows the
introduction of multiple cost drivers for a single overhead cost item. This two-stage
allocation process is illustrated in the example of the apparel factory below.
ABC focuses on activities. A key assumption in activity-based costing is that
overhead costs are caused by a variety of activities, and that different products utilize
these activities in a non-homogeneous fashion. Usually, costing the activity is an

15
intermediate step in the allocation of overhead costs to products, in order to obtain
more accurate product cost information. Sometimes, however, the activity itself is the
cost object of interest. For example, managers at Levi Strauss & Co. might want to know
how much the company spends to acquire denim fabric, as input in a sourcing decision.
The “activity” of acquiring fabric incurs costs associated with negotiating prices with
suppliers, issuing purchase orders, receiving fabric, inspecting fabric, and processing
payments and returns.
Apparel Factory Example of Two-Stage ABC Allocations:
Assume that an apparel factory uses forklifts in only two departments:
The first department is Receiving, where large rolls of fabric are unloaded from semi-
trailers and moved into storage, and later moved from storage to the cutting room.
The second department is Shipping, where cartons of finished pants are staged and then
loaded onto semi-trailers for shipment to the warehouse.
Costs associated with operating these forklifts consist of the following: 
Forklift costs:  
Operator salaries $      80,000
Maintenance 8,000
Depreciation expense 7,500
Other 2,500
Total forklift costs $      98,000
All other overhead 1,400,000
Total overhead for the factory $1,498,000
 
The factory operates two production lines. One line is for jeans, which are made from
denim fabric. The other production line is for casual slacks, which are made from a
cotton-twill fabric. Operational data for the month is as follows:
  Jeans Casual Slacks Total
Units produced 420,000 200,000 620,000
Direct labor hours 70,000 40,000 110,000
Rolls of fabric 1,750 640 2,390
Cartons shipped 52,500 20,000 72,500
The factory ships product to the company’s warehouse, not directly to customers. Hence,
to facilitate stocking at the warehouse, each carton is packed with jeans or casual slacks,
but not both. An examination of the information in the above table reveals that a carton

16
holds more slacks than jeans, and that fewer pants are cut from a roll of denim fabric
than from a roll of cotton-twill. These operational statistics are driven by the fact that
denim is a heavier-weight fabric than cotton-twill, and hence, it is bulkier. The data also
indicate that more direct labor minutes are required for a pair of slacks than for a pair of
jeans, which reflects greater automation on the jeans production line.
 
Traditional costing
Under a traditional costing system, forklift costs are pooled with all other overhead costs
for the factory (electricity, property taxes, front office salaries, etc.), and then allocated
to product based on direct labor hours (sewing operator time) for each product.
Overhead rate under traditional costing:
Total overhead costs $ 1,498,000
Quantity of allocation base (direct labor hours) ÷ 110,000
Overhead rate per direct labor hour $        13.62
   
of which the following is due to forklift costs:  
Forklift overhead $     98,000
Quantity of allocation base (direct labor hours) ÷ 110,000
Overhead rate for forklift costs per direct labor hour $     0.8909

Forklift overhead applied to product using traditional costing:

  Jeans Slacks
Overhead rate $  0.8909 $   0.8909
Quantity of allocation base (direct labor hours) x 70,000 x 40,000
Forklift costs allocated $  62,363 $   35,636
Units produced 420,000 200,000
Approximate cost per unit $0.15 $0.18

Note that all forklift overhead is allocated: $62,363 + $35,636 = $97,999 (the difference
due to rounding of the overhead rate).
If the casual slacks product manager asks why her product incurs more forklift costs on a
per-unit basis than jeans, even though casual slacks use a lighter-weight fabric, the

17
answer is that her product uses more direct labor per unit, which perhaps is not a very
satisfying explanation from her perspective.   

Activity-based costing
An ABC system might first allocate forklift costs into two cost pools: one for the
Receiving Department and one for the Shipping Department. Then costs from each of
these two departments would be allocated to the two product lines.
 
ABC first-stage allocation
The first-stage allocation might use an estimate of the amount of time the forklifts spend
in each department. A one-time study indicates that forklifts spend approximately 70%
of their time in the Shipping Department and 30% of their time in the Receiving
Department. An additional benefit of ABC is that if this information were collected
periodically, the managers of these two departments might be more willing to share the
forklifts with each other, since the reported costs of each department would then depend
on the time the forklifts spend in that department. In any case, the 70/30 allocation
results in the following first-stage allocation:
             30% of $98,000 = $29,400 is allocated to the Receiving Department
            70% of $98,000 = $68,600 is allocated to the Shipping Department
ABC second-stage allocation
  Receiving Shipping
Total costs $29,400 $68,600
Quantity of allocation base ÷ 2,390 rolls ÷ 72,500 cartons
Overhead rate $12.30 per roll $0.946 per carton
     
Allocation to Jeans    
Overhead rate $12.30 per roll $0.946 per carton
Quantity of allocation base x 1,750 rolls x 52,500 cartons
  $21,525 $49,665
Allocation to Slacks    
Overhead rate $12.30 per roll $0.946 per carton
Quantity of allocation base x 640 rolls x 20,000 cartons
$7,872 $18,920

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Total forklift costs allocated to each product:

  Jeans Slacks Total

From Receiving $21,525 $  7,872 $29,397
From Shipping 49,665 18,920 68,585
Total $71,190 $26,792 $97,982
Units Produced 420,000 200,000  
Approximate Cost per unit $0.17 $0.13  

 The $18 difference between total costs allocated of $97,982 and the original costs of
$98,000 is due to rounding.

The first-stage allocation allows the second-stage to allocate forklift costs to product
using rolls of fabric as the allocation base in Receiving, and cartons of pants as the
allocation base in Shipping. Since there are no rolls of fabric in the shipping department,
and no cartons in the Receiving Department, without the first stage allocation, there
would be no obvious choice of an allocation base that would capture the cause-and-effect
relationship between the costs of operating the forklifts, and the utilization of forklift
resources by each product in the two departments.
 
Conclusion
The traditional costing method allocates more forklift costs to slacks than to jeans on a
per-unit basis because casual slacks require more sewing effort. ABC allocates more
forklift costs to jeans than to casual slacks, on a per-unit basis, which is intuitive because
denim is a heavier-weight fabric than cotton twill.

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Cost Hierarchy:
In ABC, cost pools are often established for each level in a hierarchy of costs. For
manufacturing firms, the following cost hierarchy is commonly identified:
 
Unit-level costs: For any given product, these costs change in a more-or-less linear
fashion with the number of units produced. For example, fabric and thread are unit-level
costs for an apparel manufacturer: if the company wants to double production, it will
need twice as much fabric and thread.
 
Batch-level costs: These costs change in a more-or-less linear fashion with the number
of batches run. Machine setup costs are often batch-level costs. The time required to
prepare a machine to run one batch of product is usually independent of the number of
units in the batch: the same time is required to prepare the machine to run a batch of
100 units as a batch of 50 units. Hence, batch-level costs do not necessarily vary in a
linear fashion with the number of units produced.
 
Product-level costs: These costs are usually fixed and direct with respect to a given
product. An example is the salary of a product manager with responsibility for only one
product. The product manager’s salary is a fixed cost to the company for a wide range of
production volume levels. However, if the company drops the product entirely, the
product manager is no longer needed.
 
Facility-level costs: These costs are usually fixed and direct with respect to the facility.
An example is property taxes on the facility, or the salaries of front office personnel such
as the receptionist and office manager.
 
One reason why ABC provides more accurate product cost information is that traditional
costing systems frequently allocate all overhead, including batch-level, product-level,
and facility-level overhead, using an allocation base that is appropriate only for unit-
level costs. The better information obtained from explicitly incorporating the cost
hierarchy is illustrated in the following example:
 

20
Milwood Mills:
Milwood Mills makes decorative woodcut prints for sale to restaurants. Its Billings,
Montana factory makes two of the company’s more popular designs: Bull and Matador
and Dogs Playing Poker. Following is selected information for a typical month:
  Bull Dogs Total
Number of woodcuts produced 500 1,500 2,000
Direct materials costs $2,500 $3,300 $5,800
Direct labor costs $1,400 $1,600 $3,000
Number of batches 10 30 40
Total overhead $42,000
Batch setup costs (included in total overhead) $12,000

The traditional costing system allocates all overhead based on number of units
produced. This method allocates overhead of $21 ($42,000 ÷ 2,000 units) to each Bull
and Matador woodcut and to each Dogs Playing Poker woodcut, of which $6 ($12,000 ÷
2,000 units) represents batch setup costs.
 
The manager of the Bull and Matador production line develops a technique for doubling
the batch size on her line without incurring any additional costs. Hence, she can now
make 500 woodcuts per month using only 5 setups. She thinks this should cut her batch
setup costs in half. She reasons as follows:
 
What “drives” batch setup costs? It is the number of batches. The cost per batch is $300.
($300 per batch x 40 batches = $12,000, which agrees to the monthly information
provided above.) Using the new batch size, the batch setup cost is still $300, but instead
of spreading this $300 over 50 units, the $300 will be spread over 100 units, lowering
my per-unit batch setup cost from $6 to $3, and lowering my total unit cost by $3.
 
However, the following month, after implementation of the manager’s increased batch
size, reported costs are as follows: Total overhead drops by $1,500, which represents the
cost savings from eliminating five batch setups for the Bull and Matador production line.
Hence, total overhead drops from $42,000 to $40,500. The traditional costing system
allocates this $40,500 to 2,000 units as $20.25 per unit. This new overhead rate
represents a savings of $0.75 per unit for every woodcut: every Bull and Matador
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woodcut, and every Dogs Playing Poker woodcut. The manager of the Bull and Matador
production line is disappointed. Her reported costs did not decrease by as much as she
had anticipated, because most of the benefit from the reduction in batch setups has been
allocated to the Dogs Playing Poker production line.
 
An ABC system that explicitly recognizes the cost hierarchy would correct this problem.
Under the old production process, ABC would have allocated costs as follows: The cost
pool for batch setup costs was previously $12,000, which would have been allocated to
the two product lines based on the number of batches run by each line:

Overhead rate = total batch setup costs ÷ total number of batches

= $12,000 ÷ 40 batches = $300 per batch

Batch setup costs of $300 per batch

x 10 batches = $3,000 would have been allocated to Bull,
x 30 batches = $9,000 would have been allocated to Dogs.
 
In a second-stage allocation, the $3,000 allocated to the Bull and Matador production line
would have been allocated to 500 units for a cost of $6 per woodcut. This allocation is
the same as under the traditional costing system only because the batch size of 50
woodcuts per batch was originally the same on both production lines.
After the batch size is increased for Bull and Matador, production information is as
follows:
  Bull Dogs Total
Number of woodcuts produced 500 1,500 2,000
Direct materials costs $2,500 $3,300 $5,800
Direct labor costs $1,400 $1,600 $3,000
Number of batches 5 30 35
Total overhead $40,500
Batch setup costs (included in total overhead) $10,500

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Now ABC would allocate costs as follows:

In the first stage: $10,500 ÷ 35 batches = $300 per batch (same as before).
 
$300 per batch x 5 batches = $1,500 to Bull and Matador (50% less than before),
$300 per batch x 30 batches = $9,000 to Dogs Playing Poker (same as before).
 
In the second stage, the $1,500 is allocated to the 500 Bull and Matador woodcuts, for $3
per woodcut. This $3 per woodcut reflects the cost savings originally anticipated by the
manager of the Bull and Matador production line. The cost per woodcut for Dogs Playing
Poker remains unchanged ($9,000 ÷ 1,500 units = $6), which is appropriate because
nothing has changed on the Dogs Playing Poker production line.

ABC in the Service Sector:

ABC is as important to companies in the merchandising and service sectors as to
manufacturing companies. In fact, although the origination of ABC is generally ascribed
to manufacturing companies in the 1980s, by then hospitals were already allocating
overhead costs to departments and then to patient services using methods similar to
ABC. Hospitals were required to implement relatively sophisticated allocation processes
in order to comply with Medicare reimbursement rules. After its inception in the 1960s,
Medicare established detailed rules regarding how overhead costs should be grouped
into cost pools, and the choice of appropriate allocation bases for allocating overhead
costs to departments and then to patients. Within these rules, hospitals were able to
maximize revenues by shifting costs from areas such as pediatrics, labor and delivery,
and maternity (which have low rates of Medicare utilization) to the intensive care unit,
the critical care unit, and surgery (which have higher rates of Medicare utilization).
Other non-manufacturing industries that have benefited from ABC include financial
services firms and retailers.
 
ABC Implementation Issues:

Another refinement in product costing that often accompanies implementation of ABC

focuses on step #2 of the five-step product costing sequence: “identify the direct costs

23
associated with the cost object.” The refinement involves the following. For a given cost
object, the company attempts to identify costs currently treated as overhead that have
not been—but can be—traced directly to the cost object. In other words, costs are
moved from the overhead cost pool to the direct cost category. For example, an
accounting firm might take certain office-support expenses formerly treated as
overhead, such as printing and copying, and start tracking and assigning these costs to
specific jobs (audits, tax engagements, etc.) for internal reporting and profitability
analysis (but not necessarily for client billing purposes).
 
The successful implementation of ABC usually requires participation by managers from
non-accounting functions, such as production and marketing. Because ABC focuses on
activities, and activities often cut across departments and functional areas, implementing
ABC can improve lines of communication and cooperation within the company. On the
other hand, more accurate cost allocation does not, by itself, reduce costs. The initial
move from a traditional costing system to ABC usually shifts overhead costs from some
products to other products, with some managers “winning” and some “losing.” Some
companies have found that hiring an outside consulting firm to assist with the ABC
adoption facilitates obtaining “buy-in” by managers and employees throughout the
company. Perhaps partly for this reason, ABC implementation has become an important
consulting product for accounting firms and for many consulting firms.
Although ABC should provide the company more accurate information, it is not a
panacea; some companies that invested time and money implementing ABC did not
realize the benefits they expected. Some of these companies have reverted to simpler,
more traditional costing systems.

Exercise:

In which of the following situations are the techniques of activity-based costing most
likely to lead to improved production or marketing decisions.
 
(I)        The All-Direct Company, which incurs significant direct costs, but no overhead
costs, to manufacture its extensive and ever-changing product line.
 

24
(II)       The One-Size-Fits-All Hat Company, which makes a single product that is sold to
many different kinds of retailers, in varying volumes, through various marketing
channels, in many different geographic regions.

25
 Chapter 6

Learning objectives:

1. Describe the basic characteristics and cost flows associated with process
manufacturing.

2. Define equivalent units and explain their role in process costing. Explain the
differences between the weighted average method and the FIFO method of accounting
for process cost.

3. Prepare a departmental production report using the weighted average method.

4. Explain how process costing is affected by nonuniform application of manufacturing

inputs and the existence of multiple processing departments.

5. Appendix: Complete a departmental production report using the FIFO method.

Introduction:
Recall the discussion from the previous chapter on overhead rates. The overhead rate is
the ratio of cost pool overhead dollars in the numerator, and the total quantity of the
allocation base in the denominator: 
     

Overhead costs in the cost pool

Overhead rate = Total quantity of the allocation base
 
 
The result represents dollars of overhead per unit of the allocation base. For example, if
an apparel factory allocates overhead based on direct labor hours, the overhead rate
represents dollars of overhead per direct labor hour.
 

Normal costing:

26
Many companies calculate and apply this overhead rate using, not actual overhead costs
and the actual quantity of the allocation base, but rather budgeted overhead costs and
the budgeted quantity of the allocation base. When a company uses budgeted overhead
rates in its costing system, but all other information in the costing system is based on
actual costs, the company is using what is called a normal costing system.
 
It is important to remember that although there are no rules in management accounting,
companies always, as a matter of practice, use either budgeted numbers in both the
numerator and the denominator of the overhead rate, or actual numbers in both the
numerator and the denominator of the overhead rate. Companies never use budgeted
overhead divided by the actual quantity of the allocation base, or actual overhead
divided by the budgeted quantity of the allocation base.
 
It is also important to remember that in a normal costing system, the budgeted overhead
rate is multiplied by the actual quantity of the allocation base incurred. In Chapter 10,
we will discuss another type of accounting system, called a standard costing system,
that multiplies the budgeted overhead rate by a flexible budget quantity for the
allocation base: the amount of the allocation base that should have been used for the
amount of output achieved. However, in a normal costing system, the only budgeted
number is the overhead rate; direct costs are recorded at their actual cost, and the
overhead rate is multiplied by the actual quantity of the allocation base used during the
period. 

Advantages of Using Budgeted Overhead Rates:

There are three principal reasons that many companies in all sectors of the economy use
budgeted overhead rates, either as part of a normal costing system or as part of a
standard costing system.
Actual overhead rates are not known in a timely manner:
Factory managers often use production cost information in their monitoring of the
manufacturing process. Control of manufacturing activities is a daily or weekly process,
not a monthly or quarterly process. The challenge of collecting and reporting actual
direct costs—the cost of materials and labor used in production—within one or two

27
days of actual production is difficult, but increasingly possible. For example, all materials
used in production have already been purchased, and the cost of those materials can be
ascertained. Also, sophisticated data collection systems, often called real-time systems,
can track the movement of inventory, and track labor resources incurred at various
work stations, as production occurs. Even the quantity of the overhead cost allocation
base used in production can probably be ascertained, because the allocation base is
usually a measure of a direct input. However, many of the components that make up
overhead are not paid daily or even weekly. Utilities and property taxes are often paid
monthly or quarterly. The factory manager who wants to know the cost of production on
January 3 for the purpose of controlling operations on the factory floor will not want to
wait until the books are closed on January 31 for that information. Usually, budgeted
overhead rates are sufficiently close to actual overhead rates so that normal costing
systems provide reasonably accurate cost information for management control
purposes, and normal costing can provide this information in a timely manner.
 
Overhead rates are subject to short-run fluctuations:
For an apparel factory in El Paso, electric costs are significantly higher in July than in
January due to the cost of air conditioning. Should overhead rates be calculated and
applied separately for each month, or should overhead rates be averaged over the entire
year? The answer to this question is not clear, because it depends on the types of
decisions for which management will use factory cost information as an input. For
example, if the factory has excess capacity and management is considering suspending
factory operations for two weeks, monthly cost data will assist in scheduling the down-
time to maximize cost savings (i.e., close the factory for two weeks in July, not January).
On the other hand, if several product managers are scheduling production for the coming
year, it would seem counterproductive to provide these managers incentives to compete
with each other for January factory time, for the sake of obtaining the lower per-unit
production cost, if some of them will have to schedule production in July in any case.
Using an overhead rate that averages over the entire year might be more reasonable for
production costing purposes like this one. In fact, many companies prefer to average
overhead rates over a quarter or an entire year, and these companies usually prefer
using budgeted overhead rates instead of waiting until actual overhead is known at the
end of the period.

28
When actual overhead rates are used, production volume of each product affects
the reported costs of all other products:
This issue arises because the production volume of each product affects the total
quantity of the allocation base in the denominator of the overhead rate, whereas an
important component of the numerator—fixed overhead—is invariant to changes in
production volume. Hence, as production volume of one product decreases below
budget, the overhead rate (which is common across all products) increases, and when
that overhead rate is applied to other products, those products absorb more overhead
(and so have higher reported costs) than was budgeted. The important point here is that
the direct costs and production activity related to those other products could be exactly
as planned, but the reported costs of those products will be higher than planned, due
entirely to the production activities of another product. In a factory that makes jeans and
chinos, one might imagine the reaction of the jeans product manager when a decline in
chinos production increases the reported cost of each pair of jeans. 
Misapplied Overhead:
When budgeted overhead rates are used, it is very likely that the amount of overhead
applied to production (the debits to work-in-process) will differ from the actual
overhead incurred (credits to cash, accounts payable, and various other accounts)
during the period. This difference, which will occur whenever the budgeted overhead
rate differs from the actual overhead rate, is called misapplied overhead. If less overhead
is applied to inventory than is actually incurred, then the difference is called
underapplied overhead (it is also called underallocated overhead or underabsorbed
overhead). If more overhead is applied to inventory than is actually incurred, then the
difference is called overapplied overhead (it is also called overallocated overhead or
overabsorbed overhead).  
 
Mechanically, misapplied overhead is accumulated in one or more temporary accounts
that are closed out at the end of the period (month, quarter or year). These accounts
collect the misapplied overhead because when overhead is debited to inventory, the
corresponding credits are posted to these temporary accounts, and when overhead is
paid (or accrued), the corresponding debits are also posted to these temporary accounts.
The net difference between these debits and credits represents misapplied overhead. If

29
two temporary accounts are used, they are called something like “overhead applied” and
“overhead incurred.”
 
The nature of the closing entry to zero-out these accounts depends on the materiality of
the misapplied overhead. If the amount is small, management might take the expedient
approach of closing out all misapplied overhead to a line-item on the income statement
for the period. The misapplied overhead might be posted to cost-of-goods-sold, or might
be treated as a period expense, but in either case, the effect is to increase or decrease
income by the total amount of misapplied overhead.
 
If the amount of misapplied overhead is material, management should consider whether
the entry to close out misapplied overhead should be made in such a way as to
approximate the balances in the balance sheet and income statement inventory accounts
that would have occurred had an actual costing system been used. If so, then the entry to
close out misapplied overhead should include the inventory balance sheet accounts of
work-in-process and finished goods inventory, as well as cost-of-goods-sold on the
income statement. One technique that approximates this objective is to pro-rate
misapplied overhead based on the ending balances in work-in-process, finished goods
inventory, and cost-of-goods-sold. A more accurate technique is to pro-rate misapplied
overhead based on the amount of overhead in each of these three accounts.
 
If overhead is underapplied, some managers close out the entire amount to the income
statement (thereby decreasing income) even if the amount is material. Conservatism is
often the justification for this approach.
  
ZFN Apparel Company, Normal Costing Example:
The ZFN apparel company in Albuquerque, New Mexico makes jeans and premium
chinos. Each product line has its own assembly line on the factory floor. Overhead costs
for the factory for 2005 were budgeted for $3,600,000, but came in below budget at
$3,300,000. Budgeted production for the year was 500,000 jeans and 500,000 chinos.
Actual production was 500,000 jeans and 400,000 chinos. The reduction in chinos
output relative to plan was due to unexpected slack in the demand for casual slacks. The
budgeted direct labor hours per jean is 0.5, and per chino is 0.7. In fact, 500,000 direct

30
labor hours were used: 200,000 for jeans, and 300,000 for chinos. The average direct
labor wage rate was the same on both assembly lines, and was $14 per hour. Denim
fabric is used to make jeans, and chinos are made from a cotton twill fabric. Overhead is
allocated using direct labor hours.
The following journal entries and T-accounts illustrate how a normal costing system
records the manufacturing activities of the factory in order to derive product cost
information for jeans and chinos.  
The first five entries are identical to the ZFN example in the previous chapter. The first
entry that differs as the result of using normal costing instead of actual costing is (6).
This entry to debit overhead to work-in-process is based on an overhead rate calculated
as:         
  Budgeted Production Budgeted hours per unit Budgeted labor hours
Jeans 500,000 units x 0.5 hours per unit = 250,000
Chinos 500,000 units x 0.7 hours per unit = 350,000
Total 600,000 

The budgeted overhead rate = $3,600,000 ÷ 600,000 direct labor hours = $6.00 per
direct labor hour.
In practice, the factory would track costs by batch, or perhaps weekly, but to simplify our
example, we record only one journal entry for each type of transaction. We also make the
unrealistic assumption that there is no work-in-process at the end of the period. To focus
the presentation on inventory-related accounts, T-accounts for some non-inventory
accounts are omitted. Many companies would use two separate accounts instead of one
account to track factory overhead; one account for factory overhead incurred, and the
other account for factory overhead allocated. 
(1)       Raw Materials: denim fabric                           $ 3,000,000
            Raw Materials: cotton twill                              $ 2,250,000
                        Accounts Payable                                                       $ 5,250,000
 (To record the purchase of 600,000 yards of denim fabric at $5.00 per yard, and 500,000
yards of cotton twill fabric at $4.50 per yard.)
 
(2)        Work-in-process: Jeans                                   $2,500,000

31
                        Raw Materials: denim fabric                                       $2,500,000
To record materials requisitions for 500,000 yards, for the movement of denim from the
receiving department to the cutting room.)
 (3)        Work-in-process: Chinos                                 $2,160,000
                        Raw Materials: cotton twill                                        $2,160,000
(To record materials requisitions for 480,000 yards, for the movement of cotton twill
from the receiving department to the cutting room.)
 
(4)       Work-in-process: Jeans                                   $2,800,000
            Work-in-process: Chinos                                 $4,200,000
                        Accrued Sewing Operator Wages                              $7,000,000
(To record sewing operator wages for the year: 200,000 hours for jeans, and 300,000
hours for chinos, at $14 per hour.)
 
 (5)        Factory Overhead                                           $3,300,000
                        Accounts Payable                                                       $1,800,000
                        Accrued Wages for Indirect Labor                            $900,000
                        Accumulated Depreciation                                           $600,000
(To record overhead costs incurred during the year.)
 
(6)        Work-in-process: Jeans                                   $1,200,000
            Work-in-process: Chinos                                  $1,800,000
                        Factory Overhead                                                       $3,000,000
(To allocate overhead to production, using a budgeted overhead rate of $6 per direct
labor hour, multiplied by actual hours used in production.)       
 
 (7)        Finished Goods: Jeans                                                $6,500,000
                        Work-in-process: Jeans                                               $6,500,000       
(To record the completion of all 500,000 jeans, at $13.00 per pair.)         
 
(8)        Finished Goods: Chinos                                 $8,160,000
                        Work-in-process: Chinos                                             $8,160,000       
(To record the completion of all 400,000 chinos, at $20.40 per pair.)         

32
 
(9)       Cost of Goods Sold: Jeans                             $5,200,000
            Cost of Goods Sold: Chinos                           $7,140,000
                        Finished Goods: Jeans                                                            $5,200,000
Finished Goods: Chinos                                              $7,140,000       
(To record the sale of 400,000 jeans and 350,000 chinos.)           
 
(10)      Cost of Goods Sold: misapplied overhead     $300,000
                        Factory Overhead                                                       $300,000
           
(To close out underapplied overhead to COGS. The total amount is taken to COGS
because the result is not materially different from allocating misapplied overhead to
COGS and finished goods inventory)       

33
      
Raw Materials: Raw Materials:  
Denim Fabric Cotton Twill
(1) $3,000,000 $2,500,000 (2)   (1) $2,250,000 $2,160,000 (3)
     
       
$   500,000   $    90,000
 
                 

Accrued Sewing    
 
Operator Wages Factory Overhead
    $7,000,000 (4)   (5) $3,300,000 $3,000,000 (6)
         300,000 (10)
     
  $0
 
                 

Work-in-Process: Jeans   Work-in-Process: Chinos  

(2) $2,500,000 $6,500,000 (7)   (3) $2,160,000 $8,160,000 (8)
(4)   2,800,000   (4)   4,200,000
(6) 1,200,000   (6)      1,800,000  
$0   $0
 
                 

Finished Goods: Jeans   Finished Goods: Chinos  

(7 $6,500,000 $5,200,000 (9)   (8) $8,160,000 $7,140,000 (9)
)      
       
$1,300,000   $1,020,500
 
                 
               
Cost of Goods Sold:   Cost of Goods Sold: Chinos
 
Jeans
(9)        (9) $7,140,000    
$5,200,000       
 
               

34
 

Accounts Payable   COGS: misapplied overhead  

    $5,250,000 (1)   (10) $300,000    
  1,800,000 (5)
 
 
 
                 

The per-unit cost of finished goods inventory is calculated as follows:

 Jeans:               $6,500,000 ÷   500,000 pairs   = $13.00 per pair

Chinos:              $8,160,000 ÷   400,000 pairs   = $20.40 per pair

 These amounts can be detailed as follows:

 Input Jeans Chinos

Fabric 1 yard/jean x $5/yard = $5.00 1.2 yards/chino x $4.50/yard = $ 5.40
Direct labor 0.4 hrs/jean x $14/hr = $5.60 0.75 hrs/chino x $14/hr =$ 10.50
Overhead 0.4 hrs/jean x $6.00/hr = $2.40 0.75 hrs/chino x $6.00/hr =$ 4.50
Total $13.00 $20.40
 

 Overhead is applied using the budgeted overhead rate of $6.00 per hour. However, this
budgeted overhead rate is multiplied by the actual direct labor hours used by each
product. Therefore, the only reason that more overhead or less overhead is allocated to
each unit of product than budgeted is because each product used more of the allocation
base or less of the allocation base (in this case, direct labor hours) than planned. Jeans
used less overhead per unit than planned (0.4 versus 0.5), so less overhead is allocated
to each pair of jeans than planned. Chinos used more overhead than planned (0.75
versus 0.7), so more overhead is allocated to each pair of chinos than planned.

 The total misapplied overhead is a function of two factors: (1) the numerator in the
budgeted overhead rate differing from actual overhead incurred; and (2), the
denominator in the budgeted overhead rate differing from the actual quantity of the
allocation base incurred. In the next two paragraphs, we consider each of these two
factors.

35
 
Less overhead was incurred than planned: $3,300,000 versus $3,600,000. It is probable
that one reason actual overhead incurred was less than budgeted is that fewer units
were produced than planned. Unless all overhead is fixed, a reduction in output should
decrease the total overhead incurred.

Exercise:
 
The denominator in the budgeted overhead rate can differ from the actual quantity of
the allocation base incurred for two reasons. First, the amount of the allocation base
used per unit of product (in this case, direct labor hours per unit) can differ from plan.
Jeans used less direct labor hours per unit than planned, but chinos used more direct
labor hours than plan. Second, the level of production can differ from plan (either total
production or product mix). Because fewer units were made than planned (900,000
units versus 1,000,000 units), less overhead was allocated than otherwise would have
been the case.
9-6: Following is information for Penquo, Inc., which makes crayons in its Billings, MT
factory:  
 
  Budget Actual
Production (# of boxes of crayons) 1,000 800
Total Direct Costs (materials & labor) $ 2,000 $ 2,400
Total Machine Hours 140 100
Overhead (fixed and variable) $2,800 $3,000
 
Penquo allocates overhead using a budgeted overhead rate, using machine hours as the
allocation base. The overhead rate is then applied to product based on actual machine
hours incurred. In other words, the company uses a Normal Costing system.
 Required:
A)        What is the overhead rate?
 
B)        How much overhead would be applied to each box of crayons?
 
C)        What is the actual direct cost of each box of crayons?
36
  
The Rio Grande Tile Company uses a budgeted overhead rate, and direct labor costs (i.e.,
direct labor dollars) as the allocation base. Overhead is applied using actual labor costs
incurred. Following is information for January 2005. The labor wage rate was budgeted
at $6 per hour, but was actually $8 per hour. Overhead was budgeted at $42,000, but was
actually $49,000.

 
  Ceramic Tiles Slate Tiles Total
Production:
  Budgeted 4,000 2,000 6,000
  Actual 3,000 4,000 7,000
 
Total Direct labor hours:
  Budgeted 500 200 700
  Actual 400 300 700

 Required:

A)        Calculate the overhead rate. How much overhead would be allocated to all 4,000 slate
tiles?
 
B)        Now assume the company uses a budgeted overhead rate, direct labor hours as the
allocation base, and applies overhead based on actual direct labor hours incurred. How
much overhead would be applied to each ceramic tile?
 
C)        Now assume the company allocates overhead using direct labor hours as in part B. What
is the misapplied overhead? Is overhead overapplied or underapplied?

Cost object: A cost object is anything that we want to know the cost of. We might want
to know the cost of making one unit of product, or a batch of product, or all of Tuesday’s
production, in which case the cost objects are one unit of product, a batch of product, or
Tuesday’s production, respectively. We might want to know the cost of operating a
department or a factory, in which case the cost object is the department or factory. In a

37
service sector company, we might want to know the cost of treating a patient in a
hospital, or the cost of conducting an audit, in which case the cost object is the patient or
the audit client. In a government setting, a cost object might be a program such as “Meals
on Wheels.”
 
Product costs: A product cost is any cost that is associated with units of product for a
particular purpose. Hence, the identification of product costs depends on the purpose for
which it is done. For example, the factory manager is interested in manufacturing costs,
whereas the merchandising manager might be interested in both manufacturing and
nonmanufacturing costs, including research and development, marketing, and
advertising costs.
 
Inventoriable costs: These are costs that are debited to inventory for either external or
internal reporting purposes. For manufacturing firms, all inventoriable costs are
manufacturing costs, but the reverse is not necessarily true. In other words,
inventoriable costs are either the complete set or a subset of manufacturing costs, and
non-manufacturing costs are never included as inventoriable costs. For merchandising
firms, inventoriable cost is usually the purchase price of inventory.
 
Period costs: These are costs that are expensed when incurred, usually because they are
not associated with the manufacture of products. Examples include advertising costs and
research and development costs. Period costs are distinguished from inventoriable costs.
 
Direct costs and overhead costs: In relation to a given cost object, all costs are either
direct costs or overhead costs. Direct costs can be traced to the cost object in an
economically feasible way. Overhead costs (also called indirect costs) are associated
with the cost object, but cannot be traced to the cost object in an economically feasible
way. These terms apply to companies in all sectors of the economy and to all types of
organizations.
 
Cost driver: A cost driver is any factor that affects costs. A change in the cost driver will
cause a change in the total cost of a related cost object. Any one cost object almost

38
always has numerous cost drivers. This term applies to companies in all sectors of the
economy and to all types of organizations.
 
Cost allocation: The assignment of overhead costs to the cost object. This term applies
to companies in all sectors of the economy and to all types of organizations.
 
Cost allocation base: A quantitative characteristic shared by multiple cost objects that
is used to allocate overhead costs among the cost objects. A cost allocation base can be a
financial measure (such as the raw material cost of each unit of product) or a
nonfinancial measure (such as direct labor hours incurred in the manufacture of each
unit of product). The simplest cost allocation base is simply the number of cost objects
(e.g., the number of units produced by the factory during a period of time). 
 
The distinction between a cost driver and a cost allocation base can be summarized as
follows. A cost driver is an economic concept; it relates to the economic reality of the
business. A cost allocation base is an accounting choice that is made by accountants and
managers. Usually, the best choice for a cost allocation base is a cost driver.
 
Conversion costs: All manufacturing costs other than direct materials. 
 
Overview of Product Costing:
Product costing follows these steps:
1. Identify the cost object;
2. Identify the direct costs associated with the cost object;
3. Identify the overhead costs;
4. Select the cost allocation base to use in assigning overhead costs to the cost
object;
5. Develop the overhead rate for allocating overhead to the cost object.
The cost accounting system “builds up” the cost of product (or other cost object) by
recording to a job cost sheet, a work-in-process account, or some other appropriate
ledger, the direct costs that can be traced to the product, and a share of the overhead
costs, which are allocated to the product by multiplying the overhead rate by the
amount of the allocation base identified with the cost object.

39
Cost Objects:
Recall that a cost object is anything that we want to know the cost of, such as a product
or service.
 There is a common convention that can be confusing. We often talk about the cost object
(the thing we want to know the cost of) as one unit of product, because factory managers
and product managers speak in terms of unit costs. These managers want to know the
unit cost for product pricing, product sourcing, and performance evaluation purposes.
They do not want to talk about the cost of making 620 units, even if that is the batch size.
However, in most batch processes, there would be very little benefit and enormous
additional expense in determining the cost of each unit of product individually. Rather,
the accounting system treats the batch as the cost object, and to derive a unit cost, we
divide the cost of the batch by the number of units in the batch. Hence, loosely speaking,
we talk as if a unit of product is the cost object, but more precisely, it is the batch (or the
production run in an assembly-line process, or perhaps one day’s production in a
continuous manufacturing process) that constitutes the cost object.
 
Direct Costs:
Management accounting classifies product costs as either direct costs or overhead costs
(indirect costs). This distinction is important because costing systems handle these two
types of costs very differently. The distinction is sometimes subtle, because whether a
cost is direct or overhead is a function of the cost object, and also partly a matter of
choice on the part of managers and accountants.
 Following are three definitions of direct costs from different accounting textbooks:
 Direct costs of a cost object are costs that are related to the cost object and can be traced
to it in an economically feasible way.
o Direct costs are costs that can be directly attached to the unit under
consideration.
o Direct costs are costs that can be traced easily to specific products
o Direct costs are also called prime costs. For manufacturing companies,
direct costs usually can be categorized as either materials or labor.

40
Direct materials: materials that become part of the finished product and that can be
conveniently and economically traced to specific units (or batches) or product.
 An example of direct materials for an apparel manufacturer is fabric. All other materials,
such as thread and zippers, are probably indirect.
 
Direct labor: costs for labor that can be conveniently and economically traced to a unit
(or batch) of product. The following examples show how the determination of whether a
cost is direct or overhead depends on the identification of the cost object:
 
Examples of direct labor for an apparel manufacturer:
1. If the cost object is a single pair of pants, in a batch of several dozen pairs: Most
likely no labor is direct.
2. If the cost object is a batch of several dozen pairs of pants: Most likely sewing
operators’ wages are direct.
3. If the cost object is a production line in the factory. Add the line manager’s salary,
and possibly wages incurred in the cutting room (where rolls of fabric are cut
into panels and pieces that are then sewn together)
4. If the cost object is the entire factory:
 
Add the factory manager’s salary, wages of maintenance and janitorial workers, and
salaries of front office personnel.
 Even though it is likely that no labor is direct with respect to a single pair of pants, if
labor is direct with respect to a batch of 50 or 100 units, cost accountants would usually
(and loosely) call labor a direct cost with respect to units of product, and divide the
direct labor cost for the batch by the number of units per batch to derive the direct labor
cost per unit.

Overhead Costs:
Overhead costs are costs that are related to the cost object, but cannot be traced to the
cost object in an economically feasible way. Overhead costs are not directly traceable to
specific units of production. Examples of overhead costs incurred at an apparel

41
manufacturer, when the cost object is a batch of product, would usually include the
following:
 
 Electricity
 Factory office salaries
 Building and machine maintenance
 Factory depreciation
 
The distinction between direct costs and overhead costs relate, in some measure, to the
way the accounting system treats the cost. For example, one apparel manufacturer might
track thread using the same methods that are used to track fabric, thus treating thread as
a direct material. Another apparel manufacturer might decide that the cost of thread is
immaterial, and does not warrant the cost and effort to track it as a direct cost. For this
company, thread is an overhead cost. Therefore, whether some costs are direct or
overhead depend on a choice made by the manager and the cost accountant.
 There are three ways overhead costs can be treated in any decision-making context: (1)
they can be ignored, (2) they can be treated as a lump-sum, or (3) they can be allocated
to the products and services (i.e., to the cost objects) to which they relate. Each of these
three alternatives is appropriate, depending on the circumstances and the purpose for
which the accounting is done. However, in this chapter and throughout much of this
book, we are concerned with the third alternative: how to allocate overhead costs to
products and services.

 Cost Allocation Bases

The allocation base is the “link” that is used to attach overhead costs to the cost object. In
a manufacturing setting, the simplest allocation base is the number of units produced.
For example, if the factory makes 15,000 units, the accounting system can simply
“spread” the overhead costs evenly over all 15,000 units. The problem with using units
as an allocation base, however, is that if the factory makes a range of different products,
those products might differ significantly in their resource utilization. A deluxe widget
might require twice as much labor and 20% more materials than a standard widget, and
one might infer that the deluxe widget also requires more resources that are
represented by overhead costs.

42
 Whatever cost allocation base is chosen, it must be a “common denominator” across all
cost objects. For example, a furniture factory could allocate overhead costs across all
products using direct labor hours, because direct labor is incurred by all products made
at the factory. However, it would not seem appropriate to allocate factory overhead
based on the quantity of wood used in each unit, if the factory makes both wood
furniture and a line of plastic-molded, because no overhead would be allocated to the
plastic chairs.

Overhead Rates:
The overhead rate is the ratio of cost pool overhead dollars in the numerator, and the
total quantity of the allocation base in the denominator:

     

Overhead costs in the cost pool

Overhead rate =
Total quantity of the allocation base

The result represents dollars of overhead per unit of the allocation base. For example, if
an apparel factory allocates overhead based on direct labor hours, the overhead rate
represents dollars of overhead per direct labor hour. Assume the overhead rate is $20
per direct labor hour. Then for every hour that a sewing operator spends working on
product, $20 will be allocated to the products that the sewing operator assembles during
that hour.
 
ZFN Apparel Company, Example of Actual Costing:
The ZFN apparel company in Albuquerque, New Mexico makes jeans and premium
chinos. Each product line has its own assembly line on the factory floor. Overhead costs
for the factory for 2005 were $3,300,000. 500,000 jeans and 400,000 chinos were
produced during the year. 500,000 direct labor hours were used: 200,000 for jeans, and
300,000 for chinos. The average direct labor wage rate was the same on both assembly
lines, and was $14 per hour. Denim fabric is used to make jeans, and chinos are made
from a cotton twill fabric. Overhead is allocated using direct labor hours.

43
 The following journal entries and T-accounts illustrate how the accounting system
records the manufacturing activities of the factory in order to derive product cost
information for jeans and chinos. Journal entry (6) to debit overhead to work-in-process
is based on an overhead rate calculated as follows.
 
            $3,300,000 ÷ 500,000 direct labor hours = $6.60 per direct labor hour.
 
In practice, the factory would track costs by batch, or perhaps weekly, but to simplify our
example, we record only one journal entry for each type of transaction. We also make the
unrealistic assumption that there is no work-in-process at the end of the period. To focus
the presentation on inventory-related accounts, T-accounts for some non-inventory
accounts, and the entry to debit accounts receivable and credit revenue, are omitted.

1)        Raw Materials: denim fabric                           $3,000,000

            Raw Materials: cotton twill                            $2,250,000
                        Accounts Payable                                                       $5,250,000
 
(To record the purchase of 600,000 yards of denim fabric at $5.00 per yard, and 500,000
yards of cotton twill fabric at $4.50 per yard.)

(2)        Work-in-process: Jeans                                   $2,500,000

                        Raw Materials: denim fabric                                       $2,500,000
 
(To record materials requisitions for 500,000 yards, for the movement of denim from
the receiving department to the cutting room.)
 
 
(3)        Work-in-process: Chinos                                 $2,160,000
                        Raw Materials: cotton twill                                        $2,160,000
 
(To record materials requisitions for 480,000 yards, for the movement of cotton twill
from the receiving department to the cutting room.)

44
 
(4)       Work-in-process: Jeans                                   $2,800,000
            Work-in-process: Chinos                                  $4,200,000
                        Accrued Sewing Operator Wages                              $7,000,000
 
(To record sewing operator wages for the year: 200,000 hours for jeans, and 300,000
hours for chinos, at $14 per hour.)
 
(5)        Factory Overhead                                           $3,300,000
                        Accounts Payable                                                       $1,800,000
                        Accrued Wages for Indirect Labor                             $900,000
                        Accumulated Depreciation                                           $600,000
 
(To record overhead costs incurred during the year, including utilities, depreciation,
repairs and maintenance, and indirect wages and salaries.)
 
(6)       Work-in-process: Jeans                                   $1,320,000
            Work-in-process: Chinos                                 $1,980,000
                        Factory Overhead                                                       $3,300,000
           
(To allocate factory overhead to production, using an overhead rate of $6.60 per direct
labor hour.)           
 
(7)        Finished Goods: Jeans                                                $6,620,000
                        Work-in-process: Jeans                                               $6,620,000
           
(To record the completion of all 500,000 jeans, at $13.24 per pair.)         
 
(8)        Finished Goods: Chinos                                 $8,340,000
                        Work-in-process: Chinos                                             $8,340,000
           
(To record the completion of all 400,000 chinos, at $20.85 per pair.)         
 

45
(9)        Cost of Goods Sold: Jeans                             $5,296,000
            Cost of Goods Sold: Chinos                             7,297,500
                        Finished Goods: Jeans                                                            $5,296,000
Finished Goods: Chinos                                               7,297,500 
(To record the sale of 400,000 jeans and 350,000 chinos.)           
      
Raw Materials: Raw Materials:  
Denim Fabric Cotton Twill
(1) $3,000,000 $2,500,000 (2)   (1) $2,250,000 $2,160,000 (3)
     
 
$   500,000   $    90,000
 
                 
Accrued Sewing    
 
Operator Wages Factory Overhead
    $7,000,000 (4)   (5) $3,300,000 $3,300,000 (6)
   
 
   
  $0
                 
Work-in-Process: Jeans   Work-in-Process: Chinos  
(2) $2,500,000 $6,620,000 (7)   (3) $2,160,000 $8,340,000 (8)
(4)   2,800,000   (4)   4,200,000
(6) 1,320,000   (6)      1,980,000  
$0   $0
 
                 
Finished Goods: Jeans   Finished Goods: Chinos  
(7) $6,620,000 $5,296,000 (9)   (8) $8,340,000 $7,297,500 (9)
     
       
$1,324,000   $1,042,500
 
                 
Cost of Goods Sold: Jeans   Cost of Goods Sold: Chinos  
(9) $5,296,000       (9) $7,297,500    
   
 
                 
               
Accounts Payable      
    $5,250,000 (1)      
  1,800,000 (5)  
 
               

46
The per-unit inventory cost is calculated as follows:
 
Jeans:               $6,620,000 ÷   500,000 pairs   = $13.24 per pair
Chinos:             $8,340,000 ÷   400,000 pairs   = $20.85 per pair
 
These amounts, which are used in journal entry (9), can be detailed as follows:
 Input Jeans Chinos
Fabric 1 yard/jean x $5/yard = $5.00 1.2 yards/chino x $4.50/yard = $5.40

Direct labor 0.4 hrs/jean x $14/hr = $5.60 0.75 hrs/chino x $14/hr =$10.50

Overhead 0.4 hrs/jean x $6.60/hr = $2.64 0.75 hrs/chino x $6.60/hr = $4.95

Total $13.24 $20.85

In the above table, the direct labor hours per jean and per chino appear in the lines for
both the per-unit direct labor cost and the per-unit overhead cost, because overhead
is allocated based on direct labor hours. If the allocation base had been something
else, such as machine hours, the hours per unit would only appear in the calculation of
the direct labor cost.
 
More overhead is allocated to each pair of chinos than to each pair of pants ($4.95
versus $2.64) because direct labor hours has been chosen as the allocation base, and
each chino requires more direct labor time than each pair of jeans (0.75 hours versus
0.40 hours). Changing the allocation base cannot change the total amount of overhead
incurred, but it will usually shift costs from some products to others. For example, if
the allocation base were units of production instead of direct labor hours, the
overhead rate would be:
 
$3,300,000 ÷ 900,000 units = $3.67 per unit.
 
In this case, the total cost per pair of jeans would increase from $13.24 to $14.27, and
the total cost per pair of chinos would decrease from $20.85 to $19.57.

47
  
Because the choice of allocation base determines how overhead is allocated across
products, product managers usually have preferences over this choice (because a
lower reported product cost results in higher reported product profitability).
However, the company’s choice of allocation base should be guided, if possible, by the
cause-and-effect relationship between activity on the factory floor and the incurrence
of overhead resources. For example, direct labor hours is a sensible allocation base if
the significant components of overhead increase as direct labor hours increase. More
direct labor implies more indirect labor by human resources and accounting
personnel, janitorial staff and other support staff. Also, more direct labor implies
more machine time, which implies more electricity usage, and more repairs and
maintenance expense. For these reasons, direct labor hours is probably a better
choice of allocation base than units of product.
 

  Exercises and Problems:

 8-1: A company allocates overhead based on direct labor cost (dollars). The rate is
160% of the direct labor cost. A job has direct materials cost of $12,000 and direct
labor cost of $14,000 (700 labor hours). What is the total cost of the job? 

8-2: A multi-product manufacturing company uses many different machines and

employs a labor force with widely-varying skill levels and pay rates. Generally, the
higher paid and more skilled employees operate the more complex and expensive
machinery. If all overhead is going to be applied using a single overhead rate, based
on the information provided, which allocation base would work best in this
environment

Chapter 7

Support Department Cost Allocation

Learning objectives:

1. Describe the difference between support departments and producing departments.

2. Calculate single and multiple changing rates for a support department.

48
3. Allocate support-department costs to producing departments using the direct, sequential,
and reciprocal methods.
4. Calculate departmental overhead rates.

Introduction:
Many companies in all sectors of the economy, and not-for-profit and governmental
organizations as well, allocate service department costs to “production” or user departments,
and ultimately to the products and services that they provide. For example, hospitals use
sophisticated methods for allocating costs of service departments such as Housekeeping,
Patient Admissions, and Medical Records to patient wards and outpatient services, and then to
individual patients. Historically, these allocations were important to hospitals because
Medicare reimbursement was based on actual costs. To the extent that the hospital allocated
service department costs to Medicare patients, Medicare covered these costs.
Companies that allocate service department costs do so for one or more of the following
reasons:
1. To provide more accurate product cost information. Allocating service department
costs to production departments, and then to products, recognizes that these services
constitute an input in the production process.
2. To improve decisions about resource utilization. By imposing on division managers
the cost of the service department resources that they use, division managers are
encouraged to use these resources only to the extent that their benefit exceeds their
cost.
3. To ration limited resources. When production departments have some discretion over
their utilization of a service department resource, charging production departments for
the resource usually results in less demand for it than if the resource were “free” to the
production departments.
 
The motivation for the first reason, to provide more accurate product cost information, can be
to improve decision-making within the organization, to improve the quality of external
financial reporting, or to comply with contractual agreements in regulatory settings where
cost-based pricing is used. As discussed above, Medicare was historically a cost-based
reimbursement scheme. As another example, defense contractors that provide the U.S.
military “big ticket” items such as airplanes and ships often operate under cost-plus contracts,
under which they are reimbursed for their production costs plus a guaranteed profit. In such

49
settings, the calculation of cost includes a reasonable allocation of overhead, including
overhead from service departments.

 The distinction between the second and third reasons is important in the context of fixed
versus variable costs. In connection with the second reason, to improve decisions about
resource utilization, from the company’s perspective, a division manager making a short-term
decision about whether to utilize service department resources should incorporate into that
decision the service department’s marginal costs, which are usually the variable costs. The
manager should ignore the service department’s fixed costs if these costs will not be affected
by the manager’s decision. This reasoning suggests that only the service department’s variable
costs should be charged out.

 However, in connection with the third reason, to ration a scarce resource, if the service
department controls a fixed asset, and if demand for the asset exceeds capacity, charging users
a fee for the asset allows the service department to balance demand with supply. The fee need
not relate to the cost of obtaining the asset; rather, it is a mechanism for managing demand.
Examples would be charging departments a “rental fee” for their use of vehicles from the
motor pool, or for their use of a corporate conference facility.

 Service department costs can be allocated based on actual rates or budgeted rates. Actual
rates ensure that all service department costs are allocated. Budgeted rates provide service
department managers incentives to control costs, and also provide user departments more
accurate information about service department billing rates for planning purposes. In either
case, service department costs should be allocated using an allocation base that reflects a
cause-and-effect relationship, whenever possible. Here are some examples:
 Allocate building maintenance costs based on square footage;
 Allocate costs of the company airplane based on miles flown;
 Allocate costs of the data processing department based on CPU time.
 
In some cases, companies benefit from allocating fixed costs using a different allocation base
than variable costs. For example, fixed costs might be allocated based on an estimate of long-
term usage by the production departments.

50
 Historically, there have been three alternative methods for allocating service department
costs. These methods differ in the extent to which they recognize that service departments
provide services to other service departments as well as to production departments. All three
methods ultimately allocate all service department costs to production departments; no costs
remain in the service departments under any of the three methods.
 
 The Direct Method:
The direct method is the most widely-used method. This method allocates each service
department’s total costs directly to the production departments, and ignores the fact that
service departments may also provide services to other service departments.
 Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.)
provide services to the Machining and Assembly production departments, and in some cases,
the service departments also provide services to each other, as reflected in the following table:
Total Servic % of services provided by the service department listed at left to:
e Dept H.R. D.P. R.M. Machinin Assembly
Cost
g
$   80,000 H.R. -- 20% 10% 40% 30%
$ 120,000 D.P. 8% -- 7% 30% 55%
$ 40,000 R.M. -- -- -- 50% 50%
$ 240,000            

 The amounts in the far left column are the costs incurred by each service department. The
percentages in the other columns are the percentage of each service department’s services
provided to each department that utilizes the services of that service department. These
percentages are derived from some relevant measure of service department activity. For
example, the percentages for human resources might be based on the number of employees in
each department, or the number of new hires in each department. The percentages for data
processing might be based on the number of computers in each department. Any services that
a department provides to itself are ignored, so the intersection of the row and column for each
service department shows zero. The rows sum to 100%, so that all services provided by each
service department to the other departments are accounted for.  

 Under the direct method, each service department is allocated separately, and the order in
which the service departments are allocated does not matter. Taking one row at a time, the
percentages of the production departments are normalized, so that they add up to 100% while
still reflecting the relative usage by the production departments (relative to all of the other

51
production departments). For example, in applying the direct method for the costs of human
resources, Machining and Assembly are the only production departments that used the
services of the Human Resources Department in March, so the percentages in the columns for
machining and assembly are the only percentages that are relevant (the 20% for data
processing and the 10% for risk management are ignored). The denominator in the
normalization process is the sum of the percentages of all of the production departments. For
example, for the human resources row in the table below, the 70% is the sum of 40% for
machining and 30% for assembly in the table above.

Total Service Normalized percentage of services provided by the service

Cost Dept department listed at left to the production departments:
H.R. D.P. R.M. Machining Assembly
$   80,000 H.R. -- -- -- 40% ÷ 70% = 57% 30% ÷ 70% = 43%
$ 120,000 D.P. -- -- -- 30% ÷ 85% = 35% 55% ÷ 85% = 65%
$ 40,000 R.M. -- -- -- 50% 50%
$ 240,000            

 The risk management service department percentages do not require normalization, because
this service department provided services only to the production departments, it did not
provide any services to the other service departments. The normalized percentages are then
used to allocate each service department’s total costs to the production departments:

 Total cost Service dept. Machining Assembly

$  80,000 H.R. 57% x $80,000 = $45,600 43% x $80,000 =  $34,400
$ 120,000 D.P. 35% x $120,000 = $42,000 65% x $120,000 = $78,000
$ 40,000 R.M. 50% x $40,000 = $ 20,000  50% x $40,000 = $20,000
$ 240,000   $107,600 $132,400

 The normalization process ensures that the sum of the costs allocated to the production
departments equals the total costs incurred by each service department, even though service-
department-to-service-department services are ignored. For example, $42,000 of data
processing costs are allocated to machining and $78,000 are allocated to assembly, and these
two amounts sum to $120,000, the total costs incurred by data processing.

The Step-Down Method:

The step-down method is also called the sequential method. This method allocates the costs
of some service departments to other service departments, but once a service department’s
costs have been allocated, no subsequent costs are allocated back to it.

52
 
The choice of which department to start with is important. The sequence in which the service
departments are allocated usually effects the ultimate allocation of costs to the production
departments, in that some production departments gain and some lose when the sequence is
changed. Hence, production department managers usually have preferences over the sequence.
The most defensible sequence is to start with the service department that provides the highest
percentage of its total services to other service departments, or the service department that
provides services to the most number of service departments, or the service department with
the highest costs, or some similar criterion.
 
Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.)
provide services to the Machining and Assembly production departments, and in some cases,
the service departments also provide services to each other:
Total Cost Servic % of services provided by the service department listed at left
e Dept to:
H.R. D.P. R.M. Machinin Assembly
g
$  80,000 H.R. -- 20% 10% 40% 30%
$ 120,000 D.P. 8% -- 7% 30% 55%
$ 40,000 R.M. -- -- -- 50% 50%
$ 240,000            

The amounts in the far left column are the costs incurred by each service department. Any
services that a department provides to itself are ignored, so the intersection of the row and
column for each service department shows zero. The rows sum to 100%, so that all services
provided by each service department are charged out.
 The company decides to allocate the costs of Human Resources first, because it provides
services to two other service departments, and provides a greater percentage of its services to
other service departments. However, a case could be made to allocate Data Processing first,
because it has greater total costs than either of the other two service departments. In any case,
the company decides to allocate Data Processing second.
 In the table below, the row for each service department allocates the total costs in that
department (the original costs incurred by the department plus any costs allocated to it from

53
the previous allocation of other service departments) to the production departments as well as
to any service departments that have not yet been allocated.
   H.R. D.P. R.M. Machining Assembly
Costs prior to allocation $  80,000 $ 120,000 $ 40,000 -- --
Allocation of H.R. ($  80,000) $ 16,000 $ 8,000 $32,000 $24,000
Allocation of D.P.   $(136,000) $ 10,348 $44,348 81,304
Allocation of R.M.     $(58,348 $29,174 29,174
)
  0 0 0 $105,522 $134,478

 After the first service department has been allocated, in order to derive the percentages to
apply to the production departments and any remaining service departments, it is necessary to
“normalize” these percentages so that they sum to 100%. For example, after H.R. has been
allocated, no costs from D.P. can be allocated back to H.R. The percentages for the remaining
service and production departments sum to 92% (7% + 30% + 55%), not 100%. Therefore,
these percentages are normalized as follows:

            Risk Management:        7% ÷ 92%     =     7.61%

            Machining:                  30% ÷ 92%     =   32.61%
            Assembly:                   55% ÷ 92%     =   59.78%
                        Total:                                          100.00%
 
For example, in the table above, 59.78% of $136,000 (= $81,304) is allocated to assembly, not
55%.
 
The characteristic feature of the step-down method is that once the costs of a service
department have been allocated, no costs are allocated back to that service department. As can
be seen by adding $105,522 and $134,478, all $240,000 incurred by the service departments
are ultimately allocated to the two production departments. The intermediate allocations from
service department to service department improve the accuracy of those final allocations.

The Reciprocal Method:

The reciprocal method is the most accurate of the three methods for allocating service
department costs, because it recognizes reciprocal services among service departments. It is

54
also the most complicated method, because it requires solving a set of simultaneous linear
equations.
 
Using the data from the step-down method example, the simultaneous equations are:
H.R. = $  80,000 + (0.08 x D.P.)
D.P. = $120,000 + (0.20 x H.R.)
R.M.= $  40,000 + (0.10 x H.R.) + (0.07 x D.P.)
 Where the variables H.R., D.P. and R.M. represent the total costs to allocate from each of
these service departments. For example, Human Resources receives services from Data
Processing, but not from Risk Management. 8% of the services that Data Processing provides,
it provides to Human Resources. Therefore, the total costs allocated from Human Resources
should include not only the $80,000 incurred in that department, but also 8% of the costs
incurred by Data Processing. Solving for the three unknowns (which can be performed using
spreadsheet software):
 
H.R.    =          $  91,057
D.P.     =          $138,211
R.M.    =          $  58,781
 Hence, costs are allocated as follows:
   H.R. D.P. R.M. Machinin Assembly
g
Costs prior to allocation $80,000 $120,000 $40,000 -- --
Allocation of H.R. ($91,057)   $ 18,211 $9,106 $36,423 $  27,317
Allocation of D.P.       $ (138,211)     $9,675   $41,463    $76,016
11,057  
Allocation of R.M.     $(58,781)   $29,390   $ 29,390
  $            0 $         0 $        0 $107,276 $132,723

 To illustrate the derivation of the amounts in this table, the $36,423 that is allocated from
Human Resources to Machining is 40% of H.R.’s total cost of $91,057.

Summary of Service Department Cost Allocation Methods:

The direct method and step-down method have no advantages over the reciprocal method
except for their simplicity, and the step-down method is sometimes not very simple.
Nevertheless, the reciprocal method is not widely used. Given advances in computing power,
the reciprocal method would seem to be accessible to many companies that are not using it.

55
Presumably, these companies believe that the benefits obtained from more accurate service
department cost allocations do not justify the costs required to implement the reciprocal
method. In fact, many companies do not allocate service department costs at all, either
because they do not think these allocations are beneficial, or because they do not believe that
the benefits justify the costs.
 
Dysfunctional Incentives from Service Department Cost Allocations:
The incentives that service department cost allocations impose on managers and employees
should be carefully considered. In some cases, these allocations have unintended and
undesirable consequences. For example:
 
1. At one university, professors are “charged” for office telephone usage, which includes
a fixed monthly fee similar to the flat fee that is charged for residential telephone
service. The “charge” comes out of the professor’s “research allowance,” which can
otherwise be used for professional expenses such as journal subscriptions, professional
organization dues, and travel to conferences. Since the flat fee (as opposed to the long
distance charges) is unavoidable, it does not affect the professors’ behavior, but it is
viewed negatively, because the research allowance is effectively several hundred
dollars a year less than “advertised” by the administration.
2. At another university, state-of-the-art computer equipment in the classrooms is
purchased out of student fees. Consequently, this equipment is readily available and
“free” to the faculty when they teach. However, when a professor reserves a room for
a non-teaching purpose, such as a research presentation to fellow faculty, the
Instructional Technology service center “charges” the professor’s department
approximately $50 to use the equipment, which is far in excess of the equipment’s
marginal cost (the depreciation on the bulb in the projector). The $50 charge is
sufficient to dissuade many departments from using the equipment for non-
instructional purposes, so the equipment sits idle, and the professors use a “low tech”
solution: an overhead projector and transparencies. 

Exercise:

56
The “Big One” accounting firm has three divisions: audit, tax and consulting; two support
departments: administration and human resources. The following table shows the utilization of
support department services by the user departments:
 
Human
Administration Resources Audit Tax Consulting
Administration 10% 30% 25% 35%
Human Resources 10% 30% 35% 25%
 
Which of the following allocation methods will result in the smallest allocation of support
department costs to the Consulting Division?
a) The direct method.
b) The step-down method, beginning with Administration.
c) The step-down method, beginning with Human Resources.
d) Cannot be determined from the information given.

Chapter 8

Functional and Activity-Based Budgeting

Learning objectives:

1. Discuss budgeting and its role in planning, control, and decision making.
2. Define and prepare a master budget, identify its major components, and explain
the interrelationships of its various components.

57
3. Describe flexible budgeting, and list the features that a budgetary system should
have to encourage managers to engage in goal-congruent behavior.
4. Explain how activity-based budgeting works.

Overview:

A budget is a quantitative plan for the future that assists the organization in coordinating
activities. All large organizations budget. Many organizations prepare detailed budgets
that look one year ahead, and budgets that look further into the future that contain
relatively less detail and more general strategic direction.
 
The budget assists in the following activities:
 Planning. A budget helps identify the resources that are needed, and when they
will be needed.
 Control. A budget helps control costs by setting spending guidelines.
 Motivating Employees. A budget can motivate employees and managers.
Budgets are more effective motivational tools if employees and managers “buy
into” the budget, which is more likely to occur if they participate in the
preparation of the budget in a meaningful way.
 Communication. A budget can provide either one-way (top-down) or two-way
communication within the organization.
 
A company’s overall budget, which is sometimes called a master budget, consists of
many supporting budgets. These supporting budgets include:
 Sales budget
 Pro forma income statement
 The production budget and supporting schedules
 Budgets for capital assets and for financing activities
 Budgets for individual balance sheet accounts and departmental expenses
 Cash budget, including cash disbursements and cash receipts budgets
 Pro forma balance sheet
 
There is a logical sequence for the preparation of these budgets. The first step in a
corporate setting is almost always to forecast sales and to assemble a sales budget.

58
 
The Sales Budget:
The individuals who are best able to forecast sales are usually the sales force and product
managers. Their ability to accurately forecast sales depends on the nature of the industry
and on characteristics of the product. Demand is seasonal for many products, in which
case each month’s forecast usually incorporates information about sales for the same
month last year. Accurately forecasting sales of new products and fashion products can
be difficult. Demand for some products is sensitive to macroeconomic forces such as
interest rates and foreign exchange rates. On the other hand, given the seemingly
arbitrary way in which most of us decide where to eat lunch, restaurants can usually
predict each day’s lunch revenue with astounding accuracy.
 
Most companies face a downward-sloping demand curve for their products, which
implies that forecasting sales revenue requires predicting sales volume at the planned
sales price.

 Pro Forma Income Statement:

With planned sales prices, forecasted sales volumes, and an understanding of the cost
structure of the business, the company can assemble a pro forma income statement (an
anticipated income statement for the upcoming period). This process is illustrated below,
in a simple one-product setting, for the Guess Who Jeans Company. The planned sales
price is $40 per unit. Assume that the sales manager’s best guess of sales volume at this
price is 20,000 units for October. Then anticipated revenue for October is $800,000. The
company’s cost structure is characterized by $30 of variable manufacturing costs per
unit, and $150,000 in fixed manufacturing and S.G.&A. (selling, general and
administrative) costs. This information is sufficient to complete the pro forma income
statement that is shown below.

GUESS WHO JEANS

PRO FORMA CONTRIBUTION MARGIN

INCOME STATEMENT FOR OCTOBER
Income Statement Budgeted amount Sale of 20,000 units
Account Per unit
Revenue $40 $800,000

59
 Variable manufacturing costs:
Materials 15 300,000
Labor 10 200,000
Overhead 5 100,000
Total 30 600,000
Contribution margin $10 200,000
Fixed costs:
Manufacturing overhead 100,000
Selling, general & admin. 50,000
Total fixed costs 150,000
Operating income $50,000

The Production Budget:

The next step in the budgeting process is more complicated for manufacturing firms than for
merchandising firms, because manufacturing companies have three types of inventory
accounts: raw materials, work-in-process and finished goods. However, regardless of the
number of asset accounts involved, the goal is to determine the required additions to each
account (purchases or transfers-in from an upstream account). The calculation to determine
required additions is derived by expanding the Sources = Uses equality as follows:
 
Beginning balance + additions = transfers out + ending balance
 
This calculation sometimes uses physical quantities, and sometimes uses dollar values,
depending on which makes the most sense under the circumstances. 
 
The beginning balance equals the ending balance for the prior period, which is available either
from actual results (the ending balance sheet), or from another budget if the start of the period
being budgeted is in the future.
 
The ending balance is a target established by the company, and is usually based on anticipated
activity for the following period (that is, the period following the one for which the current
budget is being prepared).
 
Transfers-out equals the demand for the asset derived from a previous step in the budgeting
process:

60
 - If the asset account is finished goods inventory, the demand is based on cost of goods
sold, as derived from the pro forma income statement.
- If the asset account is work-in-process inventory, the demand is based on the additions
to the finished goods account, as calculated by applying the sources = uses equation
shown above to the finished goods account.
- If the asset account is raw materials inventory, the demand is based on the additions to
the work-in-process account for materials, as calculated by applying the sources =
uses equation shown above to the work-in-process account.   
 
The unknown in the sources = uses equation is additions, which can be solved for, thus
completing the production budget. The following table provides balance sheet information for
Guess Who Jeans for September 30, which is the period just ended. (This is also the beginning
balance for October 1, the period for which the budget is being prepared, because balance
sheet amounts at the end of the day on September 30 are the same as the opening balances on
the morning of October 1). We will use the information in this table to budget for October’s
production. Because Guess Who Jeans makes only one product, it is more convenient to use
physical quantities in the sources = uses equations than dollars. We assume that the budget for
October is being prepared on October 1st

GUESS WHO JEANS

BALANCE SHEET

SEPTEMBER 30 (THE MONTH JUST ENDED)

Assets Amount Liabilities Amount

Cash $  67,000   Accounts Payable $  295,000
Accounts Receivable 676,000 Line of Credit 345,000
       
Inventory:      
Raw Materials (1,800 yards)      13,500 Stockholders’ Equity:  
Work in Process (1,500 units) 35,000 Common stock 100,000

61
 Finished Goods (5,000 units) 150,000 Additional paid-in capital 72,500
  Total inventory 198,500 Retained earnings 1,009,000
      Total S/H equity 1,181,500
Property, Plant & Equipment, net      
of accumulated depreciation 880,000    
       
Total $1,821,500 Total $1,821,500
 

Required additions to finished goods inventory: Guess Who Jeans expects to sell 20,000
units each month for the next two months (October and November). The company would like
to have on hand, at the beginning of each month, 20% of next month’s sales. The company did
not achieve this operational goal for October, because 5,000 units are on hand on October 1,
and expected sales are 20,000 units, but the company came close to its goal (25% versus
20%). At the end of October, the company would like to have 4,000 units on hand (20% of
20,000 units expected to be sold in November).
Beginning balance + additions = transfers out + ending balance 5,000 units + additions =
20,000 units in expected sales + 4,000 units for desired ending inventory additions = 19,000
Hence, Guess Who Jeans should plan to transfer out 19,000 units from work-in-process to
finished goods inventory during the month of October.
Required additions to work-in-process: Guess Who Jeans would like to have on hand, at
any point in time, 1,200 units in work-in-process. The company has determined that this level
of work-in-process provides optimal efficiency on the production line. (As shown above, the
level of work-in-process is slightly higher than desired at the end of September.)
Beginning balance + additions = transfers out + ending balance 1,500 units + additions =
19,000 units transferred to finished goods + 1,200 units for desired ending WIP additions =
18,700
Hence, Guess Who Jeans should plan to start production of 18,700 units during the upcoming
month of October.
Required additions to raw materials: On average, 2 yards of fabric are required for each
unit of product. Guess Who Jeans would like to maintain 2,000 yards of fabric on hand at any
point in time. (The company had less fabric on hand than desired at the end of September.)
 
Beginning balance + additions = transfers out + ending inventory 1,800 yards + additions =
(2 yards per unit x 18,700 units) + 2,000 yards desired in ending inventory on October 31
1,800 yards + additions = 37,400 yards + 2,000 yards Additions = 37,600 yards of fabric

62
 
Hence, Guess Who Jeans should plan to purchase 37,600 yards of fabric during the month of
October. Using the budgeted cost of $7.50 per yard, the expected expenditure for these fabric
purchases is $282,000.
 
Accounts Receivable and Accounts Payable Budgets:
 
Accounts receivable: To budget for the ending balance of accounts receivable, the company
incorporates information about the rate at which receivables are collected. Guess Who Jeans
makes all sales on credit, and past experience indicates that the following collection schedule
can be anticipated:
 
            50% of sales are collected in the month of sale
            30% of sales are collected in the month following the sale
            20% of sales are collected two months following the sale
           
This collection schedule implies that on October 31, accounts receivable will consist of:
            50% of October sales
            20% of September sales
            Nothing from sales that occurred prior to September
              (E.g., August sales would be collected in August, September, and October)
 
Actual sales for September were 25,000 units.
Anticipated sales for October are 20,000 units.
 
Therefore, the budget for accounts receivable at the end of October can be calculated as
follows:
50% of October sales 20,000 units x $40 per unit x 50% =   $400,000

20% of September sales 25,000 units x $40 per unit x 20% =   $ 200,000

$600,000 

 However, this calculation does not incorporate information available about September
collections of September sales and September collections of prior month sales. Possibly,

63
September collections of September sales differed from the 50% that is budgeted, or perhaps
not all of August’s sales were collected by the end of September. This additional information
would normally be used to refine the budget of Accounts Receivable at the end of October.

 
Accounts payable: To budget for the ending balance of accounts payable, the company
incorporates information about the extent to which the company makes purchases on credit.
Guess Who Jeans pays cash for all types of purchases except for fabric purchases. The
company pays for fabric 30 days after the fabric is purchased, on average.
This payment policy implies that at the end of October, accounts payable will consist of all
October purchases of fabric, and nothing else. In the raw materials budget (see above), we
determined that $282,000 would be incurred for fabric purchases in October. Hence, this
amount is the anticipated the balance in Accounts Payable on October 31.
The cash budget:
One of the most important components of the budgeting process for most organizations is the
cash budget. The cash budget indicates how much cash the company will have on hand at the
end of each period, and also indicates when the company will need to borrow funds to cover
temporary cash shortfalls, and when the company will have excess funds to invest in short-
term financial instruments. Cash flow is so important that in some organizations, cash
balances are projected for the end of each week, or even on a daily basis.
 Often, the cash budget is assembled from supporting schedules. These schedules show, for
the period being budgeted, anticipated cash disbursements and cash receipts that arise from (1)
operating activities, (2) additions and disposals of fixed assets, and (3) financing activities.
 Cash receipts: the company anticipates that the only cash receipts that will occur in October
will come from collections of receivables. Cash receipts in October are based on anticipated
collections of sales that were made in August and September, and anticipated sales for
October, and are projected as follows:
 Sales made in Sales volume Unit sales percentage collected Collections in
the month of: during the month price during October October
August 22,000 $40 20% $176,000

September 25,000 $40 30% $300,000

October 20,000 $40 50% $400,000

$876,000

64
  

 Cash disbursements are anticipated as follows:

 Fabric purchases (for fabric acquired in September) $295,000

Manufacturing labor $189,000

Manufacturing variable overhead $94,500

Fixed manufacturing overhead (excluding non-cash items) $50,000

Fixed selling, general and admin. overhead (excluding non-cash items) $35,000

Cash payments for capital acquisitions (from the capital budget) $110,000

Payments of short-term borrowings $60,000

Total disbursements for October $833,500

This information about receipts and disbursements is used to project the ending cash balance
for the month, as follows:
 Beginning balance + cash receipts  cash disbursements = ending balance
 $67,000 + $876,000  $833,500 = $109,500
 Pro Forma Balance Sheet:
The foregoing analysis can be used to assemble a pro forma balance sheet, projecting the
balance sheet at the end of the October. The amounts in the pro forma balance sheet are
derived as follows:
 Cash: from the cash budget, shown above.
 Accounts receivable: from the accounts receivable budget, shown above.
 Raw materials inventory: from the projected ending inventory of 2,000 yards multiplied by
the budgeted price of $7.50 per yard.

Work-in-process inventory:
 
Beginning balance $   35,000

65
 + Fabric additions (37,400 yards x $7.50 per yard) $ 280,500
+ Manufacturing labor (from the cash disbursements budget) $ 189,000
+ Manufacturing variable overhead (from the cash disbursements budget) $ 94,500
 Transfers out to finished goods inventory (19,000 units x $30 per unit) $ 570,000
Ending balance $   29,000
 

 Finished goods inventory: from the projected ending inventory of 4,000 units, multiplied by
the budgeted cost of $30 per unit. (Note: the company uses Variable Costing for internal
reporting.)

 Property, plant & equipment, net of accumulated depreciation:

 Beginning balance $880,000

+ Capital acquisitions (from the cash disbursements budget) $110,000

 Depreciation expense $ 65,000

Ending balance $925,000 

 The $65,000 in depreciation expense reconciles to the non-cash portion of the $150,000 in
fixed manufacturing and fixed selling, general and administrative costs shown on the pro
forma income statement. The difference of $85,000 (i.e., the cash portion of these fixed costs)
is shown on the cash disbursements budget as $50,000 for fixed manufacturing overhead and
$35,000 for fixed selling, general and administrative overhead.

 Accounts payable: from the accounts payable budget, shown above.

 Short-term borrowings: beginning balance of $345,000 less the anticipated payment of
$60,000 as per the cash disbursements budget.
 Common stock and Additional paid-in capital: no change.
 
Retained earnings: beginning balance of $1,009,000 + October income of $50,000, as per the
pro forma income statement.

66
 GUESS WHO JEANS

PRO FORMA BALANCE SHEET

OCTOBER 31

         
Assets Amount Liabilities Amount
Cash $109,500   Accounts Payable $282,000
Accounts Receivable 600,000 Line of Credit 285,000
       
Inventory:      
Raw Materials (2,000 yards)      15,000 Stockholders’ Equity:  
Work in Process (1,200 units) 29,000 Common stock 100,000
Finished Goods (4,000 units) 120,000 Additional paid-in capital 72,500
  Total inventory 164,000 Retained earnings 1,059,000
      Total S/H equity 1,231,500
Property, Plant & Equipment,      
  net of accumulated depreciation 925,000    
       
Total $1,798,500 Total $1,798,500
 

It is interesting to note that whereas the pro forma income statement can be prepared early in
the budgeting process (at least for the results of operating activities), the pro forma balance
sheet is one of the last schedules to be prepared, because it depends on information obtained
from numerous supporting budgets and schedules.

Exercises and Problems

 
20-1: ZFN anticipates sales of 20,000 units in March, 30,000 units in April, and 40,000 units
in May. The company wants to have 20% of next month’s sales on hand at the end of the

67
previous month. In fact, at the beginning of March, the company has 4,000 units on hand.
How many units should the company produce during April?
 
 
20-2: Yue Yeung Industries has sales of $10,000 in May, $20,000 in June, and $30,000 in
July. The company collects 25% of sales in the month of sale, and the remaining 75% in the
following month. Calculate Accounts Receivable at June 30.
 
 
20-3: A merchandising company expects to sell 300 units in April, 400 units in May, and 500
units in June. The company plans to have 30% of each month’s sales, plus an additional 50
units, on hand in inventory at the beginning of each month. How many units should the
company plan to purchase in May

68
 Chapter 9

Standard Costing: A Managerial Control Tool

Learning objectives:

1. Tell how unit standards are set and why standard costing systems are adapted.
2. State the purpose of a standard cost sheet.
3. Describe the basic concepts underlying variance analysis, and explain when
variances should be investigated.
4. Compute the material and labor variances, and explain how they are used for
control.
5. Calculate the variable and fixed overhead variances, and give their definitions.
6. Appendix: Prepare journal entries for materials and labor variances, and show
how to account for overhead variances.

Introduction:
If you were to design a cost accounting system with no accounting education other than
financial accounting courses, you would probably design an accounting system that
collects, summarizes, and reports actual costs. This approach would be consistent with the
implicit assumption throughout every financial accounting course that when financial
statements report historical cost data, such as would normally be the case for cost-of-
goods-sold and ending inventory, that the information reported represents actual costs.
Therefore, it comes as a surprise to most students that the initial journal entries to record
the production and movement of inventory in the costing systems of most manufacturing
firms are not based on actual costs at all, but rather are based on budgeted per-unit costs.
 
In most manufacturing firms, the initial journal entries to debit work-in-process, finished
goods and cost-of-goods-sold are based on the actual quantity of output produced,
multiplied by budgeted data about the inputs necessary to produce those outputs, and the
budgeted costs of those inputs. Then, at the end of the month (or possibly quarterly), an
“adjusting” or “closing” entry is made to record in the inventory accounts the difference
between actual costs incurred, and the budgeted information that has formed the basis for
the journal entries during the month. The nature of this adjusting entry depends on the

69
materiality of the amounts involved. If the differences between actual costs and budgeted
costs are small, this adjusting entry might be made in an expedient manner, involving only
cost-of-goods-sold, but if the differences are large, the adjusting entry might also involve
work-in-process and finished goods inventory accounts.
 
The accounting system described above is called a standard costing system, and it is
widely-used by companies in the manufacturing sector of the economy. This chapter
describes standard costing systems, and explains why companies use them. But first we
discuss a related concept, standard costs, which constitutes an important component of
standard costing systems.    
Standard Costs:
A standard, as the term is usually used in management accounting, is a budgeted amount
for a single unit of output. A standard cost for one unit of output is the budgeted
production cost for that unit. Standard costs are calculated using engineering estimates of
standard quantities of inputs, and budgeted prices of those inputs. For example, for an
apparel manufacturer, standard quantities of inputs are required yards of fabric per jean
and required hours of sewing operator labor per jean. Budgeted prices for those inputs are
the budgeted cost per yard of fabric and the budgeted labor wage rate.
Standard quantities of inputs can be established based on ideal performance, or on
expected performance, but are usually based on efficient and attainable performance.
Research in psychology has determined that most people will exert the greatest effort
when goals are somewhat difficult to attain, but not extremely difficult. If goals are easily
attained, managers and employees might not work as hard as they would if goals are
challenging. But also, if goals appear out of reach, managers and employees might resign
themselves to falling short of the goal, and might not work as hard as they otherwise
would. For this reason, standards are often established based on efficient and attainable
performance. 
Hence, a standard is a type of budgeted number; one characterized by a certain amount of
rigor in its determination, and by its ability to motivate managers and employees to work
towards the company’s objectives for production efficiency and cost control.
 
There is an important distinction between standard costs and a standard costing system.
Standard costs are a component in a standard costing system. However, even companies

70
that do not use standard costing systems can utilize standards for budgeting, planning, and
variance analysis.
 
 
Example of a Standard Cost Sheet:
The following example shows a standard cost sheet for a deluxe widget. It is a fictional
example, yet provides a realistic picture of the level of detail involved in setting standard
costs. Many manufacturing companies would have a standard cost sheet for each product,
and would revise these cost sheets periodically, perhaps annually or once every three to
five years, to incorporate changes in prices of inputs and manufacturing processes.
 
Inter-Office Memorandum
WIDGETS UNLIMITED, LTD.
 
 
To:                  Max David                                                                 
From:             Iris Brenner
Date:               July 8
Project:           Deluxe Widget
 
Attached is a sample of a cost model I did for the Deluxe Widget. As discussed at the last
meeting, we probably want to use a model such as this to keep track of our standard costs
as they change over time. We may want to have separate models for the motor and the
housing. Please review the model and let me know of any changes that you feel would be
helpful.
 
 
Distribution:
Hayden Dubinski
Louis DuPuis
Claire Brown
Thea Kimber
Allison Kirstukas

71
 Zoe Pritchard

Deluxe Widget Standard Cost Sheet

Segments: As Cast          
    100 pieces 5.00 ea      
    500 pieces 4.00 ea.   4.00  
    1000 pieces 3.00 ea      
    material overhead @ 22%   0.88  
             
  Machining   0.1    hrs @ 92.40 9.24  
             
  Coating material overhead @ 10%   1.00  
          0.10  
             
  Total for 6 segments         91.32
  (based on qty of 500)          
             
Lining: Materials:     25.00    
    Resin   1.00    
    Adhesive   0.75    
    Prepreg   2.00    
    material overhead @ 22% 6.33    
        35.08    
  Molding:          
    Winding 0.20 hrs @ 85.00 17.00  
    Tool Assembly 0.15 hrs @ 85.00 12.75  
    Injection 0.10 hrs @ 85.00 8.50  
    Decouple 0.01 hrs @ 85.00 0.85  
    Demold 0.25 hrs @ 85.00 21.25  
      0.71 hrs   60.35  
  Total for 6 Linings         572.55
             
             
Sleeve: Material (tubing)       5.00  
    material overhead @ 22%   1.10  
             
  Machining   0.25 hrs @ 92.40 23.10  
             
  Coating       2.00  
    material overhead @ 10%   0.20  
             
  Total for 6 Sleeves         188.40
  For 6 Linings & Sleeves         760.95
             
Closure: Material       9.00  
    material overhead @ 22%   1.98  
             
  Machining   0.16 hrs @ 92.40 14.48  
             
  Total: 6 Closures         152.76
             
             
             

72
             
             
             
             
             
Ring: Material: Carbon     100.00  
    Resin     4.00  
    Prepreg     9.00  
    material overhead @ 22%   24.86  
          137.86  
             
  Molding: Winding 0.30 hrs @ 85.00 25.50  
    Tool Assembly 0.20 hrs @ 85.00 17.00  
    Resin Transfer 0.10 hrs @ 85.00 8.50  
    Demolding 0.10 hrs @ 85.00 8.50  
      0.70 hrs @   59.50  
             
  Total for Ring         197.36
             
Core: Material       0.00  
    material overhead @ 22%   0.00  
             
  Machining   0.0    hrs @ 92.40 0.00  
             
  Total for Core         200.00
  (Engineering Estimate)          
             
Top: Top from Vendor       15.00  
    material overhead @ 22%   3.30  
  Anodize       5.00  
    material overhead @ 10%   0.50  
             
  Total for Top         23.80
             
Window: Window from Vendor       80.00  
    material overhead @ 22%   17.60  
  Anodize       8.00  
    material overhead @ 10%   0.80  
  Total for Window       106.40
           
Misc. labor: Assembly and Balancing 0.75 hrs @ 92.40 69.30  
         
Spin 0.50 hrs @ 92.40 46.20  
     
Total for Misc. Labor 115.50
 
Total Deluxe Widget Standard Cost (based on quantity of 500) $1,648.08
   
Total Deluxe Widget Standard Cost w/o Sleeves and Closures $1,306.93

Standard Costing Systems:

A standard costing system initially records the cost of production at standard. Units of
inventory flow through the inventory accounts (from work-in-process to finished goods to
cost of goods sold) at their per-unit standard cost. When actual costs become known,
adjusting entries are made that restate each account balance from standard to actual (or to

73
approximate such a restatement). The components of this adjusting entry provide
information about the company’s performance for the period, particularly with regard to
production efficiency and cost control.
 
 
Standard Costing Systems and Flexible Budgeting:
There is an important connection between flexible budgeting, which was discussed in
Chapter 6, and standard costing. In fact, a standard costing system tracks inventory during
the period at the flexible budget amount. Recall that the flexible budget is the budgeted per-
unit cost multiplied by the actual number of units. Hence, a standard costing system answers
the question: what would the income statement and balance sheet look like, if costs and per-
unit input requirements were exactly as planned, given the actual output achieved (units
made and units sold). 
 
Given the point made in the previous paragraph, it follows that the adjustment made at
period-end to restate the inventory accounts for the difference between the standard cost
account balance and the actual cost account balance constitutes the difference between the
flexible budget amount and actual costs. For direct costs, such as materials and labor, this
adjusting entry represents the sum of the price (or labor wage rate) variance and the
efficiency (or quantity) variance. For overhead costs, this adjusting entry represents
misapplied overhead. For variable overhead, misapplied overhead consists of the sum of the
spending variance and the efficiency variance. For fixed overhead, misapplied overhead
consists of the sum of the spending variance and the volume variance. These overhead
variances are discussed in Chapter 17.
 
Hence, standard costing systems track inventory at flexible budget amounts during the
period, and post adjusting entries at the end of the period that provide variance information
that managers use for performance evaluation and control.
 
 
ZFN Apparel Company, Standard Costing Example:
We continue with the ZFN example from the previous two chapters. The ZFN apparel
company in Albuquerque, New Mexico makes jeans and premium chinos. Each product line

74
 has its own assembly line on the factory floor. The following table shows actual and
budgeted information for the year. There was no beginning or ending work-in-process.
  Budgeted Actual
Information Results
Units produced    
  Jeans 500,000 500,000
  Chinos 500,000 400,000
    Total 1,000,000 900,000
     
Direct Costs:    
Jeans:    
  Materials (denim)    
  Price per yard $  4.80 $  5.00
   Yards per jean x    1.10  x     1.00
      Material cost per jean $  5.28 $  5.00
     
  Direct labor    
    Wage rate $15.00 $14.00
    Hours per jean     x     0.50 x     0.40
      Labor cost per jean $  7.50 $  5.60
     
Chinos:    
  Materials (cotton twill)    
    Price per yard $  4.40 $  4.50
    Yards per chino x    1.10 x    1.20
      Material cost per $  4.84 $  5.40
chino    
     
  Direct labor $15.00 $14.00
    Wage rate x     0.70 x    0.75
    Hours per chino $10.50 $10.50
      Labor cost per chino    
  $3,600,000 $3,300,000
Factory Overhead

Most of this information is available from the previous chapter. Also, the ZFN example in the
previous chapter derived the budgeted overhead rate of $6.00 per direct labor hour, and that
same overhead rate is used by the standard costing system. Based on this information, the
standard costing system would debit the finished goods inventory account as follows:

75
 
  Jeans Chinos
Standard cost per unit:    
  Materials $5.28 $4.84
  Labor $7.50 $10.50
  Overhead $6.00 x 0.50 = $3.00 $6.00 x 0.70 = $4.20
Total standard cost per unit $15.78 $19.54
Actual units produced x    500,000 x     400,000
  Total $7,890,000  $7,816,000
 
Recall from the previous chapter that 400,000 jeans and 350,000 chinos were sold. The entries
to record the movement of inventory from the finished goods inventory account into the cost-
of-goods-sold account would multiply these sales volumes by $15.78 per jean and $19.54 per
chino.
Reasons for using a Standard Costing System:
There are several reasons for using a standard costing system:
 
Cost Control: The most frequent reason cited by companies for using standard costing
systems is cost control. One might initially think that standard costing provides less
information than actual costing, because a standard costing system tracks inventory using
budgeted amounts that were known before the first day of the period, and fails to incorporate
valuable information about how actual costs have differed from budget during the period.
However, this reasoning is not correct, because actual costs are tracked by the accounting
system in journal entries to accrue liabilities for the purchase of materials and the payment of
labor, entries to record accumulated depreciation, and entries to record other costs related to
production. Hence, a standard costing system records both budgeted amounts (via debits to
work-in-process, finished goods, and cost-of-goods-sold) and actual costs incurred. The
difference between these budgeted amounts and actual amounts provides important
information about cost control. This information could be available to a company that uses an
actual costing system or a normal costing system, but the analysis would not be an integral
part of the general ledger system. Rather, it might be done, for example, on a spreadsheet
program on a personal computer. The advantage of a standard costing system is that the
general ledger system itself tracks the information necessary to provide detailed performance
reports showing cost variances.

76
 
Smooth out short-term fluctuations in direct costs: Similar to the reasons given in the
previous chapter for using normal costing to average the overhead rate over time, there are
reasons to average direct costs. For example, if an apparel manufacturer purchases denim
fabric from different textile mills at slightly different prices, should these differences be
tracked through finished goods inventory and into cost-of-goods-sold? In other words, should
the accounting system track the fact that jeans production on Tuesday cost a few cents more
per unit than production on Wednesday, because the fabric used on Tuesday came from a
different mill, and the negotiated fabric price with that mill was slightly higher? Many
companies prefer to average out these small differences in direct costs.  
 
When actual overhead rates are used, production volume of each product affects the
reported costs of all other products: This reason, which was discussed in the previous
chapter on normal costing, represents an advantage of standard costing over actual costing,
but does not represent an advantage of standard costing over normal costing.
 
Costing systems that use budgeted data are economical: Accounting systems should satisfy
a cost-benefit test: more sophisticated accounting systems are more costly to design,
implement and operate. If the alternative to a standard costing system is an actual costing
system that tracks actual costs in a more timely (and more expensive) manner, then
management should assess whether the improvement in the quality of the decisions that will
be made using that information is worth the additional cost. In many cases, standard costing
systems provide highly reliable information, and the additional cost of operating an actual
costing system is not warrante
Summary of Actual Costing, Normal Costing and Standard Costing:
The following table summarizes and compares three commonly-used costing systems.
 
       
  Actual Costing System Normal Costing System Standard Costing System
       
   Direct (Actual prices or rates x (Actual prices or rates x (Budgeted prices or rates x
Costs: actual quantity of inputs actual quantity of inputs standard inputs allowed

77
 per output) x actual per output) x actual for each output) x actual
outputs outputs outputs

       
 Overhead Actual overhead rates x Budgeted overhead rates Budgeted overhead rates x
Costs: actual quantity of the x actual quantity of the (standard inputs allowed
allocation base incurred. allocation base incurred. for actual outputs achieved)
 
The following points are worth noting:
1. All three costing systems record the cost of inventory based on actual output units
produced. The static budget level of production does not appear anywhere in this table.
2. Actual costing and normal costing are identical with respect to how direct costs are
treated.
3. With respect to overhead costs, actual costing and normal costing use different overhead
rates, but both costing systems multiply the overhead rate by the same amount: the actual
quantity of the allocation base incurred.
4. Normal costing and standard costing use the same overhead rate.
5. Standard costing records the cost of inventory using a flexible budget concept: the inputs
“that should have been used” for the output achieved.
There are costing systems other than these three. For example, some service sector companies
apply direct costs using budgeted prices multiplied by actual quantities of inputs. For
example, many accounting firms track professional labor costs using budgeted professional
staff hourly rates multiplied by actual staff time incurred on each job

Exercise:

The Resistol Company manufactures hats. The company uses a Standard Costing System.
Production of one hat is budgeted at $10 of direct materials, and 2 hours of direct labor at $20
per hour. Overhead is budgeted at $500,000, and is allocated based on direct labor hours. The
static budget calls for production of 10,000 hats in 2005. Actual costs per hat in 2005 were $12
of direct materials, and 2.2 hours of direct labor at $19 per hour. Actual overhead was
$400,000. Actual production was 10,500 hats. Calculate the cost of goods manufactured at
standard.

CHAPTER 10: Cost-Volume-Profit

78
 
Chapter Contents:
- The Basic Profit Equation
- Assumptions in CVP analysis
- Target costing
- Leverage
- Constrained resources
- Examples
- Exercises and problems
 
The Basic Profit Equation:
Cost-Volume-Profit analysis (CVP) relates the firm’s cost structure to sales volume and
profitability. A formula that facilitates CVP analysis can be easily derived as follows:
 
            Profit =          Sales – Expenses
 
            Profit =          Sales – (Variable Costs + Fixed Costs)
 
            Profit + Fixed Costs =          Sales – Variable Costs
 
            Profit + Fixed Costs   =          Units Sold x (Unit Sales Price – Unit Variable Cost)
 
This formula is henceforth called the Basic Profit Equation and is abbreviated:
 
            P + FC = Q x (SP – VC)
 
Contribution margin is defined as  
 
Sales – Variable Costs
 
The unit contribution margin is defined as
 
            Unit Sales Price – Unit Variable Cost
 
Typically, the Basic Profit Equation is used to solve one equation in one unknown, where the
unknown can be any of the elements of the equation. For example, given an understanding of
the firm’s cost structure and an estimate of sales volume for the coming period, the equation
predicts profits for the period. As another example, given the firm’s cost structure, the

79
equation indicates the required sales volume Q to achieve a targeted level of profits P. If
targeted profits are zero, the equation simplifies to
 
            Q = FC ÷ Unit Contribution Margin 
 
In this case, Q indicates the required sales volume to break even, and the exercise is called
breakeven analysis. 
 
CPV analysis can be depicted graphically. The graph below shows total revenue (SP x Q) as a
function of sales volume (Q), when the unit sales price (SP) is $12. 
 

 
The following graph shows the total cost function when fixed costs (FC) are $4,000 and the
variable cost per unit (VC) is $5.
 

80
The following graph combines the revenue and cost functions depicted in the previous two
graphs into a single graph.

 
The intersection of the revenue line and the total cost line indicates the breakeven volume,
which in this example, occurs between 571 and 572 units. To the left of this point, the
company incurs a loss. To the right of this point, the company generates profits. The amount

81
of profit or loss can be measured as the vertical distance between the revenue line and the
total cost line.
 
Assumptions in CVP Analysis:
The Basic Profit Equation relies on a number of simplifying assumptions.
 
1. Only one product is sold. However, multiple products can be accommodated by using
an average sales mix and restating Q, SP and VC in terms of a representative bundle
of products. For example, a hot dog vendor might calculate that the “average”
customer buys two hot dogs, one bag of chips, and two-thirds of a beverage. Q is the
number of customers, and SP and VC refer to the sales price and variable cost for this
“average” customer order.
2. If the equation is applied to a manufacturer, beginning inventory is assumed equal to
zero, and production is assumed equal to sales. Relaxing these assumptions requires
additional structure on the equation, including specifying an inventory flow
assumption (e.g., FIFO or LIFO) and the extent to which the matching principle is
honored for manufacturing costs.
3. The analysis is confined to the relevant range. In other words, fixed costs remain
unchanged in total, and variable costs remain unchanged per unit, over the range of Q
under consideration.
 
Target Costing:
A relatively recent innovation in product planning and design is called target costing. In the
context of the Basic Profit Equation, target costing sets a goal for profits, and solves for the
unit variable cost required to achieve those profits. The design and manufacturing engineers
are then assigned the task of building the product for a unit cost not to exceed the target. This
approach differs from a more traditional product design approach, in which design engineers
(possibly with input from merchandisers) design innovative products, manufacturing
engineers then determine how to make the products, cost accountants then determine the
manufacturing costs, and finally, merchandisers and sales personnel set sales prices. Hence,
setting the sales price comes last in the traditional approach, but it comes first in target
costing.
 

82
Target costing is appropriate when SP and Q are predictable, but are not choice variables,
such as might occur in well-established competitive markets. In such a setting, merchandisers
might know the price that they want to charge for the product, and can probably estimate the
sales volume that will be achieved at that price. Target costing has been used successfully by
a number of companies including Toyota, which redesigned the Camry around the turn of the
century as part of a target costing strategy.  
 
Constrained Resources:
Contribution margin analysis plays an important role when a multi-product organization has a
binding resource constraint. The resource constraint can take many forms, such as production
throughput on a critical machine, freezer space, or skilled labor hours in a particular function.
In the presence of a resource constraint, the optimal production decision is to maximize the
contribution margin per unit of the constraint.
 
For example, assume that a company makes small widgets and large widgets. Small widgets
incur $5 in variable manufacturing and non-manufacturing costs, and sell for $10. Large
widgets incur $11 in variable manufacturing and non-manufacturing costs, and sell for $15. If
production throughput is constrained by the capacity of a particular machine, and both small
and large widgets require one hour of processing time on that machine, then the company
should make only small widgets, because small widgets provide a contribution margin of $5
per unit, whereas large widgets provide a contribution margin of $4 per unit. On the other
hand, if each small widget requires two hours of processing time on the machine, and large
widgets require only one hour, then the company should make only large widgets, calculated
as follows:
 
Small widgets: contribution margin per machine hour = ($10  $5) ÷ 2 = $2.50 per hour
 
Large widgets: contribution margin per machine hour = ($15  $11) ÷ 1 = $4.00 per hour
 
The company maximizes profits by making large widgets, even though large widgets have a
lower contribution margin per unit than small widgets, because large widgets require less
machine time and hence, are more efficient with respect to the limited resource. In other
words, the large widgets generate a higher contribution margin per hour on the machine that
constitutes the capacity constraint of the factory.

83
 
Leverage:
There is often a trade-off between fixed cost inputs and variable cost inputs. For example, in
the manufacturing sector, a company can build its own factory (thereby operating with
relatively high fixed costs but relatively low variable costs) or outsource production
(operating with relatively low fixed costs but relatively high variable costs). A merchandising
company can pay its sales force a flat salary (relatively higher fixed costs) or rely to some
extent on sales commissions (relatively higher variable costs). A restaurant can purchase the
equipment to launder table cloths and towels, or it can hire a laundry service.
 
A company that has relatively high fixed costs is more highly leveraged than a company with
relatively high variable costs. Higher fixed costs result in greater downside risk: as Q falls
below the breakeven point, the company loses money more quickly than a company with less
leverage. On the other hand, the company’s lower variable costs result in a higher unit
contribution margin, which means that as Q rises above the breakeven point, the more highly-
leveraged company is more profitable.  
 
There is an ongoing trend for companies to outsource support functions and other “non-core”
activities to third party suppliers and providers. Usually, outsourcing reduces the leverage of
the company by eliminating the fixed costs associated with conducting those activities inside
the firm. When the activities are outsourced, the contractual payments to the outsource
providers usually contain a large variable cost component and a relatively small or no fixed
cost component.   
 
Examples:
Breakeven: Steve Poplack owns a service station in Walnut Creek. Steve is considering
leasing a machine that will allow him to offer customers the mandatory California emissions
test. Every car in the state must be tested every two years. The machine costs $6,000 per
month to lease. The variable cost per test (i.e., per car inspected) is $10. The amount that
Steve can charge each customer is set by state law, and is currently $40.
 
How many inspections would Steve have to perform monthly to break even from this part of
his business?
 

84
Q = FC ÷ Unit Contribution Margin 
Q = $6,000 ÷ ($40  $10) = 200 inspections
 
Targeted profits, solving for volume: Refer to the information in the previous question.
How many inspections would Steve have to perform monthly to generate a profit of $3,000
from this part of his business? 
 
P + FC = Q x (SP – VC)
$3,000 + $6,000 = Q x ($40  $10)
Q = 300 inspections
 
Targeted profits, solving for sales price: Alice Waters (age 9) runs a lemonade stand in the
summer in Palo Alto, California. Her daily fixed costs are $20. Her variable costs are $2 per
glass of ice-cold, refreshing, lemonade. Alice sells an average of 100 glasses per day. What
price would Alice have to charge per glass, in order to generate profits of $200 per day?
 
P + FC = Q x (SP – VC)
$200 + $20 = 100 x (SP  $2)
SP = $4.20 per glass
 
Contribution margin: Refer to the previous question. What price would Alice have to
charge per glass, in order to generate a total contribution margin of $200 per day?
 
Total CM = Q x (SP – VC)
$200 = 100 x (SP  $2.00)
SP = $4.00 per glass
 
Target costing: Refer to the information about Alice, but now assume that Alice wants to
charge $3 per glass of lemonade, and at this price, Alice can sell 110 glasses of lemonade
daily. Applying target costing, what would the variable cost per glass have to be, in order to
generate profits of $200 per day?
P + FC = Q x (SP – VC)
$200 + $20 = 110 x ($3 – VC)
VC = $1

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 Go to the End-of-Chapter Exercises and Problems
 
Go to the Next Chapter

CHAPTER 5:  Exercises and Problems:

 
5-1: Sara, Sarah, Shara and Associates want to earn a total contribution margin of $10,000 on
sales of 1,000 units. Their sales price is $15 per unit, and their fixed costs are $5,000. What
variable cost per unit is necessary to achieve their goal?
 
5-3: The Virginia Company has fixed costs of $100,000 per month, and variable costs of $30
per unit of output. The sales price is $50 per unit of output. How many units would the
company have to sell per month, to generate profits of $30,000 per month?
 
5-4: The Charleston Company has fixed costs of $20,000 per month, and variable costs of
$15 per unit of output. The company would like to earn profits of $4,000 per month. At a
sales volume of 12,000 units per month, what sales price per unit would the company have to
charge in order to achieve its targeted monthly profit?
 

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 CHAPTER 11

TACTICAL DECISION

- Divisional income
- Return on investment
- Residual income
- Exercises and problems
 
This chapter discusses three performance measures used to valuate divisions and divisional
managers. The term “division” in this chapter is shorthand for any responsibility center that is
treated as a profit center or as an investment center. Investors and stock analysts use
analogous measures to evaluate company-wide performance.
 
 
Divisional Income:
Divisional income is a measure of divisional performance that is analogous to corporate net
income for evaluating overall company performance. Similar to related-party transactions in
the context of financial accounting, the calculation of divisional income must consider
transactions that occur between divisions, and between the division and corporate
headquarters. One type of intra-company transaction is the transfer of goods between
divisions. These transfers, which represent revenue to the selling division and a cost of
inventory to the buying division, are discussed in Chapter 23. Another type of transaction is
the receipt of services from corporate headquarters or from other responsibility centers within
the company. Examples of such services are human resources, legal, risk management, and
computer support. In many companies, these services are “charged out” to the divisions that
utilize them. These service department cost allocations were discussed in Chapter 12.  
 
Because divisional income fails to account for the size of the division, it is ill-suited for
comparing performance across divisions of different sizes. Divisional income is most
meaningful as a performance measure when compared to the same division in prior periods,
or to budgeted income for the division.

Return on Investment:
Return on investment (ROI) is calculated as:

87
 

Return on Investment = Divisional Income

Divisional Investment

The same issues arise in determining the numerator in ROI as arise in the previous subsection
with respect to deriving divisional income. As regards the denominator, senior management
must decide whether and how to allocate shared assets among divisions, such as service
departments at the corporate level, or shared manufacturing facilities. Also, management must
decide how to value the capital assets that comprise the division’s investment. These assets
can be valued at their gross book value (the acquisition cost), their net book value (usually the
acquisition cost minus depreciation expense), or less often, some other valuation technique
such as replacement cost, net realizable value or fair market value. The calculation of the
numerator should be consistent with the choice of valuation technique in the denominator. For
example, if divisional investment is calculated using gross book value, then divisional income
in the numerator should not be reduced by depreciation expense.
 
One advantage of using gross book value instead of net book value in the ROI calculation is
that net book value can discourage divisional managers from replacing old equipment, even if
new equipment would be more efficient and would increase the economic profits of the
division. This dysfunctional managerial incentive occurs because if the existing equipment is
fully depreciated, but is still functional, its replacement can reduce the division’s ROI by
lowering the numerator (due to increased depreciation expense) and increasing the
denominator (because fully depreciated assets have a net book value of zero).
 
ROI can be broken down into the following two components:
 
             

ROI = Divisional Income = Divisional Income X Divisional Revenues

Divisional Investment Divisional Revenue Divisional Investment

The first term on the right-hand side is called the return on sales (ROS). It is also called the
operating profit percentage. This ratio measures the amount of each dollar of revenue that

88
“makes its way” to the bottom line. ROS is often an important measure of the efficiency of
the division, and the divisional manager’s ability to contain operating expenses.
 
The second term on the right-hand side is called the asset turnover ratio or the investment
turnover ratio. This ratio measures how effectively management uses the division’s assets to
generate revenues. Interestingly, this ratio seems to hover around one for many companies in
a wide range of industries, particularly in the manufacturing sector of the economy.
 
Breaking ROI into these two components often provides more useful information than
looking at ROI alone, and it is an example of the type of financial ratio analysis that stock
analysts conduct in evaluating company-wide performance. In this context, two common
specifications for the denominator in the ROI calculation are assets and equity. The resulting
ratios are called return on assets (ROA) and return on equity (ROE).
 
At the divisional level, ROI controls for the size of the division, and hence, it is well-suited
for comparing divisions of different sizes. On the other hand, similar to the Internal Rate of
Return for evaluating capital projects, ROI can discourage managers from making some
investments that shareholders would favor. For example, if a divisional manager is evaluated
on ROI, and if the division is currently earning an ROI in excess of the company’s cost of
capital, then the manager would prefer to reject an additional investment opportunity that
would earn a return above the cost of capital but below the division’s current ROI. The new
investment opportunity would lower the division’s ROI, which is not in the manager’s best
interests. However, because the investment opportunity provides a return above the cost of
capital, shareholders would favor it.
  Residual Income:
One way in which financial accounting practice fails to follow corporate finance theory is that
the cost of debt is treated as an expense in arriving at net income, but the cost of equity is not.
Specifically, interest expense appears as a deduction to income on the income statement, but
dividends are shown on the statement of changes in shareholders’ equity. Hence, net income
is affected by the company’s financing strategy as well as by its operating profitability, which
can obscure the economic performance of the firm.
 

89
A simple solution to this problem is to add back interest expense (net of the tax effect) to net
income, to arrive at operating income after taxes. The performance measure called residual
income makes this adjustment, and then goes one step further, by deducting a charge for
capital based on the organization’s total asset base:
 
Residual Income = Operating Income
 (Investment Base x Required Rate of Return)
 
The company’s cost of capital is often appropriate for the required rate of return.
 
Residual income is probably the closest proxy that accounting provides for the concept of
economic profits; hence, residual income probably comes close to measuring what
shareholders really care about (to the extent that shareholders only care about maximizing
wealth). Residual income can be calculated both at the corporate level and at the divisional
level. Many companies that use residual income at the divisional level do so because
management believes that residual income aligns incentives of divisional managers with
incentives of senior management and shareholders.
 
One type of residual income calculation is called Economic Value Added. EVA was
developed by the consulting firm of Stern Stewart & Co., and is a registered trademark of that
firm. The calculation of EVA includes a deduction for the cost of capital, and also adjusts
accounting income to more accurately reflect the economic effect of transactions and the
economic value of assets and liabilities. In general, these adjustments move the income
calculation further from the reliability-end of the relevance-versus-reliability continuum, and
closer to the relevance-end of that continuum.
 
Since the 1990s, EVA has helped revive the popularity of residual income. However, it should
be emphasized that although Stern Stewart has obtained trademark protection on the term
“EVA,” the concept of residual income precedes EVA by almost half a century, and it is in
the public domain. Anyone can use residual income for any purpose whatsoever without
violating trademark, copyright or patent law, and this includes making obvious adjustments to
net income to more accurately reflect the underlying economic reality of the firm.

90
22-8: Following is selected financial information for four companies for 2005 (all amounts
are in millions):
 
Apple
Computer Pepsi Chevron The GAP
Revenue $13,931 $32,562 $198,200 $16,023
Total assets 11,551 31,727 125,833 8,821
Shareholder equity 7,466 14,320 62,676 5,425
Operating income 1,650 6,382 25,197 1,745
Net income 1,335 4,078 14,099 1,113
 
Required: Calculate each firm’s return on investment (net income on total assets), return on
sales, asset turnover ratio, and residual income using an 8% cost of capital. None of these
firms incurred significant interest expense during the year.

91
 Chapter 10

Inventory Management

Introduction:
This chapter addresses the question: What costs are capitalized as the cost of inventory? In
other words, what costs constitute the debit balance on the balance sheet for inventory, and the
debit balance on the income statement for cost of goods sold? The answer to this question
determines the extent to which the matching principle is honored for production costs.
 
The following table illustrates three alternative rules for determining which costs are
capitalized. All three are used in managerial accounting practice. The three methods are
absorption costing, variable costing, and throughput costing. The colored bars identify the
costs that each method capitalizes as inventory.

  Cost Absorption Variable Throughput

Classification Costing Costing Costing
Cost Category
Direct materials Direct, variable      
costs
Direct labor Direct, variable  
costs
Variable manufacturing Indirect,  
overhead variable costs
Fixed manufacturing Indirect, fixed    
overhead costs
All non-manufacturing Direct and      
costs indirect, variable
and fixed.

As the table indicates, non-manufacturing costs are never capitalized as part of the cost of
inventory. The three methods differ with respect to their treatment of one or more categories

92
of manufacturing costs, but they all agree that non-manufacturing costs should not be debited
as part of the cost of inventory.
 
For external financial reporting under Generally Accepted Accounting Principles, as well as
for tax reporting, companies are required to use absorption costing (also called full costing).
Hence, there is no choice from the above table for external financial reporting.
 
For internal reporting purposes, survey data suggests that approximately half of manufacturing
companies use absorption costing and approximately half use variable costing. Throughput
costing is a relatively recent phenomenon, and does not seem to be used extensively yet.
 
 
Absorption Costing:
The theoretical justification for absorption costing is to honor the matching principle for all
manufacturing costs. Fixed manufacturing overhead costs are only incurred with the
expectation that the resources represented by these costs will be used in the production of
inventory. Hence, these costs should be matched against the revenue generated from the sale
of that inventory.
 
Absorption costing requires computing an overhead rate for applying all manufacturing
overhead to units produced during the period (or else two overhead rates, one for variable
manufacturing overhead and one for fixed manufacturing overhead; or else multiple overhead
rates if the company uses activity-based costing). There are important issues related to
choosing the denominator in the overhead rate for fixed manufacturing overhead, which are
discussed in the next chapter of this book.
 
 
Variable Costing:
The theoretical justification for variable costing is that fixed manufacturing overhead (FMOH)
will be incurred in the short-run regardless of how much inventory is produced. In many
companies, even if a factory is idle, a significant portion of the FMOH is unavoidable in the
short run. For this reason, FMOH is treated as a period expense.
 

93
Variable costing used to be called direct costing with some frequency, but less so today.
Direct costing is a particularly confusing name, because the implication is that only direct
manufacturing costs are capitalized, whereas in fact, variable manufacturing overhead is also
capitalized. Even the name “variable costing” is perhaps less than ideal, because not all
variable costs are capitalized: non-manufacturing costs are not capitalized as part of the cost
of inventory under any circumstances.  
 
Under variable costing, the cost of ending inventory consists of direct manufacturing costs
(usually materials and labor) and variable manufacturing overhead. Hence, these are the costs
for which variable costing honors the matching principle, and nothing else is capitalized as
part of the cost of inventory.
 
Absorption Costing and Variable Costing Compared:
The only difference between absorption costing and variable costing is the treatment of fixed
manufacturing overhead (FMOH). Under absorption costing, FMOH is allocated to units
produced, so that there is a little bit of FMOH included in the cost of every unit of inventory.
Under variable costing, FMOH is treated as a period expense, appearing on the income
statement as a lump-sum in the period incurred.
 
Comparing income under absorption costing to income under variable costing, the following
observations can be made:
- When there are beginning and ending inventories, absorption costing and variable
costing will generally result in different inventory valuations for beginning inventory,
different inventory valuations for ending inventory, and different incomes, but it is
possible for the inventory balances and income to be the same under the two methods.
- If beginning and ending inventory levels are zero, absorption costing and variable
costing will always result in the same income.
- If beginning inventory is zero and ending inventory is positive, absorption costing will
always result in higher income than variable costing, and a higher valuation for ending
inventory.
- If beginning inventory is positive and ending inventory is zero, absorption costing will
always result in lower income than variable costing, and a higher valuation for
beginning inventory.

94
 - When inventory levels are increasing from period-end to period-end, as would be
expected when the company is growing, absorption costing will generally result in
higher ending inventory valuations than variable costing, and also higher income in
each period. The reason is that absorption costing postpones recognizing ever-
increasing amounts of fixed manufacturing overhead on the income statement, because
increasing amounts of fixed manufacturing overhead are capitalized as ending
inventory.
 
Over the life of the company (or from any point in time at which there is zero inventory to any
other point in time at which there is zero inventory), the sum of income over all periods must
be equal under the two methods. The difference between absorption costing and variable
costing is only a timing difference: the question of when fixed manufacturing overhead is
taken to the income statement.
 Income Statement Presentation:
Absorption costing, variable costing and throughput costing are each associated with an
income statement format:
 
Absorption costing uses a gross margin income statement, which starts with revenues and
subtracts cost of goods sold to derive gross margin, then subtracts non-manufacturing costs to
derive operating income. Virtually every income statement presented in connection with
external financial reporting uses a gross margin format. Gross margin income statements
separate manufacturing costs from non-manufacturing costs, which is helpful for certain types
of analyses.
 
Variable costing uses a contribution margin income statement, which starts with revenues
and subtracts variable costs (variable manufacturing costs related to units sold, plus all
variable non-manufacturing costs) to derive contribution margin, then subtracts all fixed costs
(manufacturing and non-manufacturing) to derive operating income. Contribution margin
income statements facilitate cost-volume-profit analysis. It should be emphasized that under
variable costing, not all variable costs appear on the income statement in the period incurred.
Variable manufacturing costs that have been incurred to make inventory that hasn’t been sold
yet appear on the balance sheet as part of the cost of finished goods inventory.
 

95
Throughput costing starts with revenues and subtracts direct material costs associated with
units sold to derive throughput margin, then subtracts all other costs.
 
These income statement formats do not define the costing methods. The costing methods are
defined by which manufacturing costs are capitalized, as indicated in the table at the
beginning of this chapter. It is possible, for example, to cost inventory and determine income
using the rules of absorption costing, but to then present the data in a contribution margin
format by making certain reclassifications.
 
 Numerical Example of Absorption Costing and Variable Costing:
Following is information about the operations of Ultimate DNA, Inc., for the year ended
December 31, 2006.

Direct materials used in production $300,000

Direct labor costs incurred $100,000
Variable manufacturing overhead costs incurred $  50,000
Variable non-manufacturing costs incurred $  40,000
Fixed manufacturing overhead costs incurred $  80,000
Fixed non-manufacturing costs incurred $  20,000

There was no beginning inventory. 100 units were produced, and 50 units were sold at a price
of $20,000 per unit. The variable non-manufacturing costs consist of two items: a sales
commission paid for units sold, and a transportation cost to ship finished product from the
factory to various warehouses where product is stored until it is sold.
 

Required: Prepare a Contribution Margin income statement, using Variable Costing.

 
Variable manufacturing costs:
  In total:         $300,000 materials + $100,000 labor + $50,000 variable O/H = $450,000     
  Per unit:         $450,000 ÷ 100 units = $4,500 per unit
 
Ultimate DNA, Inc.

96
 Income Statement

For the Year Ended December 31, 2006

Sales $1,000,000
Variable Costs  
  Manufacturing ($4,500 per unit x 50 units) 225,000
  Non-manufacturing 40,000
Contribution Margin 735,000
Fixed Costs  
  Manufacturing 80,000
  Non-manufacturing 20,000
Operating Income $635,000
The only costs matched to revenues are the variable manufacturing costs. All other costs are
expensed as incurred.
Required: Prepare a Gross Margin income statement, using Absorption Costing.
Fixed and variable manufacturing costs:
  In total:         $450,000 variable (from above) + $80,000 fixed = $530,000
  Per unit:         $530,000 ÷ 100 units = $5,300 per unit
Ultimate DNA, Inc.

Income Statement

For the Year Ended December 31, 2006

Sales $1,000,000
Manufacturing COGS ($5,300 per unit x 50 units) 265,000
  Gross Margin 735,000
Non-manufacturing Costs  
  Variable 40,000
  Fixed 20,000
Operating Income $675,000

The matching principle is honored for all manufacturing costs (fixed and variable), but not for
any of the non-manufacturing costs.
 
Required: Calculate the cost of ending inventory under Variable Costing.

97
 
            $4,500 per unit x 50 units = $225,000
 
Only variable manufacturing costs are capitalized. All other costs are expensed as incurred.
 
Required: Calculate the cost of ending inventory under Absorption Costing.
 
            $5,300 per unit x 50 units = $265,000
 
Only manufacturing costs (fixed and variable) are capitalized. All non-manufacturing costs
are expensed as incurred.
 
Under both Variable and Absorption Costing, all non-manufacturing costs are expensed as
incurred. For example, the variable non-manufacturing costs include a sales commission for
units sold, and a transportation cost incurred for all units shortly after they are manufactured.
Even though the transportation cost includes shipping costs for units in the warehouse and not
yet sold, this cost cannot be capitalized as part of the cost of inventory, because the
transportation cost is not a manufacturing cost, and inventory is ready for sale at the time it
leaves the factory.

 Absorption Costing and Generally Accepted Accounting Principles:

In 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting
Standards (SFAS) No. 151, to amend and clarify generally accepted accounting principles for
the calculation of inventories under absorption costing. The Board’s stated purpose for issuing
the new standard was to improve the comparability of cross-border financial reporting, by
aligning U.S. GAAP with the International Accounting Standards Board’s Statement No. 2.
 
SFAS No. 151 was the first new pronouncement on absorption costing issued by a U.S.
accounting standard-setting body in fifty years. Until SFAS No. 151, neither the Financial
Accounting Standards Board nor its predecessor, the Accounting Principles Board, had
specifically addressed absorption costing in a broad-based way. Rather, each board had
incorporated GAAP that existed at the time the board was founded. Using this genealogy,
prior to SFAS No. 151, GAAP for absorption costing could be traced to Accounting Research

98
Bulletin (ARB) No. 43, issued in 1953 by the Committee on Accounting Procedure (the
predecessor to the Accounting Principles Board).
 
Key provisions of ARB No. 43, Chapter 4 on inventory pricing, included the following:
 
A major objective of accounting for inventories is the proper determination of income through
the process of matching appropriate costs against revenues.
                                    - ARB No. 43, Chapter 4, Statement No. 2
 
As applied to inventories, cost means in principle the sum of the applicable expenditures and
charges directly or indirectly incurred in bringing an article to its existing condition and
location.
- ARB No. 43, Chapter 4, Statement No. 3
 
The definition of cost as applied to inventories is understood to mean acquisition and
production cost, and its determination involves many problems.  … Under some
circumstances, items such as idle facility expense, excessive spoilage, double freight, and
rehandling costs may be so abnormal as to require treatment as current period charges rather
than as a portion of the inventory cost.
                                    - ARB No. 43, Chapter 4. Discussion of Statement No. 3
 
SFAS No. 151 amends ARB No. 43 by eliminating the “so abnormal” criterion in this last
paragraph. Hence, items such as idle facility expense and excessive spoilage must now be
recognized as current-period charges.
With respect to idle facility expense, SFAS No. 151 requires fixed production overhead to be
allocated to inventory based on the “normal capacity” of the production facility. The
Statement defines normal capacity: “normal capacity refers to a range of production levels,
and is the production level expected to be achieved over a number of periods or seasons under
normal circumstances, taking into account the loss of capacity resulting from planned
maintenance.” The Statement notes that some variation in production levels from period to
period is expected, that normal capacity will vary based on business-specific and industry-
specific factors, and that these variations will establish the range of normal capacity. Fixed
manufacturing overhead can be allocated based on the actual level of production when actual
production approximates normal capacity. The Statement observes that judgment is required

99
to determine when a production level is abnormally low (i.e., outside the range of the expected
variation in production). Examples of factors that might cause an abnormally low production
level include significantly-reduced customer demand, labor and materials shortages, and
unplanned facility or equipment downtime.
 
Although SFAS No. 151 conveys the view of the Financial Accounting Standards Board that
the new pronouncement would not lead to significant changes in inventory accounting
practice, some companies’ financial statements may be affected. There is some evidence that
prior to SFAS No. 151, companies did not apply absorption costing in the same manner. The
vagueness in the wording of ARB No. 43 seemed to permit alternative treatments.
Furthermore, because ARB No. 43 did not require companies to disclose how they applied
absorption costing, information was generally not available about the extent to which these
alternative treatments were employed.
 
Survey data on this issue was provided in two articles that appeared in Management
Accounting by Michael Schiff (February 1987) and Steve Landekich (March 1973). These
surveys identify factory depreciation related to excess manufacturing capacity as an example
of fixed overhead that some but not all companies treated as a period expense. Under SFAS
No. 151, “The amount of fixed overhead allocated to each unit of production is not increased
as a consequence of abnormally low production or idle plant.” Hence, if the survey data in
Schiff and Landekich was still descriptive of practice in 2004, some companies will have had
to change their accounting treatment for idle capacity for inventory costs incurred during
fiscal years beginning after June 15, 2005 (the effective date of SFAS No. 151).
 
Another area that Schiff and Landekich identified where companies differed in their
application of absorption costing is the decision of whether to allocate corporate service
department costs. Under ARB No. 43, the decision not to allocate these costs seemed justified
by materiality and expediency, rather than on theoretical grounds. SFAS No. 151 states that
under most circumstances, general and administrative expenses should be included as period
charges, except for the portion of such expenses that may be clearly related to production.
This wording seems to continue to allow some latitude, and so companies might continue to
differ in their treatment of these costs.
The Value Chain:

100
The value chain is the sequence of activities that add value in a company. The following table
provides a typical list of activities in the value chain of a manufacturing firm, although some
manufacturers might outsource some of these activities.

Value Chain for a Manufacturing Firm

Research and development
Manufacturing
Marketing
Distribution
Sales
Customer service

For many industries, manufacturing costs constitute the majority of costs incurred in the value
chain. For companies in these industries, the decision to capitalize most or all manufacturing
costs as inventory, and to run these costs through the income statement when the related
inventory is sold, provides the benefits of the matching principle that are discussed in
introductory financial accounting courses.
 
However, there are some industries in which manufacturing costs are small relative to one or
more of the other activities in the value chain. For example, pharmaceutical companies incur
large research and development (R&D) costs. Under all three costing methods that are
discussed in this chapter, R&D does not become a part of the cost of inventory. In most
situations, R&D is expensed when incurred for financial reporting purposes, which clearly
fails to honor the matching principle in a significant way. Large expenditures are incurred and
taken to the income statement for many years before any revenue is realized for that drug, and
then after the drug is approved by the Food and Drug Administration, revenue is generated for
many years with no directly-related offsetting R&D expenditures. The actual manufacturing
cost of the drug can be quite small relative to the R&D expenditures that were incurred to
bring the drug to market. Of course, the situation is somewhat more complicated for large
pharmaceutical companies, because there are numerous drugs at various stages in their
lifecycles, so that R&D on some projects offset revenue from drugs for which the R&D is

101
already complete, and also, there are many R&D projects that never result in a saleable
product.
 
Another industry in which manufacturing costs are small relative to some of the other
activities in the value chain is the soft drink industry. The ingredients and processes used in
the manufacture of soft drinks are fairly inexpensive, and there are few barriers to entry.
Consequently, soft drink companies spend large amounts on marketing and advertising. These
marketing efforts are anticipated to provide long-term benefits by turning consumers into life-
long Coca-Cola® or Pepsi® drinkers. However, these costs are not capitalized as part of the
cost of inventory or as any other type of asset; rather, they are expensed when incurred
(subject to the usual accrual accounting practices).   
 
Throughput Costing:
Also called super-variable costing, throughput costing is a relatively new development.
Throughput costing treats all costs as period expenses except for direct materials. In other
words, the matching principle is honored only for direct materials.
 
A company should probably meet two criteria before it chooses throughput costing. The first
criterion relates to the nature of the manufacturing process. Throughput costing only makes
sense for companies engaged in a manufacturing process in which most labor and overhead
are fixed costs. Assembly-line and continuous processes that are highly automated are most
likely to meet this criterion. For example, thirty factory employees might be required to work
a given shift, regardless of whether the machinery is set at full capacity or less. The second
criterion is that management prefers cost accounting information that is helpful for short-term,
incremental analysis, such as whether the company should accept a one-time special sales
order at a reduced sales price. In this respect, a company’s choice of throughput costing is a
logical extension of the company’s choice of variable costing over absorption costing.  
 Eliyahu Goldratt, who developed the theory of constraints, advocates throughput costing in
his popular business novel The Goal. Although throughput costing has not gained wide
acceptance, Goldratt’s support for it has been influential.
Exercise:

15-3: Hank’s Hot Dog Factory manufactures hot dogs. The factory’s cost structure is as
follows: fixed manufacturing costs per month are $8,000. Variable manufacturing costs are

102
$0.40 per hot dog. Fixed non-manufacturing costs are $7,000 per month. Variable non-
manufacturing costs consist of a $0.20 sales commission for every hot dog sold. The sales
price per hot dog is $2.20.   

 
Required: If the company begins the month with zero inventory, makes 10,000 hot dogs, and
sells 7,000 hot dogs, what is the total cost of inventory on the Balance Sheet at the end of the
month under Variable Costing? What is income (loss) for the month under Variable Costing?
 
 
15-4: The Esquimau Pie Company makes and sells the famous Esquimau Pie ice cream bar.
The company’s cost structure is as follows: fixed manufacturing overhead is $5,000 monthly.
Variable manufacturing costs are $1.40 for each Esquimau Pie. Fixed non-manufacturing
costs are $3,000 monthly. There are no variable non-manufacturing costs. The company
begins the month with no inventory, makes 2,000 Esquimau Pies, and sells 1,000 Esquimau
Pies for $10 per pie.
 
Required:
A. What is the cost of ending inventory under Absorption Costing?
B. What is the cost of ending inventory under Variable Costing?
C. What is income under Absorption Costing?
D. What is income under Variable Costing?

Chapter 11

Chapter Contents:

103
 - Overview
- Time value of money
- Payback period
- Net present value
- Internal rate of return
- Net present value and internal rate of return, compared
- The discount rate
- Accounting rate of return
- Depreciation expense, income taxes, and capital budgeting
- Present value tables
- Exercises and problems

Overview:

Capital projects involve the acquisition of assets that generate returns over multiple periods.
Examples are the construction of a factory or the purchase of a new machine. In this context,
a dollar saved is as good as a dollar earned. Hence, capital investments that reduce operating
expenses are equivalent to capital investments that generate additional revenues.

This chapter describes four performance measures for capital projects. These performance
measures can use budgeted data as a planning tool, to decide whether to invest in a proposed
capital project or for choosing among proposed projects. Also, these performance measures
can be used retrospectively, to evaluate a capital project against planned performance or
against other projects.

A characteristic feature of capital projects is that the bulk of the cash outflows precede the
cash inflows. Although a capital project may involve cash outflows that occur over time, and
cash inflows that vary from year to year, our discussion will often assume a typical scenario
in which there is a single cash outflow for the acquisition of the asset that occurs at the
beginning of year one (called “time zero”), followed by a series of equal cash inflows that
occur at the end of each year for the life of the project. This series of cash inflows is called an
annuity.

Time Value of Money:

104
A dollar today is worth more than a dollar one year from now. The reason for this
appreciation is that cash is an asset, and like any asset, it can be invested to earn a return over
time. The discount rate is a measure of the time value of money; it measures how much
more a dollar is worth today than a dollar one year from now. For example, if you are
indifferent between receiving $1.00 today and $1.20 one year from now, your discount rate is
20%. The time value of money has nothing to do with inflation, which works in the opposite
direction. Inflation refers to the declining purchasing power of the dollar that occurs when
prices of goods and services rise over time.

Software spreadsheet applications and financial calculators include present value functions
that calculate the present value of any amount received (or paid) at any time in the future.
These tools also provide the future value, for any point in time in the future, of any amount
received (or paid) today. Before these electronic resources were commonplace, tables were
widely available that allowed one to easily calculate present values and future values for
frequently-used discount rates and time periods. Although such tables are unnecessary in
practice today, we will use them in this chapter, because they visually illustrate the relevant
concepts.

Table 1 at the end of this chapter is a present value table. It provides present value factors for
selected discount rates that range from 6% to 20%, and time periods that range from one
period to twenty periods. If the interest rates are expressed per annum, then the time periods
represent years. For example, to determine the present value of any amount X received five
years from now, at an interest rate of 8% per annum, one would find the factor at the
intersection of Row 5 and the Column for 8% (the factor is 0.6806), and multiply this factor
by the amount X.

Many situations involve a stream of equal payments or receipts over a consecutive number of
periods. For example, financing the purchase of an automobile might require monthly
payments of $1,000 for the next three years, or a proposed capital acquisition might increase
revenues by $10,000 every year for the next seven years. Such streams of cash inflows and
outflows are called annuities.

Software spreadsheet applications and financial calculators include functions that calculate
the present value and future value of annuities. Again, before these electronic resources were
widely available, tables were used to calculate the present value or future value of an annuity

105
by multiplying the annual annuity amount by the factor in the table. Table 2 at the end of this
chapter is a present value table for annuities. In order to use the table for an annuity of
monthly payments or receipts (such as the example of monthly payments for the financing of
an automobile), one can treat the rows as months if the interest rates in the column headings
are treated as monthly percentages. For example, if the annual interest rate on the car loan is
24%, the monthly interest rate is 2%, and one would need to use the column for 2% (which is
not shown in Table 2, but would have been included in tables used by practitioners).

There is an important relationship between Table 1 and Table 2. The present value of any
annuity can be calculated by using Table 1 separately for each period over which the annuity
occurs, and then summing these individual amounts. Table 2 (or the annuity present value
function on a calculator) simplifies the task, by calculating the present value of the entire
stream of payments or receipts at once. This relationship implies that one can always “build”
Table 2, row by row, by summing the entries for the corresponding column in Table 1, down
to that row. For example

Table 1: Present value of $1 received

(or paid) n years from now
N 6% 7% 8% 9%
1 0.9434 0.9346 0.9259 0.9174

2 0.8900 0.8734 0.8573 0.8417

3 0.8396 0.8163 0.7938 0.7722

4 0.7921 0.7629 0.7350 0.7084

    
Table 2: Present value of an annuity
of $1 for the next n years
N 6% 7% 8% 9%
1 0.9434 0.9346 0.9259 0.9174

2 1.8334 1.8080 1.7833 1.7591

3 2.6730 2.6243 2.5771 2.5313

4 3.4651 3.3872 3.3121 3.2397

106
0.9346 + 0.8734 + 0.8163 = 2.6243

Hence, an annuity of $1 for three years at 7% equals $2.6243, which can be derived either by
adding the three annual amounts provided in Table 1, or more simply by using the factor in
row 3 of Table 2.

Next we examine four methods for evaluating capital projects.

Payback Period:

The payback period measures the time required to recoup the initial investment in the capital
asset. Consider the following two examples.

Project Initial Cash Inflows in Year

Cost 1 2 3 4 5 6 7
A $10,000 $2,000 $2,000 $1,000 $3,000 $2,000 $1,500 $0
B $10,000 $2,000 $2,000 $2,000 $3,000 $2,000 $2,000 $2,000

The payback period for Project A is five years, because the sum of cash inflows for years one
through five is $10,000 and $10,000 is also the initial cost of the project. The payback period
for Project B is greater than four years but less than five years, because the sum of cash
inflows through year four is $9,000, and the sum of cash inflows through year five is $11,000,
while the initial cost is $10,000. In this situation, the payback period could be expressed as
4½ years.   

If cash inflows are constant from year to year during the life of the project, the payback
period can be calculated as follows:

   

Payback Period
= Initial Investment
  Annual Cash Inflow

107
The payback period has two drawbacks. First, it ignores the time value of money. However,
this drawback is somewhat mitigated by the fact that, in any case, the payback period tends to
favor projects that recover the initial investment quickly. The second drawback is that the
payback period ignores cash inflows that occur after the end of the payback period. The
following example illustrates these issues:

Project Initial Cash Inflows in Year

Cost 1 2 3 4 5 6 7
C $8,000 $2,000 $2,000 $1,000 $3,000 $0 $0 $0
D $8,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000

Both projects have a payback period of four years. However, Project D is clearly preferred to
Project C, both because Project D generates more cash inflows earlier during the payback
period ($2,000 in year three versus $1,000 for Project C, which is offset in year four), and
because Project D continues to generate returns after the payback period is over.

The payback period is a heuristic. A heuristic is a decision-aid that is easily understood and
easily communicated, but that might not always result in the best decision.

Net Present Value:

The net present value (NPV) of a capital project answers the following question:

What is the project worth in today’s dollars?

The NPV is the sum of the present value of all current and future cash inflows and outflows.
Since the present value of a cashflow that occurs today is its face value, the NPV of a project
is the sum of any cashflows that occur at time zero plus the present value of all future
cashflows.

In the typical scenario in which there is an initial cash outlay for the acquisition of an asset,
followed by cash inflows throughout the useful life of the asset, the NPV can be calculated as
follows:

108
          


   
cash inflow
NPV
= (1+k)n   initial outlay

Where k is the discount rate, n is the number of periods from time zero in which the cash
inflow occurs, and the summation is over the n periods of the life of the project. If the cash
inflows are an annuity over the life of the project, the numerator in the above equation can be
moved outside of the summation to obtain the following:

         

   
annual cash 1
NPV
= inflow  x    (1+k)n
       initial
outlay

The summation now depends only on k and n:

   

 __1___  

(1+k)n

It is exactly this term that is provided in a present value table for annuities (see Table 2 at the
end of this chapter), where k represents the discount rate in the column heading, and n
represents the number of years (the row).

________________________________________________________________________

Example: The Sunrise Bakery is considering purchasing a new oven. The oven will cost
$1,500, and the owner anticipates that the oven will increase the bakery’s future net cash
inflows by $800 per year for the next five years. What is the anticipated NPV of this capital
acquisition, if the bakery’s discount rate is 10%?

109
 

NPV = ($800 x 3.7908) – $1,500 = $3,033 – $1,500 = $1,533.

The factor 3.7908 comes from Table 2: the intersection of the column for 10% and row 5.

________________________________________________________________________

Because NPV provides an absolute measure of the return from the project, not a ratio, it tends
to favor large projects. Also, the NPV calculation implicitly assumes that free cash flows can
be reinvested at the discount rate. Despite these potential drawbacks, net present value is
usually the most reliable criterion by which to judge capital projects on an individual basis. 

Internal Rate of Return:

The internal rate of return (IRR) is the discount rate computed such that the net present value
of the project equals zero. Software spreadsheet applications and financial calculators usually
include a function that calculates the IRR. The following example illustrates how the IRR was
approximated prior to the widespread availability of these electronic tools. 

________________________________________________________________________

Example: The Sunrise Bakery is considering an expansion to its outdoor dining space that
would require an initial cash outlay of $26,000 and increase net cash inflows by $8,000 per
year for four years. The owner of the bakery does not anticipate any benefit from this
expansion after year four, because at that time she hopes to finance a major renovation of the
building that would expand the indoor dining area into the location of the patio. What is the
IRR of the proposed expansion to the current outdoor dining space?

Setting the NPV equal to zero in the NPV equation, and solving for the present value factor:

            0 = ($8,000 x the present value factor) – $26,000

             present value factor = 3.25

Looking in Row 4 of Table 2 (since the life of the annuity is four years), the closest factor to
3.25 is 3.2397 in the column for 9%. Therefore, the IRR is approximately 9%.

________________________________________________________________________

110
 

Relative to NPV, the advantage of IRR is that it provides a performance measure that is
independent of the size of the project. Hence, IRR can be used to compare projects that
require significantly different initial investments.

An important drawback of IRR is that it can induce managers to reject proposed projects that
shareholders would like the company to accept. For example, if the manager is evaluated
based on the average IRR of all capital projects undertaken, and if a proposed capital project
offers an IRR that is above the company’s cost of capital, but below the average of all capital
projects undertaken thus far, the proposed project would adversely affect the manager’s
performance measure, although it would increase economic returns to shareholders.

IRR implicitly assumes that free cashflows can be reinvested at the computed internal rate of
return. This assumption is analogous to the assumption imbedded in the NPV calculation that
free cashflows can be reinvested at the discount rate. However, in the context of IRR, the
assumption is more problematic than in the context of NPV if the IRR is unusually high or
low.

Net Present Value and Internal Rate of Return, Compared:

There is an important and close relationship between NPV and IRR. The NPV is greater than
zero if and only if the IRR is greater than the discount rate. This relationship implies that if a
single proposed capital investment is considered in isolation, both NPV and IRR will provide
the same answer to the question of whether or not the investment should be undertaken.

However, NPV and IRR need not provide the same answer if projects that require different
investments are compared. Consider the following example, comparing two projects each
with a one-year life. Assume a 10% discount rate in the NPV calculation. In this simple
setting with a one-year life, the IRR is easily calculated as the profit divided by the initial
investment.

Project Initial Payout at Net Present Value Internal Rate

Investment end of year of Return
A $1,000 $1,200 $91  [(1,200 ÷ 1.1) – 1,000] 20%
B $100 $200 $82  [(200 ÷ 1.1) – 100] 100%

111
Hence, NPV favors Project A, while IRR favors Project B. What is the “correct” answer? The
answer depends on the opportunity cost associated with the additional $900 required to
finance Project A compared with financing Project B. For example, if the company has
$1,000 to invest and can replicate Project B ten times, doing so would clearly be preferable to
Project A. On the other hand, if the company can earn only 1% on the $900 additional funds
available if Project B is chosen over Project A, then the company prefers Project A,
calculated as follows: 

Project NPV IRR

A $91, as determined above 20%, as determined above
B plus $900  $8  [($1,109 ÷ 1.1) – $1,000] ($1,109  $1,000) ÷ $1,000 =  1.1%
invested at 1%

The $1,109 in the bottom row is the total payout at the end of the year from this option,
calculated as $200 from Project B plus $909 from the $900 investment that earns 1%. The
NPV of $8 is actually less than the NPV from Project B alone, because the NPV of the $900
invested at 1% is negative.

In conclusion, NPV and IRR need not rank projects equivalently, if the projects differ in size.

The Discount Rate:

The discount rate is critical in determining whether the NPV of a project is positive or
negative (and equivalently, whether the project IRR is greater or less than the discount rate).
However, the choice of discount rate is seldom obvious.

In most situations, the appropriate discount rate is the company’s cost of capital. The cost of
capital is a weighted average of the company’s cost of debt and its cost of equity. Interest
rates on borrowings provide information about the cost of debt. Determining the cost of
equity is more difficult, and constitutes an important topic in the area of finance. The
Weighted Average Cost of Capital (WACC) is a concept from corporate finance that
frequently serves as an appropriate discount rate for capital budgeting decisions. In some
cases, however, the company would benefit from distinguishing between the existing average
cost of capital, and the marginal cost of capital, because the cost of debt generally increases
as companies become more highly leveraged.  

112
Many companies establish a company-wide hurdle rate, to communicate to managers the
appropriate discount rate for investment decisions. Often, the hurdle rate seems to exceed the
company’s cost of capital, which encourages managers to act conservatively in their capital
budgeting decisions: an outcome that is difficult to justify with finance theory.

Another option for the discount rate is the opportunity cost associated with the funds required
for the capital project. In most cases, the cost of capital and the opportunity cost should be
approximately equal. However, most of us pay a higher rate to borrow funds than we earn on
our financial investments. Hence, if a decision-maker has cash to either invest in a capital
project or invest in the financial markets, an appropriate discount rate for the capital project is
the opportunity cost of the earnings the decision-maker would have earned in the financial
markets. This rate is probably lower than the cost of raising additional financing for the
project.   

Accounting Rate of Return:

The accounting rate of return (ARR) is sometimes called the book rate of return. Of the
four capital project performance measures discussed in this chapter, the accounting rate of
return is the only performance measure that depends on the company’s accounting choices. It
is calculated as follows:

 
    Average Incremental
Annual
 
Accounting Rate of =
Income from the Project
Return
Average Net Book
Investment in the Project

In the simple setting in which the capital project consists of the purchase of a single
depreciable asset, the numerator is the average incremental annual cash inflow (additional
revenues or the reduction in operating expenses) attributable to the asset, minus the annual
depreciation expense. The denominator is the net book investment in the asset, averaged over
the life of the asset.

________________________________________________________________________

113
Example: A machine costs $12,000 and increases cash inflows by $4,000 annually for four
years. The machine has zero salvage value.

Depreciation expense = $12,000 ÷ 4 = $3,000 per year.

Incremental income from the machine = $4,000 – $3,000 = $1,000 per year.

Because income from the machine is identical in each year of its four-year life, the average
income over the life of the asset is also $1,000 annually.

For the calculation of the Net Book Investment in the denominator, even though the asset life
is four years, five points in time must be considered: time zero (the beginning of year one),
and the end of years one through four. At the time the machine is purchased (time zero), the
net book investment equals the purchase price of $12,000. As the machine is depreciated, the
accumulated depreciation account balance increases, and the net book investment decreases.

114
 Chapter 13

Transfer Pricing

Chapter Contents:
- Definition and overview
- Transfer pricing options
- Market-based transfer prices
- Cost-based transfer prices
- Negotiated transfer prices
- Survey of practice
- External reporting
- Dual transfer pricing
- Transfer pricing and multinational income taxes
- Other regulatory issues
- Exercises and problems

Definition and Overview:

A transfer price is what one part of a company charges another part of the same company for
goods or services. In the excerpt from Casablanca, Rick apparently loaned Ferrari 100 cartons
of cigarettes for which he was never repaid. Now that Ferrari owns both the Blue Parrot and
Rick’s Café, he jokes about the fact that what was previously a debt that he owed to Rick, is
now a “debt” from one nightclub that he owns to another nightclub that he owns. If Ferrari
continues to transfer cartons of cigarettes between the two clubs, he might wish to establish a
“transfer price” for cigarettes, but knowing Ferrari, he won’t bother.
 
We will restrict attention to transfers that involve a tangible product, and we will refer to the
two corporate entities engaged in the transfer as divisions. Hence, the transfer price is the
price that the “selling” division charges the “buying” division for the product. Because objects
that float usually flow downstream, the selling division is called the upstream division and
the buying division is called the downstream division. 
 

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Transferred product can be classified along two criteria. The first criterion is whether there is
a readily-available external market price for the product. The second criterion is whether the
downstream division will sell the product “as is,” or whether the transferred product becomes
an input in the downstream division’s own production process. When the transferred product
becomes an input in the downstream division’s production process, it is referred to as an
intermediate product. The following table provides examples.
 
  An external market No external market
price is available price is available
  The West Coast Division of A pharmaceutical company
a supermarket chain transfers transfers a drug that is under
The downstream oranges to the Northwest patent protection, from its
division will sell “as is” Division, for retail sale. manufacturing division to its
marketing division.
 
The downstream An oil company transfers The Parts Division of an
division will use the crude oil from the drilling appliance manufacturer
transferred product in division to the refinery, to be transfers mechanical
its own production used in the production of components to one of its
process gasoline. assembly divisions.

Transfer pricing serves the following purposes.

 
1) When product is transferred between profit centers or investment centers within a
decentralized firm, transfer prices are necessary to calculate divisional profits, which
then affect divisional performance evaluation.
2) When divisional managers have the authority to decide whether to buy or sell
internally or on the external market, the transfer price can determine whether
managers’ incentives align with the incentives of the overall company and its owners.
The objective is to achieve goal congruence, in which divisional managers will want
to transfer product when doing so maximizes consolidated corporate profits, and at
least one manager will refuse the transfer when transferring product is not the profit-
maximizing strategy for the company.
3) When multinational firms transfer product across international borders, transfer prices
are relevant in the calculation of income taxes, and are sometimes relevant in
connection with other international trade and regulatory issues.
 
The transfer generates journal entries on the books of both divisions, but usually no money
changes hands. The transfer price becomes an expense for the downstream division and
revenue for the upstream division. Following is a representative example of journal entries to
record the transfer of product:
Upstream Division:
(1)        Intercompany Accounts Receivable               $9,000
                        Revenue from Intercompany Sale                              $9,000
 

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(2)        Cost of Goods Sold – Intercompany Sales            $8,000
                        Finished Goods Inventory                                          $8,000
 
(To record the transfer of 500 cases of Clear Mountain Spring Water, at $18 per case, to the
Florida marketing division, and to remove the 500 cases from finished goods inventory at the
production cost of $16 per case.)
 
Downstream Division:
(1)        Finished Goods Inventory                              $9,000
                        Intercompany Accounts Payable                                $9,000
 
(To record the receipt of 500 cases of Clear Mountain Spring Water, at $18 per case, from the
bottling division in Nebraska)
 
 
Transfer Pricing Options:
There are three general methods for establishing transfer prices.
 
1) Market-based transfer price: In the presence of competitive and stable external
markets for the transferred product, many firms use the external market price as the
transfer price.

2) Cost-based transfer price: The transfer price is based on the production cost of the
upstream division. A cost-based transfer price requires that the following criteria be
specified:

a. Actual cost or budgeted (standard) cost.

b. Full cost or variable cost.
c. The amount of markup, if any, to allow the upstream division to earn a profit
on the transferred product.

3) Negotiated transfer price: Senior management does not specify the transfer price.
Rather, divisional managers negotiate a mutually-agreeable price.

Each of these three transfer pricing methods has advantages and disadvantages.

Market-based Transfer Prices:

Microeconomic theory shows that when divisional managers strive to maximize divisional
profits, a market-based transfer price aligns their incentives with owners’ incentives of
maximizing overall corporate profits. The transfer will occur when it is in the best interests of
shareholders, and the transfer will be refused by at least one divisional manager when
shareholders would prefer for the transfer not to occur. The upstream division is generally
indifferent between receiving the market price from an external customer and receiving the
same price from an internal customer. Consequently, the determining factor is whether the
downstream division is willing to pay the market price. If the downstream division is willing
to do so, the implication is that the downstream division can generate incremental profits for

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the company by purchasing the product from the upstream division and either reselling it or
using the product in its own production process. On the other hand, if the downstream division
is unwilling to pay the market price, the implication is that corporate profits are maximized
when the upstream division sells the product on the external market, even if this leaves the
downstream division idle. Sometimes, there are cost savings on internal transfers compared
with external sales. These savings might arise, for example, because the upstream division can
avoid a customer credit check and collection efforts, and the downstream division might avoid
inspection procedures in the receiving department. Market-based transfer pricing continues to
align managerial incentives with corporate goals, even in the presence of these cost savings, if
appropriate adjustments are made to the transfer price (i.e., the market-based transfer price
should be reduced by these cost savings).
 
However, many intermediate products do not have readily-available market prices. Examples
are shown in the table: a pharmaceutical company with a drug under patent protection (an
effective monopoly); and an appliance company that makes component parts in the Parts
Division and transfers those parts to its assembly divisions. Obviously, if there is no market
price, a market-based transfer price cannot be used.
 
A disadvantage of a market-based transfer price is that the prices for some commodities can
fluctuate widely and quickly. Companies sometimes attempt to protect divisional managers
from these large unpredictable price changes.

Cost-based Transfer Prices:

Cost-based transfer prices can also align managerial incentives with corporate goals, if various
factors are properly considered, including the outside market opportunities for both divisions,
and possible capacity constraints of the upstream division.
 
First consider the case in which the upstream division sells the intermediate product to
external customers as well as to the downstream division. In this situation, capacity
constraints are crucial. If the upstream division has excess capacity, a cost-based transfer price
using the variable cost of production will align incentives, because the upstream division is
indifferent about the transfer, and the downstream division will fully incorporate the
company’s incremental cost of making the intermediate product in its production and
marketing decisions. However, senior management might want to allow the upstream division

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to mark up the transfer price a little above variable cost, to provide that division positive
incentives to engage in the transfer.
 
If the upstream division has a capacity constraint, transfers to the downstream division
displace external sales. In this case, in order to align incentives, the opportunity cost of these
lost sales must be passed on to the downstream division, which is accomplished by setting the
transfer price equal to the upstream division’s external market sales price.
 
Next consider the case in which there is no external market for the upstream division. If the
upstream division is to be treated as a profit center, it must be allowed the opportunity to
recover its full cost of production plus a reasonable profit. If the downstream division is
charged the full cost of production, incentives are aligned because the downstream division
will refuse the transfer under only two circumstances:
 
First, if the downstream division can source the intermediate product for a lower cost
elsewhere;
 
Second, if the downstream division cannot generate a reasonable profit on the sale of the final
product when it pays the upstream division’s full cost of production for the intermediate
product.
 
If the downstream division can source the intermediate product for a lower cost elsewhere, to
the extent the upstream division’s full cost of production reflects its future long-run average
cost, the company should consider eliminating the upstream division. If the downstream
division cannot generate a reasonable profit on the sale of the final product when it pays the
upstream division’s full cost of production for the intermediate product, the optimal corporate
decision might be to close the upstream division and stop production and sale of the final
product. However, if either the upstream division or the downstream division manufactures
and markets multiple products, the analysis becomes more complex. Also, if the downstream
division can source the intermediate product from an external supplier for a price greater than
the upstream division’s full cost, but less than full cost plus a reasonable profit margin for the
upstream division, suboptimal decisions could result. 

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Negotiated Transfer Prices:

Negotiated transfer pricing has the advantage of emulating a free market in which divisional
managers buy and sell from each other in a manner that simulates arm’s-length transactions.
However, there is no reason to assume that the outcome of these transfer price negotiations
will serve the best interests of the company or shareholders. The transfer price could depend
on which divisional manager is the better poker player, rather than whether the transfer results
in profit-maximizing production and sourcing decisions. Also, if divisional managers fail to
reach an agreement on price, even though the transfer is in the best interests of the company,
senior management might decide to impose a transfer price. However, senior management’s
imposition of a transfer price defeats the motivation for using a negotiated transfer price in the
first place.
 
 
Survey of Practice:
Roger Tang (Management Accounting, February 1992) reports 1990 survey data on transfer
pricing practices obtained from approximately 150 industrial companies in the Fortune 500.
Most of these companies operate foreign subsidiaries and also use transfer pricing for
domestic interdivisional transfers. For domestic transfers, approximately 46% of these
companies use cost-based transfer pricing, 37% use market-based transfer pricing, and 17%
use negotiated transfer pricing. For international transfers, approximately 46% use market-
based transfer pricing, 41% use cost-based transfer pricing, and 13% use negotiated transfer
pricing. Hence, market-based transfer pricing is more common for international transfers than
for domestic transfers. Also, comparison to an earlier survey indicates that market-based
transfer pricing is slightly more common in 1990 than it was in 1977.  
 
Tang also finds that among companies that use cost-based transfer pricing for domestic and/or
international transfers, approximately 90% use some measure of full cost, and only about 5%
or 10% use some measure of variable cost.
 
 
External Reporting:

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For external reporting under Generally Accepted Accounting Principles, no matter what
transfer price is used for calculating divisional profits, the effect should be reversed and
intercompany profits eliminated when the financial results of the divisions are consolidated.
Obviously, intercompany transfers are not arm’s-length transactions, and a company cannot
generate profits or increase the reported cost of its inventory by transferring product from one
division to another.
 
 
Dual Transfer Pricing:
Under a dual transfer pricing scheme, the selling price received by the upstream division
differs from the purchase price paid by the downstream division. Usually, the motivation for
using dual transfer pricing is to allow the selling price to exceed the purchase price, resulting
in a corporate-level subsidy that encourages the divisions to participate in the transfer.
Although dual transfer pricing is rare in practice, a thorough understanding of dual transfer
pricing illustrates some of the key bookkeeping and financial reporting implications of all
transfer pricing schemes.
 
In the following example, the Clear Mountain Spring Water Company changes from a
negotiated transfer price of $18 per case (see the above example) to a dual transfer price in
which the upstream division receives the local market price of $19 per case, and the
downstream division pays $17 per case.
Upstream Division:
(1)        Intercompany Receivable/Payable                              $9,500
                        Revenue from Intercompany Sale                                          $9,500
 
(2)        Cost of Goods Sold – Intercompany Sales                $8,000
                        Finished Goods Inventory                                                      $8,000
 
(To record the transfer of 500 cases of Clear Mountain Spring Water, at $19 per case, to the
Florida marketing division, and to remove the 500 cases from finished goods inventory at the
production cost of $16 per case.)
 

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Downstream Division:
(1)        Finished Goods Inventory                                          $8,500
                        Intercompany Receivable/Payable                                          $8,500
 
(To record the receipt of 500 cases of Clear Mountain Spring Water at $17 per case, from the
bottling division in Nebraska)
 
Corporate Headquarters:
(1)        Interco. Receivable/Payable – Florida                       $8,500
            Corporate Subsidy for Dual Transfer Price                  1,000
                        Interco. Receivable/Payable – Nebraska                                    $9,500
 
(To record the transfer of 500 cases of Clear Mountain Spring Water from Nebraska to
Florida, at a dual transfer price of $19/$17 per case.)
 
Corporate Subsidy for Dual Transfer Price is an expense account at the corporate level. This
account and the revenue account that records the intercompany sale affect the calculation of
divisional profits for internal reporting and performance evaluation, but these accounts—as
well as the intercompany receivable/payable accounts—are eliminated upon consolidation for
external financial reporting. To the extent that the Florida Division has ending inventory, the
cost of that inventory for external financial reporting will be the company’s cost of production
of $16 per case. In other words, the transfer price has no effect on the cost of finished goods
inventory. 
Transfer Pricing and Multinational Income Taxes:
When divisions transfer product across tax jurisdictions, transfer prices play a role in the
calculation of the company’s income tax liability. In this situation, the company’s transfer
pricing policy can become a tax planning tool. The United States has agreements with most
other nations that determine how multinational companies are taxed. These agreements, which
are called bilateral tax treaties, establish rules for apportioning multinational corporate
income among the nations in which the companies conduct business. These rules attempt to
tax all multinational corporate income once and only once (excluding the double-taxation that
occurs at the Federal and state levels). In other words, the tax treaties attempt to avoid the
double-taxation that would occur if two nations taxed the same income. Since transfer prices

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represent revenue to the upstream division and an expense to the downstream division, the
transfer price affects the calculation of divisional profits that represent taxable income in the
nations where the divisions are based.
 
For example, if a U.S.-based pharmaceutical company manufactures a drug in a factory that it
operates in Ireland and transfers the drug to the U.S. for sale, a high transfer price increases
divisional income to the Irish division of the company, and hence, increases the company’s
tax liability in Ireland. At the same time, the high transfer price increases the cost of product
to the U.S. marketing division, lowers U.S. income, and lowers U.S. taxes. The company’s
incentives with regard to the transfer price depend on whether the marginal tax rate is higher
in the U.S. or in Ireland. If the marginal tax rate is higher in the U.S., the company prefers a
high transfer price, whereas if the marginal tax rate is higher in Ireland, the company prefers a
low transfer price. The situation reverses if the drug is manufactured in the U.S. and sold in
Ireland. The general rule is that the company wants to shift income from the high tax
jurisdiction to the low tax jurisdiction.
 
There are limits to the extent to which companies can shift income in this manner. When a
market price is available for the goods transferred, the taxing authorities will usually impose
the market-based transfer price. When a market-based transfer price is not feasible, U.S. tax
law specifies detailed and complicated rules that limit the extent to which companies can shift
income out of the United States. 

Other Regulatory Issues:

Transfer pricing sometimes becomes relevant in the context of other regulatory issues,
including international trade disputes. For example, when tariffs are based on the value of
goods imported, the transfer price of goods shipped from a manufacturing division in one
country to a marketing division in another country can form the basis for the tariff. As another
example, in order to increase investment in their economies, developing nations sometimes
restrict the extent to which multinational companies can repatriate profits. However, when
product is transferred from manufacturing divisions located elsewhere into the developing
nation for sale, the local marketing division can export funds to “pay” for the merchandise
received. As a final example, when nations accuse foreign companies of “dumping” product
onto their markets, transfer pricing is often involved. Dumping refers to selling product below

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cost, and it generally violates international trade laws. Foreign companies frequently transfer
product from manufacturing divisions in their home countries to marketing affiliates
elsewhere, so that the determination of whether the company has dumped product depends on
comparing the transfer price charged to the marketing affiliate with the upstream division’s
cost of production.      

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