AFDM Video Notes:

• Managerial accounting is much more recent as compared to financial accounting – financial

accounting has existed even before a book was written about it in the 15th century.
• Managerial accounting came into being in the industrial revolution in around the 19th
century.
• The rise of factories and railroads gave birth to managerial accounting.
• You need to figure out the cost per unit so you can determine the selling price and the
wages that will be paid to the laborers. This also helps you assign a value to your inventory
in your balance sheet and determine your COGS (financial accounting comes into play
here).
• Inventories are valued in the balance sheet at their cost per unit.
• Managerial accounting also helps in evaluating a large business by breaking it up into
smaller divisions.
• Managerial accounting also helps in determining transfer prices between divisions of a
large business.
• In managerial accounting, you get the company’s internal info and give it to relevant
managers so they can make informed business decisions.
• Budgets are a big part of managerial accounting.
• Managerial accounting starts off with planning and then aids in decision making, which
further requires directing & motivating employees through efficient cost allocations, which
also results in controlling actions of the managers regarding budgets.
• Budgets are plans for costs.
• Variance analysis – helps us control costs by making sure our actual expenses meet our
planned expenses and don’t go over.
• Managerial accounting also helps in performance evaluation of managers.
• Managerial Accounting vs. Financial Accounting:

Managerial Accounting Financial Accounting

Internal use – managers mostly. External use – lenders, bondholders,
regulators, owners or shareholders.
Not required by authorities. Required by authorities for reporting and
compliance.
It doesn’t have to follow GAAP. It has to follow GAAP.
It is future oriented because you are using It is past oriented because here you’re
it to make decisions for the future. looking at the performance that has already
taken place.
Concerned with the relevance and Concerned with objectivity and precision of
timeliness of information. the data.
Here the reporting is segment/division Here the reporting is consolidated.
oriented – it is required by departments or
geographical divisions.
• Cost object – any product, any job order, any division, anything that you assign a cost to;
examples: product lines, company departments, customers, etc.
• You assign costs to objects because you want to: track your company’s profitability,
evaluate the performance of the manager who’s managing that cost object, help with
determining prices (pricing decisions) for the end product resulting from these cost objects,
and control costs.
• Direct costs are traceable to the cost object, whereas indirect costs aren’t traceable to the
cost object, and by traceable, we mean that the input incurring cost can be traced back to
a specific product and only that product, and is not shared by another product being
produced in the same company.
• “Direct materials” is a term associated with manufacturing companies.
• Direct materials are inputs needed to make a finished product, and that can be traced back
in a finished product. This term includes costs incurred to acquire these materials as well,
such as shipping costs, sales taxes or custom duties.
• Raw materials can be classified into 2 categories – direct materials and indirect materials.
• Indirect materials are those raw materials that are used in the making of a product but are
very hard to trace back to the product because of their triviality in the manufacturing of
that product.
• Direct labor is also a term associated with manufacturing companies.
• Direct labor costs are the salaries or wages of the laborers who are physically involved in
the manufacture of a product being sold by a company, and who’s work can be traced back
to the product being sold by the company.
• Direct labor is sometimes called “touch labor” – laborers who touch the product being
manufactured.
• Labor can be classified into 2 categories – direct labor and indirect labor.
• Indirect labor is the labor aiding or maintaining the surroundings of direct labor so that the
direct labor can work efficiently.
• Manufacturing overheads are costs associated with only manufacturing firms and not
service providing firms.
• Manufacturing overheads are any manufacturing costs other than direct materials and
direct labor; examples: indirect materials, indirect labor and other costs such as
depreciation on factory/factory equipment only, real estate taxes on the factory, electricity
for the factory, insurance for the factory, etc.
• Manufacturing costs are of three types – direct materials, direct labor and manufacturing
overheads – they are used to calculate COGS and for other purposes too.
• Prime Costs = Direct Materials Costs + Direct Labor Costs
• Direct Labor and Manufacturing Overheads convert the Direct Materials into the Finished
Good, which is why these two costs make up the Conversion Costs.
• Conversion Costs = Direct Labor Costs + Manufacturing Overheads
• Manufacturers have 3 types of inventories: raw materials, work-in-process and finished
goods.
• Raw materials inventory – materials physically used to make the product.
• Work in process inventory – these are partially built products – the raw materials have
been moved into production and have been worked upon partially and have not been
completed into finished goods.
• Finished goods inventory are the completed products that are ready to be sold.
• When purchased raw materials are sitting idle, they will be accounted for under the raw
materials account, but when these raw materials are moved into production, they will be
accounted for under the work in process inventory account.
• You make an estimate for manufacturing overheads in the beginning, and then you keep
tracking your manufacturing overhead expenses throughout the production process, and
then at the end, you compare the estimated manufacturing overheads with the actual
manufacturing overheads.
• Work in process inventory account has all the direct costs (materials and labor), and the
manufacturing overheads account has all the indirect costs.
• When the company applies the manufacturing overhead amount, they debit the work in
process inventory account by that amount and credit the manufacturing overhead
account.
• When the partially produced products are completed, the amount under the work in
process inventory account is debited to the finished goods inventory account.
• When you sell the finished goods, the amount under the finished goods inventory gets
debited to cost of goods sold.
• The flow of costs for a manufacturer is as such (flow from one asset to another):
Cost of
Cost of Goods
Purchase of Raw Cost of Laborers Manufacturing
Sold for Finished
Materials for Production Overheads for
Goods
Production

• The 3 types of inventories all belong on the balance sheet – they are all costs that haven’t
been expensed yet.
• When the Finished Goods Inventory is sold and it becomes Cost of Goods Sold, it is then
transferred to the Income Statement – this is an expense, which reduces the company’s
net income.
• Costs at a manufacturing firm are categorized into manufacturing costs (direct materials,
direct labor and manufacturing overheads) and non-manufacturing costs (selling, general
and administrative expenses).
• Selling expenses are the costs incurred to secure orders and get products to customers
(advertising, shipping, sales commission, etc.).
• General and administrative costs are the costs incurred in the running of the organization
– the expenses of the general management of the organization.
• Cost of Goods Manufactured (COGM) is used to calculate the Cost of Goods Sold (COGS).
• Raw Materials Used = Beginning Raw Materials + Purchases – Ending Raw Materials
• Total Manufacturing Costs = Raw Materials Used + Direct Labor + Manufacturing Overhead
• Cost of Goods Manufactured = Beginning Work in Process + Total Manufacturing Costs –
Ending Work in Process
• Cost of Goods Sold = Beginning Finished Goods + Cost of Goods Manufactured – Ending
Finished Goods
• Schedule of Cost of Goods Manufactured:
Direct Materials
Beginning Raw Materials xxx
+ Purchases xxx
– Ending Raw Materials xxx
= Raw Materials Used xxx
Direct Labor xxx
Manufacturing Overheads xxx
Total Manufacturing Cost xxx
+ Beginning Work in Process xxx
– Ending Work in Process xxx
= Cost of Goods Manufactured xxx
• Costs can also be either product costs or period costs.
• Product costs are also known as inventoriable costs because they go to inventory.
• Product costs include direct materials, direct labor and manufacturing overheads.
• When you sell your inventory, the inventoriable costs flow out of the company as COGS
(COGS are like expenses).
• Period costs are expensed immediately – as they are incurred. They are all the costs that
are not product costs/not inventoriable.
• Example of period costs are SG&A expenses.
• Period costs are expensed in the period they are incurred in, as opposed to product costs
that are first expensed to inventory and then to COGS when they are sold, which might not
necessarily be in the same period as they were expensed to inventory.
• Period costs show up on the income statement, whereas product costs show up on the
balance sheet when they are inventoriable and on the income statement when they turn
to COGS upon sale of the products.
• Opportunity cost – benefit foregone/given up when you choose something.
• Sunk costs are costs that have already been incurred and cannot be changed going forward.
• Sunk costs are irrelevant in decision making because nothing can be done about those
costs.
• If you consider sunk costs in long term decision making, you’ll end up losing money that
you could’ve invested elsewhere and earned from it.
• Variable costs are costs that change with the level of activity – the “activity” term could be
a variety of things such as the number of units produced, or the number of hours worked.
• Relevant range – the range of activity within which the company expects to operate. You
can’t have infinite levels of activity for one constant fixed cost; at some point you might
have to invest more in that fixed cost for expansionary purposes.
• Fixed costs are costs that will remain constant regardless of the changes in the levels of
activity, but it is fixed for a relevant range of activity level.
• Not all fixed costs have relevant ranges, but most do.
• Step variable costs are variable costs that have a bit of a fixed cost element to it as well. It
is so called because the graph looks like steps.
• Mixed costs are sometimes called semi-variable costs. Here, you start plotting your
variable costs after your fixed cost amount on the y-axis, instead of starting from 0.
Because when your activity level is 0, your fixed costs will still be incurred, and so that is
taken into account when graphing mixed costs.
• It is often difficult to distinguish between fixed and variable costs in mixed costs because
they’re consolidated figures of both costs.
• One of the ways to break down the components of mixed costs is the high-low method.
• An assumption of the high-low method is that there is a linear relationship between the
activity level and the variable costs. The slope of this linear relationship will be the per unit
variable cost incurred.
Highest Cost - Lowest Cost
Variable Cost per Unit of Activity = Slope =
Highest Activity - Lowest Activity
Fixed Cost = Total Cost – (Variable Cost per Unit of Activity x Total Units of Activity)
NOTE: In the formula for variable cost above, you choose the highest and lowest figures
based on activity and not based on costs.
• You can also calculate the components of your mixed cost by using the least squares
regression method in Excel or any other regression software, where the y-intercept value
will be your fixed cost and your slope will be the variable cost per unit.
Y = α + x => where α is your fixed cost and  is your variable cost per unit
• In least squares regression method for calculating components of mixed cost, the statistic
R2 tells you how good your line of best fit is – how much have the errors been minimized
in plotting your graph. The higher the R2 value, the better your fit is.
• Fixed costs can be either committed or discretionary – these indicate the long-termness or
short-termness of the cost, respectively.
• You can cut back on discretionary fixed costs, but you can’t do so with committed fixed
costs.
• Examples of discretionary fixed costs include R&D budgets and advertising expenses.
• Example of committed fixed cost can be a lease on a factory.
• Cost drivers are activities that cause a cost to occur (machine hours, direct labor hours,
etc.).
• Changes in activity level cause changes in the amount of costs because of cost drivers.
• Companies should use cause and effect rationale to figure out the relevant cost drivers for
the company so that costs are calculated accurately.
• The predetermined overhead rate is an estimated rate for the overheads before their
expenses have been incurred because we need to budget for the costs accurately and
beforehand.
• Overhead costs fluctuate over time.
• In order to calculate the predetermined overhead rate, you have to choose a cost driver
that directly relates to the overhead expenses, and then use the following formula:
Budgeted Manufacturing Overheads
Predetermined Overhead Rate =
Budgeted Chosen Cost Driver
• When recording the cost for manufacturing overheads, you debit the Work In Process
account and credit the Manufacturing Overheads account.
• When you buy indirect materials, which come under manufacturing overheads, you first
debit manufacturing overheads and then you credit raw materials inventory.
• You always DEBIT actual manufacturing overheads and CREDIT estimated manufacturing
overheads.
• When you have a debit balance in the T-account of manufacturing overheads, you have an
underapplied balance (actual > estimated).
• When you have a credit balance in the T-account of manufacturing overheads, you have
an overapplied balance (actual < estimated).
• To dispose off of underapplied or overapplied manufacturing overhead balance, you can
use either of these acceptable approaches:
1. Close the balance to COGS: debit the underapplied balance to COGS and credit that
amount to Manufacturing Overhead; credit the overapplied balance to COGS and debit
that amount to Manufacturing Overhead.
2. Allocate the amount to the accounts of WIP, Finished Goods and COGS (this method is
also called proration): this is done on the basis of the proportion of all these accounts
based on their total amount; so you allocate the under or over applied balance to each
of these accounts based on their proportion of the total of these 3 accounts.
3. Adjusted Allocation Rate Approach: here you adjust your predetermined overhead rate
and then apply the new rate to the manufacturing overhead cost of each of your jobs.
• If you close an underapplied manufacturing overheads balance to COGS only, your COGS
increase and as a result, your Net Income and profitability decreases.
• If you close an underapplied manufacturing overheads balance to COGS, WIP and Finished
Goods, your COGS increases, and your WIP and Finished Goods also increase (the latter
increases assets, and the former increases expenses).
• If you close an overapplied manufacturing overheads balance to COGS only, your COGS
decreases and as a result, your Net Income and profitability increases.
• If you close an overapplied manufacturing overheads balance to COGS, WIP and Finished
Goods, your COGS decreases, and your WIP and Finished Goods also decrease (the latter
decreases assets, and the former decreases expenses).
• The journal entries for adjusted allocation rate approach are:
− If the balance is underapplied – if the job is work in process, then you debit WIP and
credit the manufacturing overheads; if the job is finished, then you debit Finished Goods
and credit the manufacturing overheads; if the job is sold, then you debit COGS and
credit the manufacturing overheads.
− If the balance is overapplied – if the job is work in process, then you credit WIP and debit
the manufacturing overheads; if the job is finished, then you credit Finished Goods and
debit the manufacturing overheads; if the job is sold, then you credit COCGS and debit
the manufacturing overheads.
• Companies use job order costing when they produce different products, and process
costing when they produce homogenous products.
• Job cost sheet has direct materials, direct labor and manufacturing overheads (applied).
• The Job Cost Sheet components are calculated as follows:
− You calculate the direct materials by recording the cost for the amount of direct
materials used for that particular job.
− You calculate the direct labor by multiplying the wage rate per hour by the number of
hours used for that particular job.
− You calculate the applied manufacturing overhead by multiplying the overhead rate
with the number of hours of manufacturing overheads used for that particular job (these
number of hours are the same as the direct labor hours in most companies).
− It can be hours or any other predetermined unit of measure.
• Journal Entries for Job Order Costing Transactions:
S.
Transaction Debit Credit Notes
No.
Purchased Raw Raw Materials
1 Cash
Materials on Cash Inventory
Purchased Raw Raw Materials Accounts
2
Materials on Credit Inventory Payable
Used a certain
Work-In-
proportion of Raw Raw Materials Only use the amount
3 Process
Materials for Inventory used, not all of it.
Inventory
production
Work-In- This is a two-step
Wages
Process journal entry, only
Payable
Incurs cost for Inventory when the wages are
4 Direct Labor for a being paid at that
Job time too. Otherwise,
Wages Payable Cash
only the first entry
will be made.
Sometimes
companies use the
raw materials
account instead of
Incur actual
Manufacturing supplies account
5 manufacturing Supplies
Overheads because raw
overhead cost
materials account
can have both direct
and indirect
materials.
This is a two-step
Manufacturing Wages journal entry, only
Incurs cost for Overheads Payable when the wages are
6 Indirect Labor for a being paid at that
Job time too. Otherwise,
Wages Payable Cash only the first entry
will be made.
 Can be for anything
7 Incurs period cost SGA Expense Cash that’s not related to
the factory.
Manufacturing
Overheads are
Recording Applied Work-In-
Manufacturing debited when they
8 Manufacturing Process
Overheads are actual and
Overheads Inventory
credited when they
are applied.
Make sure you only
Work-In-
When a particular Finished Goods use the costs for that
9 Process
Job is completed Inventory particular job and not
Inventory
other jobs too.
Finished
When a particular Cost of Goods
10 Goods
Job is sold Sold
Inventory
As a result, your
operating profit goes
down.
When you You can also use the
underapply Cost of Goods Manufacturing proration method,
11
manufacturing Sold Overheads and in that case, you
overheads will be debiting the
respective accounts
(either WIP, FG or
COGS).
As a result, your
operating profit goes
down.
When you You can also use the
overapply Manufacturing Cost of Goods proration method,
12
manufacturing Overheads Sold and in that case, you
overheads will be debiting the
respective accounts
(either WIP, FG or
COGS).

• Service industry doesn’t have inventory or COGS, so their job order costing is a little
different.
• Service industry just records costs per order. The order can be a case, a job, or a single
service that they offer.
• In the service industry, you charge direct costs (traceable costs) to jobs, and you allocate
indirect costs to jobs as well but based on an activity rate.
• The activity rate in the service industry is calculated in the same way as the manufacturing
overhead rate.
• Differences between job order costing and process costing:

Job Order Costing Process Costing

• For heterogenous products • For homogenous products
• Cost sheets are order or job wise • Cost sheets are department wise

• In process costing, there is a WIP account for every department involved in the production
process of the product.
• When making journal entries for process costing for the raw material that is being used up,
you debit the WIP accounts for the departments that need raw material, and you credit
the main raw materials account.
• When making journal entries for process costing to record the labor that has been used,
you debit the WIP accounts for the departments that have used labor in their respective
amounts, and you credit the main wages payable account.
• When making journal entries for process costing to record the amount of overheads that
have been used, you debit the WIP accounts for the departments that have used the
overheads in their respective amounts, and you credit the main applied overheads
account.
• Costs in process costing flow from one department to another, so to show this, you credit
the amount of process 1 and debit that amount to process 2 to show inventory or costs
flowing from process 1 to process 2.
• When determining how much WIP is being transferred out in process costing, you include
both the inventory that is fully complete and the inventory that is partially complete –
when you sum these up, you get the equivalent units of production. The partially complete
inventory is calculated as: Amount partially completed x Percentage completed (this is also
done separately for Direct Materials, Direct Labor and Overheads – there you have
different percentages for each head because those percentages tell you how much the
production is complete with respect to each head).
Costs at the Beginning of the Period + Costs Incurred During the Period
• Cost Per Equivalent Unit =
Units Completed During the Period + (Partially Completed Units × Percentage Completed)
• Comparison of traditional and activity-based costing:
Traditional Costing Activity-Based Costing
You use one overhead rate throughout You use different activity rates for different
the plant cost pools
Easier to implement Difficult to implement
Only allocates product costs Can allocate period costs too
Can be used for external reports Cannot be used for external reports
Requires 2 sets of books – one for internal
Requires 1 set of books
and one for external users
Less accurate More accurate – helps make best decisions
• Categorizing costs into their respective cost pools isn’t easy – involves interviewing
employees to understand the nature of costs – employees often resist the implementation
of the activity-based costing system. So, you have to do a cost-benefit analysis when you’re
deciding on which cost system to implement in the company.
• Examples of activity measures for activity-based costing:
Activity Measure
Set-ups Number of Set-ups
Customer Orders Number of Customer Orders
Order Size Machine Hours or Number of Units
Customers Number of Customers
Product Designs Number of Product Designs
Suppliers Number of Suppliers
Supplier Visits Number of Supplier Visits
Shipping Number of Shipments
Customer Service Number of Complaints
• You identify the percentages for 1 stage allocation of overheads by interviewing
st

employees to understand which cost pool consumes the most cost and so on and so forth.
• Steps for calculating activity-based rate for overheads:
1. Get the amount for all your overheads – SG&A and manufacturing
2. Identify the relevant cost pools for the overheads
3. Make the following table and use it to calculate the activity rates:
Cost Pools 1st Stage Allocation Activity Measure Activity Rate
(1st stage allocation)
Cost Pool 1 % x total overheads xxx unit of measure
/ (activity measure)
Cost Pool 2 % x total overheads
Cost Pool 3 % x total overheads
Others % x total overheads N/A N/A
• The “others” cost pool is the overhead cost that will be incurred regardless of any
production that the company does.
• The activity rates calculated in the table above are then used to multiply it with the units
of measure in each cost pool for different product lines and then all costs are summed to
find out the overhead cost for that particular product line.
• Activity based costing is used to identify customer profitability – identify the profitable and
unprofitable customers and try to either stop catering to the latter or turn them into
profitable ones; you can also use this to redesign your business strategy.
• You calculate customer profitability by calculating the operating margin, which you can do
by following these steps:
1. List down revenues
2. List down direct costs
3. Identify cost pools for the indirect costs with their activity base
4. Calculate the activity rate
5. Calculate indirect costs
6. Calculate the operating profit by subtracting the direct and indirect costs from the
revenues
7. Divide the operating profit by the revenue to get the operating margin
8. The category of customers with the highest operating margin is the most profitable
category of customers, and the category with the lowest operating margin is the least
profitable category of customers.
• Disadvantages of Activity Based Costing:
1. It is not in line with GAAP.
2. Companies, especially manufacturing ones, have to maintain 2 books/cost systems if
they use the activity-based costing system.
3. Its time consuming because you have to interview employees to identify cost pools and
their activity bases.
4. Employees can also overstate the amount of time they spend on activities, ignoring the
idle time at the company.
5. The amount of data resulting from this process is very huge, which takes a lot of time to
process into useful findings.
6. The payoff is not very immediate because this is a long-term strategy, not a short-term
strategy.
7. Employees may resist this new system.
• The contribution margin is the amount you get when you deduct the variable cost from the
sales price. You DO NOT deduct the fixed cost from the sales price here.
Contribution Margin = Sales – Variable Costs
• When you deduct the fixed cost from the contribution margin, you get the profit.
• The contribution income statement is as such:
Sales Revenue xxx,xxx
Variable Costs:
Direct Materials Used (x,xxx)
Direct Labor (x,xxx)
Manufacturing Overheads (x,xxx)
SG&A (x,xxx)
Contribution Margin xx,xxx
Fixed Costs:
Manufacturing Overheads (x,xxx)
SG&A (x,xxx)
Operating Profit xx,xxx
• The contribution margin ratio tells us what percentage of sales we earn as the contribution
margin, per dollar.
Contribution Margin
Contribution Margin Ratio =
Sales
• Contribution margin ratio is used to calculate the breakeven point and the target profit.
• When contribution margin ratios are low, that means you need to have high volume sales
in order to have more contribution margin to cover your fixed costs and have a good profit
too.
• The contribution format income statement serves 3 major purposes:
1. Organizes costs by the way they behave
2. Provides everything we need to conduct the CVP analysis
3. Allows us to easily calculate the CM ratio and DOL
• Degree of Operating Leverage:
Contribution Margin
DOL =
Net Operating Profit
• We calculate the breakeven point in the CVP (cost volume profit) analysis.
Fixed Cost
Breakeven Point (units) =
Contribution Margin per Unit
Fixed Cost
Breakeven Point (sales) =
Contribution Margin Ratio
• When doing a multi-product breakeven analysis, you need to be very sure of the
percentages you assign to your product lines in the sales mix – if those numbers go wrong,
then your analysis will not be reliable and accurate.
• The weighted average unit contribution margin in the multi-product breakeven analysis is
based on the percentages of product lines in the sales mix.
• In the multi-product breakeven analysis, you subtract the variable cost of each product
with its respective sales price and then multiply the resulting amount with the percentage
of that product in the sales mix. You do this for all products and then sum the ending
amounts to get the weighted average contribution margin per unit.
Fixed Cost
Multi-Product Breakeven Point (units) =
Weighted Average Contribution Margin per Unit
• Now, if you’re working back to see what sales you need to make in a multi-product
breakeven analysis to breakeven, you multiply the sales mix percentages with the Multi-
Product Breakeven Point to get the number of units for each product line that you have to
sell in order to make breakeven sales.
• Margin of safety is the amount of sales that can drop before you start incurring losses.
Margin of Safety ($) = Sales (actual or budgeted) – Breakeven Sales
Margin of Safety
Margin of Safety (%) =
Sales (Actual or Budgeted)
• Margin of Safety is like buffer sales.
• When you want to find out the percentage by which, if you decrease sales, you will lose
money, you first calculate the breakeven point in sales or units, as required, and then
compare that to the expected sales in either sales or units, as required – either way you’ll
get the same percentage.
• The degree of operating leverage helps us in determining what the net income will be like
if your sales are increased by a certain percentage – your net operating income will
increase by (DOL x percentage by which sales will increase) percent.
• When a firm is closer to their breakeven point, and we have an increase in sales, that’s
going to have a bigger effect on the bottom line.
• Degree of operating leverage is not constant.
• To do the CVP analysis for the number of units needed or the amount of sales to target
after-tax profit, we use the following formulas:
Target After-Tax Profit
Total Fixed Costs + ( 1 - Tax Rate
)
Number of Units =
Unit Contribution Margin
Target After-Tax Profit
Total Fixed Costs + ( )
1 - Tax Rate
Sales Dollars =
Contribution Margin Ratio
• Budgets – are plans/charting the course of how an organization is going to obtain and use
resources over a specific period of time.
• Purposes of budgeting:
• Planning – set goals for managers and employees
• Control – ensuring all employees move towards the set goal
• The budgeting process is used for:
• Allocating resources to different departments
• Forcing managers to think long term
• Coordinating the activities of different departments
• Evaluating managerial performance on the basis of budgeted and actual amounts and set
benchmarks for employees in the company
• In traditional budgeting, executive level employees would dictate numbers to frontline
managers and have them stick to those numbers. This technique evolved into participative
budgeting because the frontline managers have more information regarding the processes
and can give more accurate and realistic input to the budget.
• In participative budgeting there is higher motivation in employees because of the
budgeters collaborating with them.
• There’s more accountability on the part of employees in participative budgeting.
• A major issue with participative budgeting is budgetary slack – the frontline managers have
an incentive to understate numbers so that they are seen as outstanding performers when
they perform over and above what they stated (which is the true number).
• The budgetary slack affects the departments that follow the one that has stated incorrect
figures.
• You need some scrutinizing and policing in the participative budgeting method to avoid
budgetary slacks.
• Rolling budgets are also called continuous or perpetual budgets.
• In a rolling budget, you always have a 12-month budget – when one month ends, you
budget for the 13th month, which then becomes the 12th month of the new set of 12
months.
• Zero based budgeting – in this budgeting process, each line-item in the statement needs
to be justified – you don’t use the figures for a certain expense that have been used
historically, you start from 0 and see how much is required and then budget for it with a
realistic and approved reason.
• Master budget is a series of interrelated budgets that deal with the firm’s goals.
• The master budget begins with the sales budget – this is the foundational budget without
which other budgets cannot be made.
• Through marketing forecast, you find out how many units you expect to sell – this
forecasted amount is used by sales to come up with the sales budget, and then the
production budget uses this number to plan how much to produce.
• The SG&A budget is also created from the Sales budget.
• The ending inventory budget is created from the production budget because we want to
keep a certain ending inventory at times too.
• The production budget is used to create direct materials budget, direct labor budget and
manufacturing overheads budget, for a manufacturing firm.
• The production budget is used to create merchandising or retailing budget for a retail firm.
• The next important budget after the sales budget is the cash budget because we don’t
want to run out of cash during our operating period.
• The cash budget is the last budget you make because you need the following budgets first:
sales budget, production budget, ending inventory budget, direct materials budget, direct
labor budget, manufacturing overheads budget and the SG&A budget.
• Using these budgets, we make budgeted income statement and budgeted balance sheet.
• To make the sales budget, we need the expected sales in units and the expected selling
price of these units.
• The sales budget also includes a schedule of cash collections.
Sales Budget
Q1 Q2 Q3 Q4 Year
Units to be Sold (Q)
Selling Price per Unit (P)
Total Sales (Q x P)

Schedule of Cash Collections

Q1 Q2 Q3 Q4 Year
Accounts Receivable
(Beginning Balance)
Q1 Sales
Q2 Sales
Q3 Sales
Q4 Sales
Total Sales
• The production budget is used to plan for the number of units that need to be produced
to meet the sales need and the desired ending inventory need.
• The production budget is as follows:
Production Budget
Q1 Q2 Q3 Q4 Year
Budgeted Sales
Add: Desired Ending
Inventory
Total Production Need
Less: Beginning Inventory
Budgeted Production
• The direct materials budget, using the production budget, will be as follows:
Direct Materials Budget
Q1 Q2 Q3 Q4 Year
Required Production (in units)
Raw Materials Needed per
Unit (unit of measure)
Production Needs (unit of
measure)
Add: Desired Ending Inventory
of Raw Materials
Total Needs
Less: Beginning Inventory of
Raw Materials
Raw Materials to be Purchased
Cost of Raw Materials (per unit
of measure)
Cost of Raw Materials to be
Purchased
• The direct labor budget, using the production budget, will be as follows:
Direct Labor Budget
Q1 Q2 Q3 Q4 Year
Required Production (in
units)
Direct Labor Hours per unit
Total Direct Labor Hours
Needed
Direct Labor Cost per Hour
Total Direct Labor Cost
• The manufacturing overheads budget, using the production budget, on the basis of direct
labor hours (chosen cost driver), will be as follows:
Manufacturing Overheads Budget
Q1 Q2 Q3 Q4 Year
Budgeted Direct Labor Hours
Variable Manufacturing Overhead Rate
Total Variable Manufacturing
Overhead
Total Fixed Manufacturing Overhead
Total Manufacturing Overhead
Less: Depreciation
Cash Disbursements for Manufacturing
Overhead
• We can calculate the pre-determined overhead rate that has both the variable and fixed
costs by using the manufacturing overheads budget, using the formula:
Total Manufacturing Overhead
Pre-Determined Overhead Rate =
Budgeted Cost Driver
• This pre-determined overhead rate is then used to calculate the ending inventory and the
COGS for the budgeted income statement and budgeted balance sheet.
• The SG&A Expense has two components to it – a fixed component and a variable
component.
• The SG&A Expense Budget is as follows:
SG&A Expense Budget
Q1 Q2 Q3 Q4 Year
Budgeted Sales (in units)
Variable SG&A Expense per unit
Total Variable SG&A Expense
Fixed SG&A Expenses:
Property Taxes
Insurance
Depreciation
Advertising
Total Fixed SG&A Expense
Total SG&A Expense
Less: Depreciation
Cash Disbursements for SG&A Expense
• You have to have all other budgets made before you make the cash budget.
• The cash budget, using the disbursements of all other budgets, will be as follows:
Cash Budget
Q1 Q2 Q3 Q4 Year
Cash, Beginning Balance
Plus: Cash Receipts
Cash Available
Minus: Disbursements
Direct Materials
Direct Labor
Manufacturing Overheads
SG&A Expense
Total Disbursements
Excess (Shortage)
Borrowings
Minus: Repayments
Minus: Interest
Cash, Ending Balance
• Advantages and Disadvantages of Budgeting:
Advantages Disadvantages
Helps with planning and control. It is time consuming.
Leads to a lot of quarrels between
Force people to think about the future. departments on who should get how
much resources.
In some cases, it can be very inaccurate
Helps in achieving goals. because forecasts were not made
properly.
Helps in coordinating resources between Can result in biased forecasts because
departments. managers would want to show their
Helps in managing the cash in a company. performance as better (budgetary slack).
Allows you to measure whether you’ve Leads to wasteful spending because of a
achieved your goals and by how much. use-it or lose-it mentality.
If managers deviate from intended Leads to inflexible decision making
performance, then managers can take because your money is tied up and not
action. available for opportunities.
Can demoralize employees if the budget is
too aggressive.
• When the activity ends up being different from what was planned, then you use flexible
budgets to make adjustments.
• You do flexible budgeting by calculating your budget again based on your new activity
levels so you can compare them to your actual revenues and expenses to evaluate the
performance of your workers:
Planning Budget Activity Variances Flexible Budget
(Based on Forecasted (Flexible Budget – (Based on Actual
Activity Levels) Budget) Activity Levels)
Units (Q)
Revenue (P x Q)
Expenses:
Expense A (a x Q)
Expense B (b x Q)
Fixed Expense 1 -
Fixed Expense 2 -
Operating Profit
• If the activity variance or the revenue/spending variance is:
Item Nature of the Amount Denoted by
Revenue Positive F (favorable)
Revenue Negative U (unfavorable)
Expense Positive U (unfavorable)
Expense Negative F (favorable)
Profit Positive F (favorable)
Profit Negative U (unfavorable)
• When we start comparing our actual revenues and spending, the following schedule is
created:
Planning Flexible
Activity Revenue or
Budget Budget
Variances Spending
(Based on (Based on Actual
(Flexible Variances
Forecasted Actual Results
Budget – (Actual Result –
Activity Activity
Budget) Flexible Budget)
Levels) Levels)
Units (Q)
Revenue
(P x Q)
Expenses:
Expense A
(a x Q)
Expense B
(b x Q)
Fixed
-
Expense 1
Fixed
-
Expense 2
Operating
Profit
• Advantages and Disadvantages of Flexible Budgeting:
Advantages Disadvantages
Allows comparison between actual and Accurate formula creation for predicted
budgeted (flexible) amounts. mixed costs can be time consuming.
Very useful for businesses where costs are
Not good for companies that have
mainly driven by activity levels (high
mainly fixed costs.
variable cost firms).
You make different budget models for
different possible scenarios for comparison
(sensitivity analysis).
• Responsibility accounting is when you divide your organization into responsibility centers.
• Responsibility accounting is usually used in large decentralized organizations.
• Responsibility accounting makes it easier to reach out the relevant people assigned those
responsibilities for required action or concern.
• Responsibility center – a subunit of an organization in which the manager is responsible
for costs, revenues, profits and/or investments. There are 4 types:
Responsibility Center Manager Responsible For
Cost Center Costs
Profit Center (when costs are significant) Revenues and Costs
Revenue Center (when costs are minimal) Revenues
Investment Center Costs, Revenues & Investments
• Depending on the nature of the department, the appropriate responsibility center is
assigned to the manager of that department.
• When calculating variances between flexible budgets and actual costs, we have to see
whether the quantity was the issue, or the cost was the issue – variance analysis.
• In the variance analysis we compare standard costs/prices and quantities with actual
costs/prices and quantities to see whether we have a price variance or a quantity variance.
• Variance Analysis:
Actual Budgeted Applied
Actual Quantity x Actual Price Actual Quantity x Standard Price Standard Quantity x Standard Price

The difference between these two is The difference between these two is
the Price Variance the Quantity Variance
• Price Variance tells us the difference between the standard price that was set and the
actual price we paid.
• When SP < AP, then our price variance is unfavorable.
• When SP > AP, then our price variance is favorable.
• When SQ < AQ, then our quantity variance is unfavorable.
• When SQ > AQ, then our quantity variance is favorable.
• A favorable or unfavorable variance isn’t necessarily good or bad, respectively. It can also
reflect badly from the customer’s perspective because maybe you didn’t put enough
quantity in the product, as much as you should have, and the customer didn’t like it.
• Total Variance is the difference (if one is favorable and the other is unfavorable) between
or the sum (if both are either favorable or unfavorable) of the price and quantity variances.
• When you’re doing the variance analysis for direct materials, where not all the material
has been used, you make one slight change – you calculate the middle column of the table
above twice – once for the price variance using the total actual quantity, and once for the
quantity variance using the used actual quantity.
• Usually price variances are traced back to purchasing managers, whereas quantity
variances are traced back to production manager.
• When doing variance analysis for direct labor, we calculate rate variance instead of price
variance and efficiency variance instead of quantity variance.
• Advantages & Disadvantages of Standard Costing:
Advantages Disadvantages
Makes the standard setting process political
Allows managers to perform
because managers then set achievable goals that
variance analysis.
make them look good.
Through variance analysis,
There is a time lag because we need to know
managers can set benchmarks and
results to do the variance analysis.
identify red flags.
It facilitates responsibility doesn’t tell the root cause of an unfavorable
accounting. variance clearly.
At times, favorable variances can be misleading.
In order to meet standards, managers might
distort procedures/quality.