Module Introduction

Hello Dear Learners,

Well come to your second module on cost and management accounting. This module is a
continuation of your pervious semester course in cost and management accounting. In
the first module you studied the fundamentals of cost and management accounting and
how cost data are processed and presented for financial statement preparation and
managerial decision making purpose.

The focus in this module is on the application of cost and management techniques and
tools for managerial decision making process. The management process refers to the
different cyclical functional activities and all that activities in the process could not be
performed without the help of management accounting information. Therefore to be
successful in you carrier as an accountant who process and cost and management
information and or taking part in various operational and strategic management decisions
you need to critically go through the topics in this module, do the exercise and problems.
The module contains seven units. On the first chapter you will be acquainted with the
concept of management accounting and how it helps in managerial decisions making.
The second unit deals with how budget as management accounting is used in planning in
the organization. The third and fourth unit will expose you to the application of budget
and variance analyses as a management control function. On the last three units, the cost
volume profit analysis, relevant information and transfer pricing are discussed.

MODULE OBJECTIVES
After completing the course in this module you will be able to:

 Describe how cost and management accounting is useful in the management

decisions
 To apply the concept, techniques and tolls of management accounting in
managerial decision at various functional and level of management an
organization

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 Understand and use of budget in planning and controlling organizational
performance
 Understand the concept of standard costing and variance analysis
 Perform variance analysis and find out reason for variance for budgeted and
actual performance
 Understand and apply the concept of cost-volume-profit analysis in profit
planning
 Able to differentiate relevant and irrelevant information in decision making
 Understand transfer pricing

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 CHAPTER ONE
Introduction to Management Accounting
UNIT OUTLINE
 Unit objectives
1. Introduction
1.1. Meaning and Role of Management Accounting
1.2. The Management Process and Accounting
1.3. Financial and Managerial Accounting
 Unit Summary
 Model Exam Questions

Unit Objectives:
After completing this unit, you will be able to:

 Explain the meaning and role of management accounting

 Explain how management accounting information system facilitate functions in
the management process
 Explain the difference and relationship between managerial and financial
accounting.

1. Introduction

To manage diverse operations of organizations managers need monetary and

nonmonetary information that helps them to analyze and solve problems by reducing
uncertainty. Accounting, often referred to as the language of business, provides much of
that necessary information. Accounting language has two primary “variations.” financial
accounting and management accounting. Cost accounting is a bridge between financial
and management accounting.
Accounting information addresses three different functions: (1) providing information to
external parties (stockholders, creditors, and various regulatory bodies) for investment
and credit decisions; (2) estimating the cost of products produced and services provided
by the organization; and (3) providing information useful to internal managers who are
responsible for planning, controlling, and decision making, and evaluating performance.

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Financial accounting is designed to meet external information needs and to comply with
generally accepted accounting principles. Management accounting attempts to satisfy
internal information needs and to provide product costing information for external
financial statements.
Activity1. List and explain the three major functions of accounting information
______________________________________________________________

1.1. Meaning and Role of Management Accounting

Management accounting can be defined as the process of identification, measurement,
accumulation, analysis, preparation, interpretation, and communication of financial as
well as non financial information used by management to plan, evaluate, control within
the organization and to assure appropriate use and accountability for its resources.
The management accountant is expected to provide timely, accurate information-
including budgets, standard costs, variance analysis, support day-to-day operating
decisions, and analyses of expenditures.
The management accounting consists of accounting techniques and procedures of
gathering and reporting financial, production, and distribution data in order to meet
management’s information needs.
The importance or role of management accounting can be explained in the following
points:
1. Planning: business planning is a basic function of management. For example,
deciding what products to make, and where and when to make them, determining
the materials, labor, and other resources that are needed to achieve desired output.
In not-for-profit organizations, deciding which programs to fund. During this
planning function management needs the help of the Management Accounting
system.
2. Effective Control: Accounting information is useful in control and as a means of
communication and motivation. Periodically, management needs to evaluate as to
how well the employees are doing their jobs. Such as an appraisal of performance
results in corrective action of various kinds.

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 In general management accounting greatly assists the management in achieving better
results by making a clear shift in emphasis from mere recording of transactions to their
analysis and interpretation to give a new vista to the management.

1.2. Management Process and Accounting

The management process summarizes the major activities performed by management in

leading an organization. A manager’s work generally involves a cycle:
(a) Setting organizational objectives,
(b) Formulating an operating plan,
(c) Implementing the plan,
(d) Measuring the results,
(e) Evaluating the results to see if the plan was properly implemented and the
objectives of the organization are being accomplished.
Organizational objectives are not changed frequently, although slight modifications may
be made annually to keep them current and at a realistic level of aspiration.
The operating plan is formulated for a specific period of time, such as one year, and is
prepared in detail. Central to each of the planning activities, there is the accounting system.
Financial resources available in the business, as indicated in accounting reports, are
frequently a limiting factor in the development of organizational objectives. The planning
process results in a budget representing the formal plan of operations for the coming year.
The accounting function measures the results of operations and compares them with the
planned level of operations. Differences between the actual results and planned results help
management to evaluate each area of the business and to identify areas in which corrective
action is required
Activit1.2:
1. Define management accounting and explain its role in an organization.
_____________________________________________________________________

2. Explain how management accounting assists managers under the management

process.____________________________________________________

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 1.3. Financial and Managerial Accounting

The primary differences between these two accounting disciplines are described as
follows: Financial accounting must comply with the generally accepted accounting
principles (GAAP) or International Financial Reporting Standards (IFRS) depending
upon the accounting and reporting practice adopted by a country. The information used in
financial accounting is typically historical, quantifiable, monetary, and verifiable. These
characteristics are essential to the uniformity and consistency needed for external
financial statements. Financial accounting information is usually quite aggregated and
related to the organization as a whole. In some cases, a regulatory agency such as the
Inland Revenue and some agencies having the mandate of supervising specific sectors
such as National Banks may mandate financial accounting practices. In other cases,
financial accounting information is required for obtaining loans, preparing tax returns,
and understanding how well or poorly the business is performing.

By comparison, management accounting provides information for internal users.

Because managers are often concerned with individual parts or segments of the business
rather than the whole organization, management accounting information commonly
addresses such individualized concerns rather than the “big picture” of financial
accounting. Management accounting is not required to adhere to generally accepted
accounting principles in providing information for managers’ internal purposes. It is,
however, expected to be flexible in serving management’s needs and to be useful to
managers’ functions. A related criterion is that information should be developed and
provided only if the cost of producing that information is less than the benefit of having
it. This is known as cost-benefit analysis. These two criteria, though, must be combined
with the financial accounting information criteria of verifiability, uniformity, and
consistency, because all accounting documents and information (whether internal or
external) must be grounded in reality rather than whim.

The objectives and nature of financial and management accounting differ, but all
accounting information tends to rely on the same basic data system and set of accounts.
The accounting system provides management with a means by which costs are
accumulated from input of materials through the production process until completion and,

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ultimately, to cost of goods sold. Although technology has improved to the point that a
company can have different accounting systems designed for different purposes, some
companies still rely on a single system to supply the basic accounting information. The
single system typically focuses on providing information for financial accounting
purposes, but its informational output can be adapted to meet most internal management
requirements.
Activity1:3. Explain the difference and similarities between financial and managerial
accounting.____________________________________________________________

Model Examination Questions

PART I: MULTIPLE CHOICE QUESTIONS
(1) Pick the wrong statement from the following about management Accounting.
A) It uses information from cost accounting.
B) Solely manufacturing businesses uses it.
C) It provides information for decision-making.
D) Only [A] and [C]
E) None of the above.
(2) The management process in an organization involves the following, except
A) Setting organizational objectives.
B) Formulating an operating plan.
C) Measuring and evaluating results.
D) All of the above.
E) None of the above.
3. Managerial accounting:
A) involves the financial history of an organization.
B) Is governed by GAAP.
C) Focuses primarily on the needs of personnel within the organization.
D) Provides information for parties external to the organization.
E) Focuses on financial statements and other financial reports.
4. Managerial accounting differs from financial accounting because financial
accounting is:
A) more oriented toward the future.

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 B) Primarily concerned with external financial reporting.
C) Concerned with qualitative information.
D) Heavily involved with decision analysis and implementation of decisions.
E) None of the above.
5. Which of the following statements represents a similarity between financial
and managerial accounting?
A) Both are useful in providing information for external users.
B) Both are governed by GAAP.
C) Both draw upon data from an organization's accounting system.
D) Both use similar methods of reporting financial statements.
E) Both are solely concerned with historical transactions.

Answer to Model Examination Questions

1. C 2. E 3. C 4. B 5. C

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 UNIT TWO

MASTER BUDGET AND RESPONSIBILITY

ACCOUNTING
UNIT OUTLINE

 Unit objectives
2.1. Introduction
2.2. Budget in general
2.2.1. Strategic planning and its implementation
2.2.2. Budget and the budget Cycle
2.2.3. Purpose of budget
2.2.4. Types of budget and Budgeting techniques
2.3. Budget in business organization
2.3.1. Introduction
2.3.2. Process of developing a master budget
2.3.2.1. Process of developing an operating budget
2.3.2.2. Financial budget
2.4. Responsibility Accounting
2.5. Budget Administration
2.5.1. Budget Manual
2.5.2. Behavioral Implication of Budget
2.5.3. Budgetary Slack
 Unit summary
 Model Examination Questions

UNIT OBJECTIVES
After completing this unit, you will be able to:

 Explain the purpose of budgeting

 Explain how strategic planning is related to budgeting
 differentiate the different types of budget budgeting techniques
 prepare a master budget
 Explain the importance of cash budget in the master budgeting process
 Explain how adopting responsibility accounting facilitate management control

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2.1. Introduction

This unit contains two different topics Master Budget and Responsibility Accounting.
The first portion is about master budget which is an important management accounting
tool for planning future activities and controlling current operation in the organization.
Budgets are crucial to the ultimate financial success of any organization. Budgets are so
important, mainly because they serve as road map towards achieving organizational
goals. Budgets as a management accounting tool helps management in planning,
controlling and performance evaluation. In this unit you will study how budget is used in
planning the operation of an organization.
2.2. Budgeting in General

There are different types of organizations in today world. Generally these organizations
can be divided as profit making organization and not for profit organizations. The main
objective of profit making organization is making profit. There for in a for profit oriented
company, decisions made by management are intended to increase or at least maintain
profit. Success is measured to a significant degree by the amount of profit the
organizations earn. A not for profit organization is an organization whose goal is
something other than earning a profit for its owners. Usually its goal is to provide service.
In not for profit organization, decisions made by management ordinarily are intended to
produce the best possible service with the available resources.

Success in a not for profit organization is measured primarily by how much service the
organization provided and by how well these services are rendered. Most basically, the
success of a not for profit organizations is measured by how much it contributes to the
public well being.

Since service is vague and less measurable concept than profit, it is more difficult to
measure performance in not for profit organization. Despite these complications,
management must do what it can do to assure that resources are used efficiently and
effectively.

Despite the difference in the objective of organization, all of them have to plan what they
want to achieve. Planning is the process of establishing enterprise objective. There should

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be agreement among and all levels of management as to the objective of the company and
the proposed means of accomplishing them.

Developing a budget is a critical step in planning any economic activity. This is true for
business, for government agencies and for individuals. We must all budget our money to
meet day to day expense and plan for the major expenditure, such as buying a car or
paying for college tuition. Similarly, business of all types and government units at every
level must make financial plans to carry out routine operation, to plan for major
expenditure and to help in making financing decision.

Most people associate the word “budget” with the approving, rejecting or arguing over
various budgets. Tax payers demand that governments plan the effective use of their hard
earned tax dollars and budget not only allow government to plan spending , but also
allow tax payers to see exactly where and how their many is being spent. Government
and government agencies, however, tend to use budget only as a means of limiting
spending. In contrast, most business organizations use budget to focus attention on
company operation and financial not just to limit spending. Budget highlights potential
problem and advantage early, allowing management to take steps to avoid these problems
or use the advantages wisely. Thus, a budget is a tool that helps managers in both their
planning and control function. A budget is a formal written summery (statement) of
management plan for a specific future time period expressed in financial terms. It
normally represents primary means of communicating agreed up on objectives
throughout the business organization. Once adopted, a budget becomes an important
basis of for evaluating performance. Thus, it promotes efficiency and serves as a
deterrent to waste and inefficiency

Activity2.2: Define budget and explain why organizations prepare

budget._________________________________________________

2.2.1. Strategic Planning and Its Implementation

Planning is the first function of management. It is performed continuously because the

passages of time demand both re-planning and making new plans. More over current
feedback often necessitates newly planned action to,

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  Improve current performance deficiency
 Cope with unanticipated events that are unfavorable, and
 Take advantage of new development
Management planning is a process that includes the following five stapes
1. Establish enterprise objective and goals
2. Developing premise about the environment of the entity
3. Making decision about course of action
4. Initiating actions to activate the plans
5. Evaluating performance for re planning

The development of organization objectives is the most fundamental level of the planning
process. Objective states the desired, broad, long range future state of the organization .For
example, the objective for a manufacturing Company should relate to such basic issue as
breadth of the product line, quality of a product, growth expectations etc. The next planning
level is known as goals, which represent the broad objective brought in to sharper focuses by
explicitly specifying
 The time dimension for attainment
 Quantitative expression and
 Subdivision of responsibility
For example, goals would explicitly state such items as the following. Three years from
now the new product being developed will be introduced. The return on investment goal
for the next year will be 15% and the profit goal of product A is 5% of sales for next
year. To establish the foundation for the attainment of the enterprise objective and
specific goals, management must develop strategies to be pursued by the entity.

Strategy specify the “how’; they detailed the plan of attack to be used in pursuing the
goals operationally. For example, the strategy for a company may include expanding the
current sales territory, reducing the selling price to attract higher volume, increasing the
advertising and financing the expansion with debt rather than equity.
Finally, the most detailed level of planning occurs when management operationallize the
objective, goals and strategies already established by incorporating them in the budget. A
budget is a financial and narrative expression of the expected result from the planning
decision.

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Activit2.21: Explain the relationship between strategic planning related to budgeting.
__________________________________________________________________

2.2.2. Budget and the Budget Cycle

Most people associate the word “budget” with the approving, rejecting of resource
spending. If we associate budget with the government activities, governments usually
request their various agencies to prepare their resource requirement so as to examining
and approve the reasonableness and importance of the budget. Once the approved, the
budget then will be used as a blue print for the agencies activities and means of
controlling and limiting their spending.

In contrast, most business organizations use budget to focus attention on their companies’
operation and financial implication of their planned operation; not just to limit spending.
Budget highlights potential problem and advantage early, allowing management to take
steps to avoid these problems or use the advantages wisely.

Thus, a budget is a tool that helps managers in both their planning and control function. A
budget is a formal written summery (statement) of management plan for a specific future
time period expressed in financial terms. It normally represents primary means of
communicating agreed up on objectives throughout the business organization. Once
adopted, a budget becomes an important basis for evaluating performance. Thus it
promote efficiency and serves as a deterrent to waste and inefficiency

 Budget in brief is a future plan of action expressed in quantitative terms which

is also an aid to management control and performance evaluation

Budget can cover both financial and non financial aspects of the plan that can serve as
blue print for the organization to follow in an upcoming period. A budget covers financial
aspects and quantities of management expectation regarding income, cash flows, and
financial position. Like financial statements present the historical financial condition
and operating results of the business, budgeted balance sheet, cash flow and income
statement are also prepare to show the future financial condition and operational
performance. Budgeted financial statements are usually supported by detail schedule of

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the various operation of the firm, so budget also include nonfinancial aspects of the plan
such as units of output to be produced and sold, number of employee and working hours,
etc.

Budget is a cyclical and sequential activity. In a well managed companies, budget usually
cycles through the following steps:

1. Planning the performance of the company as a whole, as well as planning the

performance of its subunits (such as department or divisions). Managers at all
level agree on what is expected.
2. Providing a frame of reference, a set of specific expectations against which actual
results can be compared
3. Investigating variations from plans. If necessary, corrective action follows
investigation
4. Planning again, in light of feedback and changed condition.

2.2.3. Purposes of Budget

 Dear learners, based upon the explanations given above, can you mention why
budget is prepared?

Budget prepared as a formal business plan is used by all managers at different functional
areas and managerial level. Further budget is used by all types of organizations, be it a
business organization, government organization or NGO. When administered wisely
budget can provide the following benefits:

i. Efficient Allocation of Resources

Resource available to meet the objective of any organization is generally limited;

therefore efficient allocation of recourse is one of the prerequisite for successful
attainment of organizational goal. For example, an office of a city Administration must
allocate its revenue among basic societal service such as security and protection, heath,
education, infrastructure etc. In the case of business organizations, the well designed
business strategy hardly become successful without availability and efficient allocation of
resource. Therefore, adopting formal budgetary process helps organization to identify the

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resource requirement of the planed activity and allocate in accordance to the priority of
each operation in achieving org-anizational objective.

ii. Compel strategic planning and implementation of plans

The budgeting process forces managers to plan ahead. The development of budget
triggers managers to plan their operation ahead as well as to prepare on the ways of
talking any change during the implementation of the plan.

Budget enable the successful implementation of strategy that is why in most business
organization budget is considered as an integral part of strategic planning and
implementation.

iii. Facilitating coordination and communication

For any organization to be effective, each manager throughout the organization must be
aware of the plan made by other managers. In large and diverse organizations the
problem of coordination becomes critical. An important role of budgeting is to improve
the coordination among the various units of the organization. Planning or budgeting
means establishing objectives in advance and identifying the steps by which the
objectives are to be accomplished. The planning process initiates coordination and
clarification of sub-goals to achieve major enterprise goals. The coordinated plan or
budget provides a blue print for implementation and control.

 A good budgeting process facilitates communication in all direction in the

organization and help coordinating the various resources, manpower and
units of the organization so that goal of the organization is achieved.

iv. Frame work for judging performance

Once plans are in Place, Company’s performance can be measured against the budget
established for those plans. Budget can overcome two limitations of using past
performance as abases of judging actual results. one limitation is that past results
incorporate past misuse and sub standard performance and the other limitation of

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 using past performance is that the future conditions may be expect to differ from the
past.

 As a performance evaluation basis budgeted performance are better than

actual results.

V. Motivating Managers and Employees

Research shows that budgets that are challenging improve performance. An inability to
achieve budget numbers is viewed as filer. Most individuals are motivated to work more
intensely to avoid failure than to achieve success. As individuals get closer to goal they
work harder to achieve it. For this reason many executives like to set challenging but
achieve goal for their subordinates .Creating attitude of anxiety improves performance,
but overly ambitious and unachievable budget increase anxiety without motivation that is
because individuals see little chance of avoiding.

Activity2.2.3: Discuss the benefits that a company may derive from a formal budgeting
process________________________________________________________________

2.2.4. Types of budget and budgeting Techniques

The type of budget used by different organization differs based upon the nature of their
business and the purpose of the budget; however, the general frame work is the same. In
this section we will try to see the different type of budget their advantage and
disadvantage and in what circumstance organizations prefers to adopt a specific type of
budget and budgeting techniques.

(1) Strategic Plan: The most forward looking budget is the strategic plan, which sets
the overall goals and objective of the organization. Some organization won’t
classify the strategic plan as an actual budget though because it does not deal with
a specific time frame and it does not produce forecasted financial statement. In
any case, the strategic plan leads to long range planning which produce forecasted
financial statement for five or ten years. The financial statements are estimates of
what management would like to see in the company’s future financial statement.

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 Decisions made in long range planning include addition or deletion of department,
acquisition of a new equipment or building and other long term commitment.
(2) Capital Budget: Capital budget is a budget that details the planned expenditure
for facilities, equipment, new product, and other long-term investments.
(3) Master budget: A master budget is a short-term, comprehensive plan to achieve
the financial and operational goals of an organization. Master budget comprises of
the organizations overall plan for the given period and the budget for the various
functional areas the make up the organization.

Activity2.2.4(A) : Can you explain the difference between long range and short term
planning________________________________________________________________

 Long rang plane and budget gives an organization a direction and goals for
the future while short term plane and budget guide the day to day operation.
Both long term and short term budgets are relevant for archiving the overall
goal of an organization, so managers are advised to give a reasonable
attention to both short and long term budgets.

Managers who pay attention to only short term budget will quickly lose sight of long
term goals similarly managers who pay attention to only the long term budget could wind
up mismanaging day to day operation. There has to be a happy medium that allows
managers to pay attention to their short term budget while still keeping an eye on long
term plan.

Master budget can be prepared as a standalone for one year or one operating cycle or in a
continuous basis. Continuous budget or rolling budget or revolving budget are a very
common form of a master budget that simply add a month in the future as the month just
ended is dropped. Budgeting thus becomes an ongoing instead of periodic process.
Continuous budgets for managers to allow think about the next twelve months not just the
remaining month in fixed budgeting cycle. As they added a new twelfth month to
continuous budget, managers may update the other month as well. They can compare
actual monthly result with both the organization plan and the most recent revised plan.
Continuous budgeting approach in preparing master budget is adapted mostly when the
business environment is volatile to coup up with the change.

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Different organizations prepare budget using different techniques that may be grouped as
follows:

(1) Incremental budgeting: is a budget set based on past year’s actual performance.
In this technique a budget for the coming year is simply this year budgeted or
actual results plus or minus some amount for expected change on planned
operation or change in the market price. This budgeting technique is easy and
widely used, however it has its own draw back. As the base is the current year
performance or budget any anomaly in the current year performance or budget
may be incorporated in the budget.
(2) Zero based budgeting: In a dynamic business it often makes sense to 'start
afresh' when developing a budget, rather than basing ideas too much on past
performance. In this technique each budget is therefore constructed without much
reference to previous budgets. Preparing a budget afresh is usually required in
most business organizations, where the business environment is volatile that
require continues effort of incorporating changes in budget thinking.
(3) Rolling budgets: Given the speed of change and general uncertainty in the
external environment, shareholders seek quick results. US companies typically
report to shareholders every three months, compared with six months in the UK.
Rolling budgets involve evaluating the previous twelve months' performance on
an ongoing basis, and forecasting the next three months' performance.
(4) Strategic budgeting: This involves identifying new, emerging opportunities, and
then building plans to take full advantage of them. This is closely related to zero
based budgeting and helps to concentrate on gaining competitive advantage.
(5) Activity based budgeting: This examines individual activities and assesses the
strength of their contribution to company success. They can then be ranked and
prioritized, and be assigned appropriate budgets.

Activities2.2.4. (B):

2.2.1. differentiate the types of budget_______________________________

2. List and explain the different types of budgeting techniques

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 ___________________________________________________________

3. Can you explain how zero based budgeting can help in reducing the
drawbacks of incremental budgeting?

_________________________________________________________

2.3. Budgeting in business organization

2.3.1. Introduction

The type of budget and the extent of the budgeting activity vary considerably from
organization to organization. In smaller business organization, there may only be a sales
forecast, a production budget or a cash budget, larger organization generally prepare a
master budget or a comprehensive budget.

A master budget involves the development of a complete set of financial statement for the
budget period with supporting schedule. The primary responsibility for developing a
master budget is given to the controller and her or his staff. In large organization, a
special budget committee will be formed.

The budget committee is usually composed of several key executive from various
segment of the organization. People from finance, sales, purchasing, production,
engineering and accounting are usually represented. The procedure followed by this
committee in developing the budget is largely determined:

 By the authority it has over the finance budget

 By the amount of participation it allows from others within the organization.

The authority of the budget committee is determined by top management philosophy; top
management may have a predetermined profit objective in mind and will look to the
budget as a means to accomplish it. This objective may be stated in variety of ways, such
as rate of return on net asset, earning per share, or a specific amount of net income. It
may be based on operating results of previous years adjusted for expectations about the

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coming year or some desired level of profitability. When top management has a
predetermined profit objective, the budget committee must recognize it and develop a
budget that will achieve it.

If top management has no specific profit level in mind, the budget committee must first
develop some nation about what is fair and reasonable expectation for the budget period
without this, the budget process often turn in to “game” and much of the benefit is lost.

The budget committee may or may not invite other members in the organization to
participate in developing the budget. In estimating sales for the coming period, for
example, sales people may be asked to project the number of units of each product they
expect to sell in their territories.

The sales representative on the budget committee would use these as a basis for
developing the sales forecast for the entire company participation could be carried to the
extreme and every person in the organization could asked to estimate productivity in her
or his individual area. On the other extreme, the budget committee may allow no
participation. It merely may develop a budget that will achieve the desired profit and pass
it on as the standard of performance for the budget period. More will be said about the
behavioral considerations associated with employee participation in developing the
budget.

Activity 2.2.1.

1. Who are the members of a budget committee in business organizations?

__________________________________________________________________

2. Is there any difference between the budgeting process of large and small business
organizations? Explain ____________________________________________

2.3.2. Process of Developing a Budget

Although each organization is unique in the way it puts together its budget, all
budgeting process share some common elements. After organizational goals, strategies,
and long range plans have been developed, work begins on the master budget, a detailed

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budget for the coming fiscal year with some detail.
The master budget is a comprehensive financial plan for a business. It is made up of the
Operating and Financial budgets, which are in turn made up of supporting schedules
(budgets).
To envision the master budget process, picture the financial statements most commonly
prepared by companies: The income statement, the balance sheet, the cash flow
statement. Then imagine the preparation of these statements before the fiscal period
operational period.

2.3.2.1. Parts of A Master Budget

 What are the parts of a master budget?

As shown on figure on the next page master budget consists of two major parts, namely:
the operating budget and financial budget.
i Operating budget refers to the budgeted income statement and the
supporting budget schedules for various business functions in the value
chain. The operating budget basically shows the expected operating result of
the organization in the upcoming operational period.

ii The financial budget is part of the master budget made up of the capital
expenditures budget, the cash budget, the budgeted balance sheet, and the
budgeted statement of cash flow.

Activities2.3.

1. What are the two major parts of a master budget?

______________________________________________________
2. What is the difference between an operating and financial budget?
___________________________________________________________

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 An Overview of a Master Budget

Sales Budget

Ending Inventory Production Budget

Budget

Direct Material Direct Labor Budget Manufacturing

Budget Overhead Budget

Cost of Goods Sold

Budget

Operating Expense/none manufacturing

overhead/ Budget

Budgeted Income statement

Capital Cash Budget Budgeted Balance Sheet Budgeted Cash

Expenditure Flow statement
Budget

2.3.2.2. Steeps in Budget development

 Dear learners, from the above parts of this unit you have seen how budget is
useful in an organization, the types of budget and budgeting techniques. As you
all understand in most business organizations there is a formal process of
preparing budget for the coming fiscal in the form of a comprehensive master
budget. If you are asked to prepare a master budget how can you start? Is it the
operating budget or the cash budget that must be prepared? What are the
relevant data and how they are processed and result the final master budget?
Well, on the following section you are provided with answer for the above
questions with illustrative examples

22
 2.3.2.2.1. Steps in developing an operating budget
The Operating Budget refers to the budgeted income statement and all the supporting
schedules.

 Dear learners, if you are given a responsibility of preparing an operating

budget or coordinating the budgeting process, do you know where and how to
start?

One way to think about this question is to understand that the organization has more
control over some aspects of the business (for example how much to produce) and less
control over other aspects, (the demand for its product and service).
For most organizations sales is uncertain. Therefore, beginning with sales forecast, the
firm can plan the activities over which it has more control. As better information about
sales becomes available, it is reasonably easy to adjust the rest of the budget. If, on the
other hand, production is more uncertain than sales, the firm may want to begin with a
raw material and production forecast so as to reduce the uncertainty related to production.
To clearly understand the steps in development of an operating budget, conceder the
budget information gathered by the controller of Gibe Furniture Manufacturing company
during the process of budgeting for the upcoming fiscal year, 2011.

The summary of required budget information obtained from different operating units,
such as sales related information from the marketing department, production related
information from production department, direct and indirect labor related information
from the human resource department, and other manufacturing and non manufacturing
overhead budgets from other departments as well as assumptions taken for the
development of an operating budget are given as follows:
(1) The only source of revenues is sales of tables and unit sold is the only revenue
driver.
(2) Work in Process inventory is negligible and is ignored.
(3) Unit costs of direct materials purchased and finished goods sold remain unchanged
throughout each budget year.
(4) There are two types of Direct materials : Lumber and Metal
(5) There are two types of direct labor: Laminating labor and Machine labor.

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 Direct labor rates remain unchanged throughout each budget year.
(6) For computing inventor able costs, Gibe Furniture allocates all manufacturing
overhead costs using manufacturing labor hours as the allocation base.
(7) Numerical information
(a) Each table has the following product specifications:
Direct materials:
Lumber----------------- 9 board feet/table
Metal------------------- 10 board feet/table
Direct labor:
Laminating labor------0.25Hrs/table
Machine labor---------3.75 Hrs/table
(b) Inventory information in physical units for 2011.
Beginning Inventory Target Ending Inventory
Direct materials:
Lumber------------- 20,000 board feet 18,000 board feet
Metal--------------- 25,000 board feet 22,000 board feet
Finished goods:
Tables------------- 5,000 tables 3,000 tables
(c) Revenue expected from sales of tables for 2011 are:
Selling price-----------Br. 392/table
Units’ sales------------- 52,000 tables
(d) Costs expected for 2011.
2010 2011
Lumber/ board feet ------- Br. 3.90 Br. 4.00
Metal/ board feet---------- 5.80 6.00
Laminating labor/ Hr. ---- 24.00 25.00
Machine labor/ Hr. ------- 29.00 30.00
(e) Other budgeted costs and amounts for 2006 are:

 Variable non-manufacturing costs------------- 13.5% of sales

 Fixed non-manufacturing costs---------------- Br. 1,400,000
 Variable MOH costs---------------------------- Br. 9.50/DL Hr.
 Fixed MOH costs------------------------------- Br. 1,600,000

(f) The inventorable cost is Br.275/table in 2005.

Now you can see each step in the preparation of the operating budget using the budget
information given above.
Step 1: Preparing Revenue budget
The starting point for operating budget development for most business organizations is a
revenue budget. A revenue/Sales budget outlines the expected sales for each product in
units and Birr. This budget will be developed after the firm made a forecast of the

24
demand for the company’s product by taking into account. In forecasting sales different
companies may adopt different forecasting techniques, however in most cases sales
forecast take into account the following points:
 The sales volume in recent periods
 General industry and economic condition
 Market research studies
 Pricing polices
 Advertising & sales promotion
 Competition & regulatory policies
Based upon the forecasted sales the budgeted sale is prepared by a mere multiplication of
forecasted sales volume and selling price.
Budgeted Sales = Budgeted sales volume X Budgeted Selling price
The Revenue budget for Gibe Furniture, based upon budget information 7(C) is,
Schedule (1) Sales Budget
Budgeted Unit 52,000tables
X Budgeted Unit Selling Price Br 392/table
Budgeted Sales Br. 20,384,000

Step 2: preparing the production budget (in units)

After the revenues are budgeted, you would then prepare a Production Budget. The
production budget is prepared to show how many units must be produced in order to meet
your budgeted sales need and the target level of ending inventory balance for finished
goods.
The total number of budgeted production requirement, is therefore, the sum of budgeted
sales in unit and target ending inventory. However, if the firm is not new in operation,
usually some of its production requirement can be satisfied using the inventory kept of
the beginning of the period. Therefore, the banging in vestry should be deducted from the
total production requirement to determine the exact units in the production budget
Formula wise you can put the production budget in unit as follow:

Budgeted Production in unit = Budgeted Target Finished Begging

Finished
sales in unit + Goods inventory - goods inventory
The production budget for Gibe using the given information is prepared as follows

25
 Schedule (2) Production budget
Budgeted unit sales 52,000

Add: Target Finished Goods Inventory 3,000

Total requirements 55,000
Less: Beginning FG Inventory 5,000

Units to be produced 50,000

After the sales and production budgets have been developed and the efforts of the sales
and production groups have been coordinated, the next stage is the development of the
production costs (direct material, direct labor and manufacturing overheads) at budgeted
output level.
Step 3: Preparing the Direct Material Usage and Direct Material Purchase Budget
The number of units to be produced calculated in production budget Schedule is the key
to computing direct materials in quantity and Birr. The direct materials budget ties the
production to the Direct Materials that will need to be purchased in order to produce the
estimated units. Direct materials purchases needed for the budget period are determined
using this equation:
Required material to be + Estimated Estimated
Material = Used in Production ending materials - beginning
Purchase inventory materials inve ntory

The direct material usage budget in our case is prepared as follows:

Schedule 3A: DM Usage Budget
Lumber Metal Total
Physical Units Budget:
Lumber: 50,000 x 9 board feet 450,000b.f
Metal: 50,000 x 10 board feet 500,000b.f
To be used in production 450,000b.f 500,000b.f
Cost Budget:
-Available from Beginning Inventory.
Lumber: Br. 3.90 x 20,000 Br. 78,000
Metal: Br. 5.80 x 25,000 Br. 145,000
-To be obtained from purchases
Lumber: Br. 4.00 x 430,000 Br. 1,720,000
Metal: Br. 6.00 x 475,000 Br. 2,850,000
DM to be used Br. 1,798,000 Br. 2,995,000 Br. 4,793,000

26
 Schedule 3B: DM Purchases Budget
Lumber Metal Total
Physical Units Budget:
Production Budget 450,000b.f 500,000b.f
Add: Target End. Inv. 18,000b.f 22,000b.f
Total requirements 468,000b.f 522,000b.f
Deduct: Beg. Inv. 20,000b.f 25,000b.f
Units to be purchases 448,000b.f 497,000b.f
Cost Budget:
Lumber: Br.4.00 x 448,000 Br. 1,792,000
Metal: Br. 6.00 x 497,000 Br. 2,982,000
Purchases Br. 1,792,000 Br. 2,982,000 Br. 4,774,000

Sep 4: Preparation of direct manufacturing labor cost budget

This budget will show the number of employee and total hours required in producing the
budgeted level of output along with the cost. The costs in this budget usually depend on
wage rate, production method and human resource plan.
Schedule 4: DL Budget
Laminating Labor Machine Labor Total
Labor-hours Budget:
Laminating: 50,000 tables x 0.25Hrs. 12,500Hrs.
Machine: 50,000 tables X 3.75Hrs. 187,500Hrs.
Total DL Hrs. required 12,500Hrs. 187,500Hrs.
200,000Hrs
Cost Budget:
Machine: Br. 25/Hr. x 12,500Hrs. Br. 312,500
ML: Br. 30/Hr. x 187,500Hrs. Br. 5,625,000
Total DL cost Br. 312,500 Br. 5,625,000 Br. 5,937,500
Step 5: Preparing Manufacturing Overhead (MOH) Budget.
The Overhead budget shows the expected cost of all indirect manufacturing items. The
total of these costs depends on how individual overhead costs vary with respect to the
cost driver.
Gibe Furniture treats both variables MOH and fixed MOH as inventorable costs.

27
 Schedule 5: MOH Budget
At the budgeted level of 200,000 DL-Hours
Total variables MOH [Br.9.50 x200, 000] Br. 1,900,000
Total fixed MOH Br. 1,600,000
Total MOH Br. 3,500,000
Gibe Furniture inventories MOH at the budgeted rate of Br. 17.50/DL Hr.
[i.e. Br.3, 500,000/200,000Hrs.]. The budgeted MOH cost per table is Br. 70
[Br. 3,500,000/50,000tables].
Step 6: Preparing the Ending Inventory Budget
This budget is prepared for target ending raw material and ending finished goods
inventory
Schedule 6A: Computation of Unit Costs of Ending Inventory of FG
Cost/unit of
Input Input Total
DIRECT MATERIAL:
Lumber: Br. 4 /b.f 9 b.f Br. 36
Metal: Br. 6 /b.f 10b.f Br.60 Br. 96.00
DIRECT LABOR:
Laminating Labor Br. 25 /Hr. 0.25Hrs. Br. 6.25
Manufacturing Labor Br.30 /Hr. 3.75Hrs. Br.112.50 Br. 118.75
MOH Br. 17.5/Hr. 4.00Hrs. Br. 70.00
Total Br. 284.75
Step 7: Preparing Cost of goods sold (CGS) budget
The following are inputs to prepare cost of goods sold budget
 Direct material usage budget
 Direct labor budget
 Manufacturing overhead budget
 Ending and beginning finished goods inventory
 Ending and beginning working in process inventory
Schedule 7: CGS Budget
Beg. FG Inv., Jan1, 2006 (275 x 5000) Br. 1,375,000
DM Used (sch.3A) 4,793,000
DL (Sch. 4) 5,937,500

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MOH (Sch. 5) 3,500,000
CGM 14,230,500
Cost of goods available for sale 15,605,500
Less: Ending FG Inv. (sch.6B) 854,250
CGS Br. 14, 751, 25
Step 8: Preparation of None Manufacturing overhead Cost Budget
The non manufacturing cost budget include the marketing and administrative
departments’ costs required to operate the company at its projected level of sales and
production and to achieve long term company goals. Unless there is a change in the
organizations production and sales or level of activity, the nonmanufacturing cost budget
is easily prepared by taking previous year’s actual or budgeted result after making the
necessary adjustment for price change and otter similar changes between periods.
Schedule 8: Operating Expenses Budget
Variable non-manufacturing costs: 13.5% X 20,384,000 Br. 2,751,840
Fixed non-manufacturing costs 1,400,000
Total Operating Expense 4,151,840
Step 9: Preparing the Budgeted income Statement
The last effort in operational budget development is pulling all the budget schedules
prepared in all the above steps in to the income statement. The budgeted income
statement, which can also be called Performa income statement show the revenue costs of
production, operating cost and the resulting operational profit envisage in the budget
period.
BUDGETED INCOME STATEMENT
Revenues (Sch. 1) Br. 20,384,000
Less: CGS (Sch. 7) 14,751,250
Gross Profit 5,632,750
Less: Operating Expenses (Sch. 8) 4,151,840
Operating Income Br. 1,480,910

2.3.2.2.2. Financial Budgets

The remaining budgets that appear in the Master Budget make up the Financial Budget.
The Financial Budget typically consists of the capital expenditure budget, the Cash
Budget, the Budgeted Balance Sheet and the budgeted statement of cash flows. In this

29
section the focus is only on the cash budget and budgeted balance sheet, as the rest are
discussed in detail in other course modules in financial accounting and financial
managements.

i) Cash budget

Cash budget is a schedule of expected cash receipt and disbursement. It predicts the
effects on the cash position at the given level of operation. Cash budget helps to avoid
unnecessary idle cash and unexpected cash deficiencies. They thus, keep cash balance in
line with needs, ordinarily; the cash budget has the following main sections.
The beginning cash balance plus cash receipt equals the total cash available before
financing.
Cash receipts depend on the collection of accounts receivable, cash sales, and
miscellaneous recurring sources such as rental royalty receipts. Information on expected
collectable of account receivable is needed for accurate prediction.

Cash disbursement: Organizations make cash disbursement for various reasons such as:

 Payment for direct martial purchased

 Salary paid for direct labor cost and other wages
 Other disbursements for property, equipment and other long term investment
 Interest on long term borrowing
 Income tax payment
 Others,
Short time financing requirement depends on how the total cash available for needs
compare with the total cash disbursement plus the minimum ending cash balance desired.
If there is a deficiency of cash, loan will be taken, if there is excess cash, an outstanding
loan will be paid
Activities: 1. why is the cash budgeting so important in the master budgeting
process? _____________________________________
3. Why cash budget is prepared after the completion of operating budget
preparation?

30
Suppose Gibe Furniture Company had the balance sheet for the year ended December 31, 2010
as follows:
ASSETS LIABILITIES & STOCKHOLDERS’ EQUITY
Liabilities
Cash Br. 500,000 Account payable Br. 384,000
Accounts Receivable 1,881,600 Tax payable 20,460
Direct Materials Inventory 223,000 Total current 404460
Finished Goods Inventory 1,375,000 Long term debt 2,400,000
Land 1,200,000 Total current & Liability 2,804,460
Buildings & Equipment 2,300,000 Stockholders’ Equity
Accumulated Depreciation (800,000) 1,500,000 Common Stock 3,000
Retained earnings 3,872,140 3,875,140
Total Assets Br. 6,679,600 Total Liabilities & SHE Br. 6,679,600

The quarterly cash flow based on the budgeted cash effects of the operation formulated in
operating budget above is given below:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Cash Collection Br. 5,331,200 Br. 4,704,000 Br. 4,704,000 Br. 6,272,000
Disbursements:
Direct Materials 960,000 1,152,000 1,152,000 1,536,000
Payroll 1, 626 300 1,626 300 1,888,600 1,626,300
Other costs 1,580,460 1,580,460 1,580,460 1,580,460
Equipment purchase - 0- -0- 1,800,000 -0-
Interest expense 60,000 60,000 60,000 60,000
Income tax 100,000 120,460 100,000 100,000
Total Br. 4,326,760 Br. 4,539,220 Br. 6,581 060 Br. 4,902,760
Additional information
 Long term debt is Br. 2.4 million at an annual interest rate of 10% with 60,000
interest payable every quarter
 The company wants to maintain a Br. 100,000 minimum cash balance at the end of
each quarter
 The company borrows cash in multiple of Br. 1,000 at the beginning of each quarter
and repayment is made at the end of each quarter
 The company can borrow or repay money at an interest rate of 12% per year.
 Management doesn’t want to borrow any money more short term cash than is
necessary
 Interest is computed and paid when the principal is repaid
 Tax rate is assumed to be 36%.
 During the year the company paid Br. 420,640 income tax. This amount is the
remaining due for the year 2010, plus four quarter payment of each Br. 100,000
 Equipment amounting Br. 1,800,000 was bought in the 3rd quarter
 No land is bought or sold.
 Depreciation for the year is Br. 500,000.
 Long term notes payable is not repaid.
 No dividend is paid.

31
 To prepare a cash budget you need to get adequate information about the cash receipt and
disbursement made by the organization during the budget period. Most of this
information is obtained from the different schedules prepared for the operating budget
parts of a master budget. In addition to cash receipts and payments for operational
activities, information is required on planned investing and financing activity of the firm
on the budget period. Information on the companies desired minimum cash balance is
also required.

 Dear learner in preparing a cash budget noticing the following points are
essential:
1. The ending balance of cash in one quarter is the beginning balance of cash for the next
quarter.
2. In the year for total column the receipt and disbursement are totaled for the four quarters,
however the beginning balance in the column is the beginning balance in the column are the
beginning balance in for quarter 4.
3. Depreciation is not a cash disbursement,
4. The cash receipt and disbursement for operational activity appears in all the quarter as the
budgeted operation of the company will continue in without interruption. However when you
come to cash receipt and disbursement for investing and financing activities appears only on
some of the quarters. For example the firm acquired fixed asset costing Birr 1,800,000, that is
why the cash disbursement for investing activity appears only once in Q3.
5. When you cash receipt and payments related to financing activity the firm borrowed
Birr 308,000 to finance the expected short term cash shortage at quarter III, as a result cash
receipt from financing activity appeared only in this quarter. The principal amount and the
interest on borrowed money are paid at quarter IV when the firm has excess cash on hand
beyond the required amount of cash for planned payments and minimum cash balance
requirement of the quarter, as a result cash payments for financing activity appears only in
the fourth quarter.

Using all the information given above on illustration to the cash budget for Gibe Furniture
can be prepared as follow:

Cash Budget for Gibe Furniture

Quarters Total for

32
Descriptions I II III IV the year
Cash balance at the Br 500,000 Br Br Br 100,160 500,000
beginning 1,504,440 1,669,220
Add Receipts:
Cash collection from 5,331,200 4,704,000 4,704,000 6,272,000 21,011,200
customers
Total Cash available 5,831,200 6,208,440 6,372,220 6,372,160 21,011,200
for needs (X)
Deduct Disbursements:
Direct materials 960,00 1,152,000 1,152,000 1,536,000 4,800,000
Payroll 1,626,300 1,626, 300 1,888,600 1,626,300 6,767,500
Other costs 1,580,460 1,580,460 1,580,460 1,580,460 6,321,840
Interest cost(long term 60,000 60,000 60,000 60,000 240,000
debts)
Machinery purchase# 0 0 1,800,000 0 1,800,000
Income tax 100,00 120,460 100,000 100,000 420,460
Total cash 4,326,760 4,539,220 6,581,060 4,902,760 20,449,800
Disbursement(Y)
Minimum Cash Balance 100,000 100,000 100,000 100,000 100,000
desired
Total Cash needed 4,426,760 4,639,220 6,681,060 4,902,760 20,349,800
Cash excess 1,404,440 1,569,220 (307,840) 1,369,440 1,061,400
(deficiency)
Financing
Borrowing at the 0 0 308,000 0 308,000
beginning
Repayment at the end 0 0 0 (308,000) (308,000)
Interest at 12% per 0 0 0 (18,480) (18,480)
annum
Total effect of 0 0 308,000 (326,484) (18,480)
financing
Ending cash balance Br1,504,440 Br Br100,160 Br1,142,920 1,142,920
1,669,220

ii) The Budgeted Balance Sheet

The budgeted balance sheet shows the financial position of the firm during the budget
period. Each item in the budgeted balance sheet is projected in the light of the details of
the business plane expressed in all the previous budget schedules.
The budgeted balance sheet of Gibe furniture prepared on the bases of previously
developed budget is prepared as follows:

33
 Budgeted Balance Sheet of Gibe furniture
Assets
Cash Br1,142,920
Accounts Receivable 1,254,400
Direct Materials 204,000
Finished Goods 854,250 Br 3,455,570
Property plant and equipment
Land 1,200,000
Building & Equipment 4,100,000
Ac.Depreciation (1,300,000) 2,800,000 4,000,000
Total Assets 7,455,570
Liabilities and Stock Holders’ Equity
Current liabilities
Account Payables 358,000
Income Tax payables 40,075 398,075
Long term Debt(interest 10% per year) 2,400,000
Stock Holders Equity
Common Stock 3,000

Retained earnings 4,654,495 4,657,495

Total Liabilities & SHE Br 7,455,570

iii) Budgeted statement of cash flow: statement of cash flow presents cash flow from
operating, investing and financing activity in detail.
iv) Capital budgeting: is the process of making long term planning decision for
investment capital budgeting also called long term investment. Long term
investment involves the commitment of resource for projects which have long term
consequence. Such decisions usually involve large investment of money. Capital
budgeting decision have uncertain actual outcome that have long-term effect on the
organization. Poor long-term investment decision can affect the future stability of an
organization because it is often difficult for organization to recover money tied up in
bad investment. Mangers need a long term planning tool to analyze and control
investment with long-term consequence.

2.4. RESPONSIBILITY ACCOUNTINNG

34
Responsibility accounting is an underlying concept of accounting performance
measurement systems. The basic idea is that large diversified organizations are difficult,
if not impossible to manage as a single segment, thus they must be decentralized or
separated into manageable parts. These parts or segments are referred to as responsibility
centers. An underlying concept of responsibility accounting is referred to as
controllability. Conceptually, a manager should only be held responsible for those aspects
of performance that he or she can control.
The purpose of a responsibility accounting system is to ensure that each manager and
worker in an organization strives towards the overall goals set by top management. The
basis of a responsibility accounting system is the designation of each sub-unit in the
organization as a particular type of responsibility center. A responsibility center is a sub-
unit in an organization whose manager is held accountable for specified financial and
non-financial results of the sub-unit’s activities. Thus, responsibility accounting is a
system that measures the plans and actions of each responsibility center.
There are four common types of responsibility centers:
o Cost centers,
o Revenue centers,
o Profit centers, &
o Investment centers.
(i)Cost center is an organizational unit whose manager is responsible for costs only.
Examples: Production Department of Manufacturing Companies.
(ii) Revenue center is a responsibility center whose manager is held accountable for the
generation of revenues. Examples: Sales departments, marketing departments, etc
(iii) Profit centers are sub-divisions of a business assigned responsibility for both costs
and revenues. Example: - A restaurant of a large hotel
(iv) Investment centers accountable for costs, revenues and the profitable utilization of
invested capital. Example: Divisions of large companies.

The performance of each responsibility center is summarized periodically on a

performance report. A performance report shows the budgeted and actual amounts key
financial results appropriate for the type of responsibility center involved. Performance
reports also typically show the variance between budgeted and actual amounts for the
financial results conveyed in the report. The data in performance report help managers

35
use MBE (Management by Exception) to control an organization’s operations effectively.
MBE means that managers follow up on only the most significant variances between
budgeted and actual results. This allows managers to use their time most effectively.
Activities 2.3:
1. How do companies use responsibility centers and responsibility accounting?
_____________________________________________________________
2. Define the following terms and provide appropriate example taking in to
account a manufacturing type of business.
i) Cost Center____________________________________________
____________________________________________
ii) Revenue center______________________________________
____________________________________________
iii) Profit center_________________________________________
____________________________________________________
iv) Investment center __________________________________
____________________________________________________

2.5. Budget Administration

Large organization use a formal process to collect data and prepare a budget such
organization usually designate a budget director or chief budget officer. The budget
director specifies the process by which budget data will be gathered, and prepare budgets.
To communicate budget procedure and deadlines to employees throughout the
organization, the budget director often develops and disseminates a budget manual. The
budget manual says who is responsible for the required and what form the information to
take

A budget committee consisting of key senior executives is often appointed to a device the
budget director during preparation of the budget. The authority to give final approval to a
budget usually belongs to the broad of directors in business organizations or board of
trustees in many nonprofit organizations; usually the board has a subcommittee whose

36
task is to examine the proposed budget carefully and recommend approval or any
changes deemed necessary. By exercising its authority to make changes in the budget and
grant final approval, the board of directors or trustee, can wield considerable influence on
the overall direction the organization takes

2.5.1. Behavioral impact of Budget

There is no other area where the behavioral implication is more important than in
budgeting area. A budget affects virtually every one in an organization: those who
prepare the budget, those who use the budget to facilitate decision making, and those who
are evaluated using budget. The human reactions to the budgeting process can have
considerable influence on an organization

2.5.1.1. Budgetary Slack: padding the budget

The implication up on which a budget is based comes largely from people throughout an
organization. For example, the sales forecast relies on market research and analysis by
market research staff but also incorporates the projection of sales personnel. If territorial
sales manager’s performance is evaluated on the basis of whether the sales budget for the
territory is exceeded, what is the incentive for the sales manager in projecting sales? The
incentive is to give a conservative, or cautiously low sales estimate. The sales manager’s
performance will look much better in the eye of top management when a conservative
estimate is exceeded than when an ambitious estimate is not met. At least that is the
perception of many sales managers, and in the behavioral area perception is what counts
most.

When a supervisor provides a departmental cost projection for the budgetary purpose,
there is an incentive to overestimate costs when the actual cost incurred in the department
proves to be less than the inflated cost of projection, the supervisor appears to have
managed in cost effective way.

This illustration is example of padding the budget. The budget padding means under
estimating revenue or overestimating costs. The difference between the revenue or cost
projection that a person provides and a realistic estimate of the revenue or cost is called
budgetary slack.

37
For example, if a plant manager believes the annual utility cost will be Br.18, 000, but
gives a budgetary projection of Br.20, 000, the manager has built Br.200 of slack in to the
budget.

 Why do people pad budget with budgetary slacks?

There are three primary reasons. First people often perceive that their performance will
look better in their supervisor eyes if they can beat the budget. A second budgetary slack
is often used to cope with uncertainty. A department supervisor may feel confident in the
cost projection for 10 cost items. However, the supervisor may also feel that some
unforeseen event during the budgetary period could result in unanticipated cost. One way
of dealing with that unforeseen event is to pad the budget. If some negative event does
occur, the supervisor can use the budgetary slack to absorb the impact of the event and
still meet the cost budget. The third reason why cost budgets are padded is that budgetary
cost projection is often cut in the resource allocation process. Thus, we have a vicious
circle, budgetary projection are padded because they will likely be cut and they are cut
because they are likely to have need padded

 Dear learners, do you know how does an organization can solve the problem of
budgetary slack?

First, it can avoid relying on the budget as negative evaluate tool. if a department
supervisor is harassed by the budget director or some other top manager every time a
budgetary cost projection is exceeded, the likely behavioral response will be to pad the
budget. In contrast, if the supervisor is allowed some managerial discretion to exceed the
budget when necessary there will be tendency toward budgetary padding. Second
managers can be given incentive not only to achieve budgetary projections but also to
provide accurate projection.

Activity: 2.5.

1. How can budget affect individuals in an

organization._____________________________?
2. What is budgetary slack____________________

38
 3. Why individuals tend to pad budget? Explain using
example_______________________
4. How can organizations overcome the budgetary slack problem?
____________________________

Unit summary
The unit introduces the important topic of budgets. Budgets are the primary financial
planning tool used by businesses and non business organizations. If managed effectively
budget is used for planning, performance e valuation, and facilitating coordination and
communication as well as for better resource allocation.
Different organizations prepare various types of budget. The comprehensive set of budget
that covers all phases of the organizations operation is called master budget. Master
budget comprises the operation budget wish starts by sales forecasting and sale budgeting
and end up by preparing other production and nonproduction cost budgets based on the
sales budget and Performa income statement. The other main part of a master budget is a
financial budget which includes the capital expenditure budget, cash budget and the
budgeted balance sheet. The chapter explains how businesses use budgets and budgeting
as part of the management process. The concept of responsibility centers and
responsibility accounting is also discussed and related to the concept of controllability.
Model Examination Questions
Part I: Multiple Choice Questions
________1. Which of the following would be included in the cash budget, but would not
be included in the budgeted income statement?
(i) Repayment of a bank loan
(ii) Proceeds from the sale of a fixed asset
(iii) Bad debts write off
A (i) and (ii) only
B (i) and (iii) only
C (ii) and (iii) only
D (i), (ii) and (iii)
_______2. An investment center manager is:
2.2.1.1.1. Responsible for costs.
2.2.1.1.2. Held accountable for revenues.
2.2.1.1.3. Held accountable for the profitable utilization of invested capital.

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 2.2.1.1.4. All of the above.
2.2.1.1.5. All except [A].
Based on the following information answered question number 4 and 5
Gedda super market, budgeted the following sales for indicating the month;
September 2000 October 2000 November 2000
Sales on account Birr 1800000 1920000 2040000
Cash sales “ 240000 250000 260000
All merchandise marked up to sell at its invoice cost plus 25%. Merchandise inventory
at the beginning of each month 25% of the month estimated cost of goods sold.
____3. What is the cost of goods sold for the month of October 2000?
a) Birr 1440000
b) Birr 1870500
c) Birr 2170000
d) Birr 1627500
e) None
_____4. What is the projected merchandise purchase for September 2000?
A) Birr 1912500
B) Birr 1505625
C) Birr 1530000
D) Birr 2040000
E) None
Part II: Discussion Questions
1) How does the process of budgeting assist managers in conducting the
management control function?
2) The master budget contains both operational and financial budgets. What is the
difference between an operating budget and a financial budget? How do they
relate to each other?
3) Although managers are not clairvoyant, budgeting may assist in viewing the
future. How might this be so?
4) Why is it useful to complete the budgeting process with a presentation of pro
forma financial statements?
5) Why is the cash budget so important to an organization? If the cash budget
identifies a period in which a cash shortage is expected, what actions can the
organization take?
Part II: Workout Questions:

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Serra Furniture is an Elite desk manufacture. It manufactures two products.
1. Executive desks – Oak desks
2. Chairman desks – Red Oak desks
The budgeted direct cost inputs for each production in 2008 are as follows:

Particulars Executive line Chairman line

Direct material:
Oak top 16Sqf -----
Red Oak top --- 25Sqf
Oak legs 4 legs ----
Red Oak legs -- 4 legs

Direct Labor: 3 Hr 5 Hr

Unit data pertaining to the direct materials for March 2008 as follows:
Actual beginning direct material’s inventory (2008)
Particulars Executive line Chairman Line
Oak top 320 Sqf -----
Red Oak top --- 150 Sqf
Oak legs 100 legs ----
Red Oak legs -- 40 legs
Target ending direct material inventory at March 31, 2008.
Particulars Executive line Chairman Line
Oak top 192Sqf -----
Red Oak top --- 200Sqf
Oak legs 80 legs ----
Red Oak legs -- 44 legs
Unit cost data for direct cost inputs pertaining to February 2008 and March 1998 are:
Particulars February 1998 March 1998
Oak top (per sqf) Bir.18.00 Bir.20.00
Red Oak top (per sqf) Bir.23.00 Bir.25.00
Oak top (per leg) Bir.11.00
Bir.12.00
Red oak legs (per leg) Bir.17.00 Bir.18.00

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 Manufacturing labor (per Hr) Bir.30.00 Bir.30.00
Manufacturing overhead (both variable and fixed) is allocated to each desk on the basis
of budgetary direct manufacturing labor hours per desk. The budgeting variable
manufacturing overhead rate for March 1998 is Bir.35.00 per Direct manufacturing labor
Hour. The budgeted fixed manufacturing overhead for March 1998 is Bir.42, 500. Both
variable and fixed manufacturing overhead cost is allocated to each unit of finished
goods.
Data relating to finished goods inventory for March 1998 are
Particulars Executive line Chairman Line
Beginning inventory 20 units 5 units
Beginning inventory Bir.10, 480 Bir.4850
Target ending inventory 30 units’ 15 units
Budgeted sale for March 1998 are 740 units of the executive line and 390 units of
the chairman line. The budgeted selling prices per unit in March 1998 are Bir.1,
020 for an executive line desk and Bir.1600 for a chairman line desk.
Take the following assumptions in your answer:
a) Works in Process inventories are negligible and ignored.
b) Direct material inventory and finished goods inventory are determined using
the FIFO method.
c) Unit costs of direct material purchased and finished goods are constant in
March 1998.
Required:
Prepare the following budget for March, 2008
1. Revenue budget
2. production budget in units
3. Direct material usage budget and direct material purchase budget
4. Direct manufacturing labor budget
5. Ending inventory budget
6. Cost of goods sold budget
Answer key for Model Exam Questions
Part III solutions for work out questions
Solution: 1
(1) Revenue Budget for the year ended March31, 2008

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 Budgeter Revenue = Budgeted Sales in unit X Budgeted Selling Price
(1) ( 2) (3) (2)x(3)=(4)
Revenue Units selling price Total Revenue
Executive line 740 1020.00 754,800
Chairman line 390 1,600.00 624,000

(2)Production Budget in units for the year ended March31, 1998

Budgeted Production = Budgeted sales + Target finished goods inventory –
Beginning finished goods inventory.
Executive line Budgeted production= 740+30-20 =750 units
Chairman Line Budgeted production=390+15-5 =400 units
(3) Direct material usage budget & Direct material purchase Budget:

a).Direct material Usage budget in units and Birr, at end of the year March 31, 2008.

Particulars Oak Oak Red oak Red oak

Top legs top legs

Direct material used in

Production of executive l
Line (750x16) (750x4) 12,000 3000 ---- ------
Direct material used in
Production of chairman
Line (400x25) (400x4) ---- ----- 10,000 1,600
Total Direct material
Used (Sqf& Legs) 12,000 3,000 10,000 1,600
Less: Beginning
Inventory (FIFO) 320 100 150 40
Cost direct material to used
From purchases 11,680 2,900 9,850 1,560
Costs Executive line Chairman line
A) Beginning Inventory: Oak top Oak leg Red top Red leg

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1) Square feet’s & Legs 320 100 150 40
2) Cost per Square
Feet’s & Legs (In Birr.) 20.00 12.00 25.00 18.00
3) Cost (1x2) (In Birr.) 6,400 1,200 3,750 720
B) Direct material to be used
From current purchase:
1) Square feet’s & Legs 11,680 2,900 9,850 1,560
2) Cost per Square
Feet’s & Legs (In Birr.) 20.00 12.00 25.00 18.00
3) Cost (1x2) (In Birr.) 233,600 34,800 246,250 28,080
C) Total cost of Direct Material
To be used (A3 + B3) 240,000 36,000 250,000 28,800
b) Direct material purchase budget:

Executive line Chairman line

Oak top Oak leg Red top Red leg
Direct material to be used in
Production (Sqf & legs0 12,000 3,000 10,000 1,600
Add: Target ending Material
Inventory: 192 80 200 44
Total Requirement: 12,192 3,080 10,200 1,644
Less: Beginning inventory
Of Direct material (sqf &legs) 320 100 150 40
1) Direct material to be
Purchased (Sqf * legs) 11,872 2,980 10,050 1,604
2) Cost per Sqf * legs (Birr) 20.00 12.00 25.00 18.00
3) Total direct material
Purchase cost (In Birr)(1x2) 237,440 35,760 251,250 28,872
So Total Direct material purchase cost = 237,440 + 251,250 + 28,872 =Birr. 553,322
(4) Direct manufacturing labor Budget:
1 2 3 2x3=4 5 5x4=6

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 Particulars production direct labor total labor labor
total
In units Hours/unit Hours rate/Hr cost
Executive line 750 3 2,250 30.00 67,500
Chairman line 400 ` 5 2,000 30.00 60,000
Total 4,250 127,500
5) Manufacturing overhead budget at 4,250 labor Hours:
a) Variable Overhead costs:
1 2 3 2x3=4
Particulars Direct labor Hr Variable overhead Total
variable
Cost per Hour cost
Executive line 2,250 Bir.35.00 78,750
Chairman line 2,000 Bir.35.00 70,000
Total variable over head cost 148,750
b) Fixed manufacturing Overhead cost 42,500
c) Total manufacturing overhead cost (a+b) 191,250
6) Ending inventory Budget at March 31, 2008.
1 2 3 2x3=4
Particulars Sqf & Legs Cost per Sqf & legs Costs
a) Direct material ending:
Oak top 192 Bir.20.00 3,840
Oak legs 80 Bir.12.00 960
Red Oak top 200 Bir.25.00 5,000
Red Oak legs 44 Bir.18.00 792
Total costs 10,592
b) Finished goods ending inventory
1 2 3 2x3=4
Particulars Units Cost per unit Costs
Executive line 30 Bir.593.00 17,790
Chairman line 15 Bir.1, 072.00 16,080
Totals 33,870
Total ending inventory budgeted cost (a+b) = 10.592 + 33,870= Bir.44, 462

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Notes: computation of cost per unit of finished goods inventory in 1998.
Particulars cost per unit Executive line Chairman line
Input amount input amount
A) Direct materials:
Oak top Bir.20.00 units 16 Bir.320.00 --- -----
Oak legs 12.00 12 48.00 --- ---
Red oak top 25.00 units 25 Bir.625
Red oak legs 18.00 --- --- 4 72
b) Manufacturing labor 30.00 3 90.00 5 150
c) Manufacturing O.H
(See 5th requirement) 45.00 3 135.00 5 225
d) Total cost per unit 593.00 1,072.00
6) Cost of goods sold budget
Particulars Costs Total Costs
a) Beginning Finished goods inventory 15,330
b) Cost of goods manufactured:
Direct material used 554,800
Direct manufacturing labor 127,500
Direct manufacturing Overheads 191,250 873,550
c) Cost of goods available for sale (a+b) 888,880
Less: ending finished goods inventory 33,870
Cost of goods sold 855,010

UNIT FOUR
FLEXIBLE BUDGET AND VARIANCE ANALYSIS

UNIT OUTLINE

 Unit Objectives
4.1.Introduction

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 4.2.Budget and Variance
4.2.1. Fixed or Static Budget
4.2.2. Flexible Budget
4.2.3. Fixed or Static Budget Variance
4.2.4. Flexible Budget Variance
 Summary
 Model Exam Questions

Unit Objectives:

Upon completion of this Unit you will be able to:

 Explain the concept of flexible budget;

 Explain the difference between master budgets and flexible budgets.
 Prepare flexible budget;
 Describe variance analysis
 Determine the static and the flexible budget variances

4.1. Introduction
Dear learners in the previous unit you have studied the benefit of budget as a planning
tool. Hence, budgets are planning tools that are usually prepared prior to the start of the
period being budgeted. However, the comparison of the budget to actual results provides
valuable information about performance. Therefore, budgets are both planning tools and
performance evaluation tools. In this unit, therefore the discussion focuses on how
budget are used to evaluate feedback and variances aid managers in their control
function.
In evaluating performance the budgeted performance are compared with actual
operational results and the resulting variance will be examined so as to identify the causes
for variance on the bases of which performance can be rewarded for favorable variance or
corrective actions will be taken to avoid unfavorable variance on the coming operational
periods.
The unit highlights the importance of variance analysis and show how the budget initially
prepared at planning stage creates problem while comparing actual results with the
budget. In this unit you are also introduced with the advantage of flexible budget over the
static budget, steps in the preparation of flexible budget and evaluating performance
using flexible budget.

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 4.2. Budget and Variance analyses

The use of budget as performance evaluation tool focuses on determining the

discrepancies between the planned and actual performance at the end of the operating
cycle.

Variance is the difference between an amount on an actual result and the corresponding
budgeted amount i.e., the actual amount of something and the amount it was supposed to
be according to the budget. The budgeted amount is a point of reference from which
comparison may be made. The difference between budget and actual result can be
favorable or unfavorable based upon the impact of the discrepancy on the overall
profitability of the firm. If the variance has an increasing effect on the operating income
as compared to the budgeted amount, it is said to be favorable variance. On the other
hand unfavorable or adverse variance occurs when the variance has a decreasing effect
on the operating income relative to the budgeted amount.

Variances assist managers in their planning and control decisions. It enables to exercise
Management by Exception (MBE), which is the practice of concentrating attention on
areas not operating as expected and giving less attention to areas operating as expected.
Managers regularly pay attention to areas with large variances. Variances are also used in
performance evaluation. For example Production line managers in a manufacturing
company may have quarterly efficiency incentives linked to achieving a budgeted amount
of operating costs.

Activity4.1: Explain how budget can be used for performance evaluation.________

4.2.1. Fixed or Static Budget

The static budget is the budget that is based on this projected level of output, prior to the
start of the period. In other words, the static budget is the “original” budget. The static
budget variance is the difference between any line-item in this original budget and the
corresponding line-item from the statement of actual results. Often, the line-item of most
interest is the “bottom line”: total cost of production for the factory and other cost

48
centers; net income for profit centers.

 Static budget is a budget that is based on one level of activity.

Evaluating performance based upon the master budget which fixed and prepared at s
ingle level of activity may not provide accurate picture of performance. This because
usually the planned and actual output or activities levels may not be equal, as a result the
comparison is performed at two different level of activity which hides the variance
attribute to the actual performance units as well as overall organization. For example, if a
company budgeted to produce and sell 12,000 units, but the actual performance showed
only 10,000 units, the comparison of revenue, cost and profit at the budget and actual
level of output do revels only the variance resulted from the difference in the level of
output. Therefore unless the analysis is re done by adjusting the budgeted level of output
towards the actual units produced and sold, the variance is not helpful to the management
as performance evaluation tool.

 Static Budget Variance [SBV] is the difference between an actual result

and the corresponding budgeted amount in a static budget.
4.2.2. Flexible Budget
The flexible budget is a performance evaluation tool. It cannot be prepared before the end
of the period. A flexible budget adjusts the static budget for the actual level of output so
as to avoid the inherent limitation of using static budget for performance evaluation. The
flexible budget asks the question: “If I had known at the beginning of the period what my
output volume (units produced or units sold) would be, what would my budget have
looked like?” The motivation for the flexible budget is to compare apples to apples. If the
factory actually produced 10,000 units, then management should compare actual factory
costs for 10,000 units to what the factory should have spent to make 10,000 units, not to
what the factory should have spent to make 9,000 units or 12,000 units or any other
production level.
The flexible budget variance is the difference between any line-item in the flexible
budget and the corresponding line-item from the statement of actual results.

 Dear learners from the above discussion you realized that Static budget
variance does not give much information about the variances between actual
results and budgeted amounts for each line item. Hence one has to prepare
flexible budget.
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 To have a better understanding of causes for variance managers usually require variance
calculated at different level. Variance according to the degree of detailed feedback on
performance can be classified as:
 Level 0 variance analysis
 Level 1 variance analysis
 Level 2 variance analysis
 Level 3 variance analysis
 Level 4 variance analysis

In this unit the focus is on level 0, 1, and 2 variances, and the reaming will be discussed
in length on the next unit.
Activities 4.2:

1. Describe static budget. ___________________________________________________

______________________________________________________________________

2. Define master budget variance_______________________________________________

_______________________________________________________________________

3. Differentiate between flexible budget variance a static budget variance___________

____________________________________________________________________
4. Define the term variance and differentiate between favorable and unfavorable variance

__________________________________________________________________

Now let see the preparation of flexible budget as well as analysis of variance using the
following:
Illustration 4.1: Jimma Garment Co. manufactures and sells a jacket. Sales are made to
distributors who sell to independent clothing stores. Jimma Garment’s only costs are
manufacturing costs. All units manufactured in April 2003 are sold in April 2003. There
is no beginning or ending inventory. Jimma Garment has variable cost categories. The
budgeted data for April 2003 are:
Cost category Variable cost / jacket.
DM costs………………………………… Br. 60
DL costs…………………………………. 16
Variable MOH costs…………………… 12
Total variable costs ……………… Br. 88

The number of units manufactured is the cost driver for all variable-manufacturing costs.
The relevant range for the cost driver is from 0 to 12,000 jackets. Budgeted

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manufacturing fixed costs are Br. 276,000 for production between 0 & 12,000 jackets.
Budgeted selling price is Br.120/jacket. The static budget for April 2003 is based on
selling 12,000 jackets.
The actual data for April 2003 are as follows:
Units sold ………………… 10,000 jackets
Revenues …………………. Br. 1,250,000
Variable costs:
DM …………………….. 621,600
DL……………………… 198,000
Variable MOH……….. 130,500
Fixed costs …………….. 285,000

1. Level 0 or Static Budget Variance for operating income

Level zero variance analysis the least detail analysis which simply compares the
operating income at static budget income statement with the operating income at the
actual income statement. The level zero variance for Jimma Garment from the above
given data is determined as,
Actual operating income………………… Br. 14,900
Budgeted operating income……………… 108,000
SBV for operating income………………. Br. 93,100 U

The analysis revealed unfavorable variance as the actual operating income is lower than
the budgeted operating income by Birr 93,100. The result here couldn’t provide the
management useful information as it couldn’t show the contribution revenue and each
cost element to operating income variance.
2. Static Budget Variance (SBV)
Level one variance can offer management a better insight about their organizational
performance than level zero analysis. At this level, operating income variance will be
decomposed into revenue and cost component as a result the management will identify
the responsibility center that demands attention.
Static Budget Variance
Actual Static Budget Static Budget
Results (1) Variance(SBV) Result (3)
Items (2) = (1) – (3)
Unit sales 10,000 2,000U 12,000 .

Revenues Br.1,250,000 Br. 190,000U Br. 11,440,000

Variable costs:

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DM 621,600 98,400F 720,000
DL 198,000 6,000U 192,000
MOH 130,500 13,500F 144,000

Total variable 950,100 105,900F 1,056,000

costs
Contribution 299,900 84,100U 384,000
Margin
Fixed Costs 285,000 9,000U 276,000

Br. 14,900 Br. 93,100U Br. 108,000

Operating Income

Br. 93,100U______________
SBV

The static budget variance shows an unfavorable variance for revenue, fixed costs
whereas favorable variance of total variable cost. These variances are due primarily to the
fact that the static budget was built on an output level of 12,000 units, while the company
actually made and sold 10,000 units. The revenue variance might also be due to an
average unit sales price that differed from budget. The variable cost variances might also
be due to input prices that differed from budget (e.g., the price of fabric), or input
quantities that differed from the per-unit budgeted amounts (e.g., yards of fabric per
jackets) that may be identified at the later stages of the variance analysis.

Level 2-variance analysis [Flexible Budget Variance (FBV) & Sales-Volume

Variance (SVV)]

To identify the amount of variance attributed the difference in the level of output as well
as to real performance of the company, at this level the static budget variance will be
decomposed into the flexible budget variance and sales volume variance.
Flexible Budget Variance (FBV) is a better measure of operating performance because
they compare actual revenues to budgeted revenues and actual costs to budgeted costs for
the same output level.

Sales-Volume Variance (SVV) is the difference between the flexible budget amounts and
static budget amounts. It represents the variance caused solely by the difference in the

52
actual output volume and budgeted quantity of output expected to be produced and sold
in the static budget.

To determine the flexible budget variance and sales volume variance, first you need to
develop a flexible budget. The flexible budget, for the example given above is prepared at
the end of the period after the actual output level of 10,000 jackets is known. The flexible
budget is that Jimma Garment would have prepared at the start of the budget period had it
correctly forecasted the actual level of 10,000 jackets.

In preparing the flexible budget,

(1) The budgeted selling price is the same Br. 120/ jacket.
(2) The budgeted variable costs per unit are the same Br. 88/ jacket.
(3) The budgeted fixed costs are the same Br. 276, 000, are used.

The only difference between the static budget and the flexible budget is that the static
budget is prepared for the planned output level of 12,000 jackets, whereas the flexible
budget is based on the actual output of 10,000jackets.
The following stapes are used to prepare a flexible budget:
Step 1.Identify the Actual Quantity of Output produced and sold.
10,000jackets.
Step 2. Calculate the flexible budget for revenues based on Budgeted Selling Price and
Actual Quantity of Output.
Flexible B for Revenues = Br. 120 /jacket X 10,000jacket
= Br. 1,200,000
Step 3. Calculate the Flexible Budget for Costs based on Budgeted Variable Costs per
Unit, Actual Quantity of Output and Fixed Costs.
Flexible Budget for Variable Costs:
DM: Br. 60/j X 10,000j Br. 600,000
DL: Br. 16/j X 10,000j 160,000
MOH: Br. 12/j X 10,000j 120,000
FB for TVC Br. 880,000
FB for FC 276,000
FB for Costs Br. 1,156,000
Step 4: Building the flexible budget based on the information from steps 1 and 2, and
step 3 results a flexible budget presented on column 3 of the following table.

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After the flexible budget is developed it is possible to determine the flexible budget
variance by comparing the flexible budget and the actual operational results, and sales
volume variance by comparing the flexible budget results and the static budget as shown
on the following table.
Actual Flexible Flexible Sales Static
Results Budget Budget Volume Budget
Variance Variance
(1) (2) = (1) – (3) (3) (4) (5) .
Unit sales 10,000 0 10,000 2,000 12,000
Revenues 1,250,000 50,000F 1,200,000 240,000U 1,440,000
Variable costs:
DM 621,600 21,600U 600,000 120,000F 720,000
DL 198,000 38,000U 160,000 32,000F 192,000
MOH 130,500 10,500U 120,000 24,000F 144,000
Total variable costs 950,100 70,100U 880,000 176,000F 1,056,000
Contribution Margin 299,900 20,100U 320,000 64,000U 384,000
Fixed Costs 285,000 9,000U 276,000 0 276,000
Operating Income Br. 14,900 Br. 29,100U Br. 44,000 Br. 64,000U Br. 108,000
Br. 29,100U. Br. 64,000U________
FBV SVV
Br. 93,100U .
SBV

From this table, Jimma Garment sees that after adjusting for sales volume, revenue was
higher than would have been expected. The favorable Birr 50,000 variance must be due
entirely to an average sales price that was higher than planned which was Bir125 per
jacket compared to the original budget of Birr120 per jacket.

Materials costs were higher than would have been expected for a sales volume of 2,000
units. This unfavorable variance is due to higher material prices, or to inefficient
utilization of fabric (more waste than expected), or a combination of these two factors.
Labor and overhead were higher than expected, even after adjusting for the sales volume
of 2,000 units. This unfavorable flexible budget variance implies that either wage rates
were higher than planned, or labor was not as efficient as planned, or both. Similarly, the
components of variable overhead were either more expensive than budgeted, or were
used more intensively than budgeted. For example, electric rates might have been higher
than planned, or more electricity was used than planned per unit of output.

54
The fixed cost variances are identical in this table to the previous table. In other words,
the flexible budget and flexible budget variance provide no additional information about
fixed costs beyond what can be learned from the static budget variance

 Dear learners from the above discussion, you realized that flexible
budget, that is prepared after actual units outputs are known, can
provide a better feedback about performance than the static budget
prepared at the planning stage. To investigate the real causes of
variance usually it is essential to perform a further detail variance
analysis covered on the next unit of this module

Unit Summary
In this unit you have studied that how budget can assist mangers in controlling and
performance evaluation function in addition to planning. Using budget as bench mark
managers compare their planed and actual operational results or perform a variance
analysis.
Variance analysis allows management to compare discrepancies from the original plan.
The discrepancy or variance can be either favorable or unfavorable, depending upon its
effect on operating income as compared to the budget. Favorable variances contribute
positively to operating income; on the contrary unfavorable variances have a negative
effect on the operating income as compared to the plan.

The master budget prepared before starting operation is less useful for performance
evaluation as it is prepared at a single projected activity level. Variance resulted from the
comparison of actual results and static budget is termed as static budget variance.
As static budget variance is less informative, it is essential to prepare a flexible budget, to
obtain a better feedback of the variance analysis. Flexible budget is prepared by taking
the budgeted unit selling price and unit variable costs and total fixed cost at the actual
output level.

Using the flexible budget it is possible to decompose the static budget variance in to
flexible budget variance and sales volume variance.
Model Examination Questions

Part I : Multiple Choice Questions

55
1. The system that “build in” the effect of fluctuations in the level of activity in the
various budget is:

a) Static budget.
b) Master budget.
c) Flexible budget.
d) Operating budget
e) None of the above

2. A static budget:

A) is based totally on prior year's costs.

B) is based on one anticipated activity level.
C) is based on a range of activity.
D) is preferred over a flexible budget in the evaluation of performance.
E) Presents a clear measure of performance when planned activity differs from actual
activity.

3. Which of the following is true?

A.The major purpose of a fixed budget lies in its use at planning

B.A flexible budget is designed to change as volume of activity changes
C.Flexible budget enables us to compare actual level of activity
D.The importance of fixed budget is very high in controlling as compared to
its importance in planning
E. All except “D”
4. Lanther Corporation recently prepared a manufacturing cost budget for an output
of 50,000 units, as follows:

Direct materials Birr100,000

Direct labor Birr
50,000
Variable Overhead Birr 75,000
Fixed overhead Birr 100,000

Actual units produced amounted to 60,000. Actual costs incurred were: direct materials,
Birr 110,000; direct labor, Birr 60,000; variable overhead, Birr 100,000; and fixed
overhead, Birr 97,000. If Lather evaluated performance by the use of a flexible budget, a
performance report would reveal a total variance of:

A) Birr 27,000 unfavorable.

B) Birr 42,000 unfavorable.
C) Birr 3,000 favorable.
D) Birr 23,000 favorable.
E) None of the above amounts.

5. A variance is said to be unfavorable:

A. When actual operating income decrease as compared to the budget
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 B. When actual cost and expense exceeds the budgeted cost and expense
C. When actual revenue is less than budget revenue
D. When budgeted cost is greater than actual cost incurred
E. All except “D”

Part II: Discussion Questions

1) What is meant by the process of “management by exception”? How is a standard
cost system helpful in such a process?
2) Master budget prepared at the planning stage is less helpful for managerial control
and performance evaluation. Comment
3) Explain the difference between fixed and flexible budget.
4) Explain the difference between flexible budget variance and sales volume
variance.

Answer to Model Examination Questions

Part I: Multiple Choice Questions
1. C 2. B 3.E 4. C 5. E
Part II: Key to Discussion questions
1. Question no “1’ is related to section 4.2. 2. Question no “2’ is related to section 4.2.2.

3. Question no “3’ is related to section 4.2.2 4. Question no “4’ is related to section 4.2.2.

Unit Five
Cost-Volume-Profit (CVP) Analysis

UNIT OUTLINE
 Unit Objectives
5.1.Introduction
5.2.Meaning, underlying Assumptions and importance of CVP analysis
5.2.1. Meaning of CVP analysis
5.2.2. The Basic Assumptions of CVP Analysis

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 5.3.Applications of CVP Analysis
5.3.1. Break Even Analysis
5.3.2. Target operating Income Analysis
5.3.3. The impact of Income Tax on CVP Analysis
5.3.4. Sensitivity Analysis
5.3.5. Margin of Safety
5.4.Multiple Product Company and Cost-Profit-Volume Analysis
5.4.1. Contribution Margin Technique and Breakeven Point for a Multi
Product Company
5.4.2. Contribution margin technique and sales required for desired
income for a multi-product company
5.5. Not for Profit Organizations and Cost-Profit-Volume (CVP) Analysis
 Unit Summary
 Model Examination Questions

Unit Objectives:
After completing this unit you are expected to:

 What are the objectives of cost volume profit analysis (CVP Analysis)?
 Understand the assumptions underlying cost-volume-profit (CVP) analysis.
 Explain the features of CVP analysis.
 Determine the breakeven point and output level needed to achieve a target
operating income
 Understand how income taxes affect CVP analysis
 Explain CVP analysis in decision making and how sensitivity analysis helps
managers cope with uncertainty
 Apply CVP analysis to a company producing Multiple products
 Apply CVP analysis to service rendering Not for Profit organizations

5.1. Introduction
In this unit you will be introduced with one of the most powerful management accounting
toll that helps managers in quick decision about the income generated at different activity
level. The tool is termed as Cost-Volume-Profit (CVP) Analysis, as the relationship
among cost, profit and the volume of output or the level of activity is considered in the
model.

Understanding the relationship between a firm’s costs, profits and its volume levels is
very important for strategic planning. When you are undertaking a new project, you will

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probably ask yourself, “How many units do I have to produce and sell in order to
breakeven?” The feasibility of obtaining the level of production and sales indicated by
that answer is very important in deciding whether or not to move forward on the project
in question. Similarly, before undertaking a new project, you have to assure yourself that,
you can generate sufficient profits in order to meet the profit targets set by your firm.
Thus, you might ask yourself, “How many units do I have to sell in order to produce a
target income?” Breaking Even? You could also ask, “If I increase my sales volume by
certain percent, what will be the impact on my profits?” The topics in this unit are,
therefore designed to acquaint you with the ability of applying Cost-Volume-Profit
(CVP) Analysis in answering different questions while you are taking part in planning
decision in different types of organizations.
Although the term “profit” is attached in the CVP model; it does not mean that, the
application of CVP analysis is limited to business organizations only. It can be used by
government and nongovernmental organizations (NGOs) as well in planning their activity
levels in light of the recourse availability and constraints.

5.2. Meaning , underlying Assumptions and importance of CVP

analysis
5.2.1. Meaning
Examining shifts in costs and volume and their resulting effects on profit is called cost-
volume-profit (CVP) analysis. This analysis is applicable in all economic sectors,
including manufacturing, wholesaling, retailing, and service industries and not-for- profit
(NFP) organizations. CVP can be used by managers to plan and control more effectively
because it allows them to concentrate on the relationships among revenues, costs, volume
changes, taxes, and profits.

CVP analysis can be used to determine a company’s break-even point (BEP), which is
that level of activity, in units or Birr value, at which total revenues equal total costs. At
breakeven, the company’s revenues simply cover its costs; thus, the company incurs
neither a profit nor a loss on operating activities. Companies, however, do not wish
merely to “break even” on operations.

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The break-even point is calculated to establish a point of reference. Knowing BEP,
managers are better able to set sales goals that should generate income from operations
rather than produce losses. CVP analysis can also be used to calculate the sales volume
necessary to achieve a desired target profit. Target profit objectives can be stated as
either a fixed or variable amount on a before- or after-tax basis. Because profit cannot be
achieved until the break-even point is reached, the starting point of CVP analysis is BEP.
It also helps in conducting a sensitivity analysis to understand how the change in
variables in the CVP model affects the profitability.

After going through the major assumptions upon which the CVP model is developed, you
will be exposed through the application of CVP in determining the BEP, target profit; in a
single and multiple product companies. You will also come across on how CVP is used to
conduct a sensitivity analysis as well as its application in NFPs.

Notice that on advanced managerial accounting courses you will come across with
diverse and advanced applications of CVP analysis in various financial and strategic
decisions.

 Cost-volume-profit analysis determines how costs and profit react to a

change in the volume or level of activity, so that management can decide
the 'best' activity level.

5.2.2. UNDERLYING ASSUMPTIONS OF CVP ANALYSIS

CVP analysis is a short-run model that focuses on relationships among several items:
selling price, variable costs, fixed costs, volume, and profits. This model is a useful
planning tool that can provide information on the impact on profits when changes are
made in the cost structure or in sales levels. However, the CVP model, like other human-
made models, is an abstraction of reality and, as such, does not reveal all the forces at
work. It reflects reality but does not duplicate it. Although limiting the accuracy of the
results, several important but necessary assumptions are made in the CVP model. These
assumptions follow.
1. All revenue and variable cost behavior patterns are constant per unit and linear
within the relevant range.

60
 2. Total contribution margin (total revenue - total variable costs) is linear within
the relevant range and increases proportionally with output. This assumption
follows directly from assumption 1.
3. Total fixed cost is a constant amount within the relevant range.
4. Mixed costs can be accurately separated into their fixed and variable elements.
Although accuracy of separation may be questioned, reliable estimates can be
developed from the use of regression analysis or the high-low method.

5. Sales and production are equal; thus, there is no material fluctuation in

inventory levels. This assumption is necessary because of the allocation of fixed
costs to inventory at potentially different rates each year. This assumption
requires that variable costing information be available. Because both CVP and
variable costing focus on cost behavior, they are distinctly compatible with one
another.

6. There will be no capacity additions during the period under consideration. If

such additions were made, fixed (and, possibly, variable) costs would change.
Any changes in fixed or variable costs would violate assumptions 1 through 3.
7. In a multiproduct firm, the sales mix will remain constant. If this assumption
were not made, no weighted average contribution margin could be computed for
the company.
8. There is either no inflation or, if it can be forecasted, it is incorporated into the
CVP model. This eliminates the possibility of cost changes.
9. Labor productivity, production technology, and market conditions will not
change. If any of these changes occur, costs would change correspondingly and
selling prices might change. Such changes would invalidate assumptions 1
through 3.

These assumptions limit not only the volume of activity for which the calculations can be
made, but also the time frame for the usefulness of the calculations to that period for
which the specified revenue and cost amounts remain constant. Changes in either selling
prices or costs will require that new computations be made for break-even and product
opportunity analyses.

61
The nine assumptions listed above are the traditional ones associated with CVP analysis.
An additional assumption must be noted with regard to the distinction of variable and
fixed costs. Accountants have generally assumed that cost behavior, once classified,
remained constant over periods of time as long as operations remained within the relevant
range. Thus, for example, once a cost was determined to be “fixed,” it would be fixed
next year, the year after, and 10 years from now.
The above assumptions thus, imply that cost-volume-profit analysis is always based on
contribution per unit (assumed to be constant unless a question clearly says otherwise)
and never on profit per unit because profit per unit changes every time a few more or less
units are made.
Activity 5.1:
1. Explain how CVP helps for management decision making process
____________________________________________________
2. List and explain the underline assumptions in a CVP analysis
________________________________________________________

5.3. Applications of CVP Analysis

 Dear learners in the previous parts of this unit you have gone through
the meaning and underlying assumptions of CVP. As you have learnt
CVP can be used by managers in a variety of sectors as management
decision tool.

On the subsequent part of the module you will find an explanation and illustrations on the
applications of CVP in different scenarios.

5.3.1. Break Even Analysis

CVP analysis has wide-range applicability. It can be used to determine a company’s
break-even point (BEP), which is that level of activity, in units or dollars/Birr, at which
total revenues equal total costs. At breakeven, the company’s revenues simply cover its
costs; thus, the company incurs neither a profit nor a loss on operating activities.

 At the breakeven point total revenue is equal to total cost (both variable
and fixed)

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For instance Sebastopol Cinema sold 4,800 tickets during a show one month run. The
following contribution margined approach income statement show that the operating
income for the month will be zero:
Sales Revenue (4800 X Br25) --------------------------- Br 120, 000
Less Variable Cost (4800 X Br 15) -------------------------- 72,000
Total Contribution Margin----------------------------------Br 48,000
Less Fixed Costs-------------------------------------------------- 48,000
Operating Income---------------------------------------------------Br 0
The income statement above highlights (1) the distinction between variable and fixed cost
and (2) the total contribution margin, which is the amount that contributes towards
covering Sebastopol Cinema’s fixed cost and income generation. To state it differently,
each ticket sold add Birr 10 to the firm’s bottom line profit. The Birr 10 unit
contribution margin is derived by deducting the unit variable cost Birr 15 from Birr 25
the unit selling price of a ticket.

How could you compute Sebastopol Cinema’s breakeven point if you didn’t already know
it is Birr 4,800 tickets per month? Well on the following discussion you will get the
basics of CVP analysis to determine BEP and other application. CVP analysis can be
done using three alternative approaches, namely: contribution margin approach, equation
approach and graphical approach.

In discussing CVP application we will assume that the following variables have the
meanings given below:
 SP = Selling Price Per Unit
 Q = Units Produced and Sold
 VCU = Variable Cost Per Unit
 CMU=contribution margin per Unit
 CM%= contribution margin percentage (CMU÷SP)
 FC = Total Fixed Costs
 TOI =Target operating Income
 TNI=Target Net Income
 t = Tax rate

5.3.1.1. Equation Method

In using equation approach to CVP analysis, you need to convert your income statement
in the following equation form.

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 Revenue –Variable Costs- Fixed Costs = Operating Income

Your Sales Revenue is equal to the number of units sold times the price you get for each
unit sold:
Sales Revenue = SPQ

Assume that you have a linear cost function, and your total costs equal the sum of your
Variable Costs and Fixed Costs:

Total Costs = Variable costs + Fixed costs

The profit equation can, therefore rewritten as:

(SPXQ) - (VCUXQ) + FC= OI

This equation provides the most general and easiest approach to remember approach to
any CVP situation. The determination of breakeven level using this method can easily
performed by making the operating income on the right hand side of the equation zero.
Here the basic assumption is that, when you are at breakeven, your Sales Revenue minus
your Total Costs is zero.

 At breakeven point,
(SPXQ) - (VCUXQ) + FC = 0

From the information given above for the Sebastopol Cinema, you can determine the
breakeven point (BEP) using the equation approach as follows,

(Br25 X Q) – (Br15 X Q) – Br48, 000 = 0

Br10Q = Br 48,000
Q= 4,800

If Sebastopol sells fewer than 4800 tickets, it will have a loss, if it sells 4800 tickets, it
will breakeven; and if the sales are more than 4800 units, it will make a profit.

The breakeven point stated in units can be stated in terms of Birr by multiplying the
breakeven quantity and unit selling price. The breakeven point in Birr= BEQ x SP
= 4,800 x Br25

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 = Br120, 000

5.3.1.2. Contribution Margin Approach

The contribution margin technique is merely a short version of the equation technique.
The formulas used in the determination of the breakeven point in unit as well as in value
are derived by the rearrangement of the terms in the equation method above, which is
(SP x Q) – (VCU x Q) – FC= OI
Re-written equation takes the following format:
(SP-VCU) x Q = FC + OI

That is, Q= FC + OI/ (SP-VCU)

The difference between unit selling price and unit variable cost is termed as unit
contribution margin. You can replace the (P-V) by the term "Contribution Margin per
Unit (CMU),
Q= FC + OI/CMU
As you know from the discussion above at breakeven point the target operating income is
Birr 0, so replacing OI by 0, you will get,
Q= FC/ (SP-VCU)

A. Breakeven point in units using contribution Margin Approach

Breakeven point in units using this formula is determined by dividing the total fixed cost
by the contribution margin per unit due to the fact that this approach centers on the idea
that each unit sold provides a certain amount of fixed costs. When enough units have
been sold to generate a total contribution margin equals to the total expense and only
after that point the units sold contributes for profit of the organization.

The breakeven number of tickets that Sebastopol Cinema must sold to reach at breakeven
using this method can be determined as,
Q = FC/CMU
Q= Br48, 000/Br10
Q= 4,800 units

B. Determining breakeven point in terms of sales value (Dollar/Birr)

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To find the breakeven sales value, you can use contribution margin percentage in place of
contribution margin per unit in the formula you used in the determination of breakeven
units. Contribution margin percentage is simply the ratio of contribution margin to
selling price.
CM% = CMU/USP
It can also determined by dividing the total contribution margin to total sales when the
unit selling price and variable cost is not known. We will see how this formula is used in
such a situation later. Before that let see how the formula works using the above example.
CM % on our example of Sebastopol Cinema = UCM/USP
= Br 10/ Br 25
= 0.4

This can be interpreted as, units sold cover variables costs and contribute 40 percent to
cover fixed cost and increase in profit.

The break even sales amount (Birr) for Sebastopol Cinema = FC/CM%
= 48,000/0.40
= Br 120,000

The breakeven sales determined using equation method was a mere multiplication of the
breakeven point in unit and the unit selling price (4800 units x Br 25) which is exactly the
same with what you determined using a more complicated contribution margin approach.

 Why do you think using the contribution margin approach is essential?

Well, sometimes you will be given only the income statement and asked to determine the
breakeven sales without sufficient information about units selling price and unit variable
cost. In this case, only using the contribution margin ratio you can determine the
breakeven point in sales by dividing total fixed cost by CM ratio gives the break-even
point in sales dollars.

For example, Jimma Electronics Co. produces portable radios. It has released the
following Variable Costing Income Statement. This is the only financial information that
we have regarding the company’s operations:

Sales Revenue--------- 100,000

Less Variable Costs------30,000

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 Contribution Margin----- 70,000
Less Fixed Costs--------- 50,000
Operating Income ------- Br 20,000

What is the Break-Even point for Jimma Electronics Co? You do not know the number
of units that Jimma Electronics sold in a year. You do not also know the Price or the
Variable Cost per unit. Although you do not know the price or the Variable Cost per unit,
you are still able to calculate the Contribution Margin Ratio.

Contribution ratio can be determined by dividing total contribution margin to total sales.

CM% in this case is, therefore, determined as follows:

= Br 70,000 ÷ Br 100,000 or 1- variable cost ratio
= 0.7 0r 70% 1- (variable cost ÷ sales)
1-(30,000 ÷ 100,000)
0.7 Or 70%

The breakeven point in sales is also determined by dividing the total fixed cost by the
contribution margin ratio determined above as follows:
= FC/CM%
= 50,000/0.7
=Br 71,428.57
Keep in mind the reason that Jimma Electronics’ Sales Revenue is lower than it was
before is because the company sold fewer units. Keeping the price and Variable Cost per
unit remained unchanged. Let's check if Breaks Even at this Sales Revenue figure:

Sales Revenue: -------------------------------------- Br 71,428.57

Less Variable Costs (30% of 71,428.57) -------------- 21,428.57
Contribution Margin------------------------------------Br 50,000
Less Fixed Costs--------------------------------------------- 50,000
Operating Income -------------------------------------------- Br0__

5.3.1.3. Graphical Approach

You have seen how solutions to break-even problems are determined using an algebraic
formula. However, sometimes managers need information in more visual format, such as
graphs. In this approach you can construct a CVP graph by plotting total cost and total
revenue graph at different activity level. The breakeven point is found at the intersection
point of total revenue and total cost lines.
The chart or graph is constructed as follows:

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 1. Plot fixed costs, as a straight line parallel to the horizontal axis
2. Plot sales revenue and variable costs from the origin
3. Total costs represent fixed plus variable costs.
4. The breakeven point represents the intersection point of total revenue and
total cost lines
Now you can draw a CVP graph to Sebastopol Cinema following the steps given above
and locate the breakeven point.

Birr Total Revenue Line

Operating Profit
Total Cost Line

Operating Loss

120,000
Total Variable Cost
48,000
Breakeven Point
Fixed Cost Line
Fixed Cost

4,800 Units

The breakeven points for Sebastopol cinema can determined from the graph by
identifying the level of output and sales value where the total revenue and total cost line
cross to each other. In the case of Sebastopol cinema this happened when 4800 tickets
are sold for birr 120,000 in which both the unit and the Birr value are similar with what
have been determined in the equation and contribution margin approaches. The
graphical approach is usually preferred by managers as it can provide a detail insight of
the cost volume and profit relationship pictorially.
Activities 5.2.: 1. what are the different approaches in solving problems in a CVP model
____________________________________________________________________

5.3.2. Target operating Income Analysis

Using CVP analysis managers can determine the total sales in unit and Birr/Dollar
needed to reach the target profit level. The computation of sales volume in unit and/ or in
amount to attain the targeted profit is similar with that of the break even analysis, except
that the targeted profit is more than offsetting the cost. For instance, the management of

68
Sebastopol Cinema desires to get Br 9000 profit for the coming month, instead of
operating at breakeven point, how many tickets must be sold? Managers want to answer
this question to provide the necessary resource support to attain the desired profit at
already determined volume of activity. The analysis can be performed using equation
method or contribution margin approach on the basis of personal preference.

See both the methods using the information given for Sebastopol Cinema to determine
the target sales in unit and Birr to that enable the firm to earn the targeted profit of birr
9,000 cab be determined using the equation method and contribution margin method as
follows:

Equation Method to Determine Contribution Margin Approach

(Target sales unit) (Target sales unit)
(SP x Q) - (VCU x Q) -FC= TOI Q = FC +TOI/ CMU
(25 x Q) – (15 x Q) - 48,000= 9000 Q = (48,000 + 9,000)/10
10Q= 57,000 Q= 5,700
Q= 5,700
Equation Method to Determine Contribution Margin Approach
(Target sales in birr) (Target sales in birr)
TR= SP x Q Target Sales in Birr = (FC + TOI)/CM%
=25 x 5700 = (48,000 + 9000)/
= Br 142,500 40%
= Birr 142, 500

Bothe the methods provided similar result that the cinema must sell 5,700 tickets at a
total of Birr 142, 500 to meet its target profit goal of birr 9000.

 Here you can recognize that each ticket sales beyond the breakeven point
contributes to the firms operating income.

5.3.3.The impact of Income Tax on CVP Analysis

Profit seeking enterprises must pay tax on their profit, meaning that target income figures
are set at high enough to cover the firm’s tax obligation to the government. The

69
relationship between an organization‘s before tax income and after tax income is
expressed in the following formula:

After Tax income = Before Tax Income – Income Taxes

NIAT = NIBT- (NIBT x t)
= NIBT x (1-t)
Dividing both sides by (1-t) you can get:
NIAT/ (1-t) = NIBT

Which gives you the desired before tax income that will generate the desired after tax
income, given the company’s tax rate.

For instance, if the target profit given for Sebastopol Cinema above is expressed on after
tax basis and the firm is subject to a 40 percent income tax rate, what will be the required
sales of ticket in units and Birr? If you want to know how many units that you need to
produce and sell in order to generate a target Net Income (or after-tax profit), just convert
the after-tax number into a before-tax number.

NIBT = NIAT/ (1-t)

=Br 9000/ (1-0.4)
= Br 15,000

You can then substitute the before-tax profit figure in the formulas used in target
operating income analysis. The analysis of sales of tickets and amount of Sebastopol
cinema to earn the desired profit after tax can be determined using the equation and
contribution margin approach as shown on the following table:

Equation Method to Determine Contribution Margin Approach

(Target sales unit) (Target sales unit)
(SP x Q) - (VCU x Q) -FC= TOIBT Q = FC +TOIBT/ CMU
(25 x Q) – (15 x Q) - 48,000= 15,000 Q = (48,000 + 15,000)/10
10Q= 63,000 Q= 6,300
Q= 6,300
Equation Method to Determine Contribution Margin Approach
(Target sales in birr) (Target sales in birr)

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TR= SP x Q Target Sales in Birr = (FC + TOIBT)/CM%
=25 x 6300 = (48,000 + 15,000)/
= Br 157,500 40%
= Birr 157, 500

5.3.4. Sensitivity Analysis

The entire example above assumes a definite amount of certainty as far as knowledge or
assumptions of the cost structure and the sale price are concerned. However, in the real-
world, day to day problems may cause some or all of the information to change. The
question to be answered in this section is what if a change occurs in our assumption in
the previous CVP analysis? Obviously the analysis must be re-done.
Sensitivity analysis is a “what if” technique that managers use to examine how a result
will change if the original predicted data are not achieved or if an underlying assumption
changes.

In the context of CVP analysis, sensitivity analysis answers the following questions:
 What will be the operating income if units sold decrease by 15% from original
prediction?
 What will be the operating income if variable cost per unit increases by 20%?
The sensitivity of operating income to various possible outcomes broadens the
perspective of management regarding what might actually occur before making cost
commitments.
To make the concept clear let you take the Income statement of Sebastopol Cinema
prepared when the firm planned an operating profit of Birr 9000 from the sales of 5,700
tickets.
Sales Revenue :( Br25x5, 700) -------------------------------------- Br 142,500
Less Variable Costs (Br 15 x 5,700) -------------------------------------85,500
Contribution Margin----------------------------------------------------Br 57,000
Less Fixed Costs-------------------------------------------------------------48,000
Operating Income -------------------------------------------------------- Br 9,000

The management has different proposals that are assumed to increase the operating
income. To make decisions that have implication on the cost, volume and profit, the

71
management needs to conduct a sensitivity analysis. For example the following
proposals are given:

The marketing manager proposed that increasing a monthly advertising budget by Birr
4000 may result a Birr 13,000 increase on a monthly sales. This proposal, if
implemented will change the fixed cost as well as the volume of sales. As you all know
total variable cost also varies with any change in volume, therefore the proposed change
also changes the variable cost as well. So before accepting the proposal the general the
manager needs to conduct a sensitivity analysis to realize the ultimate result of changes
on fixed cost, variable cost and sales on operating income.

(1) (2) (3) = (2)-(1)

Existing Plan Proposed Plan Difference
Sales Revenue Br 142,500 155,500 13,000
Variable cost (5,700 x 15;
6220 x Br 15) 85,500 93,300 7,800
Contribution Margin 57,000 62,200 5,200
Fixed Cost 48,000 52,000 4,000
Operating Income 9,000 10,200 1,200

As you can see from the above analysis a Birr 4000 increase in the advertising budget,
which is a fixed cost increased the number of ticket that the firm is selling using the
existing plan from 5,600 to 6,220 as a result the sale revenue as well as the variable cost
increased along with the increased in sales volume. As the analysis revealed that the
operating income can increased by Birr 1,200, the manager can implement the proposed
plan.
As you have seen on the example above, Sensitivity analysis allows us to accommodate
for the dynamic nature of organizational environments by adding in new information and
adjusting our planning accordingly.

5.3.5. Margin of Safety

The margin of safety is the excess of the budgeted or actual sales over the breakeven
sales level. This tells managers the margin between current sales and the breakeven
point. In a sense margin of safety indicates the risk of losing money that a company
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 faces; that is the amount by which sales can fall before the company is in the loss area.
The margin of safety is determined using the following formula:

Margin of Safety = Sales Volume - Breakeven Sales volume

(Actual or Budgeted)

As an example, conceder the case of Sebastopol Cinema, that planed to attain a Birr 9000
before tax profit at a sales volume of 5700 units or Birr 142, 500. The breakeven point
for this company as determined on section 3 above is attained at the sales volume of
4,800 units or Birr 120,000. The margin of safety for this company is the difference
between the budgeted sales and the breakeven sales, which is 900 units (5,700unite -
4,800). The margin of safety in terms of sales value is also determined as Birr22,
500(Birr 142,500-Birr120, 000). The interpretation is that, sales volume of Sebastopol
can drop by 1100 tickets or Birr 22,500 before the firm incurs a loss, if all other things
remain constant.

In practice the margin of safety is determined in sales amount (Birr) and as a percentage
of current sales. To determine the margin of safety in percentage the following formula
can be used:
Margin of Safety (%) = Margin of safety in Birr
Sales
For Sebastopol Cinema the margin of safety percentage is,
27,500/142,500
= 19.3%

Activities5.3:
1. How can cost Volume profit (CVP) analysis be used by a company?
2. List and explain the three approaches to analyze a CVP problems
3. Explain the following terms:

i. Contribution margin
ii. Breakeven point
iii. Sensitivity analysis
iv. Margin of safety

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 5.4. Multiple Product Company and Cost-Profit-Volume Analysis

Our illustration of CVP Analysis on the previous part of this unit assumes that the
company has only one product; however in real life, companies produce a range of
products, not just one kind as was assumed in the example above. In case when a
company offers more than one product, obviously different products will have different
selling prices, variable costs per unit and, as a result, different contribution margins and
contribution margin ratios.

 Dear learners, Can CVP analysis help managers in a multi product

companies with complication of some CVP assumptions?

The answer is 'Yes’, you can perform the same similar analysis if you just obtain some
data about the product mix and the constant sales mix assumption discussed above holds
true. The term sales/revenue mix, which is essential in such a situation, is defined as the
relative proportions or combinations of quantities of products that comprise total sales.
In performing the analysis, first, you need to know proportion in which each of the
products is sold. Then you can calculate contribution margin for each product. After that
you define weighted average contribution margin, which is used in the determination of
break-even point or the amount of sales required to gain desired income (profit).
Let's illustrate it on Ethio.Tire Corporation an example. Assume, the company produces 3
types of tire: for trucks, cars and motor-bikes. The following data is available:

Truck Tire Car Tire Motor-bike

Tire
(A) Share in physical volume sold, % 30% 45% 25%
(B) Selling price per unit, Birr Birr10 Birr8 Birr7
(C) Variable cost per unit, Birr Birr7 Birr6 Birr5
(D) Contribution per unit, Birr (B - C) Birr3 Birr2 Birr2
(E) Contribution margin ratio (D ÷ B) 0.30 0.25 0.29
(F) Fixed costs total, Birr Birr10,000

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From the given above you can calculate weighted average contribution margin. To
calculate weighted average contribution margin you need to "weight" the contribution
margin per unit of these three products and present it as "three-in-one". To state it in the
form of formula,

Weighted Average Contribution Margin per Unit = CMU x Percentage of sales Mix

Using information given above you can calculate Weighted Average contribution margin
as follows:
Weighted Average Contribution Margin per Unit = (30% x Birr3) + (45% x Birr2) +
(25% x Br2) = Birr2.3
Now break-even point may be calculated using the weighted average contribution margin
as far as the given sales mixes remain as it is.

5.4.1. Contribution Margin Technique and Break-even point for a Multiple

Product Company

The calculation of breakeven point in a multi-product company follows the same logic as
in a single product company. While the numerator will be the same fixed costs, the
denominator now will be weighted average contribution margin. The modified formula is
as follows:
Break-even Point (in units) = Fixed Costs
Weighted Average Contribution Margin per Unit
For our example break-even point (in units) for Ethio.Tire Corporation, can be
determined using the formula as,
BEP (in units) = FC/ WA.CM
=Br 10,000/2.3
Br 4347.86

The company will be at breakeven if it approximately produces 4,348 units. The total
numbers of outputs required to breakeven are then split in accordance with the proportion
defined in row 1 in the above table:

Truck tires: 4,348 units x 30% = 1,304 units

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 Car tires: 4,348 units x 45% = 1,957 units
Motor-bike tires: 4,348 units x 25% = 1,087 units

Ethio.Tire Corporation will be at break-even (i.e., will get neither profit nor loss) if it
sells the above volumes of Tires at the given proportion 30%:45%:25%.

However, it is important to remember that each proportion of product mix will have
different break-even points. For example, if market situation changes and Ethio.Tire
Corporation switches to larger production of more expensive truck tires with proportion
45%:30%:25%, break-even point will change. In this case, the weighted average
contribution margin per unit will be Birr2.45 and zero profit will be earned at total level
of sales of around 4,082 valves (compared to 4,348 units).

The change occurred due to the fact that contribution ratio per unit of truck tires is the
highest (Birr3 for truck tires versus Birr2 per car or motor-bike tires). Thus, more income
can be generated by producing and selling truck tires and break-even point is reached
faster (with less total items produced and sold).

A shift in sales-mix from high-margin items to low-margin items can

cause total profit to decrease even though total sales may increase.
Conversely, a shift in the sales mix from low margin items to high
margin items can cause the reverse effect-total profit may increase even
though total sales decrease.

Break-even point for multiple product production can be calculated in Birr value as well.
Here also, the numerator is the same fixed costs. The denominator now will be weighted
average contribution margin ratio. The modified formula is as follows:

Break-even Point (in Birr) = Fixed Costs

Weighted Average Contribution Margin Ratio
Based on figures from the earlier table with information about three Tire types, the break-
even point will be reached at:

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 Break-even Point (in dollars) = Birr10,000
30% x 0.3 + 45% x 0.25 + 25% x 0.29 =
Birr36,364
Therefore, to achieve the break-even point, Ethio.Tire Corporation has to sell tires for a
total of Birr36, 364 (valid only when proportion of sales is 30%:45%:25%).
Let's check the results: ∑Sales Units x Contribution - Fixed Costs, should approximately
equal zero (rounding difference may arise): Br3 x 1,304 + Br2 x 1,957 + Br2 x 1,087 -
Br10, 000 = 0

5.4.2. Contribution margin technique and sales required for desired income for a
multi-product company

The logic to calculate sales required for designed income (profit) for a multi-product
company is the same as for a single product company. In the formula for determining the
sales required for desired profit, we just substitute contribution margin per unit for one
product with weighted average contribution margin for multiple products.
The formula to calculate the required unit sale for a given desired income is shown
below:
Unit Sales = Fixed Costs + Profit
Weighted Average Contribution Margin per Unit
And the amount of sales in dollars can be determined using the following formula:
Sales (Birr) = Fixed Costs + Profit
Contribution Margin Ratio

5.5. Not for Profit Organizations and Cost-Profit-Volume (CVP) Analysis

Managers in not-for-profit (NFP) organizations also routinely use CVP analysis to
examine the effect of activity and others short run changes on revenue and costs. For
example, activity administration must analyze the impact of increment in population on
the different tax revenue and the cost of providing services such as education,
transportation, and police protection etc. Mangers in diverse NFPs such as,
universities, Public hospitals, and charitable and development oriented nongovernmental
organizations (NGOs) are also apply CVP as operational analysis model. For instance
Jimma University can use CVP in analyzing the change in student population and its

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impact on the cost of service provision such as, cafeteria, library teaching, tutorial,
research guidance and the like.
Activity: Explain how do nonprofit organizations apply CVP model in their
administrative decisions?
___________________________________________________________________

Unit Summary
Unit five presents the cost-volume-profit (CVP) analysis model and illustrates how
managers use that model in their profit planning and answer important “what-if” business
questions. CVP analysis helps management accountants alert managers to the risks and
rewards of decisions they are considering, by illustrating how the “bottom-line” is
affected by changes in activity levels and/or key pricing or cost components. CVP
analysis is based on several assumptions, one of which is that fixed costs can be
distinguished from variable costs. However, whether a cost is variable or fixed depends
on the time period for the decision and also the range of activity (relevant range) being
considered. You were also presented with a method for applying CVP analysis to a single
product companies and companies with multiple products, and to the scenario of NFP.
Model Examination Questions
Multiple Choice Questions
1. A firm has a negative contribution margin. To reach breakeven, it must;
A. Increase Units selling Price
B. Increase sales volume
C. Decrease fixed cost
D. Decrease sales volume
E. Increase fixed cost
2. One of the following can increase breakeven point,
A. Decrease in Variable cost
B. Decrease in Fixed cost
C. An increase in selling price
D. An increase in variable cost
E. None of the above

78
3. The Environmental Filter Company is planning to sell air filter systems for Birr2, 500 per unit.
Variable costs are Birr 1,500 per unit and total fixed costs are Birr1, 000,000. What is the dollar
value of sales necessary to break even?

A. Birr 1,000,000
B. Birr 2,000,000
C. Birr 2,500,000
D. Birr 5,000,000

4. Efa Company reported sales of Birr 150,000 (20,000 units). Fixed costs amounted to Birr
20,000 and operating income for the period was birr 90,000. Determine the per-unit variable
cost.

A. Birr 1.00
B. Birr 2.00
C. Birr 4.50
D. Birr 5.50

ANSWER KEY FOR MODEL EXAM QUESTIONS

1. A 2. D 3.C 4. B

UNIT FIVE
STANDARD COSTING AND VARIANCES
UNIT OUTLINE
5.1.Introduction
5.2.Standard cost system
5.2.1. Meaning of standard costing
5.2.2. Why standard costing are used
5.2.3. Budgetary control vs. standard costing
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 5.2.4. Advantage and limitation of standard costing
5.2.5. Development of standard cost system
5.2.6. Considerations in establishing standards
5.3.Variance analysis
5.3.1. introduction
5.3.2. classification of variances
5.3.2.1.direct material and labor variance
5.3.2.2.overhead cost variance
5.3.2.3.sales variance
5.3.3. causes and disposition of variances

UNIT OBJECTS

After completing this chapter, you should be able to answer the following questions:
 Why is standard cost systems used?
 How are standards for material, labor, and overhead set?
 How are material, labor, and overhead variances calculated and disposed?
 What are the benefits organizations derive from standard costing and
variance analysis?
 How will standard costing be affected if a company uses a single
conversion element rather than the traditional labor and overhead
elements?
 How do multiple material and labor categories affect variances?

5.1. INTRODUCTION

One of the most important functions of management is control. The major aspect of
managerial control is cost control. Control normally refers to the function which ensures
the actual performance conforms to a given plan. Hence, the control function of
management can be effective only when it is preceded by planning. Standard costing is a
technique which helps management to plan and control business operations.

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The word ‘standard’ means a bench-mark or yardstick. The standard cost is a
predetermined or expected cost which determines what each product or service should
cost under given conditions. In other words, it is the expected cost of producing one unit.
It is, in effect, a budget for one unit. Standard costing may be defined basically as a
technique of cost accounting which compares the standard cost of each product or service
with the actual cost to determine the efficiency of operation so that remedial action may
be taken immediately. The institute of costs and management accounts of England
defines standard costing as “the preparation and use of standard costs, the comparison
with the actual costs, and the analysis of variances to their cause and the points of
incidence.” Variance is the difference between a budget or standard amount and the
actual amount during a given period.

5.2. STANDARD COST SYSTEMS

5.2.1. MEANING OF STANDARD COSTING

Standard costs are predetermined costs that are usually expressed on per unit basis. In
other word, standard cost is a predetermined calculation of how much costs should be
incurred under specified working condition. It is built up from an assessment of the value
of direct material, direct labor and overhead items.

5.2.2. WHY STANDARD COST SYSTEMS ARE USED

 Dear learner! Do you know why managers use standard cost?

“A standard cost system has three basic functions: collecting the actual costs of a
manufacturing operation, determining the achievement of that manufacturing operation,
and evaluating performance through the reporting of variances from standard.” These
basic functions result in six distinct benefits of standard cost systems.

Clerical Efficiency
A company using standard costs usually discovers that less clerical time and effort are
required than in an actual cost system. In an actual cost system, the accountant must
continuously recalculate changing actual unit costs. In a standard cost system, unit costs
are held constant for some period. Costs can be assigned to inventory and cost of goods
sold accounts at predetermined amounts per unit regardless of actual conditions.

81
Motivation
Standards are a way to communicate management’s expectations to workers. When
standards are achievable and when workers are informed of rewards for standards
attainment, those workers are likely to be motivated to strive for accomplishment. The
standards used must require a reasonable amount of effort on the workers’ part.
Planning
Planning generally requires estimates about the future. Managers can use current
standards to estimate future quantities and costs. These estimates should help in the
determination of purchasing needs for material, staffing needs for labor, and capacity
needs related to overhead that, in turn, will aid in planning for company cash flows. In
addition, budget preparation is simplified because a standard is, in fact, a budget for one
unit of product or service. Standards are also used to provide the cost basis needed to
analyze relationships among costs, sales volume, and profit levels of the organization.
[

Controlling
The control process begins with the establishment of standards that provide a basis
against which actual costs can be measured and variances calculated. Variance analysis is
the process of categorizing the nature (favorable or unfavorable) of the differences
between actual and standard costs and seeking explanations for those differences. A well-
designed variance analysis system captures variances as early as possible, subject to cost-
benefit assessments. The system should help managers determine who or what is
responsible for each variance and who is best able to explain it. An early measurement
and reporting system allows managers to monitor operations, take corrective action if
necessary, evaluate performance, and motivate workers to achieve standard production.

Decision Making
Standard cost information facilitates decision making. For example, managers can
compare a standard cost with a quoted price to determine whether an item should be
manufactured in-house or instead be purchased. Use of actual cost information in such a
decision could be inappropriate because the actual cost may fluctuate from period to
period. Also, in making a decision on a special price offering to purchasers, managers can
use standard product cost to determine the lower limit of the price to offer. In a similar

82
manner, if a company is bidding on contracts, it must have some idea of estimated
product costs. Bidding too low and receiving the contract could cause substantial
operating income (and, possibly, cash flow) problems; bidding too high might be
uncompetitive and cause the contract to be awarded to another company.

Performance Evaluation
When top management receives summary variance reports highlighting the operating
performance of subordinate managers, these reports are analyzed for both positive and
negative information. Top management needs to know when costs were and were not
controlled and by which managers. Such information allows top management to provide
essential feedback to subordinates, investigate areas of concern, and make performance
evaluations about who needs additional supervision, who should be replaced, and who
should be promoted. For proper performance evaluations to be made, the responsibility
for variances must be traced to specific managers.
Activity 5.1
1. Why is standard cost systems used? -------------------------------------------------------
2. What are the basic functions of standard cost systems? --------------------------------

4.2.3. BUDGETARY CONTROL vs. STANDARD COSTING

 Dear student! What makes the same and differentiate budget from
standard? Why we need to use standard value rather than using budget
amount?

Budgetary control and standard costing are comparable system of cost accounting in that
they are both predetermined of forward – looking. The common objective is of
controlling business operations by establishing predetermined targets. However, there
are a few differences between these two systems are which given below:

Budgetary control system Standard costing system

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 1. Budgetary control is related to all 1. Standard costing is related to
types of items of revenue and production and production costs.
expenditure, whether they belong to Hence, it is more rigorous and
the product or not, i.e. to all types of intensive.
business activities. Hence, it is more 2. Standard is established on the basis
extensive. of technical estimates. It is the
2. Budget is based on past experience projection of accounts.
and in most cases a projection of 3. Standard are very rigid and ‘ought
financial accounts. to be’ estimates. They fix targets.
3. Budgets are comparatively less 4. Standard costing system cannot
rigid and ‘should be’ estimates. operate well without a budgetary
They fix limits. control system. Also, it is not
4. Budgetary control can be operated possible to operate the system in
without a standard costing system. parts
It can be adopted in part. 5. Variance analysis is a subject of
5. The study of variances is not a special study of standard costing.
subject of special study as in the
case of standard costing

4.2.4. ADVANTAGES AND LIMITATIONS OF STANDARD

COSTING

Advantages of standard costing

1. The weakness of the traditional costing system can be estimated by compiling
standard costs more carefully.
2. Standard costs can be used as a yardstick against which actual costs can be
compared. It is an effective tool for planning production costs. Hence, cost control
is greatly facilitated.
3. Variance analysis helps management to have regular as well as better checks over
costs incurred. It makes the application of the principle of management by
exception more easy. That is, the management can concentrate its attention on
variances only, leaving the other aspects of cost control to be taken care of at the
lower level.

84
 4. It is a valuable guide to management in the formulation of production and price
policies in advance with certainty. It also assists management in the areas of profit
– planning, product –pricing, and inventory pricing, etc.
5. Standard costing makes the reporting of operating data more meaningful and also
fast. This makes the interpretation of management reports easy.
6. As the emphasis of the standard costing system is more on cost variations, it
makes the entire organization cost conscious. It makes the employees recognize
the importance of efficient operations so that costs can be reduced by joint efforts.
7. Labor, materials and machines can be effectively used, and economies can be
affected in addition to increase productivity. Standards may also be used as the
basis for introducing incentive schemes.

Limitations of standard costing

1. Setting of standards is a very difficult task. It requires a lot of scientific studies
such as time –study, motion study, etc., and therefore it is very costly. Small firms
may find it very difficult to operate such a system.
2. Standards are very rigid estimates and once set, are not changed for a considerable
time. This makes the standards highly unrealistic in certain industries which face
fluctuations in prices of products due to frequent changes.
3. The utility of variance analysis depends much more on the standard set. While a
loosely set standard may be ridicule the standards which are set very high may
create frustration in the minds of the workers. At the same time setting of correct
standards is also, it is difficult to apply this system when production takes more
than one accounting period.

4.2.5. DEVELOPMENT OF A STANDARD COST SYSTEM

 Dear learner! Do you know how to develop standards for production
inputs?

Although standard cost systems were initiated by manufacturing companies, these

systems can also be used by service and not-for-profit organizations. In a standard cost
system, both standard and actual costs are recorded in the accounting records. This dual
recording provides an essential element of cost control: having norms against which
actual operations can be compared. Standard cost systems make use of standard costs,

85
which are the budgeted costs to manufacture a single unit of product or perform a single
service. Developing a standard cost involves judgment and practicality in identifying the
material and labor types, quantities, and prices as well as understanding the kinds and
behaviors of organizational overhead.
A primary objective in manufacturing a product is to minimize unit cost while achieving
certain quality specifications. Almost all products can be manufactured with a variety of
inputs that would generate the same basic output and output quality. The input choices
that are made affect the standards that are set. Some possible input resource combinations
are not necessarily practical or efficient.
Once management has established the desired output quality and determined the input
resources needed to achieve that quality at a reasonable cost, quantity and price standards
can be developed. Experts from cost accounting, industrial engineering, personnel, data
processing, purchasing, and management are assembled to develop standards. To ensure
credibility of the standards and to motivate people to operate as close to the standards as
possible, involvement of managers and workers whose performance will be compared to
the standards is vital.
Material Standards
The first step in developing material standards is to identify and list the specific direct
materials used to manufacture the product. This list is often available on the product
specification documents prepared by the engineering department prior to initial
production. In the absence of such documentation, material specifications can be
determined by observing the production area, querying of production personnel,
inspecting material requisitions, and reviewing the cost accounts related to the product.
Three things must be known about the material inputs: types of inputs, quantity of inputs
used, and quality of inputs used.
In making quality decisions, managers should seek the advice of materials experts,
engineers, cost accountants, marketing personnel, and suppliers. In most cases, as the
material grade rises, so does cost; decisions about material inputs usually attempt to
balance the relationships of cost, quality, and projected selling prices with company
objectives. The resulting trade-offs affect material mix, material yield, finished product
quality and quantity, overall product cost, and product salability. Thus, quantity and cost
estimates become direct functions of quality decisions.

86
Given the quality selected for each component, physical quantity estimates of weight,
size, volume, or some other measure can be made. These estimates can be based on
results of engineering tests, opinions of managers and workers using the material, past
material requisitions, and review of the cost accounts.
Specifications for materials, including quality and quantity, are compiled on a bill of
materials. Even companies without formal standard cost systems develop bills of
materials for products simply as guides for production activity. When converting
quantities on the bill of materials into costs, allowances are often made for normal waste
of components. After the standard quantities are developed, prices for each component
must be determined. Prices should reflect desired quality, quantity discounts allowed, and
freight and receiving costs. Although not always able to control prices, purchasing agents
can influence prices. These individuals are aware of alternative suppliers and attempt to
choose suppliers providing the most appropriate material in the most reasonable time at
the most reasonable cost. The purchasing agent also is most likely to have expertise about
the company’s purchasing habits. Incorporating this information in price standards should
allow a more thorough analysis by the purchasing agent at a later time as to the causes of
any significant differences between actual and standard prices.
When all quantity and price information is available, component quantities are multiplied
by unit prices to obtain the total cost of each component. (Remember, the price paid for
the material becomes the cost of the material.) These totals are summed to determine the
total standard material cost of one unit of product.
Labor Standards
Development of labor standards requires the same basic procedures as those used for
material. Each production operation performed by either workers (such as bending,
reaching, lifting, moving material, and packing) or machinery (such as drilling, cooking,
and attaching parts) should be identified. In specifying operations and movements,
activities such as cleanup, setup, and rework are considered. All unnecessary movements
by workers and of material should be disregarded when time standards are set.
To develop usable standards, quantitative information for each production operation must
be obtained. Time and motion studies may be performed by the company; alternatively,
times developed from industrial engineering studies for various movements can be used.
A third way to set a time standard is to use the average time needed to manufacture a
product during the past year. Such information can be calculated from employees’ past

87
time sheets. A problem with this method is that historical data may include inefficiencies.
To compensate, management and supervisory personnel normally make subjective
adjustments to the available data.
After all labor tasks are analyzed, an operations flow document can be prepared that
lists all operations necessary to make one unit of product (or perform a specific service).
When products are manufactured individually, the operations flow document shows the
time necessary to produce one unit. In a flow process that produces goods in batches;
individual times cannot be specified accurately.
Labor rate standards should reflect the employee wages and the related employer costs
for fringe benefits, FICA (Social Security), and unemployment taxes. In the simplest
situation, all departmental personnel would be paid the same wage rate as, for example,
when wages are job specific or tied to a labor contract. If employees performing the same
or similar tasks are paid different wage rates, a weighted average rate (total wage cost per
hour divided by the number of workers) must be computed and used as the standard.
Differing rates could be caused by employment length or skill level.
Overhead Standards
To provide the most appropriate costing information, overhead should be assigned to
separate cost pools based on the cost drivers, and allocations to products should be made
using different activity drivers.
After the bill of materials, operations flow document, and predetermined overhead rates
per activity measure have been developed, a standard cost card is prepared. This
document summarizes the standard quantities and costs needed to complete one product
or service unit.

Data from the standard cost card are then used to assign costs to inventory accounts. Both
actual and standard costs are recorded in a standard cost system, although it is the
standard (rather than actual) costs of production that are debited to Work in Process
Inventory. Any difference between an actual and a standard cost is called a variance.

Activity.4.2
1. How are standards for material, labor, and overhead set? ---------------------------------
----------------------------------------------------------------------------------------------

88
 4.2.6. CONSIDERATIONS IN ESTABLISHING STANDARDS
 Dear learner! Do you know what should be taken into account when
you are establishing standards?

When standards are established, appropriateness and attainability should be considered.

Appropriateness, in relation to a standard, refers to the basis on which the standards are
developed and how long they will be expected to last. Attainability refers to
management’s belief about the degree of difficulty or rigor that should be incurred in
achieving the standard.

Appropriateness
Although standards are developed from past and current information, they should reflect
relevant technical and environmental factors expected during the time in which the
standards are to be applied. Consideration should be given to factors such as material
quality, normal material ordering quantities, expected employee wage rates, degree of
plant automation, facility layout, and mix of employee skills. Management should not
think that, once standards are set, they will remain useful forever. Current operating
performance is not comparable to out-of-date standards.
Standards must evolve over the organization’s life to reflect its changing methods and
processes. Out-of-date standards produce variances that do not provide logical bases for
planning, controlling, decision making, or evaluating performance.

Attainability
Standards provide a target level of performance and can be set at various levels of rigor.
The level of rigor affects motivation, and one reason for using standards is to motivate
employees. Standards can be classified as expected, practical, and ideal. Depending on
the type of standard in effect, the acceptable ranges used to apply the management by
exception principle will differ. This difference is especially notable on the unfavorable
side.

4.3. VARIANCE ANALYSIS

4.3.1. Introduction
The main advantage of the standard costing system is variance analysis. The principle of
“management by exception” is practiced easily with the help of variances. Variance may
be defined as the difference between standard and actual for each element of cost and

89
sometimes for sales. And ‘variance analyses’ may be defined as the process of analyzing
variance by sub –dividing the total variance in such a way that management can assign
responsibility for off –standard performance. When the actual results are better than
expected, a ‘favorable’ variance arises; where they are not up to the standard, an ‘adverse
variance’ occurs.

Variances help to fix the responsibilities so that management can ascertain the person
responsible for the poor results. For example, an adverse material usage variance would
indicate that excess material cost was due to inefficient use of materials. This would
enable management to fix the responsibility on the supervisor in charge of a particular
operation in which the inefficiency occurred. It may be discovered that the variance was
caused by (say) inefficient handling, purchase of poor quality materials or employment of
trainees. The important point is that the reason for the variance must be found, explained
and wherever necessary, corrective measures taken.

4.3.2. Classification of variances

 Dear learner! What do you know about budget variance? And how do
you classify it?

Budget Variances indicate the total deviation of actual costs from expected costs.
However, they do not give the complete story about deviations between budgeted and
actual results; i.e. it is not yet clear what contributed to the variances unless further
investigations are made.

Hence, a total flexible budget variance (FBV) is the difference between total actual costs
incurred and total standard cost applied to the output produced during the period. This
variance can be diagrammed as follows:

Actual Cost of Actual Production Input Standard Cost of Actual Production Output

Total Variance (FBV)

Since total variances do not provide useful information for determining why cost
differences occurred; to help managers in their control objectives, total variances are
subdivided into price and usage components. Hence, the total variance diagram can be
expanded to provide a general model indicating the two sub-variances as follows:

90
 Actual Cost of Standard Cost of Standard Cost of
Actual Production Actual Production Standard Quantity
Inputs Inputs of Inputs
(AP x AQ) (SP x AQ) (SP x SQ)

Price/Rate Variance Quantity/Efficiency variance

Total Variance (FBV)

A price/rate variance reflects the difference between what was paid for inputs and what
should have been paid for inputs. A usage /Quantity//Efficiency variance shows the cost
difference between the quantity of actual input and the quantity of standard input allowed
for the actual output of the period. The quantity difference is multiplied by a standard
price to provide a monetary measure that can be recorded in the accounting records.
Usage variances focus on the efficiency of results or the relationship of input to output

As shown above, the diagram moves from actual cost of actual input on the left to
standard cost of standard input quantity on the right. The middle measure of input is a
hybrid of actual quantity and standard price. The change from input to output reflects the
fact that a specific quantity of production input will not necessarily produce the standard
quantity of output. The far right column uses a measure of output known as the standard
quantity allowed. This quantity measure translates the actual production output into the
standard input quantity that should have been needed to achieve that output. The
monetary amount shown in the right-hand column is computed as the standard quantity
allowed times the standard price of the input.

The price variance portion of the total variance is measured as the difference between the
actual and standard prices multiplied by the actual input quantity:
i.e. Price Element= (AP -SP)(AQ

Whereas, the usage variance portion of the total variance is measured as measuring the
difference between actual and standard quantities multiplied by the standard price:
i.e. Usage Element= (AQ - SQ)(SP)

Dear student, the following sections illustrate variance computations for each cost
element (i.e. price and usage components) on input of production.
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 4.3.2.1.DIRECT MATERIAL AND LABOR VARIANCES
 Dear learner! How are material, labor, and overhead variances
calculated? How materials and labor cost variance computed when there are is only one
type (classes) of material (labor) input used in the production? What about if there are
more than one type (classes) of material (labor) input used in the production?

A. DIRECT MATERIAL COST VARIANCES:

To completely and meaningfully analyze the flexible budget variance for material, it
should be analyzed in terms of the materials price standard and the materials quantity
standard. This level of analysis resulted in: (i) material price variance that identifies the
effect of differences in prices paid for materials. (ii) Material quantity (usage) variance
that identifies the effect of difference in the quantities of materials used.

i) Material Price Variance(MPV)

A material price variance is the difference between the actual price of material/unit and
the standard price of material per unit multiplied by the actual quantity of material
purchased. In other words, the material price variance (MPV) indicates whether the
amount paid for material was below or above the standard price. Material price variance
can be calculated as:

MPV = (SP – AP) AQ

where: SP is the standard price of material per unit

AP is actual price of material per unit
AQ is the actual quantity of material
purchased and consumed

If the actual price is larger than the standard price, this variance is unfavorable (U); if the
standards are larger than the actual; the variance is favorable (F)

ii) Materials Quantity (usage) Variance(MQV)

The material quantity variance (MQV) indicates whether the actual quantity used was
below or above the standard quantity allowed for the actual output. This difference is
multiplied by the standard price per unit of material. i.e. A material quantity (usage)
variance is the difference between the actual quantity of materials used and the standard

92
quantity of materials that should have been used to produce the actual output, multiplied
by the standard price of materials per unit. It can be calculated as:

MQV = (SQ-AQ) x SP

where: SP is the standard price of material per unit

SQ is the actual quantity of material used for
units produced
AQ═ the actual quantity of material used

If the actual quantity amounts are larger than the standard quantity amounts, this variance
is unfavorable (U); if the standards are larger than the actual; the variance is favorable (F)
Example 5.1 In August 2001, East Publishing Company’s costs and quantities of paper
consumed in manufacturing its 2002 Executive Planner and Calendar were as follow:
Actual unit purchase price Br 0.16 per page
Standard quantity allowed for good production 195,800 pages
Actual quantity purchased during August 230,000 pages
Actual quantity used in August 200,000 pages
Standard unit price Br 0.15 per page
Required:
a) Calculate the total cost of purchases for August.
b) Compute the material price variance on the bases of purchase
c) Calculate the material quantity variance.
d) Total FBV
Solution:
a) Total cost of purchases for August would be:
Actual unit purchase price (a) -------------------------------- Br 0.16 per page
Actual quantity purchased during August (b) ---------------- 230,000 pages
Total cost (a x b) ------------------------------------ Br.31, 220
b) MPV = (SP – AP) AQ
= (Br 0.15 per page - Br 0.16 per page) 230,000 pages= Br. 2,300 (U)
c) MQV = (SQ-AQ) x SP
= (195,800 pages - 200,000 pages) Br 0.15 per page= Br. 630(U)
d) Total FBV═ Br 2,300U + Br. 630U═ Br.2,930 U
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Activity4.3
Iron Eagle makes wrought iron table and chair sets. During April 2001, the purchasing
agent bought 12,800 pounds of scrap iron at Br. 0.89 per pound. Each set requires a
standard quantity of 35 pounds at a standard cost of Br 0.85 per pound. During April, the
company used 10,700 pounds and produced 300 sets. For April, compute the direct
material price variance and the direct material quantity variance.
B. LABOR COST VARIANCES:

Just like we have done for material inputs, we will do the same meaningful analysis for
labor inputs. Hence, the variance investigation to flexible budget variance for labor
resulted in: (i) labor rate variance that identifies the effect of differences in the rates paid
to workers, and (ii) labor efficiently or usage variance that identifies the effect of
differences in the quantities of labor used.
i) Labor Rate Variance(LRV)

The labor rate variance (LRV) shows the difference between the actual wages paid to
labor for the period and the standard wages for all hours worked. Thus, Labor rate
variance is the difference between the actual rate of labor per hour and the standard rate
of labor per hour, multiplied by the actual hours of labor worked.

LRV= (SR-AR) x AH
Where: SR is standard rate of labor per hour
AR is actual rate of labor per hour, AH is a total actual hour of labor worked

ii) Labor Efficiency Variance (LEV)

A labor efficiency variance is the difference between the actual labor hours worked and
the standard labor hours that should have been worked to produce the actual output,
multiplied by the standard rate of labor per hour. Thus, multiplying the standard labor
rate by the difference between the actual minutes worked and the standard minutes for the
production achieved results in the labor efficiency variance (LEV)

LEV = (SH – AH) x SR

Where: SH is standard hours of labor for the actual unit produced

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 AH is actual labor hours used for the unit produced
SR is standard rate of labor per hour

Example 4.2 Sagittarius Corp. has established the following standards for the prime costs
of one of its chief product, dart boards.
Standard Qty standard Price (Rate) Total Standard cost
Direct material 8.5 pounds Br.1.80/pound Br.15.30
Direct labor 0.25 hour 8.00/hour 2.00
Br.17.30
During May, Sagittarius purchased 160,000 pounds of direct material at a total cost of
Br.304, 000. The total wages for May were Br.42, 000, 90% of which were for DL.
Sagittarius manufactured 19,000 dart boards during May; using 142,500 pounds of direct
material & 5,000 direct labor hours.
Required: Compute the following variances for May.
a) Direct material price variances
b) Direct material usage variance
c) Direct material cost variance
d) Direct labor rate variance
e) Direct labor efficiency variance
f) Direct labor cost variance
Solution
Material Variances
i). SQ = Standard Quantity of Direct material for Actual Output would be:
1 dart board = 8.5 pounds Direct material
19,000 dart boards = ?
So, SQ = 8.5 pounds Direct material x 19,000 = 161,500 pounds
ii). SP = Standard price of Direct material = Br. 1.80/pounds.
iii). AP = Actual Price of Direct material = Total cost of Direct material purchased
Total units of direct material purchased
= Br. 304,000 = Br.1.90/ pounds
160,000 pounds
iv). AQ=Actual Quantity of Direct material purchased or used = 142,500 pounds
a) MPV= (SP – AP) AQ
= (Br.1.80/pds - Br.1.90/ pds) 142,500 pounds = Br. 14,250(U)
b) MQV = (SQ-AQ) x SP
= (161,500 pounds - 142,500 pounds) Br. 1.80/pounds= Br. 34,200(F)
c) Material cost variance = MPV + MQV
= Br. 14,250 (U) + Br. 34,200 (F) = Br. 19,950 (F)
Labor Variances

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i) SR= Standard Rate of DL per hour= Br.8.00/Hr
ii) SH=Standard Hours of DL for Actual Output would be:
0.25Hrs=1dart board
? = 19,000 dart boards
SH = 0.25x19, 000=4,750Hrs
iii) AH=Actual hrs of DL used = 5,000 hrs
iv) AR= 0.9 x 42,000 = 37,800 = Br.7.56/Hr
5,000 5,000
d) LRV= (SR-AR) x AH
= (Br.8.00/Hr - Br.7.56/Hr) 5,000 hrs = Br. 2,200 (F)
e) LEV = (SH – AH) x SR
= (4,750Hrs - 5,000 hrs) Br.8.00/Hr = Br.2, 000(U)
f) labor cost variance = LRV + LEV= Br. 2,200 (F) + Br.2, 000(U) = Br. 200 (F)

c) MIX AND YIELD VARIANCES

 Dear learner! What do you know about production mix and yield?
Most companies use a combination of many materials and various classifications of direct
labor to produce goods. In such settings, the material and labor variance analysis
presented in the above section are insufficient.

When a company’s product uses more than one material, the goal is to combine those
materials in such a way as to produce the desired product quality in the most cost-
beneficial manner. Sometimes, materials can be substituted for one another without
affecting product quality. In other instances, only one specific material or type of material
can be used. For example, a furniture manufacturer might use either oak or maple to build
a couch frame and still have the same basic quality. A perfume manufacturer, however,
may be able to use only a specific fragrance oil to achieve a desired scent.
Labor, like materials, can be combined in many different ways to make the same product.
Some combinations will be less expensive than others; some will be more efficient than
others. Again, all potential combinations may not be viable.

Management desires to achieve the most efficient use of labor inputs. As with materials,
some amount of interchangeability among labor categories is assumed. Skilled labor is
more likely to be substituted for unskilled because interchanging unskilled labor for
skilled labor is often not feasible. However, it may not be cost effective to use highly
skilled, highly paid workers to do tasks that require little or no training. A rate variance
for direct labor is calculated in addition to the mix and yield variances.

96
Each possible combination of materials or labor is called a mix. Management’s standards
development team sets standards for materials and labor mix based on experience,
judgment, and experimentation. Mix standards are used to calculate mix and yield
variances for materials and labor. An underlying assumption in product mix situations is
that the potential for substitution exists among the material and labor components. If this
assumption is invalid, changing the mix cannot improve the yield and may even prove
wasteful. In addition to mix and yield variances, price and rate variances are still
computed for materials and labor.
i) Material Mix and Yield Variances

A material price variance shows the Birr effect of paying prices that differ from the raw
material standard. The material mix variance (MMV) measures the effect of substituting
a nonstandard mix of materials during the production process. The material yield
variance (MYV) is the difference between the actual total quantity of input and the
standard total quantity allowed based on output; this difference reflects standard mix and
standard prices. The sum of the material mix and yield variances equals a material
quantity variance; the difference between these two variances is that the sum of the mix
and yield variances is attributable to multiple ingredients rather than to a single one. A
company can have a mix variance without experiencing a yield variance.
Computations for the price, mix, and yield variances are given below in a format similar
to that used in the above section.

Actual Mix X Actual Mix X Standard Mix X Standard Mix X

Actual Quantity Actual Quantity Actual Quantity Standard Quantity
X Actual X Standard X Standard X Standard
Price Price Price Price

Material Price Material Mix Material Yield

Variance Variance Variance
The formula to compute material mix and yield variance would be:
To compute material mix variance:

Material Mix Variance(MMV)= (RSQ – AQ)SP

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Where, RSQ = revised standard quantity( i.e. actual quantity at standard mix)
= SQ for each material x Total AQ (OR)
Total SQ
= Total AQ X standard mix ratio
AQ= Actual Quantity at actual mix SP = standard price
To compute material yield variance:
MYV = (SQ – RSQ)SP
Where, SQ= Standard Quantity at standard mix
RSQ = Revised Standard Quantity SP = standard price

Example4.3The Scent Makers Company produces perfume. To make this perfume, Scent
makers uses three different types of fluids: Dycone, Cycone, & Bycone are used in
standard proportions of 4/10, 3/10, & 3/10 and their standard costs are Br. 6.00, Br. 3.50
& Br. 2.50 per unit, respectively. The chief engineer reported that for the past few months
the standard yield has been 80% on 100 pints of mix. The Company maintains a policy of
not carrying any direct material, as inventory storage space is costly.
Last week the company produced 75,000 pints of perfume at a total direct material
cost of Br. 449,500. The actual number of pints used and costs per unit for the three fluids
are as follows:
Material Actual Pints Cost/Pint
Dycone 45,000 Br. 5.50
Cycone 35,000 4.20
Bycone 20,000 2.75
100,000
Required
1) Compute the total direct material yield & mix variances for the last week..
2) Compute the total direct material price & usage variances for perfume made in
the last week.
Solution:
i) SQ = Standard quantity for actual output
Standard yield (80% on 100 pints of mix)
i.e. 80pints required = 100 pints of mix
For actual production of 75,000 pints = ?

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 =75,000 x 100 = 93,750 pints of mix
80
So, SQ for: Dycone: 0.4 x 93,750 = 37,500
Cycone: 0.3x93, 750= 28,125
Bycone: 0.3x93, 750= 28,125
ii) RSQ for:
Standard Mix Actual quantity Proportion RSQ
Dycone : 0.4 45,000 0.4 x 100,000 40,000
Cycone : 0.3 35,000 0.3 x 100,000 30,000
Bycone : 0.3 20,000 0.3 x 100,000 30,000
Total 100,000
Thus, the direct material cost variances, in diagram, would be:
1 2 3 4
SP x SQ SP x RSQ SP x AQ AP x AQ
Dycone: 6 x 37,500 6 x 40,000 6 x 45,000 5.5 x 45,000
Cycone: 3.5x28, 125 3.5x30, 000 3.5x35, 000 4.2 x 35,000
Bycone: 2.5x28,125 2.5x30,000 2.5x20,000 2.75x20,000
393,750 420,000 442,500 449,500
26,250U 22,500U
Yield Mix 7,000U
48,750U Price
Usage
55,750U
FBV for direct material
Note:
a) MYV = 1-2= SP x (SQ x RSQ) = Br. 26,250U
b) MMV =2-3= SP x (RSQ-AQ) = Br. 22,500U
c) MQV=1-3 = (SP x SQ) – (AP x AQ) =MYV+ MMV= Br. 48,750U
d) MPV=3-4= (SP-AP)AQ= Br. 7,000 U
e) FBV for DM= 1-4= (SP x SQ) –(AP x AQ)= MQV+ MPV= Br. 55,750 U

ii. Labor Mix, and Yield Variances

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The labor rate variance is a measure of the cost of paying workers at other than standard
rates. The labor mix variance is the financial effect associated with changing the
proportionate amount of higher or lower paid workers in production. The labor yield
variance reflects the monetary impact of using more or fewer total hours than the
standard allowed. The sum of the labor mix and yield variances equals the labor
efficiency variance. The diagram for computing labor rate, mix, and yield variances is as
follows:

(Actual Mix) X (Actual Mix) X (Standard Mix) X (Standard Mix) X

(Actual Hours) (Actual Hours) (Actual Hours) (Standard Hours)
X (Actual Rate) X (Standard Rate) X (Standard Rate) X (Standard Rate)

Labor Rate Variance Labor Mix Variance Labor Yield Variance

The formula to compute labor mix and yield variance would be:
To compute labor mix variance:
Labor Mix Variance (LMV)= (RSH – AH)SR
Where: RSH= revised standard hour (i.e. actual hours at standard mix)
= SH for each labor x Total AH ( OR )
Total SH
= Total AH X standard mix ratio
AH=Actual hours at actual mix SR= standard rate per hours

To compute Labor Yield Variance

Labor Yield Variance(LYV) = (SH-RSH)SR
Where: SH= standard hours at standard mix
RSH= revised standard hour SR= standard rate per hours

Example4.4 Buffon Legal Services has three labor classes: secretaries, paralegals, and
attorneys. The standard wage rates are shown in the standard cost system as follows:
secretaries, Br 25 per hour; paralegals, Br 40 per hour; and attorneys, Br 85 per hour. The
firm has established a standard of 0.5 hours of secretarial time and 2 hours of paralegal
time for each hour of attorney time in probate cases. The actual direct labor hours worked

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on probate cases and the standard hours allowed for the work accomplished for one
month in 2001 were as follows:
Standard Hours
Actual Labor Hrs for Output Achieved
Secretarial 500 500
Paralegal 1,800 2,000
Attorney 1,100 1,000
Total: 3, 400hrs 3,500hrs
Required: Calculate the amount of the direct labor efficiency variance for the month and
decompose the total into the following components:
1. Direct labor mix variance
2. Direct labor yield variance
Solution:
i) SR= Standard Rate per DL Hr
For Secretarial: Br. 25, Paralegal: Br 40, and for Attorney: Br 85
ii) RSH: Revised Standard hours = SH for each labor x Total AH
Total SH
RSH for Secretarial: 500 hrs x 3, 400hrs = 486hrs
3,500hrs
For Paralegal: 2,000 hrs x 3, 400hrs = 1,943hrs
3,500hrs
For Attorney: 1,000 hrs x 3, 400hrs = 971hrs
3,500hrs
a) LMV= (RSH – AH)SR
For Secretarial: (486hrs - 500 hrs) Br. 25 = Br. 350 (U)
For Paralegal: (1,943hrs - 1, 800 hrs) Br 40 = 5,720(F)
For Attorney: (971hrs - 1, 100 hrs) Br 85 = 10,965(U)
Total Br.5, 595(U)
b) LYV = (SH-RSH)SR
For Secretarial: (500 hrs - 486hrs) Br. 25 = Br. 350 (F)
For Paralegal: (2,000 hrs- 1,943hrs) Br 40 = 2,280(F)
For Attorney: (1,000 hrs - 971hrs) Br 85 = 2,465(F)
Total Br. 5, 095(F)

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Activity 4.4
1. Righting Moment Inc. is a mechanical engineering firm. The firm employs both
engineers and drafts people. The average hourly rates are Br. 80 for engineers
and Br.40 for drafts people. For one project, the standard was set at 375 hours of
engineer time and 625 hours of draftsperson time. Actual hours worked on this
project were: Engineers—500 hours at Br.85 per hour and Draftspeople—500
hours at Br.42.00 per hour. Determine the labor rate, mix, and yield variances for
this project.------------------------------------------------------------------------------------
2. How do multiple material and labor categories affect variances? --------------------
---------------------------------------------------------------------------------------------------
4.3.2.2.OVERHEAD COST VARIANCES
In developing overhead application rates, a company must specify an operating level or
capacity. Capacity refers to the level of activity. Alternative activity measures include
theoretical, practical, normal, and expected capacity. Because total variable overhead
changes in direct relationship with changes in activity and fixed overhead per unit
changes inversely with changes in activity, a specific activity level must be chosen to
determine budgeted overhead costs.

A flexible budget is a planning document that presents expected overhead costs at

different activity levels. In a flexible budget, all costs are treated as either variable or
fixed; thus, mixed costs must be separated into their variable and fixed elements. The
activity levels shown on a flexible budget usually cover the contemplated range of
activity for the upcoming period. If all activity levels are within the relevant range, costs
at each successive level should equal the previous level plus a uniform monetary
increment for each variable cost factor. The increment is equal to variable cost per unit of
activity times the quantity of additional activity.

The use of separate variable and fixed overhead application rates and accounts allows
separate price and usage variances to be computed for each type of overhead.

a. VARIABLE OVERHEAD COST VARIANCE (VOHV)

This is the difference between standard variable overheads for actual production and the
actual variable overheads.

Symbolically,

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 VOHV =SC-AC
Where: SC= standard variable overheads for actual production
AC= actual variable overheads

It can be sub –divided into Variable overhead expenditure variance, and Variable
overhead efficiency variance.

i) VOH expenditure variance is the difference between the standard variable

overheads for the actual hours worked, and the actual variable overheads
incurred. The formula for computing it is as follows:

VOH Exp. Variance = AVOH –SVOH.

Where: AVOH is actual variable overheads incurred
SVOH is standard variable overheads for the actual hours worked,

ii) VOH efficiency variance arises when the actual output produced differs from the
standard output for actual hours worked. It is a measure of extra overhead (for
saving) incurred solely because of the efficiency shown during the actual hours
worked. The formula to compute it is as follows:
VOH efficiency variance = (SHOV for actual hours worked)- (SHOV for actual output)

Example 4.5 From the following information, calculate VOH cost variances assuming
labor hours as cost driver for variable manufacturing overhead.
Budget output 5000 units
Budgeted hours 10,000
Budgeted variable overheads Br. 2,000
Actual variable overheads Br. 3,000
Actual output 4,000 units
Actual hours 12,000 hours
Solution
i) VOH cost variance =AVOH –SVOH for actual production
= Br.3, 000 - (4000 x Br 0.40*)
= Br...3,000 - Br. 1600= Br.1400 (U)
ii) VOH expenditure variance = AVOH – SVOH for actual hours worked
= Br.3000 - (12000 x 0.20**) =Br. 600 (U)
iii) VOH efficiency variance = SVOH for actual Hrs - SVOH for actual output

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 =Br. 2400 – Br. 1600=Br. 800 (U)
Workings:
*SVOH per unit of output –Br.2000/5000 = Br.0.40 per unit
** SVOH pre hours = Br.2000/10,000 = Br.0.20 per hour

b. FIXED OVERHEADS COST VARINANCE (FOHV)

This is the difference between the standard fixed overheads for actual output and actual
fixed overheads. The reasons for the variance are over absorption or under –absorption of
overheads for the actual production the budgeted production may be different form the
actual production for the actual overheads incurred. The major sub –divisions of FOHV
are FOH expenditure variance and FOH volume variance. The formula for FOHV is as
follows:
FOHV =AFOH –SFOH
Where: AFOH = actual fixed overheads.
SFOH = standard fixed overheads for actual output

Note that, if the AFOH is less than the SFOH, the variance is favorable (F), and vice
versa. This variance can be classified into two.
i) FOH expenditure variance (FOHEV)
This is the difference between Actual fixed overhead costs and Budgeted fixed overhead
(Symbolically, FOHEV= AFOH –BFOH)
If the actual is greater than the budgeted, this variance is adverse (U), and vice versa

ii) FOH volume Variance (FOHVV)

This is the difference between the budgeted fixed overheads and the standard fixed
overheads absorbed on actual production. The formula is as follows:
FOHVV =BFOH –SFOH on actual production.
If the BFOH is greater than the SFOH on actual production, the variance is adverse (U)
and vice versa.
Example 4.6: From the following data calculate FOH cost variance.
Budgeted hours: 10,000 hours; Budgeted output: 5,000 units, Budgeted FOH: Br.3,000
Actual hours: 12,000hours; Actual output: 4,800 units; Actual FOH: Br.3,600
Solution:
a. FOHV = AFOH – SFOH on actual output
= Br.3600 - (0.60* x4800)
= Br. 3600 - Br. 2880 =. Br.720 (U)

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 b. FOHEV= AHOH – BFOH
= Br.3600 – Br.3000 =. Br.600 (U)
c. FOHVV = BFOH – SFOH on actual output
= Br.3000 - (0.60 x 4800)
= Br.3000 – 2880 =. Br.120 (U)
Workings:
*SFOH per unit = Br. 3000/5000= Br.0.60 per unit

4.3.2.3.SALES VARIANCES
The standard costing system is complete only when sales variances are detailed with it as
part of comprehensive information presented to management. Sales variances are
calculated by two methods, viz., sales value method and sales margin or profit method.
Basically, changes in price and changes in sales volume give rise to sales variances. A
change in value may, in its own turn, result due to a change in quantity, or a change in
sales mix
I) SALES VALUE METHOD
The value method is used to denote variance arising due to change in sales price, quantity
mix, etc, or the sales value. The sales variances may be classified as: Sales price variance,
and Sales volume variance.
a) Sales Value Variance (SVV) is the difference between standard sales and the
actual sales.
i.e. SVV =(SS-AS)=(SP X SQ) – (AP X AQ)
Where: SP= standard price AP = actual price
SQ= standard quantity to be sold AQ= actual quantity sold

b) Sales Price Variance (SPV) is the difference between standard price of

actual quantity and actual price of the actual quantity of goods sold
i.e. SPV = AQ (SP –AP)
Where: SP= standard price AP = actual price
AQ= actual quantity sold

If the actual price is greater than the standard price, the variance is favorable, and
vice versa.
c) Sales Volume Variance (SVLV) is the difference between the actual quantity
or volume and the standard quantity or volume and the standard quantity or
volume of sales. It shows the effect of a change in volume of total sales.

105
 SVLV =SP(SQ -AQ)
Where: SQ= standard quantity to be sold AQ= actual quantity sold
SP= standard price
If the actual quantity sold is greater than the standard, the variance is favorable,
and vice versa.
Sales volume variance may be further divided into sales mix variance and sales quantity
or sub –volume variance

d) Sales Mix Variance (SMV)

Where two or more items are used in the composition of sales, the differences between
the standard compositions of sales and the actual composition or mix is called the sales
mix variance. It is a part of the value variance arising due to change in the mix. It
highlights the fact that the actual mix of sales has not been in the same ratio as budgeted

SMV= SP (Revised standard sales – Actual sales)

where: SP= standard price

Note that the revised standard sales are calculated by dividing the total actual sales
quantity in the standard proportion. If the actual sales quantity is greater than the
revised standard quantity, the variance is favorable, and vice versa.

e) Sales Quantity Variance (SQV)

This is the difference between the revised standard quantity of actual sales and the
standard quantity budgeted. This variance shows the position of actual quantity of sales,
as distinct from the mix of sales, in comparison with budgeted or expected sales.
Thus, SQV =SP (SQ -RSQ)
Where: SP= standard price SQ= standard quantity to be sold
RSQ = revised standard sales ( quantity)

If the RSQ is greater than the SQ, the variance is favorable, and vice versa.

Example5.7: calculate (i) sales variance (ii) sales price variance; (iii) sales volume
variances, (iv) sales mix variance and (v) sales quantity variance from the following
Standard Actual
Product quantity (units) price (Br.) quantity (units) price (Br.)
A 5,000 5.00 5,000 5.00

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 B 4,000 6.00 6,000 6.25
C 3,000 7.00 4,000 6.75
Total 12,000 15,000
Solution
 Sales value variance = (SP X SQ) – (AP X AQ)
Product A= (5,000 x Br. 5) – (5,000 x Br. 5) = Br 0
Product B= (4,000 x Br. 6) – (6,000 x Br. 6.25) = 13,500 F
Product C= (3,000 x Br. 7) – (4,000 x Br. 6.75) = 6,000 F
Total = Br 19,500 F
 Sales price variance =AQ (SP- AP)
Product A= 5,000 (Br. 5- Br. 5) = Br 0
Product B= 6,000 (Br. 6- Br. 6.25) = 1,500 F
Product C= 4,000 (Br. 7- Br. 6.75) = 1,000 U
Total = Br 500 F
 Sales Volume Variance =SP(SQ- AQ)
Product A = Br. 5(5,000 - 5,000) =Br 0
Product B = Br. 6(4,000 - 6,000) = 12,000 F
Product C = Br. 7(3,000 - 4,000) = 7, 000 F
Total = Br 19,000 F
 Sales mix variance =SP(RSQ* - AQ)
Product A= Br. 5(6,250 - 5,000) =Br 6,250 U
Product B = Br. 6(5,000 – 6000) = 6,000 F
Product C = Br. 7(3,750 – 4,000) = 1,750 F
Total = Br.1, 500 F
*Calculation of RSQ: total AQ x standard ratio = 15,000units x (5:4:3)

Product A= 15,000x5/12 =6,250 units

Product B =15,000x4/12 =5,000 units
Product C =15,000x3/12 =3,750 units
Total =15,000 units
 Sales quantity variance =SP(SQ- RSQ)
Product A= 5(5,000- 6,250) = Br 6,250 (F)
Product B= 6(4,000- 5,000) = 6,000 (F)
Product C= 7(3,000- 3,750) = 5,250 (F)
Total = Br 17, 500 (F)

II) SALES MARGIN METHOD OR PROFIT METHOD

Sales margin variance this is the difference between the standard margins appropriate to
the quantity of sales budgeted for a period, and the margin between standard cost and the
actual selling price of the sales effected. This variance arises due to the difference
between total budgeted profit and total actual profit
Sales Margin Variance = budgeted profit – actual profit

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Sales margin variance may be classified into the sales margin price variance and sales
margin volume
i) Sales margin price variance which is due to the difference between the
standard price of the quantity of sales affected, and the actual price of the
sales. It is the difference between the standard profit and actual profit. This
variance is similar to the price variance calculated under value method, and
the formula is as follows:
Margin price variance = AQ (Standard profit –Actual Profit)

If the actual profit is greater than the standard profit, the variance is favorable and vice
versa.
ii) Sales margin volume variance. This is the portion of total margin variance
which is due to the difference between the budgeted quantity and actual
quantity of sales. This is the amount by which standard profit differs from
budgeted profit. The formula is as follows:
Margin volume variance = standard profit (SQ -AQ)

If the actual quantity is greater than standard quantity, the variance is favorable, and vice
versa.
iii) Sales margin mix variance. This is that portion of total margin variance
which is due to the difference between the budgeted and actual quantities of
each product of which the sales mixture is composed, valuing sales at the
standard net selling prices and cost of sales at standard. That is, the difference
between the revised standard profits is the mix variance.
Margin mix variance =standard profit (RSQ –AQ)

If the actual quantity is greater than the revised standard quantity, the variance is
favorable, and vise versa
Example5.8. ABC Ltd had budget the following sales for December 2007.
Product A 9,000 units at Br.5per unit
Product B 6,500 units at Br.10per unit
Product C 12,000 units at Br 7.5per unit
As against this, the actual sales were:
Product A 10,000 units at Br.5per unit

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Product B 7,000 units at Br.10per unit
Product C 11,000 units at Br 7.5per unit
The cost per unit of A, B and C was Br.4.5, Br.8.5, and Br.6.5 respectively. Compute the
different variances to explain the difference between budgeted profit and actual profit.
Solution
i) Sales margin variance =(SM x SQ) – (AM x AQ)
Product A = (0.5 x9,000)-(1x10,000) = Br. 5,500 (F)
Product B = (1.5 x6,500)-(1x70,00) = Br. 2,750 (U)
Product C = (1x12,000)-(1.3x11,000)= Br. 2300 (F)
Total Br. 5,050 (F)
ii) Sales margin price variance = AQ(SM –AM)
Product A = 10,000 (Br. 0.5 _ Br. 1.00) = Br. 5,000 (F)
Product B =7,000 (Br. 1.5 _ Br. 1.0) =. Br. 3,500(U)
Product C = 11,000 (Br. 1.0_ Br. 1.3) =Br. 3,300 (F)
Total Br.4800 (F)
iii) Sales margin volume variance = SM (SQ –AQ)
Product A = Br. 0.5 (9,000- 10,000) = Br. 500 (F)
Product B = Br. 1.5 (6,500-7,000) = Br. 750 (F)
Product C = Br. 1.0(12,000-11,000) = Br. 1,000 (U)
Total Br. 250 (F)
iv) Sales margin mix variance =SM (RSQ –AQ)
Product A = Br. 0.5 (9,164 – 10,000) =. Br. 418(F)
Product B = Br. 1.5 (6,618 – 7,000) = Br. 573 (F)
Product C = Br. 1.0 (12,218 – 11,000) =Br. 1218(U)
Total Br.227 (U)
v) Sales margin quantity variance = SM (SQ-RSQ)
Product A = Br. 0.5(9,000 – 9,164) =Br 82 (F)
Product B = Br. 1.5(6,500 – 6,618) = Br 177 (F)
Product C = Br. 1.0(12,000 – 12,218) = Br 218(F)
TOTAL = Br. 477 (F)

*Working notes on profit per unit for budget and actual, and RSQ

BUDGET
Product SQ SP Total sales Cost per unit Total cost profit per unit Total profit

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 Br Br Br Br Br Br
Br

A 9,000 5 45,000 4.5 40,500 0.5 4,500

B 6,500 10 65,000 8.5 55,250 1.5 9,750
C 12,000 7.5 90,000 6.5 78,000 1.0 12,000
27,500 200,000 173,750 26,250
ACTUAL
A 10,000 5.5 55,000 4.5 45,000 1.0 10,000
B 7,000 9.5 66,500 8.5 59,500 1.0 7,000
C 11,000 7.8 85,800 6.5 71,500 1.3 14,300
28,000 207,300 176,000 31,300

RSQ = AQ x (Standard ratio) = 28,000 x (18:13:24)

Product A= 28,000 x 18/55 9,164
Product B = 28,000 x 13/55 6,618
Product C = 28,000 x 24/55 12,218

4.3.3. CAUSES AND DISPOSITION OF VARIANCES

In order to make the variance analysis a control instrument, the management should
investigate the causes of variances and take the necessary corrective measures. There is
no uniformity of opinion regarding the disposal of variances. Method I: where it is
desired to maintain the same standard in future, the variances must be written –off to
Profit and Loss Account. Method II: According to strict principle, the amount of
variances resulting from incorrect standards or condition beyond control, like material
price changes, wage rate increases due to fair legislation, etc., are allocated to inventories
and cost of sales in proportion to their value of closing balances. Method III: another
method is to carry forward the variances to the next financial year by crediting the same
to a reserve account to be set off in the subsequent year or years. The favorable and
adverse variances may cancel each other in the course of reasonable time and thus be
disposed of.
1. Materials price variances. (a) Causes. Change in market price, delivery costs,
purchase of non –standard materials, emergency purchases, incorrect shipping
instruction, loss of discounts, etc. (b) Disposition. If all or a portion of the price variance
is the result of inefficiencies or a saving has resulted from efficient purchasing, the
amount may be adjusted to Profit and Loss Account. If it is due to incorrect standards or
change in market price, the amount may be adjusted to inventories and cost of goods
sold. It may be mentioned that under method I, such adjustment must be made for
inventories under materials control, work –in –progress, finished goods, and cost of the

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goods sold. Under Methods II and III, such adjustments are required for inventories under
work –in –progress, finished goods, and cost of goods sold.
2. Materials usage variance (a) Causes. Poor quantity of materials: change in material
mix, product or production methods: careless handing: excessive waste or scrap; incorrect
setting of standards. (b) Disposition. The amount of usage variance resulting in
inefficiency in handling and processing materials is transferred to profit and loss account.
The amount of usage variance due to incorrect standards is apportioned to work –in –
progress, finished goods and cost of goods sold.
3. Direct wages rate variances: (a) Causes general rise due to ward or agreement, non –
standard grade, abnormal overtime or payment above or below standard rates during
seasonal or emergency operations. (b) Disposition. The amount of variance arising out of
inefficiency can be controlled if transferred to profit and loss account. The amount of
variance resulting from the use of out –of –date standards or from conditions beyond the
control of management is adjusted to work –in –progress, finished goods and cost of
goods sold, on the basis of wages or time.
4. Direct labor efficiency variance (a) Causes, Poor working conditions, abnormal idle
time, i.e. power failure, breakdown, go slow technique quality of supervision, non
standard grade of material, or employee non cooperation in service departments. (b)
Disposition. The amount of variance attributed to various forms of inefficiency which are
controllable is transferred to profit and loss account. The amount of variance resulting
from improperly prepared standard and from conditions beyond the control of
management may be adjusted to work – in – progress, finished goods, and cost of goods
sold.
5. Overhead expenditure variance (a) Causes. Under the over utilization of a service;
seasonal conditions; inefficiency in the use of a service (e.g., electricity in lieu of gas) (b)
Disposition. The amount of variance due to seasonal conditions should be treated as a
deferred item. The amount arising out of inefficiency which is controllable is transferred
to profit and loss account. The amount resulting from incorrectly prepared standard and
from conditions beyond control is adjusted to work in progress, finished goods, and cost
of goods sold.

UNIT SUMMARY

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A standard cost is computed as a standard price multiplied by a standard quantity. In a
true standard cost system, standards are derived for prices and quantities of each product
component and for each product. A standard cost provides information about a product’s
standards for components, processes, quantities, and costs.

A variance is any difference between an actual and a standard cost. A total variance is
composed of a price and a usage sub variance. The material variances are the price and
the quantity variances. The material price variance can be computed on either the
quantity of material purchased or the quantity of material used in production. This
variance is computed as the quantity measure multiplied by the difference between the
actual and standard prices. The material quantity variance is the difference between the
standard price of the actual quantity of material used and the standard price of the
standard quantity of material allowed for the actual output.

The two labor variances are the rate and efficiency variances. The labor rate variance
indicates the difference between the actual rate paid and the standard rate allowed for the
actual hours worked during the period. The labor efficiency variance compares the
number of hours actually worked against the standard number of hours allowed for the
level of production achieved and multiplies this difference by the standard wage rate.

If separate variable and fixed overhead accounts are kept (or if this information can be
generated from the records), two variances can be computed for both the variable and
fixed overhead cost categories. The variances for variable overhead are the VOH
spending and VOH efficiency variances. The VOH spending variance is the difference
between actual variable overhead cost and budgeted variable overhead based on the
actual level of input. The VOH efficiency variance is the difference between budgeted
variable overhead at the actual activity level and variable overhead applied on the basis of
standard input quantity allowed for the production achieved.

The fixed overhead variances are the FOH spending and volume variances. The fixed
overhead spending variance is equal to actual fixed overhead minus budgeted fixed
overhead. The volume variance compares budgeted fixed overhead to applied fixed
overhead. Fixed overhead is applied based on a predetermined rate using a selected
measure of capacity. Any output capacity utilization actually achieved (measured in

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standard input quantity allowed), other than the level selected to determine the standard
rate, will cause a volume variance to occur.

Actual costs are required for external reporting, although standard costs may be used if
they approximate actual costs. Adjusting entries are necessary at the end of the period to
close the variance accounts. Standards provide a degree of clerical efficiency and assist
management in its planning, controlling, decision making, and performance evaluation
functions. Standards can also be used to motivate employees if the standards are seen as a
goal of expected performance.

A standard cost system should allow management to identify significant variances as

close to the time of occurrence as feasible and, if possible, to help determine the variance
cause. Significant variances should be investigated to decide whether corrective action is
possible and practical. Guidelines for investigation should be developed using the
management by exception principle.

MODEL EXAMINATION QUESTIONS

PART I: MULTIPLE CHOICE QUESTIONS

1. A standard cost is
A. The planned unit cost of a product, component or service in a period.
B. The budgeted cost ascribed to the level of activity achieved in a budget centre in
a control period.
C. The budgeted production cost ascribed to the level of activity in a budget period.
D. The budgeted non-production cost for a product, component or service in a
period.
The following information is required for sub-questions 2 to 8
X Ltd operates a standard costing system. The following budgeted and standard cost
information is available:
Budgeted production and sales………………………… 10,000 units
Selling price ……………………………………… Br 250 per unit
Direct material cost – 3 kg x Br.10……………… 30 per unit
Direct labor cost – 5 hours x Br.8………………. 40 per unit
Variable manufacturing overheads – 5 hours x Br.4... 20 per unit
Actual results for the period were as follows:

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 Production and sales …………………………….. 11,500 units
Sales value ……………………………………… Birr 2,817,500
Direct material – 36,000 kg ……………………. 342,000
Direct labor – 52,000 hours …………………….. 468,000
Variable manufacturing overheads ………………… 195,000
2. The direct material price variance is
A. Br.18, 000U. B. Br.3, 000 U C. Br.3, 000 F D. Br 18, 000 F E. none
3. The direct material usage variance is
A Br.15, 000 U. B. Br.14, 250 U. C. Br. 14,250 F D. Br.15, 000F. E. none
4. The direct labor rate variance is
A. Br.52, 000 U B. Br.8, 000 U C. Br.8, 000 F D. Br.52, 000 F E. none
5. The direct labor efficiency variance is
A. Br.49, 500 U B. Br.44, 000 U C. Br.44, 000 F D. Br.49, 500 F E. none

Part II: SHORT ANSWER QUESTIONS

1. Explain the concept of Standard Costing? What advantages are likely to be obtained
from the application of standard costing as compared to historical costing?
2. What is standard costing? How does it differ from Budgetary Control?
3. Discuss the essential components of standard costing system.
4. What is Variance Analysis? Explain and illustrate the various types of material
variances.
5. Distinguish between
a) Material price Variance and Material Mix variance
b) Labor Efficiency variance and Labor Rate Variance

Part III: WORK OUT QUESTIONS

1. Poly Containers makes 300-gallon plastic water tanks for a variety of commercial
uses. The standard per unit material, labor, and overhead costs are as follows:
Direct material: 80 pounds @ Br.2 Br.160
Direct labor: 1.25 hours @ Br.16 per hour 20
Variable overhead: 30 minutes of machine time @ Br.50.00 per hour 25
Fixed overhead: 30 minutes of machine time @ Br.40.00 per hour 20

The overhead application rates were developed using a practical capacity of 6,000 units
per year. Production is assumed to occur evenly throughout the year.

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 During May 2001, the company produced 525 tanks. Actual data for May 2001 are
as follows:
Direct material purchased: 46,000 pounds @ Br.1.92 per pound
Direct material used: 43,050 pounds (all from May’s purchases)
Total labor cost: Br.10, 988.25 for 682.5 hours
Variable overhead incurred: Br.13, 770 for 270 hours of machine time
Fixed overhead incurred: Br.10, 600 for 270 hours of machine time
Required: Calculate the following:
a. Material price variance based on purchases
b. Material quantity variance
c. Labor rate variance
d. Labor efficiency variance
e. Variable overhead spending and efficiency variances
f. Fixed overhead spending and volume variances

2. Rock Solid Engineering Company compares actual results with a flexible budget.
The standard DL rates used in the flexible budget are established each year at the
time the annual plan is formulated and held constant for the entire year. The
standard hours allowed for the actual output of insurance claims for April in a
claims department are shown in the following schedule:
Labor Classes Standard Rate/Hrs Standard hrs for Actual output
Class III Br. 8.00 500 Hrs
Class II 7.00 500
Class I 5.00 500
Required: compute
1) DL rate & efficiency Variances
2) DL mix & Yield Variances

ANSWER TO MODEL EXAMINATION QUESTIONS

A. SOLUTIONS FOR WORKOUT QUESIONS
Q1.
a) MPV= (AP x AQ) - ( SP x AQ)
= (Bir1.92 x 46,000) - (Bir2.00 x 46,000) = Bir3,680 F
b) MQV= (SP x AQ)- ( SP x SQ)
= (Bir2 x 43,050) – (Bir2 x 42,000*) = Bir2,100 U
*SQ = 525 x 80 pounds = 42,000 pounds

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 c) LRV= (AR* x AH) –( SR x AH)
= (Bir16.10 x 682.5) - (Bir16 x 682.5) = Bir68.25 U
*AR= Bir10,988.25 / 682.5 hours = Bir16.10 per hour
d) LEV = (SR x AH) – (SR x SH*)
= (Bir16 x 682.5) - (Bir16 x 656.25) =Bir420 U
*SH= 525 x 1.25 hours = 656.25 hours
e) VOH Spending Variance= Actual VOH – (SP x AQ)
= Bir13,770 – (Bir50.00 x 270) = Bir270 U
VOH Efficiency Variance= (SP x AQ) – (SP x SQ*)
= (Bir50.00 x 270) – (Bir50.00 x 262.5) = Bir375 U
* SQ= 525 x 0.5 = 262.5 hours
f) FOH Spending Variance = Actual FOH - Budgeted FOH**
= Bir10,600 - Bir10,000 =Bir600 U
FOH Volume Variance= Budgeted FOH – (SP x SQ)
= Bir10,000 - (Bir40 x 262.50) = Bir500 F
**BFOH, annually= 6,000x Bir20= Bir120,000
BFOH, monthly= Bir120,000/ 12 months= Bir10,000
Q2.
1 2 3 4
SR x SH SR x RSH** SR x AH ARxAH
Class III 8 x 500=4,000 8 x 525=4,200 8 x 550 = 4,400 8.5 x 550=4,675
Class II 7 x 500=3,500 7 x 525=3,675 7 x 650=4,550 7.5 x 650 = 4,875 Class I 5 x 500
=2,500 5x525 = 2,625 5x375 = 1,875 5.4 x 375 = 2,025
10,000 10,500 10,825 11,575
500U 325U
750U
Yield Variance Mix Variance Rate Variance
825 U
Efficiency Variance

1,575 U
FBV for DL

**RSH: Revised Standard hours = (Standard mix x Actual total DL Hrs used)
RSH for:
Standard Standard Actual Proportion RSH
Hours Mix Hours
Class III 500 1/3 550 1/3x1, 575 525
Class II 500 1/3 650 1/3x1, 575 525
Class I 500 1/3 375 1/3x1, 575 525
1,500

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 UNIT SIX
RELEVANT INFORMATION AND DECISION MAKING

UNIT O B J E C T I V E S
After completing this chapter, you should be able to answer the following questions:
 What factors are relevant in making decisions and why?
 How do opportunity costs affect decision making?
 What are sunk costs and why are they not relevant in making decisions?
 What are the relevant financial considerations in outsourcing?
 How can management make the best use of a scarce resource?
 How does sales mix pertain to relevant costing problems?
 How are special prices set and when are they used?
 How is segment margin used to determine whether a product line should be
retained or eliminated?
UNIT OUTLINE
6.1 Introduction
6.2 Information and the decision process
6.3 The concept of relevance
6.4 Relevant information for special decision
6.4.1 special order decision
6.4.2 product line decision
6.4.3 product mix decision
6.4.4 make or buy decision
6.4.5 keep or replace decision

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 6.4.6 pricing decision
6.1. INTRODUCTION
During the last decade, increasing competition has forced many companies to refocus
their resources and to defend their core businesses against aggressors. In developing
strategies to fight this war, managers have generally reached a consensus on two strategic
criteria. First, to win a battle, the focus of organizations must be on delivering products
and services in the manner most consistent with the desires of customers. Second, no
company can do all things well. The strategies managers devise in this intensive struggle
evolve from internal evaluations in which the managers identify the functions they must
do well to survive. These functions are regarded as core competencies and maintaining
leadership in these areas is regarded as vital. All other functions, although important to
the organization, are regarded as noncore functions. By intensely focusing on core
functions, managers try to maintain a competitive advantage. However, an undesirable
consequence of focusing on only the core competencies is that the quality and capabilities
of the noncore functions can deteriorate. This deterioration, in turn, can reduce a firm’s
ability to attract customers to its products and services. Outsourcing the noncore
functions to firms that have core competencies in those functions frequently solves the
dilemma of maintaining a focus on core competencies while also maintaining excellence
in noncore functions. Managers are charged with the responsibility of managing
organizational resources effectively and efficiently relative to the organization’s goals
and objectives. Making decisions about the use of organizational resources is a key
process in which managers fulfill this responsibility. Accounting and finance
professionals contribute to the decision-making process by providing expertise and
information. Accounting information can improve, but not perfect, management
understands of the consequences of decision alternatives. To the extent that accounting
information can reduce management’s uncertainty about economic facts, outcomes, and
relationships involved in various courses of action, such information is valuable for
decision-making purposes. Many decisions can be made using relevant costing, which
focuses managerial attention on a decision’s relevant (or pertinent) facts. Relevant
costing techniques are applied in virtually all business decisions in both short-term and
long-term contexts. This chapter examines their application to several common types of
business decisions: replacing an asset, outsourcing a product or part, allocating scarce
resources, determining the appropriate sales/production mix, and accepting specially

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priced orders. In general these decisions require a consideration of costs and benefits that
are mismatched in time; that is, the cost is incurred currently but the benefit is derived in
future periods. In making a choice among the alternatives available, managers must
consider all relevant costs and revenues associated with each alternative

6.2. INFORMATION AND THE DECISION PROCESS

 Dear student! What does decision making mean? What is relevant

information for decision making?
Decision making is the process of choosing the best course of action from alternatives
available. Decision model is a method used by managers for deciding among courses of
action. Accounting information (revenue and cost information) are basic inputs in to
decision model. However, other quantitative as well as qualitative information can also
be used. In general information is divided in to relevant and irrelevant information.
Relevant information is information which is useful for decision making where as
irrelevant information is not useful for decision making. The management accountant’s
role in the decision making process is to produce relevant information to the managers
who make the decisions. Thus, the primary role of cost accountant in decision process is
to: decide what information is relevant to each decision problem, and provide accurate
and timely information (data)
Decision making process involves basically the following activities.
i. Identify and Define the Problem. The most important phase of decision
making process because all other activities in the process depend on this phase.
Incorrectly defined problems waste time and resources. That is why it is usually said that
defining a problem is solving half of the problem.
ii. Specify the Criterion. The phase in which the purpose of decision is to be
made. Is the objective to maximize profit, increase market share, minimize cost, or
improve public service? For example, cost minimization, increase the quality of product,
maximize profit, etc.
iii. Identify Possible Alternatives: Determining the possible alternatives is a
critical step in the decision process.

119
 iv. Gathering Relevant Information. Information could be subjective or
objective, internal or external to the organization, historical (past) data, or future
(expected) ones.
v. Making the Decision: Select the best alternative (course of action).
Activity6.1
1. What is decision making -------------------------------------------------------------------
2. What are the activities to be performed in decision making process -----------------
---------------------------------------------------------------------------------------------------

6.3. THE CONCEPT OF RELEVANCE

Dear student! What are the features that should be fulfilled to say information is
relevant or useful for decision you make? What are the costs and revenues relevant for
decision making?

For information to be relevant, it must possess three characteristics. It must (1) be

associated with the decision under consideration, (2) be important to the decision maker,
and (3) have a connection to or bearing on some future endeavor.
Association with Decision
Costs or revenues are relevant when they are logically related to a decision and vary from
one decision alternative to another. Cost accountants can assist managers in determining
which costs and revenues are relevant to decisions at hand. To be relevant, a cost or
revenue item must be differential or incremental. An incremental revenue is the amount
of revenue that differs across decision choices and incremental cost (differential cost) is
the amount of cost that varies across the decision choices.
To the extent possible and practical, relevant costing compares the incremental
revenues and incremental costs of alternative choices. Although incremental costs can be
variable or fixed, a general guideline is that most variable costs are relevant and most
fixed costs are not. The logic of this guideline is that as sales or production volume
changes, within the relevant range, variable costs change, but fixed costs do not change.
As with most generalizations, some exceptions can occur in the decision-making process.
The difference between the incremental revenue and the incremental cost of a
particular alternative is the positive or negative incremental benefit (incremental profit)
of that course of action. Management can compare the incremental benefits of

120
alternatives to decide on the most profitable (or least costly) alternative or set of
alternatives.
Some relevant factors, such as sales commissions or prime costs of production, are
easily identified and quantified because they are integral parts of the accounting system.
Other factors may be relevant and quantifiable, but are not part of the accounting system.
Such factors cannot be overlooked simply because they may be more difficult to obtain or
may require the use of estimates. For instance, opportunity costs represent the benefits
foregone because one course of action is chosen over another. These costs are extremely
important in decision making, but are not included in the accounting records.
Importance to Decision Maker
The need for specific information depends on how important that information is
relative to the objectives that a manager wants to achieve. Moreover, if all other factors
are equal, more precise information is given greater weight in the decision making
process. However, if the information is extremely important, but less precise, the
manager must weigh importance against precision.
Bearing on the Future
Information can be based on past or present data, but is relevant only if it pertains to a
future decision choice. All managerial decisions are made to affect future events, so the
information on which decisions are based should reflect future conditions. The future
may be the short run (two hours from now or next month) or the long run (three years
from now). Future costs are the only costs that can be avoided, and a longer time horizon
equates to more costs that are controllable, avoidable, and relevant. Only information that
has a bearing on future events is relevant in decision making.
Costs incurred in the past for the acquisition of an asset or resources are called sunk
costs. They cannot be changed, no matter what future course of action is taken because
past expenditures are not recoverable, regardless of current circumstances. Thus, the
historical cost is not relevant to the decision.
Example6.1 Marina Company, a manufacturer of a line of ashtrays, is thinking of using
aluminum instead of copper in the manufacture of its product. Historical direct material
cost was Br. 0.50 per unit. The company expected future costs for aluminum is Br 0.40
and it is unchanged for copper. Direct labor cost were Br0.80 per unit and will not be
affected by the switch in materials.
The analysis in a nutshell is as follows:

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 Copper Aluminum Difference
Direct material Br 0.50 Br 0.40 Br 0.10
Direct labor 0.80 0.80 -
In the foregoing analysis, the material cost (the expected future cost of copper compared
with expected future cost of aluminum) is the only relevant cost. The material cost met
both criteria for relevant information. That is, bearing on the future and an element of
difference between the alternatives. However, the direct labor cost will continue to be Br
0.80 per unit regardless of the material used. It is irrelevant because the second criterion –
an element of difference between the alternatives – is not met.
Example6.2 Consider a decision facing Home Appliances, a manufacturer of vacuum
cleaner, whether to “reorganize” or “do not reorganize” its manufacturing operations to
reduce manufacturing labor costs. The reorganization will eliminate all manual handling
of materials. The current manufacturing line uses 20 workers- 15 workers operate
machines and 5 workers handle materials. The 5 material-handling workers have been
hired on contracts that permit layoffs without additional payments. Each worker puts in
2,000 hours annually. The cost of reorganization (consisting mostly of equipment leases)
is predicted to be Br. 90,000 each year. The predicted production and sales of output of
25,000 units will be unaffected by the decision. Also unaffected are the predicted selling
price of Br. 250, the direct materials cost per unit of Br. 50, MOH of Br. 750,000, and
marketing costs of Br. 2,000,000. Historical labor costs were Br. 14 per hour. A recently
negotiated increase in employee benefits of Br. 2 per hour will increase labor costs to be
Br. 16 per hour in the future.
Required: Should Home Appliances reorganize its manufacturing operations to reduce
manufacturing labor costs?

Solution:
The comparative statement of for the given alternative
All Data Relevant Data
Do Not Reorganize Reorganize Do Not Reorganize Reorganize
Revenues: 250 X 25,000 Br. 6,250,000 Br. 6,250,000 - -
Costs:
DM: 50 X 25,000 1,250,000 1,250,000 - -
DL: 20 X 16 X 2,000 640,000 Br. 640,000

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 15 X 16 X 2,000 480,000 Br. 480,000
MOH: 750,000 750,000 - -
Marketing 2,000,000 2,000,000 - -
Reorganization costs - 90,000 -
90,000
Total costs Br. 4,640,000 Br. 4,570,000 Br. 640,000 Br.570, 000
Operating Income Br. 1,610,000 Br.1, 680,000 Br. (640,000) Br. (570,000)

Br. 70,000 Difference Br. 70,000 Difference

In the above statement, the financial data underlies the choice between the do not
reorganize and reorganize alternative. The first two columns present all data. The last two
columns present only relevant costs…the Br640, 000 and Br 480,000 expected future
manufacturing labor costs and Br 90,000 expected future reorganization costs that differ
the between two alternatives. The revenues, direct materials, manufacturing overhead,
and marketing items can be ignored because they do not differ between the alternatives
and, therefore, are irrelevant.

And, also note that, the past (historical) manufacturing hourly wage rate of Br 14 and
total past(historical) manufacturing labor costs of Br 560,000 (20 workers X 2,000 hours
per worker per year X Br 14 per hour) do not use in solution, because historical costs
themselves are past costs that, therefore, are irrelevant to decision making.
The analysis, in above solution, indicates that reorganizing the manufacturing operations
will increase predicted operating income by Br, 70,000 each year and we reached the
same conclusion whether we use all data or include only relevant data in analysis.

Activity6.2
1. What factors are relevant in making decisions and why? ---------------------
---------
2. How do opportunity costs affect decision making? -----------------------------
------------------------------------------------------------------------------------------
-----------------
3. What are sunk costs and why are they not relevant in making decisions? --
------------------------------------------------------------------------------------------

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 ------------------

.4. RELEVANT INFORMATION FOR SPECIFIC DECISIONS

Managers routinely choose a course of action from alternatives that have been identified
as feasible solutions to problems. In so doing, managers weight the costs and benefits of
these alternatives and determine which course of action is best. Incremental revenues,
costs, and benefits of all courses of action are measured against a baseline alternative. In
making decisions, managers must provide for the inclusion of any inherently non
quantifiable considerations. Inclusion can be made by attempting to quantify those items
or by simply making instinctive value judgments about nonmonetary benefits and costs.
In evaluating courses of action, managers should select the alternative that provides the
highest incremental benefit to the company. Rational decision-making behavior includes
a comprehensive evaluation of the monetary effects of all alternative courses of action.
The chosen course of action should be one that will make the business better off.
Decision choices can be evaluated using relevant costing techniques.
6.4.1. Special Order Decisions
One type of decision that affects output level is accepting or rejecting a special order. A
special order is a one-time order that is not considered part of the company’s normal
ongoing business. In general, a special order is profitable as long as the incremental
revenue from the special order exceeds the incremental costs of the order. Thus,
conditions to consider in a special order decisions are: (i) Customers must be from
markets not ordinarily served by the company, and (ii) the company must operate below
it maximum productive capacity
Example6.3.Consider the following details of the income statement, on absorption
costing basis (that is, both variable and fixed manufacturing costs are included in
inventoriable costs and cost of goods sold), of Samson Company for the year just ended
December 31, 20X4
Total per unit
Sales (1,000,000 units) Br 20,000,000 Br 20
Cost of Goods Sold 15,000,000 15

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 Gross Margin Br 5,000,000 Br. 5
Selling and Administrative Expenses 4,000,000 4
Operating Income Br. 1,000,000 Br. 1
Samson’s fixed manufacturing costs were Br 3 million and fixed selling and
administrative expenses were Br 2.9 million. Near the end of the year, Ethio Company
offered Samson Br 13 per unit for 100,000 unit special order. The special order would not
affect Samson‘s regular business in any way. Furthermore, the special sales order would
not affect total fixed costs and would not require any additional variable selling and
administrative expenses.
Required:

a) Should Samson accept or reject the special order?

b) Could the special order affect Samson’s regular business?

Solution:
a). The correct analysis to the above problem employs the contribution approach to
income statement, not the absorption or financial approach- that treats fixed costs, i.e.,
fixed manufacturing costs as if it were variable.
Variable manufacturing cost per unit═ 15,000,000 - 3,000,000 ═ 12per unit
1,000,000
 Total Variable manufacturing cost ═ Br. 12 x 1,000,000 ═ Br.12,000,000
 Variable selling and administrative cost per unit═4,000,000 -2,900,000═1.1per unit
1, 000, 0000
 Total Variable selling and administrative cost ═ Br. 1.1 x 1, 000, 0000 ═
Br.1,100,000( the special order does not affect this cost)
The analysis would be as follows on comparative contribution income statement.
Without special order With special order Difference: relevant
1,000,000 units to be 1,100,000 units to be amount for the
sold sold 100,000 units of
special order
Sales Br. 20,000,000 Br. 21,300,00 Br. 1,300,000
Variable Expenses:
Manufacturing Br. 12,000,000 Br.13,200,000 Br.1,200,000
Selling and Adm. 1,100,000 1,100,000
Total Variable Exp. Br. 13,100,000 Br. 14,300,000 1,200,000
Contribution Margin Br. 6,900,000 Br. 7,000,000 Br. 100,000

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Fixed Expenses:
Manufacturing Br. 3,000,000 Br. 3,000,000
Selling and Adm. 2,900,000 2,900,000
Total Fixed Expenses Br.5,900,000 Br. 5,900,000
Operating Income Br.1,000,000 Br.1,100,000 Br. 100,000

The above comparative income statements for Samson illustrates two key complete to
analyzing relevant revenues for decision: (1) distinguish relevant costs and revenues
from irrelevant ones and (2) use the contribution income statement to focus on whether
each variable cost and each fixed cost is affected by the alternatives(i.e. reject or accept)
under consideration.
In this case, the relevant revenues and costs are the expected future revenues and costs
that differ as a result of accepting the special offer ---- sales of Br 1,300,000(Br 13 per
unit X 100,000 units) and variable manufacturing costs of Br. 1,200,000 (Br 12 per units
X 100,000 units). The fixed manufacturing costs and selling and Administration costs
(including variable costs) are irrelevant. That is because these costs will not change in
total whether the special order is accepted or rejected. Based on the relevant data
analyzed above, Samson would gain an additional Br100, 000(relevant revenues, Br
1,300,000 less relevant costs Br 1,200,000) in operating income by accepting the special
order. In this example, comparing total amounts for 1,000,000 units versus 1,100,000
units or focusing only on the relevant amounts in the difference column in comparative
income statement avoids misleading implication --- the implication that would result
from comparing the Br 13 per unit selling price against the manufacturing cost per unit of
Br 15 (from Samson’s income statement on absorption costing basis) which includes both
Variable and fixed manufacturing costs.
Thus, based on the relevant data analyzed above, Samson Company should accept the
special order because it brings an additional income of Br. 100,000 for the company as:
Income with special order Br. 1,100,000
Income without special order 1,000,000
Additional income if the order had been accepted Br. 100,000

b) Yes. Unless Samson Company has effectively segments its market so that the
special order to the Ethio Company does not affect the regular business.

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6.4.2. Product Line Decisions

This is a decision relating to whether old product lines or other segments of a company
should be dropped and new ones added are among the most difficult decision that a
manager has to make. Operating results of multiproduct environments are often presented
in a disaggregated format that shows results for separate product lines within the
organization or division. In reviewing these disaggregated statements, managers must
distinguish relevant from irrelevant information regarding individual product lines. If all
costs (variable and fixed) are allocated to product lines, a product line or segment may be
perceived to be operating at a loss when actually it is not. The commingling of relevant
and irrelevant information on the statements may cause such perceptions.
In classifying product line costs, managers should be aware that some costs may appear
to be avoidable but are actually not. For example, the salary of a supervisor working
directly with a product line appears to be an avoidable fixed cost if the product line is
eliminated. However, if this individual has significant experience, the supervisor is often
retained and transferred to other areas of the company even if product lines are cut.
Determinations such as these needs to be made before costs can be appropriately
classified in product line elimination decisions.
For instance, mostly on add or delete decisions, fixed costs are divided into two
categories, avoidable and unavoidable. Avoidable costs are costs that will not continue if
an ongoing operation is changed, deleted or eliminated. These costs are relevant costs in
decision making. Unavoidable costs are costs that continue even if a subunit or an
activity is eliminated and are not relevant for decision.
Example.6.4 Eyoha Department store has three major departments: groceries, general
merchandise, and drugs. Management is considering dropping groceries, which have
consistently shown a net loss, as shown below on statement of departments’ profitability

analysis of Eyoha.

Departments
Groceries General merchandise Drugs Total
Sales Br. 100,000 Br. 8,0000 Br. 10,000 Br.190,000

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Variable CGS &
Expenses 80,000 56000 6,000 142,000
Contribution margin Br. 20,000 Br. 24000 Br. 4,000 Br. 48,000
Fixed expenses:
Avoidable Br. 15,000 Br. 10,000 Br. 1,500 Br. 26,500
Unavoidable 6,000 10,000 2,000 18,000

Total fixed expenses Br.21,000 Br. 20,000 Br.3,500 Br. 44,500

Operating income Br. (1,000) Br.4,000 Br. 500 Br. 3,500
(loss)
Required:
a) Which alternative would be recommended if the only alternatives to be
considered are dropping or continuing the grocery department? Assume that the
total assets would be unaffected by the decision and the space made available by
dropping groceries would remain idle.
b) Refer the income statement presented above. Assume that the space made
available by dropping groceries could be used to expand the general merchandise
department. The space would be occupied by merchandise that increase sales by
Br. 50,000, generate a 30% contribution margin percentage and have additional
avoidable fixed costs of Br.7, 000. Should Eyoha discontinue grocery and expand
merchandise department?
Solutions
(a). Analysis for dropping grocery department and leaving the space idle
(A) Total (B) Effect of (A – B) Total
Before change dropping grocery after change
Sales Br. 190.000 Br 100.000 Br 90.000
Variable COGS and Expenses 142.000 80.000 62.000
Contribution margin Br 48.000 Br 20.000 Br 28.000
Fixed expenses
Avoidable Br 26.500 Br 15,000 Br 11,500
Unavoidable 18.000 - 18,000
Total fixed expenses Br 44,500 Br 15,000 Br 29,500
Operating income (loss) Br 3,500 Br 5,000 Br (1,500)

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In this analysis, column 2, presents the relevant –revenues and relevant-cost analysis
using data from the grocery column in department profitability analysis of Eyoha.
Eyoha’s operating income will be Br.5, 000 (income with grocery department, Br.3500
less loss assuming grocery is dropped, Br.1500 or it implies that the cost savings from
dropping the grocery department, Br.95, 000 (Br.80, 000+ Br.15, 000), will not be
enough to offset the loss of Br.100, 000 in revenues. So, under this condition Eyoha’s
managers should decide to keep the grocery department rather dropping.
Notice that all of the grocery’s variable expenses are avoidable and relevant for decision
making. If the grocery department is discontinued, the Br 6,000 of the fixed expenses
will continue, which is irrelevant. And also note that there is no opportunity costs of
using spaces for grocery because without grocery, the space and equipment will remain
idle.
(b) Analysis for dropping the grocery department and expanding general merchandise.

(A) Total (B) Effect of (C) Effect of (A – B) + C Total

before Dropping Expanding after change
change Groceries General
Merchandise

Sales Br190,000 Br 100,000 Br 50,000 Br 140,000

Variable CGS and expense 142,000 80,000 35,000 97,000
Contribution margin Br 48,000 Br 20,000 Br 15,000 Br 43,000
Fixed expenses
Avoidable Br 26,500 Br 15,000 Br 7,000 Br 18,500
Unavoidable 18,000 - 18,000
Total fixed expenses Br 44,500 Br 15,000 Br 7,000 Br 36,500
Operating income (loss) Br 3,500 Br 5,000 Br 8,000 Br 6,500

Effect of expanding general merchandise:

Incremental revenue = Br 50,000
Incremental cost
Variable cost = (1-0.30) x 500,000 = (35,000)
Fixed cost = (7,000)
Incremental income = Br 8,000
Recommendation: As the above analysis shows, dropping grocery and using the vacated
space to expand general merchandise will be a good decision.

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Activity6.3
1. How is relevant information used to determine whether a product line should be
retained or eliminated? ---------------------------------------------------------------------

6.4.3. Optimal Use of Scarce Resources Decisions (Product Mix Decisions)

Managers are frequently confronted with the short-run problem of making the best use of
scarce resources that are essential to production activity, but are available only in limited
quantity. Scarce resources create constraints on producing goods or providing services
and can include machine hours, skilled labor hours, raw materials, and production
capacity and other inputs. Management may, in the long run, obtain a greater quantity of
a scarce resource. For instance, additional machines could be purchased to increase
availability of machine hours. However, in the short run, management must make the
most efficient use of the scarce resources it has currently.
Determining the best use of a scarce resource requires managerial recognition of
company objectives. If the objective is to maximize company profits, a scarce resource is
best used to produce and sell the product having the highest contribution margin per unit
of the scarce resource. This strategy assumes that the company is faced with only one
scarce resource. A scarce resource or a limiting factor refers to any factor that restrict or
constraint the production or sale of a product or service.
Example6.5 Jimma Computers manufactured two products, desktop computer and
notebook computer. The Company’s scarce resource is a data chip that it purchases from
a supplier. Each desktop computer requires one chip and each notebook computer
requires three chips. Currently, the firm has access to only 5,100 chips per month to make
either desktop or notebook computers or some combination of both. Demand is above
5,100 units per month for both products and there is no variable selling or administrative
costs related to either product. The desktop’s Br. 650 selling price less its Br. 545
variable cost provides a contribution margin of Br. 105 per unit. The notebook’s
contribution margin per unit is Br.180 (Br.900 selling price minus Br.720 variable cost).
Fixed annual overhead related to these two product lines totals Br. 6,570,000 and is
allocated to products for purposes of inventory valuation. Fixed overhead, however, does
not change with production levels within the relevant range
Instructions: on the bases of the above information which product is more profitable and
on which products should the firm spend its resources?

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Solution:
Present information on two products being manufactured by Jimma Computers and total
contribution margin per unit and per chip would be:
Descriptions Desktop Notebook
Selling price per unit (a) Br 650 Br 900

Variable production cost per unit:

Direct material Br.345 Br. 480
Direct labor 115 125
Variable overhead 85 Br. 545 115
Total variable cost (b) Br. 20

Unit contribution margin [(c) = (a) _ (b)] Br 105 Br.180

Chips required per unit (d) 1 3

Contribution margin per chip of per unit [(c) /(d)] Br.105 Br.60

In the above analysis, because fixed overhead per unit is not relevant in the short run, unit
contribution margin rather than unit gross margin is the appropriate measure of
profitability of the two products. Unit contribution margin is divided by the input quantity
of the scarce resource (in this case, data chips) to obtain the contribution margin per unit
of scarce resource. The last line in the above analysis table shows the Br. 105
contribution margin per chip for the desktop compared to Br. 60 for the notebook. Thus,
it is more profitable for Jimma Computers to produce desktop computers than notebooks.
At first glance, it would appear that the notebook would be, by a substantial margin, the
more profitable of the two products because its contribution margin per unit (Br. 180) is
significantly higher than that of the desktop (Br. 105). However, because the notebook
requires three times as many chips as the desktop, a greater amount of contribution
margin per chip is generated by the production of the desktops. If these were the only two
products made by Jimma Computers and the company wanted to achieve the highest
possible profit, it would dedicate all available data chips to the production of desktops.
Such a strategy would provide a total contribution margin of Br. 535,500 per month
(5,100 units * Br. 105), if all units produced were sold.

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In addition to considering the monetary effects related to scarce resource decisions,
managers must remember that all factors cannot be readily quantified and the qualitative
aspects of the situation must be evaluated in addition to the quantitative ones. For
example, before choosing to produce only desktops, Jimma Computers’ managers would
need to assess the potential damage to the firm’s reputation and markets if the company
limited its product line to a single item. Such a choice severely restricts its customer base
and is especially important if the currently manufactured products are competitively
related
Activity6.4
1. How can management make the best use of a scarce resource? ----------------------
---------------------------------------------------------------------------------------------------

6.4.4. Make or Buy (In source or out sourcing) decision

A concern with subcontracting or outsourcing has dominated business in recent
years as the cost of providing goods and services in-house is increasingly compared to the
cost of purchasing goods on the open market. Thus, a daily question faced by managers is
whether the right components and services will be available at the right time to ensure
that production can occur. Additionally, the inputs must be of the appropriate quality and
obtainable at a reasonable price. Traditionally, companies ensured themselves of service
and part availability and quality by controlling all functions internally. However, there is
a growing trend toward “outsourcing” (buying) a greater percentage of required
materials, components, and services.
This outsourcing decision (make-or-buy decision) is made only after an analysis
that compares internal production and opportunity costs with purchase cost and assesses
the best uses of available facilities. Consideration of an in source (make) option implies
that the company has available capacity for that purpose or has considered the cost of
obtaining the necessary capacity. The make versus buy decision should be based on
which alternative is less costly on a relevant cost basis; that is, taking into account only
future, incremental cash flows. In other words, in a make or buy situation with no
limiting factors, the relevant costs for the decision are the differential costs between the
two options.

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 For example, the costs of in-house production of a computer processing service that
averages 10,000 transactions per month are calculated as Br. 25,000 per month. This
comprises Br.0.50 per transaction for stationery and Br. 2 per transaction for labor. In
addition, there is a Br. 10,000 charge from head office as the share of the depreciation
charge for equipment. An independent computer bureau has tendered a fixed price of Br.
20,000 per month.
Based on this information, stationery and labor costs are variable costs that are both
avoidable if processing is outsourced. The depreciation charge is likely to be a fixed cost
to the business irrespective of the outsourcing decision. It is therefore unavoidable. The
fixed outsourcing cost will only be incurred if outsourcing takes place.
The relevant costs for each alternative can be compared as shown in Table 6.1
below. The Br. 10,000 share of depreciation costs is not relevant as it is unavoidable.
The relevant costs for this decision are therefore those shown in Table 6.2
Based on relevant costs, there would be a Br. 5,000 per month saving by outsourcing the
computer processing service.

Table 6.1 Relevant costs – make versus buy

Cost to make Cost to
buy
Stationery 10,000 @ Br. 0.50 Br. 5,000
Labour 10,000 @ Br. 2 20,000
Share of depreciation costs 10,000 10,000
Outsourcing cost 20,000
Total relevant cost Br. 35,000 Br. 30,000

Table 6.2. Relevant costs – make versus buy, simplified

Relevant cost to make Relevant cost
to buy
Stationery 10,000 @ Br. 0.50 Br. 5,000
Labour 10,000 @ Br. 2 20,000
Outsourcing cost
20,000

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Total relevant cost Br. 25,000 Br.
20,000

Note that relevant information for make or buy decision includes both quantitative and
qualitative factors. Such as:
Quantitative Factors
Buy Make
 the amount paid to supplier  variable costs incurred to produce the
component
 transportation costs  special equipment to produce the
product
 costs incurred to process  hire additional supervisory personnel
the part upon receipt to assist with making the product

Qualitative Factors
 Advantage of long term  The quality of the product is decided
relationship with suppliers to be controlled
 Possibility of shortage of  If the purchase price is likely to rise
material or labor for making due to increased demand in the
the component market, it becomes uneconomical to
buy
 Uninterrupted supply of  Where the technical know-how is to
requisite quality from reliable be kept secret and not to be passed
supplies on to the suppliers

Activity6.5
1. What are the relevant financial considerations in make versus buy decision? ---

6.4.5. Keep or Replace Equipment Decisions

The usefulness of plant assets may be impaired long before they are considered to be
worn out. Equipment may be no longer being efficient for the purpose for which it is

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used. On the other hand, the equipment may not have reached the point of complete
inadequacy. Decisions to replace usable plants assets should be based on studies of
relevant costs. The relevant costs are the future costs of continuing to use the equipment
versus replacement. The book values of the plant assets being replaced are sunk costs and
are irrelevant.
As for example, assume that a business is considered disposing of several identical
machines having a total book value of Birr 1,000,000 and an estimated remaining life of
five years. The old machines can be sold for Birr 25,000. They can be replaced by a
single high-speed machine at a cost of Birr 250,000. The new machine has an estimated
useful life of five years and no residual value. Analyses indicate an estimated annual
reduction in variable manufacturing costs from Birr 225,000, with the old machine
to Birr 150,000 with the new machine. No other changes in the manufacturing costs or
the operating expenses are expected. The relevant costs are summarized in the differential
report are as follows:
Proposal for Replacement Equipment (Differential Analysis Report – Replacement
Equipment):
Annual variable costs of present equipment (a) Birr 225,000
Annual variable costs - new equipment (b) 150,000
Annual differential decrease in cost(c= a-b) Birr 75,000
Number of years applicable (d) 5
Total differential decrease in cost (e=cxd) Birr 375,000
Proceed from sales of present equipment (f) 25,000
total (g =e+f) Birr 4, 00,000
Cost of new equipment (h) 2, 50,000
Net differential decrease in cost, 5 year total (i =g+h) Birr 1, 50,000
So, annual net differential decrease in cost – new equipment (i÷d) Birr 30,000

Additional factors are often involved in equipment replacement decisions. For example,
differences between the remaining useful life of the old equipment and the estimated life
of the new equipment could exist. In addition, the new equipment might improve the
overall quality of the product, resulting in an increase in sales volume. Other factors that
could be significant include the time value of money and other uses for the cash needed
to purchase the new equipment.
In general, in deciding whether to replace or keep existing equipment, four commonly
encountered items considered in relevance:

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 i. Book value of old equipment: irrelevant, because it is a past (historical) cost.
Therefore, depreciation on old equipment irrelevant.
ii. Disposal value of old equipment: relevant, because it is an expected future inflow that
usually differs among alternatives.
iii. Gain or loss on disposal: this is the algebraic difference between book value and
disposal value. It is therefore, a meaningless combination of irrelevant and relevant
items. Consequently, it is best to think of each separately.
iv. Cost of new equipment: relevant, because it is an expected future outflow that will
differ among alternatives. Therefore, depreciation on new equipment is relevant.

5.3.4. PRICING DECISIONS

Companies are constantly making product and service pricing decision. These are
strategic decision that affects the quantity produced and sold, and therefore cost and
revenues. To make these decisions, managers need to understand cost behavior pattern
and cost drivers. They can then evaluate demand at different prices and manage costs
across the value chain and over a products life cycle to achieve profitability.
Major influences on pricing decision
How companies prices a product or a service ultimately depends on the demand and
supply of it. Three influences on demand and supply are:-
i. Customers: - customer influences price through their effect on the demand for
a product or services, based on factors such as the features of a product and its
quality.
ii. Competitors: when there are competitors, knowledge of rivals’ technology,
plant capacity, and operating policies enables a company to estimate its
competitors’ costs-valuable information in setting its own prices.
iii. Costs – costs influence prices because they affect supply. As companies
supply more product the cost of producing each additional unit initially
declines but then eventually increase managers who understand the cost of
producing their companies product set polices that make the products
attractive to customers. In computing the relevant costs for a pricing decision,
the manager must consider relevant costs in all business functions of the value
chain.
Costing and pricing for the short run

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Short-run pricing decisions typically have a time horizon of less than a year and include
decision such as (a) pricing one time only special order with no long run implications and
(b) adjusting product mix and output volume in a competitive market.
Company’s short run pricing decisions need identify a sufficiently low price at which
company would still make a profit and assumed that (a) company has access to extra
capacity and (b) a competitor with an efficient plant and idle capacity was likely to make
a low bid. However, short run pricing does not always work this way. Companies may
experience strong demand for their products in the short-run, but they may have limited
capacity. In these cases, companies strategically increase prices in the short run to as
much as the market will bear.
In general, short run pricing decisions are responses to short-run demand and supply
condition, and the relevant costs are only those costs that will change in the short run.

Costing and pricing for the long run

Long run pricing decisions have a time horizon of a year or longer and include pricing a
product in a major market in which there is some see way in setting price. Two key
differences affect pricing for the long run versus the short run:-
1. Costs that are often irrelevant for short run pricing decisions, such as fixed costs
that cannot be changed, are generally relevant in the long run because cost can be
altered in the long run.
2. Profit margins in the long run pricing decision are often set to earn a reasonable
return on investment. Short run is opportunistic, prices are decreased when
demand is weak and increased when demand is strong.
Long run pricing is a strategic decision desired to build long run relationship with
customers based on stable and predictable prices. But to change a stable price and earn
the target long run return, a company must, over the long run, know and manage its costs
of supplying product to customers. Thus, relevant costs for long run pricing decision
include all future fixed and variable costs.

Long run pricing approaches

Two different approaches for pricing decision using product cost information are:-
1. Market based approach

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 2. Cost based/cost plus approach

1. Market based pricing

Market based pricing approach starts by management asking, given that our customers
want and how our competitors will react to what we do, what price should we charge?
Companies operating in a very competitive market, for example, commodities such as
steel, oil, and natural gas, use the market based pricing. An important form of market
based pricing is target pricing. Target price is the estimated price for a product or service
that potential customers will be willing to pay. This estimate is based on an
understanding of customer’s perceived value for a product or service and how
competitors will price competing product or service.
Hence, target operating income is the operating income that a company wants to earn on
each unit of a product or service sold and target price leads to a target cost, target cost per
unit is the estimated long run cost per unit of a product or service that, when sold at the
target price, enables the company to achieve the target operating income.
Thus, Target price - Target operating income = Target cost

Implementing target pricing and target costing

In developing target prices and target cost companies may require to follow the following
five steps:
 Develop a product that satisfy the needs of potential customers
 Choose a target price based on customer’s perceived value for the product and the
price competitors charge, and target operating income per unit.
 Drive a target cost per unit by subtracting the target operating income per unit
from the target price
 Perform cost analysis to analyze which aspects of a product or service to target for
cost reduction.
 Perform value engineering to achieve target cost. Value engineering is a
systematic evaluation of all aspect of the value chain business function with the
objective of reducing cost while satisfying customers’ needs. Value engineering
can result in improvement in product design, change in material specification, and
modification in process method. In this case, Costs can be value adding or non
value adding. Value adding costs are costs that costumers perceive as adding
utility or value while non value adding cost that do not add value to the product
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 and to customers. Value engineering will focuses on eliminating non value adding
cost and reduce as much as possible value adding cost without affecting quality of
the product and customers satisfaction.

Example6.6: Astel Company is a manufacturer of personal computer .Astel expects its

competitors to lower prices of PC. Astels management believes that it must respond by
reducing price by 20% from Br. 1000 per unit to Br.800 per unit. At this low price, Astels
marketing manager forecast an increase in annual sales from 150,000 to 200,000 units.
Astel management wants a 10% target operating income on sales revenue. The total
production cost at the moment for 150,000 units is Br. 135 million.
Required compute
a) The total target revenue
b) Total target operating income
c) Target operating income per unit
d) Current target cost per unit
Solution
a) Total target revenue ═ target price per unit x target annual unit sold
═ Br.800 per unit x 200,000 units ═ Br.160, 000,000
b) Total target operating income═ target rate x Total target revenue
═ 10% x Br.160, 000,000═ Br.16, 000,000
c) Target operating income per unit═ Total target operating income/ annual unit sold
═ Br.16, 000,000/200,000 units ═ Br.80
d) Current cost per unit═ target price per unit less target operating income per unit
═ Br.800 per unit - Br.80 ═ Br.720
2. Cost-plus pricing
Accounting information may be used in pricing decisions, particularly where the firm is a
market leader or price-maker. In these cases, firms may adopt cost-plus pricing, in which
a margin is added to the total product/service cost in order to determine the selling price.
In many organizations, however, prices are set by market leaders and competition
requires that prices follow the market (i.e. the firms are price-takers). Nevertheless, even
in those cases an understanding of cost helps in making management decisions about
what product/services to produce, how many units to make and whether the price that
exists in the market warrants the business risk involved in any decision to sell in that

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market. An understanding of the firm’s marketing strategy is therefore, essential in using
cost information for pricing decisions.
In the long term, the prices that businesses charge must cover all of its costs. If it is
unable to do so, it will make losses and may not survive. For every product/service, the
full cost must be calculated, to which the desired profit margin is added. Full cost
includes an allocation to each product/service of all the costs of the business, including
producing and delivering a good or service, and all its marketing, selling, finance and
administration costs.
The general formula for setting a cost based price adds a markup component to the
cost base to determine the prospective selling price. One way to determine the markup
percentage is to choose a markup to earn a target rate of return on investment.
The target rate of return on investment is the target annul operating income that an
organization aims to achieve divided by invested capital (asset)
i.e. TRR = Target operating income
Invested capital
Therefore, Target operating income=TRR*Invested capital

Let illustrate a cost – plus pricing formula on top company. Assume top’s engineers
have redesigned product CD into 2CD and that top uses a 12% markup on the full unit
cost of the product in developing the prospective selling price. The target product 2CD
profitability for 2000 is as follows:

Estimated total amounts Estimated total amount

for 200,000 units (1) per unit (2) = (1) 
200,000
Revenues Bir 160,000,000 Bir 800
Cost of goods sold 108,000,000 540
Operating costs 36,000,000 180
Total cost of product Bir 144,000,000 720
Operating income 16,000,000 Bir 80

Suppose that top’s target rate of return on investment is 18% and 2CD’s capital
investment is Bir 96 million. The target annual operating income for 2CD is:
Invested capital ……………………………….. Bir 96,000,000

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 Target rate of return on investment……………. 18%
Target Annual Operating income [0.18  Bir 96mln]…Bir17,280,000
Target operating income per unit of 2A
[Bir17,280,000  200,000 units] …………. Bir 86.40
This calculation indicates that top needs to earn a target operating income of Bir86.40 on
each unit of 2A. The mark up of Bir 86.40 expressed as a percentage of the full
production cost per unit of Bir720 equals 12% (Bir 86.40  Bir 720]
Thus the prospective selling price of product 2A is Bir806.40 (Full unit cost of 2A, Bir
720 plus the markup component of 12% (0.12  Bir 720= Bir 86.40).
Activity 6.6.
Differentiate the different long term pricing approach ----------------------

UNIT SUMMARY

Relevant information is logically related and pertinent to a given decision. Relevant

information may be both quantitative and qualitative. Variable costs are generally
relevant to a decision; they are irrelevant only when they cannot be avoided under any
possible alternative or when they do not differ across alternatives. Direct avoidable fixed
costs are also relevant to decision making. Sometimes costs give the illusion of being
relevant when they actually are not. Examples of such irrelevant costs include sunk costs,
arbitrarily allocated common costs, and no incremental fixed and variable costs.
Relevant costing compares the incremental revenues and/or costs associated with
alternative decisions. Managers use relevant costing to determine the incremental benefits
of decision alternatives. One decision is established as a base line against which the
alternatives are compared. In many decisions the alternative of “change nothing” is the
obvious base line case.
Common situations in which relevant costing techniques are applied include asset
replacements, outsourcing decisions, scarce resource allocations, special price
determinations, sales mix distributions, and retention or elimination of product lines.
The following points are important to remember:
1. In an asset replacement decision, costs paid in the past are not relevant to
decisions being made currently; these are sunk costs and should be ignored.

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 2. In an outsourcing decision, include the opportunity costs associated with the
outsource alternative; nonproduction potentially allows management an
opportunity to make plant assets and personnel available for other purposes.
3. In a decision involving a single scarce resource, if the objective is to maximize
company contribution margin and profits, then production and sales should be
focused toward the product with the highest contribution margin per unit of the
scarce resource.
4. In a special order decision, the minimum selling price that a company should
charge is the sum of all the incremental costs of production and sales on the order.
5. In a product line decision, product lines should be evaluated based on their
segment margins rather than on net income. Segment margin captures the change
in corporate net income that would occur if the segment were discontinued.
[

Quantitative analysis is generally short range in perspective. After analyzing the

quantifiable factors associated with each alternative, a manager must assess the merits
and potential risks of the qualitative factors involved to select the best possible course of
action. Some of these qualitative factors (such as the community economic impact of
closing a plant) may present long-range planning and policy implications. Other
qualitative factors may be short range in nature, such as competitor reactions. Managers
must decide the relevance of individual factors based on experience, judgment,
knowledge of theory, and use of logic.

MODEL EXAMINATION QUESTIONS

A) SHORT ANSWER QUESTIONS

1. Can a particular cost be relevant for one purpose, but not for other purposes? Give
three examples in which this would be the case.
2. Are sunk costs ever relevant in decision making? If so, give one or more examples.
3. You are considering the sale of your old stereo system. According to your records,
you paid Br. 500 for the stereo system. The current market value of the stereo is Br.
150. A new stereo of the same make and model could be purchased today for Br. 375.
Which of these figures is relevant to your decision to sell or keep the stereo system?
If any figures are not relevant, explain why.

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4. Kelly XY, owner of Mexican Cafe, is trying to decide whether to make Enjera or buy
them from a supplier. Kelly has come to you for advice. What factors would you tell
her to consider in making her choice?
5. What is a scarce resource? Why will the resource that is most scarce in an
organization be likely to change from time to time?
6. What is special order decision? What typical circumstances lead to the need to make
this type of decision?
7. What are the differences among avoidable fixed costs, unavoidable direct fixed costs,
and common fixed costs? Which are relevant and which are irrelevant in the decision
to keep or eliminate a particular product line?

B) WORKOUT QUESTIONS

1) Belt and Braces Ltd makes a single product which sells for Br 20. It has a full cost
of Br 15 which is made up as follows:

Direct Material Br 4
Direct Labor 6
Variable Overhead 2
General Fixed Overhead 3
Br. 15
The labor force is currently working at 90% of capacity and so there is a spare capacity
for 2,000 units. A customer has approached the company with a request for the
manufacture of a special order of 2,000 units for which he is willing to pay Br. 25,000.
Assess whether the contract should be accepted or not.

2) Buster Ltd makes four components, W, X, Y and Z, for which costs in the
forthcoming year are expected to be as follows.

W X Y Z
Production (units) 1,000 2,000 4,000 3,000

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Unit variable costs
Direct materials Br. 4 Br 5 Br 2 Br 4
Direct labor 8 9 4 6
Variable production overheads 2 3 1 2
Br 14 Br 17 Br 7 Br 12
Directly attributable fixed cost per annum and other fixed costs are as follows:
Incurred as a direct consequence of making W Br 1,000
Incurred as a direct consequence of making X 5,000
Incurred as a direct consequence of making Y 6,000
Incurred as a direct consequence of making Z 8,000
Other fixed costs (committed) 30,000
Total fixed costs Br 50,000
A subcontractor has offered to supply units of W, X, Y and Z for Br 12, Br 21, Br 10, and
Br 14 respectively.
Required: Decide whether Buster Ltd should make or buy the components and mention
some qualitative factors to be considered by Buster Ltd in decision making
3) Great Company manufacturers 60,000 units of part XL – 40:
Total costs Cost per
60,000 units unit
Direct material Br 480,000 Br 8
Direct labor 360,000 6
Variable factory overhead (FOH) 180,000 3
Fixed FOH 360,000 6
Total manufacturing costs Br 1,380,000 Br 23
Another manufacturer has offered to sell the same part to Great for Br 21 each. The fixed
overhead consists of depreciation, property taxes, insurance, and supervisory salaries.
The entire fixed overhead would continue if the Great Company bought the component
except that the cost of Br 120,000 pertaining to some supervisory and custodial personnel
could be avoided.
Required:
a. Should the parts be made or bought? Assume that the capacity now used to make
parts internally will become idle if the pats are purchased?

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b. Assume that the capacity now used to make parts will be either (i) be rented to nearby
manufacturer for Br 60,000 for the year or (ii) be used to make another product that
will yield a profit contribution of Br 250,000 per year. Should the company purchase
them from the outside supplier?

ANSWER TO MODEL EXAMINATION QUESTIONS

A. SOLUTIONS FOR SHORT ANSWER QUESTIONS

I) For questions 1, 2, 3, 4, 5, and 6 refer to section 6.3

II) For questions 7 refer to section 6.4.5
III) For questions 8 refer to section 6.4.4
IV) For questions 9 refer to section 6.4.3
V) For questions 10 refer to section 6.4.1
VI) For questions 11 refer to section 6.4.2

B. SOLUTIONS FOR WORKOUT QUESIONS

Q1
Br. Br.
Value of order 25,000
Cost of order
Direct materials (Br. 4 x 2,000) 8,000
Direct labor (Br. 6 x 2,000) 12,000
Variable overhead (Br 2 x 2,000) 4,000
Relevant cost of order ( 24,000)
Profit form order acceptance 1,000
Fixed costs will be incurred regardless of whether the special order is accepted and so are
not relevant to the decision. The contract should be accepted since it increases
contribution to profit by Br 1, 000.
Other factors to be consider in the special order decision.
a) The acceptance of the special order at a lower price may lead other customers to
demand lower prices as well.
b) There may be more profitable ways of using the spare capacity.

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 c) Accepting the special order may lock up capacity that could be used for future
full-price business.
d) Fixed costs may exist, in fact, if the contract is accepted.
Q2
a. The relevant cots are the differential costs between making and buying, and they
consist of difference in unit variable costs plus differences in directly attributable fixed
costs. Subcontracting will result in some fixed cost savings.
W X Y Z
Unit variable cost of making Br. 14 Br 17 Br 7 Br 12
Unit variable cost of buying 12 21 10 14
Br (2) Br 4 Br 3 Br 2
W X Y Z
Annual requirements (units) 1,000 2,000 4,000 3,000
Extra variable cost of buying (per annum) Br. (2,000) Br. 8,000 Br.12, 000 Br. 6,000
Fixed costs saved by buying (1,000) (5,000) (6,000) (8,000)
Extra total cost of buying (3,000) 3,000 6,000 (2,000)
b. The company would save Br 3,000 by subcontracting component W (where the
purchase cost would be less than the variable cost per unit to make internally) and would
save Br 2,000 by subcontracting component Z (because of the savings in fixed costs of Br
8,000).
c. In this question, relevant costs are the variable cots in-house manufacture the variable
costs of subcontracted units, and the saving in fixed costs.

Q3
To approach the decision form a financial point of view, the manager must focus on the
relevant or different costs. The differential cost can be obtained by eliminating from the
cost data those costs that are not avoidable – that is, by eliminating the sunk costs and the
future costs will continue regardless of whether the parts XL – 40 are produced internally
or purchased from outside. Thus, the relevant cost computation follows:

Cost To Make Cost To Buy

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 Per unit Total Per unit Total
Purchase Cost -0- -0- 21.00 1,260,000
Direct materials Br 8.00 Br 480,000
Direct labor 6.00 360,000
Variable FOH 3.00 180,000
Fixed FOH, avoidable 2.00 120,000
Total cost Br 19.00 Br 1,140,000 Br 21.00 Br 1,260,000
Recommendation: Great Company should reject the outside supplier’s offer because it
costs Br 2 less per unit to continue to make the part – XL – 40.

Relevant costs Per unit

Cost to buy Br 21.00
Cost to make 19.00
Advantage of making the part internally Br 2.00
Total advantage = Br 2.00 x 60,000units = Br 120,000
a. Assuming the space now being used to produce part XL – 40 would be
i. Rented to a nearby manufacture of Br 60,000 per annum or
ii. Used to produce other product that contributes a profit of Br 250,000 per year, the
relevant cost computation follows:
Make Buy and Buy and Buy and
Leave Rent out Produce
Facility Other
Idle Product
Cost to obtain parts Br1,140,000 Br1,260,000 Br1,260,000 Br 1,260,000
Contribution from - - - (250,000)
other products
Rent revenue - - (60,000)
Net relevant costs Br1,140,000 Br1,260,000 B1 ,200,000 Br 1,010,000
Great Company would be better off through accepting the supplier’s offer and to using
the available facility to produce the new product line. This move has the least net relevant
cost of Br 1,010,000.
CHAPTER -7

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 DECENTRALIZATION AND TRANSFER PRICING

UNIT OUTLINE
7.1.Introduction
7.2.Decentralization
7.3.Transfer pricing
UNIT BJECTIVES
 Describe management control system
 Describe the benefits and costs of decentralization
 Explain transfer pricing and the criteria used to evaluate
 Calculate transfer pricing using different methods

7.1 INTRODUCTION

A management control system is a means of gathering and using information to aid and
coordinate the planning and control decisions throughout an organization and to guide the
behavior of its managers and other employees.
In a small business, virtually all plans and decisions can be made by one individual. As a
business grows or its operation become more diverse, it becomes difficult, if not
impossible for one individual to perform these functions.
Management accounts, therefore, must have the interpersonal and analytical skills
necessary to evaluate and implement management control system, as well as the ability to
interpret out puts of these systems, and to be effective, management control systems
should be closely aligned to the company’s strategies and goals and also must fit an
organizations structure.

7.2 DECENTRALIZATION
 Dear learner! Have you made any decision for any department before?

As a business grows, it is difficult for one manager to manage the whole activity. Hence,
they need to delegate responsibility for portions of operation. This separation of a
business in to more manageable units is termed as Decentralization, the freedom of
manager at lower levels of the organization to make decision. The process of measuring

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and reporting operating activity by area of responsibility is called responsibility
accounting.

Benefit of Decentralization Limitation of Decentralization

Create greater response to local needs Suboptimal decision

Quicker decision making Duplication of asset & activity
Increase motivation Decrease loyalty to the organization as a whole
Increase creativity and productivity Increase cost of gathering information
Aids management development
Sharpens the focuses of managers

Activity 7.1
1. Define what decentralization means? And describe the merit and demerit of
it………………………………………………………………………………………

7.3 TRANSFER PRICING

In decentralized organizations, much of the decision, making power resides in its

individual submits. In these cases, the management control system often uses transfer
prices to coordinate the actions of the subunit and to evaluate their performance.

A transfer price is the price one subunit (department or division) charges for a product or
service supplied to another subunit of the same organization. If, for example, a car
manufacturer has a separate division that manufactures engines, the transfer price is the
price the engine division charges when it transfers engine to the assembly division. The
transfer price creates revenues for the selling subunit (the engine division in our example)
and purchase cost for the buying subunits (the assembly division), affecting each subunit
operating income. These operating incomes can be used to evaluate subunits performance
and to motivate their manager. The products or services transferred between sbunits of
the organization are called intermediate products. These products may either be further
worked on by the receiving subunit or, if transferred from production to marketing, sold
to an external customer.

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The three methods for determining transfer pricing are
1. Market-based transfer prices
In this case, top management may choose to use the price of a similar product or
service publicly listed, say, a trade association web site. Also top management may
select, for the internal price, the external price that subunit charges to outsider
customers. This method is preferred, (a) when the intermediate market is perfectly
competitive, (b) Interdependence of sub units is minimal, and (c) There are no other
additional costs of using market price.
2. Cost-based transfer price:
Top management may choose a transfer price based on the cost of producing the
product in question. The cost used in the cost based transfer price can be the actual
cost or the budgeted cost. Sometimes, the cost based transfer price includes the mark
up or profit margin that represents a return on subunit investment. This method is
used when market price is unavailable, inappropriate or too costly to obtain. In this
case, variable of full cost can be used as a base
3. Negotiated transfer price
In some cases, the subunit of the company are free to negotiate the transfer price
between themselves and then to decide whether to buy and sell internally or dealing
with external prices. Subunit may use information about costs and market price in
these negotiations, but there is no requirement that the chosen transfer price bear any
specific relationship to either cost or market price data. Thus, negotiated transfer price
is the outcome of a bargaining process between the selling and buying divisions.

Example7.1:
Horizon Petroleum Company has two divisions. Each division operates as a profit center.
The transportation division manages the operation of pipeline that transfers crude oil
from Mexico to Texas. The refining division manages a refining at Texas that process
crude oil in to gasoline. Gasoline is the only salable product the refinery makes and that it
takes two barrels of crude oil to yield one barrel of gasoline
Variable cost in each division is assumed to be variable with respect to single cost driver
in each division: Barrels of crude oil transported by the transportation division, barrel of
gasoline produced by the refining division. The fixed cost per unit is based on the
budgeted annual output of crude oil to be produced and transferred and the amount of

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gasoline to be produced. Horizon petroleum reports all costs and revenues of its non US
operation in US dollars using the prevailing exchange rate.
Transport Refining
Division Division
VC per unit Bir 1 Bir 8
FC per unit 3 6
Total Bir 4 Bir 14
Additional information’s
 The production division can sell crude oil to transport division in Mexico at Bir12
per barrel
 The transport division buys crude oil from the production division in Mexico and
sells it to the refining division
 The refining division can buy crude oil in Texas from external supplier at Bir21
per barrel and can sell the gasoline it produces at Bir58per barrel.
 The three divisions have sufficient capacity
Assume that 100 barrel of crude oil produced by production division is transported to the
refining division and assuming the following transfer pricing methods
Method A: Market based transfer price of Bir21 per barrel of crude oil based on the
competitive market price
Method B:Cost based transfer price at 110% of full cost where full cost are the cost of
transferred in product plus the divisions own variable and fixed cost.
Method C: Negotiated transfer price of Bir19.75 per barrel crude oil
Required
Compute the operating income for Horizon Petroleum Company and for each division
under each transfer pricing method.
Solution
i) Horizon Petroleum total operating income from purchasing, transporting and
refining the 100 barrels of crude oil and selling of the 50 barrels of gasoline is the
same, Bir600, regardless of the internal transfer price used.
Thus, Operating income would be:
Revenues: (Bir58x50 barrels of gasoline)…………………………………Bir 2, 900
Less: cost of crude oil purchases (Bir12x100) barrels of crude oil)……… Bir 1,200
Transportation cost (Bir4(1+3) x100 barrels of crude oil)…... 400
Refining costs (Bir14(6+8) x50 barrels of gasoline)…………. 700 2,300

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 Operating income……………………………………. Bir600

ii) Division operating income of horizon petroleum for 100 barrels of crude oil under alternative
transfer pricing methods would be:
Internal Internal Internal transfer a
transfers at transfer at negotiated pric
market 110% of full Bir19.25
price of cost =
Bir21/barrel Bir17.60
Transportation division
Revenues, (a) Bir21x100 = Bir17.60x100 Bir19.25x100=Bir1,92
Bir2,100 = Bir1760
Costs:
Crude oil purchase costs
(Bir12x100) Bir1200 Bir1200 Bir1200
Division VC (Bir1x100) 100 100 100
Division FC(Bir3x100) 300 300 300
Total division costs (b) Bir1600
Bir1600 1600
Division operating income(a-b) Bir325
Bir500 Bir160
Refining Division
Revenues (Bir58x50 barrels of gas oil) Bir2900
Bir2900 Bir2900
Costs:
Transportation in cost Bir21x100 = 1,760 1,925
Bir2,100
Division VC (Bir8x50) 400 400 400
Division FC(Bir6x50) 300 300 300
Total division costs (b) Bir2625
Bir2800 Bir2460
Division operating income (a-b) Bir275
Bir100 Bir440
Operating income of both division Bir600
Bir600 Bir600

MODEL EXAMINATION QUESTIONS

Discussion Question
1. What is management control system and how should it be desired?
2. What are the benefits and costs of decentralization?
3. What is a transfer price and what is it intended to achieve?
4. What methods can be used to calculate transfer prices?

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