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CMA Formula Part 1 Final

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100% found this document useful (2 votes)
3K views47 pages

CMA Formula Part 1 Final

Uploaded by

Mohammed Kashif
Copyright
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We take content rights seriously. If you suspect this is your content, claim it here.
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CMA Formulas

CMA Exam Part One

Direct
Labor Price
Variance
Calculation

Actual
Calculation Results
for Average Calculation for
Annual Growth
! ! $ the Static
Rate (AAGR)? % Budget

X
÷ =
*
*
+/-

the CMA exam


CMA formulas - Part 1

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Hi, future CMA!

My name is Stephanie Ng, and I am here to help


you pass the CMA exam. Contained herein,
you’ll find formulas, along with our exclusive
detailed explanations for each one.

But before we get too far, I’d like to share my


background with you. I am a published CPA Exam Guide
Author, Accounting Today and Going Concern contributing
writer, CFO, Institute of Management Accountants (IMA)
webinar presenter, and publisher of the website I Pass the
CMA Exam.

You’ll want to commit these formulas to memory and


understand how to apply them to complex problems on
the CMA exam. Therefore, make sure you understand what
the formula is for, how it works mathematically (e.g., if the
numerator goes up, what happens to the denominator?), and
the implications of each formula.

And be sure to read through until the end -- there’s a special


offer that I’m happy to share with you, future CMA!

To your success,
Stephanie Ng

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1 Basic EPS Calculation

ALT NAME: Net income per share


CALCULATION: (Net income – Preferred Dividends) ÷ Weighted
average number of common shares outstanding

COMPONENTS
• Net Income (Loss): The amount of profit or loss after expenses and
losses are subtracted from revenues and gains.
• Preferred Dividends: A dividend that is accrued and paid on a
company’s preferred shares.
• Weighted Average Number of Common Shares: The number of
shares of a company calculated after adjusting for changes in the
share capital over a reporting period. Generally, it can be easily
calculated using the following formula: (Beginning Outstanding
Shares + Ending Outstanding Shares) ÷ 2

DESCRIPTION
Earnings per share is a measure of how much profit a company has generated for
each outstanding share of its common stock. Because preferred dividends are meant
for preferred shareholders and not common shareholders, this is why preferred
dividends are subtracted from net income when calculating basic earnings per share.

Using earnings per share as a measurement of a company’s health has its limitations
because companies can buy back their own shares, which increases the amount
of earnings per share. Stock buybacks reduce the shares outstanding without
increasing the net income; this allows companies to manipulate the earnings per
share to make it seem like they are doing better than they actually are.

Additionally, the earnings per share calculation does not consider two other
important factors: a company’s outstanding debt, and the capital needed to generate
the earnings in question.

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1 Basic EPS Calculation

HIGH/LOW ANALYSIS
If a company has a high earnings per share, the company has more money available
to reinvest in the business or distribute to stockholders in the form of dividend
payments.

Also, a higher earnings per share ratio will often make the stock price of a company
rise.

Conversely, a low earning per share could indicate that the company is experiencing
trouble with profitability and could reduce the future stock price.

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2 Cash Flow Calculation


ALT NAME: N/A
CALCULATION: Cash from Operating Activities +/- Cash from
Investing Activities +/- Cash Provided from Financing Activities = Net
Increase (Decrease) in cash and cash equivalents during the year

COMPONENTS
• Operating Activities: Functions of a business directly related to the
day-to-day operations used to provide its goods and/or services to
the market; generally, activities related to net income.
• Examples of Cash Inflows:
• Sales of goods or services
• Interest received from loans
• Dividends received from investments
• Examples of Cash Outflows:
• Merchandise purchased from suppliers
• Materials used to manufacture products
• Income tax expense
• Interest expense
• Payroll expense
• Investing Activities: Functions of a business related to buying
and selling longer-term assets and other investments; generally
associated with long-term balance sheet items.
• Examples of Cash Inflows:
• Sale of long-term investments (e.g., bonds and other company’s stock)
• Sale of property, plant, and equipment
• Collection of principle for loans made to other entities
• Examples of Cash Outflows:
• Purchase of long-term investments (e.g., bonds and other company’s
stock)
• Purchase of property, plant, and equipment
• Loans made to other entities

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2 Cash Flow Calculation


• Financing Activities: Functions of a business involving creditors
or investors used to fund company operation; generally, activities
related to noncurrent liabilities (not due for settlement within one
year) and stockholders’ equity.
• Examples of Cash Inflows:
• Issuance of notes
• Issuance of bonds
• Issuance of common stock
• Examples of Cash Outflows:
• Dividends paid to stockholders
• Payment to redeem long-term debt or reacquire capital stock.
• Purchase of treasury stock

DESCRIPTION
First and foremost, it is essential to note that cash flow isn’t the same as profit.
Simply put, the cash flow calculation exists to help track the movement of money in
and out of a business. The amount of available cash dictates how a company makes
many significant business decisions, including whether or not to expand, develop
new products, buy back stock, pay dividends, or reduce debt.

Cash flow is also indicative of a company’s liquidity, flexibility, and overall financial
performance. When cash flow is positive, a company’s liquid assets increase,
enabling it to settle debts, reinvest in its business, return money to shareholders, or
pay expenses.

If a company has a lower level of liquidity due to profits being tied up in accounts
receivable and inventory or spending too much on capital expenditures, then there is
a chance the company may fail.

However, a large amount of cash available doesn’t always mean that a company
will be successful since the money could have been acquired by taking on an
unsustainable debt level.

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3 Declining Balance and Double Declining


Balance Depreciation Calculation

ALT NAME: N/A


CALCULATION: Current Book Value x Accelerated Depreciation %
Rate = Annual Depreciation Expense

COMPONENTS
• Current Book Value: The value at which a company carries an asset
on its balance sheet. It is calculated by subtracting accumulated
depreciation from the cost of an asset.
• Accelerated Depreciation % Rate: Straight-Line Depreciation Rate
x Specific Percentage (e.g., 150% or 200%)
• Straight-Line Depreciation Rate: 1 ÷ Useful Life of the Asset
• Annual Depreciation Expense: The portion of a depreciable asset
deemed to have been consumed or expired during a specific
accounting period.

DESCRIPTION
The declining balance method is a form of accelerated depreciation that utilizes a
percentage of the straight-line depreciation rate to calculate depreciation expense.
Commonly, the straight-line rate will be applied at a 150% or 200% accelerated
depreciation rate.

Unlike other depreciation methods, the salvage value is not deducted from the
asset’s cost under this method. The accelerated depreciation rate is applied to the
book value of the asset at the beginning of the period, and the book value of the asset
decreases year by year. When the book value of the asset is reduced to its salvage, no
more depreciation is applied.

Like other accelerated depreciation methods, larger amounts of depreciation are


expensed during the earlier years of an asset’s useful life, and smaller amounts are
expensed in later years. The declining balance method is more effective for recording
depreciation of assets that quickly lose their value, such as computer equipment and
other technology products, instead of assets that do not lose their value quickly, such
as factory equipment and machinery.

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3 Declining Balance and Double Declining


Balance Depreciation Calculation

DECLINING BALANCE METHOD


EXAMPLE A car rental company purchases a new vehicle for $35,000. The company expects the vehicle
to last for 5 years, after which the vehicle will be sold for a salvage value of $5,000. The 5-year
life of the vehicle is depreciated at 150% of the normal rate. Calculate depreciation expense
over the life of the asset using the declining balance method of depreciation.

1. Calculate the Straight-Line Depreciation Rate: 1 ÷ 5 (Useful Life of the Asset) = 20%

2. Accelerated Depreciation Rate: 20% Straight – Line Depreciation Rate x 1.5 (150%
acceleration) = 30%

3. $35,000 Year 1 Book Value x 30% Accelerated Depreciation Rate = $10,500 Depreciation
Expense

There is a variation of the declining balance method called the Variable Declining Balance
method that handles the final year of depreciation in a slightly different way. The book value of
the equipment at the beginning of year 5 is $8,403, of which 30% is $2,521.

If this depreciation is used, the book value of the equipment at the end of year 5 will be $5,882
($8,403 – $2,521), which is more than the salvage value.

Under the Variable Declining Balance method, the asset is fully depreciated to the salvage
value over its useful life, so the depreciation expense in year 5 would be $3,403 ($8,403 –
$5,000).

DOUBLE DECLINING BALANCE METHOD


EXAMPLE A car rental company purchases a new vehicle for $35,000. The company expects the vehicle
to last for 5 years, after which the vehicle will be sold for a salvage value of $5,000. Calculate
depreciation expense over the life of the asset using the double-declining method of
depreciation.

1. Calculate the Straight-Line Depreciation Rate: 1 ÷ 5 (Useful Life of the Asset) = 20%

2. Accelerated Depreciation Rate: 20% Straight – Line Depreciation Rate x 2 (200%


acceleration) = 40%

3. $35,000 Year 1 Book Value x 40% Accelerated Depreciation Rate = $14,000 Depreciation
Expense

The book value of the equipment at the beginning of year 4 is $7,560, of which 40% is $3,024.
If this depreciation is used, the book value of the equipment at the end of year 4 will be $4,536
($7,560 – $3,024), which is less than the salvage value.

As stated earlier, the asset is depreciated only to its salvage value under the declining balance
method. Therefore, the depreciation in year 4 is calculated as follows:

$7,560 Book value (Beg. Year 4) – $5,000 Salvage value = $2,560 Year 4 Depreciation Expense

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4 Depreciable Base Calculation


ALT NAME: N/A
CALCULATION: Acquisition Cost of Asset – Salvage Value of Asset =
Depreciable Base

COMPONENTS
• Acquisition Cost of Asset: The purchase price of an asset plus the
cost incurred to put the asset into service. Additional costs may
include sales tax, customs duties, freight charges, installation fees,
and testing costs.
• Salvage Value of Asset: The estimated resale value of an asset at
the end of its useful life.
• Depreciable Base: The value of the asset to be written off over time.

DESCRIPTION
Typically, the computation of the depreciable base is the first step
used to calculate depreciation expense regardless of the chosen
method of depreciation. The depreciable base represents the asset’s
value that must be allocated as an expense based on the useful life of
the asset or estimated production capability.

It should be noted that some companies use assets and scrap them as
opposed to reselling them at a salvage value; in these instances, the
depreciable base of the asset is the same as its cost.

Also, the value of a company’s assets is stated in terms of original cost


on the balance sheet. The depreciable base is only used during the
calculation of depreciation expense.

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5 Gross Profit Calculation


ALT NAME: Gross margin, Sales profit, Gross income
CALCULATION: Revenue – Cost of Goods Sold = Gross Profit
COMPONENTS
• Revenue: Income generated from sales of goods or services
associated with the primary operations before any costs or
expenses are deducted.
• Cost of Goods Sold: The accumulated total of all costs used to
create a product or service that has been sold.
• Gross Profit: The profit a company makes after deducting the
costs associated with making and selling its products or the costs
associated with providing its services.

DESCRIPTION
The gross profit figure can be used to assess a company’s efficiency at using its labor and
supplies in producing goods or services. However, it is essential to note that the metric only
considers variable costs, such as materials and direct labor. These expenses vary based on the
output level while excluding fixed costs, such as rent and insurance, that are the same amount
regardless of output level.

By reviewing the gross margin, management and investors can analyze how profitable an
organization’s core business activities or products are without considering the indirect costs.

One of the most useful purposes for calculating gross profit is to use the metric to further
calculate the gross profit margin:

Gross Profit Margin = Gross Profit ÷ Total Revenues

The gross profit margin is a popular metric among analysts and management because it
allows for a better comparison with competitors within the same industry or sector. Also, it
indicates how much gross profit a company is earning for every dollar of revenue.

Companies with high gross profit margins generally have more efficient processes and
more effective operations, and they are a safer long-term investment than their competitors.
Typically, an organization’s gross profit margin should be stable over time; substantial
fluctuations could indicate several issues, including declines in business, mismanagement of
resources, or fraud.

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6 Net Realizable Value (NRV) Calculation


ALT NAME: Cash realizable value
CALCULATION: Expected Selling Price – Total Production and
Selling Costs = NRV for Inventory

COMPONENTS
• Expected Selling Price: The value of an asset that can be realized
upon the sale of the asset.
• Total Production and Selling Costs: The estimate of costs
associated with either the completion, sale, or disposal of the asset
in question.
• Net Realizable Value: The selling price of an asset minus the costs
associated with the completion, sale, or disposal of the asset.

CALCULATION: Accounts Receivable Balance – Allowance for


Doubtful Accounts = NRV for A/R

COMPONENTS
• Accounts Receivable Balance: The amount of money owed to a
company by its debtors.
• Allowance for Doubtful Accounts: The dollar amount of invoices
that the company labels bad debt (uncollectible).
• Net Realizable Value: The amount of money owed to a company by
its debtors less the estimated value of bad debt.

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6 Net Realizable Value (NRV) Calculation


DESCRIPTION
Net realizable value is commonly associated with accounts receivable and inventory,
which are both initially recorded at cost. In some instances, the company will collect
less than the cost; when this occurs, the company must report the asset at the lower
of cost or the net realizable value (NRV).

Generally Accepted Accounting Principles (GAAP) dictate that companies should


not overstate the value of assets that can increase profits and mislead investors.
Because the calculation of NRV will always be lower than the market value of an
asset, the metric can help prevent the overstatement of the assets’ valuation.

In relation to accounts receivable, the balance is converted to cash when customers


pay outstanding invoices. Still, the balance must be adjusted for clients who don’t
make payment by subtracting the allowance of doubtful accounts from the expected
balance to be received.

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7 Straight-line Depreciation Calculation


ALT NAME: Straight Line Basis
CALCULATION: Depreciable Base ÷ Useful Life of the Asset = Annual
Depreciation Expense

COMPONENTS
• Depreciable Base: The value of the asset to be written off over time.
• Useful Life of the Asset: The period of time for which the asset will
be economically feasible for use in a business.
• Annual Depreciation Expense: The portion of a depreciable asset
deemed to have been consumed or expired during a specific
accounting period.

DESCRIPTION
Straight-line depreciation is the most commonly used and easiest to compute
method for calculating depreciation because it results in the same depreciation
expense for every accounting period. As a result, the asset’s carrying amount on the
balance sheet reduces by the same amount every accounting period.

In some cases, the straight-line depreciation method does not accurately reflect
the asset’s usage and may not be the best method depending on the specific asset.
For example, computers may not be efficiently depreciated using the straight-line
depreciation method due to rapid technological advancements.

The obsolescence of older technology should cause a computer to accumulate larger


depreciation expenses in its useful early life and smaller depreciation expense in
later periods of its useful life.

EXAMPLE A car rental company purchases a new vehicle for $35,000. The company expects the vehicle
to last for 5 years, after which the vehicle will be sold for a salvage value of $5,000. Calculate
depreciation expense over the life of the asset using the straight-line method of depreciation.

1. Calculate the Depreciable Base: $35,000 (Cost of Asset) – $5,000 (Salvage Value of Asset)
= $30,000 Depreciable Base

2. $30,000 (Depreciable Base) ÷ 5 (number of years of useful life) = $6,000 (Annual


depreciation expense)

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8 Sum-of-the-Years’-Digits
Depreciation Calculation

ALT NAME: SYD Method


CALCULATION: (Remaining Useful Life of the Asset ÷ Sum of the
years’ digits) x Depreciable Base

COMPONENTS
• Remaining Useful Life of the Asset: The remainder of the period
of time for which the asset will be economically feasible for use in a
business.
• Sum-of-the-Years’ digits: The sum of remaining asset life every
year in the asset’s useful life.
• Depreciable Base: The value of the asset to be written off over time.
• Annual Depreciation Expense: The portion of a depreciable asset
deemed to have been consumed or expired during a specific
accounting period.

DESCRIPTION
The sum-of-the-year’ digits depreciation method is an accelerated method of depreciation,
which means that a higher amount of depreciation expense is charged in the early years of an
asset’s useful life since this is when the asset is most productive.

One problem with this and other accelerated depreciation methods is that it artificially
reduces the business’s reported profit over the near term. The outcome is excessively low
profits in the near term, followed by excessively high profits in later accounting periods.

EXAMPLE A car rental company purchases a new vehicle for $35,000. The company expects the vehicle
to last for 5 years, after which the vehicle will be sold for a salvage value of $5,000. Calculate
depreciation expense over the life of the asset using the Sum-of-the-Years’ Digits method of
depreciation.

1. Calculate the Depreciable Base: $35,000 (Cost of Asset) – $5,000 (Salvage Value of Asset)
= $30,000 Depreciable Base

2. Remaining Useful Life of the Asset: 5 years (Year 1); 4 years (Year 2); 3 years (Year 3); 2
years (Year 4); and 1 year (Year 5)

3. Sum-of-the-Years’ digits: 5 + 4 + 3 + 2 + 1 = 15 years

4. Depreciation Factor: 5/15 x $30,000 Depreciable Base = $10,000 Depreciation Expense


(Year 1)

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9 Units-of-Output Depreciation
Calculation

ALT NAME: Units of Production; Units of Activity


CALCULATION: (Depreciable Base ÷ Estimated Production
Capability) x Units Per Year = Annual Depreciation Expense

COMPONENTS
• Depreciable Base: The value of the asset to be written off over time.
• Estimate Production Capability: The total number of hours of
usage of an asset or the total number of units to be produced by an
asset over its useful life.
• Units Per Year: The actual number of units produced or numbers of
hours of usage by an asset for an accounting period.
• Annual Depreciation Expense: The portion of a depreciable asset
deemed to have been consumed or expired during a specific
accounting period.

DESCRIPTION
The direct relationship between asset usage and expense in the units-of-output
method makes it the most accurate depreciation method. While most depreciation
methods base depreciation expense on the passage of time, the units-of-output
method is unique because the amount of depreciation expense is directly
proportional to the amount of asset usage in the accounting period.

As a result, the amount of depreciation expense could be higher or lower, depending


on whether there was more or less asset usage during that period. Under this
method, depreciation begins when an asset begins to produce units and ends
when the unit’s cost is fully recovered, or the unit has produced all units within its
estimated production capacity, whichever comes first.

Typically, this depreciation method is reserved for more expensive assets because it
requires that the company track asset usage, resulting in additional costs. Another
limiting factor for this method is that one must be able to estimate the total usage
over the life of an asset for this process to be applicable.

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9 Units-of-Output Depreciation
Calculation

The units-of-output method is most commonly utilized for internal bookkeeping


within manufacturing businesses because it can help present a more accurate
depiction of profits and losses.

For manufacturing companies, for which production varies based on consumer


demand, the cost of machinery can be allocated throughout the years based on how
much the asset has been used.

EXAMPLE A car rental company purchases a new vehicle for $35,000 with an estimated
capacity to be driven 200,000 miles during its 5-year life. Miles driven for each of the
five years are as follows: Year 1: 75,000 miles; year 2: 50,000 miles; year 3: 30,000;
year 4: 25,000 miles; year 5: 20,000 miles. The expected salvage value of the vehicle
is $5,000. Calculate depreciation expense over the life of the asset using the Units-
of-Output method of depreciation.

1. Calculate the Depreciable Base: $35,000 (Cost of Asset) – $5,000 (Salvage Value
of Asset) = $30,000 Depreciable Base

2. Calculate Cost Per Unit: $30,000 (Depreciable Base) ÷ 200,000 miles = $0.15 per
mile

3. Calculate Annual Depreciation Expense: $0.15 per mile x 75,000 miles (Year 1) =
$11,250

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10 Weighted-Average Cost Method


of Inventory Calculation

ALT NAME: N/A


CALCULATION: Cost of Goods Available for Sale ÷ Number of Units
Available for Sale = Weighted Average Cost per Unit

COMPONENTS:
• Cost of Goods Available for Sale: The beginning value of inventory
plus the cost of goods purchased in the accounting period.
• Number of Units Available for Sale: The total number of units in
inventory, or the number of units a company can sell.
• Weighted Average Cost per Unit: The figure used to determine the
cost of goods sold and ending inventory amounts at the end of an
accounting period.

DESCRIPTION
The weighted-average cost method of inventory valuation uses a weighted average to
determine the amounts for cost of goods sold and ending inventory as opposed to both LIFO
and FIFO, which focus on the timing and order of when goods are added to inventory.

Two common situations in which the weighted average cost method is utilized are when
inventory items are intermixed to a point where it is impossible to assign a specific cost to an
individual unit, and a company’s accounting system isn’t advanced enough to track LIFO or
FIFO.

Because tracking inventory is not necessary for the weighted-average cost method, it is
considered the simplest way to track inventory. There are, however, some disadvantages
associated with this method when inventory prices vary by a large amount.

Weighted-average cost assumes that all units are identical, which may not always be the case
due to product upgrades or additional features of newer batches. Ideally, a company will make
up for any loss from selling the most expensive units when selling the less expensive units.
Still, if there is a decline in sales, inventory may be discontinued without ever recovering the
losses associated with the sale of the expensive units.

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11 Net Income Equation


ALT NAME: Net Profit, Net Earnings, the Bottom Line
CALCULATION: Revenues + Gains – Expenses – Losses = Income
(Loss)

COMPONENTS:
• Revenues: Income generated from sales of goods or services
associated with the main operations before any costs or expenses
are deducted.
• Gains: Any economic benefit that is outside the normal operations
of a business. Common examples include the excess of money
or fair value when an asset is sold or exchanged for more than its
purchase price.
• Expenses: Costs incurred to generate revenue. Commons examples
include the cost of goods sold, operating expenses, sales, general,
and administrative expenses, and amortization/depreciation
expense.
• Losses: A decrease in net income outside the normal operations
of the business. Common examples include the sale of an asset for
less than its carrying value, the write-down of assets, or a loss from
lawsuits.
• Net Income (Loss): The amount of profit or loss after expenses and
losses are subtracted from revenues and gains.

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11 Net Income Equation


DESCRIPTION
Net income is one of the most critical indicators of a company’s
financial health as it measures the profit earned (or money lost) over
a period of time. Shareholders follow net income very closely as it
impacts many financial ratios and determines the amount of dividend
that will be paid to stockholders.

It is important to note that net income is not always a reliable figure


since management may manipulate the rules of accrual basis
accounting to modify income levels to achieve bonus payments or
meet the pressures of analyst expectations. Inversely, net income can
be artificially reduced to avoid income tax payments.

HIGH/LOW ANALYSIS:
• A higher net income could result from an increase in sales volume,
an increase in the sales price, or an increase in investment
income. A decrease in expenses, such as cost of goods sold and
sales, general, and administrative expenses, will also result in an
increased level of net income.
• Conversely, a decrease in revenue caused by reduced sales prices
or low sales volume can result in less, or negative, net income.
Likewise, an increase in the cost of goods sold and other sales,
general, and administrative expenses will cause net income to
decrease.

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12 Cost of Goods Sold (COGS)


Calculation

ALT NAME: Cost of Sales, Cost of Services


CALCULATION: Beginning Inventory + Purchases during the period
– Ending Inventory = COGS

COMPONENTS:
• Beginning Inventory: The value of goods that a company has for its
use or sale at the start of an inventory accounting period.
• Purchases During the Period: The value of goods purchased
during the period.
• Ending Inventory: The value of goods that a company has on hand
at the end of the reporting period.
• Cost of Goods Sold: The accumulated total of all costs used to
create a product or service that has been sold.

TIP To determine if an expense should be classified as a cost of goods sold, consider


whether or not the expense is the result of the initiation of a sale.

DESCRIPTION
Cost of goods sold is an indication of operational efficiency, and an organization
should aim to keep the metric as low as possible. An organization’s understanding
of its cost of goods sold is vital because it allows the organization to set prices that
result in a healthy profit margin and aids the organization in determining when to
increase prices for a particular product.

The classification of expenses as cost of goods sold is dependent on the type of


business entity. For example, a manufacturing entity’s cost of goods sold would
generally include direct labor, materials, and overhead used to create products. In
contrast, a wholesale entity’s cost of goods sold would likely be merchandise that
was purchased from a manufacturer.

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12 Cost of Goods Sold (COGS)


Calculation

The cost of goods sold figure is also susceptible to fraudulent manipulation to


alter the reported level of profits. Common methods to manipulate cost of goods
sold include incorrectly counting the inventory quantity on hand, allocating more
overhead than actually exists to inventory, and performing an incorrect period-end
cutoff.

HIGH/LOW ANALYSIS
The inventory costing methodology used by an organization to calculate the cost of
ending inventory can significantly impact the measure of cost of goods sold.

1. First in, first out method (FIFO): Assumes that the first inventory added is the
first inventory used. When prices are increasing in an inflationary environment,
lower-cost goods are used first, resulting in a lower cost of goods sold and higher
net income.

2. Last in, first out method (LIFO): Assumes that the last inventory added is the
first inventory used. When prices are increasing, higher-cost goods are used first,
resulting in a higher cost of goods sold and lower net income.

3. Average method: Uses the average price of all the goods in stock, regardless
of purchase date. This method keeps the cost of goods sold at a more balanced
level than the FIFO and LIFO methods because it prevents cost of goods sold from
being highly impacted by extreme costs of one or more purchases.

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13 Retained Earnings Calculation


ALT NAME: Earned Surplus, Retained Capital, Accumulated Earnings
CALCULATION: Beginning Retained Earnings + Net Income (Loss)
During Period – Dividends Paid During Period = Retained Earnings

COMPONENTS:
• Beginning Retained Earnings: The amount of retained earnings
from the previous accounting period.
• Net Income (Loss) During Period: The amount of profit or loss after
expenses and losses are subtracted from revenues and gains from
the current period.
• Dividends Paid During Period: The portion of a company’s
earnings paid to investors during the period.
• Retained Earnings: The profits that a company has earned to date,
less any dividends or other distributions paid to investors.

DESCRIPTION
Retained earnings is the profit amount of a business that has not been distributed to
investors and are retained by the business to, among other things, invest in working
capital or pay down outstanding liabilities.

It is important to note that retained earnings does not represent surplus cash or the
amount of cash left over after the distribution of dividends. Instead, it explains what
a company did with its profits. Since all profits and losses flow through retained
earnings, the balance is constantly changing because any income statement activity
will directly impact the net income part of the retained earnings calculation.

Growing industries and industries that rely on large amounts of capital tend to retain
more of their earnings to invest in more assets needed to operate the business; it is
also common for older companies to report higher retained earnings than similar
younger companies due to the amount of earnings accumulated over time.

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14 Measurement of Inventory at Lower


of Cost or Market (LCM) Calculation

ALT NAME: NA
TERMS:
• Upper Limit (Ceiling): Net Realizable Value (NRV) of Inventory
• Replacement Cost of Inventory
• Lower Limit (Floor): Net Realizable Value (NRV) – Normal Profit
Margin on the Inventory

COMPONENTS:
• Net Realizable Value (NRV): The expected selling price of an item
minus any selling costs or costs to complete the item.
• Replacement Cost: The market value of an item; may be expressed
in the form of purchase cost or manufacturing cost.

Determining Current Market Value using Net Realizable


Value (NRV)
• When replacement cost is lower than the market floor, the current
market value from the LCM rule is the market floor.
• When replacement cost falls between the market floor and market
ceiling, the current market value from the LCM rule is replacement
cost.
• When replacement cost is higher than the market ceiling, the
current market value from the LCM rule is the market ceiling.

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14 Measurement of Inventory at Lower


of Cost or Market (LCM) Calculation

DESCRIPTION
The lower of cost or market (LCM) is an accounting rule used to value
inventory. The LCM rule dictates that a business must record the cost
of inventory at whichever cost is lower: (a) the historical cost or (b) its
current market value.

Typically, the LCM valuation method is used when inventory has


deteriorated, or become obsolete, or market prices have declined.
Since the passage of time can bring about the aforementioned
conditions, the rule is more likely to be applicable when a business has
held inventory for a long time. For this older inventory, GAAP requires
an annual test to adjust the balance to the lower of cost or market. The
test is required so that losses on inventory are matched with earnings
for the same period. This prevents the reporting of inflated earnings
for the same period discounted inventory items are sold.

The current market value in LCM is the current replacement cost not
exceeding the ceiling of net realizable value (NRV) and not below the
floor of NRV adjusted for a normal profit margin (NRV – normal profit
margin).

At the end of the fiscal year, the remaining inventory items are
compared to the current market value. If the current market value
is less than the historical cost, the items are adjusted down to the
current market price to account for the lost value. However, if the
current market value is greater than the historical cost, the items
remain at historical cost.

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15 Warranty Liability Calculation


ALT NAME: NA
CALCULATION: Sales Forecast x Percentage of Historical Warranty
Cost based on Sales

COMPONENTS:
• Sales Forecast: The projection of achievable sales revenue based
on historical sales data and an analysis of market surveys and
trends.
• Percentage of Historical Warranty Cost based on Sales: The
percentage of revenues used to pay for warrantied repairs and
replacements from historical periods.

DESCRIPTION
If a company issues a warranty on a product it sells, the company must record a
liability to reflect the estimated costs of repairing or replacing the item under warranty.

The estimated warranty liability should be recorded in the same period as the sale, and
the warranty liability account is reduced as the company pays for warrantied repairs.

Typically, a company will compare historical sales and warranty claim data to forecast
the amount of future sales and warranty expense; if historical data is not available, the
company will use industry averages.

Depending on the warranty’s length, the warranty liability account may need to be
split between the current (payable within a year) and long-term (not payable for over a
year) liability sections of the balance sheet.

The initial recording of accrued warranty liability should be a debit to the warranty
expense account and a credit to the accrued warranty liability account; redemption of
a warranty would result in a debit to the accrued warranty liability account and a credit
to the inventory/cash account.

Companies with a minimal history of warranty expenditures may choose not to record
a liability in advance of actual warranty expense since the forecast would be that
warranty expense is immaterial. The concept of warranty liability is least common for
service companies since it is more difficult to determine what qualifies as a warranty
liability, as most services are customized.

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16 Asset Carrying Value Calculation


ALT NAME: Book Value, Carrying Amount
CALCULATIONS:
• Original Cost – Accumulated Depreciation – Asset Impairment
(Physical Assets)
• Original Cost – Amortization Expense – Asset Impairment
(Intangible Assets)
COMPONENTS:
• Original Cost: The total price paid to acquire an asset initially.
• Accumulated Depreciation: The total amount of an asset’s cost
that has been charged to depreciation expense since the asset was
placed into service.
• Amortization Expense: The write-off of an intangible asset over its
expected period of use, which reflects consumption of an asset.
• Asset Impairment: A permanent reduction in the value of a
company’s asset, typically a fixed asset.

DESCRIPTION
An asset’s carrying value represents the original amount reflected on the company’s
balance sheet, minus the accumulated depreciation of the asset and any asset
impairments.

For physical assets, such as computers and machinery, the carrying value can be
computed by subtracting accumulated depreciation from the asset’s original cost.

Similarly, the carrying value of patents and other intellectual property can be
calculated by subtracting amortization expense from the asset’s original cost.

Upon acquisition of an asset, its carrying value is exactly the same as its purchase
price. Because the original cost can be traced to a purchase document, such as a
receipt, accounting guidelines dictate that the original cost should be used to record
assets on the balance sheet instead of market value.

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17 Fair Value of an Asset Calculation


ALT NAME: NA

DESCRIPTION
Fair value represents the actual value of an asset that is agreed upon
by both the seller and the buyer, hence the usage of the term fair.

A product sold due to liquidation is not eligible for a fair value


assessment, but products sold or traded in the market where they
belong or in normal conditions are eligible.

There are multiple ways to calculate fair value depending on the


product. Some of the sources used to calculate fair value are
market prices quoted from a stock exchange (market approach), the
estimated cost to replace an asset taking into account adjustments for
obsolescence (cost approach), and the discounted cash flow method
(income approach).

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Interest Expense Calculation for


18 Amortizing a Premium or Discount
on Bonds

ALT NAME: NA
CALCULATION: Carrying Value of Bonds at Beginning of Period x
Effective – Interest Rate

COMPONENTS:
• Carrying Value of Bonds at Beginning of Period: The face amount
minus any unamortized discounts or plus any unamortized
premium, also known as book value.
• Effective-Interest Rate: The interest rate that is actually earned
or paid on an investment due to the result of compounding over a
given time period.

DESCRIPTION
The face value of a bond is the amount paid to the owner at maturity.

If bonds sell for less than face value, then they sell at a discount.

When a bond is sold at a discount, the amount of the discount must be


amortized to interest expense over the bond’s life. Because the debit
amount in the Discount on Bonds Payable account will be transferred
to the Interest Expense account, the amortization will cause each
period’s interest expense to be greater than the amount of interest
paid during each of the years that the bond is outstanding.

The preferred method for amortizing this discount is the effective


interest rate method. Under this method, the amount of interest
expense in a given accounting period will correlate with the amount
of a bond’s book value at the beginning of the accounting period.
As a result, as a bond’s book value increases, the amount of interest
expense will increase.

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Interest Expense Calculation for


18 Amortizing a Premium or Discount
on Bonds

If bonds sell for more than face value, then they sell at a premium.
When a bond is sold at a premium, the amount of the bond premium
must be amortized to interest expense over the bond’s life.

As a result, the credit balance in the Premium on Bonds Payable


account will be transferred to the Interest Expense account, reducing
the interest expense in each of the accounting periods that the bond is
outstanding.

The preferred method for amortizing this premium is the effective


interest rate method. Under this method, the amount of interest
expense in a given accounting period will correlate with the amount of
a bond’s book value. When a bond’s book value decreases, the amount
of interest expense will decrease.

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19 Simple Linear Regression Analysis


Calculation

CALCULATION: y = bx + a
COMPONENTS:
• y = The value being forecast (dependent variable)
• b = The slope of the regression line
• x = The value of the independent variable
• a = The value of y (dependent variable) if the value of x
(independent variable) is 0

DESCRIPTION
Linear regression models are used to show or predict the relationship
between two variables.

Simple linear regression analysis is a statistical tool used to quantify


the relationship between one independent variable and one
dependent variable based on past experience.

The variable that is being predicted is the dependent variable, and


the variable used to predict the dependent variable is called the
independent variable.

In simple linear regression analysis, a straight line approximates the


relationship between the independent and dependent variables.

It is important to note that regression analysis can establish a


correlation between two variables, but correlation does not prove
causation.

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20 Calculation for Average Annual


Growth Rate (AAGR)

CALCULATION: (Growth Rate in Period A + Growth Rate in Period B +


… + Growth Rate in Period n) ÷ Number of Periods

COMPONENTS:
• Growth Rate: The amount by which a variable increases over
a given period of time as a percentage of its previous value;
calculated as “(Ending Value – Beginning Value) ÷ Beginning Value.”
• Number of Periods: The number of accounting periods for which
there is a separate value for growth rate.

DESCRIPTION
The average annual growth rate (AAGR) is the average increase in the
value of an individual investment or asset over the period of a year.

The periods used to calculate the AAGR should all be of equal length
for the result to be accurate.

Also, AAGR can be calculated for any investment but will not consider
any information about an investment’s risk level caused by price
volatility.

This metric helps examine the long-term trends associated with


various investments and can help a company make business
decisions based on the amount of the return.

It is important to note that AAGR can sometimes be misleading


because it does not account for the effects of compounding between
periods.

Therefore, a separate metric known as the compounded annual growth


rate (CAGR) takes compounding into consideration when calculating
the annual growth rate.

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21 Static Budget Calculation


CALCULATION: Budgeted Quantity (BQ) x Budgeted Price (BP) =
Static Budget Amount

COMPONENTS:
• Budgeted Quantity (BQ): The estimated number of units to be
manufactured during the accounting period.
• Budgeted Price (BP): The estimated selling price for one
manufactured unit during the accounting period.
• Static Budget: An amount representing the estimated number
of units manufactured at the estimated selling price for the
accounting period.

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22 Actual Results Calculation


for the Static Budget

CALCULATION: Actual Quantity (AQ) x Actual Price (AP) = Actual


Results

COMPONENTS:
• Actual Quantity (AQ): The actual number of units manufactured
during the accounting period.
• Actual Price (AP): The actual selling price for one manufactured
unit during the accounting period.
• Actual Results: An amount representing the actual number of units
manufactured at the actual selling price for the accounting period.

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23 Flexible Budget Calculation


ALT NAME: Variable Budget
CALCULATION: Actual Quantity (AQ) x Budgeted Price (BP) =
Flexible Budget

COMPONENTS:
• Actual Quantity (AQ): The actual number of units manufactured
during the accounting period.
• Budgeted Price (BP): The estimated selling price for one
manufactured unit during the accounting period.
• Flexible Budget: An amount representing the actual number
of units manufactured at the estimated selling price for the
accounting period.

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24 Flexible Budget Variance Calculation


CALCULATION: Flexible Budget Amount (AQ x BP) – Actual Results
(AQ x AP) = Flexible Budget Variance

COMPONENTS:
• Flexible Budget Amount: Actual Quantity (AQ) x Budgeted Price
(BP)
• Actual Results for Static Budget: Actual Quantity (AQ) x Actual
Price (AP)
• Flexible Budget Variance: The difference between the actual and
estimated selling price for the actual number of units manufactured
during the accounting period.

DESCRIPTION
In contrast to a static budget, a flexible budget adjusts in response to
changes in volume or activity. In a business environment where costs
are closely related to the level of business activity, the budget will flex
because it will include a variable rate per unit of activity instead of one
fixed total amount.

The flexible budget also provides a more accurate method to track


managers’ performance because the budget is redistributed based
on actual activity levels and should remain fairly precise regardless of
the level of activity. One disadvantage of flexible budgeting is that it
can be difficult to formulate because many costs are not fully variable,
requiring a fixed cost component to be incorporated into the budget
formula. Depending on the company’s size, there may not be enough
resources to devote a large amount of time to developing the budget
formulas.

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24 Flexible Budget Variance Calculation


Furthermore, a limitation of the flexible budget is the inability to
compare budgeted revenues to actual revenues because the two
numbers are the same. The purpose of this method is to compare
actual and budgeted expenses, not revenues, so there is no way to
know whether actual revenues were above or below the estimated
amount.

A flexible budget variance is the difference between the amounts


listed in a flexible budget and actual results. Because the amounts in
a flexible budget variance are both based on the same level of activity,
the variances are much more relevant than those calculated using the
static budget.

If the amount of actual revenue is recorded in the flexible budget, any


variance will be strictly between budgeted and actual expenses. If
actual expenses are less than the flexible budget amount of expenses,
the variance is favorable (increased profits); conversely, if the actual
expenses are more than the flexible budget amount of expenses, the
variance is unfavorable (decreased profits).

Similarly, if the actual number of units sold has been recorded in the
flexible budget, then the variances could be between both standard
and actual revenue per unit and budgeted and actual expenses.
Generally, the flexible budget variance should be smaller than the
static budget variance since the unit volume or revenue level is
adjusted to match actual results. However, an unusually large flexible
budget variance may indicate that the budget formulas need to be
modified.

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25 Sales-Volume Variance Calculation


ALT NAME: Sales Quantity Variance
CALCULATION: Static Budget Amount (BQ x BP) – Flexible Budget
Amount (AQ x BP) = Sales-Volume Variance

COMPONENTS:
• Static Budget Amount: Budgeted Quantity (BQ) x Budgeted Price (BP)
• Flexible Budget Amount: Actual Quantity (AQ) x Budgeted Price (BP)
• Sales-Volume Variance: The difference between the actual and
estimated number of units manufactured during the accounting
period at the estimated selling price.

DESCRIPTION
The sales-volume variance is used to measure the change in profit due to the
difference between actual and budgeted sales quantity. The variance measures the
amount of revenue earned when the product is sold based on actual sales volume
compared to the amount of revenue a company expected to bring in based on
projected sales volume.

A favorable sales-volume variance indicates that the actual quantity of units sold was
more than the budgeted quantity of units sold; thus, actual revenues are higher than
budgeted revenues, which typically leads to higher profit.

On the contrary, an unfavorable sales-volume variance indicates that the actual


quantity of units sold is less than the budgeted quantity of units sold; thus, actual
revenues are lower than budgeted revenues, which typically leads to lower profits.

Some of the possible causes of a favorable sales-volume variance include a


decrease in product prices, a reduction in competition, and inaccurate budgeting. An
unfavorable sales-volume variance can be caused by any of the following:

1. An increase in competition
2. An increase in product prices
3. A decrease in product demand
4. A governmental restriction on exports
5. Inaccurate budgeting

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26 Directs Material Price Variance


Calculation

ALT NAME: Direct Material Spending/Rate Variance


CALCULATION: Actual Cost of Direct Materials (AP x AQ) – Actual
Quantity of Direct Materials at Standard Price (SP x AQ) = Direct
Materials Price Variance

COMPONENTS:
• Actual Cost of Direct Materials: Actual Price (AP) x Actual Quantity
(AQ)
• Actual Quantity of Direct Materials at Standard Price: Standard
Price (SP) x Actual Quantity (AQ)
• Direct Materials Price Variance: The difference between the actual
amount spent on direct materials purchased and the amount that
would have been spent had the material been purchased at the
standard price (standard prices are estimated and are used for
budgeting).

DESCRIPTION
The direct materials price variance is used to monitor the costs
incurred to produce goods and determine the purchasing
department’s efficiency in obtaining direct material at a low cost.
Keeping in mind the current market prices and anticipated changes in
material costs in the near future, companies set standard amounts for
direct materials prices.

However, several factors can cause the actual price of materials to


deviate from the standard price significantly. As a result, a business
may have to pay more or less than what was considered normal when
the standard amounts were set.

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26 Directs Material Price Variance


Calculation

If the actual price paid for materials is more than the standard price,
an unfavorable materials price variance occurs. Some of the reasons
for an unfavorable variance include an overall hike in the market
price of materials, the purchase of materials of higher quality than
the standard, an increase in the bargaining power of suppliers, the
loss of purchase discounts due to smaller order sizes, and inefficient
purchasing by the procurement staff.

Conversely, if the actual price paid for materials is less than the
standard price, a favorable materials price variance occurs. The
basis for a favorable variance may include an overall decrease in
the market price level, the purchase of materials of lower quality
than the standard, better price negotiation by the procurement staff,
implementation of improved procurement practices (e.g., soliciting
price quotes from multiple suppliers), and purchase discounts on large
orders.

In some situations, a favorable direct materials price variance needs


to be analyzed in conjunction with the direct materials quantity
variance calculation to determine if the outcome is good. For example,
a purchasing department may purchase low-quality raw material to
generate a favorable direct materials price variance that could be
offset by an unfavorable direct materials quantity variance due to
waste of low-quality direct material.

Typically, the purchasing department is responsible for the direct


materials price variance because it has control over the selection of
suppliers and the acquisition of materials.

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27 Direct Materials Quantity Variance


Calculation

ALT NAME: Direct Material Usage/Efficiency Variance


CALCULATION: Actual Quantity of Direct Materials at Standard Price
(AQ x SP) – Standard Quantity of Direct Materials at Standard Price (SQ
x SP) = Direct Materials Quantity Variance

COMPONENTS:
• Actual Quantity of Direct Materials at Standard Price: Actual
Quantity (AQ) x Standard Price (SP)
• Standard Quantity of Direct Materials Allowed: Standard Quantity
(SQ) x Standard Price (SP)
• Direct Materials Quantity Variance: The difference between the
actual number of materials used in the production process and the
amount that was expected to be used, multiplied by the standard
price.

DESCRIPTION
Direct materials quantity variance is used to determine a production
department’s efficiency in converting raw materials into finished
goods. The main way to improve efficiency for this production stage is
to reduce the amount of raw material waste.

If the actual quantity of direct materials used is less than the standard
quantity, the variance is favorable because the company could save
money on materials. A few contributing factors of a favorable direct
materials quantity variance are reduced spoilage due to higher quality
materials, advanced employee training about the efficient use of
materials, and improved maintenance of production equipment that
reduces material waste.

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27 Direct Materials Quantity Variance


Calculation

Although a favorable variance typically suggests that workers were


efficient in using raw materials, the figure may also indicate that the
production department is producing lower quality products due to
trying to reduce the total cost of materials.

Contrarily, if the actual quantity of direct materials used is greater


than the standard quantity, the variance is unfavorable since the
company used excessive materials to produce its output. Unfavorable
direct material variances are commonly caused by increased demand
for materials leading to higher prices, a materials shortage due to
the shutdown of a key supplier, ineffective price negotiation by the
purchasing agent, inexperienced workers, outdated or malfunctioning
equipment, and the purchase of substandard raw materials.

Typically, the production department is responsible for the direct


materials quantity variance because of its direct control over material
usage.

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28 Direct Labor Price Variance


Calculation

ALT NAME: Direct Labor Rate Variance


CALCULATION: Actual Cost of Direct Labor (AR x AH) – Actual Hours
of Direct Labor at Standard Rate (SR x AH) = Direct Labor Price Variance

COMPONENTS:
• Actual Cost of Direct Labor: Actual Rate (AR) x Actual Hours Worked
(AH)
• Actual Hours of Direct Labor at Standard Rate: Standard Rate (SR)
x Actual Hours Worked (AH)
• Direct Labor Price Variance: The difference between the actual
cost of direct labor and the standard cost of direct labor for the
number of hours worked.

DESCRIPTION
The direct labor price variance is used to gauge the human resources
department’s performance in negotiating lower wage rates with
employees and labor unions. An unfavorable direct labor price
variance indicates higher labor costs incurred during a period
compared to standard costs.

Possible reasons for an unfavorable variance include an increase


in the national minimum wage rate, hiring more skilling labor than
anticipated in the standard, inefficient hiring by the HR department,
and effective negotiations by labor unions.

On the other hand, a favorable direct labor price variance implies


cost-efficient employment of direct labor by the company. Some
explanations for the favorable variance could include hiring more
un-skilled or semi-skilled labor, a decrease in the overall wage
rates in the market due to an increase in the supply of labor, and an

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28 Direct Labor Price Variance


Calculation

inappropriately high setting of the standard cost of direct labor due to


inaccurate planning.

In some cases, a favorable direct labor variance may not be positive.


In certain circumstances, when low-skilled workers are recruited at a
lower wage rate, the direct labor price variance will be favorable. Still,
these workers will be inefficient, resulting in an unfavorable direct
labor efficiency variance. As a result, the direct labor price variance
should be analyzed in conjunction with the direct labor efficiency
variance to understand these variances in their totality.

Typically, production supervisors bear responsibility for labor price


variances because these differences usually arise because of how
labor is used.

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29 Direct Labor Efficiency Variance


ALT NAME: Direct Labor Quantity Variance
CALCULATION: Actual Hours of Direct Labor at Standard Rate (SR x
AH) – Standard Cost of Direct Labor (SR x SH) = Direct Labor Efficiency
Variance

COMPONENTS:
• Actual Hours of Direct Labor at Standard Rate: Standard Rate (SR) x
Actual Hours Worked (AH)
• Standard Cost of Direct Labor: Standard Rate (SR) x Total Standard
Hours (SR)
• Direct Labor Efficiency Variance: The difference between the actual
number of hours used to manufacture a certain number of units
and the number of hours allowed by standards to manufacture that
number of units multiplied by the standard direct labor rate.

DESCRIPTION
The direct labor efficiency variance is calculated in order to measure
the performance of a production department in utilizing the abilities of
its workers.

A favorable labor efficiency variance signifies better productivity of


direct labor during the period as indicated by an excessive amount of
estimated standard direct labor hours compared to the actual direct
labor hours used. Influences on the favorable variance may include
hiring higher-skilled labor, the workforce’s training in improved
production techniques, the use of better quality raw materials that
are easier to handle, and achieving a faster learning curve than
anticipated in the standard.

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29 Direct Labor Efficiency Variance


On the other hand, unfavorable variances represent lower productivity of
direct labor during a period compared to the standard, which means that
more direct labor hours were used than actually needed. Explanations
for the unfavorable labor efficiency variance include the hiring of lower-
skilled labor than the standard, a lower learning curve achieved during
the period than anticipated in the standard, a decrease in staff morale
and motivation, and increased idle time incurred during a period due to
disruption or stoppage of activities.

Also, the direct labor efficiency variance should be analyzed in


combination with the direct labor price variance because the possibility
exists that an unfavorable direct labor efficiency variance is the result of
recruiting low skilled workers.

Typically, the manager in charge of production is considered


responsible for the labor efficiency variance. Still, in some cases, the
purchasing manager could be held responsible if the acquisition of poor
materials resulted in excessive labor processing time.

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