WEEK 1- MODULE 1: OVERVIEW OF COST ACCOUNTING

I. INTRODUCTION TO COST ACCOUNTING

Cost Accounting may be defined as “Accounting for costs classification and analysis of
expenditure as will enable the total cost of any particular unit of production to be ascertained with a
reasonable degree of accuracy and at the same time to disclose exactly how such total cost
is constituted”. Thus Cost Accounting is classifying, recording an appropriate allocation of expenditure for
the determination of the costs of products or services, and for the presentation of suitably arranged  data
for the purpose of control and guidance of management.

Cost Accounting is the process of accounting for cost which begins with the recording of income
and expenditure and ends  with the preparation of statistical data.

It is the formal mechanism by means of which the cost of products or services

are ascertained and controlled.

Cost Accounting provides analysis and classification of expenditure as will enable the total cost of
any particular unit of product/service to be ascertained with a reasonable degree of accuracy and at
the same time to disclose exactly how such total cost is constituted. For example, it is not sufficient to
know that the cost of one pen is P15 but the management is also interested to know the cost of
material used, the amount of labor, and other expenses incurred so as to control and reduce its cost.

It establishes budgets and standard costs and the actual cost of operations, processes,
departments, or products and the analysis of variances, profitability, and social use of funds. 
Thus, Cost Accounting is a quantitative method that collects, classifies, summarizes, and
interprets information for product costing, operation planning and control, and decision making.

COSTING
Costing is defined as the technique and process of ascertaining costs.  The
Material (in technique in costing consists of the body of principles and rules for ascertaining
100
pesos the costs of products and services. The technique is dynamic and changes with
Labor 40 the change of time. The process of costing is the day-to-day routine of
Expenses 60 ascertaining costs. It is popularly known as an arithmetic process. For example, If
the cost of producing a product says P200, then we have to refer to material,
Total 200
labor, and expenses accounting and arrive at the above cost as follows:

Finding out the breakup of the total cost from the recorded data is a daily process. That is why it  is
called an arithmetic process/daily routine. In this process we are classifying the recorded costs
and summarizing at each element and total is called technique.

COST ACCOUNTANCY
Cost Accountancy is defined as ‘the application of Costing and Cost Accounting principles, methods, and
techniques to the science, art, and practice of cost control and the ascertainment of profitability. It includes
the presentation of information derived therefrom for the purposes of managerial decision-making. Thus,
Cost Accountancy is the science, art, and practice of a Cost Accountant.

OBJECTIVES OF COST ACCOUNTING

The following are the main objectives of Cost Accounting:
(a) To ascertain the Costs under different situations using different techniques and systems of costing
(b) To determine the selling prices under different circumstances
(c) To determine and control efficiency by setting standards for Materials, Labour and Overheads
(d) To determine the value of closing inventory for preparing financial statements of the concern
(e) To provide a basis for operating policies which may be the determination of Cost Volume
relationship, whether to close or operate at a loss, whether to manufacture or buy from the market,
whether to continue the existing method of production or to replace it with a more improved method
of production....etc
SCOPE OF COST ACCOUNTANCY
The scope of Cost Accountancy is very wide and includes the following:
(a) Cost Ascertainment: The main objective of Cost Accounting is to find out the cost of product /services
rendered with a reasonable degree of accuracy.
(b) Cost Accounting: It is the process of Accounting for Cost which begins with a recording of
expenditure and ends with the preparation of statistical data.
(c) Cost Control: It is the process of regulating the action so as to keep the element of cost within the set
parameters.
(d) Cost Reports: This is the ultimate function of Cost Accounting. These reports are primarily prepared for
use by the management at different levels. The cost reports help in planning and control, performance
appraisal, and managerial decision-making.
(e) Cost Audit: Cost Audit is the verification of correctness of Cost Accounts and checking on the adherence
to the Cost Accounting plan. Its purpose is not only to ensure the arithmetic accuracy of cost records but
also to see the principles and rules have been applied correctly.

To appreciate fully the objectives and scope of Cost Accounting, it would be useful to examine the  position
of Cost Accounting in the broader field of general accounting and other sciences. i.e Financial  Accounting,
Management Accounting, Engineering, and Service Industry.

FINANCIAL ACCOUNTING AND COST ACCOUNTING

Financial Accounting is primarily concerned with the preparation of financial statements, which summarise
the results of operations for a selected period of time and show the financial position of the company at
particular dates. In other words, Financial Accounting reports on the resources available (Balance
Sheet) and what has been accomplished with these resources (Profit and Loss Account). Financial
Accounting is mainly concerned with the requirements of creditors, shareholders, government,
prospective investors, and persons outside the management. Financial Accounting is mostly concerned
with external reporting.

Cost Accounting, as the name implies, is primarily concerned with the determination of the cost of
something, which may be a product, service, a process, or an operation according to the costing objective
of management. A Cost Accountant is primarily charged with the responsibility of providing cost data
for whatever purposes they may be required for.

The main differences between Financial and Cost Accounting are as follows:

FINANCIAL ACCOUNTING COST ACCOUNTING

It provides information about the business in a generalIt provides information to the management for
way. i.e Profit and Loss Account, Balance Sheet of the proper planning, operation, control, and decision-
business to owners and other outside partners. making.
It classifies, records and analyses the transactions in a
It records the expenditure in an
subjective manner, i.e according to the nature of the objective manner, i.e according to the purpose
expense. for which the costs are incurred.
It provides a detailed system of control
It lays emphasis on the recording aspect without for materials, labor, and overhead costs with the
attaching any importance to control. help of standard costing and budgetary
control.
It reports operating results and financial It gives information through cost reports
the position usually at the end of the year. to management as and when desired.
Cost Accounting is only a part of the
Financial Accounts are accounts of the whole business.
financial accounts and discloses the profit or loss
They are independent in nature.
of each product, job, or service.
Financial Accounts records all the commercial Cost Accounting relates to
transactions of the business and includes all expenses transactions connected with the Manufacturing
i.e Manufacturing, Office, Selling, etc. of goods and services means expenses that enter
 into production.
Financial Accounts are concerned with external Cost Accounts are concerned with
transactions i.e. transactions between business internal transactions, which do not involve any
concerns and third parties. cash payment or receipt.
Only transactions that can be measured in Non-Monetary information likes No of
monetary terms are recorded. Units / Hours etc are used.
Financial Accounting deals with actual Cost Accounting deals with partly facts
figures and facts only. and figures and partly estimates/standards.
Cost Accounts provide valuable information on
Financial Accounting does not provide information on
the efficiencies of employees and Plant
efficiencies of various workers/ Plant & Machinery.
& Machinery.

II. COST CONCEPTS

COST
Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or
rendering services. Cost, in simple words, means the total of all expenses. Cost is also defined as the amount of
expenditure (actual or notional) incurred on or attributable to a given thing or to ascertain the cost of a given thing. 

Thus it is that which is given or in-sacrificed to obtain something. The cost of an article consists of actual outgoings
or ascertained charges incurred in its production and sale. Cost is a generic term and it is always advisable to qualify
the word cost to show exactly what it meant, e.g., prime cost, factory cost, etc. Cost is also different from value as
the cost is measured in terms of money whereas value is in terms of usefulness or utility of an article.

ELEMENTS OF COST

Direct Material + Direct Labour = Prime Cost

Indirect Material+ Indirect Labour + Indirect Expenses = Overheads

DIRECT MATERIAL COST

Direct material cost can be defined as ‘The Cost of material which can be attributed to a cost object in an
economically feasible way’. Direct materials are those materials that can be identified in the product and can be
conveniently measured and directly charged to the product. Thus, these materials directly enter the product and form
a part of the finished product. For example, timber in furniture making, cloth in dressmaking, bricks in building a
house. The following are normally classified as direct materials

1. All raw materials, like jute in the manufacture of gunny bags, pig iron in the foundry, and fruits in the
canning industry.
2. Materials specifically purchased for a specific job, process, or order, like glue for bookbinding, starch powder for
dressing yarn.
3. Parts or components purchased or produced, like batteries for transistor radios.
4. Primary packing materials like cartons, wrappings, cardboard boxes, etc.

INDIRECT MATERIAL COST

Materials, the costs of which cannot be directly attributed to a particular cost object. Indirect materials are those
materials that do not normally form a part of the finished product. It has been defined as “materials which cannot be
allocated but which can be apportioned to or absorbed by cost centers or cost units”. These are:

1. Stores used in the maintenance of machinery, buildings, etc., like lubricants, cotton waste, bricks, and cement.
2. Stores used by the service departments, i.e., non-productive departments like Power House, Boiler House, and
Canteen, etc., and
3. Materials which due to their cost being small, are not considered worthwhile to be treated as direct materials.

DIRECT LABOR
The cost of employees can be attributed to a cost object in an economically feasible way. In simple words, it is that
labor that can be conveniently identified or attributed wholly to a particular job, product or process or expended in
converting raw materials into finished goods. Wages of such labor are known as direct wages. Thus it includes
payment made to the following groups of labor:

1.  Labour engaged in the actual production of the product or in carrying out an operation or process.
2. Labour engaged in adding the manufacture by way of supervision, maintenance, tool setting, transportation of
material, etc.
3. Inspectors, analysts, etc., are especially required for such production.

INDIRECT LABOR

The labor/employee cost cannot be directly attributed to a particular cost object. The wages of that labor which
cannot be allocated but which can be apportioned to or absorbed by cost centers or cost units is known as Indirect
Labour. In other words, paid to labor which are employed other than on production constitute indirect labor costs.
Examples of such labor are charge-hands and supervisors; maintenance workers; men employed in service
departments, material handling, and internal transport; apprentices, trainees, and instructors; clerical staff and labor
employed in time office and security office.

DIRECT EXPENSES

Direct expenses are expenses relating to the manufacturing of a product or rendering a service that can be identified
or linked with the cost object other than direct material cost and direct employee cost. Direct expenses include all
expenditures other than direct material or direct labor that is specifically incurred for a particular product or process.
Such expenses are charged directly to the particular cost account concerned as part of the prime cost. Examples of
direct expenses are:

1. Excise duty
2. Royalty
3. Architect or Supervisor’s fees
4. Cost of rectifying defective work
5. Traveling expenses to the city
6. Experimental expenses of pilot projects
7. Expenses of designing or drawings of patterns or models
8. Repairs and maintenance of plant obtained on hire; and
9. Hire of special equipment obtained for a contract.

OVERHEAD
Overheads comprise indirect materials, indirect employee costs, and indirect expenses which are not directly
identifiable or allocable to a cost object.

Overheads may be defined as the aggregate of the cost of indirect material, indirect labor, and such other expenses
including services as cannot conveniently be charged directly to specific cost units. Thus overheads are all expenses
other than direct expenses. In general terms, overheads comprise all expenses incurred for or in connection with, the
general organization of the whole or part of the undertaking, i.e., the cost of operating supplies and services used by
the undertaking and includes the maintenance of capital assets.
 PRIME COST
The aggregate of Direct Material, Direct Labour, and Direct Expenses. Generally, it constitutes 50% to 80% of the
total cost of the product, as such, as it is primary to the cost of the product and called Prime Cost.

COST OBJECT
The technical name for a product or service, a project, a department, or any activity to which a cost relates. Therefore
the term cost should always be linked with a cost object to be more meaningful. Establishing a relevant cost object is
very crucial for a sound costing system. The Cost object could be defined broadly or narrowly. At a broader level, a
cost object may be named as a Cost Centre, whereas at a lowermost level it may be called a Cost Unit.

COST CENTER
Defines a cost center as “a location, a person, or an item of equipment (or a group of them) in or connected with an
undertaking, in relation to which costs ascertained and used for the purpose of cost control”. The determination of
suitable cost centers, as well as analysis of cost under cost centers, is very helpful for periodical comparison and
control of cost. In order to obtain the cost of a product or service, expenses should be suitably segregated to the cost
center. The manager of a cost center is held responsible for the control of the cost of his cost center. The selection of
suitable cost centers or cost units for which costs are to be ascertained in an undertaking depends upon a number of
factors such as organization of a factory, condition of incidence of cost, availability of information, requirements
of cost, and management policy regarding selecting a method from various choices. Cost centers may be production
cost centers operating cost centers or process cost centers depending upon the situation and classification.

Cost centers are of two types-Personal and Impersonal Cost Centre. A personal cost center consists of a person or
group of persons. An impersonal cost center consists of a location or item of equipment or group of equipment.

In a manufacturing concern, the cost centers generally follow the pattern or layout of the departments or sections of
the factory, and accordingly, there are two main types of cost centers as below :

1. Production Cost Center: engaged in production work i.e engaged in converting the raw material into the finished
product, for example, Machine shop, welding shops...etc
2. Service Cost Center:  ancillary to and render service to production cost centers, for example, Plant Maintenance,
Administration...etc

The number of cost centers and the size of each vary from one undertaking to another and are dependent upon the
expenditure involved and the requirements of the management for the purpose of control.

RESPONSIBILITY CENTER
A responsibility center in Cost Accounting denotes a segment of a business organization for the activities of which
responsibility is assigned to a specific person. Thus a factory may be split into a number of centers and a supervisor
is assigned with the responsibility of each center. All costs relating to the center are collected and the Manager
responsible for such a cost center is judged by reference to the activity levels achieved in relation to costs. Even an
individual machine may be treated as a responsibility center for cost control and cost reduction.

PROFIT CENTER
A profit center is a segment of a business that is responsible for all the activities involved in the production and sales
of products, systems, and services. Thus a profit center encompasses both costs that it incurs and revenue that it
generates. Profit centers are created to delegate responsibility to individuals and measure their performance. In the
concept of responsibility accounting, profit centers are sometimes also responsible for the investment made for the
center. The profit is related to the invested capital. Such a profit center may also be termed as an investment center.

COST UNIT
Cost Unit is a device for the purpose of breaking up or separating costs into smaller sub-divisions attributable to
products or services. Cost unit can be defined as a ‘Unit of product or service in relation to which costs are
ascertained. The cost unit is the narrowest possible level of cost object. It is the unit of quantity of product, service of
time (or combination of these) in relation to which costs may be ascertained or expressed. We may, for instance,
determine service cost per tonne of steel, per tonne-kilometer of a transport service, or per machine hour. Sometimes,
single order or contract constitutes a cost unit which is known as a job. A batch that consists of a group of identical
items and maintains its identity through one or more stages or production may also be taken as a cost unit.
 A few examples of cost units are given below:

Industry/Product Cost Unit

Automobile Number of Vehicles
Cable Meters/Kilometers
Cement Tons
Chemicals/Fertilizers Liter/Kilogram
Gas Cubic Meter
Power-Electricity Kilowatt Hour
Tons/Kilometer/
Transport
Passenger
Hospital Patient Day
Hotel Bed Night
Education Student Year
Telecom Number of Calls
BPO Service Accounts Handled
Professional Service Chargeable Hours

COST ALLOCATION
When items of cost are identifiable directly with some products or departments such costs are charged to such cost
centers. This process is known as cost allocation. Wages paid to workers of the service department can be allocated
to the particular department. Indirect materials used by a particular department can also be allocated to the
department.

Cost allocation calls for two basic factors

1. Concerned department/product should have caused the cost to be incurred, and

2. the exact amount of cost should be computable.

COST APPORTIONMENT
When items of cost cannot be directly charged to or accurately identifiable with any cost centers, they are prorated or
distributed amongst the cost centers on some predetermined basis. This method is known as cost apportionment.
Thus we see that items of indirect costs residual to the process of cost allocation are covered by cost apportionment.
The predetermination of a suitable basis of apportionment is very important and usually, the following principles are
adopted

1. Service or use
2. Survey method 
3. Ability to bear.

The basis ultimately adopted should ensure an equitable share of common expenses for the cost centers and the basis
once adopted should be reviewed at periodic intervals to improve upon the accuracy of apportionment.

COST ABSORPTION
Ultimately the indirect costs or overhead as they are commonly known will have to be distributed over the final
products so that the charge is complete. This process is known as cost absorption, meaning thereby that the costs are
absorbed by the production during the period. Usually, any of the following methods are adopted for cost absorption

1. Direct Material Cost Percentage

2. Direct Labour Cost Percentage
3. Prime Cost Percentage
4. Direct Labour Hour Rate Method
5. Machine Hour Rate, etc.
 The basis should be selected after careful maximum accuracy of Cost Distribution to various production units. The
basis should be reviewed periodically and corrective action whatever is needed should be taken for improving upon
the accuracy of the absorption.

CONVERSION COST
This term is defined as the sum of direct wages, direct expenses, and overhead costs of converting raw material to the
finished products or converting material from one stage of production to another stage. In other words, it means the
total cost of producing an article less the cost of direct materials used. The cost of indirect materials and consumable
stores are included in such costs. The compilation of conversion costs is useful in a number of cases. Where the cost
of direct materials is of fluctuating nature, the conversion cost is used to cost control purposes or for any other
decision making. In contracts/jobs where raw materials are on account of the buyers, conversion cost takes the place
of total cost in the books of the producer. A periodic comparison/review of the conversion cost may give sufficient
insight as to the level of efficiency with which the production unit is operating.

COST CONTROL
Cost Control is defined as the regulation by executive action of the costs of operating an undertaking, particularly
where such action is guided by Cost Accounting.

Cost control involves the following steps and covers the various facets of the management:

Planning: The first step in cost control is establishing plans/targets. The plan/target may be in the form of budgets,
standards, estimates, and even past actual may be expressed in physical as well as monetary terms. These serve as
yardsticks by which the planned objective can be assessed.

Communication: The plan and the policy laid down by the management are made known to all those responsible for
carrying them out. Communication is established in two directions; directives are issued by higher levels of
management to the lower level for compliance and the lower level executives report performances to the higher
level.

Motivation: The plan is given effect to and performances starts. The performance is evaluated, costs are ascertained
and information about results achieved are collected and reported. The fact that costs are being complied for
measuring performances acts as a motivating force and makes individuals endeavor to better their performances.

Appraisal and Reporting: The actual performance is compared with the predetermined plan and variances, i.e
deviations from the plan are analyzed as to their causes. The variances are reported to the proper level of
management.

Decision Making: The variances are reviewed and decisions taken. Corrective actions and remedial measures or
revision of the target, as required, are taken.

ADVANTAGES OF COST CONTROL

1. Achieving the expected return on capital employed by maximizing or optimizing profit

2. Increase in productivity of the available resources
3. Reasonable price of the customers
4. Continued employment and job opportunities for the workers
5. Economic use of limited resources of production
6. Increased creditworthiness
7. Prosperity and economic stability of the industry

COST REDUCTION
Profit is the resultant of two varying factors, viz., sales and cost. The wider the gap between these two factors, the
larger is the profit. Thus, profit can be maximized either by increasing sales or by reducing costs. In a competition
less market or in case of monopoly products, it may perhaps be possible to increase the price to earn more profits,
and the need for reducing costs may not be felt. Such conditions cannot, however, exist paramount and when
competition comes into play, it may not be possible to increase the sale price without having its adverse effect on the
sale volume, which, in turn, reduces profit.

Besides, an increase in the price of products has the ultimate effect of pushing up the raw material prices, wages of
employees, and other expenses- all of which tend to increase costs. In the long run, substitute products may come up
 in the market, resulting in loss of business. Avenues have, therefore, to be explored and methods devised to cut down
expenditure and thereby reduce the cost of products. In short, cost reduction would mean the maximization of profits
by reducing costs through economics and savings in costs of manufacture, administration, selling, and distribution.

COST CONTROL VS COST REDUCTION:

Both Cost Reduction and Cost Control are efficient tools of management but their concepts and procedure are widely
different. The differences are summarised below:

COST CONTROL COST REDUCTION

Cost Control represents efforts made Cost Reduction represents the achievement in reduction
towards achieving a target or goal. of cost.
The process of Cost Control is to set up a target,
ascertain the actual performance and compare it Cost Reduction is not concerned with the maintenance of
with the target, investigate the variances, and performance according to standard.
take remedial measures.
Cost Reduction assumes the existence of concealed
Cost Control assumes the existence of standards potential savings in standards or norms which are
or norms which are not challenged. therefore subjected to a constant challenge with a view
to improvement by bringing out savings.
Cost Reduction is a corrective function. It operates even
Cost Control is a preventive function. Costs are when an efficient cost control system exists. There is
optimized before they are incurred. room for a reduction in the achieved costs under
controlled conditions.
Cost Reduction is a continuous process of analysis by
various methods of all the factors affecting costs, efforts,
Cost Control lacks a dynamic approach. and functions in an organization. The main stress is upon
the why of a thing and the aim is to have continual
the economy in costs.

III. CLASSIFICATION OF COST

Types of costing have been designed to suit the needs of individual business conditions. The basic principles
underlying all these methods are the same i.e. to collect and analyze the expenditure according to the elements of
costs and to determine the cost of each Cost Centre and or Cost Unit. Classification of cost is the arrangement of
items of costs in logical groups having regard to their nature or purpose. Items should be classified by one
characteristic for a specific purpose without ambiguity. The scheme of classification should be such that every item
of cost can be classified. In view of the above, cost classification may be explained as below:
As per Cost Accounting Standard 1 (CAS-1), the basis for cost classification is as follows:

1. Nature of expense
2. Relation to Object – Traceability
3. Functions / Activities
4. Behavior – Fixed, Semi-variable or Variable
5. Management decision making
6. Production Process
7. Time Period
Classification of cost is the process of grouping the components of cost under a common designation on the basis of
similarities of nature, attributes, or relations. It is the process of identification of each item and the systematic
placement of like items together according to their common features.

1. Classification by Nature of Expense

Costs should be gathered together in their natural groupings such as Material, Labour, and Other Direct expenses.
Items of costs differ on the basis of their nature.
The elements of cost can be classified into the following three categories. 

1. Material
2. Labour
3. Expenses

2.Classification by Relation to Cost Centre or Cost Unit:

If expenditure can be allocated to a cost center or cost object in an economically feasible way then it is called direct
otherwise the cost component will be termed as indirect. According to this criterion for classification, material cost is
divided into direct material cost and indirect material cost, Labour cost is divided into direct labor and indirect labor
cost, and expenses into direct expenses and indirect expenses. Indirect cost is also known as overhead

3.Classification by Functions:
A business enterprise performs a number of functions like manufacturing, selling, research...etc. Costs may be
required to be determined for each of these functions and on this basis, functional costs may be classified into the
following types:00

1. Production or Manufacturing Costs

2. Administration Costs
3. Selling & Distribution cost
4. Research & Development costs

Production or Manufacturing Costs: Production cost is the cost of all items involved in the production of a product
or service. These refer to the costs of operating the manufacturing division of an undertaking and include all costs
incurred by the factory from the receipt of raw materials and supply of labor and services until production is
completed and the finished product is packed with the primary packing. Manufacturing cost can also be referred to as
the aggregate of prime cost and factory overhead.
The following are considered as Production or Manufacturing Costs:-

1. Direct Material
2. Direct Labour
3. Direct Expenses and
4. Factory overhead, i.e., the aggregate of factory indirect material, indirect labor, and indirect expenses.

Administration Costs: Administration costs are expenses incurred for the general management of an organization.
These are in the nature of indirect costs and are also termed as administrative overheads. For understanding
administration costs, it is necessary to know the scope of the administrative functions. Administrative function in any
organization is primarily concerned with the following activities :

1. Formulation of policy
2. Directing the organization and
3. Controlling the operations of an organization. But the administrative function will not include control activities
concerned with the production, selling and distribution, and research and development.

Therefore, administration cost is the cost of administrative function, i.e., the cost of formulating policy, directing,
organizing, and controlling the operations of an undertaking (Administrative cost will include the cost of only those
control operations which are not related to production, selling, and distribution and research and development). In
most cases, administration cost includes indirect expenses of the following types:
1. Salaries of office staff, accountants, directors
2. Rent, rates, and depreciation of office building
3. Postage, stationery, and telephone
4. Office supplies and expenses
5. General administration expenses.

Selling & Distribution Costs: Selling costs are indirect costs related to the selling of products are services and
include all indirect costs in sales management for the organization. Distribution costs are the costs incurred in
handling a product from the time it is completed in the works until it reaches the ultimate consumer. The
selling function includes activities directed to create and stimulate demand for the company’s product and secure
orders. Distribution costs are incurred to make the saleable goods available in the hands of the customer.

Following are the examples of selling and distribution costs:

1. Salaries and commission of salesmen and sales managers.

2. Expenses of advertisement, insurance.
3. Rent, rates, depreciation, and insurance of sales offices and warehouses.
4. Cost of insurance, freight, export, duty, packing, shipping, etc.,
5. Maintenance of Delivery vans.

Research & Development Costs: Research & development costs are the cost for undertaking research to improve
the quality of a present product or improve the process of manufacture, develop a new product, market research...etc.
and commercialization thereof. R&D Costs comprises of the following:

1. Development of new product.

2. Improvement of existing products.
3. Finding new uses for known products.
4. Solving technical problems arising in the manufacture and application of products.
5. Development cost includes the costs incurred for the commercialization/implementation of research findings.

4. Classification based on Behaviour – Fixed, Semi-variable or Variable

Costs are classified based on behavior as a fixed cost, variable cost, and semi-variable cost depending upon response
to the changes in the activity levels.

Fixed Cost: Fixed cost is the cost that does not vary with the change in the volume of activity in the short run. These
costs are not affected by temporary fluctuation in activity of an enterprise. These are also known as period costs.
Example: Rent, Depreciation...etc.

Variable Cost: Variable cost is the cost of elements which tends to directly vary with the volume of activity.
Variable cost has two parts (i) Variable direct cost (ii) Variable indirect costs. Variable indirect costs are termed as
variable overheads. Example: Direct labour, Outward Freight...etc.

Semi-Variable Costs: Semi variable costs contain both fixed and variable elements. They are partly affected by
fluctuation in the level of activity. These are partly fixed and partly variable costs and vice versa. Example: Factory
supervision, Maintenance...etc.

5.Classification based on Costs for Management Decision Making

Ascertainment of cost is essential for making managerial decisions. On this basis costing may be classified into the
following types.

Marginal Costing
Marginal Cost is the aggregate of variable costs, i.e. prime cost plus variable overhead. The marginal cost per unit is
the change in the amount at any given volume of output by which the aggregate cost changes if the volume of output
is increased or decreased by one unit.

The marginal Costing system is based on the system of classification of costs into fixed and variable. The fixed
costs are excluded and only the marginal costs, i.e. the variable costs are taken into consideration for determining the
cost of products and the inventory of work-in-progress and completed products.
Differential Cost
Differential cost is the change in the cost due to a change in activity from one level to another.

Opportunity Cost
Opportunity cost is the value of alternatives foregone by adopting a particular strategy or employing resources in a
specific manner. It is the return expected from an investment other than the present one. These refer to costs that
result from the use or application of material, labor, or other facilities in a particular manner that has been foregone
due to not using the facilities in the manner originally planned. Resources (or input) like men, materials, plant and
machinery, finance, etc., when utilized in one particular way, yield a particular return (or output). If the same input is
utilized in another way, yielding the same or a different return, the original return on the forsaken alternative that is
no longer obtainable is the opportunity cost. For example, if fixed deposits in the bank are proposed to be withdrawn
for financing projects, the opportunity cost would be the loss of interest on the deposits. Similarly when a building
leased out on rent to a party is got vacated for its own purpose or a vacant space is not leased out but used internally,
say, for expansion of the production program, the rent so forgone is the opportunity cost.

Replacement Cost
Replacement cost is the cost of an asset in the current market for the purpose of replacement. Replacement cost is
used for determining the optimum time of replacement of an equipment or machine in consideration of the
maintenance cost of the existing one and its productive capacity. This is the cost in the current market of replacing an
asset. For example, when replacement cost of material or an asset is being considered, it means that the cost that
would be incurred if the material or the asset was to be purchased at the current market price and not the cost, at
which it was actually purchased earlier, should be taken into account.

Relevant Costs
Relevant costs are costs that are relevant to a specific purpose or situation. In the context of decision making, only
those costs are relevant which are pertinent to the decision at hand. Since we are concerned with future costs only
while making a decision, historical costs, unless they remain unchanged in the future period are irrelevant to the
decision-making process.

Imputed Costs
Imputed costs are hypothetical or notional costs, not involving cash outlay computed only for the purpose of decision
making. In this respect, imputed costs are similar to opportunity costs. Interest on funds generated internally,
payment for which is not actually made is an example of imputed cost. When alternative capital investment projects
are being considered out of which one or more are to be financed from internal funds, it is necessary to take into
account the imputed interest on own funds before a decision is arrived at.

Sunk Costs
Sunk costs are historical costs that are incurred i.e. sunk in the past and are not relevant to the particular decision-
making problem being considered. Sunk costs are those that have been incurred for a project and which will not be
recovered if the project is terminated. While considering the replacement of a plant, the depreciated book value of
the old asset is irrelevant as the amount is sunk cost which is to be written-off at the time of replacement.

Normal Cost & Abnormal Cost

Normal Cost is a cost that is normally incurred at a given level of output in the conditions in which that level of
output is achieved. Abnormal Cost is unusual and typical
cost whose occurrence is usually irregular and unexpected and due to some abnormal situation of the production.

Avoidable Costs & Unavoidable Costs

Avoidable Costs are those which under given conditions of performance efficiency should not have been incurred.
Unavoidable Costs are inescapable costs, which are essential to be incurred, within the limits or norms provided for.
It is the cost that must be incurred under a program of business restriction. It is fixed in nature and inescapable.

Uniform Costing
This is not a distinct system of costing. The term applies to the costing principles and procedures which are adopted
in common by a number of undertakings that desire to have the benefits of a uniform system. The methods of
Uniform Costing may be extended so as to be useful in inter-firm comparison.
Engineered Cost
Engineered Cost relates to an item where the input has an explicit physical relationship with the output. For instance,
in the manufacture of a product, there is a definite relationship between the units of raw material and labor time
consumed and the amount of variable manufacturing overhead on the one hand, and units of the products produced
on the other. The input-output relationship can be established in the form of standards by engineering analysis or by
an analysis of the historical data. It should be noted that the variable costs are not engineered costs but some
administration and selling expenses may be categorized as engineered costs.

Out-of-Pocket Cost 
This is the portion of the cost associated with an activity that involves cash payment to other parties, as opposed to
costs that do not require any cash outlay, such as depreciation and certain allocated costs. Out-of-Pocket Costs are
very much relevant in the consideration of price
fixation during trade recession or when a make-or-buy decision is to be made.

Managed Cost
Managed (Programmed or Discretionary) Costs all opposed to engineering costs, relate to such items where no
accurate relationship between the amount spent on input and the output can be established, and sometimes it is
difficult to measure the output. Examples are advertisement cost,
research and development costs, etc.,

Common Costs
These are costs that are incurred collectively for a number of cost centers and are required to be suitably apportioned
for determining the cost of individual cost centers. Examples are: The combined purchase cost of several materials in
one consignment, and overhead expenses incurred
for the factory as a whole.

Controllable and Non-Controllable Costs

Controllable Cost is that cost that is subject to direct control at some level of managerial supervision. Non-
controllable Cost is the cost that is not subject to control at any level of managerial supervision.

6. Classification by nature of Production or Process:

Batch Costing
Batch Costing is the aggregate cost related to a cost unit that consists of a group of similar articles which maintain its
identity throughout one or more stages of production. In this method,
the cost of a group of products is ascertained. The unit cost is a batch or group of identical products instead of a
single job, order, or contract. This method is applicable to general engineering factories which produce components
in convenient economical batches.
Process Costing
When the production process is such that goods are produced from a sequence of continuous or repetitive operations
or processes, the cost incurred during a period is considered
as Process Cost. The process cost per unit is derived by dividing the process cost by the number of units produced in
the process during the period. Process Costing is employed in industries where a continuous process of
manufacturing is carried out. Costs are ascertained for a specified period of time by departments or processes.
Chemical industries, refineries, gas, and electricity-generating concerns may be quoted as examples of undertakings
that employ process costing.
Operation Cost
Operation Cost is the cost of a specific operation involved in a production process or business activity. The cost unit
in this method is the operation, instead of the process. When the
manufacturing method consists of a number of distinct operations, operation costing is suitable. Operating Cost:
Operating cost is the cost incurred in conducting business activity. Operating cost refers to the cost of undertakings
that do not manufacture any product but which provide services. Industries and establishments like powerhouses,
transport and travel agencies, hospitals, and schools, which undertake services rather than the manufacture of
products, ascertain operating costs. The cost units used are Kilo Watt Hour (KWH), Passenger Kilometer and Bed in
the hospital....etc. The operation costing method constitutes a distinct type of cost but it may also be classed as a
variant of Process Cost since costs in this method are usually compiled for a specified period.
Contract Costing
The contract cost is the cost of a contract with some terms and conditions between contractee and contractor. This
method is used in undertakings, carrying out, building or constructional
contracts like constructional engineering concerns, civil engineering contractors. The cost unit here is a contract,
which may continue over more than one financial year.

Joint Costs
Joint costs are the common cost of facilities or services employed in the output of two or more simultaneously
produced or otherwise closely related operations, commodities or services.
When a production process is such that from a set of same input two or more distinguishably different products are
produced together, products of greater importance are termed as Joint Products and products of minor importance are
termed as By-products and the costs incurred prior to the point of
separation are called Joint Costs. For example in the petroleum industry petrol, diesel, kerosene, naphtha,
tar is produced jointly in the refinery process.

By-product Cost
By-product Cost is the cost assigned to by-products till the split-off point.

7.Classification by Time
A cost item is related to a specific period of time and cost can be classified according to the system of assessment
and specific purpose as indicated in the following ways

Historical Costs
Historical Costs are the actual costs of acquiring assets or producing goods or services. They are post-mortem costs
ascertained after they have been incurred and they represent the cost of actual operational performance. Historical
Costing follows a system of accounting to which all values are based on costs actually incurred as relevant from time
to time.

Predetermined Costs
Pre-determined costs for a product are computed in advance of the production process, on the basis of a specification
of all the factors affecting cost and cost data. Predetermined Costs may be either standard or estimated.

Standard Costs
A predetermined norm applies as a scale of reference for assessing actual cost, whether these are more or less. The
Standard Cost serves as a basis of cost control and as a measure of productive efficiency when ultimately posed with
an actual cost. It provides management with a medium by which the effectiveness of current results is measured and
responsibility of deviation placed. Standard Costs are used to compare the actual costs with the standard cost with a
view to determining the variances, if any, and analyzing the causes of variances, and taking proper measures
to control them.

Estimated Costs
Estimated Costs of a product are prepared in advance prior to the performance of operations or even before the
acceptance of sale orders. Estimated Cost is found with specific reference to the product in question, and the activity
levels of the plant. It has no link with actual and hence it is assumed to be less accurate than the Standard Cost.

Cost Classifications 2
 Cost Classifications
In managerial accounting, costs are classified into fixed costs, variable costs or mixed costs (based on behavior);
product costs or period costs (for external reporting); direct costs or indirect costs (based on traceability); and sunk
costs, opportunity costs or incremental costs (for decision-making).

Classification of costs based on behavior helps in cost-volume-profit analysis. Classification based on traceability is
important for accurate costing of jobs and units produced. Classification for the purpose of decision-making is
important to help management identify costs which are relevant for a decision.

Product Costs vs Period Costs

Product costs (also called inventoriable costs) are costs assigned to the manufacture of products and recognized for
financial reporting when sold. They include direct materials, direct labor, factory wages, factory depreciation, etc.

Period costs are on the other hand are all costs other than product costs. They include marketing costs and
administrative costs, etc.

Breakup of Product Costs

The product costs are further classified into direct materials, direct labor and manufacuturing overhead costs:
o Direct materials: Represents the cost of the materials that can be identified directly with the product at reasonable
cost. For example, cost of paper in newspaper printing, etc.
o Direct labor: Represents the cost of the labor time spent on that product, for example cost of the time spent by a
petroleum engineer on an oil rig, etc.
o Manufacturing overhead costs: Represents all production costs except those for direct labor and direct materials, for
example the cost of an accountant's time in an organization, depreciation on equipment, electricity, fuel, etc.

Direct Costs vs Indirect Costs

The product costs that can be specifically identified with each unit of a product are called direct product costs.
Whereas those which cannot be traced to a specific unit are indirect product costs. Thus direct material cost and
direct labor cost are direct product costs whereas manufacturing overhead cost is indirect product cost.

Prime Costs vs Conversion Costs

Prime costs are the sum of all direct costs such as direct materials, direct labor and any other direct costs.

Conversion costs are all costs incurred to convert the raw materials to finished products and they equal the sum of
direct labor, other direct costs (other than materials) and manufacturing overheads.

Fixed Costs vs Variable Costs

Fixed costs are costs which remain constant within a certain level of output or sales. This certain limit where fixed
costs remain constant regardless of the level of activity is called relevant range. For example, depreciation on fixed
assets, etc.

Variable costs are costs which change with a change in the level of activity. Examples include direct materials, direct
labor, etc.

Mixed costs (also called semi-variable costs) are costs which have both a fixed and a variable component.

Sunk Costs vs Opportunity Costs

The costs discussed so far are historical costs which means they have been incurred in past and cannot be avoided by
our current decisions. Relevant in this regard is another cost classification, called sunk costs. Sunk costs are those
costs that have been irreversibly incurred or committed; they may also be termed unrecoverable costs.

In contrast to sunk costs are opportunity costs which are costs of a potential benefit foregone. For example the
opportunity cost of going on a picnic is the money that you would have earned in that time.

A. Relevant Cost of Material

Relevant cost of material is the raw material cost that needs to be considered while taking a managerial decision.
Relevant cost of material may be in the form of incremental cash flows or opportunity cost. The historical cost of
material is irrelevant because it cannot be altered by new decisions.

Rules
The relevant cost of material shall include opportunity cost if any. When the availability of raw material is so limited
that it restricts production volume, the opportunity cost is the contribution from next best alternative production. If
the material has no alternative production use, the opportunity cost is its net disposal value. Other rules for
determination of relevant cost are given below:

Consider whether the material is currently held in stock.

o The relevant cost of material which is not currently held in inventory is its purchase cost plus opportunity cost.
o If the material required is available in inventory, the next thing we need to look at is whether or not the material is
actively being used for some other purpose.
 If yes, the relevant cost is its replacement cost plus opportunity cost. The raw material stock must be restored to fulfil
regular usage needs. Replacement cost is the actual cost to restore the stock level.
 If no, the relevant cost of the material is its opportunity cost i.e. the estimated net disposal value.

The above rules may be presented in a chart as shown below:

 Example
Company XD has received an offer to
purchase 700 units of Product A at P75
per unit.

Details about material required are as follows:

Material X Y Z
Total relevant
Quantity required per unit 1.0 kg 1.5 kg 0.4 kg costs other than
material are
Total quantity available in stock 800 kg 400 kg 100 kg P5,000.

Limit on market availability None None 500 kg

Total price per unit P14.25 P9.80 P30.00

Total disposal value per unit P7.00 P4.00 N/A

Regularly used? Yes No Yes

Quantity required for alternative use N/A N/A 400 kg

Contribution per kg from second best alternative use. N/A N/A P25.00
Required:
Determine total relevant cost and decide whether or not XD should accept the offer assuming the decision won't
affect regular sales.
Solution

Material X required to complete the offer is 700 kg [=700×1.0kg], all of which is already available in stock.
However material X is in regular use, therefore the relevant cost is its replacement cost which is P9,975
[=700kg×P14.25/kg]. Since the material is in regular use, the company has to incur an incremental cash flow in order
to restore stock levels. There is no limit on availability so the opportunity cost is zero.

The company has 400 kg of material Y in stock which has no alternative use so the relevant cost of that portion is
just its opportunity cost i.e. disposal value which P1,600 [=400kg×P4/kg]. However the total material required is
1,050 kg [=700×1.5kg] hence the company needs to purchase 650kg of material Y, the relevant cost of this second
portion is its purchase price i.e. P6,370 [=650×P9.80]. The opportunity cost of this second portion is zero because the
material X has not alternative use and also because there is no limit on availability. Total relevant cost of material Y
is P7,970 [=P1,600+P6,370].

Material Z is tricky because there is a limit on availability which restricts production options. Material Z required for
the offer is P180kg [=700×0.4kg]. First, since material Z is in regular use, its relevant cost shall include the
replacement cost of P5,400 [=180kg×P30/kg]. Further, the company has to sacrifice alternative production based on
material Z partially. Therefore the contribution lost as a result shall also be considered a relevant opportunity cost.
Material Z shortage for alternative production caused if the company choses to fulfil the offer is 80kg [=400kg–
(500kg+100kg–280kg)]. The opportunity cost is the contribution lost i.e. P2,000 [=80kg×P25/kg]. Total relevant cost
of material Z is thus P7,400 [=P5,400+P2,000]
Total relevant cost of material
= P9,975 + P7,970 + P7,400
= P25,345

Total relevant cost

= P25,345 + P5,000
= P30,345

Increase in income on accepting the offer

= 700 × P75 = P52,500 – P30,345
= P22,155

Decision: Company XD should accept the offer.

B. Prime Cost
Prime costs are the cost of direct material and direct labor in any manufacturing process. Direct materials and direct
labor costs are defined as costs that can be directly traced to each unit produced. All the prime costs are variable
costs and they are directly attributable. They do not include indirect variable costs and any fixed costs. Prime costs
are the core production costs which may form the basis of allocation of manufacturing overheads to different
products.

Production costs can be broadly classified into direct material, direct labor, variable manufacturing overheads and
fixed manufacturing overheads. Prime costs include only direct material and direct labor while conversion costs, a
related concept, include direct labor and total manufacturing overheads.

Formula
Prime costs can be calculated using any of the following formulas depending on the information available:

Prime Cost = Direct Materials+Direct Labor Cost

Prime Cost=Total Manufacturing Cost - Total Manufacturing Overheads

Example
Green Fuels is engaged in production of biofuels. At the start of financial year 2012, the company had a raw material
inventory of P10 million. During the year it purchased P320 million of raw material. The raw material inventory at
the end of 2012 amounted to P50 million. Out of the raw materials consumed P100 million went to manufacturing
overheads. The company's total labor costs are P300 million. 20% of the labor is indirect. Find prime costs.

Raw materials consumed = opening raw materials (P10 million) + purchases (P320 million) − (P50 million) = P280
million

Direct materials consumed = raw materials consumed ($280 million) − indirect materials (P100 million) = P180
million

Direct labor costs = 80% of P300 million = P240 million

Prime costs = P180 million + P240 million = P420 million

C. Conversion Costs
Conversion costs include all direct or indirect production costs incurred on activities that convert raw material to
finished goods. There are two main components of conversion costs: direct labor and manufacturing overheads.
Examples costs that may be qualify as conversion costs are wages, rent, depreciation on plant and machinery, plant
insurance, plant utilities, supervision, plant repairs and maintenance, etc. etc.

The term conversion cost is typically used in cost of production report of process costing where the percentage of
completion of partially manufactured units at the end of an accounting period is typically same for direct labor and
manufacturing overheads. In such cases, it is time-saving to calculate equivalent units and unit costs by combining
direct labor and manufacturing overheads instead of doing separate calculations for the two cost items.
Formula
Conversion costs are the sum of direct labor and manufacturing overheads.

Conversion Costs = Direct Labor + Manufacturing Overheads

Since total manufacturing costs has three components: direct material, direct labor and manufacturing overheads,
conversion costs may also be calculated using the following formula:

Conversion Costs = Total Manufacturing Costs – Direct Material

Example
Use the following information to calculate conversion cost per unit:

Completed Units 50,000

P38,00
Direct Wages
0

Indirect Wages P5,000

P29,00
Direct Material
0

Indirect Material P1,000

Equipment Depreciation P6,500

P10,00
Office Expenses
0

Factory Insurance P2,000

Assume that there was no work in process inventory at the beginning and at the end of the accounting period.

Solution

Direct Labor = 38,000

Manufacturing Overheads = 5,000 + 1,000 + 6,500 + 2,000 = 14,500

Conversion Costs = Direct Labor + Manufacturing Overheads = 38,000 + 14,500 = 52,500

P52,500  
Conversion Cost per unit = = P1.05
50,000

D. Quality Costs
Cost of quality has four components: (a) prevention costs, (b) appraisal costs, (c) internal failure costs and (d)
external failure costs. In general, an increase in prevention and appraisal costs results in a multiple-fold reduction in
(internal and external) failure costs.

Writing Tools, Inc. is a company that produces high-end writing instruments. The company has communicated a
steep target in its latest earnings call and the company’s CEO is under a lot of pressure from the Wall Street.

A meeting is held to review the situation and make changes to better position the company to meet the target. The
CEO suggests the following measures: (a) the finished goods inspection target per head shall be increased and some
inspection people shall be laid off, (b) quality training for engineers shall be postponed to the next year, (c) third-
 party inspection of some raw material shall not be required, (d) work-in-process batches shall be tested on sample
basis only and (e) shipment time target for the last quarter shall be reduced by 20%.

The company’s chief production manager has some reservations regarding the proposed decisions. The company’s
cost controller agrees with him. He suggests that the company should (a) carry out a complete quality audit of its
production process to identify improvement areas, (b) replace the existing inspection equipment, (c) appoint a supply
chain expert to liaison with suppliers and (d) install SAP Quality Management. He assures the CEO that undertaking
such quality control measure will not only increase sales in the long-run it will reduce (a) spoilage and scrap items,
(b) repairs and warranty expense, (c) inspection time of finished goods and (d) work force needed to handle
complaints and returns.

He goes on to explain that cost of quality has four components: (a) prevention costs, (b) appraisal costs, (c) internal
failure costs and (d) external failure costs. He estimates that currently an increase in prevention and appraisal costs
results in a twofold reduction in (internal and external) failure costs.

Prevention Costs
Prevention costs are costs incurred to ensure that defects are minimized and prevented at the earliest stage.
Prevention activities are most effective because preventing a unit from becoming defective at the earliest stage saves
the labor and manufacturing overheads that would have been consumed had the unit moved on in production and the
defect was identified at a later stage. Examples of prevention costs in case of Writing Tools, Inc. include:

1. Quality training for engineers

2. Hiring a supply chain expert to coordinate with suppliers
3. Carrying out a complete quality audit
4. Installing software to gather more accurate data on quality management

Appraisal Costs
Appraisal costs are costs incurred to identify defective products before they are shipped off. These include costs
incurred on inspecting raw materials, work-in-progress and finished goods.

In the above example, appraisal costs include:

1. Salaries of inspection staff

2. Maintenance and utilities of inspection equipment
3. Replacement of inspection equipment

Internal Failure Costs

Internal failure costs refer to costs incurred on the defective units before they are identified before shipment. These
costs represent the direct material, direct labor and manufacturing overheads consumed by the defective unit.

In case of Writing Instruments, Inc., these include:

1. Spoilage of material
2. Cost of scrapped units
3. Cost of disposing off the scrapped items and spoiled material
4. Production disruptions due to defective units

External Failure Costs

External failure costs are cost associated with defective units which are shipped to customers. External failure costs
are the most expensive in that they result in lost repute, extensive warranty and repair costs and in worst case may
result in legal action.

In the above-mentioned example, external failure costs are:

1. Lost sales due to bad customer experience

2. Recalls, warranty expense and repairs
3. Cost of customer services department in handling the complaints, warranty claims and recalls
Correct classification of quality costs into prevention costs, appraisal costs and internal and external failure costs will
help businesses arrive at the optimal budget for quality costs and efficient allocation among different quality control
activities.

WEEK 2- MODULE 2: COST ACCOUNTING SYSTEM

I. JOB ORDER COSTING
Cost Accounting Systems
A cost accounting system (also called product costing system or costing system) is a framework used by firms to
estimate the cost of their products for profitability analysis, inventory valuation and cost control.

Estimating the accurate cost of products is critical for profitable operations. A firm must know which products are
profitable and which ones are not, and this can be ascertained only when it has estimated the correct cost of the
product. Further, a product costing system helps in estimating the closing value of materials inventory, work-in-
progress and finished goods inventory for the purpose of financial statement preparation.

There are two main cost accounting systems: the job order costing and the process costing.

1. Job order costing is a cost accounting system that accumulates manufacturing costs separately for each job. It is
appropriate for firms that are engaged in production of unique products and special orders. For example, it is the
costing accounting system most appropriate for an event management company, a niche furniture producer, a
producer of very high-cost air surveillance system, etc.

2. Process costing is a cost accounting system that accumulates manufacturing costs separately for each process. It
is appropriate for products whose production is a process involving different departments and costs flow from one
department to another. For example, it is the cost accounting system used by oil refineries, chemical producers,
etc.

 There are situations when a firm uses a combination of features of both job-order costing and process
costing, in what is called hybrid cost accounting system.

In a cost accounting system, cost allocation is carried out based on either traditional costing system or activity-
based costing system.
1. Traditional costing system calculates a single overhead rate and applies it to each job or in each department.

2. Activity-based costing on the other hand, involves calculation of activity rate and application of overhead costs
to products based on their respective activity usage.

Based on whether the fixed manufacturing overheads are charged to products or not, cost accounting systems have
two variations: variable costing and absorption costing. Variable costing allocates only variable manufacturing
overheads to inventories, while absorption costing allocates both variable and fixed manufacturing overheads to
products. Variable costing calculates contribution margin, while absorption costing calculates the relevant gross
profit.

Still further refinement to costing accounting systems include JIT-costing, back-flush costing.

A. Pre-determined Overhead Rate

Pre-determined overhead rate (also called overhead absorption rate) is the rate at which the manufacturing
overheads are charged to work-in-process based on some underlying activity base such as direct labor hours,
machine hours, etc.

Pre-determined overhead rate is calculated at the start of a managerial accounting cycle based on total budgeted
overheads cost and some relevant cost driver such as total budgeted labor hours, total budgeted labor cost,
machine hours, etc.

Since actual manufacturing overhead costs are compiled at the period end only, the overhead application based on
pre-determined overhead rate is useful in costing products. At the end of managerial accounting cycle, the
difference between manufacturing overheads applied and actual manufacturing overheads is adjusted.

Formula
Pre-determined overheads rate equals estimated manufacturing overheads divided by total units of the cost driver
(i.e. allocation base):

Pre-determined Overhead Rate = Estimated Manufacturing Overheads ÷ Total Units of Cost Driver

Manufacturing overheads are applied to a product by multiplying the pre-determined overhead rate with units of
the cost driver:

Manufacturing Overheads Applied = Overhead Rate × Units of Cost Driver Consumed

Example
Chinar Pharmaceuticals is commencing its next accounting year. It expects to incur total manufacturing overheads
of P10 million. During the year total labor costs are expected to be P3 million for a 5,000 total labor hours and total
machine operating hours are budgeted at 100,000. Find the pre-determined overhead rate.

The company has a product named X1 which consumed 25,000 machine operating hours, find the manufacturing
overheads to be charged to the product.

Solution

Chinar Pharmaceuticals can calculate pre-determined overheads based either on total labor cost, total labor hours
or total processing hours. Selection of a cost driver is a matter of judgment. Since the company is not very labor
intensive, use of machine operating hours as a cost driver seems appropriate.

Pre-determined overhead rate based on machine operating hours equals total budgeted manufacturing overheads
(of P1,000,000) divided by total budgeted machine operating hours (which are 100,000). It gives us a pre-
determined overhead rate of P10 per machine operating hour.
 Manufacturing overheads charged to X1 = pre-determined overhead rate × machine operating hours consumed by
X1 = P10 per machine operating hour × 25,000 machine operating hours = P250,000.

B. Job Order Costing

Job order costing is a cost accounting system in which direct costs are traced and indirect costs are allocated to
unique and distinct jobs instead of departments. It is appropriate for businesses that provide non-uniform
customized products and services.

Job order costing is one of the two main cost accounting systems, the other being the process costing in which
costs are traced and allocated first to different processes carried out in different departments and then to products
and services. Many companies use costing systems that are a blend of features of both job-order costing and
process costing systems.

Companies that use job-order costing

Some of the companies that use job-order costing include:

 Accounting, consulting and legal firms

 Architects
 Manufacturers of ships and airplanes
 Book publishers
 Movie producers

The nature of their work is such that they are interested in finding profitability of different jobs and hence they
accumulate costs with reference to different jobs like audit engagement, consulting projects, books, movies, etc.

Steps in job-order costing process

In a job-order costing system, jobs are accounted for using the job-order cost sheet. The process involves the
following steps:

1. Identification of the job

2. Tracing direct costs to the job
3. Identifying the indirect costs i.e. manufacturing overheads and finding the cost allocation base for each cost.
4. Applying the indirect costs to the job using the pre-determined allocation rate.
5. Finding total cost by summing up all the cost components.
6. Closing the under/over-applied manufacturing overheads to cost of goods sold/income statement.
7. Calculating revenue and profit.

Journal entries: example

Dynamic Systems Inc. (DS) received an order to manufacture a customized airplane for the official use of the
president of Pakistan. DS will charge an amount equal to the cost of the airplane plus a 30% profit margin on cost to
the government of Pakistan. The job code is PK03.

Since the manufacture of the airplane is a one-off project, job-order costing is the most appropriate cost
accumulation system. Let us post the required journal entries in the DS costing system.

1. DS purchased raw materials (such as aluminum, fiber, etc.) at a cost of 4 million.

Material inventory 4,000,000

Accounts payable 4,000,000

2. 2.8 million worth of raw materials were used in the project as direct materials.

Work in process—PK03 2,800,000

 Inventories 2,800,000

3. 0.4 million worth of raw materials were used as indirect materials.

Manufacturing overheads 400,000

Inventories 400,000

4. Total direct labor hours consumed on the job cost 3 million. The amount is already paid.

Work in process—PK03 3,000,000

Cash 3,000,000

5. Indirect labor hours relevant to the project cost 1 million.

Manufacturing overheads 1,000,000

Cash 1,000,000

6. Other indirect costs yet to be paid were 2.5 million.

Manufacturing overheads 2,500,000

Accounts payable 2,500,000

7. Manufacturing overheads are charged to jobs at 100% of direct labor cost i.e. 3,000,000.

Work in process—PK03 3,000,000

Manufacturing overheads 3,000,000

8. The cost of PK03 is transferred from work in progress to finished goods on its completion at total cost of
8,800,000 (=direct materials cost of 2,800,000 plus direct labor cost of 3,000,000 and applied manufacturing
overheads of 3,000,000).

Finished goods 8,800,000

Work in process—PK03 8,800,000

9. Revenue is recorded at 11,440,000 [= 8,800,000 × 1.3].

Accounts receivable 11,440,000

Revenue 11,440,000

10. Actual manufacturing overheads are 3,900,000 (=indirect materials of 400,000 plus indirect labor of 1,000,000
and other overheads of 2,500,000). Applied manufacturing overheads are 3,000,000. The 900,000 worth of
manufacturing overheads under-applied is taken to the cost of goods sold or income statement.

Cost of goods sold 900,000

Manufacturing overheads 900,000

Profit on PK03 is 1,700,000 (=revenue of 11,440,000 minus finished goods of 8,800,000 and under-applied
overheads adjustment of 900,000).
C. Job Cost Sheet
Job cost sheet is a document used in a job-order costing system to record all the costs incurred on a job. In addition
to job identification details such as job number, customer name, etc., it includes particulars of direct material,
direct labor and manufacturing overheads incurred on the job. In a process costing system, the purpose of the job
cost sheet is fulfilled by the cost of production report.

Template: Following is a template

that can be used as a job cost
sheet:

II. VARIABLE AND ABSORPTION COSTING

1. Absorption/ Traditional/ Full Costing

- for external purposes and follow standards GAAP/ IFRS “ Full Matching Principle”

- comprises both variable and fixed costs where fixed cost is part of product cost

- pro-forma:

Sales

Less: Cost of Sales (variable and fixed costs)

Gross Profit

Less: operating expenses – period costs

Net income before tax

2. Variable Costing

- purpose of profitability analysis and external use only

- don’t have actual transaction where majority are forecasted and predicted.
 -do not treat fixed costs as part of manufacturing costs because regardless if there’s transaction or not, it
will still remain. Considering there’s no sale this month means the company will not have profit.

- fixed cost is part of period costs (expense out right)

- use for cvp analysis

- if problem is silent: unit sold is equal to unit produced. If units sold is not equal to unit produced, variable
costing will be based on unit sold.

- use contribution margin proforma:

Sales

Less: variable cost

Contribution margin

Less: Fixed cost

Net income before tax

WEEK 3- MODULE 3: APPLICATION OF COST INFORMATION PART I

I. COST-VOLUME-PROFIT ANALYSIS

INTRODUCTION

COST-VOLUME-PROFIT ANALYSIS
A cost-volume-profit (CVP) analysis is a systematic method of examining the effects of changes in an organization’s
volume of activity on its costs, revenue, and profit. It is useful for the management in knowing how profit is
influenced by sales volume, sales price, variable expenses and fixed expenses

Break-even point
The Break-even point is the level of sales at which profit is zero. According to this definition, at the break-even
point sales are equal to fixed cost plus variable cost. This concept is further explained by the following equation:

[Break even sales = fixed cost + variable cost]

The break-even point can be calculated using either the equation method or the contribution method. These two
methods are equivalent.

Contribution
Contribution margin is a measure of operating leverage: the higher the contribution margin is (the lower variable
costs are as a percentage of total costs), the faster the profits increase with sales. In the linear CVP analysis Model,
contribution margin is a fixed quantity and does not change with Sales.

Contribution = Sales - Variable Cost

 Margin of Safety
The margin of safety is a tool to help management understand how far sales could change before the company
would have a net loss. It is computed by subtracting breakeven sales from budgeted or forecasted sales. To state
the margin of safety as a percent, the difference is divided by budgeted sales.

Margin of safety is the difference between the intrinsic value of a stock and its market price.

In Breakeven analysis margin of safety is how much output or sales level can fall before a business reaches its
breakeven point.

Applications

1. CVP simplifies the computation of breakeven point in break-even analysis.

2. Allows simple computation of Target Income Sales.
3. It simplifies the analysis of short-run trade-offs in operational decisions.

Limitations

 Profit Maximization-the cost-volume-profit relationship is not a profit maximization technique because it does not
place any limitations upon the number of units a business can produce and sell.
 Multiple Products-cost-volume-profit relationships require simplifying assumptions to apply it to a business that
manufactures more than one product.

COST-VOLUME-PROFIT ANALYSIS

A cost-volume-profit (CVP) analysis is a systematic method of examining the effects of changes in an organization’s
volume of activity on its costs, revenue, and profit. It is useful for the management in knowing how profit is
influenced by sales volume, sales price, variable expenses, and fixed expenses. A critical part of CVP analysis is the
point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a
company will experience no income or loss. This BEP can be an initial examination that precedes a more detailed
CVP analysis.

Cost-volume-profit (CVP) analysis is a technique that examines changes in profits in response to changes in sales
volumes, costs, and prices. Accountants often perform CVP analysis to plan future levels of operating activity and
provide information about:

o Which products or services to emphasize.

o The volume of sales needed to achieve a targeted level of profit. 
o The amount of revenue required to avoid losses. 
o Whether to increase fixed costs. 
o How much to budget for discretionary expenditures. 
o Whether fixed costs expose the organization to an unacceptable level of risk.

Break-even Point Equation Method

Break-even is the point of zero loss or profit. At the break-even point, the revenues of the business are equal to its
total costs and its contribution margin equals its total fixed costs.
Break-even point can be calculated by equation method, contribution method, or graphical method. The equation
method is based on the cost-volume-profit (CVP) formula:
px = vx + FC + Profit

Where,
p is the price per unit,
x is the number of units,
v is variable cost per unit and
FC is total fixed cost.

BEP in Sales Units

px = vx + FC
At break-even point the profit is zero therefore the CVP formula is simplified
to:

Solving the above equation for x which equals break-even point in sales units, we get:

FC
Break-even Sales Units = x = p−v

BEP in Sales Pesos

Break-even point in number of sales pesos is calculated using the following formula:

Break-even Sales Peso= Price per Unit × Break-even Sales Units

Example
Price per Unit P15

Variable Cost per Unit P7

Total Fixed Cost P9,000

Calculate the break-even point in sales units and sales pesos from the following information:

Solution

We have,
p = P15
v = P7, and
FC = P9,000

Substituting the known values into the formula for breakeven point in sales units, we get:

Breakeven Point in Sales Units (x)

= P9,000 ÷ (P15 − P7)
= P9,000 ÷ P8
= 1,125 units

Break-even Point in Sales Pesos

= P15 × 1,125
= P16,875

A. Margin of Safety (MOS)

In accounting, the margin of safety is the extent to which actual or projected sales exceed the break-even sales. The
margin of safety ratio equals the difference between budgeted sales and break-even sales divided by budget sales.
The margin of safety is a measure of business risk. It represents the percentage by which a company's sales can
drop before it starts incurring losses. The higher the margin of safety, the more the company can withstand
fluctuations in sales. A drop-in sales greater than the margin of safety will cause net loss for the period.

There are different ways in which margin of safety can be expressed: (a) in units of goods sold, (b) in pesos of sales,
or (c) as a ratio.

Formula
Margin of safety in units equals the difference between the actual/budgeted quantity of sales minus the break-
even quantity.

Margin of Safety in Units = Budgeted Units - Break even Units

Where break-even units of sales equals fixed costs divided by contribution margin per unit. Margin of safety in
pesos can be calculated by multiplying the margin of safety in units with the price per unit.

Margin of Safety in (Pesos) = Margin of Safety in Units x Price per Unit

Alternatively, it can also be calculated as the difference between total budgeted sales and break-even sales in
pesos. Break-even point (in pesos) equals fixed costs divided by contribution margin ratio.

Margin of Safety (in Peso)=Budgeted Sales - Break-even Point in Pesos

The margin of safety ratio allows comparison between different companies. It can be calculated by dividing the
margin of safety (in units or dollars) by total sales (in units and dollars respectively):

Margin of Safety Ratio = MOS in Units

                                            Sales in Units

 =    MOS in Pesos

       Sales in Pesos

Example
Following is the data for the two companies. Find out which company has a better margin of safety:

Company A Company B

Sales Price per Unit 40 90

Variable Cost per Unit 32 60

Total Fixed Cost 7,000 25,000

Budgeted Sales 40,000 110,000

Solution: The following table shows calculation of margin of safety in units and dollars and the margin of safety
ratio:

Item Calculation Company A Company B

Sales Price per Unit P 40 90

Variable Cost per Unit V 32 60

Total Fixed Cost FC 7,000 25,000

 Budgeted Sales S 40,000 90,000

Budget Sales (in Units) U = S/P 1,000 1,000

Break-even Point (in Units) BU = FC/(P - V) 875 833

Break-even Point (in Pesos) BD = BU × P 35,000 75,000

Margin of Safety (in Units) MOSU = U - BU 125 167

Margin of Safety (in Pesos) MOSD = S - BD 5,000 15,000

Margin of Safety Ratio MOSU/U = MOSD/S 12.50% 16.67%

Company B has a higher margin of safety.

B. Target Income Analysis

Target income analysis is a management accounting technique used to identify a company's target income sales, the
sales level that must be achieved to earn a target net income.

Target income sales depends on a company's fixed costs, target operating income and contribution margin per unit
and/or contribution margin ratio. The target operating income in turn depends on the target net income and
applicable tax rate.

Calculating target income sales is an important part of the cost-volume-profit analysis. Every business must earn
enough revenue not only to cover its variable and fixed costs, but to be able to generate a decent return on its
investment. It is useful to have a number in mind when preparing a sales budget or assigning sales targets.

Formula
We start with a target net income and use it to work back to the sales level. First, we need to work out the target
operating income which is effectively the income before taxes:

Target Net Income=Target Operating Income x ( 1- Tax Rate)

A bit of rearrangement gives us the formula for target operating income:

Target Operating Income = Target Net Income

                                                        1-Tax Rate

Target income sales in units can be calculated by dividing the sum of total fixed costs and target operating income by
the contribution margin per unit:

Target Income Sales (in Units) =Fixed Costs +Target Operating Income

                                                               Contribution Margin per Unit

Example
Orange Juices Inc. is a company engaged in packaging and distribution of fresh orange juices. Its revenue
per liter of juice is P10. Its manufacturing costs are as follows:
Costs of raw oranges used per liter P2
The company wants to generate net income of
$150,000 at least. If the company's tax rate is
Direct labor costs per unit 1
30%, determine how many liters the company
Fixed manufacturing overheads 200,000 should be able to sell and the amount of total
sales.
Fixed administrative and distribution costs 300,000
 Solution

Target operating income

= P150,000 ÷ (1 − 30%)
= P214,286

Contribution margin per unit

= P10 − P2 − P1
= P7

Contribution margin ratio

= P7 ÷ P10
= 70%

Target income sales in units

= (P200,000 + P300,000 + P214,286) ÷ P7
= 102,041 units

Target income sales in dollars

= (P200,000 + P300,000 + P214,286) ÷ 70%
= P1,020,410

Target income sales can also be determined as product of per unit sales revenue and target income sales in units
i.e. (P10 × 102,041 = P1,020,410).

Cost-Volume-Profit Assumptions and Terminology

1. Changes in the level of revenues and costs arise only because of changes in the number of product (or
service) units produced and sold.

2. Total costs can be divided into a fixed component and a component that is variable with respect to the
level of output.

3. When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation to output
units within the relevant range (and time period).

4. The unit selling price, unit variable costs, and fixed costs are known and constant.

5. The analysis either covers a single product or assumes that the sales mix when multiple products are sold
will remain constant as the level of total units sold changes.

6. All revenues and costs can be added and compared without taking into account the time value of money.
 Operating income
= Total revenues from operations
– Cost of goods sold and operating costs (excluding income taxes)
Net income = Operating income – Income taxes

Essentials of Cost-Volume-Profit (CVP) Analysis Example

Assume that the Pants Shop can purchase pants for P32 from a local factory; other variable costs amount
to P10 per unit. The local factory allows the Pants Shop to return all unsold pants and receive a full P32
refund per pair of pants within one year. The average selling price per pair of pants is P70 and total fixed
costs amount to P84,000.
 How much revenue will the business receive if 2,500 units are sold?
2,500 × P70 = P175,000
 How much variable costs will the business incur?
2,500 × P42 = P105,000
P175,000 – 105,000 – 84,000 = (P14,000)
 What is the contribution margin per unit?
P70 – P42 = P28 contribution margin per unit
 What is the total contribution margin when 2,500 pairs of pants are sold?
2,500 × P28 = P70,000
Contribution margin percentage (contribution margin ratio) is the contribution margin per unit
divided by the selling price.
 What is the contribution margin percentage?
P28 ÷ P70 = 40%
 If the business sells 3,000 pairs of pants, revenues will be P210,000 and contribution margin
would equal 40% × P210,000 = P84,000.

Breakeven Point

Sales - Variable expenses = Fixed expenses

Total revenues = Total costs

Abbreviations:
SP = Selling price
VCU = Variable cost per unit
CMU = Contribution margin per unit
CM% = Contribution margin percentage
FC = Fixed costs
Q = Quantity of output units sold (and manufactured)
OI = Operating income
TOI = Target operating income
TNI = Target net income

1. Equation Method
(Selling price × Quantity sold) – (Variable unit cost
× Quantity sold) – Fixed costs = Operating income
Let Q = number of units to be sold to break even
P70Q – P42Q – P84,000 = 0 P28Q = P84,000
Q = P84,000 ÷ P28 = 3,000 units
2. Contribution Margin Method
P84,000 ÷ P28 = 3,000 units
P84,000 ÷ 40% = P210,000
3. Graph Method
Target Operating Income
(Fixed costs + Target operating
income)
divided either by Contribution margin percentage or Contribution margin per unit
Assume that management wants to have an operating income of P14,000.
 How many pairs of pants must be sold?
(P84,000 + P14,000) ÷ P28 = 3,500
 What peso sales are needed to achieve this income?
(P84,000 + P14,000) ÷ 40% = P245,000

Target Net Income and Income Taxes Example

Management would like to earn an after tax income of P35,711. The tax rate is 30%.

 What is the target operating income?

Target operating income

= Target net income ÷ (1 – tax rate)

TOI = P35,711 ÷ (1 – 0.30) = P51,016

 How many units must be sold?

 Revenues – Variable costs – Fixed costs

 = Target net income ÷ (1 – tax rate)

 P70Q – P42Q – P84,000 = P35,711 ÷ 0.70

 P28Q = P51,016 + P84,000

 Q = P135,016 ÷ P28 = 4,822 pairs of pants

Proof:
Revenues: 4,822 × P70 P337,540
Variable costs: 4,822 × P42 202,524
Contribution margin P135,016
Fixed costs 84,000
Operating income 51,016
Income taxes: P51,016 × 30% 15,305
Net income P35,711
 Using CVP Analysis Example

Suppose the management anticipates selling 3,200 pairs of pants. Management is considering an
advertising campaign that would cost P10,000. It is anticipated that the advertising will increase
sales to 4,000 units.

 Should the business advertise? yes

3,200 pairs of pants sold with no advertising:
Contribution margin P89,600
Fixed costs 84,000
Operating income P5,600

4,000 pairs of pants sold with advertising:

Contribution margin P112,000
Fixed costs 94,000
Operating income P18,000

 Instead of advertising, management is considering reducing the selling price to P61 per pair of
pants. It is anticipated that this will increase sales to 4,500 units. Should management decrease the
selling price per pair of pants to P61? no

3,200 pairs of pants sold with no change in the selling price:

Operating income = P5,600
4,500 pairs of pants sold at a reduced selling price:
Contribution margin: (4,500 × P19) P85,500 Fixed costs 84,000
Operating income P1,500

 Assume that the Pants Shop can sell 4,000 pairs of pants. Fixed costs are P84,000. Contribution

margin ratio is 40%. At the present time the business cannot handle more than 3,500 pairs of pants.
To satisfy a demand for 4,000 pairs, management must acquire additional space for P6,000. Should
the additional space be acquired?

Revenues at breakeven with existing space are P84,000 ÷ .40 = P210,000.

Revenues at breakeven with additional space are P90,000 ÷ .40 = P225,000

Operating income at P245,000 revenues with existing space = (P245,000 × .40)

– P84,000 = P14,000.
(3,500 pairs of pants × P28) – P84,000 = P14,000
Operating income at P280,000 revenues with additional space = (P280,000 × .40) – P90,000
= P22,000.
(4,000 pairs of pants × P28 contribution margin)
– P90,000 = P22,000

Alternative Fixed/Variable Cost Structures Example

Suppose that the factory the Pants Shop is using to obtain the merchandise offers the following:
Decrease the price they charge from P32 to P25 and charge an annual administrative fee of
P30,000.
 What is the new contribution margin?
P70 – (P25 + P10) = P35
Contribution margin increases from P28 to P35.
 What is the contribution margin percentage?
 P35 ÷ P70 = 50%
 What are the new fixed costs?
P84,000 + P30,000 = P114,000
 Management questions what sales volume would yield an identical operating income regardless of
the arrangement.
28x – 84,000 = 35x – 114,000
114,000 – 84,000 = 35x – 28x
7x = 30,000
x = 4,286 pairs of pants
 Cost with existing arrangement = Cost with new arrangement
.60x + 84,000 = .50x + 114,000
.10x = P30,000 \ x = P300,000
(P300,000 × .40) – P 84,000 = P36,000
(P300,000 × .50) – P114,000 = P36,000

Operating Leverage

Operating leverage describes the effects that fixed costs have on changes in operating income as
changes occur in units sold. Organizations with a high proportion of fixed costs have high
operating leverage. Example:

Degree of operating leverage = Contribution margin ÷ Operating income

 What is the degree of operating leverage of the Pants Shop at the 3,500 sales level under both
arrangements?
 Existing arrangement: 3,500 × P28 = P98,000 contribution margin
 P98,000 contribution margin – P84,000 fixed costs
= P14,000 operating income
P98,000 ÷ P14,000 = 7.0
New arrangement: 3,500 × P35 = P122,500 contribution margin

 P122,500 contribution margin

– P114,000 fixed costs = P8,500
P122,500 ÷ P8,500 = 14.4

The degree of operating leverage at a given level of sales helps managers calculate the
effect of fluctuations in sales on operating income.

Effects of Sales Mix on Income

Pants Shop Example. Management expects to sell 2 shirts at $20 each for every pair of pants it
sells. This will not require any additional fixed costs.
Contribution margin per shirt: P20 – P9 = P11
 What is the contribution margin of the mix?
P28 + (2 × P11) = P28 + P22 = P50

P84,000 fixed costs ÷ P50 = 1,680 packages

 What is the breakeven in peso?

  What is the weighted-average budgeted contribution margin?
Pants: 1 × P28 + Shirts: 2 × P11
= P50 ÷ 3 = P16.667
The breakeven point for the two products is: P84,000 ÷ P16.667 = 5,040 units
5,040 × 1/3 = 1,680 pairs of pants
5,040 × 2/3 = 3,360 shirts
 Sales mix can be stated in sales dollars:
Pants Shirts
Sales price P70 P40
Variable costs 42 18
Contribution margin P28 P22
Contribution margin 40% 55%
ratio
 Assume the sales mix in dollars is 63.6% pants and 36.4% shirts.
Weighted contribution would be: 40% × 63.6% = 25.44% pants
55% × 36.4% = 20.02% shirts
45.46%
Breakeven sales peso is P84,000
÷ 45.46% = P184,778 (rounding).
P184,778 × 63.6% = P117,519 pants sales
P184,778 × 36.4% = P 67,259 shirt sales

Multiple Cost Drivers Example

Suppose that the business will incur an additional cost of P10 for preparing documents associated with the
sale of pants to various customers. Assume that the business sells 3,500 pants to 100 different customers.
 What is the operating income from this sale?

 Would the operating income of the Pants Shop be lower or higher if the business sells pants to
more customers?
The cost structure depends on two cost drivers:
1. Number of units
2. Number of customers

Contribution Margin versus Gross Margin

 Contribution income statement emphasizes contribution margin.
 Financial accounting income statement emphasizes gross margin.

II. SHORT-TERM DECISION MAKING - RELEVANT COSTING

Relevant costing is a management accounting toolkit that helps managers reach decisions when they are posed
with the following questions:

1. Whether to buy a component from an external vendor or manufacture it in-house?

2. Whether to accept a special order?
3. What price to charge on a special order?
4. Whether to discontinue a product line?
5. How to utilize the scarce resource optimally?, etc.
Relevant costing is an incremental analysis which means that it considers only relevant costs i.e. costs that differ
between alternatives and ignores sunk costs i.e. costs which have been incurred, which cannot be changed and
hence are irrelevant to the scenario.

Example
Company A manufactures bicycles. It can produce 1,000 units in a month for a fixed cost of P300,000 and variable
cost of P500 per unit. Its current demand is 600 units which it sells at P1,000 per unit. It is approached by Company
B for an order of 200 units at P700 per unit. Should the company accept the order?

Solution

A layman would reject the order because he would think that the order is leading to loss of P100 per unit assuming
that the total cost per unit is P800 (fixed cost of P300,000/1,000 and variable cost of P500 as compared to revenue
of P700).

On the other hand, a management accountant will go ahead with the order because in his opinion the special order
will yield P200 per unit. He knows that the fixed cost of P300,000 is irrelevant because it is going to be incurred
regardless of whether the order is accepted or not. Effectively, the additional cost which Company A would have to
incur is the variable cost of P500 per unit. Hence, the order will yield P200 per unit (P700 minus P500 of variable
cost).

A. SPECIAL ORDER PRICING

Special order pricing is a technique used to calculate the lowest price of a product or service at which a special
order may be accepted and below which a special order should be rejected. Usually a business receives special
orders from customers at a price lower than normal. In such cases, the business will not accept the special order if
it can sell all its output at normal price. However when sales are low or when there is idle production capacity,
special orders should be accepted if the incremental revenue from special order is greater than incremental costs.

This method of pricing special orders, in which price is set below normal price but the sale still generates some
contribution per unit, is called contribution approach to special order pricing. The idea is that it is better to receive
something above variable costs, than receiving nothing at all.

Example
A company is producing, on average, 10,000 units of product A per month despite having 30% more capacity. Costs
per unit of product A are as follows:

Direct Material 8.00

Direct Labor 5.00
Variable Factory Overhead 2.00
Variable Selling Expense 0.50
Fixed Factory Overhead 3.00
Fixed Office Expense 2.00
  20.50
The company received a special order of 2,000 units of product A at P17.00 per unit from a new customer. Should
the company accept the special order, provided that the customer has agreed to pay the variable selling expenses
in addition to the price of the product?

Solution

The increment cost per unit for the special order is calculated as:

Direct Material 8.00

 Direct Labor 5.00

Variable Factory Overhead 2.00

  15.00

Since the incremental cost per unit is less that the price offered in the special order, the company should accept it.
Accepting special order will generate additional contribution of P2.00 unit and P4,000 in total.

B. SPECIAL ORDER PRICING

Special order pricing is a technique used to calculate the lowest price of a product or service at which a special
order may be accepted and below which a special order should be rejected. Usually a business receives special
orders from customers at a price lower than normal. In such cases, the business will not accept the special order if
it can sell all its output at normal price. However when sales are low or when there is idle production capacity,
special orders should be accepted if the incremental revenue from special order is greater than incremental costs.

This method of pricing special orders, in which price is set below normal price but the sale still generates some
contribution per unit, is called contribution approach to special order pricing. The idea is that it is better to receive
something above variable costs, than receiving nothing at all.

The following example is used to illustrate special order pricing:

Example
A company is producing, on average, 10,000 units of product A per month despite having 30% more
capacity. Costs per unit of product A are as follows:

Direct Material 8.00 The company received a special order of

Direct Labor 5.00 2,000 units of product A at P17.00 per unit
Variable Factory Overhead 2.00 from a new customer. Should the company
accept the special order, provided that the
Variable Selling Expense 0.50
customer has agreed to pay the variable
Fixed Factory Overhead 3.00 selling expenses in addition to the price of the
Fixed Office Expense 2.00 product?
  20.50

Solution

The increment cost per unit for the special order is calculated as:

Direct Material 8.00

Direct Labor 5.00
Variable Factory Overhead 2.00
  15.00
Since the incremental cost per unit is less that the price offered in the special order, the company should accept it.
Accepting special order will generate additional contribution of P2.00 unit and P4,000 in total.

C. SELL OR PROCESS FURTHER

A decision whether to sell a joint product at split-off point or to process it further and sell it in a more refined form
is called a sell-or-process-further decision. Joint products are two or more products which have been manufactured
from the same inputs and in a same production process (i.e. a joint process). The point at which joint products
leave the joint process is called split-off point.
 Some of the joint products may be in final form ready for sale, while others may be processed further. In such cases
managers have to decide whether to sell the unfinished goods at split-off point or to process them further. Such
decision is known as sell-or-process-further decision and it must be made so as to maximize the profits of the
business.

A sell-or-process-further analysis can be carried out in three different ways:

o Incremental (or Differential) Approach calculates the difference between the additional revenues and the
additional costs of further processing. If the difference is positive the product must be processed further, otherwise
not.
o Opportunity Cost Approach calculates the difference between net revenue from further processed product and the
opportunity cost of not selling the product at split-off point. If the difference is positive, further processing will
increase profits.
o Total Project Approach (or the comparative statement approach) compares the profit statements of both options
(i.e. selling or further processing) separately for each product. The option generating higher profit is chosen.

The following example illustrates the approaches to a sell-or-process-further decision:

Example
Product A and B are produced in a joint process. At split-off point, Product A is complete whereas product B can be
process further. The following additional information is available:

Product
Quantity in Units 5,000 10,000
Selling Price Per Unit:
At Split-Off 10 2.5
If Processed Further 5
Costs After Split-Off 20,000
Perform sell-or-process-further analysis for product B.

Solution

Incremental Approach:

Incremental Revenue 25,000

Incremental Costs 20,000
Increase in Profits Due to Further Processing $5,000
Opportunity Cost Approach:

Sales in Case of Further Processing 50,000

Costs:
Additional Costs 20,000
Opportunity Cost of Not Selling at Split-Off 25,000
Gain on Further Processing $5,000

Total Project Approach:

Split-Off Further
Point Processed
Revenue 25,000 50,000
 Costs 0 20,000
Net Revenue 25,000 30,000
5,000
Gain from Further Processing

D. ADD OR DROP PRODUCT

A decision whether or not to continue an old product line or department, or to start a new one is called an add-or-
drop decision. An add-or-drop decision must be based only on relevant information.

Relevant information includes the revenues and costs which are directly related to a product line or department.
Examples of relevant information are sales revenue, direct costs, variable overhead and direct fixed overhead. Such
decision must not be based on irrelevant information such as allocated fixed overhead because allocated fixed
overhead will not be eliminated if the product line or department is dropped.

The following example illustrates an add-or-drop decision:

Example
A company has three products: Product A, Product B and Product C. Income statements of the three product lines
for the latest month are given below:

Product Line A B C
Sales 467,000 314,000 598,000
Variable Costs 241,000 169,000 321,000
Contribution Margin 226,000 145,000 277,000
Direct Fixed Costs 91,000 86,000 112,000
Allocated Fixed Costs 93,000 62,000 120,000
Net Income 42,000 − 3,000 45,000
Use the incremental approach to determine if Product B should be dropped.

Solution

By dropping Product B, the company will loose the sale revenue from the product line. The company will also
obtain gains in the form of avoided costs. But it can avoid only the variable costs and direct fixed costs of product B
and not the allocated fixed costs. Hence:

If Product B is Dropped

Gains:

Variable Costs Avoided 169,000

Direct Fixed Costs Avoided 86,000 255,000

Less: Sales Revenue Lost 314,000

59,000
Decrease in Net Income of the Company

 
 E. SCARCE RESOURCE UTILIZATION

Scarce resource utilization (or allocation) decision is a judgment regarding the best use of scarce resources so as to
maximize the total net income of a business. Scarcity of different resources puts constraints on the amount of
product that can be produced using those resources. For example, a business may have limited number of machine
hours to utilize in production. Scarce resource allocation decision is also called limiting factors decision.

When resources are abundant, products generating relatively higher contribution margin per unit are preferred
because it leads to highest net income. However when resources are scarce, a decision in this way is unlikely to
maximize the profit. Instead the allocation of a scarce resource to various products must be based on the
contribution margin per unit of the scarce resource from each product.

A simple scarce resource allocation decision involves the following steps:

1. Calculate the contribution margin per unit of the scarce resource from each product.
2. Rank the products in the order of decreasing contribution margin per unit of scarce resource.
3. Estimate the number of units of each product which can be sold.
4. Allocate scarce resource first to the product with highest contribution margin per unit of scarce resource, then to
the product with next highest contribution margin per unit of scarce resource.

A scarce resource decision can be better explained using an example.

Example
A company has 4,000 machine hours of plant capacity per month which are to be allocated to products A
and B. The following per unit figures relate to the products:

Product A B Assuming that the company can sell all its output,
Sale Price 300 240 determine how many machine hours shall be allocated
Costs: to each product.
Direct Material 100 70
Direct Labor 65 50
Variable Overhead 20 40
Fixed Overhead 15 30
Variable Operating Expenses 40 20
Total Costs 240 210
Net Income 60 30
Machine Hours Required 1.5 1.00

Solution

Product A B
Sale Price 300 240
− Variable Cost 225 180
CM Per Unit 75 60
÷ Machine Hours Required 1.50 1.00
CM Per Machine Hour 50 60
Since the company can sell all its output, the best decision is to allocate all machine hours (i.e. scarce resource) to
product B.
 Decision Making and Relevant Information

Five-Step Decision Process

Relevant costs and relevant revenues are

expected future costs and revenues that
differ among alternative courses of
action.

Historical
costs:

Differential income
Sunk costs: Differential costs

Quantitative and Qualitative Relevant Information

One-Time-Only Special Order Example

The Bismark Co. manufacturing plant has a production capacity of 44,000 towels each month. Current
monthly production is 30,000 towels. Costs can be classified as either variable or fixed with respect to units
of output.

Total fixed direct manufacturing labor is

P45,000.

Total fixed overhead is P105,000.

Marketing costs per unit are P7 (P5 of

which is variable).

 What is the full cost per towel?

Variable (P8.50 + P5.00): P13.50
Fixed: 7.00
Total P20.50
 A hotel in San Juan has offered to buy 5,000 towels from Bismark Co. at P11.50/towel for a total of
P57,500. No marketing costs will be incurred.
 What are the relevant costs of making the towels
P8.50 × 5,000 = P42,500 incremental costs
 What are the incremental revenues ?
P57,500 – P42,500 = P15,000

Two Potential Problems in Relevant-Cost Analysis

1. Incorrect general assumptions: All variable costs are relevant. All fixed costs are irrelevant.
2. Misleading unit-cost data: Include irrelevant costs. Use same unit costs at different output levels.

Outsourcing versus Insourcing

 Outsourcing is purchasing goods and services from outside vendors.

 Insourcing is producing goods or providing services within the organization.

Make-or-Buy Decisions Example

Bismark Co. also manufactures bath accessories. Management is considering producing a part it needs (#2)
or buying a part produced by Towson Co. for P0.55. Bismark Co. has the following costs for 150,000 units
of Part #2:

Direct materials P28,000

Direct labor 18,500

Mixed overhead 29,000

Variable overhead 15,000

Fixed overhead 30,000

Total P120,500

Mixed overhead consists of material handling and setup costs. Bismark Co. produces the 150,000 units in
100 batches of 1,500 units each. Total material handling and setup costs equal fixed costs of P9,000 plus
variable costs of P200 per batch.

 What is the cost per unit for Part #2?

P120,500 ÷ 150,000 units = P0.8033/unit
 Should Bismark Co. manufacture the part or buy it from Towson Co.?

Bismark Co. anticipates that next year the 150,000 units of Part #2 expected to be sold will be
manufactured in 150 batches of 1,000 units each. Variable costs per batch are expected to decrease to
P100. Bismark Co. plans to continue to produce 150,000 next year at the same variable manufacturing
costs per unit as this year. Fixed costs are expected to remain the same as this year.
 What is the variable manufacturing cost per unit?
Direct material P28,000
Direct labor 18,500
Variable overhead 15,000
Total P61,500
P61,500 ÷ 150,000 = P0.41 per unit
 Expected relevant cost to make Part #2:
Manufacturing P61,500
Material handling and setups 15,000*
Total relevant cost to make P76,500
*150 × $100 = P15,000
Cost to buy: (150,000 × P0.55) P82,500
Bismark Co. will save P6,000 by making the part.
 Now assume that the P9,000 in fixed clerical salaries to support material handling and setup will not be
incurred if Part #2 is purchased from Towson Co.. Should Bismark Co. buy the part or make the part?
Relevant cost to make:
Variable P76,500
Fixed 9,000
Total P85,500

Cost to buy: P82,500

Bismark would save P3,000 by buying the part.

Opportunity Costs, Outsourcing, and Constraints

Assume that if Bismark buys the part from Towson, it can use the facilities previously used to manufacture
Part #2 to produce Part #3 for Krysta Company. The expected additional future operating income is
P18,000.

 What should Bismark Co. do?

Bismark Co. has three options regarding Krysta:

1. Make Part #2 and do not make Part #3.
2. Buy Part #2 and do not make Part #3.
3. Buy the part and use the facilities to produce Part #3.

Expected cost of obtaining 150,000 parts:

Buy Part #2 and do not make Part #3: P82,500

Buy Part #2 and make Part #3:
P82,500 – P18,000 = P64,500
Make Part #2: P76,500

Opportunity cost is the contribution to income that is forgone (rejected) by not using a

limited resource in its next-best alternative use.

 Assume that annual estimated Part #2 requirements for next year is 150,000. Cost per purchase order is
P40. Cost per unit when each purchase is 1,500 units = P0.55. Cost per unit when each purchase is equal
to or greater than 150,000 = P0.54.

Average investment in inventory is either:

(1,500 × .55) ÷ 2 = P412.50 or (150,000 × P0.54) = P40,500

Annual interest rate for investment in government bonds is 6%.

P412.50 × .06 = P24.75

P40,500 × .06 = P2,430

Option A: Make 100 purchases of 1,500 units:

Purchase order costs: (100 × P40) P4,000.00

Purchase costs: (150,000 × P0.55) P82,500.00

 Annual interest income:P 24.75

Relevant costs: P86,524.75

Option B: Make 1 purchase of 150,000 units:

Purchase order costs: (1 × P40) P 40

Purchase costs: (150,000 × P0.54) P81,000

Annual interest income:P 2,430

Relevant costs: P83,470

Product-Mix Decisions Under Capacity Constraints

One unit of Prod. #2 requires 7 machine-hours.

One unit of Prod. #3 requires 2 machine-hours.

What is the contribution of each product per machine-

hour?

Product #2: P1.70 ÷ 7 = P0.24

Product #3: P0.60 ÷ 2 = P0.30

Profitability, Activity-Based Costing, and Relevant Costs

Mountain View Furniture supplies furniture to two local retailers – Stevens and Cohen. The company has a
monthly capacity of 3,000 machine-hours. Fixed costs are allocated on the basis of revenues.

  Should Mountain View Furniture drop the Cohen business, assuming that dropping Cohen would
decrease its total fixed costs by 10%?
New fixed costs would be: P150,000 – P15,000 = P135,000

Cohen’s business is providing a contribution margin of P40,000.

P40,000 decrease in contribution margin

– P15,000 decrease in fixed costs

= P25,000 decrease in operating income.

 Assume that if Mountain View Furniture drops Cohen’s business it can lease the excess capacity to the
Perez Corporation for P70,000. Fixed costs would not decrease. Should Mountain View Furniture lease to
Perez?
 Equipment-Replacement Decisions
Example
Ignoring the time value of money and
income taxes, should the company
replace the existing machine?
The cost savings over a 4-year period will
be P36,000 × 4 = P144,000.
Investment = P105,000 – P14,000 =
P91,000

P144,000 – P91,000 = P53,000

advantage of the replacement machine.

Decisions and Performance Evaluation

 What is the journal entry to sell the existing machine?

Cash 14000

Accumulated Depreciation 50000

Loss on Disposal 16000

Machine 80000

 In the real world would the manager replace the machine?

An important factor in replacement decisions is the manager’s perceptions of whether the decision model
is consistent with how the manager’s performance is judged.

Top management faces a challenge – that is, making sure that the performance-evaluation model of
subordinate managers is consistent with the decision model.
 WEEK 4- MODULE 4: APPLICATION OF COST INFORMATION PART II
I. SHORT-TERM BUDGETING
Master Budgeting
Master Budget
A master budget is a set of interconnected budgets of sales, production costs, purchases, incomes, etc. and it also
includes pro forma financial statements. A budget is a plan of future financial transactions. A master budget serves
as planning and control tool to the management since they can plan the business activities during the period on the
basis of master budget. At the end of each period, actual results can be compared with the master budget and
necessary control actions can be taken.

Components of Master Budget

Master budget has two major sections which are the operational budget and the financial budget. They have
following components:

Operational Budget

1. Sales Budget
2. Production Budget
3. Direct Material Purchases Budget
4. Direct Labor Budget
5. Overhead Budget
6. Selling and Administrative Expenses Budget
7. Cost of Goods Manufactured Budget

Financial Budget

1. Schedule of Expected Cash Receipts from Customers

2. Schedule of Expected Cash Payments to Suppliers
3. Cash Budget
4. Budgeted Income Statement
5. Budgeted Balance Sheet

A. Flexible Budget
Flexible budget is budget typically in the form of an income statement that is adjustable to any level of activity such
as units produced or units sold. In a simple flexible budget, fixed costs stay constant whereas variable and semi-
variable costs change according to a standard predetermined at the beginning of an accounting period. Variable
costs may be represented as percentages of some base figure such as number of units or revenue.
When a flexible budget is adjusted to actual activity level, we call it a flexed budget. It is the budget which would
have been prepared at the beginning of the period, had the management known the exact actual output. Any
comparison between actual results and a flexed budget is more meaningful than a comparison with static budget
especially if the actual activity level deviates significantly from the budgeted activity level. This makes a flexible
budget a powerful performance evaluation tool.

Flexible budget variances may be used to determine any shortcomings in actual performance during a given period.
Flexible budget variances are simply the differences between line items on actual financial statements with those
on flexed budgets. Since the actual activity level is not available before the accounting periods closes, flexed
budgets can only be prepared at the end of the period.

Flexible budget may also be useful in planning stage at the beginning of the accounting period. When flexible
budgets are adjusted to a series of possible activity levels, the resulting data helps anticipate the effect of changes
in activity levels on revenues and costs thus allowing management to make useful adjustments to plans.

Example
Following is the static budget and actual results of Yoga Inc. for the month of April 20X4.
Actual Static
The management is pleased with the income higher than
Units 40,000 30,000 budgeted. However they understands that significant
Revenue 236,000 180,000 increase in units sold renders the comparison of actual
Variable Costs: results and the static budget unfair. You are required to
prepare a flexible budget at actual level of output and
Material 76,000 60,000
calculate flexible budget variances.
Labor 63,200 45,000
Factory Overhead 34,000 24,000
Contribution Margin 62,800 51,000
Fixed Cots:
Factory Overhead 12,880 12,000
Office Expenses 22,000 20,000
Operating Income 27,920 19,000

B. Sales Budget
Sales budget is the first and basic component of master budget and it shows the expected number of sales units of a
period and the expected price per unit. It also shows total sales which are simply the product of expected sales units
and expected price per unit.

Sales Budget influences many of the other components of master budget either directly or indirectly. This is due to
the reason that the total sales figure provided by sales budget is used as a base figure in other component budgets.
For example the schedule of receipts from customers, the production budget, pro forma income statement, etc.

Due to the fact that many components of master budget rely on sales budget, the estimated sales volume and price
must be forecasted with sufficient care and only reliable forecast techniques should be employed. Otherwise the
master budget will be rendered ineffective for planning and control.

Format and Example

Where the price per unit is expected to remain constant during the period for all units in sales, the sales budget
format will be simple as shown below.

Company A
Sales Budget
For the Year Ending December 30, 2010
 
  Quarter  
   1 2 3 4 Year
Sales Units 1,320 954 1,103 1,766 5,143
× Price per Unit P91 P92 P97 P112  
Total Sales P120,120 P87,768 P106,991 P197,792 P512,671
However if a business sells more than one product having different prices or the price per unit is expected to change
during the period, its sales budget will be detailed.

C. Schedule of Expected Cash Collections

Schedule of expected cash collections from customers shows the budgeted cash collections on sales during a
period. It is a component of master budget and it is prepared after the preparation of sales budget and before the
preparation of cash budget.

The calculation of expected cash collections is based on the total sales figure obtained from sales budget. The
management estimates the proportion in which sales are expected to be collected in the current and following
periods. This is used to determine how much sales are expected to be collected during a period.

Format and Example

The master budget of Company A continues here with the preparation of schedule of expected cash collections.
The sales figures are obtained from the sales budget of the company. 70% of sales are expected to be collected in
the quarter in which sales are made and the rest are expected to be collected in the next period. Bad debts are
negligible.

a) Q1 Sales = P120,120

    Collections in Q1 = P120,120 × 70% = P84,084;    Collections in Q2 = P120,120 × 30% = P36,036

b) Q2 Sales = P87,768

    Collections in Q2 = P87,768 × 70% = P61,438;      Collections in Q3 = P87,768 × 30% = P26,330

c) Q3 Sales = P106,991

    Collections in Q3 = P106,991 × 70% = P74,894;    Collections in Q4 = P106,991 × 30% = P32,097

d) Q4 Sales = P197,792

    Collections in Q4 = P197,792 × 70% = P138,454

Company A
Schedule of Expected Cash Collections
For the Year Ending December 30, 2010

Quarter
1 2 3 4 Year
Beginning AR P62,130       P62,130
Quarter 1 Sales (a) 84,084 P36,036     120,120
Quarter 2 Sales (b)   61,438 P26,330   87,768
Quarter 3 Sales (c)     74,894 P32,097 106,991
Quarter 4 Sales (d)       138,454 138,454
P515,463
Total Collections P146,214 P97,474 P101,224 P170,551
 D. Production Budget
Production budget is a schedule showing planned production in units which must be made by a manufacturer
during a specific period to meet the expected demand for sales and the planned finished goods inventory. The
required production is determined by subtracting the beginning finished goods inventory from the sum of expected
sales and planned ending inventory of the period. Thus:

Planned Produciton in Units

= Expected Sales in Units
+ Planned Ending Inventory in Units
− Begining Inventory in Units

Production budget is prepared after sales budget since it needs the expected sales units figure which is provided by
the sales budget. It is important to note that only a manufacturing business needs to prepare the production
budget.

Format and Example

The following example illustrates the production budget format. The expected sales units are obtained from the
sales budget of Company A. The planned ending units of 1st, 2nd and 3rd period are the beginning units in 2nd, 3rd
and 4th period respectively.

Company A
Production Budget
For the Year Ending December 30, 2010
 
  Quarter  
  1 2 3 4 Year
1,10 5,14
Budgeted Sales Units 1,320 954 1,766
3 3
+ Planned Ending Units 210 168 213 225 225
− Beginning Units −196 −210 −168 −213 −196
1,14 5,17
Planned Production in Units 1,334 912 1,778
8 2

E. Direct Material Purchases Budget

Direct material purchases budget shows budgeted beginning and ending direct material inventory, the quantity of
direct material that will be used in production, the amount of direct material that must be purchased and its cost
during a specific period. Direct material purchases budget is a component of master budget and it is based on the
following formula:

Budgeted Direct Material Purchases in Units

= Budgeted Beginning Direct Material in Units
+ Direct Material in Units Needed for Production
− Budgeted Ending Direct Material in Units

In the above formula, the direct material in units that is needed for production is calculated as follows:

Budgeted Production During the Period

× Units of Direct Material Required per Unit
= Direct Material in Units Needed for Production

Since the budgeted production figure is provided by the production budget, the direct material purchases budget
can be prepared only after the preparation of production budget.
The following
example shows the
format of a simple
direct material
Format and Example
Company A

Direct Material Purchases Budget

For the Year Ending December 30, 2010

Quarter
1 2 3 4 Year
Budgeted Production in Units 1,334 912 1,148 1,778 5,172
× DM Required per Unit (lb.) 4.00 4.00 4.00 4.00 4.00
DM Required of Production (lb.) 5,336 3,648 4,592 7,112 20,688
+ Budgeted Ending DM (lb.) 547 689 1,068 961 961
− Beginning Direct Material (lb.) −800 −547 −689 −1,068 −800
Budgeted DM Purchases (lb.) 5,083 3,790 4,971 7,005 20,849
Cost per Pound P3.10 P3.20 P3.50 P4.00  
Budgeted DM Purchases in $ P15,757 P12,128 P17,398 P28,020 P73,304
F. schedule of Expected Cash Payments
Schedule of expected cash payments to suppliers shows the budgeted cash payments on purchases during a period.
The schedule of expected cash payments is a component of master budget and it is prepared after direct material
purchases budget but before cash budget.

The expected cash collections during a period is calculated on the basis of total purchases figure, that is obtained
from direct material purchases budget, and on the percentage / proportion in which purchases are to be paid for in
the current and following periods.

Format and Example

The following example shows the format of schedule of expected cash payments to suppliers. The purchases figures
are obtained from the direct material purchases budget of company A. The company expects to pay 80% of the
purchases in the period of purchase and 20% in following period.

a) Q1 Purchases = P15,757

    Payments in Q1 = P15,757 × 80% = P12,606;    Payments in Q2 = P15,757 × 20% = P3,151

b) Q2 Purchases = P12,128

    Payments in Q2 = P12,128 × 80% = P9,702;      Payments in Q3 = P12,128 × 20% = P2,426

c) Q3 Purchases = P17,398

    Payments in Q3 = P17,398 × 80% = P13,918;    Payments in Q4 = P17,398 × 20% = P3,480

d) Q4 Purchases = P28,060

    Payments in Q4 = P28,060 × 80% = P22,448

Company A
Schedule of Expected Cash Payments
For the Year Ending December 30, 2010

  Quarter  
  1 2 3 4 Year
 Beginning AP P2,350       P2,350
Quarter 1 Purchases (a) 12,606 P3,151     15,757
Quarter 2 Purchases (b)   9,702 P2,426   12,128
Quarter 3 Purchases (c)     13,918 P3,480 17,398
Quarter 4 Purchases (d)       22,448 22,448
P70,081
Total Expected Payments P14,956 P12,853 P16,344 P25,928

G. Direct Labor Budget

Direct labor budget shows the total direct labor cost and number of direct labor hours needed for production. It
helps the management to plan its labor force requirements. Direct labor budget is a component of master budget.
It is prepared after the preparation of production budget because the budgeted production in units figure provided
by the production budget serves as starting point in direct labor budget.

Following are the calculations involved in the direct labor budget:

Planned Production in units

× Direct Labor Hours Required per Unit
= Budgeted Direct Labor Hours Required
× Cost per Direct Labor Hours
= Budgeted Direct Labor Cost

Format and Example

Following is an example showing a simple direct labor budget format. The planned production figures are obtained
from the production budget of Company A.

Company A
Direct Material Purchases Budget
For the Year Ending December 30, 2010

  Quarter
  1 2 3 4 Year
Planned Production in Units 1,334 912 1,148 1,778 5,172
× Direct Labor Hours per Unit 3.5 3.5 3.5 3.5 3.5
Budgeted Direct Labor Hours 4,669 3,192 4,018 6,223 18,102
× Cost per Direct Labor Hour P4 P5 P5 P5  
Budgeted Direct Labor Cost P18,676 P15,960 P20,090 P31,115 P85,841

H. Factory Overhead Budget

The factory overhead budget shows all the planned manufacturing costs which are needed to produce the
budgeted production level of a period, other than direct costs which are already covered under direct material
budget and direct labor budget. The overhead budget is an operational budget contained in the master budget of a
business. It has two sections, one for variable overhead costs and other for fixed overhead costs.

Total variable overhead may be calculated as the product of estimated variable cost per unit (also called variable
overhead rate) and the budgeted production units (obtained from production budget). However most businesses
will prefer to prepare a detailed overhead budget showing individual variable costs such as electricity, fuel, supplies
etc.. The fixed overhead costs are calculated as the sum of individual fixed overhead costs for example rent,
depreciation, etc. which are planned for the period.

It is also useful to calculate the expected cash disbursements for factory overhead costs at the end of overhead
budget.

Format and Example

The following example illustrates the format of a simple overhead budget. The variable overhead per unit of
Company A during the first, second, third and fourth quarter is estimated to be P12, P15, P16 and P19 respectively.
The production units figures are obtained from the production budget of the company. The company expects to
incur monthly depreciation of P3,000 and monthly rent of P2,500. There are no other fixed costs.

Company A

Factory Overhead Budget

For the Year Ending December 30, 2010

  Quarter
  1 2 3 4 Year

Variable Factory Overhead:

Budgeted Production Units 1,334 912 1,148 1,778 5,172

× Variable Overhead Rate P12 P15 P16 P19  

Total Variable Overhead P16,008 P13,680 P18,368 P33,782 P81,838

Fixed Factory Overhead:

Depreciation 9,000 9,000 9,000 9,000 36,000

Rent 7,500 7,500 7,500 7,500 30,000

Total Fixed Overhead P16,500 P16,500 P16,500 P16,500 P66,000

Total Factory Overhead P32,508 P30,180 P34,868 P50,282 P147,838

− Depreciation 9,000 9,000 9,000 9,000 36,000

Cash Disbursements for FOH P23,508 P21,180 P25,868 P41,282 P111,838

 I. Selling and Administrative Expense Budget
Selling and administrative expense budget is a schedule of planned operating expenses other than manufacturing
costs. It is a component of master budget and it is prepared by all types of businesses (i.e. manufacturers, retailers
and service providers) before the preparation of budgeted income statement. Usually it is divided in two sections:
the selling expenses and the administrative expenses.

Both selling expenses and administrative expense may be fixed or variable (see cost behaviour). For example sales
commission and freight cost on sales are variable selling expenses where as sales salaries are fixed selling expenses.
Similarly depreciation and rent on office building are fixed administrative expenses whereas office supplies and
utilities expense are variable administrative expenses.

Different variable selling and administrative expenses vary with different types activities. For example sales
commission vary with number of units sold, entertainment expenses with number of employees in the organization
etc., therefore an accurate selling and administrative expenses budget can be made by using activity based costing.

Format and Example

The following example illustrates the format of a typical selling and administrative expense budget:

J. Cost of Goods Manufactured Budget

Cost of goods manufactured budget is an operational component of master budget. It is prepared to calculate the
manufacturing costs that are expected to be incurred on budgeted finished goods. The cost of goods manufactured
budget is based on direct material purchases budget, direct labor cost budget and factory overhead budget.

The figures from direct labor budget and overhead budget are directly used in the preparation of cost of goods
manufactured budget but the direct material purchase cost needs to be adjusted as shown below:

Direct Material Purchases

+ Direct Material Beginning Inventory
− Direct Material Ending Inventory
= Cost of Direct Material Used in Production

The next step is to calculate the budgeted cost of goods manufactured as follows:

Cost of Direct Material used in Production

+ Direct Labor Cost
+ Factory Overhead Cost
= Manufacturing Cost
+ Beginning Work in Process
− Ending Work in Process
= Cost of Goods Manufactured

Format and Example

The format of cost of goods manufactured budget is shown in the following example. For the sake simplicity, we
have assumed zero work in process at the beginning and at the end of the periods.

Company A
Cost of Goods Manufactured Budget
For the Year Ending December 30, 2010

  Quarter  
  1 2 3 4 Year
Direct Material Purchases P15,757 P12,128 P17,398 P28,020 P73,304
Beginning Direct Material 2,400 1,696 2,205 3,738 2,400
Ending Direct Material −1,696 −2,205 −3,738 −3,844 −3,844
Direct Material Cost P16,461 P11,619 P15,865 P27,914 P71,860
Direct Labor Cost 18,676 15,960 20,090 31,115 85,841
Manufacturing Overhead 23,508 21,180 25,868 41,282 111,838
Total Manufacturing Costs P58,645 P48,759 P61,823 P100,311 P269,539
Beginning Work in Process 0 0 0 0 0
Ending Work in Process −0 −0 −0 −0 −0
Budgeted Cost of Goods
P58,645 P48,759 P61,823 P100,311 P269,539
Manufactured

K. Cash Budget
Cash budget is a financial budget prepared to calculate the budgeted cash inflows and outflows during a period and
the budgeted cash balance at the end of the period. Cash budget helps the managers to determine any excessive
idle cash or cash shortage that is expected during the period. Such information helps the managers to plan
accordingly. For example if any cash shortage in expected in future, the managers plan to change the credit policy
or to borrow money and if excessive idle cash is expected, they plan to invest it or to use it for the repayment of
loan.

All businesses need to maintain a safe level of cash to enable them to carry on business activities. The managers of
a business need to determine that safe level. The cash budget is then prepared by taking into consideration, that
safe level of cash. Thus, if a cash shortage is expected during a period, a plan is made to borrow cash.

Cash budget is a component of master budget and it is based on the following components of master budget:

Schedule of expected cash collections

Schedule of expected cash payments
Selling and administrative expense budget

Format and Example

The following example illustrates the format of cash budget. Company A maintains a minimum cash balance of
$5,000. In case of a deficiency, loan is obtained at 8% annual interest rate on the first day of the period.

Company A
Cash Budget
For the Year Ending December 30, 2010
   Quarter  
  1 2 3 4 Year
Beginning Cash Balance P5,200 P5,000 P5,000 P11,740 P5,200
Add: Budgeted Cash Receipts: 37,150 54,190 53,730 62,300 207,370
Total Cash Available for Use P42,350 P59,190 P58,730 P74,040 P212,570
Less: Cash Disbursements          
Direct Material 14,960 16,550 16,810 19,410 67,730
Direct Labor 8,830 9,610 9,750 11,900 40,090
Factory Overhead 10,020 10,400 11,000 11,780 43,200
Selling and Admin. Expenses 7,640 8,360 8,500 9,610 34,110
Equipment Purchases   6,000   14,000 20,000
Total Disbursements P41,450 P50,920 P46,060 P66,700 P205,130
Cash Surplus/(Deficit) P900 P8,270 P12,670 P7,340 P7,440
Financing:          
Borrowing 4,100       4,000
Repayments   −3,188 −912   −4,000
Interest   −82 −18   −100
Net Cash from Financing P4,100 −P3,270 −P930   −100
P7,340
Budgeted Ending Cash Balance P5,000 P5,000 P11,740 P7,340

Master Budget and Responsibility Accounting

Budgeting Cycle

1. Performance planning

2. Providing a frame of reference

3. Investigating variations

4. Corrective action

5. Planning again

What are the Advantages of Budgets?

1. Compels strategic planning

2. Provides a framework for judging performance

3. Motivates employees and managers

4. Promotes coordination and communication

Strategy, Planning, and Budgets

Strategy Analysis

 Long-run Planning - Long-run Budgets

 Short-run Planning - Short-run Budgets

Time Coverage of Budgets

 Budgets typically have a set time period (month, quarter, year).

 This time period can itself be broken into subperiods.

 The most frequently used budget period is one year.

 Businesses are increasingly using rolling budgets.

Operating Budget Example

Hawaii Diving expects 1,100 units to be sold during the month of August 2004. Selling price is expected
to be P240 per unit.
 How much are budgeted revenues for the month?
1,100 × P240 = P264,000

Two pounds of direct materials are budgeted per unit at a cost of P2.00 per pound, P4.00 per unit.
Three direct labor-hours are budgeted per unit at P7.00 per hour, P21.00 per unit.
Variable overhead is budgeted at P8.00 per direct labor-hour, P24.00 per unit.
Fixed overhead is budgeted at P5,400 per month.
Variable nonmanufacturing costs are expected to be P0.14 per revenue dollar.
Fixed nonmanufacturing costs are P7,800 per month.

Production Budget Example

Budgeted sales (units)

+ Target ending finished goods inventory (units)
- Beginning finished goods inventory (units)
= Budgeted production (units)

Assume that target ending finished goods

inventory is 80 units. Beginning finished goods
inventory is 100 units. How many units need to
be produced?
Direct Materials Usage Budget
Each finished unit requires 2 pounds of direct materials at a cost of P2.00 per pound. Desired ending
inventory equals 15% of the materials required to produce next month’s sales. September sales are
forecasted to be 1,600 units.
 What is the ending inventory in August? 480 pounds
September sales: 1,600 × 2 pounds per unit = 3,200 pounds
3,200 × 15% = 480 pounds (the desired ending inventory)
 What is the beginning inventory in August?
1,100 units × 2 × 15% = 330 units
 How many pounds are needed to produce 1,080 units in August?
1,080 × 2 = 2,160 pounds

Material Purchases Budget

Direct Manufacturing Labor Budget

Each unit requires 3 direct labor-hours at P7.00 per hour.

Hawaii Diving Direct Labor Budget for the Month of August 2004
Units produced: 1,080
Direct labor-hours/unit 3
Total direct labor-hours: 3,240
Total budget @ P7.00/hour: P22,680

Manufacturing Overhead Budget

Variable overhead is budgeted at P8.00 per

direct labor-hour. Fixed overhead is budgeted at
P5,400 per month.

Ending Inventory Budget

  What is the cost of the target ending inventory for materials?
480 × P2 = P960
 What is the cost of the target finished goods inventory?
80 × P54 = P4,320
Cost of Goods Sold Budget

Assume that the beginning finished goods inventory is P5,400. Ending finished
goods inventory is P4,320.
 What is the cost of goods sold? Nonmanufacturing Costs Budget
Beginning finished goods inventory P 5,400
+ Cost of goods manufactured P58,320
= Goods available for sale P63,720
– Ending finished goods inventory P 4,320
= Cost of goods sold P59,400

Budgeted Statement of Income

Hawaii Diving has budgeted sales of P264,000 for the month of August. Cost of
goods sold are budgeted at P59,400.

Financial Planning Models

 Financial planning models are mathematical representations of the interrelationships among
operating activities, financial activities, and other factors that affect the master budget.

Software

Software packages are now readily available to reduce the computational burden and time
required to prepare budgets. These packages assist managers to do sensitivity analysis.
Sensitivity Analysis
Consider Hawaii Diving. What if some parameters in the budget model were to change? For
example, what if the selling price is expected to be P230 instead of P240?
 What are expected revenues?
1,100 × P230 = P253,000 instead of P264,000
 What if the materials cost is expected to increase to P2.50 per pound instead of P2.00. What is
the cost of goods sold?
1,100 × P55 = P60,500 instead of P59,400
 Why the increase?
Because materials cost per unit become P5.00 instead of P4.00.

Cash Budget
Hawaii Diving has the following collection pattern:
In the month of sale: 50%
In the month following sale: 27%
In the second month following sale: 20%
Uncollectible: 3%
Budgeted charge sales are as follows:
June P200,000
July P250,000
August P264,000
September P260,000
 What are the expected cash collections in August?

What is Kaizen?
The Japanese use the term “kaizen” for continuous
improvement.
 Kaizen budgeting is an approach that explicitly incorporates continuous improvement during the
budget period into the budget numbers.

It was previously estimated that it should take 3

labor-hours for Hawaii Diving to manufacture its
product.
A kaizen budgeting approach would incorporate
future improvements.

Activity-Based Budgeting
Activity-based costing reports and analyzes past and current costs.
Activity-based budgeting (ABB) focuses on the budgeted cost of activities necessary to produce
and sell products and services.

Total budgeted labor-hours are:

Product A: 880 × 3 2,640
Product B: 200 × 3 600
Total 3,240

 What is the allocation rate per labor-hour?

P25,920 ÷ 3,240 = P8.00

Total cost allocated to each product line:

Product A: P8.00 × 2,640 = P21,120
Product B: P8.00 × 600 = P4,800

 Under ABB, the number of setups is the cost driver.

P25,920 budgeted machine setup cost

÷ 10 budgeted machine setup-hours
= P2,592 allocation rate per machine setup-hour.
How much machine setup related costs are allocated to each product line?
Product A Product B
P2,592 × 5 P12,960
P2,592 × 5 P12,960

Setup-related cost per unit:

Product A: P12,960 ÷ 880 P14.73
Product B: P12,960 ÷ 200 P64.80

What is a Responsibility Center?

-It is any part, segment, or subunit of a business that needs control.
-Types of Responsibility Centers:
1. Cost center
2. Profit center
3. Investment center

What is Controllability?
It is the degree of influence that a specific manager has over costs, revenues,
or other items in question. In practice, controllability is difficult to pinpoint.

A controllable cost is any cost that is primarily subject to the influence of a given responsibility
center manager for a given time period.

Responsibility accounting focuses on information and knowledge, not control.

A responsibility accounting system could exclude all uncontrollable costs from

a manager’s performance report.

II. STANDARD COSTING

 Standard Costing and Variance Analysis
Standard costing is the establishment of cost standards for activities and their periodic analysis to determine the
reasons for any variances. Standard costing is a tool that helps management account in controlling costs.

For example, at the beginning of a year a company estimates that labor costs should be P2 per unit. Such standards
are established either by historical trend analysis of the cost or by an estimation by any engineer or management
scientist. After a period, say one month, the company compares the actual cost incurred per unit, say P2.05 to the
standard cost and determines whether it has succeeded in controlling cost or not.

This comparison of actual costs with standard costs is called variance analysis and it is vital for controlling costs and
identifying ways for improving efficiency and profitability. If actual cost exceeds the standard costs, it is an
unfavorable variance. On the other hand, if actual cost is less than the standard cost, it is a favorable variance.

Variance analysis is usually conducted for:

-Direct material costs (price and quantity variances);

-Direct labor costs (wage rate and efficiency variances); and
-Overhead costs.
-Analysis of variance in planned and actual sales and sales margin is also vital to ensure profitability.

A.Direct Material Price Variance

Direct material price variance (also called direct material spending/rate variance) is the difference between the
actual amount spent on direct material purchases during a given period, and the amount that would have been
spent, had the material been acquired at the standard price.
It may also be calculated as the product of:

 the actual quantity of direct material purchased, and

 the difference between the standard price and the actual price per unit of direct material.
Formula
As described in the definitions above, direct material price variance is calculated as follows:

Direct Material Price Variance

= Standard Price of Material Purchased − Actual Spending on Material
= AQ×SP − AQ×AP
= (SP − AP) × AQ

Where,
AQ is the actual quantity of direct material purchased;
SP is the standard unit price of direct material; and
AP is the actual price per unit of direct material;

Analysis
Direct material price variance is calculated to determine the efficiency of purchasing department in obtaining direct
material at low cost. If calculated by subtracting the actual spending from the standard as shown in the above
formulas, a positive value of direct material price variance is favorable, which means that the direct material was
purchased for lesser amount than the standard price. A negative value of direct material price variance is
unfavorable because it means that the price paid to purchase the material was higher than the target price.

However, a favorable direct material price variance is not always good; it should be analyzed in the context of
direct material quantity variance and other relevant factors. It is quite possible that the purchasing department
may purchase low quality raw material to generate a favorable direct material price variance. Such a favorable
material price variance will be offset by an unfavorable direct material quantity variance due to wastage of low
quality direct material.
 Example
Calculate the direct material price variance if the standard price and actual unit price per unit of direct
material are $4.00 and $4.10 respectively; and actual units of direct material used during the period are
1,200. Determine whether the variance is favorable or unfavorable.
Standard Price P 4.00
Since the price paid by the company for the purchase of direct
− Actual Price 4.10
material exceeds the standard price by P120, the direct
Difference Per Unit − 0.10 material price variance is unfavorable.
× Actual Quantity 1,200
Direct Material Price Variance − P 120  

As described in the definitions above, direct material price variance is calculated as follows:
Direct Material Price Variance
= Standard Price of Material Purchased − Actual Spending on Material
= AQ×SP − AQ×AP
= (SP − AP) × AQ

Where,
AQ is the actual quantity of direct material purchased;
SP is the standard unit price of direct material; and
AP is the actual price per unit of direct material;

B. Direct Material Quantity Variance

Direct material quantity variance (also called the direct material usage or efficiency variance) is the difference
between the standard cost of standard material allowed for actual production, and the standard cost of material
actually used in production.

This is the same as the product of:

 standard price of a unit of direct material; and

 the difference between standard quantity of direct material allowed and actual quantity of direct material used.

Material quantity variance may be further sub-divided into:

 Direct Material Mix Variance

 Direct Material Yield Variance

Formula
The formula to calculate direct material quantity variance is:
Direct Material Quantity Variance
= Standard Quantity at Standard Price – Actual Quantity at Standard Price
= SQ × SP – AQ × SP
= (SQ − AQ) × SP
Where,
SQ is the standard quantity allowed,
AQ is the actual quantity of direct material used, and
SP is the standard price per unit of direct material.

Analysis
Direct material quantity variance is calculated to determine the efficiency of the production department in
converting raw material to finished goods. In order to improve efficiency, wastage of raw material must be
reduced. A negative value of direct material quantity variance is generally unfavorable and it implies that more
quantity of direct material has been used in the production process than actually needed. A positive value of direct
material quantity variance is favorable implying that raw material was efficiently converted to finished goods.
 As is the case when analyzing other variances, the direct material price variance needs to be assessed in the context
of other relevant variances and factors, such as direct material price variance and direct labor variances. A highly
favorable direct material quantity variance may be at the expense of, for example, an unfavorable material price
variance (high quality expensive material has less chance of wastage) or an unfavorable labor rate variance i.e.
highly skilled workers who are paid more will waste less material in production. The management therefore needs
to assess performance while taking all these relevant factors into account.

Example
Use the following information to calculate direct material quantity variance. Also describe whether the variance is
favorable or unfavorable.

Standard Price of a Unit of Direct Material P4

Standard Quantity of Direct Material Per Unit 2
Actual Units Produced During the Period 620
Actual Quantity Used During the Period 1,200
Solution

Actual Units Produced 620 In this case, the production department

× Standard Quantity of Direct Material Per Unit 2 performed efficiently and saved 40 units of
Standard Quantity Allowed 1,240 direct material. Multiplying this by the
− Actual Quantity 1,200 standard price per unit yields a favorable
direct material quantity variance of P160.
Difference 40
× Standard Price of a Unit of Direct Material P4
Direct Material Quantity Variance P 160

C. Direct Material Mix Variance

Direct material mix variance is the difference between the standard cost if direct material had been used in
standard proportion, and the standard cost of direct material used in actual proportion. In other words, it
compares the standards costs of the material used, had it been mixed in the standard mix ratio preplanned and
the standard cost of the quantity that was actually used in actual proportion.

Direct material mix variance is the same as the product of:

 the standard price per unit of direct material,

 and the difference between standard mix quantity and actual quantity of direct material used.

Direct material mix variance is one of the two components of direct material quantity variance, the other
component being direct material yield variance.

Formula
The formula to calculate direct material mix variance is therefore:

Direct Material Mix Variance

= Standard Cost of Actual Usage in Standard Mix – Standard Cost of Actual Mix
= SM × SP – AQ × SP
= (SM − AQ) × SP

Where,
SM is the standard mix quantity of direct material,
AQ is the actual quantity of material used, and
SP is the standard price per unit of direct material used.
Standard mix quantity is the quantity of a particular direct material which, if mixed with one or more different
materials in a standard ratio, would have been consumed on the actual quantity of a product produced. Standard
mix quantity is calculated by multiplying standard mix percentage of a given material by the total actual quantity
of the material used. For example, if three materials A, B, and C are mixed in ratio 5:3:2 and actual quantity of
material used is 2.5 kg then,

Standard mix quantity of material A

= 2.5 × 5 / (5 + 3 + 2)
= 2.5 × 50%
= 1.25 kg

Analysis
Direct material mix ratio is relevant where production involves two or more different direct materials in the
production of a single product and it measures the effect of direct material being mixed in a different proportion
to what was initially planned. This may result in, either higher or lower costs depending on whether the
proportion of expensive materials used is higher or lower.

A positive value of direct material mix variance is generally favorable whereas a negative value is unfavorable. A
negative value may indicate, for example, that the production process was not carried out precisely or that the
quality for some ingredient material was not on par, resulting in wastage and making it hard to follow the planned
mix ratio. To best evaluate the direct material mix variance, we therefore need to study it in the context of these
relevant factors.

Example
A product T is produced by mixing three materials: P, Q and R in a standard mix ratio of 1:2:2. Actual materials
consumed during the month ended May 31, 20X2 were 4,670g, 8,450g and 8,390g respectively. Standard prices
are P0.04/g P0.03/g and P0.02/g per gram respectively. Calculate the direct material mix variance.

Solution
Total Actual Quantity
= 4,670 + 8,450 + 8,390g
= 21,510g

Material P's Standard Mix %

= 1 ÷ (1 + 2 + 2)
= 0.2

Material Q's Standard Mix %

= 2 ÷ (1 + 2 + 2)
= 0.4

Material R's Standard Mix %

= 2 ÷ (1 + 2 + 2)
= 0.4
Material P Q R
Total Actual Quantity (g) 21,510 21,510 21,510
× Standard Mix % 0.2 0.4 0.4
Standard Mix Quantity (g) 4,302 8,604 8,604
− Actual Quantity (g) 4,670 8,450 8,390
Difference (g) – 368 154 214
× Standard Price (P/g) 0.04 0.03 0.02
Individual Material Mix Variance (P) − 14.72 4.62 4.28
− 5.82
Total Direct Material Mix Variance (P)
 D. Direct Material Mix Variance
Direct material mix variance is the difference between the standard cost if direct material had been used in
standard proportion, and the standard cost of direct material used in actual proportion. In other words, it
compares the standards costs of the material used, had it been mixed in the standard mix ratio preplanned and
the standard cost of the quantity that was actually used in actual proportion.

Direct material mix variance is the same as the product of:

 the standard price per unit of direct material,

 and the difference between standard mix quantity and actual quantity of direct material used.

Direct material mix variance is one of the two components of direct material quantity variance, the other
component being direct material yield variance.

Formula
The formula to calculate direct material mix variance is therefore:

Direct Material Mix Variance

= Standard Cost of Actual Usage in Standard Mix – Standard Cost of Actual Mix
= SM × SP – AQ × SP
= (SM − AQ) × SP

Where,
SM is the standard mix quantity of direct material,
AQ is the actual quantity of material used, and
SP is the standard price per unit of direct material used.

Standard mix quantity is the quantity of a particular direct material which, if mixed with one or more different
materials in a standard ratio, would have been consumed on the actual quantity of a product produced.
Standard mix quantity is calculated by multiplying standard mix percentage of a given material by the total
actual quantity of the material used. For example, if three materials A, B, and C are mixed in ratio 5:3:2 and
actual quantity of material used is 2.5 kg then,

Standard mix quantity of material A

= 2.5 × 5 / (5 + 3 + 2)
= 2.5 × 50%
= 1.25 kg

Analysis
Direct material mix ratio is relevant where production involves two or more different direct materials in the
production of a single product and it measures the effect of direct material being mixed in a different
proportion to what was initially planned. This may result in, either higher or lower costs depending on whether
the proportion of expensive materials used is higher or lower.

A positive value of direct material mix variance is generally favorable whereas a negative value is unfavorable. A
negative value may indicate, for example, that the production process was not carried out precisely or that the
quality for some ingredient material was not on par, resulting in wastage and making it hard to follow the
planned mix ratio. To best evaluate the direct material mix variance, we therefore need to study it in the
context of these relevant factors.

Example
A product T is produced by mixing three materials: P, Q and R in a standard mix ratio of 1:2:2. Actual materials
consumed during the month ended May 31, 20X2 were 4,670g, 8,450g and 8,390g respectively. Standard prices
are P0.04/g P0.03/g and P0.02/g per gram respectively. Calculate the direct material mix variance.
Solution

Total Actual Quantity

= 4,670 + 8,450 + 8,390g
= 21,510g

Material P's Standard Mix %

= 1 ÷ (1 + 2 + 2)
= 0.2

Material Q's Standard Mix %

= 2 ÷ (1 + 2 + 2)
= 0.4

Material R's Standard Mix %

= 2 ÷ (1 + 2 + 2)
= 0.4

Material P Q R
Total Actual Quantity (g) 21,510 21,510 21,510
× Standard Mix % 0.2 0.4 0.4
Standard Mix Quantity (g) 4,302 8,604 8,604
− Actual Quantity (g) 4,670 8,450 8,390
Difference (g) – 368 154 214
× Standard Price (P/g) 0.04 0.03 0.02
Individual Material Mix Variance (P) − 14.72 4.62 4.28
Total Direct Material Mix Variance (P) − 5.82

E. Direct Labor Rate Variance

Direct labor rate variance (also called direct labor price or spending variance) is the difference between the
total cost of direct labor at standard cost (i.e. direct labor hours at standard rate) and the actual direct labor
cost.

This is the same as the product of:

the actual direct labor hours, and

the difference between the standard direct labor rate and actual direct labor rate.
Direct labor rate variance is very similar in concept to direct material price variance.

Formula
As described in the definition, the formula to calculate direct labor rate variance is:

Direct Labor Rate Variance

= Actual Direct Labor Hours at Standard Cost – Actual Direct Labor Cost
= AH × SR – AH × AR
= (SR − AR) × AH

Where,
SR is the standard direct labor rate
AR is the actual direct labor rate
AH are the actual direct labor hours
Analysis
Direct labor rate variance determines the performance of human resource department in negotiating lower
wage rates with employees and labor unions. A positive value of direct labor rate variance is achieved when
standard direct labor rate exceeds actual direct labor rate. Thus positive values of direct labor rate variance as
calculated above, are favorable and negative values are unfavorable.

However, a positive value of direct labor rate variance may not always be good. When low skilled workers are
recruited at a lower wage rate, the direct labor rate variance will be favorable however, such workers will likely
be inefficient and will generate a poor direct labor efficiency variance. Direct labor rate variance must be
analyzed in combination with direct labor efficiency variance.

Example
Calculate the direct labor rate variance if standard direct labor rate and actual direct labor rate are P18.00 and
P17.20 respectively; and actual direct labor hours used during the period are 130. Is the variance favorable or
unfavorable?

Solution

Standard Rate P 18.00 Since the actual labor rate is lower than the standard rate,
− Actual Rate 17.20 the variance is positive and thus favorable.
Difference Per Hour 0.80
× Actual Hours 130
Direct Labor Rate Variance P104

F. Direct Labor Efficiency Variance

Direct labor efficiency variance (also called direct labor usage variance) is the difference between the standard
cost of standard direct labor hours allowed for actual production, and the standard cost of labor hours actually
used in production.
This is the same as the product of:
the standard direct labor rate, and
the difference between the standard direct labor hours allowed and actual direct labor hours used.
The direct labor efficiency variance is similar in concept to direct material quantity variance.
Formula
The following formula is used to calculate direct labor efficiency variance:

Direct Labor Efficiency Variance

= Standard Hours at Standard Rate – Actual Hours at Standard Rate
= SH × SR − AH × SR
= (SH − AH) × SR

Where,
SH are the standard direct labor hours allowed,
AH are the actual direct labor hours used, and
SR is the standard direct labor rate per hour.

The standard direct labor hours allowed (SH) in the above formula is the product of standard direct labor hours
per unit and number of finished units actually produced.

Analysis
The purpose of calculating the direct labor efficiency variance is to measure the performance of the production
department in utilizing the abilities of the workers. A positive value of direct labor efficiency variance is
obtained when the standard direct labor hours allowed exceeds the actual direct labor hours used. Thus a
positive value is favorable. A negative value of direct labor efficiency variance means that excess direct labor
hours have been used in production, implying that the labor-force has under-performed.
It is necessary to analyze direct labor efficiency variance in the context of relevant factors, for example, direct
labor rate variance and direct material price variance. It is quite possible that unfavorable direct labor efficiency
variance is simply the result of, for example, low quality material being procured or low skilled workers being
hired. In case of low quality direct material, the direct material price variance will likely be favorable and in the
later case, the direct labor rate variance will probably be favorable; both at the expense of direct labor
efficiency variance.

Example
Use the following information to calculate direct labor efficiency variance. State whether the variance is
favorable or unfavorable.

Standard Rate Per Hour of Direct Labor P18

Standard Direct Labor Hours Required Per Unit 0.2
Actual Units Produced During the Period 620
Actual Direct Labor Hours Used During the Period 130
Solution

Actual Units Produced 620 Since the direct labor efficiency variance
× Standard Direct Labor Hours Per Unit 0.2 is negative, it is unfavorable.
Standard Direct Labor Hours Allowed 124
− Actual Direct Labor Hours Used 130
Difference −6
× Standard Direct Labor Rate P 18
Direct Labor Efficiency Variance − P 108

G. Variable Overhead Spending Variance

Variable Overhead spending variance (also called variable overhead rate variance) is the product of actual units
of the allocation base of variable overhead and the difference between standard variable overhead rate and
actual variable overhead rate. The formula to calculate the variable overhead spending variance is:

VOH Spending Variance = ( SR − AR ) × AU

Where,
SR is the standard variable overhead rate
AR is the actual variable overhead rate
AU are the actual units of allocation base

The standard variable overhead rate is the same as variable overhead application rate. The allocation base is
usually the number of labor hours used. The above formula can also be stated alternatively as follows:

VOH Spending Variance = ( SR × AU ) − Actual Variable Overhead Cost

Analysis
A positive value of variable overhead rate is obtained when standard variable overhead application rate is more
than actual variable overhead rate whereas a negative value of variable overhead rate is obtained when actual
variable overhead rate exceeds standard variable overhead rate. Thus a positive value of variable overhead
spending variance is favorable and a negative value is unfavorable.

In case of a negative variable overhead spending variance, production department is usually responsible.

Example
Calculate variable overhead spending variance if actual labor hours used are 130, standard variable overhead
rate is P9.40 per direct labor hour and actual variable overhead rate is P8.30 per direct labor hour. Also specify
whether the variance is favorable or unfavorable.
 Solution

Standard Variable Overhead Rate P 9.40 The variable overhead variance

− Actual Variable Overhead Rate − 8.30 calculated above is favorable.
Difference Per Hour P 1.10
× Actual Labor Hours 130
Variable Overhead Spending Variance P143

H. Variable Overhead Efficiency Variance

Variable overhead efficiency variance is the product of standard variable overhead rate and the difference
between the standard units allowed of the variable overhead application base and actual units used of the
variable overhead application base. Assuming that variable overhead application base is direct labor hours, the
formula to calculate variable overhead efficiency variance will be:

VOH Efficiency Variance = ( SH − AH ) × SR

Where,
SH are standard direct labor hours allowed
AH are the actual direct labor hours
SR is the standard variable overhead rate

The standard direct labor hours allowed (SH) in the above formula is calculated by multiplying standard direct
labor hours per unit and actual units produced.

Analysis
As the name suggests, variable overhead efficiency variance measure the efficiency of production department
in converting inputs to outputs. Variable overhead efficiency variance is positive when standard hours allowed
exceed actual hours. Therefore a positive value is favorable implying that production process was carried out
efficiently with minimal loss of resources.

On the other hand when actual hours exceed standard hours allowed, the variance is negative and unfavorable
implying that production process was inefficient.

Example
Calculate the variable overhead efficiency variance using the following figures:

Number of Units Produced 620

Standard Direct Labor Hours Per Unit 0.2
Actual Direct Labor Hours Used 130
Standard Variable Overhead Rate P9.40
 
Solution
 
Actual Units Produced 620
× Standard Direct Labor Hours Per Unit 0.2
Standard Direct Labor Hours Allowed 124
 
Standard Hours Allowed 124
− Actual Hours Used 130
Difference −6
× Standard Variable Overhead Rate P9.4
Direct Labor Efficiency Variance − P56.4
The variance calculated above is negative and thus unfavorable.
 I. Fixed Overhead Volume Variance
Fixed overhead volume variance is the difference between fixed overhead applied to production for a given
accounting period and the total fixed overheads budgeted for the period.

Fixed overhead volume variance occurs when the actual production volume differs from the budgeted
production. In this way, it measures whether or not the fixed production resources have been efficiently
utilized.

While fixed overheads are supposed to be fixed, to facilitate timely reporting, the budgeted fixed overhead cost
needs to be applied to units produced at a standard rate. Because this standard application rate is based on
estimated production level, an increased or reduced actual production will respectively result in a higher or
lower total fixed overhead applied to production and thus it will differ from the total budgeted figure. This
difference is the fixed overhead volume variance.

Fixed overhead volume variance is one of the two components of total fixed overhead variance, the other
being fixed overhead budget variance. The fixed overhead volume variance itself may be sub-classified into:

FOH volume capacity variance

FOH volume efficiency variance

Formulas
Fixed overhead volume variance is calculated as follows:

Fixed Overhead Volume Variance

= Applied Fixed Overhead – Budgeted Fixed Overhead

Applied Fixed Overhead

= Overhead Application Rate × Standard Input Qty. Allowed for Actual Production

Whereas, the input quantity is a suitable basis used to apply fixed overheads to production. It may be a
measure such as labor hours, units of utilities consumed, machine hours used, units produced, etc. This is also
called an overhead application basis.

Overhead application rate is the standard fixed overhead cost per unit of input quantity and it is calculated
using the following formula:

Standard Fixed Overhead Rate

= Budgeted Fixed Overhead
         Budgeted Units

Analysis
Fixed overhead volume variance is favorable when the applied fixed overhead cost exceeds the budgeted
amount. This is because the units produced in such a case are more than the quantity expected from current
production capacity and this reflects efficient use of fixed resources.

The standard fixed overhead applied to units exceeding the budgeted quantity represent cost saved because
units were essentially produced at no additional fixed overhead. The result is a lower actual unit cost and
higher profitability than the budgeted figures.

An unfavorable fixed overhead volume variance occurs when the fixed overhead applied to good units
produced falls short of the total budged fixed overhead for the period. This is because of inefficient use of the
fixed production capacity.

When calculated using the formula above, a positive fixed overhead volume variance is favorable.
 Example
Calculate the fixed overhead volume variance using the following figures:

Budgeted Fixed Overheads P50,000

Budgeted Units 10,000 Applied Fixed Overhead
Actual Units Produced 10,700 = 10,700 × P5
Solution = P53,500

Fixed Overhead Volume Variance

FOH Application Rate
= P53,500 – P50,000
P50,000 = P3,500 Favorable
= = P5 per unit
10,000

J. Fixed Overhead Budget Variance

Fixed overhead budget variance (also known as FOH spending variance) is the difference between the total
fixed overhead as per the fixed overhead budget for a given accounting period and the total fixed overheads
actually incurred during the period.

In other words, FOH budget variance is the amount by which the total fixed overhead calculated as per the
fixed overhead application rate exceeds or falls short of the actual total fixed overhead cost incurred for the
period.

Even though fixed overheads are assumed to be fixed, their actual figure may differ from the amount estimated
at the start of the period and this difference is represented by fixed overhead variances which are FOH budget
variance and FOH volume variance.

Formula
Fixed Overhead Budget Variance
= Budgeted Fixed Overhead – Actual Total Fixed Overhead

In case of fixed overhead, the budgeted and flexible budget figures are exactly the same.

Analysis
Fixed overhead budget variance is favorable when actual fixed overhead incurred are less than the budgeted
amount and it is unfavorable when the actual fixed overheads exceed the budgeted amount.

Causes of fixed overhead budget variance include:

o budgeted fixed overhead being inaccurate

o unplanned expansion of production capacity resulting in step costs
o unexpected changes in prices

Fixed overhead budget variance is one of the two main components of total fixed overhead variance, the other
being fixed overhead volume variance.

Example
Steptech Inc. manufactures fitness monitoring products. It estimated its fixed manufacturing overheads for the
year 20X3 to be P37 million. The actual fixed overhead expenses for the year 20X3 were P40 million.

Fixed Overhead Budget Variance

= P37 million – P40 million
= P3 million (unfavorable)

The variance is unfavorable because the actual spending was higher than the budget.