Cost and Management Accounting 1&2

Understand the concept of cost and managerial Accounting

Cost and managerial accounting are two forms of accounting that are used for internal decision-
making by managers and business owners. They help to measure, analyze, and interpret the
financial performance and position of a company, as well as to plan and control its operations.

Cost accounting is a subset of managerial accounting that focuses on capturing and analyzing the
total cost of production by assessing the variable and fixed costs of each step of production, as
well as the direct and indirect costs of the products or services12. Cost accounting helps to
determine the optimal level of output, pricing, product mix, and profitability.

Managerial accounting is a broader term that encompasses cost accounting as well as other
techniques and methods that provide relevant and timely information to managers for planning,
directing, and controlling the activities of a company32. Managerial accounting techniques
include margin analysis, constraint analysis, capital budgeting, inventory valuation and product
costing, trend analysis and forecasting, and many others3. Managerial accounting helps to set
goals, evaluate performance, allocate resources, and make strategic decisions.

Understand the Objectives of Cost and Management Accounting; List the classifications of costs

The objectives of cost and management accounting are:

 To ascertain the cost of production and profitability of products or services by measuring and
analyzing the variable and fixed costs, direct and indirect costs, and other relevant costs 123.
 To determine the selling price of products or services by considering the cost of production,
market conditions, demand and supply factors, and profit margin 23.
 To control and reduce the costs by identifying and eliminating wasteful or inefficient activities,
processes, or resources, and by implementing standard costing, budgeting, variance analysis, and
other techniques123.
 To ascertain the profit or loss of each activity, department, or segment by comparing the actual
costs and revenues with the budgeted or standard costs and revenues 23.
 To assist management in decision-making by providing relevant and timely information for
planning, directing, and controlling the operations of the company, such as product mix, make or
buy, outsourcing, expansion, diversification, etc.425.

Some of the classifications of costs are:

1. Direct costs and indirect costs: Direct costs are costs that can be directly traced to a specific cost
object, such as a product or service. Indirect costs are costs that cannot be directly traced to a
specific cost object, but are incurred for the benefit of multiple cost objects 16.

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2. Fixed costs and variable costs: Fixed costs are costs that do not change with the level of output or
activity. Variable costs are costs that change proportionately with the level of output or activity16.
3. Operating costs and non-operating costs: Operating costs are costs that are incurred for the
normal operations of the company, such as raw materials, labor, rent, etc. Non-operating costs
are costs that are not related to the normal operations of the company, such as interest, taxes,
fines, etc.4
4. Product costs and period costs: Product costs are costs that are assigned to the products or
services that are sold by the company. They include direct materials, direct labor, and
manufacturing overhead. Period costs are costs that are expensed in the period in which they are
incurred. They include selling and administrative expenses 16.
5. Sunk costs and opportunity costs: Sunk costs are costs that have already been incurred and
cannot be recovered. Opportunity costs are costs that represent the potential benefit that is
foregone as a result of choosing one alternative over another

Apply different costing techniques in the real business practices

Different costing techniques are methods or approaches that are used to measure and analyze the
costs of production and profitability of products or services. Some of the common costing
techniques are:

 Standard costing: This technique involves setting predetermined or expected costs for each unit
of output or activity, and then comparing them with the actual costs to determine the variances or
deviations. Standard costing helps to monitor and control the costs, evaluate the performance,
and take corrective actions1.
 Activity-based costing: This technique involves allocating the indirect or overhead costs to
different activities or processes based on their consumption of resources. Activity-based costing
helps to identify the cost drivers, improve the accuracy of product costing, and eliminate the non-
value-added activities12.
 Marginal costing: This technique involves separating the fixed and variable costs, and then
calculating the contribution margin (sales revenue minus variable costs) for each unit of output
or activity. Marginal costing helps to determine the break-even point, the margin of safety, and
the optimal product mix13.
 Lean accounting: This technique involves applying the principles of lean manufacturing to
reduce waste, improve efficiency, and eliminate unnecessary accounting activities. Lean
accounting helps to streamline the accounting processes, provide relevant and timely
information, and support continuous improvement 12.
 Throughput costing: This technique involves treating only direct materials as product costs, and
all other costs (including direct labor and overhead) as period costs. Throughput costing helps to
maximize the throughput (sales revenue minus direct materials cost) and minimize the operating
expenses14.

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 Different costing techniques can be applied in different business practices depending on the
nature, size, and complexity of the business. For example:

 Standard costing can be applied in businesses that have stable and repetitive production
processes, such as manufacturing or construction.
 Activity-based costing can be applied in businesses that have multiple products or services,
diverse customers, and complex overhead costs, such as banking or healthcare.
 Marginal costing can be applied in businesses that have high variable costs, low fixed costs, and
fluctuating demand, such as retail or hospitality.
 Lean accounting can be applied in businesses that have adopted lean manufacturing or lean
management practices, such as automotive or aerospace.
 Throughput costing can be applied in businesses that have high direct labor and overhead costs,
low direct materials cost, and limited capacity constraints, such as software or consulting.

Differentiate Direct matrial, labor and Overhead costs, Allocate overhead costs

Direct material, labor and overhead costs are the three major components of product costs that
are incurred to create a product that is intended for sale to customers.

 Direct material costs are the costs of raw materials that can be directly traced to a specific
product or service. For example, the cost of wood for making a table or the cost of fabric for
making a shirt are direct material costs12.
 Direct labor costs are the costs of wages and salaries that can be directly traced to a specific
product or service. For example, the cost of carpenters for making a table or the cost of tailors for
making a shirt are direct labor costs12.
 Overhead costs are the costs that cannot be directly traced to a specific product or service, but are
incurred for the benefit of multiple products or services. Overhead costs include indirect material
costs, indirect labor costs, and other miscellaneous costs, such as utilities, depreciation, rent,
etc. For example, the cost of nails for making tables and chairs, the cost of supervisors for
overseeing multiple production processes, and the cost of electricity for running the machines are
overhead costs12.

Overhead costs can be allocated to different products or services based on some reasonable and
consistent basis, such as direct labor hours, machine hours, direct material costs, etc. The
allocation process involves the following steps:

 Identify the overhead cost pool, which is the total amount of overhead costs that need to be
allocated.
 Identify the cost allocation base, which is the measure or driver that causes the overhead costs to
be incurred.
 Calculate the predetermined overhead rate, which is the ratio of the overhead cost pool to the
total amount of the cost allocation base.
 Apply the predetermined overhead rate to each product or service by multiplying it by the actual
amount of the cost allocation base used by each product or service.

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 Compare the applied overhead with the actual overhead at the end of the period and adjust for
any underapplied or overapplied overhead.

For example, suppose a company has a cost pool of manufacturing overhead that includes
indirect materials, indirect labor, and other miscellaneous costs. The company uses direct labor
hours as its cost allocation base. The company estimates that it will incur $100,000 of
manufacturing overhead and use 10,000 direct labor hours in a year. The predetermined
overhead rate is calculated as:

Predetermined overhead rate = Overhead cost pool / Total cost allocation base = $100,000 /
10,000 hours = $10 per hour

The company produces two products: A and B. Product A uses 4,000 direct labor hours and
product B uses 6,000 direct labor hours in a year. The applied overhead for each product is
calculated as:

Applied overhead for product A = Predetermined overhead rate x Actual cost allocation base =
$10 per hour x 4,000 hours = $40,000

Applied overhead for product B = Predetermined overhead rate x Actual cost allocation base =
$10 per hour x 6,000 hours = $60,000

The total applied overhead is $40,000 + $60,000 = $100,000. If the actual overhead incurred by
the company is different from $100,000 at the end of the year, then an adjustment is needed to
account for the difference.

Classify costs based on various criterias

Costs can be classified based on various criteria, such as their nature, function, behavior,
relevance, or relation to a product or service. Some of the common criteria for cost classification
are:

 By nature: This criterion involves classifying costs according to their basic characteristics, such
as material, labor, or overhead. For example, direct material costs are the costs of raw materials
that can be directly traced to a specific product or service12.
 By function: This criterion involves classifying costs according to their purpose or role in the
organization, such as production, administration, selling, or distribution. For example, production
costs are the costs incurred in the manufacturing process of a product or service 12.
 By behavior: This criterion involves classifying costs according to their response or change with
respect to the level of output or activity, such as fixed, variable, or mixed. For example, fixed
costs are the costs that do not vary with the level of output or activity12.

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 By relevance: This criterion involves classifying costs according to their usefulness or
importance for decision making, such as relevant or irrelevant, differential or incremental, sunk
or opportunity. For example, relevant costs are the costs that differ between alternatives and
affect the decision12.
 By relation to a product or service: This criterion involves classifying costs according to their
traceability or allocability to a specific product or service, such as direct or indirect. For example,
direct labor costs are the costs of wages and salaries that can be directly traced to a specific
product or servic

Perform Job order costing from Process costing method, Apply job and process costing methods
in the operations of different firms

Job order costing and process costing are two methods of tracking and allocating the costs of
production. The main difference between them is the type of products or services they are used
for.

 Job order costing is a method of tracking and allocating the costs of individualized or customized
products or services. This method is suitable for businesses that produce unique or different
products or services for each customer, such as tailor shops, law firms, hospitals, etc. In job order
costing, each product or service is considered a separate job or order, and the costs of materials,
labor, and overhead are traced and assigned to each job using a job cost sheet or a database. The
total cost of each job is then divided by the number of units produced or services rendered to
obtain the unit cost12.
 Process costing is a method of tracking and allocating the costs of mass-produced or
homogeneous products or services. This method is suitable for businesses that produce large
volumes of identical or similar products or services, such as oil refineries, food manufacturers,
paint factories, etc. In process costing, the production process is divided into several departments
or stages, and the costs of materials, labor, and overhead are accumulated and averaged over all
the units that pass through each department or stage. The unit cost is then obtained by adding up
the costs per unit from each department or stage12.

To perform job order costing from process costing method, one would need to identify and
separate the individual jobs or orders that are included in the process costing system. This would
require tracing back the materials, labor, and overhead costs that are allocated to each unit in
each department or stage to their original sources. Then, one would need to assign these costs to
each job or order using a job cost sheet or a database. This would result in a more detailed and
accurate cost information for each job or order, but it would also increase the complexity and
cost of the costing system.

To apply job and process costing methods in the operations of different firms, one would need to
consider the nature and characteristics of the products or services they produce, as well as their
production processes and customer requirements. For example:

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 A furniture company that makes custom-made sofas and chairs for individual customers would
use job order costing to track and allocate the costs of each sofa and chair according to their
specifications, materials, labor hours, and overhead rates.
 A bakery that makes large batches of breads and pastries for wholesale and retail customers
would use process costing to track and allocate the costs of flour, sugar, eggs, butter, yeast,
baking time, packaging, etc. over all the units that are produced in each baking cycle.
 A car repair shop that provides various services such as oil change, tire rotation, brake
inspection, etc. for different customers would use a hybrid costing system that combines job
order costing and process costing. The shop would use job order costing to track and allocate the
costs of parts and labor for each service performed for each customer. The shop would also use
process costing to track and allocate the costs of utilities, rent, depreciation, etc. over all the
services performed in a given period

Explain how Overhead costs are allocated

Overhead costs are the costs that cannot be directly traced to a specific product or service, but are
incurred for the benefit of multiple products or services. Overhead costs include indirect material
costs, indirect labor costs, and other miscellaneous costs, such as utilities, depreciation, rent, etc.

Overhead costs are allocated to different products or services based on some reasonable and
consistent basis, such as direct labor hours, machine hours, direct material costs, etc. The
allocation process involves the following steps:

 Identify the overhead cost pool, which is the total amount of overhead costs that need to be
allocated.
 Identify the cost allocation base, which is the measure or driver that causes the overhead costs to
be incurred.
 Calculate the predetermined overhead rate, which is the ratio of the overhead cost pool to the
total amount of the cost allocation base.
 Apply the predetermined overhead rate to each product or service by multiplying it by the actual
amount of the cost allocation base used by each product or service.
 Compare the applied overhead with the actual overhead at the end of the period and adjust for
any underapplied or overapplied overhead.

For example, suppose a company has a cost pool of manufacturing overhead that includes
indirect materials, indirect labor, and other miscellaneous costs. The company uses direct labor
hours as its cost allocation base. The company estimates that it will incur $100,000 of
manufacturing overhead and use 10,000 direct labor hours in a year. The predetermined
overhead rate is calculated as:

Predetermined overhead rate = Overhead cost pool / Total cost allocation base = $100,000 /
10,000 hours = $10 per hour

The company produces two products: A and B. Product A uses 4,000 direct labor hours and
product B uses 6,000 direct labor hours in a year. The applied overhead for each product is
calculated as:

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 Applied overhead for product A = Predetermined overhead rate x Actual cost allocation base =
$10 per hour x 4,000 hours = $40,000

Applied overhead for product B = Predetermined overhead rate x Actual cost allocation base =
$10 per hour x 6,000 hours = $60,000

The total applied overhead is $40,000 + $60,000 = $100,000. If the actual overhead incurred by
the company is different from $100,000 at the end of the year, then an adjustment is needed to
account for the difference.

Explain the Purpose of Cost allocations and perform cost allocations using different approaches

The purpose of cost allocation is to assign costs to cost objects, such as products, services,
departments, or programs, based on their use of resources or their contribution to the generation
of costs. Cost allocation can serve several purposes, such as:

 To make decisions: Cost allocation can help managers and other decision-makers to evaluate the
profitability, performance, and efficiency of different cost objects and to choose among
alternative courses of action. For example, a manager can use cost allocation to decide whether
to continue or discontinue a product line based on its contribution margin 12.
 To reduce waste: Cost allocation can help managers and other decision-makers to identify and
eliminate the sources of waste, inefficiency, or non-value-added activities in the production or
delivery of products or services. For example, a manager can use cost allocation to monitor and
control the overhead costs and to implement cost reduction strategies 12.
 To determine pricing: Cost allocation can help managers and other decision-makers to set the
selling price of products or services based on their full cost or their marginal cost. For example, a
manager can use cost allocation to calculate the break-even point, the target profit, and the
optimal price for a product or service12.
 To comply with regulations: Cost allocation can help managers and other decision-makers to
comply with the legal or contractual requirements for reporting or disclosing the costs of
products or services. For example, a manager can use cost allocation to prepare financial
statements, tax returns, or grant proposals that require accurate and consistent cost information 12.

There are different methods of cost allocation that can be used depending on the nature and
characteristics of the costs and the cost objects. Some of the common methods are:

 Direct method: This method involves allocating the costs directly to the cost objects without
considering any interrelationships among the cost objects. This method is simple and easy to
apply, but it may ignore some relevant costs that are shared by multiple cost objects 13.
 Step-down method: This method involves allocating the costs sequentially from one cost object
to another based on a predetermined order of allocation. This method recognizes some
interrelationships among the cost objects, but it may create some biases depending on the order
of allocation13.

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 Reciprocal method: This method involves allocating the costs simultaneously to all the cost
objects based on a system of equations that reflect all the interrelationships among the cost
objects. This method provides the most accurate and comprehensive cost information, but it may
be complex and difficult to apply


Define Activity based costing and Management

Activity-based costing (ABC) is a method of allocating overhead costs to products or services

based on the activities they consume. ABC recognizes that different products or services may
require different types and amounts of resources, and that overhead costs are driven by various
factors, such as the number of orders, setups, inspections, etc. ABC aims to assign overhead
costs more accurately and equitably to products or services based on their actual consumption of
resources12.

Activity-based management (ABM) is a way of managing and improving the performance and
profitability of a business based on the information provided by ABC. ABM involves
identifying, analyzing, and evaluating the activities that consume resources and generate value in
a business, and then implementing changes to optimize the efficiency and effectiveness of those
activities. ABM can be applied at both the operational and strategic levels of a business 23.

Some of the benefits of ABC and ABM are:

 They provide more accurate and relevant cost information for decision making, such as pricing,
product mix, outsourcing, etc.
 They help to identify and eliminate non-value-added or wasteful activities that increase costs
without adding value to customers.
 They help to improve the quality and customer satisfaction by focusing on the activities that
create value for customers.
 They help to enhance the competitiveness and profitability of a business by reducing costs and
increasing value

Analyze cost-volume-profit techniques to determine optimal managerial decisions.

Cost-volume-profit (CVP) analysis is a technique that examines how changes in costs and sales
volume affect a company’s profit. CVP analysis can help managers to make optimal managerial
decisions, such as setting the selling price, choosing the product mix, determining the production
level, and planning the budget12.

To perform CVP analysis, managers need to know the following information:

 The sales price per unit of the product or service

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 The variable cost per unit of the product or service
 The total fixed cost of the company
 The sales volume or quantity of the product or service

Using this information, managers can calculate the following measures:

 Contribution margin (CM): This is the difference between the sales price and the variable cost
per unit. It represents the amount of revenue that contributes to covering the fixed cost and
generating profit12.
 Contribution margin ratio (CMR): This is the ratio of the contribution margin to the sales price
per unit. It represents the percentage of revenue that contributes to covering the fixed cost and
generating profit12.
 Break-even point (BEP): This is the level of sales volume or revenue that results in zero profit or
loss. It is where the total revenue equals the total cost 12.
 Margin of safety (MOS): This is the difference between the actual or expected sales volume or
revenue and the break-even point. It represents the amount of sales volume or revenue that can
drop before the company incurs a loss12.
 Target profit: This is the desired level of profit that the company wants to achieve. It can be
expressed as a dollar amount or a percentage of sales12.

The following formulas can be used to calculate these measures:

 CM = Sales price per unit - Variable cost per unit

 CMR = CM / Sales price per unit
 BEP (in units) = Total fixed cost / CM
 BEP (in dollars) = Total fixed cost / CMR
 MOS (in units) = Actual or expected sales volume - BEP (in units)
 MOS (in dollars) = Actual or expected sales revenue - BEP (in dollars)
 MOS (as a percentage) = MOS (in dollars) / Actual or expected sales revenue
 Target profit (in units) = (Total fixed cost + Target profit) / CM
 Target profit (in dollars) = (Total fixed cost + Target profit) / CMR

For example, suppose a company sells a product for $100 per unit, with a variable cost of $60
per unit. The total fixed cost of the company is $120,000. The company expects to sell 4,000
units in a year. Using CVP analysis, we can calculate:

 CM = $100 - $60 = $40

 CMR = $40 / $100 = 0.4
 BEP (in units) = $120,000 / $40 = 3,000 units
 BEP (in dollars) = $120,000 / 0.4 = $300,000
 MOS (in units) = 4,000 - 3,000 = 1,000 units
 MOS (in dollars) = ($100 x 4,000) - $300,000 = $100,000
 MOS (as a percentage) = $100,000 / ($100 x 4,000) = 0.25 or 25%
 Target profit (in units) = ($120,000 + $60,000) / $40 = 4,500 units
 Target profit (in dollars) = ($120,000 + $60,000) / 0.4 = $450,000

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 Using CVP analysis, managers can answer questions such as:

 How many units must be sold to break even or to achieve a certain target profit?
 What is the impact of changing the sales price or the variable cost per unit on the break-even
point or the target profit?
 What is the safety margin for a given level of sales volume or revenue?
 How sensitive is the profit to changes in costs or sales volume?
 Understand the concept of CVP analysis, absorption and Variable Costing

Understand the concept of CVP analysis, absorption and Variable Costing

CVP analysis, absorption costing, and variable costing are related concepts that deal with the
measurement and analysis of costs and profits.

 CVP analysis is a technique that examines how changes in costs and sales volume affect a
company’s profit. CVP analysis can help managers to make optimal managerial decisions, such
as setting the selling price, choosing the product mix, determining the production level, and
planning the budget12.
 Absorption costing is a method of valuing inventory and calculating cost of goods sold that
includes all manufacturing costs (direct material, direct labor, and both variable and fixed
overhead) as product costs. Absorption costing is in accordance with GAAP and is used for
external reporting purposes13.
 Variable costing is a method of valuing inventory and calculating cost of goods sold that
includes only variable manufacturing costs (direct material, direct labor, and variable overhead)
as product costs. Variable costing treats fixed overhead as a period cost and excludes it from
inventory valuation. Variable costing is not in accordance with GAAP and is used for internal
decision-making purposes13.

The main difference between absorption costing and variable costing is the treatment of fixed
manufacturing overhead. Under absorption costing, fixed overhead is allocated to each unit of
product based on a predetermined overhead rate. Under variable costing, fixed overhead is
expensed in the period incurred. This difference affects the value of inventory, cost of goods
sold, gross margin, net income, and break-even point.

The main advantage of variable costing over absorption costing is that it provides more useful
information for CVP analysis and managerial decisions. Variable costing separates fixed and
variable costs and shows the contribution margin of each product or service. Variable costing
also avoids the problem of overproduction, which can artificially inflate profits under absorption
costing by shifting fixed overhead from income statement to balance sheet 13.

The main disadvantage of variable costing over absorption costing is that it does not comply with
GAAP and cannot be used for external reporting purposes. Variable costing also ignores the fact
that fixed overhead is necessary for production and should be included in product costs

Understand the concept of CVP analysis, absorption and Variable Costing

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 CVP analysis, absorption costing, and variable costing are three important concepts in
managerial accounting. They help managers to plan, control, and evaluate their operations and
decisions. Here is a brief explanation of each concept:

 CVP analysis: This is a method of analyzing the relationship between cost, volume, and profit. It
shows how changes in sales price, sales volume, variable cost, fixed cost, and product mix affect
the profit and break-even point of a business1. CVP analysis can be used for decision making,
such as pricing, product mix, outsourcing, and capital budgeting.
 Absorption costing: This is a method of valuing inventory and measuring income that includes
all manufacturing costs (direct material, direct labor, variable overhead, and fixed overhead) as
product costs. Absorption costing is also known as full costing or traditional costing. It is
required by GAAP for external reporting purposes23. Absorption costing can result in higher
inventory value and higher income than variable costing, but it may not reflect the actual cost
behavior and may distort CVP analysis4.
 Variable costing: This is a method of valuing inventory and measuring income that includes
only variable manufacturing costs (direct material, direct labor, and variable overhead) as
product costs. Variable costing is also known as direct costing or marginal costing. It is not
allowed by GAAP for external reporting purposes, but it is useful for internal decision making
and CVP analysis23. Variable costing can result in lower inventory value and lower income than
absorption costing, but it may reflect the actual cost behavior and support CVP analysis

Prepare a master budget and demonstrate an understanding of the relationship between the
components

A master budget is a comprehensive plan that summarizes the financial and operational goals of
an organization for a specific period, usually a year. A master budget consists of several
interrelated sub-budgets that cover different aspects of the organization’s activities, such as sales,
production, expenses, cash flows, and capital investments 12.

The main components of a master budget are:

 Sales budget: This is the starting point of the master budget. It shows the expected sales volume
and revenue for each product or service, based on the market analysis, demand forecast, pricing
strategy, and sales goals of the organization12.
 Production budget: This shows the number of units that need to be produced to meet the sales
budget and the desired inventory level. It depends on the sales budget, the beginning inventory,
and the ending inventory12.
 Direct materials budget: This shows the quantity and cost of raw materials that need to be
purchased and used for production. It depends on the production budget, the beginning inventory

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 of materials, the ending inventory of materials, and the standard material usage and price per
unit12.
 Direct labor budget: This shows the quantity and cost of direct labor hours that need to be
employed for production. It depends on the production budget, the standard labor hours and rate
per unit, and the labor efficiency and availability12.
 Manufacturing overhead budget: This shows the variable and fixed overhead costs that need to
be incurred for production. It depends on the production budget, the predetermined overhead
rate, and the allocation base (such as direct labor hours or machine hours) 12.
 Cost of goods sold budget: This shows the cost of goods sold for each product or service, based
on the direct materials, direct labor, and manufacturing overhead budgets. It also shows the gross
margin or gross profit for each product or service12.
 Selling and administrative expense budget: This shows the variable and fixed selling and
administrative expenses that need to be incurred for supporting the sales and operations of the
organization. It includes expenses such as salaries, commissions, advertising, depreciation,
utilities, etc.12.
 Income statement budget: This shows the projected income statement for the organization, based
on the sales revenue, cost of goods sold, selling and administrative expenses, interest expense,
income tax expense, and net income12.
 Cash budget: This shows the expected cash inflows and outflows for the organization during the
budget period. It includes cash receipts from sales and other sources, cash payments for
purchases and expenses, cash surplus or deficit, financing activities (such as borrowing or
repaying loans), and ending cash balance12.
 Capital expenditure budget: This shows the planned purchases and disposals of long-term assets
(such as property, plant, and equipment) by the organization during the budget period. It also
shows the sources and uses of funds for financing these investments 12.
 Balance sheet budget: This shows the projected balance sheet for the organization at the end of
the budget period. It includes assets (such as cash, inventory, accounts receivable), liabilities
(such as accounts payable, loans), and equity (such as retained earnings) 12.

To prepare a master budget, managers need to follow a logical sequence that starts with
estimating sales revenue and ends with projecting financial statements. The sub-budgets are
interdependent and consistent with each other. The master budget helps managers to plan ahead,
coordinate activities, allocate resources, control operations, evaluate performance, and
communicate goals

To prepare a master budget, you need to follow these steps:

1. Estimate the sales revenue and volume for each product or service based on the market analysis,
demand forecast, pricing strategy, and sales goals. This will form the sales budget.
2. Estimate the production volume for each product or service based on the sales budget and the
desired inventory level. This will form the production budget.
3. Estimate the direct materials required for each product or service based on the production budget
and the standard material usage per unit. This will form the direct materials budget.
4. Estimate the direct labor required for each product or service based on the production budget and
the standard labor hours per unit. This will form the direct labor budget.

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5. Estimate the manufacturing overhead costs for each product or service based on the production
budget and the predetermined overhead rate. This will form the manufacturing overhead budget.
6. Calculate the cost of goods sold for each product or service based on the direct materials, direct
labor, and manufacturing overhead budgets. This will form the cost of goods sold budget.
7. Estimate the selling and administrative expenses for each product or service based on the sales
volume and the fixed and variable costs per unit. This will form the selling and administrative
expense budget.
8. Prepare a projected income statement for the organization based on the sales revenue, cost of
goods sold, selling and administrative expenses, interest expense, income tax expense, and net
income. This will form the income statement budget.
9. Prepare a projected cash flow statement for the organization based on the cash receipts from
sales and other sources, cash payments for purchases and expenses, cash surplus or deficit,
financing activities, and ending cash balance. This will form the cash budget.
10. Prepare a projected capital expenditure plan for the organization based on the planned purchases
and disposals of long-term assets and the sources and uses of funds for financing these
investments. This will form the capital expenditure budget.
11. Prepare a projected balance sheet for the organization based on the assets, liabilities, and equity
at the end of the budget period. This will form the balance sheet budget.

The relationship between the components of a master budget is that they are interdependent and
consistent with each other. The sales budget is the starting point of all other budgets, as it
determines how much revenue and volume are expected from each product or service. The
production budget depends on the sales budget and the desired inventory level, as it determines
how much output is needed to meet demand and maintain stock. The direct materials, direct
labor, and manufacturing overhead budgets depend on the production budget, as they determine
how much resources are needed to produce output. The cost of goods sold budget depends on
these three budgets, as it determines how much it costs to produce output. The selling and
administrative expense budget depends on the sales volume, as it determines how much it costs
to support sales and operations. The income statement budget depends on all these budgets, as it
summarizes how much profit or loss is generated by each product or service. The cash budget
depends on all these budgets, as it shows how much cash is generated or used by each activity.
The capital expenditure budget depends on all these budgets, as it shows how much investment is
needed or made in long-term assets. The balance sheet budget depends on all these budgets, as it
shows how much assets, liabilities, and equity are held by the organization at the end of the
period.

Explain the relevant costing technique and apply it to decision making

Relevant costing technique is a method of analyzing the costs and benefits of different
alternatives based on the changes in cash flows that they cause. Relevant costing technique helps
managers to make optimal decisions by focusing on the costs and revenues that are relevant to a
specific situation and ignoring the ones that are not12.

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 The basic steps of relevant costing technique are:

 Identify the alternatives or options available for the decision

 Identify the relevant costs and revenues for each alternative
 Compare the net benefit (or net cost) of each alternative
 Choose the alternative that maximizes the net benefit (or minimizes the net cost)

Relevant costs and revenues are those that differ among the alternatives and affect the future
cash flows of the organization. They can be classified as:

 Incremental costs and revenues: These are the additional costs and revenues that occur due to
choosing one alternative over another12.
 Avoidable costs and revenues: These are the costs and revenues that can be eliminated or
avoided by choosing one alternative over another12.
 Opportunity costs and revenues: These are the costs and revenues that are forgone or sacrificed
by choosing one alternative over another12.

Some examples of relevant costs and revenues are:

 Variable costs and revenues: These are the costs and revenues that vary with the level of activity
or output. They are usually relevant for decisions involving changes in volume, such as make or
buy, accept or reject, or sell or process further12.
 Fixed costs and revenues: These are the costs and revenues that do not vary with the level of
activity or output. They are usually irrelevant for decisions involving changes in volume, unless
they differ among the alternatives or can be avoided by choosing one alternative over another 12.
 Sunk costs and revenues: These are the costs and revenues that have already been incurred or
received in the past or are committed for the future. They are irrelevant for any decision, as they
cannot be changed by choosing one alternative over another12.

Some examples of applying relevant costing technique to decision making are:

 Make or buy decision: This involves deciding whether to produce a product or service internally
or outsource it to an external supplier. The relevant costs for this decision are the variable costs
of making the product or service, the fixed costs that can be avoided by buying it, and the
opportunity cost of using the internal resources for other purposes. The relevant revenue is the
price paid by the external supplier12.
 Accept or reject decision: This involves deciding whether to accept a special order from a
customer at a lower price than the normal price. The relevant costs for this decision are the
variable costs of producing and delivering the special order, and the opportunity cost of using the
capacity for other orders. The relevant revenue is the price offered by the customer 12.
 Sell or process further decision: This involves deciding whether to sell a product at its current
stage of production or process it further to add more value. The relevant costs for this decision
are the additional variable costs of processing the product further, and any fixed costs that can be
avoided by selling it at its current stage. The relevant revenue is the difference between the
selling price at each stage of production

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 Perform cost variance analysis and demonstrate the use of standard costs in flexible budgeting.

Cost variance analysis is a technique that compares the actual costs incurred by an organization
with the standard or budgeted costs for the same level of activity. Cost variance analysis helps
managers to identify the causes and sources of deviations from the expected performance and to
take corrective actions if needed12.

Standard costs are the predetermined or estimated costs of producing a unit of output or
performing a unit of activity. Standard costs are based on historical data, industry benchmarks,
engineering studies, or other methods. Standard costs are used to set performance targets, prepare
budgets, evaluate efficiency, and calculate variances12.

Flexible budgeting is a method of preparing budgets that adjusts the budgeted costs and revenues
according to the actual level of output or activity achieved. Flexible budgeting allows managers
to compare the actual results with the budgeted results for the same level of activity, rather than
with a fixed or static budget that is based on a predetermined level of activity. Flexible budgeting
enhances the usefulness and accuracy of variance analysis 12.

To perform cost variance analysis using standard costs in flexible budgeting, managers need to
follow these steps:

 Prepare a flexible budget for the actual level of output or activity achieved, using the standard
costs per unit of output or activity.
 Compare the actual costs incurred with the flexible budgeted costs for the same level of output or
activity.
 Calculate the total cost variance, which is the difference between the actual costs and the flexible
budgeted costs. The total cost variance can be further divided into two components: price
variance and efficiency variance.
 Calculate the price variance, which is the difference between the actual price paid (or received)
for an input (or output) and the standard price for that input (or output), multiplied by the actual
quantity of input (or output) used (or sold). The price variance can be calculated for direct
materials, direct labor, variable overhead, fixed overhead, and sales revenue.
 Calculate the efficiency variance, which is the difference between the actual quantity of input (or
output) used (or sold) and the standard quantity allowed for that input (or output), multiplied by
the standard price for that input (or output). The efficiency variance can be calculated for direct
materials, direct labor, variable overhead, and sales volume.
 Analyze the causes and sources of variances, and take corrective actions if needed.

For example, suppose a company produces and sells widgets. The standard costs and revenues
per widget are:

 Sales price: $100

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 Direct materials: 2 kg at $5 per kg
 Direct labor: 1 hour at $20 per hour
 Variable overhead: 1 hour at $10 per hour
 Fixed overhead: $50,000 per month

The company planned to produce and sell 10,000 widgets in a month. However, it actually
produced and sold 9,000 widgets. The actual costs and revenues were:

 Sales revenue: $900,000

 Direct materials: 18,000 kg at $4.5 per kg
 Direct labor: 8,500 hours at $22 per hour
 Variable overhead: $85,000
 Fixed overhead: $48,000

To perform cost variance analysis using standard costs in flexible budgeting, we can follow these
steps:

 Prepare a flexible budget for 9,000 widgets using the standard costs per widget:

Item Flexible Budget

Sales revenue $900,000

Direct materials $90,000

Direct labor $180,000

Variable overhead $90,000

Fixed overhead $50,000

Total cost $410,000

Net income $490,000

 Compare the actual costs with the flexible budgeted costs:

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 Item Actual Cost Flexible Budget Variance

Sales revenue $900,000 $900,000 $0

Direct materials $81,000 $90,000 $9,000 F

Direct labor $187,000 $180,000 $7,000 U

Variable overhead $85,000 $90,000 $5,000 F

Fixed overhead $48,000 $50,000 $2,000 F

Total cost $401,000 $410,000 $9,000 F

Net income $499,000 $490,000 $9,000 F

F = favorable; U = unfavorable

 Calculate the total cost variance for each item:

Total cost variance = Actual cost - Flexible budgeted cost

Item Total Cost Variance

Direct materials $9,000 F

Direct labor $7,000 U

Variable overhead $5,000 F

Fixed overhead $2,000 F

 Calculate the price variance and the efficiency variance for each item:

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 Price variance = (Actual price - Standard price) x Actual quantity

Efficiency variance = (Actual quantity - Standard quantity) x Standard price

Item Price Variance Efficiency Variance

Direct materials $9,000 F $0

Direct labor $17,000 U $10,000 F

Variable overhead $0 $5,000 F

Note: For sales revenue, the price variance is the difference between the actual selling price and
the standard selling price, multiplied by the actual sales volume. The efficiency variance is the
difference between the actual sales volume and the standard sales volume, multiplied by the
standard selling price. In this example, both variances are zero because the actual selling price
and sales volume are equal to the standard ones.

 Analyze the causes and sources of variances, and take corrective actions if needed.

For example, the favorable direct materials price variance may indicate that the company was
able to negotiate a lower price with its suppliers or that it purchased lower quality materials. The
unfavorable direct labor price variance may indicate that the company had to pay higher wages
due to labor shortage or overtime. The favorable direct labor efficiency variance may indicate
that the workers were more productive or that the standard was set too high. The favorable
variable overhead efficiency variance may indicate that the company used less machine hours or
electricity than expected. The favorable fixed overhead variance may indicate that the company
reduced some fixed costs or that it had a higher production capacity than planned

Elaborate the purpose of developing budget and construct Master budget for mfg firms

The purpose of developing a budget is to plan and control the financial and operational activities
of an organization for a specific period. A budget helps managers to set goals, allocate resources,
coordinate actions, monitor performance, and evaluate results 12.

A master budget is a comprehensive plan that summarizes the financial and operational goals of
a manufacturing firm for a specific period, usually a year. A master budget consists of several
interrelated sub-budgets that cover different aspects of the manufacturing firm’s activities, such
as sales, production, expenses, cash flows, and capital investments 12.

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 To construct a master budget for a manufacturing firm, managers need to follow a logical
sequence that starts with estimating sales revenue and ends with projecting financial statements.
The sub-budgets that are included in a master budget for a manufacturing firm are:

 Sales budget: This shows the expected sales volume and revenue for each product or service,
based on the market analysis, demand forecast, pricing strategy, and sales goals of the firm 12.
 Production budget: This shows the number of units that need to be produced to meet the sales
budget and the desired inventory level. It depends on the sales budget, the beginning inventory,
and the ending inventory12.
 Direct materials budget: This shows the quantity and cost of raw materials that need to be
purchased and used for production. It depends on the production budget, the beginning inventory
of materials, the ending inventory of materials, and the standard material usage and price per
unit12.
 Direct labor budget: This shows the quantity and cost of direct labor hours that need to be
employed for production. It depends on the production budget, the standard labor hours and rate
per unit, and the labor efficiency and availability12.
 Manufacturing overhead budget: This shows the variable and fixed overhead costs that need to
be incurred for production. It depends on the production budget, the predetermined overhead
rate, and the allocation base (such as direct labor hours or machine hours) 12.
 Cost of goods sold budget: This shows the cost of goods sold for each product or service, based
on the direct materials, direct labor, and manufacturing overhead budgets. It also shows the gross
margin or gross profit for each product or service12.
 Selling and administrative expense budget: This shows the variable and fixed selling and
administrative expenses that need to be incurred for supporting the sales and operations of the
firm. It includes expenses such as salaries, commissions, advertising, depreciation, utilities,
etc.12.
 Income statement budget: This shows the projected income statement for the firm, based on the
sales revenue, cost of goods sold, selling and administrative expenses, interest expense, income
tax expense, and net income12.
 Cash budget: This shows the expected cash inflows and outflows for the firm during the budget
period. It includes cash receipts from sales and other sources, cash payments for purchases and
expenses, cash surplus or deficit, financing activities (such as borrowing or repaying loans), and
ending cash balance12.
 Capital expenditure budget: This shows the planned purchases and disposals of long-term assets
(such as property, plant, and equipment) by the firm during the budget period. It also shows the
sources and uses of funds for financing these investments 12.
 Balance sheet budget: This shows the projected balance sheet for the firm at the end of the
budget period. It includes assets (such as cash, inventory, accounts receivable), liabilities (such
as accounts payable, loans), and equity (such as retained earnings

Prepare analyses of various special decisions, using relevant costing and benefits

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 Relevant costing and benefits are the costs and benefits that differ among the alternatives and
affect the future cash flows of the organization. They are used to analyze various special
decisions, such as make or buy, accept or reject, sell or process further, keep or drop, and product
mix12.

To prepare analyses of various special decisions using relevant costing and benefits, managers
need to follow these steps:

 Identify the alternatives or options available for the decision

 Identify the relevant costs and benefits for each alternative
 Compare the net benefit (or net cost) of each alternative
 Choose the alternative that maximizes the net benefit (or minimizes the net cost)

Some examples of preparing analyses of various special decisions using relevant costing and
benefits are:

 Make or buy decision: This involves deciding whether to produce a product or service internally
or outsource it to an external supplier. The relevant costs for this decision are the variable costs
of making the product or service, the fixed costs that can be avoided by buying it, and the
opportunity cost of using the internal resources for other purposes. The relevant benefit is the
price paid by the external supplier12.

For example, suppose a company can produce a component for $20 per unit, which includes $12
of variable cost and $8 of fixed cost. The company can also buy the component from an external
supplier for $18 per unit. The company has excess capacity and can use its resources to produce
another product that can generate $5 per unit of contribution margin. To analyze this decision,
we can compare the relevant costs and benefits of making and buying the component:

Relevant Net Benefit

Alternative Relevant Costs Benefits (Cost)

$-20 per
Make $20 per unit $0 unit

$18 per unit + $5 per unit $-23 per

Buy of opportunity cost $0 unit

The company should choose to make the component, as it has a higher net benefit (or lower net
cost) than buying it.

 Accept or reject decision: This involves deciding whether to accept a special order from a
customer at a lower price than the normal price. The relevant costs for this decision are the

20
 variable costs of producing and delivering the special order, and the opportunity cost of using the
capacity for other orders. The relevant benefit is the price offered by the customer 12.

For example, suppose a company sells a product for $100 per unit, which includes $60 of
variable cost and $40 of fixed cost. The company has a capacity of 10,000 units per month and
normally sells 9,000 units per month. A customer offers to buy 500 units at $80 per unit. To
analyze this decision, we can compare the relevant costs and benefits of accepting and rejecting
the special order:

Net Benefit
Alternative Relevant Costs Relevant Benefits (Cost)

$60 per unit x 500 $80 per unit x 500

Accept units = $30,000 units = $40,000 $10,000

Reject $0 $0 $0

The company should choose to accept the special order, as it has a higher net benefit than
rejecting it.

 Sell or process further decision: This involves deciding whether to sell a product at its current
stage of production or process it further to add more value. The relevant costs for this decision
are the additional variable costs of processing the product further, and any fixed costs that can be
avoided by selling it at its current stage. The relevant benefit is the difference between the selling
price at each stage of production12.

For example, suppose a company produces two products: A and B. Product A can be sold at its
current stage for $50 per unit, which includes $30 of variable cost and $20 of fixed cost. Product
A can also be processed further into Product B, which can be sold for $70 per unit. The
additional variable cost of processing Product A into Product B is $15 per unit. There is no
change in fixed cost. To analyze this decision, we can compare the relevant costs and benefits of
selling Product A or processing it further into Product B:

Net
Relevant Benefit
Alternative Costs Relevant Benefits (Cost)

$50 per unit - $30

per unit = $20 per $20 per
Sell Product A $0 unit unit

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 Net
Relevant Benefit
Alternative Costs Relevant Benefits (Cost)

$70 per unit - $50

Process further $15 per per unit = $20 per
into Product B unit unit $5 per unit

The company should choose to sell Product A, as it has a higher net benefit than processing it
further into Product B.

Prepare analyses of various special decisions, using relevant costing and benefits.

Relevant costing and benefits are important concepts in accounting and decision making. They
help to identify and analyze the costs and benefits that are relevant for a specific decision 12. A
cost or benefit is relevant if it changes as a result of the decision23. A cost or benefit is irrelevant
if it does not change or has already been incurred12.

Some examples of irrelevant costs are sunk costs, which are past costs that cannot be
recovered23, committed costs, which are future costs that cannot be avoided2, re-apportionment
of existing fixed costs, which do not affect the total costs2, and depreciation and book values,
which are not cash flows24.

Some examples of relevant costs and benefits are incremental costs and revenues, which are
the additional costs and revenues caused by the decision23, opportunity costs, which are the
revenues forgone by choosing one alternative over another25, and avoidable costs, which are the
costs that can be eliminated by choosing one alternative over another 15.

To prepare analyses of various special decisions, using relevant costing and benefits, you need to
follow these steps:

 Identify the alternatives and the decision criteria

 Identify the relevant costs and benefits for each alternative
 Compare the relevant costs and benefits of each alternative
 Choose the alternative that maximizes the net benefit or minimizes the net cost
 Evaluate the sensitivity of the decision to changes in assumptions or estimates

Understand different types of budgetary systems, prepare flexible budgets and perform variance
analysis prep

22
 Budgetary systems are the methods and procedures used by organizations to plan, control, and
evaluate their financial activities. There are different types of budgetary systems that vary in
their scope, approach, and purpose12. Some of the common types of budgetary systems are:

 Incremental budgeting: This type of budgeting uses the previous year’s actual figures as the
basis for the current year’s budget. It adjusts the figures by adding or subtracting a percentage to
reflect expected changes. Incremental budgeting is simple and easy to understand, but it may
ignore external factors, perpetuate inefficiencies, and create budgetary slack 1.
 Activity-based budgeting: This type of budgeting starts with the output or outcome goals of the
organization and then determines the inputs or resources required to achieve them. It links the
budget to the activities that drive the costs and revenues. Activity-based budgeting is more
realistic and accurate, but it may be complex and time-consuming to implement 1.
 Value proposition budgeting: This type of budgeting focuses on the value that each item in the
budget creates for the customers, staff, or other stakeholders. It asks questions such as why is this
item included in the budget, does it create value, and does the value outweigh the cost. Value
proposition budgeting aims to avoid unnecessary expenditures, but it may be subjective and
difficult to measure value1.
 Zero-based budgeting: This type of budgeting assumes that all department budgets are zero and
requires managers to justify every expense from scratch. It evaluates each item based on its
merits and benefits. Zero-based budgeting eliminates wasteful spending, but it may be costly and
time-consuming to prepare12.

A flexible budget is a type of budget that adjusts to different levels of activity or output. It shows
the expected costs and revenues for various levels of sales volume or production output. A
flexible budget helps managers to compare actual performance with budgeted performance at the
same level of activity. It also helps managers to identify and analyze variances3 .

Variance analysis is a process of comparing actual results with budgeted results and explaining
the causes of differences. Variance analysis helps managers to evaluate performance, identify
problems, and take corrective actions. There are two types of variances: favorable and
unfavorable. A favorable variance occurs when actual results are better than budgeted results,
such as higher revenues or lower costs. An unfavorable variance occurs when actual results are
worse than budgeted results, such as lower revenues or higher costs

budgets and perform variance analysis

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