SBA BOOK

STRATEGIC
BUSINESS ANALYSIS
BSMA 3113 2024 EDITION

TABLE OF CONTENTS
CHAPTER 1
STRATEGIC PLANNING 1
Purpose of Strategic Planning 3
Strategic Planning Model 4
Strategic Planning Framework 5
Key Components of Strategic Plan 6
Strategic Planning Process 8
Common Challenges in Strategic Plan 9
Summary 11
Self-Test Problem 12
Case Study 18
References 19
CHAPTER 2
Profit Planning and Cost-Volume-Profit Analysis 20
Cost-Volume-Profit Analysis 22
Strategic Role Of CVP Analysis 23
Assumptions and Limitations of CVP Analysis 24
Basic CVP Analysis 24
Multi-Product CVP Analysis 28
CVP Sensitivity Analysis 30
Margin of Safety and Degree of Operating Leverage 31
Summary 34
Case Study 35
References 40
CHAPTER 3
Short-Term Budgeting 41
Budgeting Basics 43
Advantages of Budgeting 44
Budgeting Models 45
Master Budget 47
Flexible Budgeting 55
Case Study 71
References 73
CHAPTER 4
Responsibility Accounting and Segment Evaluation 74
Organizational Structures 76
Managerial Roles 78
Responsibility Centers 79
Performance Evaluation 80
Summary 86
Case Study 90
References 92
TABLE OF CONTENTS
CHAPTER 5
Transfer Pricng 93
Related Parties 94
Related Party Transactions 96
Transfer Prices 97
Summary 106
Case Study 112
References 113
CHAPTER 6
Nonroutine Operating Decisions 114
Types of Decisions 116
Routinary vs. Non routinary Decisions 117
Relevant and Irrelevant Cost 118
Application of relevant costing 119
Summary 133
Case Study 137
References 139
CHAPTER 7
Product Pricing and Profit Analysis 140
Product Pricing 142
Factors to Consider in Product Pricing 142
Gross Profit Variance Analysis 147
Multi-Product Gross Profit Variances 150
Summary 152
Case Study 158
References 159
CHAPTER
1
STRATEGIC
PLANNING
Strategic Planning
INTRODUCTION
Strategic planning has evolved significantly since its inception, transitioning from annual budget
planning in the 1950s to long-range planning in the 1960s due to increasing demand. The oil shocks of
the 1970s prompted a shift towards strategic planning that emphasized identifying emerging trends
rather than relying solely on historical data, leading to a more dynamic approach to management. By
the 1980s, strategy development moved from executives to operating managers, culminating in the
concepts of strategic thinking and management, which focus on innovative strategies and their
implementation through scenario planning and continuous adaptation..
Strategic planning is a structured process that helps organizations define their long-term vision
and goals while adapting to changes in their environment. It involves several interconnected phases,
including clarifying the organization's mission, conducting assessments like SWOT analysis, setting
measurable objectives, and developing actionable strategies. This dynamic approach allows
organizations to manage complexity, optimize resources, and foster sustainable growth by ensuring
that all efforts align with their core values and strategic priorities. Ultimately, a well-crafted strategic
plan serves as a roadmap for achieving desired outcomes and navigating future challenges.
Learning Objectives
After reading this chapter, learners should be able to:
Understand the concept of strategic planning and its significance in various organizational
contexts.
Explain how strategic planning aligns organizational goals, guides resource allocation, and
establishes performance benchmarks.
Recognize the essential elements of a strategic plan, including vision and mission statements,
situational analysis, and strategic goals.
Recognize potential obstacles organizations may face during strategic planning and
implementation and propose solutions to overcome these challenges.
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PURPOSE OF STRATEGIC PLANNING
Strategic planning serves as a crucial framework for organizations to define their direction and
make informed decisions that align with their long-term goals. The purpose of strategic planning can be
understood through several key aspects:
1. Establishing a Clear Direction
Strategic planning helps organizations articulate their vision and mission, providing a clear sense of
direction. By defining what they aim to achieve in the long term, organizations can align their
resources and efforts toward common objectives. This clarity reduces ambiguity and helps all
stakeholders understand the organization's priorities and aspirations, fostering a unified approach to
achieving goals.
2. Setting Realistic Goals and Objectives
Through strategic planning, organizations can set realistic, measurable goals that are aligned with
their vision. These goals serve as benchmarks for success and guide decision-making processes. By
breaking down the overarching vision into specific objectives, organizations can create actionable
plans that facilitate progress and accountability.
3. Enhancing Operational Efficiency

A well-structured strategic plan acts as a roadmap for operational activities, ensuring that all
functions within the organization are aligned with strategic objectives. This alignment enhances
operational efficiency by guiding resource allocation and prioritizing initiatives that contribute to
achieving the strategic goals. As a result, organizations can minimize waste and optimize performance
across various departments.
4. Anticipating Changes and Challenges
Strategic planning enables organizations to anticipate changes in the external environment, such as
market trends or competitive pressures. By conducting thorough situational analyses (e.g., SWOT
analysis), organizations can identify potential risks and opportunities, allowing them to adapt
proactively rather than reactively. This foresight is essential for navigating uncertainties and
maintaining competitiveness in dynamic markets.
5. Facilitating Better Decision-Making

With a strategic plan in place, decision-makers have a framework to evaluate options based on how
well they align with the organization's goals. This structured approach leads to improved decision-
making by providing criteria for assessing the potential impact of various actions on the organization's
long-term success.
6. Improving Resource Allocation

Strategic planning helps organizations allocate resources more effectively by identifying priority
areas that require investment or attention. By understanding where resources are most needed to
achieve strategic objectives, organizations can optimize their budgets and human capital, ensuring
that efforts are focused on initiatives that drive growth and innovation.
7. Creating Accountability and Engagement

A strategic plan fosters accountability among employees by clearly defining roles, responsibilities,
and expectations related to achieving organizational goals. When employees understand how their
work contributes to the broader mission, they are more likely to be engaged and motivated to perform
at their best. This engagement is critical for cultivating a culture of collaboration and shared purpose
within the organization.
8. Ensuring Long-Term Sustainability

Ultimately, strategic planning is vital for ensuring an organization’s long-term sustainability and
success. By establishing a solid foundation based on clear objectives, effective resource management,
and proactive risk assessment, organizations can navigate challenges more effectively and position
themselves for future growth in an increasingly competitive landscape.
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In summary, the purpose of strategic planning extends beyond mere goal-setting; it encompasses
creating a comprehensive framework that guides an organization toward its desired future state while
enhancing operational efficiency, fostering accountability, and enabling proactive adaptation to
change.
STRATEGIC PLANNING MODELS

Organizations are always looking for ways to improve. It's how they maintain relevance and, more
importantly, profitability. However, simply wanting to improve does not result in progress. It takes
strategy first, followed by a model to put that approach into action. A strategic planning model
describes how an organization takes its strategy and develops a plan to apply it in order to improve
operations and fulfill its objectives.
Basic Strategic Planning Model
This foundational model focuses on establishing essential elements such as the mission, vision,
values, and objectives of an organization. It is particularly useful for teams with little experience in
strategic planning or limited resources.
Example: A startup organic juice bar could use this model to create a mission statement like, “To
provide healthy, delicious, and environmentally-friendly beverage options to health-conscious
consumers,” and set goals to establish its brand and promote sustainability.
Goal-Based Strategic Planning Model
This model emphasizes setting clear, measurable objectives. It often employs a SWOT analysis
(Strengths, Weaknesses, Opportunities, Threats) to inform strategic decisions.
Example: A mid-sized tech company might define its goal as increasing market share by 15%
within a year, using data from a SWOT analysis to identify key areas for improvement and
opportunities in emerging markets.
Strategic Alignment Model

This model ensures that all strategies align with the overall business goals and values. It is
especially beneficial during transitions like mergers or acquisitions.
Example: A company undergoing a merger can use this model to realign its strategies by ensuring
that all departments understand the new organizational goals and work collaboratively towards them.
Scenario Model
Scenario planning is a strategic management tool that helps organizations envision various possible
futures and develop strategies to address them. This model is particularly useful in dynamic
environments where external factors can significantly impact operations.
Example: Renewable Energy Company: A company specializing in renewable energy might use
scenario planning to prepare for potential government policy changes regarding environmental
regulations. By developing scenarios that include strict regulations versus more lenient ones, the
company can create adaptive strategies for investment in technology or market expansion based on
the most likely outcomes.
Cascade Strategy Planning Model
The cascade model is a strategic planning framework that helps organizations align their goals and
objectives across various levels, ensuring that every part of the organization is working towards the
same overarching strategy. This model emphasizes the importance of breaking down high-level
strategic goals into actionable tasks for different departments and teams, facilitating a coherent
execution of strategy throughout the organization[10].
Example: General Electric, a multinational conglomerate, has utilized the cascade planning model
to enhance its operational efficiency and align its diverse business units with corporate strategy.
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STRATEGIC PLANNING FRAMEWORKS
A strategic framework is a structure designed to help organizations develop an action plan to
achieve their goals. This entails using various strategic planning models to guide the organization
toward effective strategy implementation and goal realization, tailored to specific scenarios where they
are most effective. Essentially, it serves as a blueprint that organizations follow to map out their
strategic direction and actions required to achieve their objectives and these commonly include the
following:
SWOT Analysis
A SWOT analysis is a high-level model used at the beginning of an organization’s strategic

planning. It is an acronym for “strengths, weaknesses, opportunities, and threats.” Strengths and
weaknesses are considered internal factors, and opportunities and threats are considered external
factors. Using a SWOT analysis as part of your strategic business model helps an organization identify
where they’re doing well and in what areas they can improve.
Example: A small bakery uses SWOT analysis to assess its strengths (e.g., high-quality
ingredients), weaknesses (e.g., limited marketing), opportunities (e.g., local events for expansion), and
threats (e.g., competition from larger chains) to develop a focused business plan.
VRIO Framework
The VRIO framework is another strategic planning tool designed to help companies evaluate their
competitive advantage. VRIO stands for value, rarity, imitability, and organization. With this
framework, the organization can study its firmed resources and find out whether or not the company
can transform them into sustained competitive advantages.
Example: A tech startup evaluates its proprietary software with the VRIO framework, examining its
value to users, its rarity among competitors, whether it is hard to imitate, and how well the company is
organized to support it, to confirm it offers a competitive edge.
Gap Planning
Gap planning is also referred to as a “Need-Gap Analysis,” “Need Assessment,” or “the Strategic-
Planning Gap.” It is used to compare where an organization is now, where it wants to be, and how to
bridge the gap between. It is primarily used to identify specific internal deficiencies.
Example: A nonprofit organization uses gap planning to identify the difference between current
volunteer numbers and the desired level, then creates a strategy to recruit and train additional
volunteers to meet service goals.
Blue Ocean Strategy

Blue Ocean Strategy poses the idea for organizations to develop in an “uncontested market space”
(e.g. a blue ocean) instead of a market space that is either developed or saturated (e.g. a red ocean). If
your organization is able to create a blue ocean, it can mean a massive value boost for your company,
its buyers, and its employees.
Example: An online bookstore creates a "blue ocean" by offering a unique subscription service
that provides customers with personalized reading lists, setting it apart from typical online
booksellers.
Porter’s Five Forces

Porter’s Five Forces is an older strategy execution framework (created by Michael Porter in 1979)
built around the forces that impact the profitability of an industry or a market. The five forces it
examines are:
1. The threat of entry: Could other companies enter the marketplace easily, or are there numerous
entry barriers they would have to overcome?
2. The threat of substitute products or services: Can buyers easily replace your product with
another?
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3. The bargaining power of customers: Could individual buyers put pressure on your organization
to, say, lower costs?
4. The bargaining power of suppliers: Could large retailers put pressure on your organization to
drive down the cost?
5. The competitive rivalry among existing firms: Are your current competitors poised for major
growth? If one launches a new product or files a new patent—could that impact your company?
Example: A local coffee shop examines Porter’s Five Forces by considering how easily new cafes
might open nearby, whether customers might switch to at-home coffee makers, and the influence of
suppliers and customer bargaining power on pricing.
PESTLE Analysis
A PESTLE analysis assesses six external influences on a company: Political, Economic, Social,
Technology, Legal, and Environmental. This framework is well suited to the idea stage for a company
as it allows you to gain an understanding of the external environment to identify a potential
opportunity for your company.
Example: A renewable energy company conducts a PESTLE analysis to study how political policies,
economic trends, social awareness of climate change, technological advances, legal regulations, and
environmental factors will affect its market and growth potential.
KEY COMPONENTS OF A STRATEGIC PLAN

Every successful business begins with a clear plan that outlines its direction and priorities. A
strategic plan brings focus to an organization, helping it navigate toward its goals over time. To make
a strategic plan effective, certain key components must be included. Each component serves as a
building block that contributes to the overall structure of the plan, ensuring clarity and cohesion in
the organization’s path forward.
Vision Statement
The vision statement presents a brief look at the future of the business, describing what it aims to
become and where it aspires to be. A clear vision helps to guide decision-making and inspires
employees to work toward the same overarching goal.
Example: To be the leading brand in sustainable luxury fashion, crafting bags that empower our
customers to make stylish and environmentally responsible choices.
Mission Statement
The mission statement explains the core purpose of the business within its industry. It describes the
business’s primary services or products, the target audience, and what makes it unique compared to
competitors. This statement grounds the organization in its day-to-day purpose and distinguishes it in
the market.
Example: To inspire the fashion world by designing eco-conscious bags that merge luxury and
sustainability without compromising on quality.
Goals and Objectives
Every strategic plan should outline both short- and long-term goals to keep the organization on
track toward its vision. Goals provide direction, while objectives are specific, measurable actions that
help achieve these goals.
Examples:
Short-term goals:
Launch a new line of bags made from upcycled materials within the next six months.
Increase brand visibility on social media by 20% through collaborations with eco-conscious
influencers.
Reduce production waste by 15% within the next year by optimizing material usage.
Open a pop-up store in a major metropolitan area to increase direct customer engagement by the
next quarter.
Train all sales staff in sustainable fashion practices and brand values within three months.
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Long-term goals:
Expand the product line to include vegan leather options within two years.
Establish a buy-back program to encourage customers to return old bags for recycling or
refurbishing within three years.
Achieve 100% carbon neutrality in all operations by 2027.
Open permanent retail locations in two new international cities within five years.
Increase brand recognition by 25% within five years through strategic partnerships and global
marketing campaigns.
SWOT Analysis
A SWOT analysis is a tool that helps a business identify its internal strengths and weaknesses, as
well as external opportunities and threats. It helps the organization understand its position in the
market and develop strategies for growth or risk management.
Example: SWOT Analysis for a Luxurious Bag Brand
Strengths: High-quality craftsmanship; commitment to sustainable materials; unique, luxurious

designs; strong brand identity in eco-luxury segment.
Weaknesses: Higher price point compared to non-sustainable competitors; limited production due
to focus on handcrafted quality; niche market appeal.
Opportunities: Growing market for sustainable luxury fashion; increasing customer interest in
ethical and eco-friendly brands; potential for partnerships with green fashion initiatives.
Threats: Competition from established luxury brands moving into sustainable fashion; rising costs
of sustainable materials; economic downturns affecting high-end consumer spending.
Action Plan
An action plan outlines the steps the business will take to achieve its goals, based on insights from
the SWOT analysis. Each step includes specific actions, deadlines, resources, and who is responsible,
ensuring a structured approach to achieving goals and addressing challenges.
Example: Action Plan for Launching Vegan Leather Bag Collection
Action 1: Source high-quality vegan leather from certified eco-friendly suppliers and conduct
quality testing.
Responsible Team: Sourcing and quality control team
Resources Needed: Supplier contracts, testing facilities, ethical sourcing certifications
Deadline: March 30, 2025
Action 2: Design a signature collection around the vegan leather material, ensuring the line
remains consistent with the brand’s luxury aesthetic.
Responsible Team: Product design team
Resources Needed: Design software, prototype materials, design workshops
Deadline: April 15, 2025
Action 3: Launch a digital and in-store marketing campaign to introduce the new collection and
educate customers on the benefits of vegan leather.
Responsible Team: Marketing and sales teams
Resources Needed: Social media content creators, digital advertising budget, in-store displays
Deadline: May 30, 2025
Key Performance Indicators (KPIs)
KPIs are measurable metrics that help businesses track progress toward their goals. They provide
insights into various areas of performance, allowing the business to make data-driven adjustments as
needed.
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Examples of KPIs for a Luxurious Brand Business:
Customer satisfaction score

Social media engagement rate
Percentage of production materials that are sustainably sourced
Sales growth rate of the new product line
Number of bags recycled or refurbished through the buy-back program
Monthly website traffic increase following the campaign launch
Revenue generated per pop-up event or retail location
STRATEGIC PLANNING PROCESS

The strategic planning process is a structured approach that organizations follow to develop,
implement, and evaluate their strategic plan. This process involves a series of steps that guide the
organization from initial analysis to ongoing evaluation. Each step is crucial, as it helps the organization
stay aligned with its goals and adapt to any changes in the business environment.
1. Defining the Vision and Mission
The strategic process begins with a clear understanding of the organization’s vision and mission.
This foundational step ensures that all strategies and actions will support the organization’s core
purpose and long-term goals. By defining its vision and mission upfront, the organization establishes a
shared sense of direction.
2. Setting Goals and Objectives
Once the vision and mission are established, the next step is to define specific goals and objectives.
Goals are broad, long-term aims, while objectives are measurable steps that help achieve those goals.
This phase involves determining what the organization aims to accomplish and setting priorities that
will focus its resources and efforts.
3. Conducting a Situational Analysis

Before deciding on a course of action, it’s important to understand the current environment. Tools
like SWOT (Strengths, Weaknesses, Opportunities, Threats) or PEST (Political, Economic, Social,
Technological) analysis provide valuable insights into the organization’s internal capabilities and
external challenges. This analysis helps the organization identify its position in the market and
anticipate potential obstacles.
4. Formulating Strategy
With a clear understanding of the organization’s goals and the environment, it’s time to develop
strategies that align with both. Strategic formulation involves creating a plan that leverages the
organization’s strengths, addresses its weaknesses, and seizes opportunities in the market. This stage
includes deciding on competitive strategies, market positioning, and resource allocation.
5. Implementing the Strategy

A strategy is only effective if it is implemented well. This step involves putting the plan into
action by assigning roles, allocating resources, and establishing a timeline. Communication is key, as
all team members must understand their responsibilities and how their work contributes to the
broader strategy. Effective implementation ensures that strategies move from paper to reality, with
each team actively contributing.
6. Evaluating and Controlling
The final step in the strategic process is ongoing evaluation. Regularly reviewing progress helps
the organization stay on track, make adjustments, and respond to any changes in the environment.
Key Performance Indicators (KPIs) and other metrics are used to measure success, allowing the
organization to assess whether it is achieving its objectives. This step ensures that the strategic plan
remains a dynamic tool, adaptable to new challenges and opportunities.
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The strategic planning process is a continuous cycle of planning, action, and evaluation. By
following this structured approach, organizations can create strategies that are both flexible and
resilient, capable of adapting to changing circumstances while staying true to their core goals. The
strategic process ensures that every action taken contributes to the organization’s overall success,
making it an essential practice for sustainable growth.
COMMON MISCONCEPTIONS ABOUT STRATEGIC PLANNING

Strategic planning is an essential process that helps an organization set a clear direction, engage
stakeholders, and make meaningful changes.
According to Laura Johansson, strategic planning is a powerful tool for growth, but there are
several misconceptions that can undermine its effectiveness. Here are some of the most common
misunderstandings about strategic planning:
1. Strategic Planning Is Quick and Easy
Strategic planning takes time, focus, and resources. It’s not a simple task that can be completed in a
few hours. Effective planning requires a thoughtful approach, allowing team members to think
creatively and carefully about the organization’s direction. The process often involves discussing
possibilities, identifying potential challenges, and reconsidering the organization’s current path. A
typical strategic planning process can range from a multi-day retreat to a months-long process,
depending on the organization’s needs and goals.
2. Strategic Planning Is the Same as an Annual Work Plan

An annual work plan and a strategic plan are related, but they serve different purposes. An annual
work plan focuses on short-term tasks and responsibilities for the current year, while a strategic plan
looks further into the future, typically covering 2-5 years. The strategic plan should outline big-picture
goals and initiatives, not the detailed tasks found in a work plan. Once the strategic plan is in place, its
major actions and goals can then be integrated into annual work plans, ensuring alignment with the
organization’s broader vision.
3. An Outside Consultant Can Do All the Planning
While consultants can provide valuable insights and facilitate the planning process, the plan itself
should come from within the organization. A strategic plan that is created without input from key
team members is less likely to be effective because it may lack ownership. When people within the
organization contribute to the planning process, they bring their expertise, knowledge of the
company’s strengths, and understanding of its challenges. This involvement fosters buy-in, increases
the likelihood of successful implementation, and builds internal skills and ownership of the plan.
4. Strategic Planning Is Only for Leadership

Strategic planning should involve everyone, not just the top executives. Engaging employees,
customers, clients, and even community partners provides fresh perspectives and insights that are
often missed at the executive level. This collaborative approach not only strengthens the plan but also
builds goodwill and a sense of ownership among participants. Everyone in the organization should
understand how their role connects to the larger vision, and each team or department can create its
own plan that aligns with the overall strategy.
5. Once the Plan Is Complete, the Process Is Over

Strategic planning doesn’t end once the plan is written. A completed strategic plan is just the
beginning. The organization should “work the plan” by incorporating its goals into annual work plans,
ensuring that all team members are aligned with the strategic vision. Regular check-ins, such as
quarterly reviews, are essential for tracking progress, celebrating achievements, learning from
challenges, and adjusting the plan as needed. Engaging stakeholders in this ongoing process helps keep
the plan relevant and ensures that it adapts to changes in the environment.
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Strategic planning is a valuable but complex process. It requires time, resources, and a
willingness to involve a variety of stakeholders, not just leaders or external consultants. A successful
strategic plan should be realistic, integrated into work plans, and continually revisited to ensure it
stays up-to-date and impactful. In this way, strategic planning becomes a dynamic tool that evolves
with the organization, driving it toward its long-term goals.
COMMON CHALLENGES IN STRATEGIC PLANNING

Strategic planning is an essential part of running a business. It allows organizations to define their
vision, set goals, and prioritize resources for achieving them. However, strategic planning is not a
simple task; it comes with various challenges that can hinder its effectiveness. Here are some common
challenges of strategic planning and some practical solutions to help the organizations to overcome
them.
1. Lack of Clarity
One of the most common challenges of strategic planning is the lack of clarity. It can happen due to
a lack of data, insufficient market research, or unclear business objectives. Without a clear
understanding, creating a focused strategy that aligns with the overall goals and objectives of the
organization is impossible. To overcome this challenge, companies should conduct regular market
research and keep their financial and business goals in mind. It is also beneficial to involve key
stakeholders in the planning process to ensure a comprehensive understanding of the business’s
objectives and targets.
2. Resistance to Change
Strategic planning is often about making changes that can bring growth and innovation to an
organization. However, there will always be employees who are resistant to change. This could be due
to fear, a lack of trust in leaders, or being stuck in their ways. To overcome this challenge, companies
need to involve employees in the planning process, communicate with them regularly, and create an
atmosphere of positivity and innovation within the organization.
3. Lack of Resources
Another common challenge of strategic planning is the lack of resources, both financial and human.
A lack of resources can hinder the execution of the plan and its effectiveness. To overcome this
challenge, companies should prioritize their resources and allocate them wisely. This also means
identifying the areas most in need of investment, recognizing the opportunity cost of investing in less
critical areas, and looking for creative ways to use resources more efficiently.
4. Implementation Hurdles.
Even the best strategic plan can fail if it’s not successfully executed. Sometimes, the planning phase
may be fast and efficient, but the implementation stage may prove to be daunting and time-consuming.
This can happen if a company doesn’t have adequate support, communication, or sufficient buy-in
from staff and stakeholders. To overcome this challenge, companies need to build a culture of
accountability, allocate resources effectively, and encourage teamwork and collaboration to achieve
successful implementation.
5. Reactive Management
Reactive management is a common obstacle to effective strategic planning. In some organizations,
managers tend to focus on short-term concerns, which can make it difficult to focus on long-term
strategy and growth. To overcome this challenge, companies need to implement a proactive
management approach. This involves effective planning, monitoring, and analyzing results, and the
ability to quickly respond and adapt to changes in the market or competitive landscape.
In conclusion, strategic planning is vital for a company’s growth and success. Many organizations
struggle to implement effective tactics of strategic planning due to a variety of hindrances. Taking
advantage of these strategies will allow an organization to soar beyond its targets by carefully defining
its direction for future progress.
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SUMMARY
This chapter introduced the evolution, definition, and importance of strategic planning as a structured
process that empowers organizations to define their long-term vision and goals while effectively
responding to changes in the business environment. The journey of strategic planning, from its origins
in annual budget planning to its current emphasis on dynamic, long-term strategies, highlights its
critical role in fostering organizational success. The chapter outlined the various purposes of strategic
planning, emphasizing the need for a clear direction, realistic goal-setting, operational efficiency,
proactive problem anticipation, improved decision-making, optimal resource allocation, enhanced
accountability and engagement, and, ultimately, long-term sustainability. It discussed how strategic
planning serves as a roadmap, ensuring that all organizational efforts align with core values and
strategic priorities.
Additionally, the chapter delved into different strategic planning models, such as the Basic Strategic
Planning Model, Goal-Based Model, Strategic Alignment Model, Scenario Model, and Cascade Strategy
Planning Model. Each model offers unique approaches to developing actionable plans that cater to an
organization’s specific needs and context. Key components necessary for an effective strategic plan
were also discussed, including vision and mission statements, goals and objectives, SWOT analysis,
action plans, and Key Performance Indicators (KPIs). By incorporating these components, organizations
can create comprehensive frameworks that guide their path toward success. The strategic planning
process was presented as a continuous cycle of defining vision and mission, setting goals, conducting
situational analysis, formulating strategies, implementing plans, and evaluating progress. This
structured approach not only allows for strategic adaptability but also ensures alignment and
coherence throughout the organization.
However, the chapter also addressed common misconceptions and challenges associated with strategic
planning. It highlighted the need for clarity, the importance of managing resistance to change,
overcoming resource limitations, navigating implementation hurdles, and moving from reactive to
proactive management. In conclusion, effective strategic planning is an ongoing commitment that
requires time, engagement from multiple stakeholders, and a willingness to adapt. By understanding
and addressing the complexities of strategic planning, organizations can thrive, ensuring that their
efforts are directed toward sustainable growth and long-term success.
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SELF- TEST
Quiz Time!
Direction: Choose the letter of the best answer from the choices given.
1. Strategic planning is a structured process that helps organizations define their long-term _______ and
_______.
a) objectives; values
b) goals; mission
c) vision; goals
d) priorities; challenges
2. A SWOT analysis identifies strengths, weaknesses, ________, and threats.

a) opportunities
b) outcomes
c) objectives
d) improvements
3. Which model ensures that all strategies align with overall business goals and values?
a) SWOT analysis
b) Scenario model
c) Strategic alignment model
d) Cascade model
4. In a VRIO framework, what does "I" stand for?

a) Integrity
b) Investment
c) Imitability
d) Impact
5. PESTLE analysis stands for Political, Economic, Social, _______, Legal, and Environmental factors.
a) Technology
b) Territorial
c) Trade
d) Team
6. The _______ model is particularly useful for teams with limited strategic planning experience or
resources.
a) Basic Strategic Planning
b) Goal-Based Planning
c) Cascade Planning
d) Blue Ocean
7. What is the first step in the strategic planning process?

a) Setting goals and objectives
b) Conducting a situational analysis
c) Defining the vision and mission
d) Implementing the strategy
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8. Porter’s Five Forces model examines factors impacting an industry’s _______.

a) innovation
b) profitability
c) leadership
d) technology
9. Which component of a strategic plan describes the primary services or products?

a) Vision statement
b) Mission statement
c) Goals and objectives
d) Key Performance Indicators
10. Gap planning is also known as _______.

a) Need-Gap Analysis
b) PESTLE Analysis
c) Vision Analysis
d) Scenario Planning
11. _______ are specific, measurable actions that help achieve goals.
a) Visions
b) Objectives
c) Strategies
d) Resources
12. A well-structured strategic plan serves as a _______ for achieving desired outcomes.
a) vision
b) roadmap
c) benchmark
d) test
13. Scenario planning helps organizations envision various possible _______.

a) outcomes
b) profits
c) futures
d) strengths
14. The _______ model emphasizes breaking down high-level goals into tasks for departments and teams.
a) Basic Strategic Planning
b) VRIO
c) Cascade
d) Scenario
15. The vision statement presents a brief look at the _______ of the business.
a) past
b) foundation
c) future
d) strategy
Chapter 1
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Strategic Planning
19. An action plan outlines specific _______ for achieving goals.

a) outcomes
b) values
c) steps
d) budgets
20. Strategic planning allows organizations to manage _______ and foster growth.
a) changes
b) goals
c) budgets
d) complexity
21. If a startup wants to identify its internal strengths and external opportunities, which model should it
use?
a) VRIO
b) SWOT
c) Scenario
d) PESTLE
22. A company facing a rapidly changing market would benefit most from which model?
a) Cascade
b) Basic Strategic Planning
c) Scenario Planning
d) Goal-Based
23. For a company to understand the bargaining power of its customers, it should use:
a) SWOT
b) Porter’s Five Forces
c) PESTLE
d) Cascade
24. Which statement would a company’s leaders use to inspire employees with a long-term vision?
a) Mission statement
b) SWOT analysis
c) Vision statement
d) Action plan
25. A team with limited resources and strategic experience should start with:
a) Scenario Planning
b) Basic Strategic Planning
c) Goal-Based Planning
d) VRIO Framework
26. If a company wants to explore untapped markets to avoid competition, which model might it use?
a) SWOT Analysis
b) Blue Ocean Strategy
c) VRIO
d) Strategic Alignment
Chapter 1
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Strategic Planning
27. When prioritizing initiatives to improve efficiency, which component would a company use?
a) Action Plan
b) Vision Statement
c) SWOT Analysis
d) Mission Statement
28. If a nonprofit wants to recruit volunteers to close a service gap, which model fits best?
a) PESTLE
b) Gap Planning
c) Scenario Model
d) Porter’s Five Forces
29. Which strategic process step helps identify the company’s position in the market?
a) Defining Vision and Mission
b) Situational Analysis
c) Goal Setting
d) Strategy Formulation
30. A retail company needs to ensure its expansion strategy matches its core values. Which model
should it apply?
a) VRIO
b) Scenario
c) Strategic Alignment
d) Basic Strategic Planning
31. To prevent waste and optimize resources, a company might focus on which strategic planning
purpose?
a) Setting goals
b) Enhancing efficiency
c) Vision development
d) Benchmarking
32. When an organization needs specific roles and responsibilities for accountability, it should focus on:
b) KPI development
c) Action Planning
d) VRIO Framework
33. If a team wants a better understanding of factors like Political and Economic impacts, it should
conduct a:
a) SWOT Analysis
c) PESTLE Analysis
d) Blue Ocean Strategy
34. When a team needs to create a plan for adapting to unforeseen industry changes, they should use:
a) Cascade Planning
b) Scenario Planning
c) SWOT Analysis
d) Mission Statement
Chapter 1
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Strategic Planning
35. If an organization needs to analyze both internal and external influences to improve, it should use:
a) VRIO
b) SWOT
c) Scenario
d) Strategic Alignment
36. When focusing on long-term success and resilience, which purpose is being emphasized?
a) Risk taking
b) Sustainability
c) Efficiency
d) Profit maximization
37. A company needing to understand customer needs for tailored services should focus on:
a) VRIO
b) Mission Statement
c) PESTLE
d) Porter’s Five Forces
38. If a business wants to protect against industry threats, which framework would help?
a) Blue Ocean
c) Cascade
39. For a team to assess its adaptability to industry trends, it might use:
a) Vision
b) SWOT
c) Scenario
d) Gap Planning
40. To determine how resources should be allocated, a company would develop:

a) Mission
b) Action Plan
c) SWOT
d) Scenario
41. If a company wants to avoid competitive imitation, which element of VRIO is critical?
a) Value
b) Rarity
c) Inimitability
d) Organization
42. To guide employees in daily decisions, an organization should clarify its:

a) Vision
b) Objectives
c) Values
d) Action plan
Chapter 1
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Strategic Planning
43. When a company sets out to become an industry leader, this is part of its:
a) Strategy
b) Mission
c) Vision
d) SWOT
44. If an organization conducts a SWOT analysis and finds strong market demand, this is classified as:
a) Weakness
b) Threat
c) Strength
d) Opportunity
45. When executives work to align strategy with core operations, they're using:
b) Strategic Alignment
c) Goal-Based
46. For specific, detailed tracking of goal completion, the best tool is:
a) KPIs
b) SWOT
c) Mission
d) Vision
47. Which framework includes evaluating threats from substitute products?

a) Porter’s Five Forces
b) VRIO
c) PESTLE
d) Cascade
48. To help employees understand the company's purpose, a business should communicate its:
a) Mission
b) Scenario
c) SWOT
d) Action plan
49. A company wanting to focus on untapped market space for growth would use:
a) Porter’s Five Forces
b) Blue Ocean Strategy
c) VRIO
d) SWOT
50. Analyzing both employee skills and potential external hires would fall under:
a) Gap Planning
b) Scenario
c) SWOT
d) PESTLE
Chapter 1
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Strategic Planning
CASE STUDY
Best Buy - Storefront Strategy
Best Buy, the multinational electronics retailer, is an excellent example of how a shift in
business strategy can lead to rapid growth. In 2012, Best Buy faced fierce market competition with
online platforms like Amazon and big-box stores like Walmart and Home Depot. As a result, the
company lost over a billion dollars in revenue in a single quarter.
Rather than closing stores or developing new products, Best Buy's leadership decided to leverage
an existing asset not being utilized to its full potential: its storefronts. Best Buy started using its
stores as "mini-warehouses," providing faster shipping times, easier customer pick-up, and
improved product availability. As a result of enhancing convenience for the customer, Best Buy
increased its willingness to pay (WTP).
Best Buy is an exceptional example of a value-based business strategy because it subsequently

lowered willingness to sell (WTS) with this initiative. By keeping the vast network of stores intact
and allowing vendors to build showrooms within its stores, Best Buy provided a cost-effective option
for its vendors. This additional value lowered vendors' WTS, leading to product discounts.
Summary: Faced with declining revenues due to competition from online retailers, Best Buy shifted
its strategy by leveraging its physical stores as "mini-warehouses." This innovative approach
allowed for faster shipping and improved customer service, demonstrating how strategic planning
can adapt to market changes and enhance customer value. This case highlights the importance of
utilizing existing resources creatively to meet new challenges.
Chapter 1
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Strategic Planning
REFERENCES
[1]https://www.progressio.org.uk/sites/de [11]https://www.clearpointstrategy.com/blo
fault/files/3_Strategicplanning.pdf g/strategic-planning-models
[2]https://actiosoftware.com/en/what-are- [12]https://asana.com/resources/strategic-
the-advantages-and-disadvantages-of- planning-models
strategic-planning/ [13]https://caulcbua.pressbooks.pub/busines
[3]https://www.imd.org/blog/strategy/stra sinforesearchguide/chapter/__unknown__-1
tegic-planning-process/ 6/#:~:text=A%20PESTLE%20analysis%20ass
[4]https://www.ninety.io/blog/strategic- esses%20six,potential%20opportunity%20fo
plan-examples r%20your%20company.
[5]https://www.projectmanager.com/blog
/strategic-planning-models [6]https://ctb.ku.edu/en/table-of-
[6]https://www.mural.co/blog/strategic- contents/structure/strategic-
planning-models planning/vmosa/main
[7]https://www.notion.so/blog/strategic- https://addzerosnow.com/2023/10/overcomi
planning-models ng-common-challenges-of-strategic-
[[8]https://bscdesigner.com/scenario- planning-for-effective-business-growth/
planning.htm
[9]https://www.synario.com/resources/bl https://www.indeed.com/career-
og/scenario-planning-in-strategic- advice/career-development/elements-of-
management/ strategic-planning
[10]https://cmoe.com/glossary/cascading- http://www.laurajohansson.com/blog/2019/3
strategy/ /25/five-common-misconceptions-
concerning-strategic-planning
Chapter 1
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CHAPTER
2
PROFIT PLANNING AND

COST-VOLUME-PROFIT
ANALYSIS
Profit Planning and Cost-Volume-Profit Analysis
INTRODUCTION
Corporate managers aim to maximize shareholder wealth. However, since there is no clear,
singular path to achieve this goal they must select a specific strategy and create plans and controls to
implement it. As planning is inherently forward-looking it involves uncertainty, which can be
mitigated by information. Controlling involves aligning actual performance with these plans making
information essential to the process. Much of the data managers rely on for planning and control
pertains to the interconnections between product costs, selling prices, and sales volumes. Altering
any of these key elements will affect the others. For instance, a manager might need to assess
whether increasing advertising spending for a certain product would be justified by the resulting
rise in sales volume and contribution margin.
This chapter emphasizes the importance of understanding how cost, volume, and profit interact.
Grasping these relationships is crucial for forecasting future conditions (planning) and for analyzing,
assessing, and responding to outcomes (controlling). Before a company can generate profit, it must
first achieve its break-even point, meaning it needs to earn enough sales revenue to cover all costs.
By connecting cost behavior with sales volume, managers can utilize the cost-volume-profit model
for effective planning and control.
Additionally, the chapter introduces the concepts of margin of safety and degree of operating
leverage. The insights provided by these models assist managers in understanding how changes in
volume can impact organizational profitability.
Learning Objectives
Explain cost-volume-profit (CVP) analysis, the CVP model, and the strategic role of CVP
analysis.
Identify the assumptions and limitations of CVP analysis and their effect on the proper
interpretation of the results.
Apply CVP analysis for breakeven planning.
Adapt CVP analysis for multiple products.
Employ sensitivity analysis to more effectively use CVP analysis when actual sales are
uncertain.
Understand how margin of safety and operating leverage are used in business.
Chapter 2
21
COST-VOLUME-PROFIT ANALYSIS
Cost-volume-profit (CVP) analysis is a method for analyzing how operating decisions and
marketing decisions affect profit based on an understanding of the relationship between variable
costs, fixed costs, unit selling price, and the output level. CVP analysis has many applications:
Deciding whether to make or buy a given product or service.

Determining the best product mix.
Performing strategic what-if analyses.
Setting prices for products and services.
Introducing a new product or service.
Replacing a piece of equipment.
Determining the breakeven point.
Cost-Volume-Profit (CVP) analysis relies on a clear model that illustrates the relationships
among three key factors: costs, sales, and profits, and how these factors change in a predictable
manner as activity volume fluctuates. The CVP model can be expressed as:
Operating Profit = Sales - Total Costs
In this equation, operating profit refers to profit before taxes and excludes any unusual or
nonrecurring items. When there are no such items, operating profit is equivalent to before-tax
income. Since our focus is on how costs and sales change with volume, it’s essential to
differentiate between variable and fixed costs. This leads us to a rearranged version of the
equation:
Sales = Fixed Costs + Variable Costs + Operating Profit
Next, if we substitute sales with the product of the number of units sold and the selling price,
and replace variable costs with the product of unit variable cost and the number of units sold, the
CVP model can be reformulated as follows:
Units sold x Price = Fixed cost

+ Units sold x Unit variable cost
+ Operating profit
For ease of use, this model is often represented symbolically as: p x Q = F + (v x Q) + N

where,
Q = units sold
p = unit selling price
F = total fixed cost
v = unit variable cost
N = operating profit
Chapter 2
22
STRATEGIC ROLE OF CVP ANALYSIS

CVP analysis helps companies carry out their plans by showing how changes in sales volume
affect costs and profits. Many businesses, those aiming to be cost leaders, try to boost their sales
(often by cutting prices) to lower their overall operating expenses and their fixed costs per unit.
CVP analysis gives a way to predict how growing sales will impact profits. It also points out the
risks of raising fixed costs if sales drop.
Strategic Questions Answered by CVP Analysis
1. What is the expected level of profit at a given sales volume?

2. What additional amount of sales is needed to achieve a desired level of profit?
3. What will be the effect on the profit of a given increase in sales?
4. What is the required funding level for a governmental agency, given desired service levels?
5. Is the forecast for sales consistent with forecasted profits?
6. What additional profit would be obtained from a given percentage reduction in unit
variable costs?
7. What increase in sales is needed to make up a given decrease in price to maintain the
present profit level?
8. What sales level is needed to cover all costs in a sales region or product line?
9. What is the required amount of increase in sales to meet the additional fixed charges from a
proposed plant expansion?
CVP analysis plays a key role in life-cycle costing and target costing. When a product is new, CVP
analysis helps predict if it will make enough money. It also aids target costing by showing how
different designs with varied target costs affect profit.
CVP analysis proves useful later in the life cycle too, during production planning to find the
most efficient manufacturing process. These production choices include the right time to swap out
a machine, which type of machine to purchase, when to switch to automation, and when to hire an
outside company for manufacturing. CVP analysis is also employed at the end of the cost life cycle
to figure out the most effective marketing and distribution systems. For instance, CVP analysis
helps decide whether to compensate salespeople with a salary or commission to lower costs. Also, it
assists in evaluating how desirable a discount program or promotional plan might be.
CVP analysis plays a part in strategic positioning. Companies that aim to lead on cost need CVP
analysis when they make things. Here, CVP analysis helps find the cheapest ways to produce
things like using machines, getting others to do the work, or making sure everything's top-notch.
On the flip side, businesses that want to stand out use CVP analysis early on to check if new
products will make money and if adding new stuff to old products is worth it. These ideas work for
shops and places that provide services too.
Chapter 2
23
ASSUMPTIONS & LIMITATIONS OF CVP ANALYSIS

Cost-Volume-Profit (CVP) analysis is a short-term model that examines the relationships among
selling price, variable costs, fixed costs, volume, and profit. This framework serves as a valuable
planning tool offering insights into how profit is affected by changes in cost structures or sales
levels. However, several key assumptions limit the accuracy of the CVP model. These assumptions
include:
Linear Revenue and Cost Behavior: It is assumed that revenue and variable costs behave
consistently per unit and are linear within the relevant range.
Contribution Margin Linearity: The total contribution margin (total revenue minus total variable
costs) is also considered linear within the relevant range and increases proportionately with output
following from the first assumption.
Constant Total Fixed Costs: Total fixed costs are assumed to remain unchanged within the
relevant range indicating that no capacity expansions will occur during the analysis period.
Separation of Mixed Costs: Mixed costs can be accurately divided into fixed and variable
components. While this separation may be subject to some inaccuracies, reliable estimates
can be obtained using methods like regression analysis or the high-low method.
Equal Sales and Production: It is assumed that sales volume matches production volume,
leading to stable inventory levels. This assumption is crucial because fixed costs can be
allocated to inventory differently each year, necessitating access to variable costing
information. The compatibility between CVP analysis and variable costing stems from their
shared focus on cost behavior.
Constant Sales Mix in Multi-Product Firms: In cases where multiple products are sold, it
is assumed that the sales mix remains consistent. This assumption allows for the
calculation of a weighted average contribution margin and contribution margin
percentage.
Labor productivity, production technology, and market conditions will not change. If any of these
changes were to occur, costs would change correspondingly, and selling prices might change. Such
changes would invalidate assumptions 1 through 3.
These assumptions limit the activity volume for which the calculations can be made as well as the
time frame for the usefulness of the calculations. If changes occur in selling price or cost, new
computations must be made for break-even and CVP analysis.
CONTRIBUTION MARGIN AND BREAK EVEN POINT

Profit planning or profitability optimization is the development of a work plan for company
operations expressed in a calculation. Profit planning is useful to assist management in planning,
budgeting and decision making both short and long term in order to achieve company goals.
Chapter 2
24
Contribution Margin
CM per unit equals selling price per unit minus total variable cost per unit, which includes
production, selling, and administrative cost. Unit contribution margin is constant because revenue
and variable cost have been needed as being constant per unit. Total CM is the difference between
total revenue and total variable cost for all units sold. This amount fluctuates in direct proportion to
sales volume. On either a per-unit or a total basis, CM indicates the amount of revenue remaining
after all variable costs have been covered. This amount contributes to the coverage of fixed cost and
the generation of profit.
Effective use of the CVP model requires an understanding of three additional concepts: the
contribution margin, the contribution margin ratio, and the contribution income statement. The
contribution margin is both a unit and a total concept. The unit contribution margin is the
difference between unit sales price and unit variable cost:
p - v = Unit contribution margin
The unit contribution margin measures the increase in operating profit for a unit increase in
sales. If sales are expected to increase by 100 units, profits should increase by 100 times the
contribution margin. The total contribution margin is the unit contribution margin multiplied by the
number of units sold.
For example, assume that OBX Seating, a manufacturer of chairs, is interested in developing a
new product, a desk chair, that would be priced at P95 and would have variable costs of P55 per
unit. Assume also that the new product will have no effect on sales of existing products. The
investment would require new fixed costs of P80,000. The company expects sales of 2,600 units in
the first year and 2,800 units in the second year. The data for OBX Seating are summarized in Figure
2.1.
Table 2.1 Data for OBX Seating: Desk Chair
Per Unit 2022 2023
Fixed cost P80,000 P80,000
Revenue P95
Variable cost P55
Planned
2,600 units 2,800 units
production
Planned sales 2,600 units 2,800 units
Chapter 2
25
Table 2.2 Contribution Income Statements for OBX Seating’s Proposed Desk Chair
2022 2023
Change Notes
Amount Percent Amount Percent
Sales 247,000 100.00% 266,000 100.00% 19,000 100.00% is the sales rate
57.89% is the variable cost

Variable Cost 143,000 57.89% 154,000 57.89% 11,000
rate
Total Contribution 42.11% is the contribution

104,000 42.11% 112,000 42.11% 8,000
Margin margin ratio
Fixed Costs P80,000 P80,000 0
Operating Profit 24,000 32,000 8,000 8,000 = 42.11% x 19,000
The unit contribution margin for each desk chair would be P40 (95-55). Using the unit contribution
margin, we see that if OBX expects to sell 2,600 tables in 2022, it can expect to increase total
contribution margin in 2022 by 104,000 ($40 x 2,600) and operating profit by 24,000 (104,000 - 80,000
fixed cost). In 2023 profits increased as sales increased by 200 units, from 2,600 to 2,800 units. Since
fixed costs are the same in both years, the increase in profits from 2022 to 2023 is equal to the
change in total contribution margin from 2022 to 2023, that is, unit contribution of P40 times the
increase in units sold, or $8,000 (P40 contribution per unit x 200 units). These results are shown in
Table 2.2.
A measure of the profit contribution per sales dollar is the contribution margin ratio, which is the
ratio of the unit contribution margin to unit sales price (p - v) / p. The contribution margin ratio for
OBX’s proposed desk chair is 42.11% (95-55)/95. The ratio identifies the amount of increase (or
decrease) in profits caused by a given increase (or decrease) in sales. What is the effect on operating
profit of an increase of 19,000 in sales from 2022 to 2023? We can quickly calculate that profits will
increase by 8,000 (19,000 x 42.1052) from 2022 to 2023.
A useful technique to illustrate the information developed in the CVP analysis is using the
Contribution Income Statement. The contribution income statement focuses on cost behavior—it
divides fixed costs and variable costs. In contrast to the traditional income statement which focuses
on cost type—product cost and non-product cost. In the contribution income statement, variable
costs are removed from sales to calculate total contribution margin. In contrast, the conventional
income statement– product costs are subtracted from sales to get gross margin. Table 2.2 shows the
contribution income statement for OBX’s desk chairs. Note that the sales increase of 200 units and
P19,000 caused an P8,000 increase in profits as predicted by the contribution margin and
contribution margin ratio. It is not possible to predict the change in profit from a given change in
sales with the traditional income statement, which does not separate variable and fixed costs.
Chapter 2
26
The contribution margin may be computed in at least four (4) ways, as follows:
1. CM = Sales - Variable Costs
2. CM = Fixed Costs + Profit
3. CM = Units sold x Unit Contribution Margin
4. CM = Sales x Contribution Margin Rate
Likewise, you should have observed the following important relationships:

Profit = Contribution Margin - Fixed costs
Variable Cost Rate = Variable Cost/ Sales
= Unit Variable Cost/ Unit Sales Price
CM Rate = Contribution Margin / Sales
= Unit Contribution Margin/ Unit Sales Price
=100% - VCRation
BREAK EVEN POINT IN UNITS AND IN PESOS

A company’s break-even point (BEP) is that level of activity, in units or pesos, at which total
revenue equals total cost. Thus, at BEP, the company generates neither a profit nor a loss in
operating activities. Companies, however, do not wish merely to “break-even” on operations. The
BEP is calculated to establish a point of reference. Knowing BEP, managers are better able to set
sales goals that should result in profits from operations rather than losses.
Example:
Fixed Costs (FC): P100,000
Sales Price per Unit (SP): P25
Variable Cost per Unit (VC): P15
Units Sold: 15,000 units
ACTUAL SALES BREAK EVEN SALES
Units Price Amount Units Price Amount
Sales 15,000 25 375,000 Sales 10,000 25 250,000
Variable Cost 15,000 15 225,000 Variable Cost 10,000 15 150,000
Total Total
Contribution 15,000 10 150,000 Contribution 10,000 10 100,000
Margin Margin
Fixed Costs 15,000 100,000 Fixed Costs 10,000 100,000
Operating Operating
15,000 50,000 0
Profit Profit
Chapter 2
27
Break-Even Point in Units

Break Even Point (Units) = Fixed Costs / Sales Price per Unit−Variable Cost per Unit
Using the formula:

Break Even Point (Units) = 100,000 / 25 - 15
= 100,000 / 10
= 10,000 units
This means you need to sell 10,000 units to cover all costs.
Break-Even Point in Pesos

Break Even Point (Pesos) = Fixed Costs / Contribution Margin Ratio
where,
Contribution Margin Ratio = Contribution Margin / Sales Price per Unit

= SP = SP−VC / SP
Using the formula:
CM = 25 − 15 = 10
CMR = 10 /25 = 0.4
Break Even Point (Pesos) = 100,000 / 0.4

= 250,000
This indicates that you need to generate 250,000 pesos in sales revenue to break even.
MULTI-PRODUCT CVP ANALYSIS

Companies often develop and sell multiple items, some of which may be connected. To conduct a
CVP analysis in a multiproduct organization, one needs assume that:
The product sales mix remains steady as total sales volume fluctuates.
The average contribution margin ratio remains constant while total sales volume varies.
Example:
An organization makes and sells three products N, O and P. The products are sold in the given
proportions N:O:P = 2:1:3. The organization's fixed costs are $79,000 per month and details of the
products are as follows.
Product Selling price P per unit Variable cost P per unit The organization wishes to
earn a profit of $53,000
next month. Calculate the
required sales value of each
N 24 18
product in order to achieve
this target profit.
O 17 14
P 21 15
Chapter 2
28
Solution:
1. Calculate contribution per unit.
N O P
P per unit P per unit P per unit
Selling price 24 17 21
Variable cost 18 14 15
Contribution 6 3 6
2. Calculate contribution per mix.

= (6 x 2) + (3 x 1) + (6 x 3)
= 33
3. Calculate the required number of mixes.

= (Fixed costs + required profit)/contribution per mix
= (79,000 + 53,000)/33
= 4,000 mixes
4. Calculate the required sales in terms of the number of units of the products and sales revenue of
each product.
Selling Sales revenue

Product Units
price required
P per unit P
F 4,000 x 2 8,000 24 192,000
G 4,000 x 1 4,000 17 68,000
H 4,000 x 3 12,000 21 252,000
Total 512,000
The sales revenue of P512,000 will generate a profit of $53,000 if the products are sold in the mix
2:1:3.
Alternatively, the C/S ratio could be used to determine the required sales revenue for a profit of
$53,000. The method is again similar to that demonstrated earlier when calculating the breakeven
point. Multi-product analysis can assist in understanding how each product or service impacts the
overall profitability and performance. It can help businesses determine which items or services are
the most and least profitable, as well as how to optimize your sales mix and price strategy. It can
also assist them in determining how changes in expenses, prices, or demand will affect the profit
margin and break-even point. Multi-product analysis can also assist in making rational choices
regarding introducing new products or services, eliminating existing ones, and broadening or
contracting production capacity.
Chapter 2
29
CVP SENSITIVITY ANALYSIS

CVP analysis becomes an important strategic tool when managers utilize it to assess the
sensitivity of profits to potential changes in expenses or sales volume. If costs, pricing, or volumes
change considerably, the firm's strategy may also need to change. For example, if there is a
possibility that sales levels may fall below expectations, management should minimize anticipated
fixed cost investments. The additional capacity will not be required if sales fall, although it will be
difficult to minimize fixed costs in the short run. Sensitivity analysis refers to a group of methods
that investigate how an amount changes when the factors used to forecast it change. Sensitivity
analysis is particularly important when a great deal of uncertainty exists about the potential level of
future sales volumes, prices, or costs.
What-if analysis is the calculation of an amount given different levels for a factor that influences that
amount. It is a common approach to sensitivity analysis when uncertainty is present. Many times it is
based on the contribution margin and the contribution margin ratio.
Example:
Consider a company with the following base case assumptions:
Fixed Costs: 3,400
Variable Cost per Unit: 8.30
Sales Price per Unit: 10.00
Sales Volume: 2,500 units
Scenario 1: Increase Sales Price by 2%

New Sales Price: P 10.20
The unit contribution margin is P 1.9 (P10.20 - 8.30). The CMR, BEP (pesos), and operating profit
are as follows:
CMR = P 1.9/ P 10.20 = 19%
BEP (pesos) = P 3,400/ 19% = P 18,252.63
Operating profit = ?
Contribution Margin (2,500 units x P 1.9) P 4,750 Contribution Margin

increases, leading to
higher profits.
Fixed Costs (3,400)
Operating Profit P 1,350
Scenario 2: Decrease Sales Volume by 10%

New Sales Volume: 2,250 units
The CMR, BEP (pesos), and operating profit are as follows:
CMR = P 1.7/ P 10 = 17%
BEP (pesos) = P 3,400/ 17% = P 20,000
Operating Profit = ?
Chapter 2
30
Contribution Margin (2,250units x P 1.7) P 3,825 This reduction typically

results in decreased
profits due to lower
Fixed Costs (3,400)
total revenue.
Operating Profit P 425
Scenario 3: Change in Costs

Decrease Fixed Costs by 60% and increase Variable Costs by 10%.
The CMR, BEP (pesos), and operating profit are as follows:
CMR = P 0.87/ P 10 = 8.7%
BEP (pesos) = P 3,400/ 8.7% = P 39,080.50
Operating profit = ?
Contribution margin ( 2,500 units x P 0.87) P 2,175 This scenario can show
whether the increase in
variable cost outweighs
Fixed Costs (1,360)
the benefit of reduced
fixed costs.
Operating profit P 815
CVP relationships can be formally analyzed using standard metrics to evaluate risk/reward
relationships at existing sales levels or prospective sales levels. Two of these metrics are margin of
safety and degree of operating leverage.
Companies use the margin of safety (MS) and degree of operating leverage (DOL) concepts as
follows:
the MS indicates how far (in units, in sales dollars, or as a percentage) a company is
operating from its BEP; the MS% is equal to (1 - DOL).
the DOL shows the percentage change that would occur in profit given a specified
percentage change in sales from the current level; the DOL is equal to (1 - MS%).
MARGIN OF SAFETY
In accounting, the margin of safety indicates how much sales can decline before a company
reaches its breakeven point—the level at which total revenues equal total costs, resulting in neither
profit nor loss. The formula for calculating the margin of safety is:
Margin of safety in units = Actual sales in units - Break-even sales in units

Margin of safety in Pesos = Actual sales in Pesos - Break-even sales in Pesos
Margin of safety % = Margin of safety in units - Actual unit sales or
= Margin of safety in Pesos / Actual sales Pesos
Chapter 2
31
Example:
Units Amount Rate
Actual Sales
Actual Sales 600,000 P 24,000,000 100.00%
Rate
Breakeven
Less: Breakeven Sales 400,000 P 16,000,000 66.66%
Sales Rate
Margin of
Margin of safety 200,000 P 8,000,000 33.33%
Safety Rate
In units: 600,000 actual - 400,000 BEP = 200,000 units

In sales P: P24,000,000 actual sales - P 16,000,000 BEP sales = P 8,000,000
As a percentage: 200,000 / 600,000 = 33.33% or P 8,000,000 / P 24,000,000 = 33.33%
A higher margin of safety suggests that a company can withstand a greater decline in sales before
incurring losses, providing a cushion against market volatility and operational risks. It also provides
confidence to invest in growth initiatives without immediate concern for revenue fluctuations.
Conversely, a low margin may prompt management to cut costs or adjust pricing strategies to
enhance profitability. The product with a relatively low margin of safety ratio is the riskier of the
two products and therefore usually requires more of management’s attention. Understanding and
calculating this metric can lead to more resilient financial strategies and investment choices.
DEGREE OF OPERATING LEVERAGE

Another measure that is closely related to the MS and provides useful management information is
the company’s degree of operating leverage. It is a financial metric that quantifies the sensitivity of
a company's operating income to changes in sales. It reflects the proportion of fixed costs in a
company's cost structure relative to variable costs, thereby influencing how fluctuations in sales
impact profitability.
DOL measures how much the operating income (or Earnings Before Interest and Taxes, EBIT)
will change in response to a change in sales revenue. A higher DOL indicates that a small
percentage increase in sales can lead to a significantly larger percentage increase in operating
income, making the company more sensitive to sales fluctuations. Conversely, a lower DOL suggests
that changes in sales will have a smaller impact on operating income.
The DOL can be calculated using several formulas, but the most common is:
Degree of Operating Leverage = Percentage in EBIT
Percentage in Sales
Alternatively, it can be expressed as:
DOL = Contribution Margin / Profit before tax
This calculation assumes that fixed costs do not increase when sales increase.
Example:
Assume that Bill Company is currently selling 600,000 clocks. If Bill increases sales by 20 percent,
the 60 percent change in profits equals the DOL multiplied by the percentage change in sales or
(3.00 x 20%). If sales decrease by the same 20 percent, the impact on profits is a negative 60
percent.
Chapter 2
32
Current (600,000 clocks) Current (600,000 clocks) Current (600,000 clocks)
Sales 24,000,000 28,800,000 19,200,000
Variable cost (29.00 perclock) (17,400,000) (20,880,000) (13,920,000)
Contribution margin 6,600,000 7,920,000 5,280,000
Fixed cost (4,400,000) (4,400,000) (4,400,000)
Profit before tax 2,200,000 3,520,000 880,000
Degree of operating leverage = Contribution margin / Profit before tax
(6,600,000 - 2,200,000) 3.00
(7,920,000 - 3,520,000) 2.25
(5,280,000 - 880,000) 6.00
Profit increase = 3,520,000 - 2,200,000 = 1,320,000 (or 60.00% of the original profit).
Profit decrease = 880,000 - 2,200,000 = (1,320,000) (or −60% of the original profit).
The DOL lowers when sales increase from the BEP. When there is a low margin of safety,
operating leverage increases. In reality, at the BEP, the DOL is infinite since each rise from zero
represents an infinite percent change. If a corporation operates around the BEP, each percentage
rise in sales might have a huge influence on net income. As sales increase from the break-even
point, margin of safety increases but the degree of operating leverage declines. The relationship
between the MS percentage (MS%) and DOL is as follows:
MS% = 1 / DOL
DOL = 1 / MS%
This relationship is proved in Table 2. using the 600,000-clock sales level information for Bill.
Therefore, if one of the two measures is known, the other can be easily calculated.
Break-even sales = 400,000 units; Current sales 600,000 units

Margin of safety % = Margin of safety in units - Actual sales in units
= [(600,000 - 400,000) / 600,000]
= 0.33, or 33% (rounded)
Degree of operating leverage = Contribution margin / Profit before tax
= 6,600,000 - 2,200,000
=3
Margin of safety = (1 / DOL) = (1 / 3) = 0.33, or 33% (rounded)
Degree of operating leverage = (1 / MS%) = (1 / 0.33) = 3 (rounded)
Implications of High and Low DOL

High DOL:
Companies with high DOL typically have a larger proportion of fixed costs relative to variable
costs. This structure allows them to leverage increases in sales into greater profits after
surpassing their break-even point.
However, this also means they face higher risks during downturns; if sales decline, they still
must cover substantial fixed costs, which can lead to significant losses.
Low DOL:
Companies with low DOL have higher variable costs and lower fixed costs. This setup provides
more stability since their expenses decrease with declining sales.
Such companies may not benefit as much from increases in sales because their profit margins
are less sensitive to changes in revenue.
Chapter 2
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SUMMARY
This chapter covered CVP analysis, which is a linear model of the relationships between costs,
revenues, and production levels. Breakeven planning defines the output level at which profits are
zero. Breakeven analysis is used in planning and budgeting to determine the value of existing and
anticipated products and services. CVP analysis is frequently used in revenue planning to calculate
the number of sales required to attain a particular profit level by adding it to the breakeven
equation. CVP analysis is used in cost planning to determine the required cost reduction to achieve
desired profits or the required change in fixed cost for a given change in variable cost.
Sensitivity analysis is helpful because earnings in business entities with relatively large fixed
expenses are more sensitive to changes in sales volume. The margin of safety and operating leverage
assess the sensitivity, or risk, of changes in sales levels.
With two or more goods, CVP analysis assumes a consistent sales mix between them and the break
even point is calculated using the weighted-average contribution margin.
There are several limits to employing breakeven analysis. For example, we assume that total fixed
and unit variable costs remain constant.
Chapter 2
34
CASE STUDY
Background: Air Land Transport, Inc. (ALTI), a mid-sized freight forwarding company was
founded in 1987 by Preston Smith. Over the course of three decades, Preston grew ALTI from a
single office with just one employee and no clients to a national company with more than 50 offices,
500 employees and $250,000,000 in revenues. ALTI grew by specializing in the shipment of unusual,
time-sensitive freight with special shipping requirements that major freight carriers couldn’t
handle well in their large, monolithic shipping systems such as sensitive electronic equipment and
high-value medical products. Freight forwarders such as ALTI, don’t own the trucks and planes
being used to transport shipments. Instead, they rely on specialized trucking and air transport
companies that cater to large shippers like ALTI who can bundle together numerous small
shipments into larger single shipments headed from one destination to another.
Outcome: The case demonstrated how CVP analysis could guide strategic decisions about market
entry by providing insights into necessary sales volumes and financial goals. This approach helped
management assess risks and opportunities associated with expansion.
In this case, an accounting analyst for a mid-sized logistics company is asked to determine whether
a possible expansion into a new geographic market can achieve management’s required financial
goals. Studying CVP analysis in a real-world context enhances student understanding of the topic
and allows students to understand that CVP can be used to assist managers when making a wide
array of business decisions.
Tad Phillips settled into his normal spot in the executive conference room at ALTI’s Denver
headquarters. He had become very accustomed to the regular Monday morning meetings with
ALTI’s executive team to review the prior week’s business activities. Tad had spent the past three
years as an accounting analyst for ALTI after earning his accounting degree and spending four
years as an Operations Assistant in ALTI’s Memphis office. His combination of operations
experience and accounting knowledge had allowed Tad to quickly advance at ALTI, and he now
found himself giving regular advice to ALTI’s top decision makers.
As the executive team began arriving, Tad noticed a new face to the weekly meeting - Rich
Summers, head of Western Region Sales. He and Rich had worked closely the previous year on
developing an aggressive pricing offer to fend off competition for the Factor Medical account, one
of ALTI’s largest clients on the west coast. The meeting agenda didn’t mention anything about Rich
or Factor Medical, so Tad was curious about Rich’s attendance at the meeting. Preston Smith, CEO of
ALTI, began the meeting, “We’re going to deviate from our usual schedule this week. Rich Summers
called me last night with some big news about the Factor Medical account. Factor is expanding into
the eastern U.S. region and is going to open a new distribution hub in Nashville. Based on our
established relationship, Rich has convinced Factor to give us the first opportunity to bid on being
their exclusive shipper for all their overnight and two-day shipments. Factor has told Rich that if
we give them great rates and can promise our dependable service, they won’t even take bids from
anyone else. The catch is that they want to see our bid in three days”. The energy level in the room
immediately jumped as the executives began to process the implications of this news. ALTI had
seen their revenues reach
Chapter 2
35
$250,000,000 in the previous year, and Factor Medical accounted for nearly 10% of that revenue.
Charlene Rayman, ALTI’s CFO, excitedly turned to Rich and asked, “Are they projecting the same
level of business in their Nashville distribution center as their Los Angeles distribution center?”. Rich
gave a little smile and shook his head, “Not exactly. Factor projects that their Nashville shipments
will only be about 10% of their Los Angeles shipments during the first few years, but they also think
their eastern operations could surpass their western operations within a decade”. Charlene, like
everyone else in the room, started rapidly calculating estimates related to the possible news account.
“I want this new business as long as it makes us money, and Rich assures me that this one can make
us a lot of money.” Preston said plainly. “I’m not as confident as Rich about the profits available from
the new Factor shipments, but they’re a vital client for us. We need to give them a bid quickly, so we
need to understand what we can and can’t offer,” Preston continued. Tad had done the financial
analysis for the opening of nearly a dozen new offices since taking over as Accounting Analyst. He
was very familiar with Preston’s two rules on expanding into new cities-– don’t lose money in the
first year, and make at least 40,000 of operating income in the second year. Tad was also very
familiar with how thinly ALTI had been forced to cut the profit margins on the Factor Medical
account the prior year to fend off competition.
Preston turned to Tad, “Don’t bother giving us a review of last week’s activities, Tad. You and Rich
need you to start modeling estimates on a new Nashville office immediately. Rich has already done a
lot of background work which means you won’t have to start from scratch. You two were vital to
keeping Factor Medical last year, so we’re expecting the same again. We’ll all meet back here
tomorrow morning to see what you’ve come up with”.
As Tad walked back to his office to meet with Rich, his mind was racing with all the costs and
estimates they would need to quickly put together. Rich walked into the office right behind Tad, “You
look a little overwhelmed, Tad! Don’t worry too much. We have a lot of great truck lines and air
cargo options from Nashville, and they’re all cheap. We’ll make lots of money with this one.”
“I appreciate the enthusiasm,” Tad replied, “but I’ll worry less when I see some analysis showing that
this expansion will work for ALTI. You know the projected shipping volumes and how much we can
charge Factor to ship from Nashville, so you come up with those two elements; and I’ll come up with
projections for costs of our new office and our shipping costs. Email everything you have so far, and
let’s get to work.” Tad’s previous experience estimating costs of new offices allowed him to quickly
put together a list of the typical elements and associated costs necessary to get up and running
inNashville (See Exhibit 1 - Appendix). He knew that some costs – rent, utilities, office supplies,and
furniture/equipment rental – would be paid monthly, while all employee salaries would be paid
weekly. He also knew that these costs were stable and didn’t tend to change as long as operations
remained within a normal range.
Tad also relied on his previous experience when choosing trucking and air cargo vendors to use
from Nashville. Cost was always a major factor when choosing a trucking or air cargo vendor, but
reliability couldn’t be ignored either. ALTI had won many accounts because of their reputation for
getting important shipments delivered on-time, so Tad knew that a cheaper vendor wasn’t always
the best choice. ALTI would be shipping both overnight and two-day shipments to three different
geographic zones for Factor Medical. Zone 1 would be for destinations within 300 miles of Nashville.
This meant all Zone 1 shipments could be moved by one of ALTI’s trucking vendors. Zone 2
shipments would be for destinations between 301 and 600 miles of Nashville, while Zone 3
shipments would be for any destination more than 600 miles. Two-day shipments to zones 2 and 3
could still be sent by truck line, but overnight shipments to these zones would have to be moved by
one of ALTI’s air cargo vendors. Tad decided to use cost estimates from some of ALTI’s most reliable
vendors, despite the fact that they didn’t necessarily offer the lowest cost.
Chapter 2
36
Soon after Tad finished his cost estimates, Rich provided him with a proposed pricing list for
Factor Medical and estimated monthly shipping volumes from Factor’s Nashville distribution center.
Rich told Tad that pricing for Factor Medical would not change for the first two years, but that Factor
expected a 15% increase in shipping volume in their second year of operations. Tad also knew that
he could lock in prices with ALTI’s Nashville trucking and air cargo vendors for two years, but that
the costs of operating the new office would increase approximately 2% each year. With all of this
data, Tad had everything he needed to determine whether ALTI could break even in their first year
of operations in Nashville, and whether ALTI could make the required $50,000 of operating income
in year 2.
CASE SUMMARY:
Air Land Transport, Inc. (ALTI), founded in 1987, specializes in transporting sensitive and
time-critical freight. With a nationwide presence, ALTI serves high-value clients, such as
Factor Medical. At a recent executive meeting, ALTI’s CEO announced that Factor Medical was
expanding operations and invited ALTI to bid as their exclusive shipper for a new Nashville
hub, presenting a significant business opportunity. Accounting analyst Tad Phillips and sales
head Rich Summers were tasked with developing a bid proposal. Tad, leveraging his
experience in cost projections and vendor selection, set out to analyze the financial viability
of the expansion. Factoring in stable pricing, estimated shipment volumes, and expected cost
increases, Tad aimed to ensure that ALTI would meet profitability goals in both the first and
second years.
Chapter 2
37
REINFORCING THE CONCEPTS!

After grasping the the different principles and techniques in cost-volume-profit analysis, sensitivity
analysis, and degree of operating leverage, let us consider the following sample problem to find
out their interrelationships.
Sample Problem. CVP Sensitivity Analysis

VoltEdge Electronics Ltd. is preparing for the upcoming fiscal year and needs to employ a profit
planning strategy to ensure its profitability. The following operating data are used:
Unit Sales Price P 500
Unit Variable Cost P 300
Total Fixed Cost P 4,500,000
Sales Volume P 100,000
Required:
1. Based on the original data, determine the CMR, BEP in pesos, Operating Profit, MSR, and the DOL.
2. Based on the following changes in the variables of profit, determine the new CMR, BEP in pesos,
operating profit, MSR, and DOL.
a. Unit sales price increase by 8%
b. Unit variable cost decrease by 3%
c. Total fixed costs and expenses increase by P 500,000
d. Quantity sold increases by 20,000
e. Unit sales price decreases by P 10, unit variable cost increase by 5%, total fixed costs decrease
by 10%, and units sold increases to 150,000
3. Give an analysis on the data determined in requirement 2.
Solutions/Discussions:
Let us first be reminded on the following formulas:
CMR = UCM/USP wherein:
BEPP = FC/CMR CMR = Contribution on Margin Rate
P = CM-FC MSR = Margin of Safety Rate
MSR = MS - BS BEPP = Breakeven Point in Pesos
DOL = 1/MSR DOL = Degree of Operating Leverage
= BS/MS P = Profit
Computations for Requirement 1 and 2.
Changes USP UVC TFC QS CMR BEPP P MSR DOL
1 Original Data P 500 P 300 P 4.5 M 100,000 40.00% P 11.250 M P 15.5 M 77.5% 1.29
2a USP ↑ by 8% P 540 P 300 P 4.5 M 100,000 44.44% P 10.126 M P 19.5 M 81.25% 1.23
2b UVC ↓ by 5% P 500 P 285 P 4.5 M 100,000 43.00% P 10.465 M P 17 M 79.07% 1.26
2c FC ↑ by 500,000 P 500 P 300 P5M 100,000 40.00% P 12.500 M P 15 M 75.00% 1.33
2d QS ↑ by 20,000 P 500 P 300 P4.5 M 120,000 40.00% P 11.250 M P 19.5 M 81.25% 1.23
2e USP ↓ by P10 UVC ↑

by 5% FC ↓ by P 450 P 315 P 4.05M 150,000 30.00% P 13.500 M P 16.2 M 80.00% 1.25
10% QS ↑ to 150,000
Chapter 2
38
REINFORCING THE CONCEPTS!

3. Based on the data presented above, here’s the analysis derived:
a. Profit is a key objective in optimizing the measure of short-term performance. While the
DOL reflects the medium term performance.
b. Profit and DOL are inversely related to each other. As the profit increases, the DOL tends to
decrease, and vice versa which means that a small change in sales leads to a larger change in
profit, which is typical in businesses with high fixed costs.
c. For instance, an increase in unit sales price immediately boosts up its profit, but reduces its
DOL, while an increase in fixed cost reduces profit, but increases the DOL.
d. Unit variable cost makes an indirect relationship towards the profit and DOL. As the unit
variable decreases, profit and DOL increase as implied in case 2b.
e. Overall, case 2a represents the most significant improvement, where the unit sales price
increases by 8%. This scenario results in the highest profitability and the most favorable
financial health, with a low BEPP, and reduced financial risk as indicated by the DOL.
Chapter 2
39
REFERENCES
[1]https://www.wallstreetmojo.com/cost-volume- [20]https://www.researchgate.net/publication/27
profit-analysis/ 6375718_Cost-Volume-
[2]https://gocardless.com/guides/posts/cost- Profit_Analysis_for_a_Multi-
volume-profit-analysis/ Product_Company_Micro_Approach
[3]https://en.wikipedia.org/wiki/Cost%E2%80%93 [21]https://fpa-trends.com/article/why-cost-
volume%E2%80%93profit_analysis volume-profit-analysis-cvp-should-be-main-step-
[4]https://www.investopedia.com/terms/c/cost- your-annual-profit-plan
volume-profit-analysis.asp [22]https://courses.lumenlearning.com/wm-
[5]https://corporatefinanceinstitute.com/resource managerialaccounting/chapter/sensitivity-
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[6]https://www.datarails.com/cost-volume-profit- [23]https://saylordotorg.github.io/text_manageri
analysis/ al-accounting/s10-03-using-cost-volume-profit-
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profit-analysis/ %20Sensitivity%20Analysis.pdf
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VolumeProfit_as_Important_Indicator_for_Planni
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[19]https://saylordotorg.github.io/text_managerial
-accounting/s10-02-cost-volume-profit-analysis-fo
Chapter 2
40
CHAPTER
3
SHORT-TERM
BUDGETING
Short-Term Budgeting
INTRODUCTION
In today’s fast-paced world, managing finances can feel like a juggling act. With unexpected
expenses lurking around every corner and the temptation of instant gratification at our fingertips,
it’s easy to lose track of where our money goes.
Short-term budgeting emerges as a crucial strategy for individuals seeking to navigate the
complexities of their financial landscapes with precision and foresight. By focusing on immediate
financial goals and expenditures, short-term budgeting enables individuals to allocate resources
efficiently, respond to unforeseen circumstances, and cultivate a disciplined approach to spending.
Whether saving for a vacation, paying off debt, or simply trying to make ends meet, mastering
the art of budgeting can help us understand how to create and stick to a budget which guides an
individual in making informed decisions that lead to financial stability and peace of mind.
This chapter covers the budgeting process and preparation of the master budget. Budgeting is
important for organizations of all sizes, especially those with large quantities of monetary, human,
and physical resources.
Learning Objectives
After studying this chapter, learners should be able to:
Describe the role of budgets in the overall management process.

Identify the benefits provided by a budget.
Outline the budgeting process
Deal with uncertainty in the budgeting process.
Prepare a master budget and explain the interrelationships among its supporting schedules.
Chapter 3
42
BUDGETING BASICS
A budget is a plan expressed in quantitative terms, on how to acquire and use the resources of an
entity during a budget period—typically a fiscal year or a certain future period of time. It includes
both financial and nonfinancial aspects of anticipated projects and operations. It serves as a guideline
for operations and a projection of the operating results for the budgeted period. The process of
preparing a budget is called budgeting.
Budgets are integral to the overall management process of organizations, serving as a structured
framework for planning, resource allocation, and performance evaluation. They translate strategic
goals into actionable financial plans, enabling departments to set clear objectives and prioritize their
efforts effectively. By fostering communication and collaboration among various functions, budgets
establish accountability by assigning specific targets to managers and teams, ensuring that everyone
is aligned with the organization’s overarching goals.
Additionally, budgets function as a control mechanism that allows organizations to monitor
financial performance through variance analysis and performance measurement. This enables
managers to identify discrepancies between actual results and budgeted figures, facilitating timely
corrective actions. By forecasting revenues and expenditures, budgets also play a crucial role in risk
management, helping organizations identify potential financial risks and prioritize investments.
Ultimately, effective budgeting supports informed decision-making and ensures that resources are
allocated efficiently, contributing to the long-term sustainability and success of the organization.
Short-term budgeting helps in planning for immediate financial needs, ensuring that expenses do
not exceed income during the specified period. It serves as a tool for survival, particularly for
businesses, by maintaining cash flow to meet obligations like payroll and supplier payments.
Budgeting Process
The role of accounting during the budgeting process is to:
Provide historical data on revenues, costs, and expenses.
Express management’s plans in financial terms.
Prepare periodic budget reports.
The budgeting process is a critical component of financial management for organizations, whether
they are businesses, nonprofits, or government entities. It serves as a roadmap for achieving
strategic goals and ensuring fiscal responsibility. A well-structured budgeting process ensures that all
stakeholders understand their roles in achieving the organization's objectives and fosters
accountability among managers.
The process usually includes the formation of a budget committee. The company assigns the most
qualified personnel for the preparation of the budget. Next is the determination of the budget period
which should be long enough to show the effort of managerial policies, and short enough so that
estimates can be made with reasonable accuracy. Additionally, the management should specify the
budget guidelines. Top management should initiate preparation of budget for lower level managers
to be more active in budget preparation which is subject for negotiation, review, and approval.
Lastly, the budget can be revised during implementation as long as it is reasonable and with consent
of the Budget Committee.
Chapter 3
43
Budget Committee
The budget committee supervises all financial issues and is often the highest authority in a
budgetary system. The committee establishes and approves budget goals for major business units,
coordinates budget preparation, resolves conflicts, approves the final budget, monitors operations
throughout the year, and reviews results at the end. The budget committee authorizes important
adjustments to the budget during the term. A budget committee often includes the CEO or vice
president, heads of strategic business divisions, and the CFO.
The Budget Committee’s Principal Functions:

1. Formulate and decide on general policies relating to the firm’s budgetary system.
2. Request, review, and revise (if necessary) individual budget estimates from the different
segments of the organization.
3. Approve budgets and subsequent revisions therein.
4. Receive, evaluate, and analyze budget reports.
5. Recommend necessary actions to improve operational efficiency and effectiveness.
ILLUSTRATION 3.1
ADVANTAGES AND LIMITATIONS OF BUDGETING

In order to be effective management tools, budgets must be based upon:
ο A sound organizational structure in which authority and responsibility are clearly defined.
ο Research and analysis to determine the feasibility of new products, services, and operating
techniques.
ο Management acceptance which is enhanced when all levels of management participate in the
preparation of the budget, and the budget has the support of top management.
Chapter 3
44
TABLE 3.1
The primary benefits and limitations of budgeting is as follows:
USES/ ADVANTAGES OF
LIMITATIONS OF BUDGETING
BUDGETING
1. Since budgeting means planning for the

future, the plan itself, as well as the
figures therein, are merely estimates,
1. It requires all levels of management to requiring a certain amount of judgment.
plan ahead. 2. To be successful, a budgetary system
2. It provides definite objectives for requires the cooperation and
evaluating performance.
participation of all members of the
3. It creates an early warning system for
organization.
potential problems.
4. It facilitates the coordination of 3. Some managers think that budget
activities within the business. restricts their investments and limits
5. It results in greater management their decision-making power, making it
awareness of the entity’s overall difficult to sell the idea of budgeting to
operations.
some people in the organization.
6. It motivates personnel throughout the
4. The development and installation of a
organization.
7. It directs the activities toward the good budgetary system may be time-
achievement of organizational goals. consuming and too costly for some
organizations, such that the benefits
that can be derived from budgeting may
be outweighed by its costs.
BUDGETING MODELS
1.Fixed / Static Budget
Description: financial plan that remains unchanged throughout a specified period, typically based
on historical data and forecasts.
Pros:
Cost Control: Encourages accountability by setting fixed expense limits.
Simplicity: Easy to create and manage without ongoing adjustments.
Cons:
Misleading Variances: Significant variances may not accurately reflect performance, complicating
decision-making.
Resource Allocation Issues: Fixed budgets can hinder optimal resource distribution across
departments.
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2.Flexible Budget
Description: a budget that is adjusted based on actual level of activity.
Pros:
Realism and Adaptability: Reflects actual performance, allowing for responsive adjustments.
Scenario Planning: Models various activity levels, beneficial for startups and seasonal businesses.
Cons:
Time-Consuming: Requires ongoing monitoring and adjustments, which can be resource-intensive.
Less Accountability: Adjustments can lead to overspending due to reduced pressure on budget
adherence.
3.Activity-based Budget
Description: Budgets are created based on the costs of activities required to produce goods or
services.
Pros:
Resource Allocation: Helps prioritize spending based on operational activities.
Detailed Insights: Provides a granular view of resource allocation.
Cons:
Complexity: Requires detailed analysis and can be time-consuming.
Implementation Challenges: May deter adoption due to its complexity.
4.Zero-based Budget
Description: Every expense must be justified for each new period, starting from a "zero base,"
rather than relying on previous budgets.
Pros:
Cost Control: Encourages scrutiny of all expenses, potentially uncovering waste.
Alignment with Goals: Ensures that spending aligns with current organizational objectives.
Cons:
Time-Consuming: Requires significant effort to prepare and justify each budget item.
Complex Implementation: Can be challenging to execute effectively in larger organizations.
5.Continuous / Rolling Budget

Description: A dynamic approach that continuously updates the budget by adding new periods as
they occur, allowing for real-time adjustments.
Pros:
Flexibility: Adapts quickly to changing business conditions.
Improved Accuracy: Uses actual data to forecast future budgets more accurately.
Cons:
Resource Intensive: Requires regular updates and can be labor-intensive.
Short-Term Focus Risk: May lead to prioritizing short-term results over long-term strategy
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6.Kaizen Budgeting
Description: It assumes the continuous improvement of products and processes, usually by way of
many small innovations rather than major changes.
Pros:
Continuous Improvement: Focuses on small, incremental changes that lead to sustainable
efficiency gains.
Cost Reduction: Promotes efficiency without drastic budget cuts.
Cons:
Potential for Employee Burnout: Continuous improvement pressure can lead to stress among
employees.
Risk of Overemphasis on Minor Issues: Focus may shift to small improvements, neglecting larger
strategic concerns.
7.Life Cycle Budget

Description: It estimates a product’s revenues and expenses over its entire life cycle beginning
with research and development, proceeding through the introduction and growth stages, into the
maturity stage, and finally, into the harvest or decline stage.
Pros:
Comprehensive Cost Evaluation: Considers all costs over an asset's lifespan, providing a true cost
of ownership.
Cost Optimization: Encourages identification of efficient solutions, balancing short-term expenses
with long-term gains.
Cons:
Subjectivity in Estimates: Assumptions can be subjective, leading to variability in results.
Uncertainty in Projections: Future cost estimates are uncertain, relying on assumptions that may
change.
Master Budget
Master Budget represents the overall plan of the organization for a given budget period. It
consists of all the individual budgets for each of the segments of the organization aggregated or
consolidated into one overall budget for the entire firm. A master budget reflects an organization’s
operating and financing plans for the upcoming budget period.
Steps in Making a Master Budget

1. Establish basic goals and long-range plans to serve as guidelines.
2. Prepare sales forecast for the budget period.
3. Estimate Cost of Goods Sold and Operating Expenses.
4. Determine the effects of the budget on tha assets, liability, and equity.
5. Prepare Projected Income Statement and Projected Balance Sheet.
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ILLUSTRATION 3.2
Example: The Master Budget: An Overview
OPERATING BUDGET
1.Budgeted Income Statement: the important end-product of the operating budgets.
ο This budget indicates the expected profitability of operations for the budget period.
ο The budgeted income statement provides the basis for evaluating company performance.
Sales Budget
Sales budget is the starting point in preparing the master budget. Each of the other budgets
depends on the sales budget. It is derived from the sales forecast and it represents management’s
best estimate of sales revenue for the budget period.
The preparation of a sales budget is influenced by a variety of internal and external factors.
Internal factors are those within the control of the business, such as past sales trends, sales
promotion measures, and the efficiency of the sales force. Other key internal elements include the
selling and distribution system, marketing research, pricing policies, production capacity,
customer types, and the geographical scope of marketing efforts. These factors collectively shape
the business's ability to forecast sales accurately and allocate resources effectively.
On the other hand, external factors are largely uncontrollable and relate to the broader
environment in which a business operates. These include government policies affecting taxation
and trade, competition levels in various markets, and the overall standard of living that influences
consumer behavior. Additionally, economic conditions, population dynamics, price fluctuations,
and the effectiveness of distribution channels play significant roles in shaping sales potential.
Understanding both internal and external factors is essential for businesses to develop realistic
sales budgets that align with their strategic objectives and market realities.
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Sales budget is the starting point in preparing the master budget. Each of the other budgets
depends on the sales budget. It is derived from the sales forecast and it represents management’s
best estimate of sales revenue for the budget period.
The preparation of a sales budget is influenced by a variety of internal and external factors.
Internal factors are those within the control of the business, such as past sales trends, sales
promotion measures, and the efficiency of the sales force. Other key internal elements include the
selling and distribution system, marketing research, pricing policies, production capacity, customer
types, and the geographical scope of marketing efforts. These factors collectively shape the
business's ability to forecast sales accurately and allocate resources effectively.
On the other hand, external factors are largely uncontrollable and relate to the broader
environment in which a business operates. These include government policies affecting taxation
and trade, competition levels in various markets, and the overall standard of living that influences
consumer behavior. Additionally, economic conditions, population dynamics, price fluctuations,
and the effectiveness of distribution channels play significant roles in shaping sales potential.
Understanding both internal and external factors is essential for businesses to develop realistic
sales budgets that align with their strategic objectives and market realities.
To create an effective sales budget, businesses should define goals, analyze past sales data,
estimate sales volume and pricing strategies, account for discounts, and break down revenue
estimates by categories. Regularly reviewing and adjusting the budget ensures it remains aligned
with market conditions.
Sample Problem 3.1 Estimated Sales in Units and Pesos

The management of Galvez Corporation is preparing sales estimates for the upcoming year and
is considering three possible economic scenarios: high growth, moderate growth, and low growth.
Based on economic forecasts, they expect a 35% chance of high growth, 50% chance of moderate
growth, and 15% chance of low growth. The projected unit sales under each scenario are 150,000
units, 100,000 units, and 60,000 units respectively. Each unit is expected to sell for P 80. The
company estimates that 4% of gross sales will be uncollectible.
Required:
1. Budgeted units to be sold in the coming year
2. Budgeted amount of sales, net of doubtful accounts.
Solutions
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Production Budget
A production budget shows planned production for a given period. It follows from the sales
budget and is based on information about the type, quantity, and timing of units to be sold. Sales
information is combined with beginning and ending Finished Goods Inventory information so that
managers can schedule necessary production.
Company management determines ending inventory policy. Desired finished goods in ending
inventory balance is generally a function of the quantity and timing of demand in the upcoming
period as related to the firm's capacity and speed to produce particular units.
Frequently, management wants ending finished goods inventory to equal a given percentage of the
next period’s projected sales. Other alternatives include:
• a constant amount of inventory,

• a buildup of inventory for future high-demand periods, or
• near-zero inventory under a just-in-time system.
The decision about ending inventory levels often relates to whether a firm wants to have constant
production with varying inventory levels or variable production with constant inventory levels.
If scheduled production exceeds the maximum capacity available, management must either
reduce the budgeted sales level or seek alternate ways to meet demand. If the available capacity
exceeds the projected output level, the budget gives management enough time to discover other
applications for the idle capacity or to schedule other activities like preventative maintenance and
trial runs of new production processes. Another advantage of having a budget is the ability to
coordinate sales and production activities, allowing businesses to spot imbalances between capacity
and output.
Table 3.1. Pro-Forma Budgeted Production

Example:
Montefalco Manufacturing is preparing its production budget for the upcoming year. They project
that 100,000 units of their product will be sold. The company aims to have 20,000 units in finished
goods inventory at the end of the year to meet demand. The beginning finished goods inventory is
expected to be 15,000 units.
Required: Calculate the budgeted production for the upcoming year.
Solutions
Projected sales 100,000
Add: Finished goods Inventory - End 20,000
Total Goods Available for Sale 120,000
Less: Finished Goods Inventory - Beg (15,000)
Budgeted Production P 105,000
a) Direct Materials: shows both the quantity and cost of direct materials to be purchased. A direct
materials purchase budget shows the amount of direct materials, such as raw materials or
component parts, to be purchased during the period (in both units and cost) to meet the production
and ending materials inventory requirements. A direct materials usage budget shows the amount
and budgeted cost of direct materials required for production. The quantities of direct materials are
derived from the following formula:
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Direct Materials Units Required for Production

+ Desired Ending Direct Materials Units
– Beginning Direct Materials Units
= Required Direct Materials Units to be Purchased
ο Direct material must be acquired in sufficient quantities to meet production requirements and
adhere to the company's targeted ending inventory guidelines. The desired ending inventory is a
key component in the budgeting process; inadequate inventories could result in temporary
shutdowns of production.
Table 3.2. Pro-Forma Budgeted Direct Materials Used and Purchases

Example:
Alleje Furniture Co. is preparing its direct materials budget for the upcoming year. The company
plans to produce 50,000 tables, and each table requires 4 kg of wood. The budgeted ending
inventory for wood is set at 10,000 kg, while the beginning inventory is 8,000 kg. The cost per
kilogram of wood is P 50.
Required: Calculate the budgeted direct materials used, the total materials for use, the budgeted
direct material purchases in units, and the budgeted materials purchases in pesos.
Budgeted Direct Materials used = Budgeted production x Std. Materials per hour
Solutions
b) Direct Labor: contains the quantity (hours) and cost of direct labor necessary to meet
production requirements. The direct labor budget is critical in maintaining a labor force that can
meet the expected levels of production. It is also used in preparing the budgeted cost of goods sold
and the cash budget. The budgeted direct labor cost is derived from multiplying the standard
direct labor hours per hour to budgeted direct labor hours.
Table 3.3. Pro-Forma Budgeted Direct Labor

Example:
Amberwood Cabinetry is preparing its direct labor budget for the next production period. They
plan to produce 12,000 cabinets, and each cabinet requires 1.5 direct labor hours . The direct labor
rate per hour is P 80.
Required: Calculate the budgeted direct labor hours and the budgeted direct labor cost.
Budgeted Direct Labor hours = Budgeted production x Std. DLH per unit
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Solutions
(12,000 x 1.5) 18,000
x DL Rate per hour 80
Budgeted DL cost P1,440,000
The direct labor budget helps organizations control one of their largest expenses—labor—which can
account for up to 70% of total costs in some industries. It also assists in forecasting hiring needs and
managing employee schedules effectively, ensuring that staffing levels align with production
demands. Moreover, by comparing actual labor costs against budgeted amounts, companies can
identify variances and adjust operations accordingly to improve efficiency.
c)Manufacturing Overhead: shows the expected variable and fixed manufacturing

overhead costs for the budget period. Overhead costs are the third production cost that must be
budgeted by month and for the quarter.
Variable Overhead Costs: These costs fluctuate with production levels and include expenses like
utilities, maintenance supplies, and some labor costs (e.g., wages for machine operators). The
variable overhead rate can be calculated by estimating the cost per unit of production and
multiplying it by the budgeted production units.
Fixed Overhead Costs: These costs remain constant regardless of production levels and typically
include rent, salaries of supervisory staff, and depreciation of equipment. Fixed costs are summed
up to determine the total fixed overhead for the period.
Table 3.4. Budgeted Factory Overhead Computations
Example:
Tristan Manufacturing is preparing its factory overhead budget for the next period. The company
plans to produce 15,000 units. The variable overhead cost per unit is P 12, and the fixed overhead
rate is calculated based on a normal capacity of 18,000 units with a fixed overhead rate of P 8 per
unit.
Required: Calculate the budgeted total overhead.
Budgeted variable overhead = Budgeted production x Std. Var OH per unit

Budgeted fixed overhead = Normal capacity x Std. OH rate/unit
Solutions
Budgeted variable overhead
(15,000 x 12) P 180,000
Budgeted fixed overhead
(18,000 x 8) 144,000
Budgeted total overhead P 324,000
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d)Inventory Levels
Maintaining appropriate inventory levels is critical for several reasons:
Flexibility: High inventory levels allow companies to respond quickly to unexpected spikes in
demand.
Cost Management: Companies must balance the costs associated with carrying excess inventory
against potential lost sales due to stockouts. This involves considering storage costs and
opportunity costs related to tied-up capital.
Production Scheduling: The timing of production is essential. For example, if higher sales are
anticipated in certain months, production should be scheduled accordingly to ensure adequate
supply.
Cost of Sales Budget

Information from the cost of goods manufactured and cost of goods sold budgets for a period
appear in two other budgets for the same period. The budgeted income statement uses the cost of
goods sold to determine the gross margin for the period, and the balance sheet includes the
finished goods ending inventory in total assets.
Selling and Administrative Expenses Budget

These are the anticipated selling and administrative expenses for the budget period. This
budget classifies expenses as either variable or fixed. This budget is also used in preparing the
budgeted income statement and the cash budget.
Financial Expenses Budget

Creating a financial expenses budget is crucial for effective money management. Start by
calculating your net income, which is your total earnings after taxes and deductions. Next, list
your monthly expenses, categorizing them into fixed expenses (like rent and insurance) and
variable expenses (such as groceries and entertainment). It's important to distinguish between
needs—essential costs for living—and wants—discretionary spending that can be adjusted. A
popular budgeting method is the 50/30/20 rule, where 50% of your income goes to needs, 30% to
wants, and 20% to savings and debt repayment.
Once you have established your budget, track your actual spending against your planned
amounts using budgeting tools or apps. This monitoring will help you identify areas where you
can cut back if necessary. Regularly review and adjust your budget to reflect changes in your
financial situation or goals. By maintaining a disciplined approach to budgeting, you can better
manage your expenses, build savings, and work towards achieving your financial objectives.
Budgeted Income Statement

The budgeted (pro forma) income statement describes the expected net income for an
upcoming period. In the event that the budgeted income for the period falls short of the
prespecified goal, management can investigate, during the budget-negotiation process, actions to
improve operating results.
Once the budgeted income statement has been approved, it can be used as the benchmark against
which the performance of the period is evaluated.
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FINANCIAL BUDGET
Cash Budget: shows anticipated cash flows.
Because cash is so vital, this budget is often considered to be the most important financial
budget.
The cash budget contains three sections:
Cash receipts.
Cash disbursements.
Financing.
ο Companies obtain data for preparing the cash budget from other budgets and from information
provided by management.
ο A cash budget contributes to more effective cash management. It shows managers when
additional financing is necessary well before the actual need arises and it indicates when excess
cash is available for investments or other purposes. It helps management assess the effectiveness
of credit practices (i.e., whether customers are paying for purchases within the designated credit
period).
Example:
CASH BUDGET
Beginning cash balance
+ Cash receipts (collections)
= Cash available for disbursements
﹣ Cash needed for disbursements:
Cash payments for accounts payable for month
Cost of compensation
Total cost of overhead minus depreciation
Total S&A cost minus depreciation
= Cash excess or deficiency
- Minimum desired cash balance
= Cash needed or available for investment or financing
+ Various financing measures
= Ending cash balance
Cash Receipts and Accounts Receivable
The cash receipts budget gives details about expected collections of cash from operations over
the upcoming period. Investment and financing operations generate cash receipts that are shown
elsewhere in the cash budget. Because not all sales are conducted on a cash basis, managers must
translate sales data using an expected collecting pattern to convert into cash receipts. This
method takes into account recent collection patterns as well as management's assessment of
potential changes that could disrupt present collection patterns. Recessionary conditions, rising
interest rates, looser lending rules, and poor collection efforts can all impair current collection
patterns.
Example:
Schedule of Cash Receipts (Collections) from Sales
Dollars of credit sales for month
x Percent collection for month of sale
= Credit to accounts receivable for months sales
﹣ Allowed and taken sales discounts
= Receipts for current month’s credit sales
+ Current month’s cash receipts for prior months’ credit sales
= Cash receipts for current month
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Cash Disbursements and Accounts Payable

These disbursements are typically derived from other operational budgets, such as the purchases
budget, labor budget, and overhead budget. For instance, if a company makes purchases on credit,
it may pay 80% of the purchase price in the current quarter and the remaining 20% in the
following quarter13. This timing affects both cash flow management and accounts payable.
Example:
Schedule of Cash Payments for Purchases
Units to be purchased
x Cost per unit
= Total cost purchases
x Percent payment for current purchases
= Debit to accounts payable for month’s purchases
﹣ Purchase discounts taken
= Cash payments for current month’s purchases
+ Cash purchases
+ Current month’s payments for prior months’ purchases
= Cash payments for accounts payable for current month
Budgeted Balance Sheet

The budgeted balance sheet is developed from the budgeted balance sheet for the preceding
year and the budgets for the current year. The last step in a budget-preparation cycle usually is to
prepare the budgeted (pro forma) balance sheet. The starting point in preparing a budgeted balance
sheet is the expected financial position at the beginning of the budget period. The budgeted balance
sheet incorporates the effects of all operations and cash flows during the budget period and shows
projected balances at the end of the budget period.
Budgeted Statement of Cash Flows

Information found on the income statement, balance sheet, and cash budget is also used to
prepare a statement of cash flows (SCF). This statement can assist managers in performing the
following functions:
• judging the company’s ability to handle fixed cash outflow commitments,

• adapting to adverse changes in business conditions,
• undertaking new commitments, and
• assessing the quality of company earnings by indicating the relationship between net income and
net cash flow from operations.
FLEXIBLE BUDGETING
A flexible budget projects budget data for various levels of activity. In essence, the flexible
budget is a series of static budgets at different levels of activity. Flexible budget reports are
appropriate for evaluating performance since both actual and budgeted costs are based on the
actual activity level achieved.
To develop the flexible budget, management should:

Identify the activity index and the relevant range of activity.
Identify the variable costs and determine the budgeted variable cost per unit of activity for each
cost.
Identify the fixed costs and determine the budgeted amount for each cost.
Prepare the budget for selected increments of activity within the relevant range.
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Flexible budget reports are another type of internal report. The flexible budget report
consists of two sections:
Production data for a selected activity index, such as direct labor hours.
Cost data for variable and fixed costs.
The flexible budget report provides a basis for evaluating a manager’s performance in two
areas:
—- Production control & Cost control.
Example:
Galvez Electronics is operating at 40% capacity and currently produces 8,000 units. The company
wants to estimate profits if it scales production to 60% and 80% capacity. Here are the additional
details:
At 60% capacity, raw material costs will increase by 3%, and the selling price per unit will fall by
3%.
At 80% capacity, raw material costs will increase by 6%, and the selling price per unit will fall by
6%.
Unit cost of each product is P150, and each unit is sold for P170.
The breakdown of unit costs is as follows:
Material: P80
Labor: P25
Factory overhead: P25 (30% fixed)
Administrative overhead: P20 (60% fixed)
Required: Calculate the estimated profits for Galvez Electronics when operating at 60% and 80%
capacity. Include critical comments on the financial impact of scaling production.
Solution:
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Let's break down the calculations for the 40% output level (8,000 units).
Sales:
Price per unit at 40% output: P170
Total Sales: P170 per unit x 8,000 units = P1,360,000
Material Cost:
Cost per unit: P80
Total Material Cost: P80 per unit x 8,000 units = P640,000
Labor:
Cost per unit: P25
Total Labor Cost: P25 per unit x 8,000 units = P200,000
Fixed FOH:
Fixed FOH per Unit: P7.5 (30% of total overhead)
Total Fixed FOH: P7.5 per unit x 8,000 units = P60,000
Fixed FOH is constant regardless of output level: P60,000
Variable FOH:
Variable FOH per unit: P17.5 (70% of total overhead)
Total Variable FOH: P17.5 per unit x 8,000 units = P140,000
Fixed AdOH:
Fixed AdOH per unit: P12 (60% of total AdOH)
Total Fixed AdOH: P12 per unit x 8,000 units = P96,000
Fixed AdOH is constant regardless of output:P96,000
Variable AdOH:
Variable AdOH per unit: P8 (40% of total overhead)
Total Variable AdOH: P8 per unit x 8,000 units = P64,000
Total Cost:
Total Cost: 640,000 + $200,000 + $60,000 + $140,000 + $96,000 + $64,000 = $1,200,000
Profit:
Profit: $1,360,000 (Sales) - $1,200,000 (Total Cost) = $160,000
60% Output Level:
The number of units produced increases.
To get the total units at 60% output level, the calculation will be 8,000 units divided by 40% to get
20,000 which will be the units at the 100% output level. And then, multiply 20,000 at 60% and get
12,000 units. The per-unit price changes at 60% capacity, raw material costs will increase by 3%,
and the selling price per unit will fall by 3%.
Sales:
Price per unit at 60% output: P170 x 97% = P164.9 (100% - 3%)
Total Sales: P164.9 per unit x 12,000 units = P1,978,800
Materials Cost:
Cost per unit: P80 x 103%=P82.4
Total Material Cost: P82.4 per unit x 12,000 units = P988,800
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Total Labor costs increase proportionally with the number of units.

Labor Cost:
Cost per unit: P25
Total Labor cost: P25 per unit x 12,000 units = P300,000
Total Fixed costs remain constant but the Fixed Cost per unit will change.
Fixed FOH per unit: P60,000/12,000 units = P5
Fixed AdOH per Unit: P96,000/12,000 units = P8
Total Variable costs increase proportionally with the number of units.

Variable FOH per unit: P17.5 x 12,000 units = P210,000
Variable AdOH per unit: P8 x 12,000 units = P96,000
Total Cost:
Total Cost: $988,800 + $300,000 + $60,000 + $210,000 + $96,000 + $96,000 = $1,750,800
Profit:
Profit: P1,978,800 (Sales) - P1,750,800 (Total Cost) = P228,000
80% Output Levels:

The number of units produced increases.
To get the Total units at 80% output level, multiply 20,000 at 80% then the units at 80% output level
will be 16,000. The per-unit price changes at 80% capacity, raw material costs will increase by 6%,
and the selling price per unit will fall by 6%.
Sales:
Price per unit at 80% output: P170 x 94% = P159.8 (100% - 6%)
Total Sales: P159.8 per unit x 16,000 units = P2,556,800
Materials Cost:
Cost per unit: P80 x 106%=P84.8
Total Material Cost: P84.8 per unit x 16,000 units = P1,356,800
Total Labor costs increase proportionally with the number of units.

Labor Cost:
Cost per unit: P25
Total Labor cost:P25 per unit x 16,000 units = P400,000
Total Fixed costs remain constant but the Fixed Cost per unit will change.
Fixed FOH per unit: P60,000/16,000 units = P3.75
Fixed AdOH per Unit: P96,000/16,000 units = P6
Total Variable costs increase proportionally with the number of units.

Variable FOH per unit: P17.5 x 16,000 units = P280,000
Variable AdOH per unit: P8 x 16,000 units = P128,000
Total Cost:
Total Cost: P1,356,800 + P400,000 + P60,000 + P280,000 + P96,000 + P128,000 = P2,320,800
Profit:
Profit: P2,556,800 (Sales) -P2,320,800 (Total Cost) = P236,000
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SELF- TEST
APPENDIX 3.1 MASTER BUDGET SCHEDULES
This section illustrates the computations, mechanics, and interrelationships in a master budget.
Although the illustrative data are presented separately per problem, they are interrelated. The
concept is to individually show budgetary computations per major account later will be
consolidated in budgeted financial statements. The data pertain to B-Thirteen Corporation.
Problem 1. Projected Sales and Estimated Collections from Customers
B-Thirteen Corporation made the following projections for its sales in the coming year, 2025:
Projected units sold
Economy Q1 Q2 Q3 Q4 Probability
Good 80,000 102,000 90,000 120,000 50%
Fair 70,000 90,000 80,000 100,000 30%
Bad 60,000 70,000 65,000 80,000 20%
The unit sales price is expected to remain constant at P30. All sales are made on credit.
Customer receivables are collected 50% in the quarter following sales, 30% in the quarter
following sales, and 15% in the second quarter following sales. The remaining 5% is considered
uncollectible. The account receivables balance on December 31, 2024, is estimated to be P313,000,
25% of which comes from the third quarter sales of 2024.
Required:
1. Schedule 1. Projected sales in units and pesos per quarter for 2025.
2. Schedule 2. Estimated collections from customers per quarter and for the year 2025.
Solutions/ Discussions:
●The projected unit sales are computed by considering the probability of occurrence.
Expected units sold

Q1 Q2 Q3 Q4
Good (projected sales x 50%) 40,000 51,000 45,000 60,000
Fair (projected sales x 30%) 21,000 27,000 24,000 30,000
Bad (projected sales x 20%) 12,000 14,000 13,000 16,000
73,000 92,000 82,000 106,000
(*) For example:

Q1 (80,000 units x 50%) 40,000 units
Q2 (70,000 units x 30%) 21,000
Q3 (60,000 units x 20%) 12,000
Expected sales in units 73,000 units
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Schedule 2. Budgeted Collections from Customers
Sales of Credit sales Q1 Q2 Q3 Q4 Total
Q3, 2024 391,250.00 58,687.50 58,687.50
Q4, 2024 469,500.00 140,850.00 70,425.00 211,275.00
Q1, 2025 2,190,000.00 1,095,000.00 657,000.00 328,500.00 2,080,500.00
Q2, 2025 2,760,000.00 1,380,000.00 828,000.00 414,000.00 2,622,000.00
Q3, 2025 2,460,000.00 1,230,000.00 738,000.00 1,968,000.00
Q4, 2025 3,180,000.00 1,590,000.00 1,590,000.00
Budgeted
1,294,537.50 2,107,425.00 2,386,500.00 2,742,000.00 8,530,462.50
collections
The credit sales in the third quarter of year 2024 were P 391,250 (i.e., P313,000 x 25% / 20%). Eighty percent
(80%) of this sales has been collected at the end of 2024. Hence, to get the total sales from the third quarter of
2019, we have to divide the remaining receivable from this quarter by 20%, which is the remaining
receivable balance.
The credit sales in the fourth quarter of 2019 were P 469,500 (i.e., P 313,000 x 75% / 50%). Fifty percent (50%)
of this sales has been collected by the end of 2024. As such, to get the total sales, we have to divide the
remaining receivable from this quarter by 50%, which is the remaining receivable balance.
Problem 2. Budgeted Production, Materials Purchases, and Payments to

Suppliers
B-Thirteen Corporation has the budgeted units sales of its product in 2024 up to the first quarter of
2025 as follows:
2024
1st quarter 73,000
2nd quarter 92,000
3rd quarter 82,000
4th quarter 106,000
2025
1st quarter 90,000
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The company has a policy of maintaining finished goods inventory equal to 30% of the next
quarter’s sales and materials inventory of 20% of current quarter’s requirements. It takes 3 lbs. of
material MA-13 to produce a unit of product. The materials inventory at the start of the year was
recorded at 90,000 pounds.
Material MA-13 costs P 1.65 per pound to purchase. The terms of the purchase are 2/30, n/45. The
company pays 70% of its purchases in the quarter of purchase and avail of the 2% trade discount.
The remaining balance is paid in the following quarter. The accounts payables at December 31, 2019
are valued at P 90,000.
Required: For the year 2025:
1. Schedule 3. Budgeted production per quarter and in total.

2. Schedule 4. Budgeted materials purchases per quarter and in total.
3. Schedule 5. Budgeted payments to merchandise suppliers
Solutions/Discussions
Schedule 3. Budgeted Production
Q1 Q2 Q3 Q4 Total
Budgeted sales in
73,000.00 92,000.00 82,000.00 106,000.00 353,000.00
units
+FGI, end 27,600.00 24,600.00 31,800.00 27,000.00 27,000.00
Total needs 100,600.00 116,600.00 113,800.00 133,000.00 380,000.00
-FGI, beg 21,900.00 27,600.00 24,600.00 31,800.00 21,900.00
Budgeted sales in
78,700.00 89,000.00 89,200.00 101,200.00 358,100.00
pesos
Finished goods-end = 30% x next quarter’s sales

Q1 = 92,000 units x 30% = 27,600 units
Q2 = 82,000 units x 30% = 24,600
Q3 = 106,000 units x 30% = 31,800
Q4 = 90,000 units x 30% = 27,000
● Finished goods - beg = the ending of the previous quarter
Q1 = 73,000 units x 30% = 21,900 units
● The ending inventory of the fourth quarter is the ending inventory of the year
and the beginning inventory of the first quarter is the beginning of the year.
Chapter 3
61
Schedule 4. Budgeted Materials Purchases
Q1 Q2 Q3 Q4 Total
Budgeted
78,700.00 89,000.00 89,200.00 101,200.00 358,100.00
Production
* materials per unit 3.00 3.00 3.00 3.00 3.00
Budgeted materials
236,100.00 267,000.00 267,600.00 303,600.00 1,074,300.00
usage in lbs
+Material Inv, end 47,220.00 53,400.00 53,520.00 60,720.00 60,720.00
Total materials
283,320.00 320,400.00 321,120.00 364,320.00 1,135,020.00
needs
-Material Inv, beg 90,000.00 47,220.00 53,400.00 53,520.00 90,000.00
Budgeted materials
193,320.00 273,180.00 267,720.00 310,800.00 1,045,020.00
purchases in lbs
*material cost per lb 1.65 1.65 1.65 1.65 1.65
Budgeted materials
318,978.00 450,747.00 441,738.00 512,820.00 1,724,283.00
purchases in pesos
Materials inventory end = 20% x Current quarter’s needs
Q1 = 236,100 units x 20% = 47,220 lbs.

Q2 = 267,000 units x 20% = 53,400
Q3 = 267,600 units x 20% = 53,520
Q4 = 303,600 units x 20% = 60,720
Schedule 5. Budgeted Payments to Merchandise Suppliers
Purchase Credit
Q1 Q2 Q3 Q4 Total
date Purchase
Q4, 2024 300,000.00 90,000.00 90,000.00
Q1, 2025 318,978.00 218,818.91 95,693.40 314,512.31
Q2, 2025 450,747.00 309,212.44 135,224.10 444,436.54
Q3, 2025 441,738.00 303,032.27 132,521.40 435,553.67
Q4, 2025 512,820.00 351,794.52 351,794.52
Budgeted payments 308,818.91 404,905.84 438,256.37 484,315.92 1,636,297.04
The credit purchases in the fourth quarter of 2024 were P 300,000 (i.e., P 90,000 / 30%).
The 70% have been paid in the quarter the purchases were made.
The payment made to suppliers in the quarter of purchase accounting for 70% of all
purchases is subject to 2% trade discount. Example, payment made in Q1 of 2025 for
purchases made in Q1 of 2025 is P 218,818.91 (i.e., P 318,978 x 70% x 98%). The payment
made in the following quarter accounting for the remaining 30% of the purchases is not
subject to 2% trade discount.
Chapter 3
62
Problem 3. Budgeted Direct Labor and Factory Overhead

B-Thirteen Corporation pays its production personnel at a rate of P 35 per direct labor hour. It
takes 0.20 standard hours to complete a finished unit. The corporation pays its labor costs in the
month the payroll is recorded.
The standard variable overhead rate is P 7 per direct labor hour and the standard fixed overhead
rate is P 5 per direct labor hour. The company’s normal capacity is 80,000 units or 16,000 direct
labor hours. Twenty-five percent (25%) of the total fixed overhead is non-cash. Overhead costs are
paid 85%in the quarter the overhead is incurred and the remainder is paid in the month following
the quarter of incurrence. The overhead costs incurred in the fourth quarter of 2024 are P 95,000
variable and P 85,000 fixed.
The budgeted production in units for 2025 are estimated at: Q1, 78,700 units, Q2, 89,000 units; Q3,
89,200 units, and Q4, 101,200 units.
Required: For the year 2025
1. Schedule 6: Budgeted labor costs per quarter and in total.

2. Schedule 7: Budgeted factory overhead in quarter and in total.
3. Schedule 8: Budgeted cash payments for labor and overhead in quarter and in total.
Schedule 6. Budgeted Labor Costs
Q1 Q2 Q3 Q4 Total
Budgeted Production 78,700.00 89,000.00 89,200.00 101,200.00 358,100.00
*direct labor hrs per unit 0.20 0.20 0.20 0.20 0.20
Budgeted direct labor hrs 15,740.00 17,800.00 17,840.00 20,240.00 71,620.00
*direct labor rate per hr 35.00 35.00 35.00 35.00 35.00
Budgeted direct labor cost 550,900.00 623,000.00 624,400.00 708,400.00 2,506,700.00
Schedule 7. Budgeted Factory Overhead
Q1 Q2 Q3 Q4 Total
Var FOH 110,180.00 124,600.00 124,880.00 141,680.00 501,340.00
F FOH 80,000.00 80,000.00 80,000.00 80,000.00 320,000.00
Budgeted FOH 190,180.00 204,600.00 204,880.00 221,680.00 821,340.00
Variable factory overhead = Production x Variable Overhead rate per DLH

Q1 = 15,740 DLH x P 7 = P 110,180
Q2 = 17,800 DLH x P 7 = 124,600
Q3 = 17,840 DLH x P 7 = 124,880
Q4 = 20,240 DLH x P 7 = 141,680
● Fixed factory overhead = Normal capacity x Fixed overhead rate per DLH
E.g., Q1 = 16,000 DLH x P 5 = P 80,000
Chapter 3
63
Schedule 8. Budgeted cash payments to labor and overhead
Q1 Q2 Q3 Q4 Total
Direct labor
550,900.00 623,000.00 624,400.00 708,400.00 2,506,700.00
cost
VOH Amt
Q4, 2024 95,000.00 14,250.00 14,250.00
Q1, 2025 110,180.00 93,653.00 16,527.00 110,180.00
Q2, 2025 124,600.00 105,910.00 18,690.00 124,600.00
Q3, 2025 124,880.00 106,148.00 18,732.00 124,880.00
Q4, 2025 141,680.00 120,428.00 120,428.00
Budgeted
payment 107,903.00 122,437.00 124,838.00 139,160.00 494,338.00
VFOH
FOH
Q4, 2024
63,750.00 9,562.50 9,562.50
(85k*75%)
Q1,2025
60,000.00 51,000.00 9,000.00 60,000.00
(80k*75%)
Q2, 2025
60,000.00 51,000.00 9,000.00 60,000.00
(80k*75%)
Q3, 2025
60,000.00 51,000.00 9,000.00 60,000.00
(80k*75%)
Q4, 2025
60,000.00 51,000.00 51,000.00
(80k*75%)
Budgeted
payment 60,562.50 60,000.00 60,000.00 60,000.00 240,562.50
FFOH
Total
168,465.50 182,437.00 184,838.00 199,160.00 734,900.50
payment OH
Chapter 3
64
Problem 4. Budgeted Statement of Profit or Loss

Consider the data and solutions in sample problems “1” to “3”. The standard costs of B-Thirteen
Corporation are summarized below:
The standard costs are the same from the year 2024 to 2025. The work-in-process inventories are
estimated at 15% of the current production put into the process. The work-in-process on December
31, 2024 is determined at P80,000. Operating expenses are budgeted at 25% of sales in a quarter.
Non-cash operating expenses including accruals and prepayments are estimated at 15% of sales.
Other income from operations is projected at 10% of sales. The actual of 2024 and the estimated
accrued and prepaid items in 2025 are as follows:
Required: For the year 2025

1. Schedule 9. Budgeted cost of goods manufactured and sold.
2. Schedule 10. Budgeted statement of profit or loss.
3. Schedule 11. Budgeted cash payments to operating expenses.
4. Schedule 12. Budgeted cash receipts from other revenues.
Chapter 3
65
Schedule 9. Budgeted cost goods manufactured and sold

Q1 Q2 Q3 Q4 Total
Materials used 283,320.00 320,400.00 321,120.00 364,320.00 1,289,160.00
Direct labor 550,900.00 623,000.00 624,400.00 708,400.00 2,506,700.00
FOH 190,180.00 204,600.00 204,880.00 221,680.00 821,340.00
Total Factory
1,024,400.00 1,148,000.00 1,150,400.00 1,294,400.00 4,617,200.00
Cost
+WIP inv, beg 80,000.00 165,660.00 197,049.00 202,117.35 80,000.00
Total cost put
1,104,400.00 1,313,660.00 1,347,449.00 1,496,517.35 4,697,200.00
in process
-WIP inv, end 165,660.00 197,049.00 202,117.35 224,477.60 224,477.60
Cost of goods
938,740.00 1,116,611.00 1,145,331.65 1,272,039.75 4,472,722.40
manufactured
+FG inv, beg 336,165.00 423,660.00 377,610.00 488,130.00 336,165.00
Total goods
available for 1,274,905.00 1,540,271.00 1,522,941.65 1,760,169.75 4,808,887.40
sale
-FG inv, end 423,660.00 377,610.00 488,130.00 414,450.00 414,450.00
Cost of goods
851,245.00 1,162,661.00 1,034,811.65 1,345,719.75 4,394,437.40
sold
● Material used = Materials used in units x Standard materials cost per unit
Q1 = 78,700 lbs. X P3.6 = P 283,320
Q2 = 89,000 lbs. X P3.6 = P 320,400
Q3 = 89,200 lbs. X P3.6 = P 321,120
Q4 = 101,200 lbs. X P3.6 = P 364,320
● The work-in-process of December 31, 2024 is the beginning work-in-process of 2025.
● Work-in-process inventory, ending = 15% x current production costs put into process. E.g., Q1 =
P1,104,400 x 15% = P165,660
● Finished goods inventories = FG on hand x Standard unit cost (i.e., P15.35)
Units Costs
FG - beg FG - end Unit Cost FG - beg FG - end
Q1 21,900 27,600 P15.35 P 336,165 P 423,660
Q2 27,600 24,600 15.35 423,660 377,610
Q3 24,600 31,800 15.35 377,610 488,130
Q4 31,800 27,000 15.35 488,130 414,450
Chapter 3
66
Schedule 10. Budgeted Statement of Profit or Loss
Q1 Q2 Q3 Q4 Total
Sales 2,190,000.00 2,760,000.00 2,460,000.00 3,180,000.00 10,590,000.00
COGS 851,245.00 1,162,661.00 1,034,811.65 1,345,719.75 4,394,437.40
-Operating
328,500.00 414,000.00 369,000.00 477,000.00 1,588,500.00
expenses
+Other income 219,000.00 276,000.00 246,000.00 318,000.00 1,059,000.00
Income before
1,229,255.00 1,459,339.00 1,302,188.35 1,675,280.25 5,666,062.60
tax
-Income tax
491,702.00 583,735.60 520,875.34 670,112.10 2,266,425.04
(40%)
Net profit/loss 737,553.00 875,603.40 781,313.01 1,005,168.15 3,399,637.56
Schedule 11. Budgeted Cash Payments to Operating Expenses
Q1 Q2 Q3 Q4 Total
Operating
expenses 328,500.00 414,000.00 369,000.00 477,000.00 1,588,500.00
incurred
+Accrued Exp,
15,000.00 18,000.00 25,000.00 11,000.00 15,000.00
beg
+Prepaid Exp,
8,000.00 9,000.00 8,300.00 10,700.00 10,700.00
end
Total 351,500.00 441,000.00 402,300.00 498,700.00 1,614,200.00
-Accrued Exp,
18,000.00 25,000.00 11,000.00 18,000.00 18,000.00
end
-Prepaid Exp,
5,000.00 8,000.00 9,000.00 8,300.00 5,000.00
beg
Operating
328,500.00 408,000.00 382,300.00 472,400.00 1,591,200.00
expenses paid
The beginning accrued expenses balance in quarter 1 (i.e., P 15,000) is the beginning of the year.
The ending prepaid expenses balance in quarter 4 is the ending balance of the year.
Chapter 3
67
Schedule 12. Budgeted Cash Receipts from Other Revenues
Q1 Q2 Q3 Q4 Total
Other revenues
219,000.00 276,000.00 246,000.00 318,000.00 1,059,000.00
earned
+Accrued Inc,
6,600.00 1,500.00 4,100.00 9,200.00 6,600.00
beg
+Deferred Inc,
4,500.00 5,600.00 11,400.00 12,900.00 12,900.00
end
Total 230,100.00 283,100.00 261,500.00 340,100.00 1,078,500.00
-Accrued Inc,
1,500.00 4,100.00 9,200.00 11,300.00 11,300.00
end
-Deferred Inc,
3,200.00 4,500.00 5,600.00 11,400.00 3,200.00
beg
Other revenues
225,400.00 274,500.00 246,700.00 317,400.00 1,064,000.00
received
Problem 5. Budgeted Cash Flows

Consider all the data and solutions in sample problems “1 to “.4”. Other cash transactions and
information are as follows:
a. Non-current assets are to be acquired in the second and third quarters of 2024 in the amounts of
P 500,000 and P 2755,000, respectively. Some old non-current assets are to be sold at its book value
for P 268,000 in the third quarter.
b. Dividends are to be paid in February for P 600,000 and July for P 360,000.
c. The minimum cash balance is set at P 800,000. In case of deficit, the corporation can avail a credit
line in multiples of P 50,000 from a financing institution at a rate of 12% per annum. Interest is paid
quarterly based on the outstanding balance at the beginning of the quarter. Payments to
borrowings in multiples of P 50,000 are made whenever cash is available determined at the
beginning of the quarter. The cash balance on January 1, 2025 is expected to equal the minimum
cash balance.
Required: For the year 2025:
1. Schedule 13. Cash budget

2. Schedule 14. Budgeted Statement of Cash Flows.
Chapter 3
68
Schedule 13. Cash Budget

Q1 Q2 Q3 Q4 Total
Cash balance 800,000.00 813,253.09 613,335.25 1,249,740.88 800,000.00
+Cash receipts
Collections *from
1,294,537.50 2,107,425.00 2,386,500.00 2,742,000.00 8,530,462.50
customers
*from other revenues 225,400.00 274,500.00 246,700.00 317,400.00 1,064,000.00
Sale of non-current
268,000.00 268,000.00
assets
Total cash available for
2,319,937.50 3,195,178.09 3,514,535.25 4,309,140.88 10,662,462.5
use
-Cash payment
Merchandise purchases 308,818.91 404,905.84 438,256.37 484,315.92 1,636,297.04
Direct labor 550,900.00 623,000.00 624,400.00 708,400.00 2,506,700.00
Factory overhead 168,465.50 182,437.00 184,838.00 199,160.00 734,900.50
Operating expenses 328,500.00 408,000.00 382,300.00 472,400.00 1,591,200.00
Acquisition of
500,000.00 275,000.00 775,000.00
noncurrent assets
Dividends 600,000.00 360,000.00 960,000.00
Total cash payments 1,956,684.41 2,118,342.84 2,264,794.37 1,864,275.92 8,204,097.54
Cash balance before

363,253.09 1,076,835.25 1,249,740.88 2,444,864.96 2,458,364.96
Financing
Financing Cash:
Borrowings (beg) 450,000.00 450,000.00
Payment to borrowing
450,000.00 450,000.00
(end)
Interest paid (end) 13,500.00 13,500.00
Net financing 450,000.00 (463,500.00) 0.00 0.00 (13,500.00)
Cash balance, end 813,253.09 613,335.25 1,249,740.88 2,444,864.96 2,444,864.96
Cash balance - ending = Total cash available for needs - Total cash payments + Net Financing
The cash balance for the year is the cash balance at the beginning of the first quarter and the
ending balance of the year equals the ending balance of the fourth quarter.
Chapter 3
69
Schedule 14. Budgeted Statement of Cash Flows
Q1 Q2 Q3 Q4 Total
Operating activities
Collection from
1,294,537.50 2,107,425.00 2,386,500.0 2,742,000.0 8,530,462.50
customers
From other
225,400.00 274,500.00 246,700.00 317,400.00 1,064,000.00
revenue
To merchandise
(308,818.91) (404,905.84) (438,256.37) (484,315.92) (1,636,297.04)
suppliers
To direct labor (550,900.00) (623,000.00) (624,400.00) (708,400.00) (2,506,700.00)

To factory
(168,465.50) (182,437.00) (184,838.00) (199,160.00) (734,900.50)
overhead
To operating
(328,500.00) (408,000.00) (382,300.00) (472,400.00) (1,591,200.00)
expenses
Net operating
163,253.09 763,582.16 1,003,405.63 1,195,124.08 3,125,364.96
inflow/ outflow
Investing activities
Sale of noncurrent
268,000.00 268,000.00
assets
Acquisition of
(500,000.00) (275,000.00) (775,000.00)
noncurrent assets
Net investing
(500,000.00) (7,000.00) (507,000.00)
activities
Financing activities
Dividends paid (600,000.00) (360,000.00) (960,000.00)
Borrowings 450,000.00 450,000.00

Payments to
(450,000.00) (450,000.00)
borrowings
Interest paid (13,500.00) (13,500.00)

Net financing
(150,000.00) (463,500.00) (360,000.00) (973,500.00)
activities
Net cash inflows /

13,253.09 (199,917.84) 636,405.63 1,195,124.08 1,644,864.96
outflows
+Cash balance, beg 800,000.00 813,253.09 613,335.25 1,249,740.88 800,000.00

Cash balance, end 813,253.09 613,335.25 1,249,740.88 2,444,864.96 2,444,864.96
The business needs to borrow in the first quarter of the year to maintain the minimum cash
balance of P800,000. The amount borrowed is computed as follows:
Cash balance - beginning P 800,000
Net operating cash inflows 163,253.09
Dividends paid (600,000)
Cash balance before financing 363,253.09
Minimum cash balance (800,000)
Cash need P 436,746.91
Borrowings (in multiples of P 50,000) P 450,000
The beginning cash balance of the first quarter is the beginning cash balance of the year, and
the ending cash balance of the fourth quarter is the ending cash balance of the year.
Chapter 3
70
CASE STUDY
Volkswagen AG
While most automobile companies talk about bankruptcy, merger, collapse, and liquidation,
Volkswagen AG is posting solid earnings. Based in Wolfsburg, Germany, and Europe’s biggest
automaker by sales, Volkswagen (VW) managed the global economic recession well by focusing on
emerging markets such as China and Brazil and continually reducing costs. VW is the leading auto
firm in China, not Toyota or Nissan. VW’s market share in Western Europe rose to 20% in 2009 from
17.9% a year ago. While shrinking demand for new cars in major markets and high raw-material
costs, and unfavorable exchange rates have reduced earnings of most European automakers, VW
anticipated these conditions through excellent strategic planning and continues to take market
share from rival firms worldwide.
The German truck maker and engineering company MAN AG is VW’s largest single shareholder at
30%, and its business too has been good. MAN’s third quarter of 2008 saw profit jump 34%, lifted by
strong sales of trucks, diesel engines, and turbo machinery. VW is currently spending $1 billion to
build a new plant in Chattanooga, Tennessee, for the production of a midsize sedan in 2011 with
initial capacity of 150,000 cars annually. VW’s plans for 2018 include increasing its U.S. market share
from 2% to 6% by selling 800,000 vehicles annually in the United States. By 2018, VW also plans to
export 125,000 vehicles from North America to Europe. VW‘s plans include large expansions at its
Puebla, Mexico, plant.While most auto companies are cutting expenses, VW is increasing is 2009 U.S.
marketing budget by 15% in its Audi AG luxury division. The Audi ads even ran during the 2009
Super Bowl.
For all of 2008, VW’s net profit rose 15% to 4.75 billion euros and revenues rose 4.5% to 114 billion.
VW expects flat or even slight declines in 2009 but some of its competitors are incurring billion
dollar losses.VW has cars named for climate patterns, insects, and small mammals. Along with the
New Beetle, VW’s annual production of 6 million cars, trucks, and vans includes such models such as
Passat (trade wind), Jetta (jet stream), Rabbit, and Fox. VW also owns several luxury carmakers,
including AUDI, Lamborghini, Bentley, and Bugatti. Other VW makes include SEAT (family cars,
Spain) and SKODA (family cars, the Czech Republic). VW operates plants in Africa, the Americas,
Asia/Pacific, and Europe. VW holds 68% of the voting rights in Swedish truck maker Scania and
about 30% of MAN AG. VW also offers consumer financing.
VW is acquiring Porsche Automobile Holding SE and merging their auto brands into VW. Based in
Stuttgart, Germany, Porsche already owns 51 percent of VW but has weakened in 2009 after taking
on $12 billion in new debt.
VW is in talks with China’s BYD Co. to build hybrid and electric vehicles powered by lithium
batteries. Based in Shenzhen, BYD will supply VW with the battery technology. This will be the first
automotive partner for BYD, which is one of the world’s largest suppliers of cell
phone batteries.
VW is building a new assembly plant in Indonesia for $47 million about 1 hour east of Jakarta, the
capital. This plant will assemble the Touran and employ about 3,000 persons. Toyota already has a
manufacturing plant in Indonesia and dominates that market. Currently many VW vehicles are
imported into Indonesia, thus being subject to a 200% tariff.
Chapter 3
71
VW reported 2nd quarter 2009 earnings of $397 million; the Audi division was the biggest
contributor to the gains.Volkswagen AG (VW) successfully navigated the economic downturn by
focusing on growth in emerging markets like China and Brazil, cost-cutting, and strategic planning.
As Europe’s largest automaker, VW increased its Western Europe market share to 20% in 2009 and
leads the Chinese market. While competitors struggle, VW has expanded production with new
plants in Tennessee and Indonesia, aiming to increase U.S. market share and exports by 2018. VW
also owns premium brands (Audi, Lamborghini, Bentley) and plans to merge Porsche under its
umbrella. Collaborating with China’s BYD on battery technology, VW is positioning itself in hybrid
and electric vehicle markets. Despite challenging conditions, VW's revenues and profits rose in 2008,
outperforming most competitors.
Source: Based on Christoph Rauwald, “VW Earnings Buck AutoIndustry Trend,” Wall Street Journal
(October 31, 2008): B3; Christoph Rauwald, “Volkswagen to Raise Output by 2018,” Wall Street
Journal (April 28, 2009): B3.
Chapter 3
72
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[11]https://www.gacities.com/Resources/GMA budget/
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for-Georgias-Municipalities/Step-by-Step- nefactoryoverheadbudget74673.html
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[12]https://www.hcsd.iu5.org/Induction/Fina calculate-and-budget-manufacturing-
nce/budgeting%20process.pdf overhead/
[13]https://www.milestone.inc/blog/8-steps- [28]https://courses.lumenlearning.com/wmm
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[14]https://mrsc.org/explore- overhead-budget/
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[15] https://theinvestorsbook.com/sales- [30]https://courses.lumenlearning.com/wm-
budget.html managerialaccounting/chapter/180
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CHAPTER
4
RESPONSIBILITY
ACCOUNTING AND
SEGMENT EVALUATION
Responsibility Accounting and Segment Evaluation
INTRODUCTION
In today’s competitive business environment, companies need to adapt quickly to changes in
technology and market demands. Without effective coordination among different parts of the
organization, businesses may struggle to achieve their goals, and even risk failure. Responsibility
accounting is one approach that helps organizations manage these challenges by assigning specific
responsibilities to managers in different areas called “responsibility centers.” These managers are
accountable for their decisions and actions, which makes it easier to track performance across the
organization.
Responsibility accounting not only helps evaluate how each area is performing but also supports key
decisions like cost control and profit planning. By clearly defining who is responsible for what, this
system helps create an environment where managers can focus on their specific areas while working
toward the organization’s overall goals. When practiced consistently, responsibility accounting can
also help reduce ethical issues, encouraging transparency and accountability at all levels. [1]
Learning Objectives
After reading this chapter learners should be able to:
Explain why organizational structure is important for effective managerial reporting.

Describe the differences between centralization, decentralization, and empowerment.
Determine the advantages and disadvantages of using centralized and decentralized
organizational structure.
Differentiate among authority, responsibility, and accountability.
Identify and discuss the various types of responsibility centers.
Explain how controllability relates to responsibility accounting.
Create a performance report for a specific business segment.
Assess a profit center's performance through segment margin analysis.
Evaluate an investment center's performance using ROI, residual income, economic value added,
equity spread, and other assessment models.
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ORGANIZATIONAL STRUCTURES
Understanding Organizational Structures: Centralization vs. Decentralization
In the ever-evolving world of organizational management, two prevailing structures

centralization and decentralization have garnered attention for their distinct approaches to
decision-making and operational efficiency. Each of these models has its own set of advantages and
disadvantages, making it essential for leaders to understand the implications of their organizational
structure in fostering employee engagement, enhancing productivity, and achieving strategic goals.
Centralization : A Hierarchical Approach
Centralization refers to the concentration of management and decision-making power at the top
of the organizational hierarchy. In centralized organizations, strategic planning, goal setting,
budgeting, and talent deployment are typically conducted by a single, senior leader or leadership
team. [2]
For example, a small family diner owned by a married couple probably uses centralized
management. The couple themselves order inventory, decide the marketing direction, and hire new
employees. As a company with centralized management grows, they add new levels of mid- and
lower-level managers, each of whom answers to a superior with very strictly defined roles in the
company. [3]
Advantages of a Centralized Management

Clear Leadership: Centralization creates a simple structure where everyone knows who to
report to, making decisions faster and more organized.
Shared Goals: Centralization helps keep everyone on the same page, with leaders clearly
sharing the organization’s goals.
Lower Costs: By following standard procedures and making decisions centrally, the
organization can save on administrative and other costs.
Uniformity and Consistency in Work: Centralized procedures lead to uniform, high-quality
work throughout the organization.
Disadvantages of a Centralized Management
Limited Input from Employees: Employees have little say in decisions, which can lower
creativity and motivation.
Heavy Workload for Leaders: Leaders in centralized systems handle all major decisions, which
can be overwhelming and may slow things down.
Delays in Work: Employees may have to wait for directions from the top, slowing down their
productivity.
Less Loyalty from Employees: Limited freedom to make decisions can lead to lower
commitment from employees. [4]
Decentralization : Empowering Lower Management
Decentralization refers to a structure where formal decision-making power is distributed across

multiple individuals or teams. [2] In such an organization, most of the planning, strategy and
decision to implement them are taken by the people in the middle and lower levels of management.
[5]
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For example is when a manager at a call center or retail store is allowed to make instant
decisions that impact their work environment. Decentralized management is found most often in
areas with a lot of direct contact with clients and customers, since it allows the managers closest to
the “Action” have more flexibility. [3]
Advantages of Decentralization
Employee Motivation: Decentralization improves job satisfaction and morale among lower-
level managers, providing more independence and encouraging teamwork.
Supports Growth and Flexibility: Each division has the freedom to be creative, fostering
healthy competition within the organization. Decentralization helps employees develop
management skills, supports succession planning, and contributes to long-term growth.
Faster Decisions: Decentralization allows authorized personnel to make quick, well-informed
decisions based on their immediate situation, speeding up the process.
Relief for Top Executives: With lower-level managers taking on more responsibilities, top
executives can focus on broader planning and high-level decision-making.
Disadvantages of Decentralization
Less Uniform: Each division has autonomy, making it challenging to ensure that all parts of the
organization work together smoothly.
Impact of External Factors: Issues like market changes, trade union actions, and government
regulations can complicate decentralized operations.
Limited for Small Product Lines: Decentralization may not be as effective in smaller
companies or those with fewer products, where it’s harder to maintain independent units.
Higher Costs: Decentralized organizations often need to pay more to retain skilled employees
and manage multiple autonomous units, which can increase expenses. [6]
Although the pendulum may be swinging back toward decentralization, centralized structures
still could offer potentially significant cost savings. Determining which model is right for your
organization is critical to any restructuring effort—the decision has the ability to impact not just
your organization’s costs and efficiency but also customer satisfaction and employee engagement.
[2
Striking the Balance and Empowering Employees

While the trend in many organizations has been shifting towards decentralization, there remains
a potential for significant cost savings with centralized models. Therefore, organizations must
thoughtfully evaluate their operational needs and employee engagement strategies. A hybrid
approach, combining elements of both structures, may often yield the most beneficial outcomes,
allowing organizations to maintain efficiency while empowering employees.
Empowerment
Empowerment is a management philosophy that focuses on allowing an organization’s
employees to make independent decisions and feel empowered to take action as they see
fit. [7] It provides employees with the means to make important decisions, spur strategic
change, and then help ensure those decisions and actions are improved continuously. [8]
To foster a culture of empowerment, leadership must:
1. Give employees a voice by regularly providing them with safe ways to offer
suggestions, ask questions, or raise concerns
2. Listen to the feedback from employees and act upon their suggestions.
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3. Foster a culture that prioritizes the psychological safety of its workforce and is open to change.
4. Recognize employees frequently and with incentives to increase their engagement and
confidence.
5. Support workforce development through training in areas where the employee's voice is
necessary or interesting [9]
MANAGERIAL ROLES
Understanding Managerial Roles: Authority, Responsibility, and Accountability
In the realm of management, clarity in roles and expectations is paramount for achieving
organizational goals. Among the essential components that shape effective management are three
interrelated concepts: authority, responsibility, and accountability. While these terms are often
used interchangeably, they encompass distinct characteristics that play crucial roles in
organizational dynamics. Understanding the differences and relationships between these roles is
vital for managers and employees alike.
Authority : The Power to Direct

Can be defined as the power vested in managers by senior executives to assign duties, tasks, and
responsibilities to subordinates. This power is important for effective management because it
facilitates the organization’s ability to function efficiently. When managers possess the authority to
allocate tasks, they can ensure that resources are optimized, and that team members are working
toward common objectives.
Authority comes in various forms, from positional authority granted through official titles and
roles, to personal authority that stems from respect, expertise, or charisma. Regardless of its source,
authority is critical for establishing a clear hierarchy within an organization, allowing managers to
lead and guide their team effectively.
Responsibility : The Commitment to Deliver

Responsibility refers to the obligation of managers and employees to perform assigned duties to
the best of their ability. Once a task is delegated, the individual who receives the assignment
assumes responsibility for its execution. This commitment is essential for task completion and is
often linked to specific roles within a team or organization.
Responsibility is inherently task-specific; each team member assigned to a project has particular
duties that contribute to the overall success of the endeavor. The focus on responsibility ensures
that everyone understands their specific contributions and is motivated to see the task through to
completion. Importantly, fulfilling responsibility requires not only commitment but also the
necessary skills and competencies to succeed.
Accountability : The Measure of Ownership

The ability to perform the assigned duties. [10]
Authority, Responsibility, and Accountability: Disparities

Authority, Responsibility, and Accountability are essential management parts and have distinct
characteristics. However, there is a relation between these three terms but differs from each other
in business terms.
Authority is the power delegated by senior executives to assign duties to all employees for better
functioning. Responsibility is the commitment to fulfill a task given by an executive. Accountability
makes a person answerable for their work based on their position, strength, and skills.
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Responsibility is task-specific, every team member can be responsible for an assigned

task to complete a project. Accountability arises after an incident has happened regarding
the work. It is the way to establish ownership of the results. [11]
Responsibility Centers
Understanding Responsibility Centers in Business Management
In the realm of business management, the concept of responsibility accounting plays a crucial role
in ensuring that different segments of an organization function effectively towards achieving
overarching corporate goals. At the heart of this concept lie responsibility center distinct areas
within a company that are delineated based on the functions, accountability, and financial metrics
tied to them. This segregation not only enhances clarity in operational performance but also
establishes a framework for accountability among employees.
What is a Responsibility Center?

The heart of the information system based on the responsibility accounting concept, is internally
separated company’s areas called responsibility centers [12]. A responsibility center is a
functional business entity with its own goals and objectives, dedicated staff, policies and procedures,
and financial reports. It gives managers specific responsibility for revenues generated, expenses
incurred, and funds invested. This refers to senior managers of a company to trace all financial
activities and results of a business back to specific employees. Doing so preserves accountability and
may also be used to calculate bonus payments for employees [13].
Responsibility centers are categorized into four main types, each serving different operational
objectives and managerial responsibilities:
1. Investment Center - This is responsible not only for profits, but also for the return on funds
invested in the group's operations. A typical investment center is a subsidiary entity for which the
subsidiary's president is responsible.
2. Profit Center - This is responsible for revenues and expenses, which result in profits and losses. A
typical profit center is a product line for which a product manager is responsible.
3. Revenue Center - This is responsible for generating sales. A typical revenue center is the sales
department, where the sole focus of the sales manager’s activity is generating more sales.
4. Cost Center - responsible for the incurrence of certain costs. A typical cost center is the janitorial
department, whose manager tries to keep costs down while still providing a mandated level of
service. The IT and accounting departments are also usually treated as cost centers. [13]
Significance of Responsibility Centers

Establishing responsibility centers within a company offers multiple advantages. Firstly, it enhances
managerial accountability by linking performance metrics directly to specific individuals or teams.
This clear delineation makes it easier to trace financial activities and results back to responsible
employees, fostering a performance-oriented culture.
Additionally, responsibility centers facilitate strategic planning and decision-making. By analyzing

the financial outcomes of various centers, senior management can make informed decisions regarding
resource allocation, performance improvement initiatives, and incentive structures. Furthermore, this
structured approach aids in identifying areas of inefficiency, thereby informing cost reduction
strategies that can enhance overall financial health.
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Performance Evaluation in Responsibility Centers:

A Key to Organizational Efficiency
Performance evaluation of responsibility centers involves systematically assessing the performance
of individual units or departments within an organization. It aims to determine how well each
responsibility center has met its objectives and whether it has efficiently utilized resources.
When implemented effectively, it aligns individual and departmental goals with organizational
objectives, drives continuous improvement, and contributes to goal attainment. [14]
Understanding Responsibility Centers

Responsibility centers are specific departments or units assigned with particular responsibilities,
typically classified into several categories: cost centers, revenue centers, profit centers, and investment
centers. Each type of responsibility center plays a different role within the organization, and the
performance evaluation methods vary accordingly. Among these, cost centers are frequently
emphasized due to their direct impact on an organization's financial health.
Basis of Evaluation Responsibility Centers
Cost Center Manager Performance

Managers assess cost center performance against allocated budgets, focusing on critical indicators
such as cost efficiency and financial discipline. Regularly generated reports offer valuable insights,
empowering management decisions regarding resource allocation, process enhancements, and overall
organizational efficiency. [15]
Evaluation Technique: Variances between actual and budgeted costs.
Figure 4.1. Cost Center Performance Report
Clothing Retail Department

Monthly Performance Report
For the Month Ended January 2025
Salaries and wages
Budget P350,000
Actual P(349,500)
Variance P500 F
Training
Budget P10,000
Actual P(12,000)
Variance P(2,000) U
Depreciation
Budget P5,000
Actual P(5,000)
Variance - -
Office Supplies
Budget P1,000
Actual P(750)
Variance P250 F
Total P366,000 P367,250 P(1,250) Net Loss U
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When determining if a variance is favorable or unfavorable, see if the actual amount is larger or
smaller than the budget amount. A favorable variance is one where the actual cost is less than
budgeted. The department saved money, which is a good thing. Unfavorable variances occur when the
company spends more than planned. For salaries, the actual amount is less than the budget. Because
this is an expense, the actual cost less than the budgeted cost is favorable. [16]
Revenue Center Manager Performance

The performance of a revenue center is measured based on its output, where the objective is to meet
or exceed the budgeted sales revenue and profit margin targets. [17]
Evaluation Technique: Variances between actual and budgeted revenue/sales.
Figure 4.2. Revenue Center Performance Report
Midwest Region Sales District

Standard Model
Budget P1,000,000
Actual P1,090,000
Variance P(90,000) F
Deluxe Model
Budget P950,000
Actual P930,000
Variance P20,000 U
Executive Model
Budget P500,000
Actual P550,000
Variance P(50,000) F
Total P2,450,000 P2,570,000 P(120,000) F
A revenue center performance report looks similar to a cost center performance report. The only
difference with a revenue center performance report is the determination of favorable or unfavorable
variances. For the Standard Model, the actual is more than the budget. Here, we are discussing
revenue. Higher revenue is good, so the $90,000 variance is favorable. The Deluxe Model has sales of
$20,000 lower than budgeted, which could be better and unfavorable. [16]
Profit Center Manager Performance

A profit center manager controls the cost directly incurred by the profit center and not the allocated
cost. Measuring the performance of the profit center manager includes considering only those costs
and revenues over which the profit center manager has direct control [18]. Therefore, his performance
is evaluated by comparing their actual results to their budget and measuring their ability to control
costs and generate revenue [19].
Evaluation Technique: Segment margin analysis.
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Figure 4.3. Profit Center Performance Report
Standard Model Product

Budget Actual Variance

Sales P6,500,000 P6,650,000 P(150,000) F
Less: Variable Costs P3,500,000 P3,575,000 P(75,000) U
Contribution Margin P3,000,000 P3,075,000 P(75,000) F
Less: Direct Fixed Costs P2,000,000 P1,999,000 P1,000 F
Segment Margin P1,000,000 P1,076,000 P(76,000) Net Loss F
Its only difference in the cost and profit center performance report is the inclusion of revenue and
expenses on the report. For contribution margin and profit (segment margin), when the actual is
higher than the budget, that is a positive. The higher your contribution margin and profit, the better.
That would be a favorable variance. When contribution margin and profit are less than budgeted, it is
unfavorable. [16]
Evaluating Investment Center Manager Performance: Key Metrics and Examples
In today’s competitive business landscape, companies are under constant pressure to optimize their
performance and maximize returns on investments. One critical area of focus within many
organizations is the performance assessment of investment centers—specialized segments that utilize
capital to invest in fixed and working assets to generate profit. The evaluation of an investment center
is generally framed within a set of financial metrics that provide insight into its operational
effectiveness.
Companies evaluate the performance of an investment center according to the revenues it brings in
through investments in capital assets compared to the overall expenses. It utilizes capital in order to
purchase other assets and focuses on generating returns on the fixed assets or working capital
explicitly invested specifically in the investment center. [20]
Key Metrics for Evaluation:
Return on Investment (ROI): This metric serves as a measure of profitability by assessing how
effectively a segment utilizes its invested capital to generate profitable returns. The basic
formula for ROI is:
Return on Investment (ROI) - measures the degree of profitability by dividing gross profit over
investment. [21]
ROI = Segment Profit/ Segment Investment
If ROI >1, then it is good for the business. Moreover, to increase the ROI profit should increase and
investment must be reduced.
Increase in ROI = Increase in Profit Decrease in Investment
Example:
De Guzman Enterprises reported an investment of P8,000,000 in operating assets. In 2024, De

Guzman generated P2,200,000 in profit from P16,000,000 in total sales.
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Require: Calculate the following for De Guzman Enterprises:
1. Profit margin for 2024

2. Asset turnover for 2024
3. Return on investment for 2024
4. ROI under each of these independent assumptions:
a. Sales increased from P16 million to 18 million and profit increased from P2,200,000 to P2,600,000.
b. Sales remain the same, but costs and expenses decrease while profit increases by P500,000.
c. The total investment in assets decreases by P600,000 without affecting the profit.
Solutions:
1. Profit margin or return on sales is computed as follows:
Profit margin = Profit / Net sales = P2,200,000/ P16,000,000 = P13.75%
2. The assets turnover is determined as follows:

Assets turnover = Net sales/ Assets = P16,000,000/ P8,000,000 = 2
3. ROI = Return on sales x Assets turnover = 13.75% x 2 = 27.5%

Or ROI may be computed directly as ROI = Profit / Average assets used = P2,200,000/ P8,000,000 = 27.5%
4. a. ROI = P2,600,000/ 18,000,000 = 14.44%
b. ROI = (P2,200,000 + P500,000) / P8,000,000 = 33.75%
c. ROI = P2,200,000 / P7,400,000 = 29.73%
Additional Evaluation Techniques

Besides ROI, companies can leverage other key metrics to gauge investment center performance:
The Residual Income Model - represents the excess of income earned from the desired or target
income. [21]
Segment income Px
Less: Minimum income x (Investment x Implied Interest rate)
Residual income Px
Example:
Hidalgo Corporation has reviewed the following date for its Western Division’s performance in
2024:
Net Sales P15,000,000

Costs and expenses 13,200,000
Average operating assets 7,000,000
Desired minimum (or imputed) rate
of return established by management 17%
Average industry rate of return 23%
Income tax rate 30%
Calculate the Western Division’s residual income.
Solutions:
Segment profit (P15 million - P13.2 million) P1,800,000
Less: Minimum income (P7 million x 17%) 1,190,000
Residual Income P610,000
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Since a division's residual income is positive, it has met the profitability expectations or
standards set by top management and is, therefore, considered acceptable.
Economic Value Added (EVA) - a more precise version of residual income that considers after-tax
operating income, weighted average cost of capital, and current obligations. [21]
Operating Profit After Tax (EBIT x after-tax rate) Px

Less: Minimum income (Investment x Weighted Average Cost of Capital) x
Economic value added Px
Example:
Riego Enterprises operates the Delta Division, a branch in the consumer goods industry. The
company provided the following information regarding Delta Division’s performance for the year
2024:
Divisional income before interest and taxes P 150 million

Interest expense P 40 million
Tax rate 35%
Weighted average cost of capital 11%
Average total assets
Carrying amount P 80 million
Current value P 110 million
Average current liabilities P 30 million
Required: Economic value added (EVA) assuming the investment base is:
1. Market value of long-term financing.

2. Carrying amount of long-term financing.
3. Market value of total assets.
4. Carrying amount of total assets.
Solution:
1. Investment base is the market value of long-term financing.
OPAT (P 150 million x 65%) P 97.5 million

Less: Minimum return on market value of long-term financing
[( P 110 million – P 30 million) 11%] P 8.8 million
Economic value added P 88.7 million
2. Investment base is the carrying amount of long-term financing.
OPAT P 97.5 million

Less: Minimum return on carrying amount of long-term financing
[( P 80 million – P 30 million) 11%] P 5.5 million
Economic value added P 92 million
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3. Investment base is the market value of the total asset
OPAT P 97.5 million

Less: Minimum return on market value of the total assets
(P 110 million x 11%) P12.1 million
Economic value added P85.4 million
4. Investment base is the carrying amount of the total asset
OPAT P97.5 million

Less: Minimum return on carrying amount of the total assets
(P 80 million x 11%) P 8.8 million
Economic value added P 88.7 million
Equity Spread - calculates the value creation of equity. [21]
Shareholders’ equity – beginning Px

Multiply: (Return on equity – Cost of equity rate) x%
Equity spread Px
Example:
Mercadejas Corporation wants to assess its performance using the concept of equity spread. Here
are the details for its current year:
Shareholders’ equity at the beginning of the year P25,000,000

Return on Equity (ROE) 18%
Cost of equity rate 12%
Required: Calculate Mercadejas Corporation’s equity spread.
Solutions:
Shareholders’ equity – beginning P25,000,000
x (Return on equity – Cost of equity rate)
(18% - 12%) 6%
Equity spread P1,500,000
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SUMMARY
This chapter covers organizational structures, focusing on centralization and decentralization.
Centralization consolidates decision-making at the top of the hierarchy, offering clear leadership and
cost savings but limiting employee input. Decentralization distributes decision-making across various
levels, increasing flexibility and employee engagement but potentially causing inconsistency and
higher costs. The decision between centralization and decentralization is a strategic one that has
profound implications for organizational culture, employee satisfaction, and operational success.
It also discusses empowerment, where employees are given the authority to make decisions,
fostering engagement, innovation, and personal development.
The chapter explains the roles of authority, responsibility, and accountability in management.
Authority refers to the power to assign tasks, responsibility is the duty to complete those tasks, and
accountability means being answerable for the results. By understanding the balance between
authority, responsibility, and accountability, organizations can create a work environment that not
only enhances team dynamics but also drives sustainable growth and success.
Fostering responsibility centers and implementing robust performance evaluation strategies will
enable leaders to cultivate an accountable and engaged workforce. In an era marked by rapid change
and complexity, these strategic choices will equip organizations to meet challenges head-on while
capitalizing on opportunities for innovation and improvement. Ultimately, an organization that
prioritizes these managerial principles will be well-positioned to navigate the evolving business
landscape and achieve enduring success.
Lastly, the chapter outlines responsibility centers, which are organizational units with specific
financial and operational goals. These centers include investment centers, profit centers, revenue
centers, and cost centers. Each is evaluated based on performance metrics relevant to its function,
supporting accountability and alignment with broader organizational objectives.
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SELF- TEST
Let’s be RESPONSIBLE!!
Ready to put your responsibility accounting knowledge to the test? Let's dive into these real-world
scenarios and see how it all fits together.
Problem 1
The following information pertains to the product produced by the Wheat Bread Division of
Marby Food Ventures Corporation:
Per unit
Selling Price P180
Manufacturing costs:
Prime Costs 85
Variable Factory overhead 30
Fixed factory overhead 12
Selling and administrative costs:
Variable 24
Fixed (total P135, 000) 9
During the period, the Wheat Bread Division produced 15,000 units and sold 13,500 units, both as
budgeted. There was no beginning and ending work in process inventories, and there was no
beginning finished goods inventory during the period.
There was no difference between the total budgeted and actual fixed costs. Variable
manufacturing costs vary with production, while variable selling costs vary with sales. Central
administration costs are allocated to the different divisions of the company. For this period, central
administration costs allocated to the Wheat Bread Division amounted to P200,000.
Questions:
1. How much is the Wheat Bread Division’s manufacturing margin?
2. Wheat Bread Division’s contribution margin was?
ANSWERS:
Sales ( 13,500 units x P180) P2,430,000

Less: Variable manufacturing cost
(13,500 x [P85 + P30]) 1,552,500
Manufacturing margin P 877,500
Manufacturing margin P 877,500

Less: Variable selling and administrative costs
(13,500 x P24) 324,000
Contribution margin P 553,500
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Problem 2
The Pinoy Loaf Division of Marby Food Ventures Corp. is classified as an investment center.
For the month of November, it had the following operating statistics:
Sales P1,425,000
Cost of goods sold 870,000
Operating expenses 463,800
Total assets 980,000
Weighted average cost of capital 8%
Marby Food Ventures Corp average stockholder’s equity is 600,000. It is subject to an income tax
rate of 40%.
1. What is its return on investment?
2. Its residual income amounts to what?
ANSWERS:
1. ROI = Operating Income ÷ Investment or Assets

= (P 1,425,000 – P870, 000 – P463, 800) ÷ P980, 000 = 9.31%
2. Sales P1,425,000
Less: costs and expenses
(P870, 000 + P463, 800) 1,333,800
Actual Income 91,200
Less: Desired Income or imputed charge
On investment (P980, 000 x 8%) 78,400
Residual Income P 12,800
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Problem 3
EXO Corp’s net income for the year 2024 was 890,000. Other pertinent data for the corporation
are as follows:
January 1 December 31
Stockholders’ Equity (120,000 shares outstanding) P1,260,000 P2,991,000
Price per share 40 65
Dividends per share 6
The company’s cost of equity capital is 10%. For purposes of measuring its performance, EXO
Corp computes its Economic Value Added. It also computes the following:
1. Equity value creation by multiplying the beginning equity capital by the difference between
the return on equity (Net Income / Beginning equity) and the percentage cost of equity.
2. Market Value Added which is the difference between the value of equity (Outstanding shares
x Market price) and the equity supplied by stockholders.
3. Total shareholders’ return which is equal to the change in stock price plus dividends per
share, divided by the initial stock price.
Question:
Considering the given data, EXO Corporation’s equity value creation, market value added, and
total shareholders return are;
ANSWERS:
Equity Value
Creation = Beg. Equity Capital x [(Net income/beg equity) – Percentage Cost of capital]
= P 1,260,000 x [(P 890,000/ P 1,260,000) – 10%] = P 764,000
Market Value Added

= Market Value of equity – Equity supplied by stockholders
= (Outstanding shares x market price) – Equity supplied by stockholders
= (P 120,000 shares x P65) – ([120,000 x P40] + [P 2,991,000 – P 1,260,000])
= P 3,000,000 – P 1,731,000
= P1,269,000
Total Shareholder’s Return = (∆ in Stock Price + Dividends per share)/ initial stock in price
= [(P65 – P40) + 6] ÷ P40
= 77.5%
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CASE STUDY
Korea Tourism Organization
The Korea Tourism Organization (KTO) began in 1962 as a government-owned corporation

responsible for the Korean Tourism industry. The corporation has concentrated primarily on
promoting Korea as a tourist destination and has contributed significantly to attracting foreign
tourists. Starting in the 1980s, domestic tourism promotion was also an essential function of the
KTO. Public tourism demand has been increasing due to an improved standard of living, increased
disposable income, and an enhanced transportation network. The KTO continues to help develop
tourism within Korea by addressing current trends in the tourism industry. Inbound visitors
amounted to over 6 million in 2005, and the tourism industry is increasingly important in the
Korean economy. In response to such circumstances, the KTO endeavors to develop Korean
traditional culture into high-quality tourism products and resources in conjunction with local
governments and the tourism industry. To improve tourism transportation, accommodation
infrastructure, tourist information systems, and overall service, the company also works to
eliminate undesirable aspects of the tourism atmosphere through various public campaigns. Also,
the KTO is endeavoring to make Korea a worldwide attractive tourism destination, play a pivotal
role in the developing of the Korean tourism industry as a national strategic industry, and
strengthen Korea’s competitiveness by focusing on significant strengths and utilizing expert
knowledge.
Korea Tourism Organization (KTO) categorizes its six divisions and one department into cost
centers, profit centers, and investment centers, depending on the responsibilities of the segment's
managers. In addition, the KTO builds the business units of which divisions are composed as
responsibility centers based on their levels of responsibility. A partial organization chart for the vice
president of investment & development indicates how the company's various business units are
classified in terms of responsibility. To more accurately measure the performance of responsibility
centers and control their costs for enhancing the KTO corporate value, a more appropriate
responsibility costing system that segregates costs attributable to the responsibility centers from
expenses that are not. The KTO, like most modern large organizations, has both operating and
support departments (service departments).
The central purposes of the KTO are carried out in the operating departments: marketing
planning team, Korean Convention Bureau, Korean Tourism Investment Center, Korean Travel Card,
and so on. In contrast, support departments provide services or assistance to the operating
departments. Examples of support departments include the finance & accounting team, human
resources team, budgeting team, and general affairs team. The costs incurred by its’ support
departments are usually allocated to its operating departments through the cost allocation method
selected.
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About their responsibility reporting, a different kind of financial statement is required for
evaluating the performance of a responsibility center that emphasizes segments rather than the
performance of the company as a whole. The three levels of responsibility reporting in the partial
organization have been indicated and numbered. These levels apply to other divisions in the
organization. That is, these constructs tend to emphasize the parallel relationship between the levels
of responsibility and the reports that are directed at each of the levels and serve as an anchor chart
in that it will enable one to refer back to this as individual responsibility centers, reporting is
discussed through the various levels of responsibility. Under the responsibility accounting system,
the KTO focuses on the first level of responsibility reporting to more appropriately evaluate the
performance of the responsibility centers in the division.
Summary: The Korea Tourism Organization (KTO), established in 1962, promotes tourism in Korea,
targeting both international and domestic visitors. Increased living standards and improved
infrastructure have driven tourism growth, with over 6 million foreign visitors in 2005. KTO
collaborates with local governments to enhance Korea's appeal by developing cultural tourism and
improving infrastructure, information systems, and services. KTO’s structure includes various
divisions categorized as cost, profit, and investment centers, with responsibility centers set up to
manage performance effectively. Support departments like finance and HR assist the operating
teams with costs allocated to maximize efficiency and corporate value.
Source:https://archives.kdischool.ac.kr/bitstream/11125/30083/1/%28A%29%20Study%20on%20the%
20responsibility%20accounting%20and%20economic%20value%20added.pdf
Chapter 4
91
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on/339302404_Responsibility_accounting_ /what-is-a-responsibility-center.html
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046/ap_centralization_versus_decentraliza responsibility-
tion_apr_2016.pdf centres/#:~:text=Performance%20evaluation
[3]https://www.personalfinancelab.com/fi %20of%20responsibility%20centres%20invol
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knowledge/management/centralized-and- 20performance,it%20has%20efficiently%20u
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[4]https://corporatefinanceinstitute.com/r [15]https://www.enerpize.com/hub/cost-
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[6]https://www.vedantu.com/commerce/a for-cost-revenue-and-profit-centers/
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[8]https://asq.org/quality- center-manager-the-manager-a-and-the-sub-
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srsltid=AfmBOor4B-WdSlxUu4bvvUJQRY- same-costs-and-revenues-b-should-only-be-
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[9]https://asq.org/quality- revenues-of-the-sub-
resources/employee-empowerment? unit.html#:~:text=Answer%20and%20Explan
srsltid=AfmBOor4B-WdSlxUu4bvvUJQRY- ation%3A&text=A%20profit%20center%20m
EBECZidIzE20KDa_VFK82i6K3w0TM anager%20controls,center%20manager%20h
[10]https://www.toppr.com/guides/funda as%20direct%20control.
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[11]https://www.vedantu.com/commerce/ vestment-
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ion/314980238_RESPONSIBILITY_ACCOUN [21]https://www.accountingverse.com/manag
TING_INSPIRATION_FOR_SEGMENT_REPO erial-accounting/responsibility-
RTING accounting/performance-evaluation.html
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CHAPTER
5
TRANSFER
PRICING
Transfer Pricing
INTRODUCTION
In today’s increasingly globalized business environment, transfer pricing plays a critical role in
international commerce. It affects the allocation of profits among different jurisdictions and can have
significant tax implications. A transfer price determines the cost to charge another division,
subsidiary, or holding company for services rendered. Transfer prices typically reflect the going
market price for that good or service. Transfer pricing can also apply to intellectual property such as
research, patents, and royalties.
As the sale of goods, provision of services, or the transfer of intangible assets like intellectual
property, transfer pricing arises when two or more related entities within a multinational
corporation engage in transactions. These transactions need to be priced to determine the profit each
entity earns and the taxes they owe in their respective jurisdictions. [1]
Learning Objectives
After reading this chapter, students should be able to
Explain the rationale behind transfer pricing.

Define the related party and the transfer price.
Explain the issue of interdependence.
Differentiate between arm's length and linked party transactions.
Explain the importance of transfer pricing in segment reporting.
Identify the different basis for transfer prices, their appropriate applications, and explain their
importance to segment evaluation.
Evaluate various options for multinational transfer pricing for the overall objective of the
company.
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Transfer Pricing
RELATED PARTIES
Transfer pricing is concerned with the determination of the prices charged in transactions between
two related companies. It refers to controlled transactions that are considered cross-border
between related parties and it may be:
a wholly owned company
affiliated
subsidiary
special purpose entity or
a business enterprise, which has a legal existence to conduct commercial and other operations.
Figure 5.1 The Related Parties
Company C
(subsidiary )
Company A
(affiliate)
Company D
(subsidiary )
Parent
Company
Company E
(affiliate)
Company B
(affiliate)
Company F
(wholly owned entity)
Related parties include not only parties within the same group but also parties that have a link of
direct or indirect control, including control over the board of directors. Transfer pricing deals with
the determination of the prices charged in transactions performed between related companies.
Transactions between related parties should observe the arm's length principle. As such, prices
charged in related-party transactions should not differ from prices charged in third-party
transactions under comparable circumstances (market value).
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Transfer Pricing
Related-Party Transactions
Understanding Related-Party Transactions and Transfer Pricing in Conglomerates
What is a Related-party transaction?

It refers to a deal or arrangement made between two parties who are joined by a pre existing
business relationship or common interest. [2]
Issue of Interdependence
Transfer pricing occurs when one autonomous unit sells to or buys from another inside the same
company conglomerate. It is also an interdependence issue since independent business unit
managers can select how they operate their business operations, engage with external suppliers and
customers, and collaborate with linked divisions. The organization of a company's economic activity
determines the interdependence level between its divisions. When each division operates in a
distinct product market, the degree of interdependence between them is likely to be minimal.
There are at least three interdivisional transfer and it includes the:

1. Selling Division
2. Buying Division
3. Parent Company
Whenever there is an interdivisional transaction, there are at least three independent but related
parties affected. Lets say, Juanito Dynamics Corp. (parent company) oversees both Salazar
Kitchenware Solutions and Garcias Innovations. Salazar Kitchenware Solutions (selling division) is
trying to sell its most recent range of energy-efficient kitchen appliances to Garcias Innovations
(buying division), which wants to incorporate cutting-edge technology into its sustainable product
offerings. In this scenario, the central issue is: What transfer price is to be used in the interdivisional
transaction?
Figure 5.2 The Transfer Price Environment
Juanito Dynamic Corp.
Salazar Kitchenware
Gracias Innovation
Solution At what transfer price? (Buying Division)
(Selling Division)
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Transfer Pricing
Goal Congruence and Suboptimization
Another issue on transfer pricing arises when the entity goal of the transacting division center runs
in conflict with the overall goal of the organization.
When the overall goal of the organization prevails over that of the divisional goals, it is called
goal congruence.
When the entity goal of the division prevails over the overall organization goals, it is called
suboptimization.
Managerial effort is the extent to which a manager attempts to accomplish a goal. Goal congruence
and managerial effort are managerial motivations. Motivation is the desire to attain a specific goal
(goal congruence) and the commitment to accomplish the goal (managerial effort).
TRANSFER PRICES
Understanding Transfer Pricing: A Deep Dive into Its Mechanisms and Implications
What is Transfer Price?

Transfer pricing refers to the prices of goods and services that are exchanged between companies
under common control. For example, if a subsidiary company sells goods or renders services to its
holding company or a sister company, the price charged is referred to as the transfer price. [3]
Below are the advantages and disadvantages of implementing transfer pricing strategies.
[4]
PROS:
Enables efficient resource allocation and financial management across borders.
Provides tax optimization opportunities that can enhance profitability.
Supports strategic business functions by aligning costs with company's goals.
CONS:
Risks include potential legal consequences for non-compliance.
Complex and resource-intensive to implement and maintain.
Potential for internal conflicts due to differing impacts on various divisions.
Basis for Transfer Pricing

1. Market-based pricing
2. Cost-based pricing
3. Negotiated pricing
4. Arbitrary pricing
5. Dual pricing
1. Market-based pricing
Market-based pricing is a pricing strategy that considers a product's market demand and supply.
The prices of goods or services are determined by what consumers are willing to pay. The market-
based pricing method is also called competitive pricing, which means that the prices are set based
on the level of competition in that particular market. [5]
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Transfer Pricing
Example: When a person goes to the grocery store and sees different brands with different prices,
the person might see that some brands have a higher price than other brands because they have
more demand for their products.
2. Cost-based pricing
Cost-based transfer pricing is a method of setting prices when selling products to divisions within
the same company. It is useful when external market information is unavailable during the trading
stage; however, market-based transfer pricing is more practical when there is a competitive
external market for your product. [6]
Example: In contract manufacturing, a manufacturing enterprise contracts exclusively with one

client (principal) and assumes limited risks. Many car-producing MNEs operate under that model.
Another example is the provision of simple administrative
At what services.
transfer price?
3.Negotiated pricing
Negotiated transfer pricing is a middle ground where the selling and the buying divisions,
supervised by the top management, agree on the best price for both. The two negotiate at arm's
length and decide to sell or buy from the external market or trade within themselves. Unlike the
cost-based transfer, the negotiated transfer approach minimizes conflicts between divisions, and
like market-based transfer pricing, it encourages divisional profit maximization. [7]
4.Arbitrary pricing
The management sets it in the corporate headquarters. Its strength is anchored on the premise that
the entire corporate organization must promote its overall goals (optimization) over and above the
division’s goals (sub-optimization). On the contrary, it does not jibe well with the very principle of
decentralization, where authority is given to division managers to make decisions about their
operations.
5.Dual pricing
Dual pricing sets different prices for the same product or service in other markets. A business may
use this tactic for various reasons, but it is often an aggressive move to take market share away
from competitors. [8]
Basic Transfer Price
Sample Problem 5.1. Basic Transfer Prices
Tech Innovations Inc. has two independent divisions, Software Solutions and Hardware Systems,
that operate in the same market. Software Solutions develops a software application called
"SmartApp," which Hardware Systems purchases from an external supplier at P150 per license. The
relevant production data for Software Solutions is as follows:
Variable development costs: P100
Allocated overhead costs: P30
Required: Determine the profit for Software Solutions, Hardware Systems, and Tech Innovations
Inc. if an interdivisional transfer of goods occurred under each of the following transfer prices:
1. Market price of P150.

2. Variable development costs of P100.
3. Negotiated price of P120.
4. Dual pricing.
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Transfer Pricing
If the transfer price is the market price, the selling division reports the entire profit of P50 and
as a result, the report shows a higher return on investment, residual income, or EVA. In the
sales division, managers are more likely to receive additional benefits like employment
bonuses and other perks and privileges, assuming everything is the same throughout all
divisions.
If the transfer price is based on costs, the buying division registers all the profit of P50, reports
better return on investment, residual income, or EVA, and the purchasing division manager
would have a larger probability of receiving more prizes and recognition, providing
everything is the same throughout all divisions.
If the transfer price is based on negotiated pricing, both the selling and purchasing
departments participate in transaction profit, claim better return on investment, residual
income, or EVA, have an equal probability of being considered in the following round of
promotions or granting of rewards, assuming everything is the same across divisions.
If the transfer price is based on dual pricing, both the selling and the purchasing divisions
record profit at P50, claim a substantially better return on investment, residual income, or
EVA, and have identical likelihood of being considered in the following round of promotions
or award giving, assuming. There are no differences between the divisions.
The assigned factory overhead is not included in the computation of divisional profit for
performance reasons because it does not reflect the controllable performance and does not
alter regardless of the choice to purchase the product from an outside source or a relative
division. It should have been readily apparent that the transfer price is optional from the
perspective of the Parent corporation. First, the divisions are in the same country and covered
by the same tax laws and regulations. Second, the transfer price is an input cost and revenue
involving the same amount. Therefore, it is merely a transfer payment and has no influence
on the overall performance of the parent company. If, in this situation, the transacting
divisions are protected by different sets of tax rules and regulations despite being located in
the same country with varying tax effects, the variation in the tax effects should be addressed
in the study of the parent corporation.
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Transfer Pricing
Overall, Tech Innovations Inc.'s profit stays at P50 despite the differences in transfer prices
between transactional divisions. Following the doctrine of goals congruence, a controlling firm
should continue advising its buying branch to purchase goods from its selling division as long
as the incremental expenses of producing items are less than the cost of buying the same from
an outside.
Minimum transfer prices
The top management typically sets the transfer pricing policy. The segment's goal is also relevant, but
the organization's overall goal is paramount. The other factors that are considered in setting the
transfer price are:
excess capacity,
the opportunity cost of the transfer transaction,
international tax issues (e.g., income taxes, sales taxes, value-added taxes inventory, payroll taxes,
and other governmental charges), and
other international issues include foreign exchange rate fluctuations and limitations on profit
transfers outside the host country.
The challenge in setting the minimum transfer price is of interest both to the selling and buying
divisions.
In the perspective of the selling division, the minimum transfer price (MTP) is as follows:
With excess capacity

MTP = Regular Incremental Cost + Opportunity Cost – Savings
Without excess capacity

MTP = Regular Sales Price + Other Incremental Cost + Opportunity Cost – Savings
Regular incremental costs include variable production costs, incremental overhead, and regular
marketing, selling, and administration expenses. Other incremental costs pertain to those aside from
the regular incremental costs.
When there is no excess capacity, the minimum transfer price starts from the regular sales price,
which already includes the regular incremental costs of production and sales, fixed overhead, which
should be transferred and charged to the buying division, and regular contribution margin, which
becomes opportunity costs if the regular sales are sacrificed instead of accepting the buying
division's order.
Sample Problem 5.2. Minimum Transfer Prices
Malabanan Foods, Inc. has two divisions: the Pasta Division and the Sauce Division. The Pasta
Division produces "packs" of spaghetti, which are used by the Sauce Division in various culinary
products. The spaghetti sells for an average of P40 per pack, and the division has the capacity to
produce 15,000 packs per month. The Sauce Division uses approximately 4,000 packs of spaghetti
each month for its production. The operating information for the Pasta Division at its current level
of operations (10,000 packs per month) is summarized below:
Sales (all external): P 400,000

Variable costs per pack:
Production: P 10
Selling: P2
General and Administrative Expenses: P1
Fixed costs per pack (based on a capacity of 15,000 packs):
Production: P1
Selling: P2
General and Administrative Expenses: P3
The Sauce Division currently pays P 20 per pack for spaghetti obtained from an external supplier.
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Transfer Pricing
Required: Determine the following:
1. Minimum Transfer Price assuming there is excess capacity in the Pasta Division.
2. Minimum Transfer Price assuming there is no excess capacity and the Sauce Division needs 6,000
packs.
3. Minimum Transfer Price assuming the Sauce Division needs 5,500 packs but is willing to pick up
the goods from the factory, resulting in a savings of P 2 per pack in selling expenses.
Solutions / Discussions:
1. with Excess Capacity

Min. Transfer Price = Incremental Costs + Opportunity Costs - Savings = P13.00
Incremental Costs include Variable Production and Expenses (e.g., P10 for production + 2 for selling
+ 1 for general and administrative expenses)
2. With no excess capacity
Min. Transfer Price = Regular sales price + Other incremental costs + Opportunity costs - Savings
= P40 + P0.67 = P40.67
The opportunity cost is the lost contribution margin on regular sales (e.g., P6,000 rolls - P4,000
packs) x P2 = P4,000), and if spread over the 6,000 packs ordered, would be P0.67 per pack.
3. Min. Transfer Price = (P40 - P2.00) + 0.55 = P 38.55
The opportunity cost is the lost contribution margin on regular sales (e.g., P5,500 rolls - P4,000
packs) x P2 = P3,000), and if spread over the 5,500 packs ordered, it would be P 0.55 per pack .
Transfer Price for Services

Many central departments of a corporation may sell services to clients and each other. The
department providing services to a second department generates revenue from this action. The
second department's purchase of services occurs through the same transfer. For example, a
corporation usually bills administrative services, including computer processing, accounting,
payroll, and staff, to the supported departments. Equitable transfer prices must be set in each
scenario to evaluate the department's ROI performance.
The following steps may be followed in setting the transfer price for services:
1. Identify the numerous departments that provide different services.
2. Evaluate the skill and experience of service providers.
3. Estimate the costs associated with providing the service. Factors like time requirements, the
qualifications and cost of the facilities required to perform the service should be examined.
4. Adopt one or more of the product transfer principles covered in this module.
Multinational Transfer Pricing

Multinational transfer pricing applies when the transacting divisions are addressed or located in
different countries of operations. In multinational transfer pricing, the objectives of the holding
company govern to minimize costs and maximize profit. Costs are minimized if the internal costs of
producing the goods are lower than the costs of acquiring the goods externally. A special focus of
multinational transfer pricing is the analysis of international tax effects incurred or paid by the
parent or holding company to the host countries. The holding company would endeavor to reduce
the overall tax payments by striking the best transfer price that would result in the lowest total tax
payments to be made. Also, to record the shipping expenses in the country having lower applicable
tax rates.
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Transfer Pricing
How does transfer pricing benefit multinational companies?

Transfer pricing can help multinational companies allocate resources efficiently, optimize tax
liabilities by utilizing favorable tax regimes, and manage the supply chain more effectively by
strategically setting prices for transactions between their own subsidiaries. [9]
Sample Problem 5.3. Multinational Transfer Prices
Global Enterprises Ltd. has two international divisions: one located in Vietnam and the other in
Thailand. The Thailand Division manufactures product "55B", which is a key ingredient needed by
the Vietnam Division. Both divisions operate independently, and below are the relevant data
regarding their operations:
Global Enterprises Ltd. is considering allowing the Thailand Division to supply the "55B" product to
the Vietnam Division. The Thailand Division has sufficient capacity to meet the Vietnam Division's
demand without affecting its local and other international sales. If this transfer takes place, the
shipping charges, freight, customs duties, and other costs incurred will amount to P 50 per unit.
Required: Calculate the overall profit of Global Enterprises Ltd. if the transfer price and the shipping
costs are noted as follows:
Options Transfer price Shipping costs to be recorded by:

1 P 400 Thailand Division
2 P 400 Vietnam Division
4 P 150 Thailand Division
6
The 6th option is for the Vietnam Division to buy the materials locally, and the Thailand Division sells
the goods in the domestic market.
Solutions/ Discussions
The computations of the consolidated net profit shall be as follows:
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Transfer Pricing
Based on the analysis above, the best transfer price for the overall goal congruence of the
enterprise is option no. 6 which would result in the highest profit after taxes of P 310.00. That is,
the transfer price at P150 and the Vietnam Division would absorb the cost of shipping and related
expenses.
Quality Management Measurements

Feedback and performance evaluations are vital in influencing management. Feedback concerning
management performance may take the shape of financial and non-financial measurements that
may be internal and produced outside the body.
Examples of economic and external measures are stock price, industry, the average return on equity,
return on assets, return on sales, debt-to-equity ratio, and price-earnings ratio. Internal and financial
indicators include cost variations, return on investment, and residual income; other financial
statistics include income, break-even point, break-even time, and return on sales.
What Is Break-Even Time (BET)?

Break-even time (BET) is an essential concept that allows businesses to understand the relationship
between their costs and profits. It calculates how long it'll take for a company to break even after
investing money in a particular project/activity and when their expenses will be matched by their
revenue. [10]
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Transfer Pricing
Non-financial indicators or measurements are critical in modern, quality-driven enterprises.

Emphasis is placed on Kaizen or continuous improvement, value chain analysis, process innovation
(or reengineering), and process mapping, in which standards focus on process analyses rather than
absolute cost benchmarks.
Factors That Affect Break-Even Time

1. COGS includes the direct production costs associated with producing goods, such as materials,
labor costs, packing supplies, shipping fees, etc.
2. The selling price also plays a vital role in determining BET, as higher prices may lead to greater
profits, but fewer customers could mean fewer sales volumes.
3. The number of units significantly sold affects BET since it determines how much revenue each
sale generates and whether it covers all the associated expenses incurred in running the business.
BET represents the amount of time it takes for a business to break even and make no money or lose
none, despite covering all their costs. [11]
Product development time pertains to the period where the product is conceptualized, designed,
approved, and the prototype made and readied for commercial production. As customer tastes,
preferences, needs, and wants change now more frequently, the product life cycle shortens and the
quickness of addressing customer wants, etc becomes a critical factor in a business's growth and
relevance.
What is Manufacturing Cycle Time?
Production companies use manufacturing cycle time as a significant performance measure. It
describes the length of time it took to finish a product, starting with the
raw materials and ending with the finished result.
It is used to measure the total time needed to produce a product, the efficiency of the process and
the productivity of the workers.
Divide the net production time by the total number of items to get a different perspective on the
production cycle time.
The total amount of time needed to turn raw materials into completed goods is known as the
manufacturing cycle time. This covers the time required for loading, machining, assembly,
inspection, moving materials, and waiting.
Manufacturing cycle time is composed of a number of different components, including setup
time, machine running time, material handling time, and quality control time.
Manufacturing cycle time is a key metric for measuring the success of a production process. It can
be used to identify inefficiencies and areas for improvement.
Manufacturing cycle time is also used to determine the cost of production and can help in making
decisions on pricing and production planning.
Manufacturing cycle time is an important factor in determining the overall productivity of a
manufacturing process and should be closely monitored and managed.
It is, in essence, the period of time between receiving the customer's purchase order and/or "Start
Work" notification. Then rolling the product off the production line. [12]
What Is a Balanced Scorecard (BSC)?

A balanced scorecard (BSC) is a strategic management performance metric that a company can use to
improve internal business operations and external results.1 It's a way for organizations to focus on
processes that, when combined, can help them meet their financial goals.
The balanced scorecard considers four perspectives essential to value creation for an organization:
the financial perspective and a focus on customers, internal business processes, and learning and
growth. Within these areas, the BSC measures and monitors the key performance data critical to an
organization's success. [13]
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Transfer Pricing
What Are the Four Perspectives of the Balanced Scorecard?
The four perspectives of a balanced scorecard are:

1. learning and growth
2. business processes
3. customer perspectives
4. financial data.
These four areas, which are also called legs, make up a company's vision and strategy. As such, they
require a firm's key personnel, whether that's the executive and/or its management team(s), to
analyze the data collected in the scorecard. [14]
What Are the 7 Main Elements of the Balanced Scorecard?
Traditionally, a balanced scorecard is made up of four perspectives. That number can be expanded to
take into account three more to drive an organization's improvement and success from a strategic
management perspective. [15]
Here are the seven main elements:

Financial performance
Customer satisfaction
Internal processes
Learning and growth
Strategy and vision alignment, ensuring that scorecard activities support the organization's goals
Governance and accountability, which create trust and transparency
Communication and feedback mechanisms, including regular performance reviews, to keep
improvements on track
Minimum Transfer Price

A general rule for making transfers to maximize a company’s profits in either a perfect or imperfect
market. use the formula:
Transfer Price = Differential costs per unit + Lost contribution margin per unit on outside sales
(or opportunity costs per unit)
The price set by the transfer pricing formula is equal to the differential costs (generally the variable
costs) of the goods being transferred plus the contribution margin per unit lost to the selling division
due to giving up outside sales. It also represents the lower limit since the selling division must receive
at least the amount shown by the formula if sold only to outside customers. The transfer price can be
more than the amount shown by the formula, but for an internal transfer to take place, the transfer
price should not exceed the purchase price from the outside supplier.
Suppose the selling division has sufficient idle capacity to meet the demand of another division
without cutting into the sales of its regular customers. In that case, it does not have any opportunity
costs. Hence, the lowest acceptable transfer price will equal the differential or variable costs per unit.
From the perspective of a buying division, the maximum acceptable transfer price is equivalent to
the price offered by the outside
supplier.
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SUMMARY
Transfer pricing involves establishing the prices for transactions between related companies, such as
subsidiaries or wholly owned entities, and is guided by the arm's length principle, which dictates that
these prices should resemble those charged in similar transactions between unrelated parties.
Related-party transactions occur between entities that share a pre-existing business relationship or
common interests, and they present unique challenges due to potential interdependence among
business units. Each division may pursue different objectives, leading to conflicts in decision-making
and pricing strategies.
Transfer pricing can utilize various pricing methods, including market-based pricing, which reflects
market demand and competition; cost-based pricing, which is aligned with production costs when
market data is lacking; negotiated pricing, where divisions agree on prices; arbitrary pricing set by
management without full consideration of division needs; and dual pricing, which sets different
prices for the same product in different markets.
Minimum transfer prices are critical in these transactions, calculated based on available capacity or
opportunity costs connected to internal transfers. Implementing effective transfer pricing strategies
can help multinational corporations achieve efficient resource allocation and optimize tax liabilities
while ensuring that the goals of individual divisions align with the overall corporate strategy.
Performance measurement through financial and non-financial indicators is essential for assessing
these strategies’ effectiveness and emphasizing continuous improvement practices. Additionally, key
performance indicators, such as break-even time and manufacturing cycle time, help companies
evaluate their operational efficiency and productivity, ultimately contributing to informed decision-
making and strategic management.
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Transfer Pricing
SELF- TEST
Strengthening the Foundation!
After learning the concept of transfer price, let us delve deeper into its application by considering the
following problems.
Sample Problem. Transfer Prices
PROBLEM 1. Digital Pulse Corporation has two divisions, which are the Computer Chip Division and
the Computer Division. The Computer Chip Division manufactures one product, a "super chip," that
can be used by both the Computer Division and other external customers. The following information
is available on this month's operations in the Computer Chip Division:
Selling price per chip P 60

Variable costs per chip P 30
Fixed production costs P 50,000
Fixed SG&A costs P 85,000
Monthly capacity 10,000
External sales 6,000
Internal sales 0
Presently, the Computer Division purchases no chips from the Computer Chips Division but instead
pays
P 45 to an external supplier for the 5,000 chips it needs each month.
1. Assume that next month's costs and levels of operations in the Computer and Computer Chip
Divisions are similar to this month. What is the minimum of the transfer price range for a possible
transfer of the super chip from one division to the other?
Incremental Cost of the chip (Variable Cost per chip) = P30
2. Assume that next month's costs and levels of operations in the Computer and Computer Chip
Divisions are similar to this month. What is the maximum of the transfer price range for a possible
transfer of the chip from one division to the other?
External Price paid for the chip = P 45
3. Assume, for this question only, that the Computer Chip Division is selling all that it can produce to
external buyers for P 60 per unit. How would selling division profits be affected if it sells 5,000 units
to the Computer Division at P 45?
Monthly capacity P 10,000 The selling division would decrease its profit
Multiply: 60 by P 75,000.
P 600,000
Less: 5,000 x 45 (225,000)
5,000 x 60 (300,000)
P 75,000
PROBLEM 2. BuildCore Corporation produces various products used in the construction industry.
The Plumbing Division produces and sells 150,000 copper fittings each month. Relevant information
for last month follows:
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Transfer Pricing
Total sales (all external) P 300,000

Expenses (all on a unit base):
Direct materials (variable) P 60
Direct labor (variable) 25
Overhead (20% variable) 15
Other information
Sales price 120
Selling expenses (15% variable) 20
The Plumbing Division is producing and selling at full capacity. What is the minimum selling price
that the division would consider as a “transfer price” to the other division on which no variable
period costs would be incurred?
Direct materials P 60
Direct labor 25
Overhead 3
Selling expenses 3
91
PROBLEM 3. Toyota Inc. has two divisions: the Manufacturing Division, which is responsible for
producing and assembling cars, and the Parts and Components Division, which often focuses on
producing auto parts and components (e.g., engines) that the Manufacturing Division buys from an
external supplier at P 85 per piece. The engine sells for an average of P78. The Components Division
has the capacity to produce 20,000 engines per month, while the manufacturing division
uses approximately 12,000 supplies of engines each month in its production. The relevant production
data of the Parts and Components Division at its present level of operations (8,000) is as follows:
Sales (all external) P 800, 000

Variable costs per engine:
Production 64
Selling 11
General and administrative expenses 5
Fixed costs per engine:
Production 12
Selling 8
General and administrative expenses 5
Required: Determine the profit for the Parts and Components Division, and Manufacturing Division,
if an interdivisional transfer of goods occurred under each of the following scenarios:
1. Market price of P 85.

2. Variable production costs of P 64.
3. Negotiated price of P75
4. Dual Pricing
5. Minimum transfer price.
6. Minimum transfer price, assuming the Manufacturing Division needs 12,500 engines.
7. Minimum transfer price, assuming the Manufacturing Division needs 14,000 engines but is
willing to pick up the goods from the factory resulting in a saving in selling expenses of P 2.00 per
engine.
The profits of the concerned divisions are computed as follows:
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Transfer Pricing
Solutions for requirements number 5-7:

5. With excess capacity
Min. transfer price = Incremental Costs + Opportunity Costs - Savings = P 80.00
The incremental cost includes variable production and expenses (e.g., P64+P11+P5)
6. With no excess capacity

Min. transfer price = Regular sales price + Other incremental costs + Opportunity costs - Savings
= P 78 + P 0.44 = P 78.44
The opportunity cost is the lost contribution margin on regular sales P 5,500 (e.g., 12,500 units –
12,000 x P 11 = P5,500), and if spread over the 12,500 units ordered, would be P 0.44 per unit.
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Transfer Pricing
7. Min. Transfer Price = (P 78 – P 2.00) + 1.57 = P 77.57
The opportunity cost is the lost contribution margin on regular sales P 3,000 [e.g., (14,000 units –
12,000 units) x P 11 = P 22,000], and if spread over the 14,000 units ordered would be P 1.57 per
unit.
Sample Problem. Multinational Transfer Pricing

The General Electric firm operates with two international divisions, General Power, which operates
in the U.S., and General Healthcare, which operates in the Philippines. General Power provides
power generation equipment that General Healthcare needs in their related operations. The divisions
are operating independently and below are the selected data on their operations:
U. S Philippines
Unit sales price P 630 P 950
Unit variable production costs 470 130
Domestic price of the material (power generation eqpt) 500
Tax rate 70% 30%
General Electric Firm, is entertaining the possibility of the U.S Division supplying the product “power
generation” needs of the Philippine Division. The U.S Division has enough capacity to accommodate
the possible demand of the Philippine Division, and its local and other international markets would
not be affected by its contemplated sales to the Philippine Division. If ever the transfer pushes
through, shipping charges, freight, customs duties, and other incremental and similar costs of
transactions would be P 60 per unit.
Required: Determine the overall profit of General Electric Firm, if the transfer price and the
recording of the shipping and related costs are as follows:
Options Transfer price Shipping costs are to be recorded by

1 P 630 China Division
2 P 630 Philippine Division
4 P 470 China Division
6
The 6th option is for the Philippine Division buys the materials locally and the U.S Division sells the
goods in the domestic market.
The computations of the consolidated net profit shall be as follows:
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Transfer Pricing
Based on the analysis above, the best transfer price for the overall goal congruence of the
enterprise is option no. 6 which would result in the highest profit after taxes of P 242.00. That
is, the Philippine Division buys the materials locally, and the U.S. Division sells the goods in
the domestic market.
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Transfer Pricing
CASE STUDY
TRANSFER PRICING-VODAFONE CASE STUDY:
Transfer pricing refers to the setting of the price for goods and services sold between related legal
entities within an enterprise. This is to ensure fair pricing of the asset transferred. The case dates
back to the financial year 2007-8, involving the sale of Vodafone India Services Private Ltd., the call
center business of Vodafone, to Hutchison, and the tax authorities demanded capital gain tax for this
transaction. The Income Tax department had demanded that Rs.8,500 crore be added to the
company’s taxable income. Vodafone has repeatedly clashed with the authorities over taxes since it
bought Hutchison’s mobile business in 2007. Vodafone acquired the telecom business of Hutchison in
India to enter the Indian market. And the British company is also fighting another case with the tax
authorities relating to this transaction. In this current transfer pricing case, Vodafone argued in the
High Court that the Income Tax Department had no jurisdiction in this case because the transaction
was not an international one and did not attract any tax. The dispute on transfer pricing surfaced
after the IncomeTax Department issued a draft transfer pricing order in December 2011 and added
Rs. 8,500 crore to Vodafone’s taxable income for the sale of the call center business. In 2013, the
Income Tax Department issued a tax demand of Rs. 3,700 crore to Vodafone India. However, the IT
tribunal stayed the demand during the proceeding of the case and asked Vodafone to deposit Rs. 200
crore by February 15, 2014. It complied with the order. However, Vodafone argued that the sale of
the call center business was between two domestic companies and the transfer pricing officer had no
jurisdiction over the deal. On Thursday, Vodafone India did not issue any elaborate statement. It said:
“Vodafone welcomes today’s decision by the Bombay High Court.” The tax authorities are likely to
challenge the decision in the Supreme Court. In October 2015, Vodafone won a transfer pricing case
having an additional demand of Rs.3,200 crore from the tax authorities in the Bombay High
Court.“The High Court has reversed the decision of the tax tribunal that the recasting of the
framework agreement between a taxpayer and Indian business partners was to be regarded as a
transfer of call options by the assessee to its Parent entity merely because the latter was a confirming
party. The tribunal, in so holding, had rejected taxpayers' contention that the Supreme Court in its
case had already settled the issue in its favor,” Arun Chhabra, Director, Grant Thornton Advisory said
while commenting on the case. In a major relief to British telecom major Vodafone in the transfer
pricing case, the Bombay High Court on Thursday ruled in its favor, setting aside a tax demand of Rs.
3,700 crore imposed on
Vodafone India by the income tax authorities. This is likely to benefit multinational companies such
as IBM, Royal Dutch Shell, and Nokia, which face similar tax demands. The division bench
comprising SC Dharmadhikari and AK Menon said in an oral order that relying upon the earlier
Supreme Court judgment, the court is of the view that there is no transfer of the 'call options' and
hence the transaction is not falling within the purview of transfer pricing. [16]
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Transfer Pricing
REFERENCES
[1]https://boycewire.com/transfer- [6]https://www.supermoney.com/encyclo
pricing-definition-and-examples/ pedia/transfer-price
[2]https://www.investopedia.com/terms/r/ [7]https://corporatefinanceinstitute.com/r
related-partytransaction.asp esources/economics/transfer-pricing/
[3]https://corporatefinanceinstitute.com/r [8]https://www.financestrategists.com/we
esources/economics/transfer-pricing/ alth-management/break-even-time/
[4]https://study.com/academy/lesson/mar [9]https://www.deskera.com/blog/manufa
ket-based-transfer-pricing-definition- cturing-cycle-time/
computation.html [10]https://www.investopedia.com/terms/
[5]https://www.indeed.com/career- b/balancedscorecard.asp
advice/career-development/cost-based- [11]https://www.researchgate.net/publica
transfer-pricing tion/303975679_Transfer_Pricing-
A_Case_Study_of_Vodafone
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CHAPTER
6
NONROUTINE
OPERATING DECISIONS
Nonroutine Operating Decisions
INTRODUCTION
A manager or group of managers acting in their official capacities on behalf of the
organization makes an organizational decision. It is an ongoing, dynamic activity that
influences every other organization-related activity. The decision-making process is an
essential part of running a business because it is an ongoing activity. Ultimately, it is the
culmination of the team's collective professional experience, technical expertise, and
scientific knowledge. Decision-making in management is important because you may
encounter situations where you have several options that may impact the workplace in
different ways. They may affect employees, other members of management or the
company's reputation.[1]
Running a successful business means establishing an overall strategy and set of policies to
move the organization forward and ensure its long-term success. Management is made up
of 3 hierarchical levels of management: strategic management, tactical management and
operational management. It is essential to understand these different levels of management
so that any company can adapt effectively to its internal and external environment.[2]
Learning Objectives
Distinguish between tactical, strategic, and operational choices.

Distinguish between routine and non-routine choices.
When making decisions, talk about the distinction between relevant and irrelevant costs.
Provide instances of decisions made during nonroutine operations.
In a variety of scenarios requiring nonroutine operating decisions, present pertinent expenses
and quantitative analysis.
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6.1 TYPES OF DECISIONS
The decision that a manager has to take may range from setting of goals and targets for the
entire business enterprise to specific decisions regarding day-to-day activities. Some of them may
have only short-term implications, while others may have long-term implications on the enterprise.
From these points of view, managerial decisions can be broadly classified into three categories,
namely, strategic, tactical and operational decisions.
1. Strategic Decisions
Strategic decisions are major choices of actions and influence the whole or a major part of
business enterprise. They contribute directly to the achievement of common goals of the
enterprise. They have long-term implications on the business enterprise. They may involve major
departures from practices and procedures being followed earlier. Generally, strategic decisions
are unstructured and thus, a manager has to apply his business judgment, evaluation and
intuition into the definition of the problem. These decisions are based on partial knowledge of the
environmental factors which are uncertain and dynamic. Such decisions are taken at the higher
level of management.
For instance, these often include plans regarding annual budgets and audits or the hiring of
new executives. Strategic decision-making usually begins with the following questions:
In what shape is the company now?
Where do we want to take it?
And how are we going to get it there?
Strategic decisions focus on ways to expand, what new services to introduce, and building
ideal customer profiles. Strategic decisions are the first to be made and all other decisions flow
from them.
2. Tactical decisions
These decisions relate to the implementation of strategic decisions. They are directed towards
developing divisional plans, structuring workflows, establishing distribution channels, and
acquisition of resources such as men, materials and money. These decisions are taken at the middle
level of management.
Tactical decisions are the next class of critically important business decisions. They focus
on more specific implementations of the general strategy with a medium-term effect on a business.
For example, developing a sales strategy or assigning tasks to staff members are tactical decisions.
However, a tactical decision can act as a prompt response to a changing market environment. For
example, a decision to introduce discounts as a response to price changes from competitors.[3]
3. Operational decisions
These decisions relate to day-to-day operations of the enterprise. They have a short-term
horizon as they are taken repetitively. These decisions are based on facts regarding the events
and do not require much of a business judgment. Operational decisions are taken at lower levels
of management. As the information is needed for helping the manager to make rational, well
informed decisions, information systems need to focus on the process of managerial decision
making.
An operational decision structure is made up of these steps:

Input data
Decision logic
Conclusion or action
Organizations need ways to make decisions requiring higher complexity while remaining as
responsive to opportunities and market disruptions.[4]
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Strategic and tactical decisions are compared below.
Table 6.1. Strategic v. Tactical Decisions
In general, strategies and tactics share a symbiotic relationship, with each assisting the
goals of the other. Establishing a strategy may make it easier for you to develop and employ
effective tactics as a senior employee or manager, as the actions you take serve a unified goal.
Conversely, effective tactics are a crucial component of effective strategizing, as tactics allow you
to realize your strategic goals.[2]
6.2 ROUTINARY VS NON-ROUTINARY DECISIONS

Decision-making can be divided into a number of categories according to its significance,
influence, and scope. Different authorities have classed decisions in different ways, including
routine and nonroutine decisions.
Routine decision-making, in simple terms, involves choices made regularly, often without the
need for extensive analysis. These are the day-to-day decisions that individuals and organizations
make as part of their regular activities. They are typically repetitive and involve selecting from
familiar options. These decisions are generally straightforward and don’t require a lot of time or
in-depth evaluation.
Example:
Setting daily work schedules
Replenishing office supplies
Approving routine expenses
Lower-level managers or employees often handle routine decisions as they are closely tied to
daily operations. Because these decisions recur frequently, organizations may establish
guidelines or procedures to streamline the process and ensure consistency. In essence, the
routine decision is about efficiently managing everyday tasks and activities, keeping the wheels
of an organization running smoothly.
Characteristics of Routine Decision-Making

1. Repetitive Nature. Routine decisions in an organizational context are characterized by their
repetitive occurrence. These are choices that need to be made regularly to ensure the smooth
day-to-day functioning of the organization. For instance, deciding on work schedules, managing
office supplies, or handling routine administrative tasks are common examples.
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2. Established Guidelines. In routine decision-making, organizations often have established

guidelines, rules, or standard operating procedures (SOPs) in place. These guidelines serve as a
framework that simplifies the decision-making process. When a decision falls under these
guidelines, it can be made more efficiently.
3. Low Complexity. These decisions tend to be of low complexity. They are typically
straightforward and do not require extensive analysis, deep thinking, or complex evaluation. Since
these decisions are recurring and familiar, they can be made quickly.
4. Delegated Authority. In many cases, organizations delegate routine decision-making to lower-

level managers or employees.[5]
6.3 RELEVANT COSTS

Classifying costs as either irrelevant or relevant is useful for managers making decisions about the
profitability of different alternatives. Costs that stay the same, regardless of which alternative is
chosen, are irrelevant to the decision being made. It is important to formally define and document
costs that should be excluded from consideration when reaching a decision. It helps to understand
the difference between irrelevant and relevant costs to make a critical business decision. These costs
can either make your company more profitable or put the company under.[5]
Relevant costs
Relevant costs are those used in making a decision. If a cost is not used in a specific situation that
needs to be decided upon, that cost is irrelevant in that situation. A decisional situation needs specific
sets of relevant costs. a cost that is relevant in a particular decision may be irrelevant in another.
Relevant costs have two (2) important features – differential and future-oriented.
Differential costs (or incremental costs) change from one alternative to another. In making a
decision, you have at least two (2) alternatives or options. If a cost differs from one option to another,
that cost is differential. Incremental costs refer to those that increase in costs from one option to
another. The normal examples of incremental costs are direct materials, direct labor, variable
overhead and variable expenses. Avoidable fixed overhead may also be an incremental cost.
Future costs are referred to as planned costs, budgeted costs, projected costs, or estimated costs.
Future costs are yet to be incurred in upcoming activities. If a cost is not a future cost, it is
automatically not relevant.
A cost to be relevant must be both differential and future cost. Sunk cost (or past costs, historical
cost) cannot be changed further, cannot be incurred in the future, and could not be relevant in
decision-making.
Nonroutine operating decisions use relevant costs and as such is sometimes referred to as relevant
costing, incremental costing, or differential costing.
Examples of relevant costs include:

Future cash flows: Cash expenses which will be incurred in the future,
Avoidable costs: Only the costs which can be avoided in a certain decision,
Opportunity costs: Cash inflow which would have to be sacrificed,
Incremental Costs: Only the incremental or differential costs related to the different alternatives.
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Irrelevant Costs
Irrelevant costs are costs, either positive or negative, that would not be affected by a
management decision. Irrelevant costs, such as fixed overhead and sunk costs, are therefore
ignored when that decision is made. However, it’s critical for a manager to be able to distinguish
an irrelevant cost in order to potentially save the business.
Examples of irrelevant costs:

Sunk costs: Expenditures which have already been incurred
Committed costs: Future costs which cannot be altered
Non-cash expenses: Depreciation and amortization
Overheads: General and administrative overheads
To improve decision-making or to make better decisions, a business needs to understand the

difference between relevant cost vs. irrelevant cost. Following are the differences between
relevant cost vs. irrelevant cost [6].
6.4 APPLICATION OF RELEVANT COSTING
Every scenario in which regular operating procedures are not applicable is handled using relevant
costing. But only the subsequent decision-making scenarios:
Make or buy (insource or outsource) a component or part?
Accept or reject a special sales order?
Drop or continue a segment or division?
Sell-as-is or process further a completed product?
Continue or temporarily shutdown operations?
What is the winning bid price, highest or lowest?
Optimization of scarce resources
Sell now or later a product
Replace or retain an old asset?
Scrap or rework the defective unit
Determining the indifference point
6.1 Make or buy (insource or outsource) a component or part?

A make-or-buy decision is the act of choosing between manufacturing a product in-house or
purchasing it from an external supplier. Also referred to as an outsourcing decision, a make-or-buy
decision compares the costs and benefits associated with producing a necessary good internally to
the costs and benefits of hiring an outside supplier to provide the resources in question. To compare
costs accurately, a company must consider all aspects of the acquisition and storage of the items
versus creating them in-house, which may require the purchase of new equipment, as well as added
labor cost.[8]
Sample Problem 6.1

Pepito Shoe Company specializes in the production of custom-made shoes. The company is currently
evaluating whether to manufacture or outsource the production of shoe model P-101. The cost per
unit for producing 5,000 units of shoe model P-101 is detailed below:
Direct materials: P 20.00
Materials handling costs (20%): P 4.00
Direct labor: P 15.00
Variable overhead: P 5.00
Fixed overhead: P 10.00
Total Cost: P 54.00
A competitor, Patrick Shoe Corp., has offered to sell Pepito Shoe Company the same model for P 50
per unit. If Pepito accepts Patrick’s offer, P 5 of the fixed overhead per unit could be eliminated. The
materials handling costs related to receiving and inspecting external shipments are considered
relevant and must be included in the overall costs.
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If Pepito outsources the production of shoe model P-101, it could reallocate half of its production
capacity to a new shoe line, "Sporty", expected to generate a contribution margin of P 100,000
annually. Additionally, Pepito anticipates saving P 20,000 per year from reduced expenses related to
the in-house production of shoe model P-101. The other half of the facilities could be rented out,
generating an additional income of P 70,000 per year.
Patrick Shoe Corp. requires that Pepito implements specific quality control measures, which result in
an equipment rental cost of P 90,000 that will be charged to Pepito Shoe Company.
6.4 APPLICATION OF RELEVANT COSTING
SOLUTIONS:
Unit Costs
Computations To MAKE To BUY
Purchase price P 50.00
Direct materials P 20.00
Materials handling costs P20 x 20% 4.00 10.00
(P 50.00 x 20%)
Direct labor 15.00
Variable overhead 5.00
Avoidable fixed overhead 5.00
Savings from outsourcing P 20,000/5,000 4.00
Rental income from released facilities P 70,000/5,000 14 .00
Contribution margin from a new product- Sporty P 100,000/5,000 20.00
Rental expense P90,000/5,000 (18.00)
Total relevant costs P49.00 P80.00
Savings per unit if the parts are made P 31.00
Total savings if the parts are made 5,000 x P31 P155,00
Based on the quantitative analysis above, it is advisable for Pepito Shoe Company to make part of the
P-101 model for a total saving of P 155,000.
2. The indifference price of the alternatives make or buy is computed as follows:
Unit cost to make P 49.00

Added (Deducted) back to the relevant costs to buy,
except for the purchase price and related handling costs:
Rental expenses (18.00)
Contribution margin from a new product 20.00
Rental income from released facilities 14.00
Savings from outsourcing 4.00
Purchase price and handling costs P 69.00
Purchase price from the supplier P 69.00 / 120% P 57.50
The handling costs are 20% of the purchase price.
3. The purchase price with a P 12 – saving per part shall be computed as follows:
Gross purchases price including handling costs P 69.00

Required savings (12.00)
Gross purchase price with savings P 57.00
Net purchase price P 57.00 / 120% P 47.50
4. The sunk cost in the decision to make or buy the part shall be the unavoidable fixed costs of P 5.00
(e.g. 10.00 fixed cost - 5 avoidable cost ) or a total of P 25,000 (e.g., 5,000 x P 5)
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In making these decisions, the guiding principle is always to maximize profitability.
Make or Buy a Component or Part? ... an Insourcing vs. Outsourcing issue...

A product is composed of different parts. Not all parts of the product are manufactured by a
company. A
part may be outsourced from a supplier based on the following reasons:
1. Lack of technology, man labor hours, machine hours, systems expertise, or financing.
2. Savings or discontinuance of unprofitable segment operations.
3. Legal or cultural limitations, or,
4. Strategic business relations.
The total relevant costs of each option should be taken when deciding to make or buy a part.
Whichever option gives a lower relevant cost would be a better alternative, assuming no other
quantitative and qualitative factors are to be considered.
Choosing to Make or Buy
The results of a quantitative analysis may be sufficient to make a determination as to which

approach is more cost-effective. At times, a qualitative analysis is also necessary to address any
concerns a company might have that it cannot measure specifically. A make-or-buy decision can be
a make-or-break decision for businesses, especially those in highly competitive markets. However,
it is not irreversible. If circumstances change, a company can change from a "make" strategy to a
"buy" strategy or vice versa.[7]
Sample Problem 6.1. Make or Buy a Part
Delicious Delights Inc. manufactures part Y-89 for use in its production cycle. The cost per unit for
10,000 units of part Y-89 are as follows:

Materials handling costs (20%) 1.60
Direct labor 15.00
Fixed overhead 10.00
Total P 38.60
Sweet Treats Ltd. has offered to sell Delicious Delights Inc. 10,000 units of part Y-89 for P 35 per
unit. If Delicious Delights accepts Sweet Treats' offer, P 3 of the fixed overhead per unit could be
eliminated. The materials handling costs pertaining to the cost of receiving and inspecting incoming
materials and other components are not included in the overhead.
If the part is outsourced from an outside supplier, one-half of the released facilities could be used to
produce a new product line, Jelly Bites, which is expected to generate a contribution margin of P
80,000 a year. Additionally, savings of P 12,000 are expected if the parts are purchased outside. The
other half of the released facilities could be rented out for P 50,000 per annum.
Sweet Treats Ltd. requires that equipment be leased to meet the order of Delicious Delights Inc. The
equipment rental cost of P 70,000 shall be charged to the buying company.
Required: For Delicious Delights Inc.:

What alternative is better, make or buy the part, and by how much is its advantage?
Indifference price of the two alternatives.
Purchase price to have a savings of P 10.00 per part.
The sunk cost (or irrelevant cost) in the decision of making or buying a part.
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The tabulated relevant costs of making and buying the part are as follows:
UNIT COSTS
Computations To MAKE To BUY
Purchase price P 35.00
Materials handling costs P 8.00 x 20% 1.60 7.00 (P 35.00 x
20%)
Direct labor 15.00
Avoidable fixed overhead 3.00
Savings if the part is bought P 12,000/10,000 (1.20)
Rental income from released facilities P 50,000/10,000 ( 5.00)
Contribution margin from a new product P 80,000/10,000 (8.00)
Rental expense if the part is bought P 70,000/10,000 7.00
Total relevant costs P 30.60 P 34.80
Savings per unit if the parts are made P 4.20
Total savings if the parts are made 10,000 x P 4.20 P42 ,000
Variable production costs (e.g., direct materials, direct labor, and variable overhead) are
incremental costs, differential costs, and are relevant costs.
Avoidable fixed overhead costs are also relevant costs since they vary from one option to
another. If a part is manufactured, the avoidable fixed cost is incurred; but if the part is
purchased, it is avoided.
Unavoidable fixed overhead cannot be avoided regardless of the decision made whether to
make or buy. It does not change; it is irrelevant.
Materials handling costs apply to both materials and other items being purchased. The rate used in
the allocation of the material handling costs is constant, but the amount allocated to various
departments differs depending on the base amount of items purchased. This makes the materials
handling costs relevant for the make or buy short-term decision.
Savings from parts bought, rental income from released facilities, and contribution margin from a
new product all happen when the part is bought. They are all inflows, either in the form of savings or
additional income, and are thus deducted from the costs of buying.
Variable and fixed selling and administrative expenses are not considered in the analysis
because they are not affected by the decisions; they will not change and are irrelevant in the decision
at hand.
Based on the quantitative analysis above, it is advisable for Delicious Delights Inc. to make the part.
2. The indifference price of the alternatives to make or buy is computed as follows:
Unit cost to make P 30.60

Added (deducted) back to the relevant costs to buy,
except for the purchase price and related handling costs:
Rental expenses ( 7.00)
Contribution margin from a new product 8.00
Rental income from released facilities 5.00
Savings if the part is bought 1.20
Purchase price and handling costs P 36.80
Purchase price from the supplier P 36.80 / 120% P 30.67
The handling costs are 20% of the purchase price.
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3. The purchase price with a P 10 savings per part shall be computed as follows:
Gross purchase price including handling costs P 36.80
Required savings (P 10.00)
Gross purchase price with savings P 26.80
Net purchase price: P 26.80 / 120% P 22.33
4. The sunk cost in the decision to make or buy the part shall be the unavoidable fixed costs of P 7.00
(e.g., P 10 – P 3) or a total of P 70,000 (e.g., 10,000 x P 7).
6.2 Accept or reject a special sales order?
There are times when a customer places a special order for a large volume at lower prices than that
usually charged by the business. In this event, the business should properly decide whether to accept
or reject the special order. When the company is operating at less than its maximum capacity and
the company has enough capacity to produce and fill the special order, the order should be accepted
if the additional sales exceed the additional variable costs. When the company has no excess
capacity, the cost to be considered must include the lost contribution margin from sacrificing regular
sales to be able to fill up the special order.[9]
Sample Problem 6.2

Freezy Co. has a manufacturing capacity of 30,000 air conditioning units per year. Below is a
summary of the operating results for the year ending December 31, 2022:
Total Per Unit

Sales of 25,000 units P3,000,000 P120.00
Less:Variable costs and
1,500,000 60.00
expenses
Contribution margin 1,500,000 60.00
Less:Fixed costs and
800,000
expenses
Operating income 700,000
Total Per Unit

Sales (30,000 units) P 3,000,000 P 100.00
Less: Variable costs and expenses 1,800,000 60.00
Contribution margin 1,200,000 P 40.00
Less: Fixed costs and expenses 800,000
Operating income 400,000
A potential client has offered to buy 10,000 units at P 100 per unit in the upcoming year. Assume
that all costs for Freezy Co. next year will be at the same levels and rates as in the prior year.
Required: Should Freezy Co. accept or reject the special sales order? Consider the following cases
independently.
1. The corporation has no alternative use of the idle capacity.

2. The corporation can rent out the idle capacity for P 300,000.
3. The corporation can use the idle capacity to produce a new product that could contribute a
P650,000 contribution margin.
4. If the special order is accepted, 2,500 units of regular sales are expected to be lost.
5. Assuming a distributor has ordered 8,500 units and the corporation has to sacrifice some of its
regular customers to accommodate the special order.
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1. Incremental sales (10,000 units x P 100) P 1,000,000
Incremental costs (10,000 units x P 60) 600,000
Incremental profit P 400,000
2. Incremental Contribution Margin (10,000 x P 40) P 400,000

Rent income if the facility is rented out (300,000)
Net advantage of accepting the special order P 100,000
3. Incremental Contribution Margin (10,000 x P 40) P 400,000

Contribution Margin from a new product (650,000)
Net advantage of rejecting the special order P 250,000
4. Incremental Contribution Margin P 400,000

Contribution Margin lost from regular sales (2,500 units x P 60) (150,000)
Net increase in profit from accepting the special sales P 250,000
5. Incremental Contribution Margin (8,500 units x P 40) P 340,000

Lost contribution margin (1,500 units x P 60) (90,000)
Net incremental profit P 250,000
6.3 Drop or continue a segment or division?

Some product lines or business segments tend to under-perform compared to others. When
deciding to add a new product line or drop an existing one, the management must consider relevant
benefits and costs. As a rule, product lines or business segments should be evaluated based on
traceable revenues and costs. Allocated fixed costs should be removed from the analysis of income
since the company will incur in the entire amount with or without the product line or segment.[10]
Sample Problem 6.3

Hammzy Company is evaluating the performance of its specialty ham division, which currently
contributes a P 300,000 contribution margin to overhead. The total overhead allocated to this
division is P 700,000, but P 100,000 of that cannot be eliminated even if the division is discontinued.
Required:
1. Should Hammzy Company discontinue the specialty ham division?
2. Compute the controllable segment margin to support your decision.
SOLUTIONS:
1. The controllable segment margin is computed as follows:

Less: Avoidable fixed costs (P 700,000 – P 100,000) 600,000
Controllable segment margin (P300,000)
1. Hammzy Company should discontinue the specialty ham division because it has a negative
controllable segment margin. If the division is dropped, the loss is eliminated, and the overall
profit of the enterprise will increase by P 300,000.
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6.4 Sell-as-is or process further a completed product?

The sell or process further decision is the choice of selling a product now or processing it further to
earn additional revenue. This choice is based on an incremental analysis of whether the additional
revenues to be gained will exceed the additional costs to be incurred as part of the additional
processing work. The sell or process further decision most commonly arises when two or more
products are generated by a manufacturing process. At the point when the products can be split
apart (the split-off point), there is a choice to sell the goods immediately or attempt to capture
additional value by engaging in more processing. This decision may vary over time, based on
changes in the market prices of a product at each stage of processing. If the market price declines
for a later-stage product, it can make more sense to sell it without additional processing.
Conversely, if the market price increases for a later-stage product, the better choice may be to
continue with additional processing in order to reap higher profits.[11]
Sample Problem 6.4

Regine Company produces and sells two products, the cakes and cookies with the following income
statement data in 2024.
Cakes Cookies Total
Sales 500,000 400,000 700,000
Variable Cost 200,000 160,000 360,000
Contribution margin 300,000 240,000 540,000
Avoidable fixed costs 120,000 80,000 200,000
Segment margin 180,000 160,000 340,000
Allocated fixed costs 150,000 150,000 300,000
Profit (Loss) 30,000 10,000 40,000
Required: Assuming all things shall be constant in the following business period, except as
provided below, determine the effect of the following independent cases to the overall profit of the
enterprise.
1. Product Cakes are dropped.
2. Product Cakes are dropped and 20% of the allocated fixed cost is eliminated.
3. Product Cakes is dropped and the released facility is used to produce and sell 30% more of
Product Cookies.
4. Product Cakes is discontinued and 50% of the product’s avoidable fixed costs would remain with
a corresponding 10% decrease in the sales of product Cookies.
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SOLUTIONS:
a. Decrease in profit due to lost positive segment margin of cakes P (180,000)
b. Decrease in profit due to lost positive segment margin of cakes P (180,000)

20% drop in allocated fixed cost (P 300,000 x 20%) 60,000
Net decrease in overall profit P (120,000)
c. Decrease in profit due to lost positive segment margin of cakes P (180,000)

30% increase in the CM of cookies (P 240,000 x 30%) 72,000
Net decrease in overall profit ( P108,000)
d. Contribution margin P 180,000

Avoidable fixed costs(50% x 120,000) (60,000) P120,000
10% decrease in CM of cookies (P 240,000 x 10%) (24,000)
Net increase in the overall profit P 96,000
6.5 Continue or temporarily shutdown operations?
A shutdown point is a level of operations at which a company experiences no benefit for continuing
operations and therefore decides to shut down temporarily—or in some cases permanently. It
results from the combination of output and price where the company earns just enough revenue to
cover its total variable costs. The shutdown point denotes the exact moment when a company’s
(marginal) revenue is equal to its variable (marginal) costs—in other words, it occurs when the
marginal profit becomes negative.[12]
Sample Problem 6.5
David Co. manufactures and sells face shields. The company typically sells 100,000 units per month,
but due to a decline in market demand, sales are expected to drop to only 5,000 units per month
during the months of September and October. The management team is considering temporarily
shutting down operations to avoid losses during these months. If the company shuts down, they will
still incur security and maintenance costs amounting to P 150,000 per month. Restarting operations
will require a cost of P 250,000 for mobilization and other startup costs.
The company has an annual fixed cost of P 18,000,000, which is allocated evenly over 12 months.
However, during the shutdown months, the fixed costs are expected to decrease by 50%. Below are
the other sales and cost data:
● Unit sales price of P 400
● Unit variable production costs of P 160
● Unit variable expenses of P 60
SOLUTIONS:
1. Calculate the shutdown costs.
Allocated fixed costs (P18,000,000 x 2/12 x 50%) P 1,500,000

Security and insurance (P 150,000 x 2 months) 300,000
Restart-up cost 250,000
Shutdown cost P 2,050,000
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2. The total fixed cost in the months of July and August P 3,000,000
( P 18,000,000 x 2/12).
The unit contribution margin (P 400 – P 220) P 180
Therefore, the shutdown point is 13,834, computed as follows:
Shutdown point ( P 3,000,000 – P 2,050,000 / P 180 ) 5,277.78 units

To prove, we have:
Contribution margin (5,277.78 x P 180) P 950,000

Less: Fixed costs and expenses ( 3,000,000)
Loss from continuing the operations P (2,050,000)
Shutdown costs P 2,050,000
3. Continue or shutdown?
Contribution margin (5,000 units x 2 mos. x P 180) P 1,800,000

Less: Fixed costs and expenses 3,000,000
Loss from continuing the operations (1,200,000)
Less: Shutdown costs (2,050,000)
Advantage of continuing the operations P 850,000
6.6 What is the winning bid price, highest or lowest?
A bid price is a price for which somebody is willing to buy something, whether it be a security,
asset, commodity, service, or contract. It is colloquially known as a “bid” in many markets and
jurisdictions. Generally, a bid is lower than an offered price, or “ask” price, which is the price at
which people are willing to sell. The difference between the two prices is called a bid-ask spread.
Bids are made continuously by market makers for security and may also be made in cases where a
seller requests a price where they can sell. Sometimes, a buyer will present a bid even if a seller is
not actively looking to sell, in which case it is considered an unsolicited bid.[13]
Sample Problem 6.6 _ Part 1 Minimum Bid Price

Russell Tech, Inc., manufactures high-quality printers for commercial use. The costs associated with
producing a specific model of printer are detailed below:
Direct materials: P 250,000

Direct labor: P 150,000
Overhead:
➢ Supervisor’s salary of P 30,000
➢ Fringe benefits on direct labor of P 15,000
➢ Depreciation of P 40,000
➢ Rent of P 20,000
Total costs of P 505,000
If production of this printer model were discontinued, the production capacity would remain idle,
and the supervisor would be laid off. When asked to submit a bid for the next contract for this
printer model, what should be the minimum bid price?
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SOLUTIONS:
The minimum price should at least be equal to the incremental cost of manufacturing.
Direct materials P 250,000
Direct labor 150,000
Supervisor’s salary 30,000
Fringe benefits on direct labor 15,000
Incremental costs/ Minimum price P 445,000
Sample Problem 6.6 _ Part 2 Maximum Bid Price

Dyesebel Water Refilling Station has the following annual costs:
● Water and Supplies of P 1,500,000
● Labor of P 600,000
● Overhead of P 300,000
● Total of P 2,400,000
The overhead is 40% fixed. Of the fixed overhead, P 60,000 goes to the salary of the station manager.
The remainder of the fixed overhead has been allocated from total company overhead. Assuming
the station manager remains and that Dyesebel continues to pay the manager’s salary, what is the
maximum cost Dyesebel would be willing to pay an outside firm to service the water refilling
station?
SOLUTIONS:
Water and Supplies P 1,500,000
Labor 600,000
Variable overhead (P 300,000 x60%) 385,000 180,000
Incremental costs/ Maximum price P 2,280,000
6.7 Optimization of scarce resources

Resource optimization is the process of allocating and managing resources in the most efficient way
possible. It matters because resources are expensive, and often in short supply. Using them in a way
that maximizes their value to your business is key to running a sustainable business.[14]
Sample Problem 6.7

Sabrina Construction Company has a total of 60,000 available equipment hours and a fixed
overhead rate of P 5 per hour. It is considering to use the equipment for two major construction
projects with the following costs and production data:
Project A Project B
Cost if purchased from outside supplier P 85 P 120
Direct materials 15 30
Direct labor 35 40
Factory overhead at P 10 per hour 20 30
Annual demand in units 25,000 20,000
1. Assuming that there is no market limitation, which project should Sabrina Construction Company
undertake?
2. Considering the market limits, how should Sabrina Construction Company use its limited
equipment hours to maximize profit?
3. Assuming that the unit direct materials cost of Project B decreases to P 25 and considering the
market limit, how would the limited equipment hours be used to maximize profit?
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3. Assuming that the unit direct materials cost of Project B decreases to P 25 and considering the
4. Assuming that the unit direct

materials cost of Project B
decreases to P 25 and
considering the market limit, Project A Project B
how would the limited
equipment hours be used to
maximize profit?
Number of hours per unit(P20
2 hrs 3 hrs P30 per unit/P10 per hour
per unit/P10 per hour)
Fixed overhead per unit(P5 per
P10 P15 (P5 per hr. X 3 hrs. Per unit)
hr. X 2 hrs. Per unit)
Variable factory overhead (P20-
P10 P15 (P30-P15)
P10)
SOLUTIONS:
1. The contribution margin per hour is computed below:
Project A Project B
Unit sales price P 85 P 120
Unit direct materials cost (15) (30)
Direct labor (35) (40)
Variable factory overhead (10) (15)
Unit contribution margin 25 35
/ No. of hrs. per unit 2 hrs. 3 hrs.
Contribution margin per hour P 12.5 P 11.67
Rank (1) (2)
2. Considering the market limits, how should Sabrina Construction Company use its limited
equipment hours to maximize profit?
Product Units Hours per unit Total hours

Rank 1 Project A 25,000 2 hrs. 50,000
Rank 2 Project B 1,000 3 hrs. 3,000 (squeezing balance)
Sabrina Construction Company will use all its 60,000 equipment hours to produce 25,000 units of
Project A and 1,000 units of Project B to maximize profit.
3.Assuming that the unit direct materials cost of Project B decreases to P 25 and considering the
Project A Project B
Unit contribution margin P 25 P 45
/ No. of hrs. per unit 2 hrs 3 hrs
Contribution margin per hour P 12.5 15
Rank (2) (1)
The 60,000 equipment hours would be used as follows:
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6.8 Sell now or later a product

In some cases, it is anticipated that a product's sales price will rise with age. Instances of these are
historical objects, jewelry, artifacts, artworks, fashion clothing, wines, and land. If the item isn't sold
right away, it will be locked up and occasionally kept in a designated location. Keeping the item
would mean expenses for upkeep, storage, and lost opportunities due to the product's financial
lockup. If the anticipated increase in sales exceeds the additional expenses incurred by holding onto
the product and then selling it at a later date.
Sample Problem 6.8

Juan owns 8,000 units of a traditional Filipino delicacy, "Bibingka," which is currently out of favor
but is anticipated to become popular again in the next 8 months. The total cost of producing these
units is P320,000, of which 70% is variable. The delicacy is stored in a facility for which Juan pays a
monthly rental of P5,000. The regular sales price for "Bibingka" is P50 per unit; however, when it
regains popularity, it is expected to sell for P35 per unit. A local store has offered Juan to purchase
all 8,000 units for P15 per unit and will pick the products up from his storage.
Sell Now Sell Later

Sales (8,000 x P 15) P 120,000 P 280,000 (8,000 x P 35)
Less: Storage costs (P 5,000 x 8 mos.) (40,000)
Incremental profit 120,000 P240 ,000
Net advantage P 120,000
1. If Juan sells now, he would receive P120,000.

2. If he sells later, he would receive P240,000 after accounting for storage costs.
Juan should sell the products later because the net advantage from selling later is higher by
P120,000
6.9 Replace or retain an old asset?

A company may consider replacing a fixed asset it currently owns and operates with one that is
more efficient to reduce operating costs. The company can use differential analysis to compare the
cost of keeping its original asset and the cost of replacing it with something new. Replacing the
equipment will generate revenue from the sale of the original asset, but the cost of acquiring the
new asset will also be incurred. Each alternative has different annual operating costs. The purchase
price of the original equipment is a sunk cost that will not be recouped or changed regardless of the
decision; therefore, it is ignored. Each alternative independently generates a loss, so the choice with
the lower loss is preferable. The company should keep and operate the original equipment.[15]
Sample Problem 6.9

Randall Bake Shop has an opportunity to acquire a new oven to replace its existing oven. The
following data are gathered relative to the new and old assets.
Old New
Book value 300,000 800,000
Purchase Price 600,000 1,200,000
Life in years 6 years 6 years
Salvage value- current 30,000 None
Salvage value after - x years None 100,000
Variable operating expenses 500,000 350,000
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SOLUTIONS:
Savings (P 150,000 x 6 yrs.) P 900,000
Salvage value of old equipment 30,000
Purchase price of new equipment (1,200,000)
Net cash inflows in favor of replacing (6 years) P 270,000
6.10 Scrap or rework the defective unit

Scrap and rework costs are a manufacturing reality impacting organizations across all industries
and product lines. Scrap and rework costs are caused by many things—when the wrong parts are
ordered, when engineering changes aren’t effectively communicated or when designs aren’t
properly executed on the manufacturing line.No matter why scrap and rework occurs, its impact on
an organization is always the same—wasted time and money. And while no one, especially an
operations manager, wants to admit it, these expenses add up quickly and negatively impact the
bottom line.[16]
Sample Problem 6.10

De Chavez y Co. has 10,000 obsolete face masks carried in inventory at a manufacturing cost of P 25
per unit. If the masks are reworked for P5 per unit, they could be sold for P 10 per unit. If the masks
are scrapped, they could be sold for a total of P 12,000.
Required:
1. Should De Chavez Co. sell the face masks as scrap or rework them?
2. What is the sunk cost in the decision to be made?
SOLUTIONS:
1. Incremental revenue from reworking (10,000 units x P 10) P 100,000

Less:Incremental costs of reworking (10,000 units x P 5) ( 50,000)
Incremental profit from reworking 50,000
Incremental profit from selling as scrap (12,000)
Net advantage of reworking P 38,000
2. Sunk cost in the decision:

The sunk cost in this decision is the manufacturing cost of the face masks P 250,000
(10,000 units x P25)
These costs have already been incurred and cannot be recovered; therefore, they are irrelevant to
the decision-making process regarding whether to rework or scrap the face masks.
6.11 Determining the indifference point

The indifference point is the level of volume at which total costs, and hence profits, are the same
under both cost structures. If the company operated at that level of volume, the alternative used
would not matter because income would be the same either way. At the cost indifference point,
total costs (fixed cost and variable cost) associated with the two alternatives are equal.[17]
Sample Problem 6.11
Garcia Publishing Company employs 30 sales representatives to sell their educational books. The
average book sells for P 500 and the company currently pays its sales representatives a 10%
commission on each book sold. The management is now considering a new compensation scheme,
which includes a flat monthly salary of P 10,000 plus a 5% commission on the sales made.
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SOLUTIONS:
The indifference point is computed as follows:
Let x = units sold
500 x = total sales
Commission 1 = 10% (500x) = 28,000 x

Monthly Salary for 30 sales representatives = P 10,000 x 30 = P 300,000
Commission 2 = 5% (500x) + 300,000 = 25x + 300,000
(*P 300,000 = P 10,000 per month x 30 sales representatives)
At the indifference point:

[ 50x = 25x + 300,000 ]
[ 50x - 25x = 300,000 ]
[ 25,000= 300,000 ]
[ x = 300,000/25,000 ]
x = 12 units
Total sales = P 500,000 (12 units)

= P 6,000,000
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SUMMARY
The chapter offers a detailed examination of the multifaceted nature of business decision-making,
highlighting the distinctions between various types of decisions that managers must navigate in
the course of their operations. It begins by categorizing decisions into two principal types: strategic
and tactical. Strategic decisions are long-term in nature and shape the overall direction of the
organization, encompassing aspects such as mergers, acquisitions, and significant investments.
Tactical decisions, conversely, are short-term actions taken to implement the strategic vision, often
involving day-to-day operations such as budgeting, resource allocation, and marketing strategies.
In further elaborating on decision-making, the document distinguishes between routine and
nonroutine decisions. Routine decisions are those that occur frequently and often follow
established procedures, while nonroutine decisions involve unique situations that require careful
consideration and analysis. This differentiation is crucial, as it informs how managers should
approach various scenarios.
A significant focus of the document is the concept of relevant and irrelevant costs. Relevant costs
are those that will be directly affected by a decision and should be considered when analyzing
options. Examples include variable costs associated with manufacturing a product or costs tied to a
specific project. In contrast, irrelevant costs, such as sunk costs—costs that have already been
incurred and cannot be recovered—should not influence decision-making. This understanding is
pivotal for effective economic reasoning and assists managers in avoiding common pitfalls
associated with decision-making, such as the tendency to cling to past expenditures.
This chapter then presents several practical decision-making scenarios that managers frequently
encounter. One prominent example is the "make or buy" decision, where companies must
determine whether to produce a product in-house or purchase it from an external supplier. This
decision involves analyzing cost structures, quality control, and strategic fit with the company's
long-term goals. Another scenario discussed is whether to accept or reject a special order, which
requires evaluating the contribution margin provided by the order against any additional costs
incurred, often ignoring fixed costs that will remain regardless of the decision.
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SELF TEST PROBLEM

Putting Your Knowledge to the Test!
Ready to take your decision-making skills to the next level? Let's apply the principles of non-
routine operating decisions to these challenging problems.
Problem 1.
INB Company produces a single product. INB Company has received a special order for 5,000 units
of its product at a price of P25 per unit. INB Company's normal selling price is P30 per unit and its
variable production costs are P18 per unit, and its fixed production costs are P40, 000 per month.
INB Company has excess capacity to produce the special order without affecting its regular
production.
Should the company accept the special order? YES
Solution and Discussion:

To make an informed decision, we need to analyze the relevant costs and revenues associated with
the special order.
Relevant Costs:
Variable Costs
Variable cost per unit = P18
Total variable cost for the special order = 5,000 units * P18/unit = P90,000
Relevant Revenues:
Revenue from the special order:
Revenue per unit = P25
Total revenue from the special order = 5,000 units * P25/unit = P125,000
Incremental Profit:
Incremental profit = Total revenue - Total variable cost
Incremental profit = P125,000 - P90,000 = P35,000
PROBLEM 2
HYBE manufactures product MA-13 for use in its production line. The manufacturing costs per unit
for 25,000 units of product MA-13 are as follows;
Direct materials P9
Direct labor 28
Variable overhead 17
Fixed overhead allocated 16
Total P 70
Company SooSoo has offered to sell 25,000 units of product MA-13 to HYBE for P65 per unit. HYBE
will make the decision to buy the part from SooSoo if there is an overall savings of P50,000. If
HYBE accepts SooSoo’s offer, P10 per unit of the fixed overhead allocated would be totally
eliminated. Furthermore, HYBE has determined that the released facilities could be used to save
relevant costs in the manufacture of A-7. For HYBE to have an overall saving of P50, 000, the
amount of relevant costs that would have to be saved by using the released facilities in the
manufacture of product MA-13 would have to be?
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SELF TEST PROBLEM

Solution:
The unit variable cost is P54, and the avoidable fixed overhead is P10 per unit. A net savings in the
amount of P50, 000 is a condition before HYBE buys the parts from SooSoo. The required savings
from released facilities is determined as follows:
Make Buy
Purchase price (25,000 x P65) P1, 625,000
Variable production costs (25,000 x P54) P 1,350,000
Avoidable fixed overhead (25,000 x P10) 250,000
Net savings from buying (50,000)
Totals P1, 600, 000 P1, 575, 000
Savings from released facilities
(P1, 600, 000 – P1, 575,000) = P 25, 000
The amount to be saved by using the released facilities in the manufacture of a product is
P25,000.
PROBLEM 3
Chromosome Company manufactures LED light at a cost of P135 per unit that includes P38 of fixed
overhead. It needs 90,000 of these LED lights yearly, and CBX Corp. offers to sell these items to
Chromosome at P112 per unit. If Union decides to purchase the plugs, P360, 000 of the annual fixed
overhead applied will be eliminated, and the company may be able to rent the facility previously
used for manufacturing the LED lights. If Chromosome purchases the lights but does not rent the
unused facility, the company would?
Solution:
Make Buy
Unit purchase price P 112
Unit variable production cost (135 – P38) P 97
Avoidable fixed overhead (P360, 000 /90,000 units) 4 -
Net relevant unit costs P 93 P 112
Net advantage P 19
The company would be losing P19 per unit if it buys the plugs and is not able to rent out the
unused facility.
PROBLEM 4
The SC division of EXO Corporation is being evaluated for elimination. It has a contribution to
overhead of P880,000. It receives an allocated overhead of P1.6 million, 13% of which cannot be
eliminated. The elimination of SC division would affect-pre-tax income by?
Solution:
In deciding to drop or continue a division, the focus of the analysis is the segment (or direct)
margin. As long as the product margin is positive and there are no other opportunity costs, the
department, product or process should be discontinued. The marginal analysis format is shown
below:
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SELF TEST PROBLEM

Sales PX
Less: Variable CGS X
Manufacturing margin X
Less: Variable expense X
Contribution margin X
Less: Direct fixed costs and expenses X
Segment (Direct) margin X
Less: Allocated fixed cost and expenses X
Net Income PX
Applying this principle in the problem, we have:

Controllable fixed overhead (P1.6 million x 87%) (1, 392, 000)
Segment margin P (512,000)
Since the segment margin is negative, the division should be dropped to eliminate the negative
segment margin and increase the overall net income by P512, 000.
Problem 5.
Riego Steel Company manufactures cement on a cost-plus basis. The cost of a particular cement the
company manufactures is shown below:
Direct materials P 680,000
Direct labor 415,000
Overhead:
Supervisor’s salary 60,000
Fringe benefits on direct labor 45,000
Depreciation 38,000
Total P 1, 238, 000
If the production of the cement were discontinued the production capacity would be idle, and the
supervisor will be laid off. Should there be a next contract for this engine, the company should bid
a minimum price of?
Solution:
The minimum bid price should at least equal the incremental costs or production plus opportunity
costs, if any. The incremental costs are:
Direct materials P680, 000
Direct labor 415, 000
Supervisor’s salary 60, 000
Fringe benefits on direct labor 45, 000
Incremental costs P1, 200,000
The costs of depreciation and rental are irrelevant costs because they are expected to be incurred
regardless of whether the bidding is won or not. The minimum bid price is the incremental costs at
P1, 200, 000.
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CASE STUDY
Assessing the Structure of Nonroutine decision processes in Airline Operations Control
In the dynamic environment of Airline Operations Control, managing the network of schedules
in the face of unexpected events is the main task of decision-makers. Low-impact disruptive events
happen relatively often, and most operations control decision-makers are experienced
professionals who have dealt with such disruptions many times. High Impact disruptions on the
other hand, don’t occur frequently. Control professionals should be able to deal effectively with
novel situations. However, operations control management of the airline in question has observed
that under comparable non-routine circumstances decision outcomes vary considerably case by
case. This is problematic, because wrong decisions under highly disruptive circumstances can lead
to loss of control, resulting not only in potentially high costs as flight delays accumulate, but also in
reputational damage. Moreover, insights into the decision-making process itself are lacking, and
hence Airline Operations Control management believes they have no control over the decision
process.
During routine operations, the duty managers and operations controllers have distinct
responsibilities. A routine disruption would include, for example, a delay of an inbound
intercontinental flight due to a technical issue. The operations controller decides whether to delay
several outbound flights to ensure connections for transfer passengers, or rebook passengers onto
later flights. The duty manager’s main task is monitoring the overall decision-making process, and
ensuring smooth cooperation between the different Airline Operations Control departments, such
as maintenance and crew planning. For scenarios with a potentially big impact on the flight
schedule, responsibilities of the duty managers and the operations controllers intersect due to
either the timing and/or the size of the event. Non-routine issues are usually escalated to the duty
manager, because these often involve problems that transcend individual flights or aircraft and
hence have a bigger impact on the flight schedule. An example would be the issuing of an operator
bulletin by an aircraft manufacturer, signaling a newfound technical issue with a specific aircraft
type that needs to be addressed within a 24-hour period. In such a case, the duty manager has final
responsibility in the decisions that need to be made, as he is also the one who needs to inform the
Airline Operations Control management. He would however usually take those decisions in
cooperation with the operations controllers.
Due to the low frequency of large scale disruptions and shift rotations, Airline Operations
Control decision-makers are confronted only one to three times per year with such events.
Moreover, not only is it difficult to get adequate feedback on solutions due to the unstructured
nature of the environment at the airline, studied feedback is also not formalized in the disruption
management process. It could be argued that in Airline Operations Control, regardless of the
nature of the problem, solutions on a high level are to a large extent similar and thus familiar. For
example, in case of disruptions, whether small or large, eventually most actions come down to
delaying or canceling flights. However, this can only explain why the decision-making process is
initially rule-based. Determining the size and timing of the actions is what really matters, as these
will largely shape the flight schedule and the goals that are aimed for. For example: canceling a
large number of flights right at the moment of impact of a disruption might save costs as delays are
limited, but canceling the same number of flights over a longer time span might free up resources
during the rest of the day and hence provide more flexibility in case of additional unexpected
issues.
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Summary: The situation in Airline Operations Control highlights the challenges of nonroutine
operating decisions, which arise during unexpected, high-impact disruptions. Unlike routine
disruptions, which are handled through established procedures, nonroutine decisions are complex,
uncertain, and vary widely in their outcomes. These decisions, such as how to respond to a sudden
technical issue or large-scale operational failure, often involve critical trade-offs and require
coordination across departments. The lack of formalized feedback and decision-making
frameworks exacerbates the difficulty in managing such events, leading to inconsistent outcomes
and potentially high costs or reputational damage. Ultimately, nonroutine decisions in this context
are characterized by their unpredictability, high stakes, and the need for adaptive, well-
coordinated action.
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REFERENCES
[1] https://www.indeed.com/career- [11]https://www.accountingtools.com/arti
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executive.com/en/management-levels- 20the%20choice%20of,of%20the%20additi
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[4] https://www.higson.io/blog/operational- dprice.asp
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[6] ounting_(Jonick)/09%3A_Differential_Anal
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drop.html
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CHAPTER
7
PRODUCT PRICING
AND PROFIT ANALYSIS
Product Pricing and Profit Analysis
INTRODUCTION
In the mind of the consumer, there’s always a question, "Am I going to get enough value out of
this product/service if I pay a PX amount of money for it?" Alternatively, consumers can often be
presented with the price of a product and think to themselves—if only it was just a bit cheaper.
Interestingly enough, the price increase can cause consumers to perceive the value of a given
product as significantly higher. Therefore, the importance of pricing is evident, and it’s
understandable why business owners need to pay attention to this issue.
Pricing decisions and profitability analysis are two sides of the same coin in business strategy. A
successful pricing strategy should be rooted in data and profitability considerations. To strike the
right balance between revenue generation and cost management, companies must continuously
analyze their profitability and adapt their pricing strategies to the ever-changing market dynamics.
In the world of business, companies must go beyond revenue generation and emphasize
profitability in order to ensure long-term success. Setting the right price for your product isn’t just
about covering costs; it’s about maximizing profits while remaining competitive. Analyzing product
profitability enables businesses to make informed decisions and optimize the financial
contributions of their products. By delving into profit calculation, pricing models, and variance
analysis, businesses can strategize to enhance their overall financial performance.
Learning Objectives
1. Recognize why pricing is a crucial part of business strategy.

2. Identify some factors to consider in pricing a product.
3. Describe various product pricing models.
4. Apply cost-based pricing methods to calculate markup rates.
5. Distinguish between costs and expenses that are based on cost and those that are not.
6. Connect pricing strategies to profitability.
7. Calculate variances including sales price, sales quantity, cost price, cost quantity, sales mix, and
overall sales volume.
8. Discuss common reasons for sales and cost variances that impact profit.
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PRODUCT PRICING
Product pricing involves setting a sales price for a product or service, taking into account all
costs involved in its production and sales, as well as what customers are prepared to pay [1]. It
involves determining the cost of the products they're selling to customers. There are many pricing
strategies companies can choose from, depending on their needs and the perceived value of their
products. The main goal of these strategies is to set a price that's higher than the product's
production cost but is still appealing to customers to encourage them to make a purchase. [2]
An example of product pricing is a software company’s pricing model. Software companies

typically offer tiered pricing, meaning their product can be sold at different levels of features and
usage. To determine the relative value at each tier, they must carefully measure the additional
value it provides against the price customers are willing to pay. [1]
Several key factors influence product pricing:

Overhead Costs: This covers all expenses associated with making a product or providing a
service, such as labor, marketing, advertising, and shipping costs.
Competition: What are similar businesses charging for comparable products or services?
Companies should take competitors’ pricing into account when setting their own prices.
Price Sensitivity (Demand Elasticity): How responsive are customers to price changes? If
raising prices leads to a sharp drop in demand, it may not be profitable to increase prices.
Value Proposition: The price should reflect the value of the product or service, considering
added features, quality, customer support, and brand reputation that customers gain from
their purchase.
Pricing Strategy: Strategies like loss leaders, price skimming, penetration pricing, and
premium pricing can guide how prices are set. Companies should choose a strategy that fits
their objectives and market conditions.
Product Complexity: Businesses with complex products (such as multi-feature software) may
need flexible pricing models, like subscriptions or pay-as-you-go options, depending on the
product’s complexity.
Though setting a price may appear straightforward, small differences in price can
significantly influence customer decisions, especially in competitive markets where customers
tend to seek the best deal. [1]
FACTORS TO CONSIDER IN PRODUCT PRICING

To set a competitive yet profitable price, companies need to consider multiple
aspects like costs, demand, and their target market.
1. Costs
For sustainable operations, a business must generate revenue exceeding the costs of
creating and selling its products or services. Costs may include:
Research and development (R&D)

Ongoing maintenance (especially for software)
Production expenses (e.g., materials, labor, utilities)
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Shipping and distribution

Marketing and advertising
Sales and customer support
Rent and utilities
Some companies operate remotely or outsource tasks, minimizing costs. SaaS and e-commerce
businesses, for instance, may function with a lean team. Regardless of the structure, accurately
calculating all costs is essential to setting profitable prices.
2. Market Demand
Setting a price is relatively straightforward; understanding what customers are willing to pay
and if there's enough demand is more complex. Key practices for assessing demand include:
Recognizing the value the product offers customers

Analyzing customer demographics, needs, and buying behaviors
Studying competitor pricing
Considering seasonal demand shifts
New products may benefit from pilot pricing tests with a select customer base to gather insights.
3. Target Audience
Knowing the ideal customer profile (ICP)—based on customer data and market insights—helps
companies align prices with customer expectations. By targeting the right demographic,
businesses can optimize profitability through tailored pricing strategies
such as discounts for bulk purchases, volume-based pricing (like enterprise plans), or tiered
subscriptions (common in SaaS).
Customers' price sensitivity may vary based on factors like location, age, and income level, so
pricing may need adjustments across different customer segments.
4. Market Price
Competitors will likely be offering similar products. Understanding the value of a product helps in
setting a competitive price. Pricing can be flexible, allowing businesses to test different models,
offer discounts, or adjust prices as market conditions change.
5. Ideal Profit Margin
Profit margin—revenue left after covering expenses—ensures a business can sustain operations,
compensate employees, and deliver returns to investors. Two main profit margins include:
Gross Profit Margin: Revenue remaining after subtracting production costs.

Net Profit Margin: Revenue left after all expenses, including overhead and marketing.
Ideal margins vary by industry and company size. For instance, e-commerce businesses may target
around a 10% profit margin, while SaaS companies aim for a combined growth and profit rate of
40% (the “rule of 40”).
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6. Distribution Channels
Pricing should account for the costs associated with distribution channels, such as retail stores,
e-commerce platforms, or direct-to-consumer (D2C) sales. For example, selling through Amazon
involves a commission fee (typically 15%), while software companies often rely on sales teams and
technology for distribution.
Each channel’s unique costs and logistics must be factored into the overall pricing strategy.
PRICING MODELS
Pricing models are strategies that businesses use to determine the price of their products or
services. These models take into account factors like production costs, the perceived value from the
customer's perspective, and the nature of the product, such as whether it is a retail item or a
service. Many companies also use a variety of pricing models for different products or combine
various strategies to maximize profit, which could be done from different perspectives, such as
cost-plus pricing, flat rate pricing, high-low pricing, and market-based pricing.
1. Cost-Plus Pricing
Cost-plus pricing is a pricing strategy where a business determines the price of a product by
adding a fixed markup to the cost of producing or acquiring the product. The cost of production
refers to the total expenses involved in creating or acquiring a product, which includes the costs of
raw materials, labor, overhead, and other associated expenses. This encompasses everything
needed to bring the product from concept to completion. The markup is the percentage added to the
cost of production in order to set the selling price, with the goal of ensuring the business generates
a profit. The markup allows the company to cover its costs and earn a return on the product,
providing a profit margin for the business.
Formula:
Selling Price = Cost of Production + (Cost of Production × Markup Percentage)
For example, Arenas Company produces chairs, with each chair costing P 50 to manufacture,
which includes expenses like materials, labor, and overhead. The company aims to make a 30%
profit on each chair. Determine the selling price.
Selling Price = Cost of Production + (Cost of Production × Markup Percentage)
Selling Price = P 50 + (P 50 × 30%)
Selling Price = P 50 + P 15
Selling Price = P 65
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To determine the selling price, a 30% markup would be added to the P 50 production cost. This
results in a markup of P 15, bringing the total price to P 65 per chair, ensuring the company
covers its costs and achieves the desired profit.
2. Flat Rate Pricing
Flat rate pricing is a pricing strategy is a streamlined pricing strategy that establishes a single
fixed fee to provide access to all features of a product. It involves charging a fixed fee for a product
or service, regardless of the time, resources, or extra costs required to provide it. This pricing model
integrates both labor and material costs, offering a clear and straightforward pricing approach that
serves the interests of both businesses and customers. The formula for flat rate pricing can be
expressed as:
Formula:
Flat rate price = (Hourly Rate × Hours of Work) + (Materials Cost × Markup Percentage)
The hourly rate refers to the price a business charges per hour of service or labor.
The hours of work represents the total time spent on the job.
Material cost refers to the expense of the raw materials or components required to manufacture
a product or finish a project.
The markup percentage is applied to the material costs to account for extra business expenses,
including procurement, storage, or material waste.
For example, Maderazo Plumbing Company charges a flat rate for repairing a broken water
heater. The company charges P 500 per hour for its labor, and the repair job takes 3 hours to
complete. The materials required for the repair, such as parts and equipment, cost P 1,500.
Additionally, the company applies a 20% markup on the materials to cover procurement, storage,
and potential material waste, as well as to ensure profitability. How is the flat rate price calculated
for a plumbing repair service?
Labor Cost = Hourly Rate × Hours of Work

Labor Cost = P 500 × 3
Labor Cost = P 1,500
Markup on Materials = Materials Cost × Markup Percentage

Markup on Materials = P 1,500 × 0.20
Markup on Materials = P 300
Flat Rate Price = Labor Cost + Markup on Materials

Flat Rate Price = P 1,500 + P 300
Flat Rate Price = P 1,800
The total flat rate price is determined by adding the labor cost of P 1,500 and the markup of
P300, giving a final flat rate price of P 1,800 for the entire repair. This flat rate price remains
consistent, regardless of the time spent or materials used.
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3. High-Low Pricing
High-Low Pricing is a pricing strategy where a business sets prices higher than average initially
and then offers substantial discounts or promotional sales at specific times to attract customers.
This method is often used in retail and other consumer goods sectors, aiming to create a sense of
urgency for buyers to purchase when discounts are offered while still maintaining higher prices
during non-sale periods. The high prices initially suggest premium value or exclusivity, and when
discounts are applied during sales events, customers are drawn by the lower prices, resulting in
increasing demand.
For example, De Sagun Clothing Store sells a jacket for P 150 during the regular season.
However, during end-of-season or holiday promotions, the price of the same jacket is reduced to P
100. The higher regular price motivates customers to consider purchasing before the sale, while the
discounted price encourages them to take advantage of the offer before it ends.
4. Market-Based Pricing
Market-based pricing refers to the practice of setting the price at which a good or service is
based on the current prices in the marketplace for similar items. Unlike cost-based pricing, which
primarily considers production costs, market-based pricing focuses on several key factors such as
demand, the perceived value of the product and brand, competition within the market, and the
product's position within its life cycle. This pricing method helps businesses remain competitive
and respond to customer demand effectively. Here are several common methods used in market-
based pricing:
Discriminatory Pricing, also known as price discrimination, refers to the practice of charging
different prices to different customers for the same or similar product or service based on factors
like customer characteristics, behavior, or willingness to pay.
Promotional Pricing, involves offering temporary price reductions to boost demand for a
product. There are several methods to promote a product, including price discounts, coupons,
giveaways, loyalty programs, and more.
Loss Leader Pricing, companies typically set prices lower than the average market rate, which
is commonly seen in retail businesses. Its primary goal is to attract a larger volume of customers,
with the expectation that they will purchase additional items at regular prices, thereby offsetting
the loss from the discounted product.
Psychological Pricing is a marketing strategy that leverages consumer psychology to influence

buying decisions by setting prices that appear more attractive. An example of psychological pricing
is when a retailer sells an item for P 9.99 instead of P 10.00.
Premium Pricing allows a company to set a higher price for its products or services compared
to its competitors. Luxury brands such as Apple and Rolex are prime examples of companies that
use this pricing strategy.
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GROSS PROFIT VARIANCE ANALYSIS

Most business owners understand profitability from a fundamental standpoint. If the revenue
from sales covers expenses, the business is turning a profit. Profits mean that a company is
generating a positive cash flow that helps keep the business in operation. Profitability tends to be
one of the primary goals of business owners, as they seek to have a profitable experience and
capitalize on material gain. [1]
However, business owners should look beyond a simple profit peso amount. The basic peso
amount doesn’t indicate why the business is profitable. Analyzing key metrics can help business
owners determine whether their company is healthy and if their profitability is sustainable. By
calculating and comparing metrics, owners can identify the areas of the business that are working
well and those that need improvement.
One way to determine whether a business is profitable is from its gross profitability. Gross profit
is the revenue left over after you deduct the costs of making a product or providing a service [25].
It is presented as:
Sales P x (quantity sold x unit sales price)
Cost of goods sold x (quantity sold x unit cost price)
Gross profit Px
Profit variance is a metric that measures the difference between a company's actual profits and
its expected or budgeted profits, which are commonly from last year’s report. It's calculated by
taking the actual profit (or loss) and subtracting the budgeted profit (or loss). If the result is positive,
it means that the company has exceeded its profit targets, and if it's negative, it means the company
has fallen short of its targets. [26]
This Year Last Year Net Variance

Sales Px Px Px
Less: Cost of goods sold x x x
Gross profit Px Px Px
Data treated as Actual Budgeted
The Sales Variances

Net sales variance includes the sales price variance and sales quantity variance. It is presented
as:
SPV = (USPTY – USPLY) QSTY = USP x QSTY

SQV = (QSTY – QSLY) USPLY = Q x USPLY
where: SPV = Sales price variance

SQV = Sales quantity variance
USPTY = Unit sales price this year (i.e., actual price)
USPLY = Unit sales price last year (i.e., standard price)
QSTY = Quantity sold this year (i.e., actual quantity)
QSLY = Quantity sold last year (i.e., standard quantity)
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The Cost of Sales Variances
Cost of sales variance includes the cost price variance and cost quantity variance. It is
presented as:
CPV = (UCPTY – UCPLY) QSTY = UCP x QSTY

CQV = (QSTY – QSLY) UCPLY = Q x UCP
where: CPV = Cost price variance

CQV = Cost quantity variance
UCPTY = Unit cost price this year (i.e., actual price)
QSTY = Quantity sold this year (i.e., actual quantity)
QSLY = Quantity sold last year (i.e., standard quantity)
The Gross Profit Variance
Gross profit variance can be analyzed based on sales and cost of goods sold (COGS)
variances, presented as:
Sales variances:
Sales price variance Px
Sales quantity variance x Px
Cost of goods sold variances:
Cost price variance x
Cost quantity variance x x
Gross profit variance Px
And are broken down into price and quantity (or volume) factors:
Price factor:
Sales price variance Px
Cost price variance x Px
Net price variance
Quantity factor:
Sales quantity variance x
Cost quantity variance x x
Net quantity variance
Gross profit variance Px
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The gross profit variance analysis follows the direct materials variance analysis
The formulas used to calculate the sales and cost variances are similar to the ones used for
direct material price and quantity variances, as explained:
Materials Price Variance = (Actual Unit Price – Standard Unit Price) x Actual Quantity Sold
Materials Quantity Variance = (Actual Quantity – Standard Quantity) x Standard Unit Price
If: Actual unit price = Unit sales price this year
Standard unit price = Unit sales price last year
Actual quantity = Quantity sold this year
Standard quantity = Quantity sold last year
By substitution, we have the sales variances as:
SPV = (USPTY – USPLY) QSTY = USP x QSTY

SQV = (QSTY – QSLY) USPLY = Q x USPLY
Variances are commonly classified as favorable or unfavorable. A favorable variance occurs

when revenue is higher than expected or expenses are lower than expected. An unfavorable
variance occurs when revenue is lower than expected or expenses are higher than expected. [27]
Contribution Margin Variance Analysis
The contribution margin can be stated on a gross or per-unit basis. It represents the incremental
money generated for each product/unit sold after deducting the variable portion of the firm's costs.
[29]
Contribution Margin (CM): variance difference between the actual contribution margin per unit
and the budgeted contribution margin per unit, multiplied by the actual number of units sold. If the
actual CM is greater than the budgeted CM per unit, a variance is favorable; otherwise, it is
unfavorable. [30]
Contribution Margin Variance = (Actual CM Per Unit - Budgeted CM Per Unit) × Actual Sales
Gross Profit Variance Analysis... Only a variance rate is given
In gross profit variance analysis, there are times when we don’t have complete data on the unit
sales price, unit cost, or exact units sold. Instead, we might only have percentage changes (or
variance ratios) in price and quantity. While this limited information requires a slightly different
approach, the key variances we need to calculate remain the same.
Sales Variance Analysis
To analyze sales variances, we typically work with three key values:
Sales this year = QSTY x USPTY

Applied sales this year = QSTY x USPLY
Sales last year = QSLY x USPLY
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where: Sales and Applied sales this year are sales price variance
Applied Sales this year and Sales last year are sales quantity variance
In most cases, the sales this year and sales last year figures are available, and our goal is to
calculate what the sales would be this year if we used last year’s unit sales prices. To find this, we
apply one of the two following formulas, depending on whether we have a sales price variance
ratio or a sales quantity variance ratio:
If the given is Then,

1. Sales price variance rate : STY @ USPLY = Sales this year / (1 + Sales price
variance ratio)
2. Sales quantity variance rate : STY @ USPLY = Sales last year x (1 + Sales quantity
variance ratio)
Cost Variance Analysis
For cost analysis, we use a similar approach to separate the effects of cost price and quantity
changes on the overall cost variance. Here, we typically consider the following values:
Cost this year = QSTY x UCPTY

Applied cost this year = QSTY x UCPLY
Cost last year = QSLY x UCPLY
where: Cost and applied cost this year are cost price variance
Applied cost this year and cost last year are cost quantity variance
With the above information, our goal is to calculate what the cost this year would be if we
applied last year’s unit cost prices. Depending on whether we are given a cost price variance ratio
or a cost quantity variance ratio, we can use one of the following formulas:
If the given is Then,

1. Cost price variance rate : CTY @ UCPLY = Cost this year / (1 + Cost price
variance ratio)
2. Cost quantity variance rate : CTY @ UCPLY = Cost last year x (1 + Cost quantity
variance ratio)
Multi-Product Gross Profit Variances
In multi-product operations, companies often evaluate profit performance by breaking

down net quantity variance into two components: sales mix variance and sales yield variance.
Sales mix variance shows the impact on profit when the proportion of different products sold
varies from the planned or "base" mix, helping to highlight the sales team’s effectiveness in
promoting more profitable products. Sales yield variance, sometimes called the final sales
volume variance, measures how well the company
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achieved its overall sales volume target, irrespective of product mix.
Together, these variances offer a clearer picture of sales performance by separating the effect
of product mix from total volume sold. Importantly, while these two new variances provide deeper
insights, the computations for sales price variance and cost price variance remain unchanged. This
approach enables companies to assess profitability drivers effectively, ensuring both mix and
volume targets contribute optimally to the bottom line. [28]
In a sales mix analysis, the following variance computations constitute the

accounting for gross profit variation:
Sales price variance = USP x QSTY Px

Cost price variance = UCP x QSTY x
Sales mix variance:
Gross profit this year at UGP last year Px
- Gross profit this year @ Average unit
gross profit last year x
Sales mix variance x
Sales yield variance (Final sales volume variance)
Gross profit this year @ Average unit gross
profit last year x
- Gross profit last year x
Sales yield variance x
Net gross profit variance Px
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SUMMARY
Pricing is the practice of setting a product’s or service's price to cover costs, appeal
to customers, and achieve profit goals. Many companies also use a variety of pricing
models for different products or combine various strategies to maximize profit, which
could be done from different perspectives, such as cost-plus pricing, flat rate pricing, high-
low pricing, and market-based pricing.
Cost-plus pricing is a pricing strategy where a business determines the price of a

product by adding a fixed markup to the cost of producing or acquiring the product. The
flat rate pricing strategy is a streamlined pricing strategy that establishes a single fixed fee
to provide access to all features of a product. High-Low Pricing is a pricing strategy where
a business sets prices higher than average initially and then offers substantial discounts or
promotional sales at specific times to attract customers. On the other hand, market-based
pricing refers to the practice of setting the price at which a good or service is based on the
current prices in the marketplace for similar items.
Businesses also rely on gross profit variance analysis to assess profitability. This
method looks at the difference between actual and expected profits by analyzing
variances in sales price, quantity sold, and cost of goods. Such analysis helps companies
determine which products or practices are most profitable and make necessary
adjustments to maximize earnings.
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SELF- TEST
Emphasizing the Core Ideas!
After learning the various concepts regarding Chapter 7, let us solidify your learning from
product pricing and profit planning through the following problems.
Sample Problem. Product Pricing

1. PM Mineral Company is evaluating two options for purchasing new machinery to increase
production capacity. Option A is a less expensive machine with a lower upfront cost, while
Option B is more expensive but promises lower operating and maintenance costs over its
lifetime.
Required: Determine which option is the most cost-effective using life-cycle costing.
Provided here is the calculation of Life Cycle Cost:
Option A:
Operating Cost = 20,000 x 10 yrs. = 200,000
Maintenance Cost = P 5,000 x 10 yrs. = 50,000
P 100,000 + P 200,000 + P 50,000 + 10,000 - P5,000 = P 355,000
Option B:
Operating Cost = 10,000 x 10 yrs. = 100,000
Maintenance Cost = P 2,000 x 10 yrs. = 20,000
P 150,000 + P 100,000 + P 20,000 + 8,000 - P10,000 = P 268,000
Strategic Analysis:
Option A has a total life cycle cost of P355,000, while Option B has a total life cycle cost of
P268,000. Despite the higher initial purchase cost of Option B, its lower operating,
maintenance, and disposal costs result in a significantly lower overall life cycle cost.
Option B would be the more cost-effective choice, as the savings in operating and maintenance
costs over the life of the machine far outweigh the initial investment. This highlights how life
cycle costing helps businesses evaluate options not just based on initial costs but also
considering long-term financial impacts.
Chapter 7
153
2. A company that manufactures custom-made chairs is anticipating setting a new price
for its new line of chairs using cost-based pricing. The following are the data relative to
the products:
Per Unit
Direct labor 30.00
Variable expenses 6.00
Fixed expenses 4.00
Total costs and expenses P 120.00
The company desired a 30% profit return on its investment of P5 million. It expects to sell
60,000 units of custom made chairs. Determine its unit sales price.
Per Unit
Direct labor 30.00
Variable expenses 6.00
Fixed expenses 4.00
Total costs and expenses P 120.00
Add: Profit (P 5 million x 30% / 60,000 units) 25.00
Unit sales price P 145.00
In this example, using cost-based pricing, the company has set a price of P145 for the chair. The
cost-based pricing method ensures that the company covers its costs and achieves a 30% profit
margin. However, the company should also consider market demand, competitor pricing, and
customer perceptions to avoid being too rigid in its approach.
In this example, using cost-based pricing, the company has set a price of P145 for the chair. The
cost-based pricing method ensures that the company covers its costs and achieves a 30% profit
margin. However, the company should also consider market demand, competitor pricing, and
customer perceptions to avoid being too rigid in its approach.
Chapter 7
154
Sample Problem. Multi-Product Profit Variances
Walmart Corporation sells three products: home furnishings (A), clothing (B), and
electronics (C). The sales, cost of goods sold, and gross profit of the three products in 2023
and 2024 are given below.
2023 2024
Sales A (7,000 units x P 9) P 63,000 (15,000 units x P 6) P 90,000
B (29,000 units x P 6) 174,000 (23,000 units x P 8) 184,000
C (11,000 units x P 10) 110,000 (14,000 units x P 13) 182,000
374,000 456,000
Costs A (7,000 units x P 8) 56,000 (15,000 units x P 5) 75,000
B (29,000 units x P 3) 87,000 (23,000 units x P 6) 138,000
C (11,000 units x P 7) 77,000 (14,000 units x P 5) 70,000
220,000 283,000
Gross profit (47,000 x P 3.276596) P 154,000 (52,000 units x P3.32692) P 173,000
Required: Compute the sales price variance, cost price variance, sales mix variance, and
sales yield variance.
The change in gross profit variance to be analyzed is:
Gross profit this year P 173,000
Less: Gross profit last year 154,000
Increase in gross profit P 19,000 F
The increase in gross profit is analyzed as follows:

Sales price variance = USP x QSTY
A = (P 3) U x 15,000 units = P (45,000) U
B = P 2 F x 23,000 units = 46,000 F
C = P 3 F x 14,000 units = 42,000 F
Net sales price variance P 43,000 F
Cost price variance = UCP x QSTY
A = (P 3) F x 20,000 units = (60,000) F
B = P 3 U x 22,000 units = 66,000 U
C = (P2) x 13,000 units = (26,000) F
Net cost price variance (20,000) F
Sales mix variance:
Gross profit this year at UGP last year
A = (15,000 units x P 1) = 15,000
B = (23,000 units x P 3) = 69,000
C = (14,000 units x P 3) = 42,000
Total 126,000
Chapter 7
155
- Gross profit this year @ Average unit gross

profit last year (52,000 units x P 3.276596) 170,383
Net sales mix variance (44,383) U
Sales yield variance
Gross profit this year @ Average unit gross
profit last year 170,383
- Gross profit last year 154,000
Net sales yield variance 16,383 F
Net gross profit variance P 35,000 F
UGP last year = USP last year – UC last year

e.g., Product A (P 9– P 8) P1
Product B (P 6– P 3) 3
Product C (P 10 – P 7) 3
UGP last year = GP last year/ Total units sold last year
= P 154,000 / (7,000 +29,000 + 11,000)
= P 3.276596
You may refer to the previous discussions on sales price variance and cost price variance.
The sales mix variance may be alternatively computed as follows:
Chapter 7
156
The total units sold in 2024 are 52,000 units (i.e., 15,000 + 23,000 + 14,000). The fractions
7/47, 29/47, and 11/47 were developed based on the standard sales mix last year (where
A = 7,000 units, B = 29,000 units, and C = 11,000 units).
The third column (quantity sold this year at standard sales mix) determines the
expected quantity sold based on the standard sales mix of the last year.
If the actual quantity sold per product is greater than the actual quantity at standard
sales mix, the mix variance is unfavorable; otherwise, the mix variance is favorable.
The sales yield variance may be alternatively computed as follows:

Quantity sold this year 52,000 units
- Quantity sold last year 47,000
Yield variance in units 5,000 F
x Average unit gross profit last year P 3.276596
Yield variance in pesos P 16,383 F
The sum of the sales mix variance and the sales yield variance is the net quantity
variance:
Quantity variance = Q x Unit gross profit rate last year
A = 8,000 F x P 1 P 8 ,000 F
B = (6,000) U x P 3 (18,000)U
C = 3,000 F x P 3 9,000 F
Net quantity variance (P 1,000) U
The changes in quantity ( Q) are computed as follows:

A = (15,000 units –7,000 units) = 8,000 units F
B = (23,000 units – 29,000 units) = (6,000) U
C = (14,000 units – 11,000 units) = 3,000 F
To check, we have:
Sales mix variance (P 14,516) U
Sales yield variance 16,383 F
Net quantity variance P 1,867 F
Chapter 7
157
CASE STUDY
Flevy Management Insights Case Study
Dynamic Pricing Strategy for IT Solutions Provider in B2B Sector
A mid-size IT solutions provider specializing in B2B services is facing significant challenges in

balancing telesales effectiveness and optimizing its sales and operations planning (S&OP) processes.
Externally, the organization is contending with a 20% decline in lead conversion rates due to
increasing market saturation and a shift in client expectations towards more personalized and
flexible pricing models. Internally, inefficiencies in S&OP have led to misalignment between sales
forecasts and operational capabilities, resulting in lost opportunities and diminished customer
satisfaction. The primary strategic objective of the organization is to implement a dynamic pricing
strategy that enhances telesales effectiveness and aligns with optimized S&OP processes, ultimately
improving lead conversion rates and customer satisfaction.
This IT solutions provider is experiencing stagnation in a highly competitive market,

primarily due to its traditional pricing models and misaligned S&OP processes. The emergence of
agile competitors offering more personalized pricing options and the company's internal challenges
in accurately forecasting demand highlight the need for a strategic overhaul. The organization must
embrace dynamic pricing and S&OP optimization as critical levers for regaining its competitive edge
and meeting evolving customer expectations.
Source:https://flevy.com/topic/sandop/case-dynamic-pricing-strategy-it-solutions-provider-b2b-sector
Dynamic Pricing Strategy for Infrastructure Firm in Southeast Asia
A Southeast Asian infrastructure firm is grappling with the strategic challenge of

optimizing its pricing mechanisms through comprehensive process analysis and design.
Facing a 20% decline in bid win rates and a 15% increase in project costs, the
organization struggles with both internal inefficiencies and an increasingly competitive
landscape. The primary strategic objective is to implement a dynamic pricing strategy
that enhances profitability and competitive positioning.
The organization is currently at a critical juncture, indicating potential issues rooted in
outdated pricing models and a lack of agility in financial decision-making. The sector's
rapid evolution, coupled with the organization's static pricing strategies, suggests an
urgent need for a pricing overhaul to regain market competitiveness.
Source:https://flevy.com/topic/process-analysis-and-design/case-dynamic-pricing-strategy-
infrastructure-firm-southeast-asia
Chapter 7
158
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STRATEGIC

BSMA 3113 2024 EDITION

3. Enhancing Operational Efficiency

5. Facilitating Better Decision-Making

6. Improving Resource Allocation

7. Creating Accountability and Engagement

8. Ensuring Long-Term Sustainability

STRATEGIC PLANNING MODELS

Strategic Alignment Model

A SWOT analysis is a high-level model used at the beginning of an organization’s strategic

Blue Ocean Strategy

Porter’s Five Forces

KEY COMPONENTS OF A STRATEGIC PLAN

Goals and Objectives

Example: SWOT Analysis for a Luxurious Bag Brand

Strengths: High-quality craftsmanship; commitment to sustainable materials; unique, luxurious

Example: Action Plan for Launching Vegan Leather Bag Collection

Key Performance Indicators (KPIs)

Customer satisfaction score

STRATEGIC PLANNING PROCESS

3. Conducting a Situational Analysis

5. Implementing the Strategy

6. Evaluating and Controlling

COMMON MISCONCEPTIONS ABOUT STRATEGIC PLANNING

2. Strategic Planning Is the Same as an Annual Work Plan

4. Strategic Planning Is Only for Leadership

5. Once the Plan Is Complete, the Process Is Over

COMMON CHALLENGES IN STRATEGIC PLANNING

2. A SWOT analysis identifies strengths, weaknesses, ________, and threats.

4. In a VRIO framework, what does "I" stand for?

7. What is the first step in the strategic planning process?

8. Porter’s Five Forces model examines factors impacting an industry’s _______.

9. Which component of a strategic plan describes the primary services or products?

10. Gap planning is also known as _______.

13. Scenario planning helps organizations envision various possible _______.

19. An action plan outlines specific _______ for achieving goals.

40. To determine how resources should be allocated, a company would develop:

42. To guide employees in daily decisions, an organization should clarify its:

47. Which framework includes evaluating threats from substitute products?

Best Buy is an exceptional example of a value-based business strategy because it subsequently

PROFIT PLANNING AND

Deciding whether to make or buy a given product or service.

Operating Profit = Sales - Total Costs

Sales = Fixed Costs + Variable Costs + Operating Profit

Units sold x Price = Fixed cost

For ease of use, this model is often represented symbolically as: p x Q = F + (v x Q) + N

STRATEGIC ROLE OF CVP ANALYSIS

Strategic Questions Answered by CVP Analysis

1. What is the expected level of profit at a given sales volume?

ASSUMPTIONS & LIMITATIONS OF CVP ANALYSIS

CONTRIBUTION MARGIN AND BREAK EVEN POINT

Table 2.1 Data for OBX Seating: Desk Chair

Per Unit 2022 2023

Fixed cost P80,000 P80,000

Variable cost P55

Planned sales 2,600 units 2,800 units

57.89% is the variable cost

Total Contribution 42.11% is the contribution

Fixed Costs P80,000 P80,000 0

Operating Profit 24,000 32,000 8,000 8,000 = 42.11% x 19,000

Contribution Margin Ratio = Contribution Margin / Sales Price per Unit