Management Accounting

Process Costing
• Costing method applicable where goods or services result

from a sequence of continuous or repetitive operations or
processes. Costs are averaged over the units produced during
the period.
• A processing department is any location in an organization
where materials, labor, or overhead are added to the product.
The output from a processing department is homogeneous
• Aggregates manufacturing costs by departments or by
production processes. Total manufacturing costs are
accumulated under two major categories
- Direct materials and conversion costs (the sum of direct labor
and factory overhead applied).
- Unit cost is determined by dividing the total costs charged to
a cost center by the output of that cost center. In that sense,
the unit costs are averages.
Process Costing
Importance
• It is very important that a company chooses the
appropriate type of costing system for their
product type and industry. One type of costing
system that is used in certain industries is
process costing that varies from other types of
costing (such as job costing) in some ways. In
Process costing unit costs are more like
averages, the process-costing system requires
less bookkeeping than does a job-order costing
system. So, a lot of companies prefer to use
process-costing system.
Process Costing
Industries most suitable / When process costing is applied?
• Production quantity is uniform.

• One order does not affect the production process.
• Customer orders are filled from the manufacturer’s stock.
• Continuous mass production through an assembly line
approach.
• A standardization of the process and products exists.
• Cost control on a depart basis rather than on a customer or
product basis is desired.
• Continuity of demand for the output.
• Quality standards can be implemented on a departmental basis
– for example, on-line inspection as processing proceeds.
• Process costing is appropriate for companies that produce a
continuous mass of like units through a series of operations or
processes. - petroleum, coal mining, chemicals, textiles, paper,
plastics, glass and food processing.
• Process costing is suitable for industries producing
homogeneous products and where production is a continuous
flow.
Process Costing
Reasons for use
• A company may manufacture thousands or millions of units of
product in a given period of time.
• Products are manufactured in large quantities, but products
may be sold in small quantities, sometimes one at a time
loaves of bread), a dozen or two at a time (eggs, cookies), etc.
• Managers need to maintain cost control over the
manufacturing process. Process costing provides managers
with feedback that can be used to compare similar product
costs from one month to the next, keeping costs in line with
projected manufacturing budgets.
• A fraction-of-a-cent cost change can represent a large dollar
change in overall profitability, when selling millions of units of
product a month.
• Materials part way through a process (e.g. chemicals) might
need to be given a value, process costing allows for this. By
determining what cost the part processed material has incurred
such as labor or overhead an "equivalent unit" relative to the
value of a finished process can be calculated.
JOB ORDER VS PROCESS COSTING
SIMILARITIES IN JOB ORDER AND PROCESS COSTING
• Both systems determine a product cost by measuring the

amount of direct materials and direct labor used and allocating
overhead costs
• Both systems allocate overhead using a predetermined
overhead rate(s)
• Both systems maintain perpetual inventory records with
subsidiary ledgers for materials, work in process, and finished
goods.
• Both systems have the same basic purposes- to assign material,
labor, and overhead costs to products and to provide mechanism
for computing unit product cost.
• Both systems use the same basic manufacturing accountants,
including manufacturing overhead, Raw materials, Work in process,
and Finished Good.
DIFFERENCES IN JOB ORDER AND PROCESS COSTING
Job Order Costing

1- Many different jobs during each period, with each job having different production requirement
2- Costs are accumulated by individual job.
3- Job cost sheet is the key document controlling the accumulation of costs by a job.
4- Job-order cost accounting accumulates costs by specific jobs, contracts, or orders.
5- The job-order cost method is appropriate when the products are manufactured in identifiable
lots or batches, or when the products are manufactured to customer specifications.
6-Widely used by manufacturers like printing, aircraft, construction, auto repair, and services.
Process Costing
1-A single product is produced either on continuous basis or for long periods. All units are
identical.
2-Costs are accumulated by departments.
3-The department production report is the key document showing the accumulation of costs.
4-Unit costs are computed by department on the department production report
5-A process costing system, like a job-order costing system is a cost-accumulation system that
produce the unit manufacturing cost for a given process.
6-Per-unit manufacturing costs are used primarily for product costing, inventory valuation, and
income determination. Per-unit cost data are vital for pricing purposes. Also Usued for pricing
finished products but also for selecting the “right” product mix in order to maximize
production.
Comparing Job-Order and Process Costing
1- In all manufacturing systems, direct material, direct labor, and
manufacturing overhead are charged to Work in Process Inventory.
As we complete the production process, goods are transferred to
the Finished Goods Inventory. Finally, when we sell the finished
goods, we transfer the cost to cost of goods sold.
DM+DL+FOH=WIP=FG=COGS
2- In a job-order cost system costs are traced to individual jobs. All of
the jobs in process make up the company’s Work in Process
Inventory.
DM+DL+FOH=JOB (Costs are traced and applied to individual
jobs in a job-order cost system=FG=COGS
3) In a process costing systems, costs are traced to departments that
process the goods. In some companies there may be several
processing departments that goods must pass through to become
finished goods. Material, labor and overhead costs transferred from
one department’s WIP to another department’s WIP account are
called transferred-in costs.
DM+DL+FOH=PD Costs are traced and applied to departments
in a process cost system =FG=COGS
Process Costing
Four Steps in process Costing
Summarize the flow of physical units.
Summary of all units on which some work done in the department during the period. Input
must equal output. This step helps detect “lost units” during the process. Relationship be
expressed as follows:
Beginning inventory + Units started for the period = Units completed and transferred +
Ending inventory
Compute output in terms of equivalent units.

To determine the unit cost of a product in a processing environment, it is important to
measure the “total amount of work” done during the period. Partially completed units are
measured on an “equivalent whole unit basis”. Equivalent units are measure of how many
whole units of production are represented by the units completed plus partially completed
units.
Summarize the total costs to be accounted for and compute unit costs per equivalent unit.
This step summarizes the total costs assigned to the department during the period. The
unit costs per equivalent is compute as follows:
Total cost incurred during period / Units cost based on Equivalent units of production
during the period
Account for units completed and transferred out and units in ending work-in-progress.
The process costing method uses what is called the “cost of production report”. It
summarizes both total costs and unit costs charged to a department and indicates the
allocation of total costs between wok in progress inventory and the units completed and
transferred out to the next department (or the finished goods inventory). The “cost of
production report” covers all four steps and is the source for monthly journal entriest
.
Process Costing
Calculating Equivalent Units
• Equivalent units of production for a period

can be calculated in two different ways
– Weighted Average method

– First in First Out (FIFO) method
Process Costing
Equivalent Units ― Weighted Average Method
* Makes no distinction between work done in prior

or current periods.
• Blends together units and costs from prior and
current periods.
• Determines equivalent units of production for a
department by adding together the number of
units transferred out plus the equivalent units in
ending work in process inventory
Process Costing
Double Diamond Skis reported the following

activity in Shaping and Milling Department for
the month of May:
Percent Completed
Shaping and Milling Department Units Materials Conversion
Beginning work in process 200 55% 30%
Units started into production in May 5,000
Units completed during May and 4,800 100% 100%

transferred to the next department
Ending work in process 400 40% 25%

Process Costing
The third step is to identify the equivalent units of
production in ending work in process with respect to
conversion for the month (100 units) and add this to the
4,800 units from step one.
Materials Conversion
Units completed and transferred
to the next department 4,800 4,800
Work in process, June 30:
400 units × 40% 160
400 units × 25% 100
Equivalent units of Production in
during the month of May 4,960 4,900
Process Costing
Equivalent units of production always equals:
+ Equivalent units remaining in work in process
Materials Conversion
to the next department 4,800 4,800
Work in process, June 30:
400 units × 40% 160
400 units × 25% 100
Equivalent units of Production in
during the month of May 4,960 4,900
X-Process Costing
Equivalent Units ― Weighted Average Method -Compute and Apply Costs
Beginning work in process: 200 units
Materials: 55% complete $ 9,600

Conversion: 30% complete 5,575
Production started during May 5,000 units

Production completed during May 4,800 units
Costs added to production in May

Materials cost $ 368,600
Conversion cost 350,900
Ending work in process 400 units

Materials: 40% complete
Conversion: 25% complete
Process Costing
Formula
Cost of beginning
Cost per
work in process + Cost added during
equivalent =
inventory the period
unit Equivalent units of production
X-Process Costing
Here is a schedule with the cost and equivalent

unit information.
Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, May 1 $ 15,175 $ 9,600 $ 5,575
Costs added in the Shipping
and Milling Department 719,500 368,600 350,900
Total cost $ 734,675 $ 378,200 $ 356,475
Equivalent units 4,960 4,900

Cost per equivalent unit
X-Process Costing
Here is a schedule with the cost and equivalent

unit information.
Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, May 1 $ 15,175 $ 9,600 $ 5,575
Costs added in the Shipping
and Milling Department 719,500 368,600 350,900
Total cost $ 734,675 $ 378,200 $ 356,475
Equivalent units 4,960 4,900

Cost per equivalent unit $ 76.25 $ 72.75
Total cost per equivalent unit = $76.25 + $72.75 = $149.00
$356,475 ÷ 4,900
$378,200 unitsunits
÷ 4,960 = $72.75
= $76.25
X-Process Costing
Computing the Cost of Units Transferred Out
Shaping and Milling Department

Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials Conversion Total
Ending work in process inventory:
Equivalent units of production 160 100
Cost of ending work in process inventory $ 12,200 $ 7,275 $ 19,475
Units completed and transferred out:

Units transferred to the next department 4,800 4,800
Cost of units transferred out $ 366,000 $ 349,200 $ 715,200
Reconciling Costs
Shaping and Milling Department
Cost Reconciliation
Costs to be accounted for:
Cost of beginning work in process inventory $ 15,175
Costs added to production during the period 719,500
Total cost to be accounted for $ 734,675
Cost accounted for as follows:

Cost of ending work in process inventory $ 19,475
Cost of units transferred out 715,200
Total cost accounted for $ 734,675
Process Costing
Equivalent Units ― FIFO Method
• Formula for Calculating Equivalent Units―FIFO
method:
• Equivalent Units of Production = Equivalent units to
complete beginning inventory* + Units started and
completed during the period + Equivalent units in ending
work in process inventory
• *Equivalent units to complete beginning inventory = Units
in beginning inventory × (100% − Percentage completion
of beginning inventory)
• Or, the equivalent units of production can also be
determined as follows:
• Equivalent Units of Production = Units transferred out +
Equivalent units in ending work in process inventory −
Equivalent units in beginning inventory.
Process Costing
• Quantity Schedule:
• Units in process at beginning (all materials 1/2 labor and
factory overhead FOH) 4,000
• Units started in process 40,000
• 44,000

• Units transferred to next department 38,000
• Units completed and on hand 1,000
• Units still in process (all materials,
2/3 labor and factory overhead) 3,000
Units lost in process 2,000
44,000
Process Costing
Unit cost:
Materials = $19,840 / 38,000 = $0.522 per unit
Labor = $24,180 / 39,000 = $0.620 per unit
Factory overhead = $22,580 / 39,000 = $0.579 per unit
X-Process Costing
Cost Charged to Dept ― FIFO Method
X-Process Costing
Cost Accounted Far - FIFO Method
* 34,000 units × $1.720 per unit = $58,514. To avoid decimal discrepancy, the cost
transferred from current production is computed as follows:
$71,040 - ($6,838 + $5,685) = $58,517
Why Use an Allocation Base?
Manufacturing overhead is applied to jobs that
are in process. An allocation base, such as
direct labor hours, direct labor dollars, or
machine hours, is used to assign
manufacturing overhead to individual jobs.
We use an allocation base because:
1. It is impossible or difficult to trace overhead costs to particular jobs.
2. Manufacturing overhead consists of many different items ranging
from the grease used in machines to production manager’s salary.
3. Many types of manufacturing overhead costs are fixed even though
output fluctuates during the period.
Manufacturing Overhead Application
The predetermined overhead rate
(POHR) used to apply overhead to
jobs is determined before the period
begins.
Estimated total manufacturing
overhead cost for the coming period
POHR =
Estimated total units in the
allocation base for the coming period
Ideally, the allocation base

is a cost driver that causes
overhead.
The Need for a POHR
Using a predetermined rate makes it
possible to estimate total job costs sooner.
Actual overhead for the period is not

known until the end of the period.
The Need for a POHR
Instead of using a predetermined overhead rate, a company could wait until the end of the accounting
period to compute an actual over head rate based on actual total manufacturing costs and the actual
total units in the allocation base for the period. However, managers cite several reasons for using
predetermined over head rates instead of actual overhead rates:
• Managers would like to know the accounting system's valuation of completed
jobs before the end of the accounting period. Suppose, for example a company
waits until the end of the year to compute its overhead rate. Then there would
be no way for managers to know the cost of goods sold for a job until the close
of the year. The job may be completed and shipped before the end of the year.
The seriousness of this problem can be reduced to some extent by computing
the actual overhead more frequently, but that immediately leads to another
problem as discussed below.
• If actual overhead rates are computed frequently, seasonal factors in overhead
costs or in the allocation base can produce fluctuations in the overhead rates.
For example, the cost of heating and cooling a production facility will be
highest in the winter and summer months and lowest in the spring and fall. If an
overhead rate were computed each month or each quarter, the predetermined
overhead rate would go up in the winter and summer and down in the spring
and fall. Tow identical jobs, one completed in winter and one completed in
spring, would be assigned different costs if the overhead rate were computed
on a monthly or quarterly basis. Managers generally feel that such fluctuations
in overhead rates and costs serve no useful purpose and are misleading.
• The use of predetermined overhead rate simplifies the record keeping. To
determine the overhead cost to apply t a job, the accounting staff simply
multiplies the dir
Application of Manufacturing
Overhead
Based on estimates, and
determined before the
period begins.
Overhead applied = POHR × Actual activity
Actual amount of the allocation

based upon the actual level of
activity.
Overhead Application Rate
Estimated total manufacturing
overhead cost for the coming period
POHR =
Estimated total units in the
allocation base for the coming period
$640,000
POHR =
160,000 direct labor hours (DLH)
POHR = $4.00 per DLH
For each direct labor hour worked on a

particular job, $4.00 of factory overhead
will be applied to that job.
Job-Order Cost Accounting
PearCo Job Cost Sheet
Job Number A - 143 Date Initiated 3-4-05
Date Completed 3-5-05
Department B3 Units Completed 2
Item Wooden cargo crate
Direct Materials Direct Labor Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours Rate Amount
X7-6890 $ 116 36 8 $ 88 8 $ 4 $ 32
Cost Summary Units Shipped

Direct Materials $ 116 Date Number Balance
Direct Labor $ 88
Manufacturing Overhead $ 32
Total Cost
Unit Product Cost
Job-Order Cost Accounting
PearCo Job Cost Sheet
Job Number A - 143 Date Initiated 3-4-05
Date Completed 3-5-05
Department B3 Units Completed 2
Item Wooden cargo crate
Direct Materials Direct Labor Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours Rate Amount
X7-6890 $ 116 36 8 $ 88 8 $ 4 $ 32
Cost Summary Units Shipped

Direct Materials $ 116 Date Number Balance
Direct Labor $ 88
Manufacturing Overhead $ 32
Total Cost $ 236
Unit Product Cost $ 118
Application of FOH
Compute under applied or

over applied overhead
cost and prepare the
journal entry to close the
balance in Manufacturing
Overhead to the
appropriate accounts.
Problems of Overhead Application
The difference between the overhead cost applied to

Work in Process and the actual overhead costs of a
period is referred to as either under applied or over
applied overhead.
Underapplied overhead Overapplied overhead

exists when the amount of exists when the amount of
overhead applied to jobs overhead applied to jobs
during the period using the during the period using the
predetermined overhead predetermined overhead
rate is less than the total rate is greater than the total
amount of overhead actually amount of overhead actually
incurred during the period. incurred during the period.
Overhead Application Example
PearCo’s actual overhead for the year was
$650,000 with a total of 170,000 direct
labor hours worked on jobs.
How much total overhead was applied to
PearCo’s jobs during the year? Use
PearCo’s predetermined overhead rate of
$4.00 per direct labor hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000
Overhead Application Example
PearCo’s actual overhead for the year
was $650,000 with a total of 170,000
direct labor hours worked on jobs.
PearCo has overapplied
How much total overhead was applied to
overhead for the
PearCo’s year
jobs during the year? Use
by $30,000. What will
PearCo’s predetermined overhead rate
PearCo do?
of $4.00 per direct labor hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH × 170,000 DLH = $680,000
Disposition of Under- or Over
applied Overhead
Generally any balance in the account is
treated in one of the two ways.
• Closed out to cost of goods sold.
• Allocated between work in process (WIP),
finished goods and cost of goods sold in pr
oportion to the overhead applied during th
e current period in the ending balances of t
hese account
Disposition of Under- or Over
applied Overhead
• Allocated Between Accounts Second
Method )
• Allocation of under or over applied overhead
between work in process (WIP), finished goods
and cost of goods sold (COGS) is more accurate
than closing the entire balance into cost of
goods sold. The reason is that allocation assigns
overhead costs to where they would have gone
in the first place had it not been for the errors in
the estimates going into the
predetermined overhead rate
Disposition of Under- or Over applied Overhead
Marginal Costing/Absorption costing
• Marginal cost:
• Other names – Incremental cost
Variable cost
Direct Cost ( Contribution approach )
Period cost –( known some times )
Marginal cost means –
suppose the total cost of making 1 shoe is $30 and the total cost of
making 2 shoes is $40. The marginal cost producing the second shoe is
$40 - $30 = $10
Therefore- The marginal cost of an additional unit of output is the cost of

the additional inputs needed to produce that output.
The marginal cost of a product –“ is its variable cost”. This is normally taken
to be; direct labor, direct material, direct expenses and the variable part of
overheads and the fixed costs of the period are written-off in full against the
aggregate contribution
In economics and finance, marginal cost is the change in total cost that
arises when the quantity produced changes by one unit. That is, it is the
cost of producing one more unit of a good.
Marginal cost /costing
• The concept of marginal cost first arose in
manufacturing environments where, if fixed costs are
ignored, the cost of producing one more unit is only
the cost of the extra materials and labor consumed
• In general terms, marginal cost at each level of

production includes any additional costs required to
produce the next unit. If producing additional product
requires, for example, building a new factory, the
marginal cost of those extra products includes the
cost of the new factory.
• Marginal cost does not include any sunk costs

(because they have already occurred ) and usually does
not contain any indirect costs (as long as indirect
costs are not increased by the action in question).
• Preferred for internal decision making
• The theory of marginal costing may, therefore, be understood in
the following two steps:
• If the volume of output increases, the cost per unit in normal

circumstances reduces. Conversely, if an output reduces, the cost
per unit increases. If a factory produces 1000 units at a total cost of
$3,000 and if by increasing the output by one unit the cost goes up
to $3,002, the marginal cost of additional output will be $.2.
• If an increase in output is more than one, the total increase in cost
divided by the total increase in output will give the average marginal
cost per unit. If, for example, the output is increased to 1020 units
from 1000 units and the total cost to produce these units is from
$1,000 to $1,045, the average marginal cost per unit is $2.25. It can
be described as follows:
• Additional cost =
Additional units $ 45 = $2.25
20
Features of Marginal Costing
Cost Classification
The marginal costing technique makes a sharp
distinction between variable costs and fixed costs. It
is the variable cost on the basis of which production
and sales policies are designed by a firm following
the marginal costing technique.
• Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit
measurement is valued at marginal cost. It is in
sharp contrast to the total unit cost under
absorption costing method.
• Marginal Contribution
Marginal costing technique makes use of marginal
contribution for marking various decisions. Marginal
contribution is the difference between sales and
marginal cost. It forms the basis for judging the
profitability of different products or departments.
• Things You'll Need to Calculate Average Marginal Cost
Determine the changes in the amounts of products sold for each
product. For instance, a company might look at five different
products during a six-month period. If product A was selling at
a rate Of 1,000 units per day during the first week and rose to
2,000 units a week during the last week of the period, the
change in items sold would be 1,000
.Calculate the change in the amount of expense to the business in
order to accommodate the change in units produced. For
instance, if it costs the company $5,000 to produce 1,000 units
and $7,000 to produce 2,000 units, the change in cost would be
$2,000.Divide the figure determined in Step 2 by that
determined in Step 1. For example, 2,000 divided by 1,000
equals 2, or "$2.“
Repeat this process for each type of product sold to determine the
marginal cost for each item. Add the marginal cost for each
type of product and divide by the number of products being
analyzed in order to find the average marginal cost. For
instance, if the marginal costs for products A, B, C and D were
$2, $5, $3 and $6, the total would be $16. Divide 16 by four since
there are four products being analyzed, and you will find an
average marginal cost of $4.
Advantages
• Marginal costing is simple to understand.
• By not charging fixed overhead to cost of production, the effect of varying
charges per unit is avoided.
• It prevents the illogical carry forward in stock valuation of some proportion of
current year’s fixed overhead.
• The effects of alternative sales or production policies can be more readily
available and assessed, and decisions taken would yield the maximum
return to business.
• It eliminates large balances left in overhead control accounts which indicate
the difficulty of ascertaining an accurate overhead recovery rate.
• Practical cost control is greatly facilitated. By avoiding arbitrary allocation of
fixed overhead, efforts can be concentrated on maintaining a uniform and
consistent marginal cost. It is useful to various levels of management.
• It helps in short-term profit planning by breakeven and profitability analysis,
both in terms of quantity and graphs. Comparative profitability and
performance between two or more products and divisions can easily be
assessed and brought to the notice of management for decision making.
• Disadvantages
• The separation of costs into fixed and variable is difficult and sometimes gives
misleading results.
• Normal costing systems also apply overhead under normal operating volume and this
shows that no advantage is gained by marginal costing.
• Under marginal costing, stocks and work in progress are understated. The exclusion
of fixed costs from inventories affect profit, and true and fair view of financial affairs of
an organization may not be clearly transparent.
• Volume variance in standard costing also discloses the effect of fluctuating output on
fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating
levels of production, e.g., in case of seasonal factories.
• Application of fixed overhead depends on estimates and not on the actuals and as
such there may be under or over absorption of the same.
• Control affected by means of budgetary control is also accepted by many. In order to
know the net profit, we should not be satisfied with contribution and hence, fixed
overhead is also a valuable item. A system which ignores fixed costs is less effective
since a major portion of fixed cost is not taken care of under marginal costing.
• In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the
assumptions underlying the theory of marginal costing sometimes becomes
unrealistic. For long term profit planning, absorption costing is the only answer.
Marginal Costing/Absorption costing
• Absorption costing / full costing method
• Is a costing system which treats all costs of production as
product costs, regardless weather they are variable or
fixed. The cost of a unit of product under absorption
costing method consists of direct materials,
direct labor and both variable and fixed
overhead. Absorption costing allocates a
portion of fixed manufacturing overhead cost
to each unit of product, along with the
variable manufacturing cost. Because absorption
costing includes all costs of production as product costs, it
is frequently referred to as full costing method. And
generally used for external reporting purpose
Absorption costing
Limitations of / Criticisms against Absorption Costing
• You might have observed that in absorption costing,

a portion of fixed cost is carried over to the
subsequent accounting period as part of closing
stock. This is an unsound practice because costs
pertaining to a period should not be allowed to be
vitiated by the inclusion of costs pertaining to the
previous period and vice versa.
• Further, absorption costing is dependent on the

levels of output which may vary from period to
period, and consequently cost per unit changes due
to the existence of fixed overhead. Unless fixed
overhead rate is based on normal capacity, such
changed costs are not helpful for the purposes of
comparison and control.
Absorption costing
Advantages of Absorption Costing:
• It recognizes the importance of fixed costs in production;
• This method is accepted by Inland Revenue as stock is
not undervalued;
• This method is always used to prepare financial accounts;
• When production remains constant but sales fluctuate
absorption costing will show less fluctuation in net profit
and
• Unlike marginal costing where fixed costs are agreed to
change into variable cost, it is cost into the stock value
hence distorting stock valuation.
Disadvantages of Absorption Costing:
• As absorption costing emphasized on total cost namely
both variable and fixed, it is not so useful for management
to use to make decision, planning and control; as the
manager’s emphasis is on total cost, the cost volume profit
relationship is ignored..
Absorption costing
• Features which distinguish marginal costing from absorption costing are as
follows.
The value of closing stock will be higher in absorption costing than in marginal
costing.
• As a consequence of carrying forward an element of fixed production overheads
in closing stock values, the cost of sales used to determine profit in absorption
costing will:
– include some fixed production overhead costs carried forward into opening
stock values of the current period;
– exclude some fixed production overhead costs incurred in the current period
by including them in closing stock values.
• In contrast marginal costing charges the actual fixed costs of a period in full to
P/L of the period.
• In absorption costing, ‘actual’ fully absorbed unit costs are reduced by producing
in greater quantities, whereas in marginal costing, unit variable costs are
unaffected by the volume of production (that is, provided that variable costs per
unit remain unaltered at the changed level of production activity). Profit per unit in
any period can be affected by the actual volume of production in absorption
costing; this is not the case in marginal costing.
• In marginal costing, the identification of variable costs and of contribution
enables management to use cost information more easily for decision-making
purposes
• In absorption costing, however, the effect on profit in a period of changes in both:
– production volume; and
– sales volume;
is not easily seen, because behaviour is not analysed and incremental costs
are not used in the calculation of actual profit.
Absorption costing
• Net profits are not the same because of the following reasons:
• 1. Over and Under Absorbed Overheads
• In absorption costing, fixed overheads can never be absorbed
exactly because of difficulty in forecasting costs and volume of
output. If these balances of under or over absorbed/recovery
are not written off to costing profit and loss account, the actual
amount incurred is not shown in it. In marginal costing,
however, the actual fixed overhead incurred is wholly charged
against contribution and hence, there will be some difference in
net profits.
• 2. Difference in Stock Valuation
• In marginal costing, work in progress and finished stocks are
valued at marginal cost, but in absorption costing, they are
valued at total production cost. Hence, profit will differ as
different amounts of fixed overheads are considered in two
accounts.
Absorption costing
• The profit difference due to difference in stock
valuation is summarized as follows:
• When there is no opening and closing stocks, there will be
no difference in profit.
• When opening and closing stocks are same, there will be
no difference in profit, provided the fixed cost element in
opening and closing stocks are of the same amount.
• When closing stock is more than opening stock, the profit
under absorption costing will be higher as comparatively a
greater portion of fixed cost is included in closing stock
and carried over to next period.
• When closing stock is less than opening stock, the profit
under absorption costing will be less as comparatively a
higher amount of fixed cost contained in opening stock is
debited during the current period.
Unit Cost Computations
Harvey Company produces a single
product
with the following information available:
Number of units produced annually 25,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 10
Selling & administrative expenses $ 3
Fixed costs per year:

Manufacturing overhead $ 150,000
Selling & administrative expenses $ 100,000
Unit Cost Computations
Unit product cost is determined as follows:
Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 10 $ 10
Fixed mfg. overhead
($150,000 ÷ 25,000 units) 6 -
Unit product cost $ 16 $ 10
Under absorption costing, selling and

administrative expenses are
always treated as period expenses and
deducted from revenue as incurred.
Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional

information for Harvey Company.
– 20,000 units were sold during the year at a
price of $30 each.
– There were no units in beginning inventory.
Now, let’s compute net operating
income using both absorption
and variable costing.
Absorption Costing
Absorption Costing
Sales (20,000 × $30) $ 600,000
Less cost of goods sold:
Beginning inventory $ -
Add COGM (25,000 × $16) 400,000
Goods available for sale 400,000
Ending inventory (5,000 × $16) 80,000 320,000
Gross margin 280,000
Less selling & admin. exp.
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net operating income $ 120,000
Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
All fixed
Goods available for sale 250,000 manufacturing
Less ending inventory (5,000 × $10) 50,000 overhead is
Variable cost of goods sold 200,000 expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Selling & administrative expenses 100,000 250,000
ACTIVITY BASED COSTING ( ABC )
A TOOL TO AID DECISION MAKING
Historical development / Need for ABC
• Traditionally cost accountants arbitrarily added a broad
percentage of analysis into the indirect cost. In addition,
activities include actions that are performed both by
people and machine
• These traditional costing systems are often unable to
determine accurately the actual costs of production
and of the costs of related services. Consequently
decisions based on inaccurate data especially where
there are multiple products are in correct
• For example, increased automation has reduced labor,
which is a direct cost, but has increased depreciation,
which is an indirect cost. Consequently, when multiple
products share common costs, there is a danger of one
product subsidizing another.
Historical development / Need for ABC – Conti--
• Take the example of manufacturing industry where
increasing technology and productivity improvements
have reduced the relative proportion of the direct costs of
labor and materials, but have increased relative
proportion of indirect costs
• However, as the percentages of indirect or
overhead costs rose, this technique became
increasingly inaccurate, because indirect costs were
not caused equally by all products. For example, one
product might take more time in one expensive machine
than another product—but since the amount of direct
labor and materials might be the same, additional cost
for use of the machine is not being recognized when the
same broad 'on-cost' percentage is added to all products
• ABC seeks to identify cause and once costs of activities

have been identified, then cost of each activity is
attributed to each product to the extent that the product
uses the activity. In this way ABC often identifies
areas of high overhead costs per unit and so directs
attention to finding ways to reduce the costs or to
charge more for costly products.
• Activity based costing system help to manage
overhead and understand profitability of products
and customers and therefore is a powerful tool for
decision making.
• Like manufacturing industries, financial institutions
have diverse products and customers, which can
cause cross-product, cross-customer subsidies
ABC system have two costing systems-- -

- Official costing system for preparing
external financial reports
- Activity based costing system that is
used for internal decision making and
managing activities.
Definition and Explanation
• (ABC) is a special costing model that identifies activities in an
organization and assigns the cost of each activity with resources
to all products and services according to the actual consumption
by each. This model assigns more indirect costs (overhead) into
direct costs compared to conventional costing models
• In traditional cost accounting systems, the objective is to value

inventories and cost of goods sold for external financial reports
in accordance with the
generally accepted accounting principles (GAAP). In activity
based costing (ABC) system the objective is to understand
overhead and the profitability of products and customers and to
manage overhead.
• ABC methodology assigns an organization's resource costs

through activities to the products and services provided to its
customers
• Costing method designed to provide cost information for
strategic and other decisions that potentially affect capacity and
therefore "fixed cost".
Aims of model
• Organization can soundly estimate the cost

elements of entire products and services
requiring decisionson
- Either identify and eliminate those products and
services that are unprofitable Or
- lower the prices of those that are overpriced
(product and service portfolio aim) or
- Identify and eliminate production or service
processes that are ineffective
USAGE
• Used as a tool for understanding product

and customer cost and profitability based
on the production or performing processes.
• Has predominantly been used to support
strategic decisions such as pricing,
outsourcing, identification and
measurement of process improvement
initiatives
Advantages / Benefits
• More accurate costing of products / services,
customers, distribution channels.
• Better understanding of overhead.
• Easier to understand for everyone.
• Utilizes unit cost rather than just total cost.
• Makes visible waste and
non-value added activities.
• Enables costing of processes, supply chains,
and value streams
• Activity Based Costing mirrors way work is
done
• Facilitates benchmarking
Disadvantages
• Implementing an ABC system is a major project that
requires substantial resources. Once implemented an
activity based costing system is costly to maintain.
• ABC produces numbers such as product margins, that are
odds with the numbers produced by traditional costing
systems.
• Activity based costing data can be easily misinterpreted
and must be used with care making decisions.
• Before making any significant decision using activity based
costing data, managers must identify which costs are really
relevant for the decisions at hand.
• Reports generated by this systems do not conform to
generally accepted accounting principles (GAAP Two
costing system may be desired - one for internal use and
one for preparing external reports
• External reports are less detailed than internal reports.
• It may be difficult to make changes to the company’s
accounting system.
Limitations
• Substantial resources required to implement and difficult to
implement for small gains, and a poor value
• However, application of an activity based recording may be
applied without change in an incremental activity based
accounting
• Even in ABC, some overhead costs are difficult to assign to
products and customers, such as the chief executive's salary.
These costs are termed 'business sustaining' and are not
assigned to products and customers because there is no
meaningful method.
• Although some may argue that costs untraceable to activities
should be "arbitrarily allocated" to products, it is important to
realize that the only purpose of ABC is to provide information to
management. Therefore, there is no reason to assign any cost in
an arbitrary manner.
• Does not conform to GAAP. Two costing system may be desired
• Resistance and potential misinterpretation of unfamiliar numbers
Treatment of cost under ABC
• Non manufacturing cost and activity based costing
• In traditional cost accounting system,
Only manufacturing costs are assigned to products. Selling, general,
and administrative expenses are treated as period costs. However,
many of these non-manufacturing costs are also part of the costs of
producing. For example commissions paid to salespersons, shipping
costs, and warranty repair costs can be easily traced to individual
products.
• In activity based costing
Products are assigned all of the costs-manufacturing as well as non-
manufacturing-which can reasonably be assigned The entire cost of
the product is determined rather than just its manufacturing cost.
• Manufacturing costs and activity based costing
• In traditional cost accounting,
All manufacturing costs are assigned to products-even manufacturing
costs that are not caused by the products. For example, a portion of
the factory security guard's wages would be allocated to each product
even though the guards wages are totally unaffected by which
products are made or not made during a period.
• In activity based costing,
Cost is assigned to a product only if there is a good reason to believe
that the cost would be affected by decisions concerning the product.
How Costs are Treated Under ABC
THREE WAYS
Plant wide Overhead Rate
• Previously Plant wide overhead rate or predetermined overhead rate,
used to be charged throughout an entire factory based on direct labor
hours or machine hours.
• Previously cost and activity data had to be collected by hand and all
calculations were done with paper and pen. Consequently, the
emphasis was on simplicity and a single overhead cost pool for an
entire department. Direct labor was an allocation base for overhead
costs.
• In the labor-intensive production processes of that time, direct labor
was a large component of product costs--larger than it is today.
• Moreover, managers believed direct labor and overhead costs highly
correlated.
• And finally most companies produced a very limited variety of
products that required similar resources to produce, so little
difference in the overhead costs attributable to different products.
Under these conditions, it was not cost effective to use a more
elaborate costing system.
Plant wide Overhead Rate – Conti—
• Conditions have changed. Many companies now sell a large variety of
products and services that consume significantly different overhead
resources. Consequently, a costing system that assigns essentially the
same overhead cost to every product may no longer be adequate.
Additionally, many managers now believe that overhead costs and
direct labor are no longer highly correlated and that other factors drive
overhead costs.
• On an economy wide basis, direct labor and overhead costs have been
moving in opposite directions for a long time. As a percentage of total
cost, direct labor has been declining, whereas overhead has been
increasing.
• Companies are creating new products and services in different
volume, batch size and complexity.. Finally, software system and other
technology have dramatically reduced the cost of collecting and
manipulating data--making more accurate costing systems such as
activity based costing much less expensive to build and maintain.
• Nevertheless, direct labor remains a viable base for applying
overhead to products in some companies--particularly for external
reports. Direct labor is an appropriate allocation base for overhead
when overhead costs and direct labor are highly correlated. And
indeed, most companies throughout the world continue to base
overhead allocations on the direct labor or machine hours..
• Departmental Overhead Rates:
Rather than use a plant wide overhead rate (

predetermined overhead rate), many companies have a
system in which each department has its own overhead
rate (multiple predetermined overhead rates). The nature
of the work performed in each department will determine
the department's allocation base.
For example, overhead costs in machining department may

be allocated on the basis of the machine-hours incurred
in that department. In contrast, the overhead costs in an
assembly department may be allocated on the basis of
direct labor-hours incurred in that department.
Departmental Overhead Rates:
• Unfortunately, even departmental

overhead rates will not correctly assign
overhead costs in situations where a
company has a range of products that
differ in volume, batch size, or complexity
of production..
• The Cost of Idle Capacity and Activity Based Costing
• In traditional cost accounting, predetermined

overhead rates are computed by dividing budgeted
overhead costs by a measure of budgeted activity such
as budgeted direct labor hours. This results in applying
the costs of unused, or idle capacity to products,
• In activity based costing system, products are
charged for the costs of capacity they use and not for the
costs of capacity they do not use. The costs of idle
capacity is not charged to products in activity based
costing system these costs are considered to be
period costs that flow through to the income statement
as an expense of the current period.
INTRODUCTION TO STANDARD COSTING
The success of a business enterprise depends to a greater
extent upon how efficiently and effectively it has controlled its
cost. In a broader sense the cost figure may be ascertained
and recorded in the form of Historical costing and
Predetermined costing.
• One of the important objectives of cost accounting is
effective cost ascertainment and cost control. Historical
Costing is not an effective method of exercising cost control
because it is not applied according to a planned course of
action. And also it does not provide any yardstick that can be
used for evaluating actual performance. Based on the
limitations of historical costing it is essential to know before
production begins what the cost should be so that exact
reasons for failure to achieve the target can be identified and
the responsibility be fixed..
MEANING - STANDARD COST
• Standard Cost
• The word "Standard" means a "Yardstick" or "Bench
Mark." The term "Standard Costs" refers to Pre-
determined costs.
• Brown and Howard define - a Pre-determined Cost
which determines what each product or service should
cost under given circumstances. This definition states
that standard costs represent planned cost of a
product.
Institute of Cost and Management Accountant, London
"is the Pre-determined Cost based on technical
estimate for materials, labour and overhead for a
selected period of time and for , a prescribed set of
working conditions.”
MEANING - STANDARD COSTING
• Standard Costing is a concept of accounting for determination of
standard for each element of costs. These predetermined costs are
compared with actual costs to find out the deviations known as
"Variances.”
• Chartered Institute of Management Accountants England - Standard
Costing as "the Preparation and use of standard costs, their
comparison with actual costs and the analysis of variances to their
causes and points of incidence."
• From the above definition, the technique of Standard Costing may
be summarized as follows :
(1) Determination of appropriate standards for each element of cost.
(2)' Ascertainment of information about actuals and use of Standard
Costs.
(3) Comparison of actual costs with Standard Costs, the differences
known as Variances.
(4) Analysis of Variances to find out the causes of Variances.
(5)Reporting to the responsible authority for taking remedial
measures.
Difference - Estimated Costs & Standard Costs
• Although, Pre-determination is the essence of both Standard
Costing and Estimated Costing, the two differ as under
• Standard Costing – Estimated Cost
S- 1)It is used on the basis of scientific.
E- 1) It is used on the basis of statistical facts and figures.
S- 2) It emphasises "what the cost should be."
E -2) It emphasises "what the cost will be."
S -3)It is used to evaluate actual performance and it serves as an
effective tool of cost.
E-3) It is used to cost ascertainment for fixing sales price.
S- 4)It is applied to any industry engaged in mass Production
E- 4) It is applicable to concern engaged in construction work.
S- 5) It is a part of accounting system and standard costing
variances are recorded in the books of accounts.
E-5) It is not a part of accounting system because it is based on
statistical facts and figures
Standard Costing and Budgetary Control
• Relationship: Common : principles
• 1- Determination of standards for each
element of costs in advance.
• 2- For both of them measurement of actual
performance is targeted.
• 3- Comparison of actual costs with standard
cost to .find out deviations.
• 4- Analysis of variances to find out the
causes.
• 5- Give the periodic report to take corrective
measures.
Standard Costing and Budgetary
Control- Difference
• Budgetry Control
• (1) Budgets are projections of financial accounts. ..
• (2) As a statement of both income and expenses it
• forms part of budgetary control.
• (3) Budgets are estimated costs. They are "what the
• cost will be."
• (4) Budget can be operated with standards.
• (5) In budgetary control variances are not revealed
• through the accounts.
• (6) Budgets are prepared on the basis of historical facts
• and figures.
Standard Costing and Budgetary Control-
Difference
• Standard Costing
(1) Standard Costing is projection of cost accounts.
(2 )Standard costing is not used for the purpose of
forecasting.
(3)Standard Cost is the "Norms”or what cost should be. “
(4) Standard Costing cannot be used without budgets
(5) Under standard costing variances are revealed
through different accounts.
(6 )Standard cost are planned and prepared on the basis
of technical estimates.
ADVANTAGES – STANDARD COSTING
• It guides the management to evaluate the production
performance.
• It helps the management in fixing standards.
• Standard costing is useful in formulating production
planning and price policies.
• It guides as a measuring rod for determination of
variances.
• It facilitates eliminating inefficiencies by taking
corrective measures.
• It acts as an effective tool of cost control.
• It helps the management in taking important decisions.
• It facilitates the principle of "Management by
Exception."
• Effective cost reporting system is possible.
LIMITATIONS OF STANDARD COSTING
• Standard costing is expensive and a small concern
may not meet the cost.
• Due to lack of technical aspects, it is difficult to
establish standards.
• Standard costing cannot be applied in the case of a-
concern where non-standardised products are
produced.
• Fixing of responsibility is'difficult. Responsibility
cannot be fixed in the case of uncontrollable variances.
• Frequent revision is required while insufficient staff is
incapable of operating this system.
• Adverse psychological effects and frequent
technological changes will not be suitable for standard
costing system.
TYPES OF STANDARDS TO
BE APPLIED
. Ideal Standard
• Basic Standard

• Current Standard

• Expected Standard

• Normal Standard
TYPES OF STANDARDS TO BE APPLIED
Ideal Standard: which can be attained under the most favourable
conditions possible. In other words, ideal standard is based on
high degree of efficiency. It assumes that there is no wastage, no
machine breakdown, no power failure, no labour ideal time in the
production process, In practice, difficult to attain this ideal
standard.
• Basic Standard: known as Bogey Standard. Use is unaltered
over a long period of time. In other words this standard is fixed in
relation to a base year and is not changed in response to
changes in material costs. labour costs and other expenses as
the case may be. The application of this standard has no·
practical importance from cost control and cost ascertainment
point of view.
• Current Standard: The term "Current Standard" refers to "a standard
established for use over a short period of time related to current
conditions which reflects the performance that should be attained during
the period." These standards are more suitable and realistic for control
purposes.
TYPES OF STANDARDS TO BE APPLIED
Expected Standard: Expected Standard may be

defined as "the standard which may be anticipated to be
attained during a future specified budget period." These
standards set targets which can be achieved in a normal
situation. As such it is more realistic than the Ideal
Standard.
Normal Standard: This standard resents an average
standard in past which, it is anticipated, can be attained
over a future period of time, preferably long enough to
cover one trade cycle. The usefulness of such standards is
very limited for the purpose of cost control.
SETTING OF STANDARDS
For each element of costs as given below :
– Direct Material
– Direct Labour
– Overheads
– Fixed Overheads
– Variable Overheads
• Standard for Direct Material Cost

• Material Quantity or Usage Standard. (Purchase Related
• Material Price Standard. ( Purchase related
• Material Usage Standard: ( consumption related, Material
specifications and quality of materials required to manufacture
a product with a allowance for normal loss due to unavoidable
occurrence of evaporation, breakage etc.
• Standard for Direct Labour Cost
• Fixation of Standard Labour Time
Labour Standard time is fixed and it depends upon the
nature of cost unit, nature of operations performed,
Time and Motion Study etc. While determining the
standard time normal ideal time is allowed for fatigue
and other contingencies.
• Fixation of Standard Rate :
The standard rate fixed for each job will be determined
on the basis of methods of wage payment such as Time
Wage System, Piece Wage System, Differential Piece
Rate System and Premium Plan etc.
• Setting Standards for Overheads
• Problems Involved while setting standards for overheads:
• 1-Determination of standard overhead cost
• 2-Estimating the production level of activity to be measured in
terms of common base like machine hours, units of production and
labour hours.
• Setting of overhead standards is divided into fixed overhead.
variable overhead and semi-variable overhead. The determination
of overhead rate may be calculated as follows
• Standard Overhead Rate
• Standard Overhead Rate =Standard overhead for the budget
period / Standard Production for the budget period
• Standard Variable Overhead Rate = Standard overhead for
the budget period / Standard Production for the budget
period
• Standard Hour:
Usually production is expressed in terms of units,

dozen. kgs, pound, litres etc. When productions are
of different types, all products cannot be expressed in
one unit. Under such circumstances, it is essential to
have a common unit for all the products. Time factor
is common to all the operation. Standard Time as a
"hypothetical unit pre-established to represent the
amount of work which should be performed in
onehour at standard performance.”
VARIANCE ANALYSIS
• Variances" may be defined as the difference between Standard
Cost and actual cost for each element of cost incurred during a
particular period.
• The term "Variance Analysis" may be defined as the process
of analyzing variance by subdividing the total variance in such a
way that management can assign responsibility for off-Standard
Performance.
• The variance may be favourable variance or unfavourable variance.
Actual performance when better than Standard, it is "Favourable
Variance.” Similarly, when actual performance is below the standard
it is called as "Unfavourable Variance.“
• Variance analysis helps to fix the responsibility so that
management can ascertain -
• The amount of the variance
• The reasons for the difference between the actual performance and
budgeted performance
• The person responsible for poor performance
• Rremedial action to be taken
TYPES OF VARIANCES
• Variances may be broadly classified into two categories
• (A) Cost Variance and
• (B) Sales Variance. '
• (A) Cost Variance
• Total Cost Variance is the difference between
Standards Cost for the Actual Output and the Actual
Total Cost incurred for manufacturing actual output.
The Total Cost Variance Comprises the following
– I. Direct Material Cost Variance (DMCV)
– II. Direct Labour Cost Variance (DLCV)
– III. Overhead Cost Variance (OCV)
TYPES OF VARIANCES
• Direct Material Variances
Also termed as Material Cost Variances.
The Material Cost Variance is the difference between the
Standard cost of materials for the Actual Output and the
Actual Cost of materials used for producing actual
output. The Material Cost Variance is calculated as
• Material Cost Variance MCV = SC - AC
• (or) ( SQ * SP ) – ( AQ * AP )
• Note: If the actual costs is more than standard cost the
variance will be unfavourable or adverse variance and.
if the actual cost is less than standard cost the variance
will be favourable variance. The material cost variance
is further classified into: SEE NEXT SLIDE
FURTHER CLASSIFICATIONS –
MATERIAL COST VARIANCE
Further classifications of the material cost variance
Material Price Variance
Material Usage Variance
Material Mix Variance
Material Yield Variance
• Material Price Variance (MPV)
• Is due to the difference between the Standard Price
specified and the Actual Price paid for purchase of
materials. Material Price Variance may be calculated as
MPV : AQ ( SP – AP )
• Note : If actual cost of materials is higher than standard
then variance is negative ( - )
FURTHER CLASSIFICATIONS – CONTINUED
Material Usage Variance (MUV):
Refers to the difference between the standard cost of
standard quantity of material for actual output and the
Standard cost of the actual material used and is
calculated as under
MUV = SP (SQ - AQ )
Note: This Variance will be favorable when standard
cost of actual material is more than the Standard
material cost for actual output, and Vice Versa.

FURTHER CLASSIFICATIONS – CONTINUED
Verification :
• The following equations may be used for
verification of Material Cost Variances :
Material Cost Variance
Material Price Variance + Material Usage Variance
Material Usage Variance

• Material Mix Variance – Material Yield Variance
• Material Cost Variance
• Material Mix Variance + Material Yield Variance
FURTHER CLASSIFICATIONS
LABOR COST VARIANCE
Labour Variances can be classified into:
– Labour Cost Variance (LCV)

– Labour Rate Variance or Wage Rate Variance
– Labour Efficiency Variance / Time Variance
– Labour Idle Time Variance
– Labour Mix Variance
– Labour Revised Efficiency Variance
– Labour Yield Variance

LABOR COST VARIANCE
• Labour Cost Variance (LCV)
• Difference between the Standard Cost of labour
allowed for the actual output achieved and the
actual wages paid. It is also termed as Direct Wage
Variance or Wage Variance and is calculated as
follows:
• Standard Cost of Labour - Actual Cost of Labour
(or)
SR * ST for actual output – Actual Time * Actual rate
Note: If the Standard rate is higher than the actual
rate, the variance will be favourable and vice versa.
LABOR COST VARIANCE
• Labour Rate Variance or Wage Rate Variance
• It is that part of labour cost variance which is due to the
difference between the standard rate specified and the
actual rate paid. This variances arise from the following
reasons:
• Change in wage rate.
• Faulty recruitment.
• Payment of overtime.
• Employment of casual workers etc.
• It is expressed as follows :
• Actual Time ( Standard Rate – Actual Rate )
• Note: If the Standard rate is higher than the actual rate,
the variance will be favourable and vice versa.
LABOR COST VARIANCE
• Labour Efficiency Variance / Time Variance
• It is that portion of the Labour Cost Variance which
arises due to the difference between standard labour
hours specified and the actual labour hours spent.
• The usual reasons for this variance are
• (a) poor supervision
• (b) poor working condition
• (c) increase in labour turnover
• (d) defective materials.
• It may be calculated as following:
• LEV = SP (SLH - ALH )
• Note: If actual time taken is more than the specified
standard time, the variance represents unfavourable
and vice versa.
LABOR COST VARIANCE
Labour Idle Time Variance

• Arises due to abnormal situations like strikes,
lockout, breakdown of machinery etc. In other
words, idle time occurs due to the difference
between the time for which workers are paid
and that which they actually expend upon
production. It is calculated as follows :
Idle Time Variance = Idle Hours x Standard Rate
OVERHEAD COST VARIANCE
• Overhead may be defined as the aggregate
of indirect material cost, indirect labour cost
and indirect expenses.
• Overhead Variances may arise due to the
difference between standard cost of
overhead for actual production and the
actual overhead cost incurred.
• Overhead Variances can be classified as :
• Variable Overhead Variances:
• Fixed Overhead Variance:
OVER HEAD COST VARIANCE
• Overhead Variances can be classified as :
• Variable Overhead Variances:
• Variable Overhead Cost Variance
• Variable Overhead Expenditure Variance
• Variable Overhead Efficiency Variance
• Fixed Overhead Variance:
– Fixed Overhead Cost Variance
– Fixed Overhead Expenditure Variance
– Fixed Overhead Volume Variance
– Fixed Overhead Capacity Variance
– Fixed Overhead Efficiency Variance
– Fixed Overhead Calendar Variance
VARIABLE OVER HEAD COST VARIANCE
Variable Overhead Cost Variance
SVOH for Actual Production – AVOH for Actual Production
Variable Overhead Expenditure Variance

(SVOH Rate per hour – AVOH Rate per hour )* Actual Time
OR
SVO Heads allowed – AVO Heads
Variable Overhead Efficiency Variance: :
SR per Hour* ( SH for actual production – Actual Hours )
VERIFICATION
Variable Overhead Cost Variance
VO Expenditure Variance + VO Efficiency Variance
FIXED OVER HEAD COST VARIANCE
Fixed Overhead Cost Variance
which is due to over absorption or under absorption of overhead for the
actual production. In other words, the variance is the difference
between the standard fixed overheads allowed for the actual
production and the actual fixed
( Actual Fixed OH) - ( SFOH for Actual Production)

OR
(SFOHR per hour – Actual Overheads) * Actual Output
Fixed Overhead Expenditure Variance (Budgeted Variance

( Budgeted Fixed Overheads – Actual Fixed Overheads )
Fixed Overhead Volume Variance
(BFOH – SFOH for Actual Production ) Note: If budgeted
fixed overhead is greater than standard fixed overhead on actual
production, the variance is unfavourable and vice versa.
Relevant Costs for Decision
Making
Cost Concepts for Decision
Making
A relevant cost is a cost that differs
between alternatives.
2
1
Identifying Relevant Costs
An avoidable cost can be eliminated, in whole
or in part, by choosing one alternative over
another. Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.
Two broad categories of costs are never

relevant in any decision. They include:
Sunk costs.
Future costs that do not differ between the
alternatives.
Relevant Cost Analysis: A Two-
Step Process
Step 1 Eliminate costs and benefits that do not differ
between alternatives.
Step 2 Use the remaining costs and benefits that
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.
Different Costs for Different
Purposes
Costs that are

relevant in one
decision situation
may not be relevant
in another context.
Cynthia, a Boston student, is considering visiting her friend in New York.
She can drive or take the train. By car, it is 230 miles to her friend’s
apartment. She is trying to decide which alternative is less expensive
and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569
$45 per month × 8 months $1.60 per gallon ÷ 32 MPG
$18,000 cost – $4,000 salvage value ÷ 5 years

Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569
Some Additional Information

7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25
Which costs and benefits are relevant in Cynthia’s
decision?
The cost of the The annual cost of

car is a sunk cost insurance is not
and is not relevant. It will remain
relevant to the the same if she drives
current decision. or takes the train.
However, the cost of gasoline is clearly relevant

if she decides to drive. If she takes the train,
the cost would now be incurred, so it varies
depending on the decision.
decision?
The monthly
The cost of school parking
maintenance and fee is not
repairs is relevant. In relevant because
the long-run these it must be paid if
costs depend upon Cynthia drives or
miles driven. takes the train.
At this point, we can see that some of the average

cost of $0.569 per mile are relevant and others are
not.
decision?
The decline in resale The round-trip train

value due to additional fare is clearly relevant.
miles is a relevant If she drives the cost
cost. can be avoided.
Relaxing on the train is The kennel cost is not

relevant even though it relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.
decision?
The cost of parking is

relevant because it can
be avoided if she takes
the train.
The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.
From a financial standpoint, Cynthia would be better
off taking the train to visit her friend. Some of the
non-financial factor may influence her final decision.
Relevant Financial Cost of Driving
Gasoline (460 @ $0.050 per mile) $ 23.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 114.86
Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00
Total and Differential Cost Approaches
The management of a company is considering a new labor saving
machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
As you can see, the only costs that differ between the alternatives are
the direct labor costs savings and the increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
We can efficiently analyze the decision by 62,000

Other
Rent on new machine
-
62,000
3,000
-
(3,000)
looking at the different costs and revenues

Total fixed expenses
62,000
Net operating income
$ 18,000 $
65,000
30,000
(3,000)
12,000
and arrive at the same solution.

Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Net annual cost saving from renting the new machine $ 12,000
Using the differential approach is desirable for

two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.
Learning Objective 2
Prepare an analysis
showing whether a product
line or other business
segment should be
dropped or retained.
Adding/Dropping Segments
One of the most important

decisions managers make is
whether to add or drop a business
segment, such as a product or a
store.
Let’s see how relevant costs
should be used in this type of
decision.
Due to the declining popularity of

digital watches, Lovell Company’s
digital watch line has not reported
a profit for several years. Lovell
is considering dropping this
product line.
A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch segment
only if its profit would increase. This would
only happen if the fixed cost savings
exceed the lost contribution margin.
Let’s look at this solution.

Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
Digital Watches
Sales $ 500,000
Investigation has revealed that total fixed general
Variable manufacuring costs $ 120,000
factory overhead and general
administrative
Commissions expenses would75,000
not be affected if
200,000
the digital
Contribution watch line is dropped. The fixed
margin $ 300,000
general factory overhead and general
administrative expenses assigned
Salary of line manager to this product
90,000
would be of
Depreciation reallocated
equipment to other product lines.
50,000
Digital Watches
Sales $ 500,000
The equipment
Variable usedcosts
manufacturing to manufacture
$ 120,000
digital watches has no resale
Commissions 75,000 200,000
value
Contribution or alternative use.
margin $ 300,000
Depreciation of equipment 50,000
Should Lovell retain or drop
Rent - factory space the digital watch
70,000 segment?
A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)
Comparative Income Approach
The Lovell solution can also be obtained by

preparing comparative income statements
showing results with and without the digital
watch segment.
Let’s look at this second approach.

Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
General factory overhead 60,000
Depreciation 50,000 If the digital watch
line is dropped, the
General admin. expenses 30,000 company gives up
Total fixed expenses 400,000 its contribution
margin.
Solution
Keep Drop
Digital Digital
Sales $ 500,000 $ - $ (500,000)
Shipping 5,000 - 5,000
General factory overhead 60,000 60,000 -
Depreciation 50,000
Advertising - direct On 100,000
the other hand, the general
Rent - factory space factory overhead would be the
70,000
General admin. expenses 30,000
Total fixed expenses
same. So this cost really isn’t
400,000
Net operating loss $ (100,000) relevant.
Solution
Keep Drop
Digital Digital
Sales $ 500,000 $ - $ (500,000)
Manufacturing expenses
But we wouldn’t
120,000
need a
- 120,000
Shipping manager for5,000 the product -line 5,000
Commissions anymore.
75,000 - 75,000
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Total fixed expenses 400,000
Solution
Keep Drop
Digital Digital
Sales $ 500,000 $ - $ (500,000)
If variable
Less the digital watch line is dropped, the net -book value
expenses:
Manufacturing expenses 120,000 -
of the equipment would be written off. The 120,000
Shipping 5,000 - 5,000
depreciation that would have
Commissions been taken- will flow75,000
75,000
through
Total variable the income statement
expenses 200,000as a loss -instead.200,000
Depreciation 50,000 50,000 -
Total fixed expenses 400,000
Solution
Keep Drop
Digital Digital
Sales $ 500,000 $ - $ (500,000)
Shipping 5,000 - 5,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)
Prepare a make or buy

analysis.
The Make or Buy Decision
When a company is involved in more than

one activity in the entire value chain, it is
vertically integrated. A decision to carry out
one of the activities in the value chain
internally, rather than to buy externally from
a supplier is called a “make or buy”
decision.
Vertical Integration- Advantages
Smoother flow of
parts and materials
Better quality
control
Realize profits
Vertical Integration-
Disadvantage
Companies may fail
to take advantage of
suppliers who can
create economies of
scale advantage by
pooling demand from
numerous
companies.
The Make or Buy Decision: An
Example
• Essex Company manufactures part 4A that
is used in one of its products.
• The unit product cost of this part is:
Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30
• The special equipment used to manufacture
part 4A has no resale value.
• The total amount of general factory overhead,
which is allocated on the basis of direct labor
hours, would be unaffected by this decision.
• The $30 unit product cost is based on 20,000
parts produced each year.
• An outside supplier has offered to provide the
20,000 parts at a cost of $25 per part.
Should we accept the supplier’s offer?

Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000
20,000 × $9 per unit = $180,000

Cost
Make Buy

Total cost $ 30 $ 340,000 $ 500,000
The special equipment has no resale

value and is a sunk cost.
Cost
Make Buy

Total cost $ 30 $ 340,000 $ 500,000
Not avoidable; irrelevant. If the product is

dropped, it will be reallocated to other products.
Cost
Make Buy

Total cost $ 30 $ 340,000 $ 500,000
Should we make or buy part 4A?

Opportunity Cost
An opportunity cost is the benefit that is
foregone as a result of pursuing some
course of action.
Opportunity costs are not actual dollar outlays
and are not recorded in the formal accounts
of an organization.
How would this concept potentially relate to

the Essex Company?
Prepare an analysis
showing whether a special
order should be accepted.
Key Terms and Concepts
A special order is a one-time

order that is not considered
part of the company’s normal
ongoing business.
When analyzing a special

order, only the incremental
costs and benefits are
relevant.
Special Orders
 Jet, Inc. makes a single product whose normal

selling price is $20 per unit.
 A foreign distributor offers to purchase 3,000
units for $10 per unit.
 This is a one-time order that would not affect the
company’s regular business.
 Annual capacity is 10,000 units, but Jet, Inc. is
currently producing and selling only 5,000 units.
Should Jet accept the offer?

Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Marketing costs 20,000
Total fixed costs 48,000
Special Orders
If Jet accepts the offer, net operating

income will increase by $6,000.
Increase in revenue (3,000 × $10) $ 30,000
Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 6,000
Note: This answer assumes that fixed costs are

unaffected by the order and that variable marketing
costs must be incurred on the special order.
Determine the most

profitable use of a
constrained resource and
the value of obtaining
more of the constrained
resource.
Key Terms and Concepts
When a limited resource
of some type restricts
the company’s ability to
satisfy demand, the
company is said to have
a constraint.
The machine or process

that is limiting overall
output is called the
bottleneck – it is the
constraint.
Utilization of a Constrained
Resource
• When a constraint exists, a company should
select a product mix that maximizes the total
contribution margin earned since fixed costs
usually remain unchanged.
• A company should not necessarily promote
those products that have the highest unit
contribution margin.
• Rather, it should promote those products
that earn the highest contribution margin in
relation to the constraining resource.
Resource: An Example
Ensign Company produces two products and
selected data are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.
Resource
• Machine A1 is the constrained resource
and is being used at 100% of its
capacity.
• There is excess capacity on all other
machines.
• Machine A1 has a capacity of 2,400
minutes per week.
Should Ensign focus its efforts on

Product 1 or Product 2?
Resource
The key is the contribution margin per unit of
the constrained resource. 1
P roduct
2
Contributi on m a rgi n pe r uni t $ 24 $ 15
Ti m e re qui re d to produce one uni t ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contributi on m a rgi n pe r m i nute $ 24 $ 30
Product 2 should be emphasized. Provides more

valuable use of the constrained resource machine A1,
yielding a contribution margin of $30 per minute as
opposed to $24 for Product 1.
Resource
The key is the contribution margin per unit of
the constrained resource.
Contribution m a rgi n pe r uni t $
1
24
P roduct
$
2
15
Ti m e re qui re d to produce one uni t ÷ 1. 00 m i n. ÷ 0. 50 m in.
Contribution m a rgi n pe r m inute $ 24 $ 30
If there are no other considerations, the best

plan would be to produce to meet current
demand for Product 2 and then use remaining
capacity to make Product 1.
Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)
Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.
Resource

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Resource

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units
Resource
According to the plan, we will produce 2,200
units of Product 2 and 1,300 of Product 1.
Our contribution margin looks like this.
Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000
The total contribution margin for Ensign is $64,200.

Managing Constraints
Finding ways to At the bottleneck itself:

process more • Improve the process
units through a • Add overtime or another shift
resource
bottleneck
• Hire new workers or acquire
more machines
• Subcontract production
• Reduce amount of defective
units produced
• Add workers transferred from
non-bottleneck departments
Prepare an analysis
showing whether joint
products should be sold at
the split-off point or
processed further.
Joint Costs
• In some industries, a number of end
products are produced from a single raw
material input.
• Two or more products produced from a
common input are called joint products.
• The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off point.
Joint Products
Oil
Common
Joint
Production Gasoline
Input
Process
Chemicals
Split-Off
Point
Joint Products
Joint
Costs Oil
Separate Final
Processing Sale
Common
Joint Final
Production Gasoline
Input Sale
Process
Separate Final
Chemicals
Processing
Sale
Split-Off Separate
Point Product
Costs
The Pitfalls of Allocation
Joint costs are often
allocated to end products on
the basis of the relative
sales value of each product
or on some other basis.
Although allocation is needed for

some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.
Sell or Process Further
Joint costs are irrelevant in decisions
regarding what to do with a product from
the split-off point forward.
It will always be profitable to continue

processing a joint product after the split-
off point so long as the incremental
revenue exceeds the incremental
processing costs incurred after the split-
off point.
Sell or Process Further: An
Example
• Sawmill, Inc. cuts logs from which
unfinished lumber and sawdust are the
immediate joint products.
• Unfinished lumber is sold “as is” or
processed further into finished lumber.
• Sawdust can also be sold “as is” to
gardening wholesalers or processed
further into “presto-logs.”
Data about Sawmill’s joint products

includes:
Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40
Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20
Analysis of Sell or Process Further

Per Log
Lumber Sawdust
Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Per Log
Lumber Sawdust

Profit (loss) from further processing $ 80 $ (10)
Per Log
Lumber Sawdust

Profit (loss) from further processing $ 80 $ (10)
Should we process the lumber further

and sell the sawdust “as is?”
BASIC FRAME WORK OF BUDGET
What is budget
* A financial document used to project future income and
expenses. The budgeting process may be carried out by
individuals or by companies to estimate whether the
person/company can continue to operate with its
projected income and expenses.It is a plan for saving,
borrowing and spending
• An itemized forecast of an individual's or company's
income and expenses expected for some period in the
future. With a budget, an individual is able to carefully
look at how much money they are taking in during a given
period, and figure out the best way to divide it among a
variety of categories
• A detailed quantitative plan for acquiring and using
financial and other resources over a specified future time
• Budgeting.
The act of preparing a budget is called
budgeting.
• Budgetary control
The use of budgets to control an
organization’s activity is known as
budgetary control
Why budget?
Why important for an organisation, project or department to
have a budget?
• An essential management tool. Without a budget, you are like a pilot

navigating in the dark without instruments.
• The budget tells you how much money you need to carry out your
activities.
• The budget forces you to be rigorous in thinking through the
implications of your activity planning. At times when the realities of
the budgeting process force you to rethink your action plans.
• Used properly, the budget tells you when you will need funds to
• carry out your activities.
• The budget enables you to monitor your income and expenditure
• The budget is a basis for financial accountability and transparency.
How much should have been spent and received & actual results ??
• You cannot raise money from donors unless you have a budget.
Donors use the budget as a basis for deciding what you are asking
for is reasonable and well-planned.
Who should be involved in budgeting?
• Budgeting is a difficult and responsible job.
• Whoever does the budgeting must:
- Understand the values, strategy and plans of the organisation
- Understand what it means to be cost effective and cost efficient
- Understand what is involved in generating and raising funds. It is
usually a good idea to have a small budgeting team. This mean that one
person does a draft budget which is then discussed and commented on
by the team.
• The following would normally be involved in the budgeting process:
The Finance Manager; Marketing Manager, Purchase Manager

Project Manager and/or Director of the organisation or department.
• Where an organisation has branches and /or regions, or several departments, then each
branch, region or department should draw up the budget for its own work. These budgets
then need to be consolidated (put together) in an overall budget for the organisation. Each
branch, region or department should be able to see how its budget fits into the overall budget,
and should be able to monitor its budget on a monthly basis. Financial monitoring works best
when those closest to the spending take responsibility for the budget
Planning and Control
Planning – Control –
involves involves the
developing steps taken by
objectives and management
preparing various that attempt to
budgets to achieve ensure the
these objectives. objectives are
attained.
BUDGETING – ADVANTAGES
( What can budgeting do for you )
• Planning orientation ( Define Goals & Objectives –
Thinkabout plans & Communicate )
Budget process takes management away from its short-
term, day-to-day management of the business and
forces it to think longer-term. This is the chief goal of
budgeting, even if management does not succeed in
meeting its goals as outlined in the budget - at least it is
thinking about the company's competitive and financial
position and how to improve it.
• Profitability review.
A properly structured budget points out what aspects of
the business produce money and which ones use it,
which forces management to consider whether it should
drop some parts of the business, or expand in others.
BUDGETING – ADVANTAGES- CONT--
• Assumptions review.
The budgeting process forces management to think about
why the company is in business, as well as its key
assumptions about its business environment. A periodic
re-evaluation of these issues may result in altered
assumptions, which may in turn alter the way in which
managements decides to operate the business.
• Performance evaluations.
You can work with employees to set up their goals for a
budgeting period, and possibly also tie bonuses or other
incentives to how they perform. You can then create
budget versus actual reports to give employees feedback
regarding how they are progressing toward their goals.
This system of evaluation is called responsibility Acct

• Funding planning.
A properly structured budget should derive the amount of cash that
will be spun off or which will be needed to support operations. This
information is used by the treasurer to plan for the company's
funding needs.
• Cash allocation.
There is only a limited amount of cash available to invest in
fixed assets and working capital, and the budgeting process forces
management to decide which assets are most worth investing in.
• Bottleneck analysis. ( Uncover bottle necks )

Nearly every company has a bottleneck somewhere, and the
budgeting process can be used to concentrate on what can be done
to either expand the capacity of that bottleneck or to shift work
around it.
• Other advantages of budget
• 1. You can actually SEE whether or not you
spend more than you make
.
• 2. You are immediately forced to think about
how to correct problems if you have them
• 3. It helps everyone involved come to the

same level of understanding
The Budget Committee
Functions & Responsibilities
A standing committee responsible for
– overall policy matters relating to the budget
– coordinating the preparation of the budget
– Settlement of disputes between segments
of organisation
– Approve final budget & receive periodic
reports on the progress in attaining budget
goals.
Self-Imposed Budget
Top M an ag em en t
M id d le M id d le
M an ag em en t M an ag em en t
S u p ervis or S u p ervisor S u p ervisor S u p ervis or
A budget is prepared by managers with the full cooperation

And participation of other managers at all levels and disputes
resolved with consultation. A participative
budget is also known as a self-imposed budget.
Self-Imposed Budget
Point for considerations
If no control and system of check &
balance is present, self-imposed budget
may be too loose and allow too much
“budgetary slack.” The result will be
inefficiency and waste. Therefore,
immediate superiors must carefully review
any self-imposed budget.
Advantages of Self-Imposed Budgets
1. Individuals at all levels of the organization are viewed
as members of the team whose judgments are valued
by top management.
2. Budget estimates prepared by front-line managers are
often more accurate than estimates prepared by top
managers.
3. Motivation is generally higher when individuals
participate in setting their own goals than when the
goals are imposed from above.
4. A manager who is not able to meet a budget imposed
from above can claim that it was unrealistic. Self-
imposed budgets eliminate this excuse.
Human Factors in Budgeting
The success of budgeting depends upon
three important factors:
1. Top management must be enthusiastic
and committed to the budget process.
2. Top management must not use the
budget to pressure employees or blame
them when something goes wrong.
3. Highly achievable budget targets are
usually preferred when managers are
rewarded based on meeting budget
targets.
Self-Imposed Budgets
Most companies do not rely exclusively upon
self-imposed budgets in the sense that top
managers usually initiate the budget process
by issuing broad guidelines in terms of overall
profits or sales.
A stretch level budget /
A highly achievable budget
• In establishing a budget, how challenging should budget
targets be?
• A stretch level budget is one that has only a small
chance of being met and in fact may be met less than
half the time by even the most capable managers.
• A highly achievable budget is one that is challenging,
but which can be met through hard work. Managers
usually prefer highly achievable budgets. Such budgets
are generally coupled with bonuses that are given when
budget targets are met, along with added bonuses when
these targets are exceeded.
Are believed to build a manager's confidence and to
generate commitment to the budget program.
The Master Budget: An Overview
• The master budget is a summary of
company's plans that sets specific targets
for sales, production, distribution and
financing activities. It generally culminates
in a cash budget, a
budgeted income statement, and a
budgeted balance sheet. In short, this
budget represents a comprehensive
expression of management's plans for
future and how these plans are to be
accomplished.
The Master Budget: An Overview
Sales
Budget
Ending
Finished Goods
Budget Selling and
Production
Administrative
Budget
Budget
Direct Direct Manufacturing

Materials Labor Overhead
Budget Budget Budget
Cash
Budget
Budgeted Financial Statements

The Master Budget
• Advantages and Disadvantages
Some advantages of a master budget are
– It can give an idea of where a company wants to go
and what it has to do in order to get there.
– It will also allow the company to realistically project
future cash flows which in turn would help in getting
certain types of financing.
• Some disadvantages of a master budget
include the time involved in producing such a
budget. This is primarily the reason a smaller
company may not make a master budget if the
company has a very small managerial staff.
Sales Budget
• The sales budget expressed in both dollars and units
is the starting point in preparing the master budget.
• A detailed schedule showing the expected sales for the
budget period
• All other items in the master budget including production,
purchase, inventories, and expenses, depend on it in
some way. The sales budget is constructed by
multiplying the budgeted sales in units by the selling
price.
• An accurate sales budget is the key to the entire
budgeting in some way. If the sales budget is sloppily
done then the rest of the budgeting process is largely a
waste of time.
• The sales budget help determine how many units will
have to be produced.
Sales Budget - Sample

HAMPTON FREEZE, INC.
Sales Budget
For the Year Ended December 31, 2003
Quarter
1 2 3 4 Year
Budgeted sales in cases 10,000 30,000 40,000 20,000 100,000
Selling price per case $ 20.00 $ 20.00 $ 20.00 $ 20.00 $ 20.00
-----------
------------ ------------ ------------ ------------
-
Total sales $ 200,000 $600,000 $800,00 $400,000 2,000,000
====== ====== ====== ====== ======
Percentage of sales collected in the
70%
period of the sales
Percentage of sales collected in the
30%
period after the sales
70% 30%
Sales Budget – Sample
Expected cash collection
Schedule of Expected Cash Collections
Accounts receivable, beginning
1 $90,000 $90,000
balance
2 First quarter sales 140,000 $60,000 200,000
3 Second quarter sales 420,000 $180,000 600,000
4 Third quarter sales 560,000 $240,000 800,000
5 Fourth quarter sales 280,000 280,000
----------- ----------- ----------- ----------- -----------
6 Total cash collections $230,000 $480,000 $740,000 $520,000 $1,970,000
1 Cash collections from last years fourth-quarter sales.
2 $200,000 × 70%; $200,000 × 30%
3 $600,000 × 70%; $600,000 × 30%
4 $800,000 × 70%; $800,000 × 30%
5 $400,000 × 70%
6 Uncollected fourth quarter sales appear as accounts receivable on the company's end of year balance sheet.
Budgeting Example
 Royal Company is preparing budgets for the
quarter ending June 30.
 Budgeted sales for the next five months are:
 April 20,000 units
 May 50,000 units
 June 30,000 units
 July 25,000 units
 August 15,000 units.
 The selling price is $10 per unit.
The Sales Budget
The individual months of April, May, and June are
summed to obtain the total projected sales in units
and dollars for the quarter ended June 30th
Expected Cash Collections
• All sales are on account.
• Royal’s collection pattern is:
 70% collected in the month of sale,
 25% collected in the month following
sale,
 5% uncollectible.
• The March 31 accounts receivable
balance of $30,000 will be collected in
full.
From the Sales Budget for May.

Production Budget
• The production budget is prepared after the sales budget
. The production budget lists the number of units that must
be produced during each budget period to meet sales
needs and to provide for the desired ending inventory.
- Budgeted sales in units -------------------

- Add desired ending inventory ------------------
=Total need ------------------
- less beginning inventory --------------------
=Required production -------------------
Production requirements for a period are influenced by the
desired level of ending inventory. Inventories should be
carefully planned. Excessive inventories tie up funds and
create storage problems. Insufficient inventories can lead
to either lost sales or crash production efforts in the
following period.
Production Budget
Hampton Freeze, Inc.
Production Budget
Quarter
1 2 3 4 Year
Budgeted sales (see sales budget) 10,000 30,000 40,000 20,000 100,000
Add desired ending inventory of finished goods* 6,000 8,000 4,000 3,000 3,000
------------ ------------ ------------ ----------- -----------
Total needs 16,000 38,000 44,000 23,000 103,000

Less Beginning inventory of finished goods** 2,000 6,000 8,000 4,000 2,000
------------ ------------ ------------ ------------ ------------
Required production 14,000 32,000 36,000 19,000 101,000
====== ====== ====== ====== ======

*Twenty percent of the next quarters sales. The ending inventory of 3,000 cases is assumed
**The beginning inventory in each quarter is the same as the prior quarter's ending inventory
The Production Budget
• The management at Royal Company

wants ending inventory to be equal to 20%
of the following month’s budgeted sales in
units.
• On March 31, 4,000 units were on hand.
 Let’s prepare the production budget.

Budgeted May sales 50,000

Desired ending inventory % 20%
March 31
Desired ending inventory 10,000
ending inventory
Direct Materials Budget
• Direct materials budget is prepared after computing
production requirements by preparing a production budget
. Direct materials budget or materials budgeting details
the raw materials that must be purchased to fulfill the
production requirements and to provide for adequate
inventories. The required purchases of raw materials are
computed as follows:

- Raw materials needed to meet the production schedule
- Add desired ending inventory of raw materials
=Total raw materials needs
- Less beginning inventory of raw materials
=Raw materials to be purchased
Direct materials budget is usually accompanied by a

schedule of expected cash disbursements for raw
materials. This schedule is needed to prepare the overall
cash budget
Quarter
1 2 3 4 Year
Required production in cases (see

14,000 32,000 36,000 19,000 101,000
production budget page)
Raw materials needed per case (pounds) 15 15 15 15 15
Production needs (pounds) 210,000 480,000 540,000 285,000 1,515,000
1 Add desired ending inventory of raw material 48,000 54,000 28,500 22,500 22,500
Total needs 258,000 534,000 568,500 307,500 1,537,500
Less beginning inventory of raw materials 21,000 48,000 54,000 28,500 21,000
Raw materials to be purchased 237,000 486,000 514,000 279,000 1,516,500
Cost of raw materials per pound $0.20 $0.20 $0.20 $0.20 $0.20
Cost of raw materials to be purchased $47,400 $97,200 $102,900 55,800 $303,300
=====
======= ======= ======= = =======
=
Percentage of purchases paid for in the period of the

50%
purchase
Percentage of purchase paid for in the period after

50%
purchase
50% 50%
Schedule of Expected Cash Disbursement for Materials
2 Accounts payable, beginning balance $25,800 $25,800
3 First-quarter purchase 23,700 $23,700 47,400
4 Second-quarter purchases 48,600 $48,600 97,200
5 Third-quarter purchase 51,450 $51,450 102,900
6 Fourth-quarter purchase 27,900 27,900
---------- ---------- ---------- ---------- ----------
Total cash disbursement $49,500 $72,300 $100,050 $79,350 $301,200

1 Ten percent of the next quarter's needs. For example, the second-quarter production needs are 480,000 pounds.
Therefore, the desired ending inventory for the first quarter would be 10% 480,000 pounds = 48,000 pounds. The
ending inventory of 22,500 pounds for the quarter is assumed
2 Cash payments for the last year's fourth-quarter materials purchases.
3 $47,500 × 50%; $47,500 × 50%.
4 $97,200 × 50%; $97,200 × 50%.
5 $102,900 × 50%; $102,900 × 50%.
6 $55,800 × 50%. Unpaid fourth quarter's purchases appear as accounts payable on the company's end of year balance
sheet
The Direct Materials Budget
Assumed ending inventory

Expected Cash Disbursement for
Materials
• Royal pays $0.40 per pound for its
materials.
• One-half of a month’s purchases is paid for
in the month of purchase; the other half is
paid in the following month.
• The March 31 accounts payable balance is
$12,000.
 Let’s calculate expected cash
disbursements.
Expected Cash Disbursement for
Materials
Expected Cash Disbursement for Materials
Direct Labor Budget
• The direct labor budget is developed

from the production budget. Direct labor
requirements must be computed so that
the company will know whether sufficient
labor time is available to meet the
budgeted production needs. By knowing in
advance how much labor will be needed
throughout the budget year, the company
can develop plans to adjust the labor force
as situation requires
Direct Labor Budget
Direct Labor Budget
Quarter
1 2 3 4 Year
Required production in cases (

14,000 32,000 36,000 19,000 101,000
see production budget page)
Direct labor hours per case 0.40 0.40 0.40 0.40 0.40
-------- --------- -------- -------- --------
Total direct labor hours needed 5,600 12,800 14,400 7,600 40,400
Direct labor cost per hour $15.00 $15.00 $15.00 $15.00 $15.00
-------- -------- -------- -------- --------
Total direct labor cost* $84,000 $192,000 $216,000 $114,000 $606,000
===== ===== ===== ===== =====

* This schedule assumes that the direct labor work force will be fully adjusted to the total
direct labor hours needed each quarter.
The Direct Labor Budget
• At Royal, each unit of product requires 0.05 hours
(3 minutes) of direct labor.
• The Company has a “no layoff” policy so all
employees will be paid for 40 hours of work each
week.
• In exchange for the “no layoff” policy, workers agree
to a wage rate of $10 per hour regardless of the
hours worked (no overtime pay).
• For the next three months, the direct labor
workforce will be paid for a minimum of 1,500 hours
per month.
 Let’s prepare the direct labor budget.
Greater of labor hours required

or labor hours guaranteed.
Manufacturing Overhead Budget:
Following is the manufacturing overhead budget of Hampton Freeze Inc. (Hampton Freeze Inc.
Manufacturing Overhead Budget
Quarters
1 2 3 4 Year
)see direct labor budget( Budgeted direct labor hours 5,600 12,800 14,400 7,600 40,400
Variable overhead rate $4.00 $4.00 $4.00 $4.00 $4.00
--------- --------- --------- --------- ---------
Variable manufacturing overhead $22,400 $51,200 $57,600 $30,400 $161,600
Fixed manufacturing overhead 60,600 60,600 60,600 60,600 242,400
--------- --------- --------- --------- ---------
Total manufacturing overhead 83,000 111,800 118,200 91,000 404,000
Less depreciation 15,000 15,000 15,000 15,000 60,000
--------- --------- --------- --------- ---------
Cash disbursement for manufacturing overhead $68,000 $96,800 $103,200 $76,000 $344,000
======= ======= ======= ======= =======

Total manufacturing overhead (a) $404,000
Budgeted direct labor-hours (b) 40,400
------------
Predetermined overhead rate for the year (a) / (b) $10.00
• At Royal, manufacturing overhead is applied to
units of product on the basis of direct labor
hours.
• The variable manufacturing overhead rate is
$20 per direct labor hour.
• Fixed manufacturing overhead is $50,000 per
month and includes $20,000 of noncash costs
(primarily depreciation of plant assets).
 Let’s prepare the manufacturing overhead

budget.
Total mfg. OH for quarter $251,000

= $49.70 per hour *
Total labor hours required 5,050
* rounded
Depreciation is a noncash charge.

Ending Finished Goods Inventory Budget
• After preparing sales budget, production budget,

direct materials budget, direct labor budget, and
manufacturing overhead budget the
management has all the data needed to
calculate unit product cost. This calculation is
needed for two reasons
• First, to determine cost of goods sold on the
budgeted income statement; and second, to
know what amount to put on the balance sheet
inventory account for unsold units. The carrying
cost of unsold units is calculated on the ending
inventory finished goods budget
Hampton Freeze Inc.
Absorption Costing Bases
Item Quantity Cost Total

Production Cost Per Case:
$0.20 per
Direct materials 15 Pounds $3.00
pound
15.00 per
Direct labor 0.40 hours 6.00
hour
10.00 per
Manufacturing overhead 0.40 hours 4.00
hour
---------
Unit product cost $13.00
======
Budgeted finished goods inventory:
Ending finished goods inventory (
3,000
see production budget)
Unit production cost (see above) $13.00
-----------
Ending finished goods inventory in dollars $39.00
Selling and Administrative Expense Budget
• At Royal, the selling and administrative expenses
budget is divided into variable and fixed components.
• The variable selling and administrative expenses are
$0.50 per unit sold.
• Fixed selling and administrative expenses are $70,000
per month.
• The fixed selling and administrative expenses include
$10,000 in costs – primarily depreciation – that are not
cash outflows of the current month.
Let’s prepare the company’s selling and

administrative expense budget.
Selling and Administrative Expense
Budget
Cash Budget | Cash Budgeting:
Cash budget is composed of four major
sections.
• The receipts section. ( Inflow ) except for
financing from banks like sales etc
• The disbursements section ( Outflow – planned
for budget like material, labour overheads, admin
and selling exp etc 7 equipment purchase,
dividend etc
• The cash excess or deficiency section
• The financing section
Cash Budget | Cash Budgeting
The cash excess or deficiency section is computed as follows:
Cash balance beginning XXXX

Add receipts XXXX
Total cash available --------
Less disbursements XXXX
XXXX
Excess (deficiency) of cash available over disbursements --------
XXXX
If there is a cash deficiency during any period, the company will

need to borrow funds
Cash balance, beginning $42,500 $40,000 $40,000 40,500 42,500
Add receipts:
1,970,00
Collections from customers See sales budget 230,000 480,000 740,000 520,000
0
2,012,50
Total cash available 272,500 520,000 780,000 560,500
0
Less disbursements:
Direct materials material budget 49,500 72,300 100,050 79,350 301,200

Direct labor Labor budget 84,000 192,000 216,000 114,000 606,000
Manufacturing overhead Overhead budget 68,000 96,800 103,200 76,000 344,000

Selling and Administrative sell. & adm. budget 93,000 130,900 184,750 129,150 537,800
Equipment purchases 50,000 40,000 20,000 20,000 130,000
Dividends 8,000 8,000 8,000 8,000 32,000
---------- ---------- ----------
------------ ------------
-- -- --
1,951,00
Total disbursements 352,500 540,000 632,000 426,500
0
---------- ---------- ----------
------------ ------------
-- -- --
Excess/deficiency of cash available over
(80,000) (20,000) 148,000 134,000 61,500
disbursements
Financing:
Borrowings (at beginning)* 120,000 60,000 - - 180,000
(100,000 (180,000
Payments (at beginning) - - (80,000)
) )
Interest** - - (7,500) (65,00) (14,000)
(107,500
Total financing 1200,000 (60,000) (86,500) (14,000)
Budgeted Income Statement
• A budgeted income statement can be
prepared from the data developed in:
• Sales budget
• Ending finished goods inventory budget
• Selling and administrative expense budget
• Cash budget
• It shows the company's planned profit for the

upcoming budget period, and it stands as a
benchmark against which subsequent company
performance can be measured.
Hampton Freeze Inc.
Other Budgets References
Sales Sales budget $2,000,000
Sales budget,
Less cost of goods sold* 1,300,000
Ending finished goods inventory budget
--------------
Gross margin 700,000
Less selling and administrative
Selling and administrative expense budget 577,800
expenses
--------------
Net operating income 122,200
Less interest expense Cash budget 14,000
--------------
Net income $108,200

Budgeted Balance Sheet
Hampton Freeze Inc.
December 31, 2009
Assets
Current assets:
Cash 1 $47,500
Accounts receivable 2 120,000
Raw materials inventory 3 4,500
Finished goods inventory 4 39,000
-------------
Total current assets $211,000
Plant and equipment:
Land 5 80,000
Building and equipment 6 830,000
Accumulated depreciation 7 (392,000)
--------------
Plant and equipment, net $518,000
--------------
Total assets $729,000
Hampton Freeze Inc.

December 31, 2009
Assets
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable (raw materials) 8 $27,000
Stockholders' equity:
Common stock, no par 9 $175,000
Retained earnings 10 526,000
--------------
Total stock holders' equity 701,100
--------------
Total liabilities and stockholders equity $729,000
Incremental budgeting
Based on slight changes from the

preceding period's budgeted results or
actual results. This is a common approach
in businesses where management does
not intend to spend a great deal of time
formulating budgets, or where it does not
perceive any great need to conduct a
thorough evaluation of the business
Incremental budgeting
The primary advantage
• It is simple to use, being based on either

recent financial results or a recent budget.
• Also, if a program requires funding for
multiple years in order to achieve a certain
outcome, incremental budgeting is
structured to ensure that the funds will
keep flowing to the program.
Incremental budgeting – Demerits
• Several downsides that make it a less than ideal choice.
• Incremental in nature. It assumes only minor changes from the

preceding period, when in fact there may be major structural
changes in the business or its environment
• Fosters overspending. It fosters an attitude of "use it or lose it"

in regard to budgeted expenditures, since a drop in
expenditures in one period will be reflected in future periods,
too.
• Budgetary slack. Managers tend to build too little revenue

growth and excessive expenses, so that they will always have
favorable variances.
• Budget review. When the budget is carried forward with minor

changes, there tends to be little incentive to conduct a
comprehensive review of the budget, so that inefficiencies and
budgetary slack are automatically rolled into new budgets.
Incremental budgeting – Demerits
• Variance from actual. When the incremental budget is based on

a prior budget, there tends to be a growing disconnect between
the budget and actual results
• .
• Perpetuates resource allocations. If a certain amount of funds
were allocated to a specific business area in a prior budget,
then the incremental budget assures that funding will be
allocated there in the future, too
• Risk taking. Since an incremental budget allocates most funds
to the same uses every year, it is difficult to obtain a large
funding allocation to direct at a new
• In short, incremental budgeting results in such a conservative
mindset in a business that it may actually be a noticeable driver
in destroying a company over the long term
Zero Based Budgeting (ZBB)
• The base line is zero rather than last

year's budget.
• Required to justify all budgeted
expenditures, not just changes in the
budget from the previous year
• Is an alternative approach that is
sometimes used particularly in
government and not for profit sectors of
the economy.
• Zero based budgeting approach Requires

considerable documentation. The manager must prepare
a series of decision packages in which all of the activities
of the department are ranked according to their relative
importance and the cost of each activity is identified
• Under zero based budgeting (ZBB) ,the review is
performed every year.. Whether or not a company
should use annual reviews is a matter of judgment. In
some situations, annual zero based reviews may be
justified; in other situations they may not because of the
time and cost involved. However, most managers would
at least agree that on occasion zero based reviews can
be very helpful.
Advantages | benefits
* Efficient allocation of resources, as it is based on needs and

benefits.
• Drives managers to find cost effective ways to improve operations.
• Detects inflated budgets.
• Municipal planning departments are exempt from this budgeting
practice.
• Useful for service departments where the output is difficult to
identify.
• Increases staff motivation by providing greater initiative and
responsibility in decision-making.
• Increases communication and coordination within the organization.
• Identifies and eliminates wasteful and obsolete operations.
• Identifies opportunities for outsourcing.
• Forces cost centers to identify their mission and their relationship to
overall goals.
Disadvantages | Limitations.
• Difficult to define decision units and decision packages, as it is time-

consuming and exhaustive.
• Forced to justify every detail related to expenditure. The research
and development (R&D) department is threatened whereas the
production department benefits.
• Necessary to train managers. Zero based budgeting (ZBB) must be
clearly understood by managers at various levels to be successfully
implemented. Difficult to administer and communicate the budgeting
because more managers are involved in the process.
• In a large organization, the volume of forms may be so large that no
one person could read it all. Compressing the information down to a
usable size might remove critically important details.
• Honesty of the managers must be reliable and uniform. Any manager
that exaggerates skews the results.
Rolling budget
• A rolling budget ( also known as a continuous budget, a perpetual
budget, or a rolling horizon budget.)
• We will use the following example to explain the meaning of a
rolling budget.
• Let’s assume that a company’s accounting year ends on each
December 31. Prior to the start of the year 2011, the company
prepares its annual budget which is detailed by month for January
through December 2011. This budget could become a rolling budget
if after January 2011 the company drops the budget for January
2011 and adds the budget for January 2012. This rolling budget now
covers the one year, or 12-month, period of February 1, 2011
through January 31, 2012. At the end of February 2011, the rolling
budget will drop February 2011 and will add February 2012. At this
point the rolling budget will cover the one year period of March 1,
2011 through February 29, 2012.
• The benefit of a rolling budget is that the company’s management
will always have a budget that looks forward for one full year.
Rolling budget
• Advantages and Disadvantages of the
Rolling Budget
• This approach has the advantage of having
someone constantly attend to the budget model
and revise budget assumptions for the last
incremental period of the budget. The downside
of this approach is that it may not yield a budget
that is more achievable than the traditional
static budget, since the budget periods prior to
the incremental month just added are not
revised.
Flexible budget?
• A flexible budget, or “flex” budget, itemizes
different expense levels depending upon changes
in the amount of actual revenue. This approach
varies from the more common static budget,
which contains nothing but fixed amounts that do
not vary with actual revenue levels.
• In its simplest form, the flex budget will use
percentages of revenue for certain expenses,
rather than the usual fixed numbers. This allows
for an infinite series of changes in budgeted
expenses that are directly tied to revenue volume
Flexible budget
Advantages
• Since the flexible budget restructures itself based on activity
levels, it is a good tool for evaluating the performance of
managers
Disadvantages
• Though the flex budget is a good tool, it can be difficult to
formulate and administer. One problem with its formulation is
that many costs are not fully variable, instead having a fixed
cost component that must be included in the flex budget
formula.
• Another issue is that a great deal of time can be spent
developing step costs, which is more time than the typical
accounting staff has available, especially when in the midst of
creating the standard budget. Consequently, the flex budget
tends to include only a small number of step costs, as well as
variable costs whose fixed cost components are not fully
recognized

Management Accounting

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Process Costing

• Costing method applicable where goods or services result

• Production quantity is uniform.

SIMILARITIES IN JOB ORDER AND PROCESS COSTING

• Both systems determine a product cost by measuring the

Job Order Costing

Compute output in terms of equivalent units.

• Equivalent units of production for a period

– Weighted Average method

* Makes no distinction between work done in prior

Double Diamond Skis reported the following

Units started into production in May 5,000

Units completed during May and 4,800 100% 100%

Ending work in process 400 40% 25%

Beginning work in process: 200 units

Materials: 55% complete $ 9,600

Production started during May 5,000 units

Costs added to production in May

Ending work in process 400 units

Here is a schedule with the cost and equivalent

Equivalent units 4,960 4,900

Here is a schedule with the cost and equivalent

Equivalent units 4,960 4,900

Shaping and Milling Department

Units completed and transferred out:

Cost accounted for as follows:

Ideally, the allocation base

Actual overhead for the period is not

Overhead applied = POHR × Actual activity

Actual amount of the allocation

POHR = $4.00 per DLH

For each direct labor hour worked on a

Cost Summary Units Shipped

Cost Summary Units Shipped

Compute under applied or

The difference between the overhead cost applied to

Underapplied overhead Overapplied overhead

Therefore- The marginal cost of an additional unit of output is the cost of

• In general terms, marginal cost at each level of

• Marginal cost does not include any sunk costs

• If the volume of output increases, the cost per unit in normal

• You might have observed that in absorption costing,

• Further, absorption costing is dependent on the

Fixed costs per year:

Under absorption costing, selling and

Let’s assume the following additional

• ABC seeks to identify cause and once costs of activities

ABC system have two costing systems-- -

• In traditional cost accounting systems, the objective is to value

• ABC methodology assigns an organization's resource costs

• Organization can soundly estimate the cost

• Used as a tool for understanding product

• Departmental Overhead Rates:

Rather than use a plant wide overhead rate (

For example, overhead costs in machining department may

Departmental Overhead Rates:

• Unfortunately, even departmental

• The Cost of Idle Capacity and Activity Based Costing

• In traditional cost accounting, predetermined