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BUSINESS 5

Strategic Planning
1. Market and risk analysis 3
2. Strategy development, implementation and monitoring 9
3. Planning techniques: Forecasting and projection 14
4. Planning techniques: Budget and analysis .44
5. Planning techniques: Coordinating information from various sources for integrated planning 72
6. Terminology 75
7. Class questions 77
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MARKET AND RISK ANALYSIS
The analysis of markets typically relates to the identification of markets and their contribution to strategic objectives. The
analysis of target markets followed by the variance analysis that generally accompanies sales and marketing decisions is
covered here. Risk analysis is described as part of the Enterprise Risk Management Integrated Framework published by the
Committee on Sponsoring Organizations (COSO) and provides a foundation for strategic planning.
I. ITARGET MARKET ANALYSIS IWho is Ol,\V cL\si-otMev
A. Target Markets from a Management Perspective
Careful analysis of the target market (the customer) is essential to development of a
consistent strategy that will contribute to the success of a company. 1) <sP fey
1. Positioning Strategy <Sc:l\les - o-P L.2) tit
Once the target market has been determined and properly analyzed for buying
patterns, perceptions, desires of the consumers, etc., the firm will attempt to position
itself and its strategy consistent with the customer's perception of the firm.
2. Illustration
The simple quadrant view of a hypothetical market is shown below. Clearly, the
innovator that focuses on product differentiation has targeted quadrant 1, while the
price leader has targeted quadrant 4.
SELECTIVE DISTRIBUTION

<sP t Voll.\lMe +
D II
STYLE FAD ---------+---------HIGHLYFUNCTIONAL
MASS DISTRIBUTION
B II
PVlce
<sP +Voll.\lMe t
B. Sales Variances and Target Market Analysis
Various types of sales variance analyses are valuable to a firm to evaluate the effectiveness
of its identification of target markets and its strategies to capture those markets. The sales
variance is comprised of various components, as briefly described below.
1. Sales Volume Variance
The sales volume variance is a flexible budget variance that distills volume activity from
other sales performance components. The sales volume concept can be refined to
include analysis of sales mix, market share and selling price. The basic sales volume
variance is as follows:
[
Actual BUdgeted]
Sales volume variance = Id . - I . x Standard,contribution margin per unit,
so units sa es units
<sp-vc
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Sales Mix Variance
The sales mix variance evaluates the impact of the company's departure from the
planned mix of products anticipated by its budget.
5 I . . _ [Actual product _ Budgeted PrOduct] Actual Budgeted contribution margin
a es mix variance - sales mix ratio sales mix ratio x sold units x per unit of that product
3. Sales Quantity and Market Variances
a. Sales Quantity Variance
The sales quantity variance is a measure of the change in the number of actual
sold units from those budgeted and can be expanded to include analysis of the
anticipated size of the market and the share of the target market.
[ ]
Budgeted contribution
Product sales _ Actual sold _ Budgeted sales Budgeted product . 't
. . - . . x .. x mar In er unl
quantity variance units of product units of product sales mix ratio f h
g
P d
o t at pro uct
b. Market Size Variance -rotc:l\l sc:l\les o-P h,,)Cl.wy Cc:l\vS
The market size variance is a measure of the effect the size of the entire market
for the product has on the contribution margin for the firm.
(1) Interpretation and Use
A firm increases its market size by capturing additional sales in existing
markets or broadening its appeal to other target markets.
(2) Strategic Risks
Seeking other target markets is often a difficult and risky direction for
management to make since it involves the decision to allocate new
resources to new markets, even considering the fact that the potential to
increase profits often far exceeds a similar effort in increasing market
share in existing target markets. Firms risk declines in revenues and
overcapacity if their efforts take place in a time of declining market size.
. [ ] Budgeted contribution
Market SIZe Actual market Expected market Budgeted . .
. =.. . - . . . x x mar In er unit
variance size (In units) size (In units) market share ( . hgt d
P
)
welg e -average
-
o-P l\o\AL\stvy

c. IMarket Sharelvariance - OL\v %o-P lL\)CL\vy
The market share variance measures the effect of a firm's market share on the
firm's contribution margin.
(1) Interpretation and Use
When the market share variance iitavorable) it is a sign that the company
is successful in a strategy designed to build market share. (Note that
although a differentiation strategy is likely not to focus on building market
share, a reduction in expected market share would still seriously affect the
profit of the firm.)
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(2) Strategic Risks
Achieving target market share is often a crucial element in a firm's strategic
plan, and a decrease in market share is almost never a positive sign
because it generally means competitors have entered the market and/or
the firm's competitive advantage has been reduced.
[ ]
Budgeted contribution
Market share Actual Budgeted Actual ""t
. = - x" "x mar In er unl
variance market share market share Industry units ( . hgt d
P
)
welg e -average
4. Selling Price Variance (or sales revenue flexible budget variance)
The selling price variance measures the aggregate impact of a selling price different
from budget. The decision of a firm to increase or decrease selling price is one that is
relatively simple to implement; however, pricing policies must be evaluated in relation
to success (or failure) of other variable components.
a.
b.
II. RISK ANALYSIS
Strategy and Mission ,,;Jr voh",,,,,e
Firms may reduce prices in an effort to move into a cost leadership strategy or
increase rices in an effort to ut a differentiation strate into lace. Variance
results have specific implications in analyzing the effectiveness of the firm in
reaching its target markets. Voh",,,,,et b""t <spt
Interpretation
A favorable variance in price and market share may exhibit untapped profit
potential for a firm. On the other hand, if a firm plans to increase its market share
or sales volume simply by reducing sales prices, it may risk reducing the
profitability of the firm if the expected volume increase is not enough to cover the
reduction in price.
[
Actual SP Budgeted SP ]
Selling price variance = xActual sold units
Unit Unit
Risk analysis is integral to an organization's strategic planning process. Analysis of risk includes a
number of specific components identified by the Committee on Sponsoring Organizations (COSO).
A. Objective Setting
1. Entity-wide objectives are established (e.g., market position, profitability, etc.).
2. Sub-objectives associated with operations, reporting, etc., support entity-wide
objectives.
3. Objectives are set within an organization's risk appetite.
a. IRisk appetitelis the organization's willingness to bear risk. - Level o-P VlS\::.
b. Risks are identified in terms of possible events which are, in turn, characterized
by their likelihood (probability) and impact (severity).
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o-P-Pshove oil c.

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IRisk-averselorganizations are generally willing to assume high impact risks if
there is a I<DW likelihood of occurence, and similarly, accept a higher liklihoo<Jl of
occurrence of low impact risk.
Risk appetite can generally be expressed in terms of a "risk map" as follows:
ANALYSIS OF RISK APPETITE
Exceeds Risk Appetite
E",vlvo",,,,,,e,,,tOl.l
AOl.""'0l.8
e
;=
o
..J
Low
AN elL L A RY MAT ERI A L (for Independent ReView)
Medium
(Likelihood)
High
O-P
OCCL\V've",ce
oil spl11
B. Event Identification
1. Events are Classified as Either Positive or Negative
a. Negative Events (risks)
Risks require assessment and response
b. Positive Events (opportunities)
Opportunities require consideration in establishing objectives
2. Organizations May Use a Variety of Event Identification Techniques
a. Event Inventories
Management develops listings of potential events based on internal or generic
data.
b. Event Workshops
A facilitator brings together a cross functional team to develop a listing of events
that could pose risks.
c. Interviews
One on one interviews are conducted to solicit the candid views of staff.
Bs-6
d. Questionnaires and Surveys
Questionnaires or surveys are provided to the most relevant staff for responses.
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e. Process Flow Analysis
Flow chart analyses of processes are prepared and reviewed for potential risks.
f. Leading Event Indicators and Escalation Triggers
Potential events and their lead indicators are identified. A threshold associated
with the lead indicator is identified for management to act.
g. Loss Event Tracking
Statistics pertaining to loss events are documented in a schedule. Information
such as lost time and associated costs are developed and distributed to relevant
staff.
h. Ongoing Event Identification
Data sources of possible event discovery are listed and classified by both
external and internal factors. For example, political lobbyists would provide
insight with regard to external political factors.
C. Risk Assessment
1. Risks are Assessed on an Inherent and Residual Basis
a. Inherent risk for the enterprise is similar in concept to the idea of inherent risk in
audits. It represents the risk to an organization when management takes no
action to limit likelihood or impact of risk.
b. Residual risk is the risk that remains after management has taken action to
mitigate the risk.
c. Risk maps define risk exceeding the risk appetite as the amount of residual risk
the organization is not willing to bear.
2. Risks are Evaluated from the Perspective of Their Likelihood and Impact
a. Likelihood represents the probability of occurrence.
b. Impact represents the degree to which the risk will impede achievement of
organizational objectives.
3. Risks are Evaluated on a Quantitative and Qualitative Basis
a. Qualitative Methods
(1) Nominal Measurements
Grouping of events into like kinds.
(2) Ordinal Measurements
Listing of events in order of importance.
b. Quantitative Methods
(1) Interval Measurement
Numerical scale measurements of events.
(2) Ratio Measurement
Proportional scale measurements of events.
END OF ANCILLARY MATERIAL
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International Risk Assessment - Accounting Practices
1. IInternational business with it the risk that reported financial data are
inconsistent with U.S. GAAP and IFRS. These differences cause the following types of
risk:
a. (Process Risk)
Process controls, data, and systems used to collect new information required by
IFRS and accounting policies are inadequate to sustain two reporting systems
under GAAP and IFRS.
b. (System Risk)
New configuration settings and data mappings will need to be defined,
implemented, and embedded into the reporting system to facilitate dual reporting
in U.S. GAAP and IFRS.
c. General Business Risk
Existing contract terms, entities, covenants, legal agreements, vendor, and
consumer relationships will need to be reassessed to see if and how they
conform to requirements under IFRS.
2. The International Accounting Standards to make standards
equivalent or compatible through the issuance and use of International Financial
Reporting Standards (IFRS) as a means of mitigating the risk of inconsistent reporting.
Bs-8
a.
tV
b.
Management must be aware of the local reporting requirements and act
accordingly. Some countries have replaced their local standards with those of
IFRS. Others have not. Some have hybrid reporting
D
' ,. , d did' . ..
Iscrepancles In reporting stan ar scan ea to inconsistencies In accounting
terminology and reporting practices that obfuscate financial reporting and detract
from U.S. GAAP's goal of financial reporting transparency.
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STRATEGY DEVELOPMENT, IMPLEMENTATION AND MONITORING
I. STRATEGY DEVELOPMENT
A. Strategy is Developed After Consideration of a Range of Choices
1. Strategy can be accomplished through different steps (e.g., market share can be
increased by acquisitions, or more aggressive marketing, etc.). Choices must be
evaluated relative to their likelihood of success.
2. Strategy links mission and values with related objectives (e.g., strategies involving
capturing larger market share would have implications on production objectives).
B. Strategy Development Considers Risk Ris\c. t Rei-lAY''' t
Strategy development and the establishment of organizational objectives are bounded by risk
appetite. Risk appetite will help guide resource allocation and coordinate the deployment of
people, processes and infrastructure throughout the organization.
1. Companies Must Establish a Risk Tolerance (Ris\c. el\ppei-li-e)
IRisk tolerancelmeasures acceptable levels of variation to the achievement of
management's objectives. Risk tolerance should be expressed in the same units as
the related objectives.
C. Components of Strategy ~ R oRe
Strategy represents organizational objectives, which are typically comprised of the following:
1. Strategic Objectives BEe '3
The hi h level oals that su 0 he mission and vision of the or anization and the
manner in which shareholder value will be created are considered strategic objectives.
Consideration of risk is inherent in setting strategic objectives. Management's selection
of objectives considers alignment of objectives with mission and vision and is
consistent with the organization's risk appetite.
2. Related Objectives
The specific objectives that permeate the organization in support of strategic
objectives are related objectives. Related objectives should be consistent with
strategic objectives as regards risk appetite and be both measurable and understood.
Related objectives are comprised of the following:
a. Operations Objectives
Efficiency and effectiveness of operations is the focus of operations objectives.
Objectives that call upon the organization to improve cycle time or adopt changes
in technology represent operations objectives.
b. Reporting Objectives
Relevance, accuracy and timeliness are typically the objectives for reporting.
Reporting objectives focus on both internal and external reports.
c. Compliance Objectives
Ongoing compliance with laws, rules and regulations (e.g., taxation and other
regulatory requirements regarding pricing or workplace safety) is the focus of
compliance objectives.
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II.
III.
ORGANIZATIONAL PERFORMANCE MEASURES
A. (Performance Measures} General
Performance measures used by the business enterprise not only contemplate comparison of(i)
actual results for the organization to plans, they also include the process of developing the
performance measures for the organization in relation to either the industry or industry
component in which the enterprise competes.
B. Performance Measures - Organizational
Performance measurement contemplates the ideas of overall organizational performance
measures in comparison to achievement of specific financial and non-financial standards as
well as comparisons to other organizations in relation to qualitative performance.
Organizational performance measures define the mechanics of the different types of
r+ {scorecardspr reports used to measure either financial or qualitative issues.
- Respo"sibilli-y is Aepe"Ae"t
FINANCIAL SCORECARDS - General L\pO" pV'opeV' eI\"A el\L\thoV'ii-y
Financial scorecards take many forms, including budget versus actual and other variance reports,
as well as overall analysis of business performance. Financial performance is often a function of
organizational decisions and the performance objectives given to each segment.
A. Types of Responsibility Segments
IResponsibility segmentsl sometimes referred to as strategic business units (SBUs), are
-ta generally classified around four financial measures (performance objectives) for which
managers may be held accountable. SBUs are highly effective in organizing performance
requirements and in establishing accountability for financial responsibility.
1.
Lowest
Cost SBU
Managers are held responsible for controlling costs.
2. Revenue SBU
Managers are held responsible for generating revenues.
"CRPI"
3. Profit SBU
Managers are held responsible for producing a target profit (accountability for both
revenues and costs).
BOel\V'A 4. Investment SBU "tw\ost ll\c.e eI\" i"Aepe"Ae"t bL\si"ess"
Managers are held responsible for return on the assets invested to produce the
earnings generated by the SBU.
B. Establishing Designs fo(Financial Scorecards)- Poi"teA "Al'
Thelfeedback functionllinks planning, control, and performance evaluations and is integral to
evaluating and reporting performance.
1. Accurate and Timely
Feedback must be accurate and timely to be effective.
2. Understandable
Performance measurement reports must be tailored to the audience receiving them to
ensure that they are understood and that they are focused on the accountability
measures.
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3. Specific Accountability
Strategic business units isolate a financial level of accountability for managers. The
effectiveness of each strategic business unit is often subdivided into additional
categories including:
a. Product Lines
Some strategic business units involve multiple products. Costs, sales, profits or
returns associated with each of these products can be analyzed for further insight
into the sources of profits or losses.
Geographic Areas
C.
-ta
Strategic business units also cross geographic boundaries. Performance can
generally be traced by geographic location or geographic market to provide
additional insight into results.
c. Customer
Often the most significant segment classification is a classification by major
customer. The relative profitability or losses associated with anyone customer
may influence management's decisions to either drop the customer or to
reevaluate the relationship in regards to any marginal benefits to the business
(e.g., contribution of the customer to fixed costs, etc.).
. . . .-Not CO\\Tvolle1\ble - ve\\t
Accounting DecIsions - Allocation ot(Common Costs) 1
Managers have(control):)Ver variable costs and over controllable fixed costs. Performanc}-r eel\se
evaluations dealing with controllable margins will factor in these costs. Common costs are
not controllable. Approaches to the rational allocation of central administrative costs must be
understood by responsible managers and must be fair and logical to motivate employees that
common costs do not represent an arbitrary burden.
Contribution margin measures the excess of revenues over variable costs (or the contribution
to fixed costs) for a company or division.
Controllable Margin
1. Definition
Contribution by SBU is a refinement of contribution margin reporting and represents the
difference between contribution margin and controllable fixed costs.
2. Identifying Controllable I Avoidable Fixed Costs
Controllable fixed costs are those costs that managers can impact in less than one year
(e.g., advertising and sales promotion).
B.
III. FINANCIAL SCORECARDS - Contribution Reporting
Profit SBUs are normally responsible for generating a level of profit in relation to controllable costs.
Contribution reporting formats are generally used to clearly show the degree to which the profit
strategic business units have generated has covered variable or controllable costs.
Contribution Margin == Co,,+volle1\ble
-t
Ct--\ - CFC ==
A.
Rev. - \lC == Ct--\
I
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Concept Example
The following concept example displays the manner in which a contribution by a SBU might
be displayed in a financial scorecard for a Profit SBU.
EXAMPLE
Delta Manufacturing has four regions that it has organized into Profit Strategic Business Units. Delta's Management has
designed a financial performance evaluation report that focuses on contribution margin and controllable margins. The
report is designed as follows:
Delta Manufacturing
Performance Evaluation
.....
Region 1 Region 2 Region 3 Region 4
Revenues 200 300 150 450
~ V a r i a b l e costs;> (150) (250) (125) (350)
~ Contribution margin 50 50 25 100
kControliable fixed costs;> (25) (25) (10) (50)
Controllable margin 25 25 15 50
Noncontrollable fixed costs (15) (15) (6) (44)
Contribution by SBU 10 10 9 6
Untraceable costs
Operating Income 10 10 9 6
Untraceable
Costs Total
1,100
(875)
225
(110)
115
(80)
35
(20) (20)
(20) 15
-ta B.
IV. INON-FINANCIALlscORECARDS
Non-financial scorecards provide formal reporting of qualitative and non-financial quantitative
dimensions of the business enterprise.
A. Types of Non-financial Data
1. Qualitative
Qualitative data represent those selected aspects of operations whose measurements
may often be difficult or imprecise and are generally not numerical. Employee morale,
QL\(:I\llty ~ customer satisfaction, etc., are examples of qualitative considerations.
2. Quantitative - (}\\L\tMevic(:I\l) :F Rev. "v e)Cp. "v pv,,-PH'
Quantitative considerations in various decisions represent those aspects of operations
whose measurements may be reduced to numerical measurements. Reduction in
travel time or distance displayed in hours or miles represents a non-financial
quantitative consideration.
Balanced Scorecard IIFICA
II
The balanced scorecard gathers information or{multiple dimensionspf an organization's
performance defined bylcritical success factorslr,ecessary to accomplish firm strategy.
Critical success factors are classified as:
Financial Pv,,-Pit IIA-rVCS
Il
Internal business processes E-P-Picie",t pV"AL\CH"'"
Customer satisfaction t--\(:I\vket s\!\(:I\ve
Advancement of innovation and human resource development (learning & growth) Rete",H"", ,,-P
key etMpl"yees
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1. Purpose
"FICA"
The purpose of a balanced scorecard is to emphasize that no one dimension of
operations will accomplish an organization's business objectives.
2. Sample Format
Balanced scorecards can be designed in any number of ways. Typically, the scorecard
describes the classifications of critical success factors, the strategic goals, the tactics,
and the related measures associated with both strategic and tactical goals.
EXAMPLE
Instafab Manufacturing is building their business using a cost leadership strategy. The management of Instafab has
identified four strategic goals, one associated with each classification of critical success factors, to help its business grow.
Those strategic goals include:
1. Capturing additional market share,
2. Maintaining low costs that are supported by low prices,
3. Becoming a low price leader, and
4. Linking strategy with reward and recognition.
Help Instafab design tactics to achieve their strategic goals, define measures that they might use, and organize them in the
manner of a balanced scorecard.
Legend:
1. Critical Success Factors (those items in bold)
2. Strategic Goals (those items in italics)
3. Tactics and Measures (those items in regular font)
Tactics
FINANCIAL PERSPECTIVE:
Capture increasing market share
Maintain customer base
Steadily expand services
INTERNAL BUSINESS PROCESSES:
Maintain low costs that are supported by low prices
Improve distribution efficiency
Maintain consistent production
CUSTOMER PERSPECTIVE:
Become a low price leader
Increase customer satisfaction
Anticipate customer needs before competitors
ADVANCE LEARNING & INNOVATION (HUMAN RESOURCES):
Link strategy with reward and recognition
Promote entrepreneurial culture
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Measures
Company vs. industry growth
Volume trend line
% of sales from new products
Costs compared to competitor
% of perfect orders
First pass rates
Our cost vs. competition
Customer surveys
%of products in R&D being test marketed
Net income per dollar of variable pay
Annual reports
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PLANNING TECHNIQUES: FORECASTING AND PROJECTION
5.
3.
,...---4.
Numerous financial models are designed and used for different decision-making situations. Operational decision models
anticipate activity that occurs over the short term and includes breakeven analysis and profit planning, make or buy
decisions, add or drop segment decisions, sell or process further decisions, and others.
COST-VOLUME-PROFIT (CVP) ANALYSIS FOR DECISION-MAKING - Breakeven Analysis
Cost-volume-profit analysis associates the revenues and costs in an economic model that allows
managers to anticipate profits at different levels of sales and production volume. The point at which
revenues equal total costs is termed the breakeven point. Cost-volume-profit analysis is
synonymous with breakeven analysis.
A. Assumptions
1. Classification of Costs b}(Behavior)
a. All costs can be separated into either variable or fixed costs, depending on the
behavior of the cost.
b. Volume is the only relevant factor affecting cost.
2. General Assumptions and Characteristics Ovev
,otAl \lC a. All costs behave in a linear fashion in relation to production volume. see fc:l\8
e
41
I Ib. Cos(behaviors)are anticipated to remain constant over the relevant range of
'coos
t
tAs
1
::c- FC + (\Io1l.\"",-e) production volume because there is an assumption that the efficiency of
l.\\tlt production does not change.
c. Costs show greater variability over time. The longer the time period, the greater
the percentage of variable costs. The shorter the time period the greater the
percentage of fixed-costs.
Use of Single Product
Although cost-volume-profit analysis can be performed for more than one product, in its
simplest form, the model assumes that the product mix remains constant. This fvotAl.\d
effectively produces the economic dynamic of one product. GAAP < vs.
R)CetA vs. Vc:l\v. ""
Contribution Approach (Direct Costing) is Used Rather than Absorption Costing fevlOQ\
The contribution approach to the income statement is used for breakeven analysis.
Identifying each element of cost as fixed or variable defines its relationship to volume
and to the computation of breakeven.
Selling Prices Remain Unchanged
The volume of transactions produces a uniform contribution margin per unit and a
predictable projected contribution margin based on volume.
B. Contribution Approach vs. Absorption Approach
1. Contribution Approach <sP - VC CM
The contribution approach to the income statement uses variable costing (also called
Although it does not represent generally accepted accounting
principles, the contribution approach is extremely useful for internal decision-making.
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a. Equation
The contribution approach identifies the contribution of each transaction to
covering fixed-costs and in computing breakeven point in revenue dollars or units.
l-i\e"",ovlZoe!
Revenue
Less: Variable costs Dl-i\ + DL + \/Q\v. 0/\-\ + \/Q\v. 'SGA
Contribution margin fl)CeA 0/\-\ + fl)CeA 'SGA
Less: Fixed costs
Net income
PASS KEY
Variable costs include direct labor, direct material, variable manufacturing overhead, shipping
and packaging, and variable selling expenses.
Fixed costs include fixed overhead, fixed selling, and most general and administrative
expenses.
b. Presentation
(1) Total or Per Unit
The revenue, variable costs, and contribution margin may be expressed in
total and on a per unit basis.
(2) Unit Contribution Margin
The unit contribution margin is the unit sales price minus the unit variable
cost, amounts that are assumed to remain constant.
c. Contribution Margir(Ratio)
The contribution margin ratio is the contribution margin expressed as a
percentage of revenue.
PASS KEY
The contribution ratio formula is expressed as follows: $Ov rev L\\\lt
-ta Contribution margin ratio =IContribution margin/revenue
l
(PvoAL\ct VS. revloA)
2. Absorption Approach GAAP - ""'L\lHr1e ster - ""'Q\tchl\\8 rVl\\clr1e
The absorption approach does not segregate fixed and variable costs.
51
a.
+ CoGl-i\

EI

Equation
The equation for the absorption approach follows:
Revenue
Less: Cost of goods sold Dt-\ + DL + \/l7I.v. o/H + fl)CeJ. oH (pVOJ.l.\C+)
Gross margin
Less: Operating expenses fl)CeA Q\",A VQ\v. 'SGA (pevloA)
Net income
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Presentation D"", DL O\\\A VO\v. o/H - pvoAt.\ct costs both \N\ethoAs
The absorption approach to the income statement is required by generally
accepted accounting principles for external reporting.
PASS KEY
Comparison of Costs Included in Product Cost
Absorption Costing
1. Direct materials
2. Direct labor
3. Manufacturing overhead, both variable
and fixed
Variable (Direct) Costing
1. Direct materials
2. Direct labor
3. Variable manufacturing overhead variable
and fixed - all fixed manufacturing costs
are treated as period costs
1 '31 3. Contribution Approach vs. Absorption Approach
The difference between the contribution approach and the absorption approach is the
-ta treatment of fixed factory overhead. Selling, general, and administrative expenses are
period costs under both methods.
a. Treatment Factory Overhead1- O\\ly Al-P-PeVe\\Ce
(1) Contribution Approach - Period Cost - GAAP - e)Cpe\\Se l\N\\N\eAlO\tely
Under the contribution approach (variable costing), all fixed factory
""e\N\OVlz.e! overhead is treated as a period cost and is expensed in the period
incurred. Inventory values include only the variable manufacturing costs,
so cost of goods sold includes only variable manufacturing costs.
(2) Absorption Approach - Product Cost - GAAP - e)Cpe\\Se whe\\ solA
Under the absorption approach (absorption costing), all fixed factory
overhead is treated as a product cost and is included in inventory values.
Cost of goods sold includes both fixed costs and variable costs.
Treatment of Selling, General, and Administrative Costs
Selling, general, and administrative expenses are period costs used in the
determination of net income under both methods.
(1) Variable Costing
Under variable costing, the variable selling, general, and administrative
expenses (SG&A) are part of the total variable costs for the contribution
margin calculation.
(2) Absorption Costing
Under absorption costing, the selling, general, and administrative
expenses are part of operating expenses and are reported on the income
statement separately from cost of goods sold.
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Contribution Margin vs. Gross Margin (absorption)
The general income statement formats of both methods are presented below:

Gross profit margin may also be stated as a
percentage, which is calculated as gross margin (or
profit) divided by net sales.
GAA
Absorption (Full Cost) Method
Sales 1)M + 1)L +
Less: Cost of goods sold /
Gross margin* ALL 0 H
Less: Variable selling and
administrative expenses
Fixed selling and variable
administrative expenses
Operating income
$XX

XX
(X)
Contribution Margin
Variable (Direct) Cost Method
Sales
Less: Variable cost of goods sold
(excludes fixed overhead)
Contribution margin from
manufacturing
Less: Variable selling and administrative
expense
Contribution margin
Less: Fixed expenses:
Fixed manufacturing overhead
Fixed selling and administrative
expenses
Total fixed expenses
$XX
DM + DL + Vc:l\V. o/H

$XX

$XX
$XX
4. Effect on Income
If all production is sold every period, both methods produce the same operating income
figures. However, if the number of units sold is more or less than the number of units
produced, the operating income figures will be different.
P d t
G t th S I t Less o/H
a. ro uc Ion rea er an a es' \- L" LI. ""Lt
rnl.\S fVO"t"lr
If units produced exceed units sold, then some units are added to ending
inventory and income is higher under absorption costing than under variable
costing. Under absorption costing, a portion of the fixed manufacturing overhead
is included with each unit in ending inventory and thus, removed from this
period's costs. Under direct costing, however, all fixed manufacturing overhead
is considered a period cost and is expensed in the period incurred.
. I Move o/H
b. Sales Greater than Production \- L" LI. ""L I
rnl.\S fVO"t"l r y
If units sold exceed units produced, then ending inventory is less than beginning
inventory and income is lower under absorption costing than under variable
costing. Under absorption costing, the fixed manufacturing overhead carried
over from a previous period as a part of beginning inventory is charged to this
period's cost of sales. Under variable costing, however, those fixed costs would
have been charged to income in the period they were incurred.
PASS KEY
Examiners frequently ask about the difference between variable and absorption costing and the manner in
which the Net Income under either method can be reconciled to one another. Follow the simple steps
below to compute difference (remember to read Appendix III for an expanded discussion):
Step #1: Compute fixed cost per unit (Fixed manufacturing overhead/Units produced)
Step #2: Compute the change in income (Change in inventory units x Fixed cost per unit)
Step #3: Determine the impact of the change in income:
No change in inventory:
Increase in inventory:
Decrease in inventory:
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Absorption net income =Variable net income
Absorption net income> Variable net income
Absorption net income < Variable net income
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Becker Professional Education I CPA Exam Review
5. Absorption (Full) and Variable (Direct) Costing
a. Absorption (GAAP) Costing
Absorption costing capitalizes fixed factory overhead expenses as part of the
cost of inventory (goods manufactured and not yet sold) in accordance with
generally accepted accounting principles (GAAP). Therefore, absorption costing
includes direct material, direct labor, and all overhead (variable and fixed) as
inventoriable costs. Absorption costing is also referred to as "normal,"
"conventional," "absorption," "full," or "full absorption" costing.
(1) Absorption Costing - Benefits
(a) Absorption costing is GAAP.
(b) The Internal Revenue Service requires the use of the absorption
method for financial reporting.
(2) Absorption Costing - Limitations
(a) The level of inventory affects net income because fixed costs are a
component of product cost.
(b) The net income reported under the absorption method is less reliable
(especially for use in performance evaluations) than under the
variable method because the cost of the product includes fixed costs
and, therefore, the level of inventory affects net income.
b. Variable (Direct) Costing
In variable (or direct) costing, only variable costs are included in the cost of the
manufactured product (inventory cost). Fixed costs are excluded from inventory
and are applied as a period cost (i.e., expensed).
(1) Management Tool
Variable costing is used as a management tool to identify contribution
margin, calculate breakeven, and expedite profit planning.
(2) Two Expense Categories
Variable costing recognizes only two major categories of expense:
(a) Variable expenses
(b) Fixed expenses
(3) Benefits of Variable Costing
(a) Variable costing attains the objectives of management control
systems, as the costs are listed separately so they may be easily
traced to and controlled by management.
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(b) The net income reported under the contribution income statement is
more reliable (especially for use in performance evaluations) than
under the absorption method because the cost of the product does
not include fixed costs and, therefore, the level of inventory does not
affect net income.
(c) Variable costing isolates the contribution margins in financial
statements to aid in decision-making (the contribution margin is
defined as sales price less all variable costs, including variable sales
and administrative costs, and breakeven analysis is often based on
contribution margins).
(4) Limitations of Variable Costing
(a) Variable costing is not GAAP.
(b) The Internal Revenue Service does not allow the use of the variable
cost method for financial reporting.
6. Concept Example - Absorption vs. Variable Costing
EXAMPLE
1. What is the cost of the product for inventory located in the finished goods warehouse under absorption and variable
costing?
a. Absorption costing
b. Variable costing
$'1.00
2. What is the cost of the product delivered to the customer under variable costing? $8".'30
Variable Cost
GAAP Costs of Costs of of Product
Production Production Delivered to
Costs Total Costs "Absorption" "Variable" Customer
Direct materials $1.00 $1.00 $1.00 $1.00
Labor:
Direct 4.00 4.00 4.00 4.00
Indirect (fixed building maintenance) 0.50 0.50 - -
Overhead:
Variable 1.50 1.50 1.50 1.50
Fixed 2.00 2.00 - -
Commissions to salesman 1.00 - - 1.00
Freight out 0.80 - - 0.80
-- --
Total $10.80 $9.00 $6.50 $8.30
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Business 5
SALES
7.
Becker Professional Education I CPA Exam Review
Concept Exercise - Variable (Direct) Costing Income Statement
EXAMPLE
(DIRECT COSTING) INCOME STATEMENT
For the month ended October 31, Year X
$ 400,000
Less variable expenses:
Production expenses:
Raw materials
Direct labor
Fringe benefits
Royalties
Factory supplies
Electrical power
Scrap and spoilage
Selling expenses:
Sales commissions
Fringe benefits
Delivery expense
Advertising expense
Total variable expense
Contribution margin (variable margin)
Less fixed costs:
$ 80,000
135,000
22,500
3,500
2,100
3,000
600
15,000
2,300
10,000
26,000
246,700
53,300
(300,000)
$ 100,000
Cost of sales (mostly rent and equipment depreciation)
SG&A (mostly office rent and officers' salaries)
Net income (under direct costing)
1. What is the contribution margin ratio to sales?
2. What is the "contribution margin" if sales are doubled?
3. What is the "net income" if sales are doubled?
4. What is the "net income" if sales are tripled?
END OF ANCILLARY MATERIAL
$ 10,000
15,000 (25,000)
$ 75,000
Answer
2SOla
$200,000
$17'>,000
$27'>,000
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Becker Professional Education I CPA Exam Review Business 5
-+C.
Breakeven Computation
Breakeven analysis determines the sales required (in dollars or units) to result in zero profit
or loss from operations. After breakeven has been achieved, each additional unit sold will
increase net income by the amount of the contribution margin per unit.
1. Standard Formulas
The contribution approach to the income statement makes it easy to calculate the
breakeven point in either units or sales dollars.
a. Units
The breakeven point in units can be determined by dividing the unit contribution
margin into the total fixed costs:
TotaI fixed costs
Contribution margin per unit
<Sc:l'Jes $ BE
Breakeven point in units --_.....:._-
= <sP fev
b. Sales Dollars
There are two approaches to computing break even in sales dollars.
(1) Contribution Margin per Unit
Compute the breakeven point in units, and then multiply those breakeven
units by the selling price per unit:
Unit pricexBreakeven point (in units) = Breakeven point (in dollars)
(2) Contribution Margin Ratio ] Pev oV $
Divide total fixed costs by the contribution margin ratio (i.e., the
contribution margin as a percentage of revenue per unit or unit price):
Total fixed costs Q.E L <!'"p L
.. .. Breakeven point D fev
Contribution margin ratio
PASS KEY
Memorize all breakeven formulas!
Breakeven formulas are generally derived from the same equation:
Breakeven point (BEP) occurs when sales equals total cost (variable plus fixed costs)
You can algebraically determine any number of variations of this formula. Be sure you know their
components.
Total sales dollars at the BEP Total variable costs + Total fixed costs
Unit sales price x Units at BEP = (Units at BEP + Variable cost per unit) + Total fixed costs
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Vse the s4ll\\o\o\e i",-po. 2.'3 & 2.5
EXAMPLE
Green Grass Industries has total fixed costs of $150,000, and the company's contribution margin represents
60% of revenue per unit. If the unit price is $125, how many units must Green Grass sell to breakeven?
1920 sP \2.5 \00:7.] P -L L..a .,/ L
a. 720 c., \lC ey "''''lr 4lI\\o\o\O"''''rS 4lI\"'Q\. /. Sr4ll\Y
b. 1,200 d. 2,000 CM 75 '0:7. s4lI\\o\o\e o-p vol",\o\o\e
Solution: Choice "d" is correct. Green Grass must sell 2,000 units to breakeven. -rot4ll\1 FC \ 50/000
$150,000 .
-----'---- = $250,000 breakeven sales (In dollars)
0.60
$250,000
----'-------'--- = 2,000 breakeven sales (in units)
$125
sP fey ",,,,it
Selling price 125
Contribution % x 60%
Contribution margin 75
Total fixed cost
Divided by CM V",its
BE sales in units
150,000
7 $75
2,000
2. Required Sales Volume for Target Profit
Breakeven analysis can be extended to calculate the required sales dollars or unit
sales required to produce a targeted profit.
a. Basic Formula
The formula is modified to treat the desired net income before taxes as another
fixed cost as follows:
Sales = Variable costs + (Fixed costs + Net income before taxes)

-+
I
Fixed cost +Profit EB-r
-
Contribution margin ratio Oy fey ''''''It
(\ - .40)
b. Tax Considerations EB-r)C (\ - -r) ::- Nl
Computation of sales necessary to produce a specific target profit after taxes
requires adjustment of the breakeven formula to compute target profit before
taxes based on target profit after taxes and insert the computed before tax target
profit into the original formula, as follows.
(1) Calculate target profit before tax:
Target profit before tax = Target profit after tax + Tax
(2) Calculate the breakeven point in sales:
Sales = Variable costs + Fixed costs +Target profit before taxes
PASS KEY
Computation of target profit before tax based on the target profit after tax is the ratio of the
target profit after tax divided by one minus the tax rate.
Target profit before tax = Target profit after tax/{l- Tax rate)
Bs-22
Nl '0/000
EB-r::- (\ _-r) (\ - .40) ::-
\00/000 + FC
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EXAMPLE
Green Grass Industries has total fixed costs of $150,000, and the company's contribution margin represents 60% of revenue
per unit. Last year, Green Grass earned $50,000 pre-tax, and this year it would like to improve upon that figure by 20%. If
the unit price is $125, how many units must Green Grass sell to meet this objective? -r EB-r
a. 2,500 c. 3,000 'Step \ 1..,.- EB-r 50/000 )C \.2. '0/000
b. 2,800 d. 3,200
Solution: Choice "b" is correct. Green Grass must sell 2,800 units to meet its objective.
2. \ 0/000
.'0
$350/000
'S4l'\les
\ 50/000 + '0/000
Sales= FC+-r4l'\yetEB-r 2.\0000 .
Contribution margin ratio 'Step 2. " $/ 2. 800 "''''ltS
'0/000 CM pey ",,,,it 75 /
150,000+(50,000xl.20) \ 2.5 )C '0%
60% CM Y4l'\Ho
= Variable costs + Fixed costs + Net income before taxes
Sales = Unit pricexUnits sold
S I
210,000
a es=--'------
.60
$125x Units = [(1-0.60)($125x Units)] + $150,000 + ($50, OOOx 1.20) Sales = $350,000
$125x Units = ($50 x Units) + $150,000 + $60,000 Sales
C
\lC Units =
($125-$50)xUnits = $210,000 -r .- + Selling price
$75xUnits=$210,000 \50/000 + l50)(l.,800), U' $350,000
Units =$210,000/$75 2.10/000 \40/000 nlts= $125
. Unlts=2,800
Unlts=2,800 '350/000 - 2.10/000 Pyo-Pit (fB-r) '0/000
2./800
)C \2.5
'350/000
$ s4l'\les
$350/000 2. 800
$\2.5 /
'SP pey ",,,,it
II. CVP ANALYSIS - Profit Performance Assuming Different Operating Levels
';:A. Predicting Profit Performance
A after equal to the units sold times the contribution margin per
unit.
1. Predicting Profit Performance Based on Volume
EXAMPLE
Green Grass Industries has total fixed-costs of $150,000, and the company's contribution margin represents 60% of revenue
per unit. If the unit price is $125, how much net profit will Green Grass earn if it sells 2,200 units?
a. $7,200
b. $12,000
c. $19,200
d. $15,000
BE ",,,,its pey 2.2.
Solution: Choice "d" is correct. Green Grass must sell 2,000 units to breakeven.
$150,000
---=$250,000 breakeven sales (in dollars)
0.60
$250,000
---=2,000 breakeven sales (in units)
$125
2./2.00 - 2./000 2.00 E)Ccess ovey BE
)C $75 CM pey ",,,,it
$\5/000 EB-r
Green Grass achieves a contribution margin of $75 per unit ($125 x .6).
Green Grass will earn 200 x $75 or $15,000 net profit on units sold subsequent to breakeven.
2./2.00 )C \2.5 $2.75/000
"2.'0
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\5/000 EB-r
-rC FC + \lC
\50/000 + l50)(l./2.00),
2.'0/000 \ \ 0/000
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2.
Becker Professional Education I CPA Exam Review
Setting Selling Prices Based on Assumed Volume
Breakeven formulas are applied to determine product price as part of an overall plan for
profitabi Iity.
EXAMPLE
Green Grass Industries has total fixed-costs of $150,000 and the company's contribution margin represents 60% of revenue
per unit at the current selling price of $125 or a contribution margin of $75 per unit and implied variable costs of $50 per
unit. If the company has determined that the market saturation level is 2,200 units, what must the selling price be in order
to achieve an after tax profit of $6,000 for the year assuming a tax rate of 40%.
a. $122.73
b. $125.00
c. $147.72
d. $152.27
Solution: Choice "a" is correct. The selling price must be $122.73 per unit.
If we assume the required after tax profit is $6,000, then the pretax profit is computed as follows:
After tax profit
Tax rate adjustment (1 - .4)
Pre-tax profit
$ 6,000

$10,000
To compute breakeven point in units (or target profit in units), we will use the following formula:
(Fixed costs + Target profit) .;- Contribution margin = Required units
To derive our required selling price, we insert the known variables into our formula and derive the selling price as follows:
($150,000 + $10,000) .;- (Required selling price - $50) = 2,200
The selling price is derived algebraically as follows:
$160,000';- (Required selling price - $50) = 2,200
$160,000 = 2,200 x (Required selling price - $50)
$160,000 = (2,200 x Required selling price) - $110,000
$270,000 = 2,200 x Required selling price
$270,000';- 2,200 = Required selling price
$122.73 = Required selling price
B. Margin of Safety Concepts
The margin of safety is the excess of sales over breakeven sales and is generally expressed
in either dollars or as a percentage.
-+1.
Sales Dollars
The margin of safety expressed in dollars is calculated as follows:
Total sales (in dollars) - Breakeven sales (in dollars) = Margin of safety (in dollars)
2. Percent
The margin of safety can also be expressed as a percentage of sales, as indicated
below:
Margin of safety in dollars . f f
-----"------'------ =Margin 0 sa ety percentage
Total sales
Bs-24
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Pev f8. 2'3 1) -rC FC + (\IC fev )C tit
2) FC 1 A-rC
Business 5
fe
v
C. Breakeven Charts
Breakeven charts graphically display the results of breakeven analysis. The charts shown
below display alternative methods of presentation for Green Grass Industries:
Becker Professional
EXAMPLE - BREAKEVEN CHART 1
Green Grass Industries
Breakeven Chart: Pure Graph of Fixed Cost
--Sales
--Total Cost
fixed Costs
(\IC fe
v
)C VOll.\lM )
_ar_la_e_C_o_st_s___ --Fixed Cost
-,---

50,000
250,000
300,000
350,000
100,000
(DV) 200,000
Dollars
.... FC 4
50
,000)

level o-P
totc:l\l
cost
o 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400 2600 2,B'00
Units (IV)
EXAMPLE - BREAKEVEN CHART 2
Green Grass Industries
Breakeven Chart: Pure Graph of Fixed Cost
350,000
300,000 +-----------------------T'----'lP'-"l-"'-------::
250,000 +--------------------c::;ooo__
--Variable Cost
--Total Cost
100,000
50,000
Variable Costs
o 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400 2600
Units
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EXAMPLE - BREAKEVEN CHART 3
Green Grass Industries
Profit Volume Chart
100,000
--Fixed Cost
--Profit (Loss)
--Breakeven
50,000 +------------------------
(50,000) +---------------c.......=--------------

"0
"'C
<:
QJ
E
o
u
<:
l1ll
..6 (100,000) +--------=.........'---------------------

QJ
g (150,000) r....c:;---------------------
(200,000) +------,----,----,---,---------,-----,----,---------,----,---,-------,----,----,-------,
o 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400 2600
Units sold at $125 per unit
III. TARGET COSTING (used for target pricing)
Target costing is a technique used to establish the product cost allowed to ensure both profitability
per unit and total sales volume.
-+A.
Cost Determination
The concept of target costing requires the selling price of the product to determine the
production costs to be allowed.
<Step 1
Market Circumstances Creating Target Costing F 1 $10 -L
ov e)Cc:l\tMp e, pev
As competition (typically from a "cost leader") sets prices, any change in price could )C
easily cause a customer defection. Target costing is the first step in establishing cost PVO-Plt
controls to ensure ongoing profitability.
'30':
$3
Target Cost Computation
The target cost of the product is the market price minus profit calculated as follows:
III 10 - '3
-+Target cost = Market price - Required profit
- ,: O-P pVlce
Implications of Target Costing '30': o-P 10
2.
1.
B.
If management commits to a target cost, serious measures must be employed to reduce
costs. Although the mechanics are simple, the implications can be far reaching.
1. Compromised Quality
The firm may have to sacrifice quality (by reducing costs), but this can have the effect
of loss of sales.
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2. Increased Marketing and Downstream Costs
Firms competing in this type of environment may incur increased downstream costs in
an attempt to differentiate their products and create brand loyalty (and a competitive
advantage).
3. Increased Complexity in Cost Measurement
Advanced cost management techniques may have to be employed to attain a higher
productivity level.
4. Product Redesign
The product may have to be redesigned to provide for the reduction of costs throughout
the life cycle of a product (referred to as the Kaizen Method).
IV. TRANSFER PRICING
A transfer price is the price charged for a good or service by one division (or segment) of a
business to another division (or segment) of a business. Transfer prices may be based on market
price, cost (variable or full), a negotiated amount, or dual pricing (the revenue to one segment is not
the same as the cost to another segment).
A. Managerial Goals of Transfer Pricing Policy
1. Promote Goal Congruence
Transfer pricing policy seeks to promote goal congruence (each division or segment
manager should be motivated by the results produced by transfer pricing to make
decisions that benefit both the division and the organization as a whole).
2. Motivate Segment Managers
Transfer pricing policy seeks to motivate selling division (or segment) managers to
reduce costs and buying division managers to use resources more efficiently, as
bonuses are often based on division (or segment) operating performance.
3. High Level of Division Autonomy
Transfer pricing policy seeks to provide a high level of division autonomy (the degree to
which the division is free to make decisions) where the division has decentralized
authority.
B. Transfer Pricing Methods
1. Transfer Pricing - Based on Market Price
Market price is used when divisions (or segments) are minimally interdependent and
the market is perfectly competitive. Transfers at market price will lead to optimum
decisions; however, the market price, while the most objective price, is often difficult to
determine.
a. Transfer Prices - Below Market
Transfer prices set below market price will motivate division (segment) managers
to sell to outsiders.
b. Transfer Prices - Above Market
Transfer prices set above market price will motivate division (segment) managers
to buy from outside vendors. Managers in the selling division (segment) will not
be disciplined by the marketplace.
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Becker Professional Education I CPA Exam Review
Transfer Pricing - Based on Cost
Cost (actual or budgeted) is used when a division (segment) can get a better price from
an outside supplier. Transfer prices based on cost can lead to sub-optimal decisions if
cost includes some fixed items. The buying division (segment) will treat transfer prices
as variable.
Bs-28
a. Full Cost Transfer Pricing
Under the full cost transfer pricing method, the transfer price is set at the variable
cost plus the allocated fixed costs of the item as determined by the seller.
b. Variable Cost Transfer Pricing
Under the variable cost transfer pricing method, the transfer price is set at the
variable cost of the item as determined by the seller.
3. Transfer Pricing - Based on Negotiated Prices
Transfer prices negotiated between divisions or segments are referred to as negotiated
prices. This technique serves to duplicate many of the elements of market pricing while
keeping costs within the organization.
4. Transfer Pricing - Based on Dual Pricing
Dual pricing involves multiple bases for transfer pricing and is used when one transfer
price will not meet all the goals of a single transfer pricing policy.
C. Other Transfer Pricing Issues
1. Customized Transfer Pricing Policies
Many companies have different transfer pricing policies for different segments.
Opportunities to buy or sell from or to outside parties motivate adoption of different
transfer pricing policies. The goals of transfer pricing (e.g., goal congruence,
motivation, and segment autonomy) cannot be met with one policy for all
circumstances.
2. Sourcing Decisions
Companies must make sourcing decisions as part of the development of transfer
pricing policies. The character of these decisions includes:
a. Divisional Selling Authority
Divisional selling authority is the degree to which a division (or segment) may sell
to outsiders or the degree to which a division (or segment) is restricted to selling
only to other company divisions (segments).
b. Divisional Buying Authority
Divisional buying authority is the degree to which a division (or segment) may
buy from outside sources or the degree to which a division (or segment) may buy
only from other company divisions (segments).
3. Justification
Adoption of the same transfer price for cost accounting and tax purposes helps justify a
given pricing policy.
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PASS KEY
Business 5
B'3 [1.
2.
The examiners require that candidates be able to distinguish between cost-volume-profit analysis, target costing, and
transfer pricing. Cost-volume-profit analysis provides analysts with the tool to project target profits based on additional
sales, while target costing requires the organization to hold costs to a predetermined level as a means of establishing price
and projecting operating results. Transfer pricing is generally used as a means of distributing costs between segments and,
although it should not impact overall contribution margin, should be instrumental in coordinating the economic activity of
multidivisional organizations and establishing a basis for evaluating individual segment performance.
END OF ANCILLARY MATERIAL
V. OPERATIONALCoECISION ANALYSIS)- Marginal Analysis
The operation decision method referred to as marginal analysis contemplates decisions covering
(a) introduction of a new product or changes in output levels of existing products, (b) acceptance or
rejection of special orders, (c) making-or-buying a product or service, and (d) adding or dropping a
segment.
A. Focus of(MarginaDAnalysis
Marginal analysis focuses on the future revenues and future costs and
costs, i.e., those that that are associated with a decision.
Relevant Revenues and Costs
Future revenues and future costs that are identified will differ between the decisions in
any type of marginal analysis.
Irrelevant (Sunk) Costs
Any costs, including allocated costs, that do not differ between alternatives should be
ignored in a marginal cost analysis.
B. Marginal Costs
1. Definition
Marginal costs are the sum of the costs required for a one-unit increase in activity.
2. Composition
Marginal costs include all variable costs and any avoidable fixed-costs associated with
a decision.
VI. SPECIAL ORDERS AND PRICING
Special order decisions are defined as that require the firm to
decide if a special order should be accepted or rejected. Decisions of this character involve both
the mathematics of comparing the offered price of the special order to the relevant costs as well as
the strategic issues that relate to acceptance or rejection of the order.
A. Determining(RelevanO<;osts
As with most determinations of relevant costs, special orders include consideration of most
direct and variable costs as well as incremental costs. Decisions typically ignore absorption
costing. - Vl.\col.\tvol14l'\ble costs
II'Sl.\l.\\c.II
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a.
Business 5
1.
'Specl4l'\l
ovtAev
Becker Professional Education I CPA Exam Review
Capacity Issues
Special orders are short-term decisions that often assume excess capacity. Fixed
costs will not be relevant to these decisions because fixed costs will not change within
the short-term.
Presumed@xcess C a p a c i t ~ Accept i-P 'SP ~ \lC (l.e., velev4l'\",t cost)
If there is excess capacity, compare the incremental (additional) costs of the
order to the incremental (additional) revenue generated by the order. This
process compares the variable cost per unit to the revenue generated per unit.
Provided the selling price per unit is greater than the variable cost per unit, the
contribution margin will increase and the special order should be accepted.
Selling Price
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Shipping and handling costs::- \l4l'\v.
Fixed selling costs
Total cost
b. Presumed Full Capacity Accept i-P 'SP ~ \lC + oppovt",,,,iry
If the company is operating at full capacity, the opportunity cost of producing the
special order as a component of the variable cost per unit should be included in
the analysis.
CM i", $ -Pove!10 oC J-
. . 1 ::- pe.v ~ (1) The opportunity cost is the contribution margin that would have been
'Slz.e SpeCl4l'\ ovtAev ''''''It produced if the special order were not accepted.
(2) The production that is forfeited to produce the special order is referred to
as the next best alternative use of the facility.
EXAMPLE - SPECIAL ORDER WITH EXCESS CAPACITY
Kator Company is a manufacturer of industrial components. One of their products that is used as a
sub-component in auto manufacturing is KB-96. This product has the following financial structure per
unit:
'Step \
Kator has received a special, one-time order for 1,000 KB-96 parts. Assuming Kator has ~
capacity. the minimum acceptable price for this one-time special order is in excess of:
a. $47 'SP ~ \lC Accept
@ $50
c. $60
d. $77
Solution: Choice "b" is correct. The minimum acceptable price for this special order is in excess of $50.
Of the six cost elements in the financial structure, the two that are fixed (fixed manufacturing
overhead and fixed selling) can be subtracted from the $90 total cost because they are not relevant to
the decision to accept or reject the special order. The incremental per-unit production cost for the
special order is $50.
Bs-30
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EXAMPLE: SPECIAL ORDER WITH NO EXCESS CAPACITY
$57
$60
$70
$87 d.
a.
c.
Assume the same financial structure as in the previous concept example. Kator has received a special,
one-time order for 1,000 KB-96 parts. Assume that Kator is operating at(ull Also assume
that the next best alternative use of their capacity on existing equipment is the production of LB-64,
which would produce a contribution margin of $10,000. The minimum acceptable price using the
original data for this one-time special order is in excess of:
l'Step \1 'SP '> \lC + oC

$\0/000 := $\0 + $50
\ /000 ",,,,its
\..'Siz.e
Solution: Choice "b" is correct. The minimum acceptable price for this special order is in excess of $60.
Kator's next best alternative use of its capacity would produce a contribution margin of $10,000 for
1,000 units (or $10 per unit). This $10 contribution margin (the opportunity cost of this special order
decision) would have to be added to the $50 derived in the previous example to determine the
minimum justifiable price for the special order. The minimum acceptable price would, therefore, be in
excess of $60.
B. Strategic Factors
In the event of operation at capacity, acceptance of a special order also requires
consideration of a number of strategic factors, including:
1. The effect on regular-priced sales and other long-term pricing issues.
2. The possibility of future sales to this customer.
3. The possibility of exceeding plant capacity or the complexities of the order itself.
4. The pricing of the special order.
5. The impact of income taxes.
6. The effect on machinery and/or the scheduled machine maintenance program.
VII.
I-P velev4l'\",t costs to \o\o\4l'\\c.e J.. t-I\ \c. "t
MAKE VS. BUY + oppovt",,,,iry costs o-P p",vch4l'\se pVlce 4l'\ e l
The decision to make or buy (also referred to as insourcing vs. outsourcing) involves a similar
decision matrix as accepting or rejecting a special order. Managers must determine whether the
opportunity costs associated with making a product with available capacity are less than the
contribution margins associated with using that capacity for additional business.
Making a product or providing a service within an organization presents the risk that the service
will not use resources as efficiently as possible.
Buying a product or service from outside vendors may offer more expertise or choices, but it
carries the typical risks of inflexibility, loss of control, loss of confidentiality, and a locked-in
relationship with a vendor.
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3.
Business 5
A.
Bs-32
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Determining Relevant Costs and Other Make or Buy Issues
1. Various Capacity Issues
a. First, Use Existing Capacity Efficiently
Make-or-buy decisions attempt to use existing capacity as efficiently as possible
before purchasing from an outside supplier. These decisions are made by
comparing the cost of making the product internally (insourcing) to the cost of
buying the product externally (outsourcing). The lower cost option becomes the
decision.
b. Capacity Considerations
(1) Excess Capacity
If there is excess capacity, the cost of making the product internally is the
cost that will be avoided (or saved) if the product is not made. This will be
the maximum outside purchase price.
(2) No Excess Capacity
If there is no excess capacity, the cost of making the product internally is
the cost that will be avoided (saved) if the product is not made plus the
opportunity cost associated with the decision.
2. (RelevanDCosts \r4l'\vl4l'\ble OV
Relevant costs for make-or-buy decisions are the future costs that will be used to make
the decision of whether to make an item or buy an item.
a. The relevant costs are the expected (or future) costs and those that are
otherwise@voidable)
b. Historical costs are not relevant to the make-or-buy decision, except to the extent
that they are used to predict or estimate future cash outlays (including the
income tax effects).
c. Only those...o-s-t-s-th-a-t-c-h-a-n-g...... a result of a decision are relevant.
(Controllable)Costs
The ability to control cost is evaluated when formulating a make-or-buy decision. By
classifying a cost as either controllable or uncontrollable, the specific level of
management responsible for the cost is identified.
a. Controllable costs are those costs that can be authorized at a specific level of
management.
b. Uncontrollable costs at a specific level are costs that were authorized at a
different level.
EXAMPLE
A manufacturing department manager has control over the materials and supplies used in the
manufacturing department (i.e., controllable costs), but that manager has no control over the fixed
asset depreciation allocated to the department (i.e., uncontrollable costs). (sunk the
book value of old equipment) and allocated fixed factory overhead costs are never relevant in a make-
or-buy decision.
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BUY
Ilh,cvelMe",t",1
11
II""", '"",1
11
B. Consideration of Differential Costs and Revenues Re1ev",,,,t
Two or more alternatives are always compared in make-or-buy decisions.
1. Differential/Incremental Costs
A differential cost is the difference in cost between two alternatives. An incremental
cost only refers to an increase in cost from one alternative to another. The terms
"differential costs" and "incremental costs" are often used synonymously in practice.
2. Differential Revenue
Differential revenue is the difference in revenue that results from choosing one course
of action over another.
EXAMPLE
Offset Manufacturing reported the following costs for making part number 125:
Total Cost for
(29]99)units Cost per Unit
Direct materials $ 10,000 $ .50
Direct labor 40,000 2.00
Variable factory overhead 20,000 1.00
';:IFixed factory overheadKCol1tvoll"'ble 40,000 2.00
Total cost Ul1col1tvoll",ble $110,000 20/000:= Cost to lM",ke
'1otJ.. shotJ..1"A stJ..",k/tJ..",co",tvoll",b1e costs
An outside manufacYurer approaches Offset Manufacturing and offers to sell them the same part Cost to PtJ..y
Should Offset Manufacturing make or buy the part?
It appears that Offset should buy the part because the difference between the $5.50 manufacturing cost and the $5.00
purchase price represents a $0.50 per part yotJ.. co",si."Aev stJ..",k costs -
.;: The key to answering this question properly is to compare expected future costs (relevant costs) of the alternatives.
Assume that the capacity now used to make part number 125 will become idle if the parts are purchased. Also assume that
the $10,000 factory floor supervisor's salary is the only fixed cost that will be eliminated. - -rhtJ..s co",tvoll",p1e,
The following analysis can then be made: ve1ev",,,,t, wm ch"''''Be
20,000 tJ..",i.ts
MAKE
580 000 -r 7/1111111 ==- 54.00
$10,000 $0.50
40,000 2.00
20,000 1.00
10 000 0.50
Pu rchase cost
Direct materials ]
Direct labor lII/C
Variable factory overhead
Fixed factory overhead (avoidable)
Total relevant costs
Difference:
I
Total
$20,000
Per Unit
$1.00
Total
$100,000
5100000
Per Unit
$5.00
55.00
Identify the additional costs for making (or the costs avoided when buying) a component part or piece.
The decision will be for the company to make the product internally because there is a $20,000 total and a $1 per unit lower
cost related to this option.
The supervisor's salary of $10,000 would be avoidable (unnecessary) if Offset Manufacturing decided to "buy" instead of
"make." -rhe othev'30,000 o/H i.B",ove"A ",ot ",voi."A",p1e
If Offset Manufacturing decided to buy part number 125, the $10,000 would then become relevant because it is an
additional cost of making the component.
Unavoidable costs (i.e., costs that will continue despite the company's decision of whether to make or buy) are not relevant
because they do not have an impact on the decision.
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Business 5
C.
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Qualitative Factors
The organization should consider the quality of the product produced, the reliability of the
product, and the value of service contracts or other warranties. Risks associated with
outsourcing or buying outside the organization often includes inflexibility, loss of control, and
less confidentiality.
VIII. SELL OR PROCESS FURTHER
The decision regarding additional processing is made based on profitability. Accurately and
appropriately tracing relevant costs to the additional activities associated with selling or processing
further is integral to proper decision-making.
A. Joint Costs
1. Definition of Joint Costs - cost -
Joint costs are the costs of a single process that yields multiple products (e.g., the
processing of a pig to produce ham, bacon, and pork chops). Joint costs cannot be
traced to an individual product.
2. Split-off Point
The split-off point is the point in the process where the products become identifiable.
3. Joint Costs are Sunk Costs
Joint costs represent sunk costs and are never relevant to decisions of whether to sell
or to process further. Allocation of joint costs is arbitrary and useless for decision-
making.
B. Separable
Separable costs are costs split-off point that can be traced to individual
products and are relevant to decisions of whether to sell or to process further.
C.
-+1.
2.
If the incremental revenue exceeds the incremental cost, the organization should
process further.
If the incremental cost exceeds the incremental revenue, the organization should sell at
the split-off point.
IX. ADD OR DROP A
The decision to add or drop a business segment relates to tracing its relevant costs.
A. Classification of Costs
The fixed costs associated with the segment must be identified as either avoidable (relevant)
or unavoidable, even if the segment is discontinued.

Bs-34
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B. Decision Factors
A firm should compare the fixed costs that can be avoided if the segment is dropped (i.e., the
cost of running the segment) to the contribution margin that will be lost if the segment is
dropped.
-+1.
2.
The firm should keep the segment if the lost contribution margin exceeds avoided fixed
costs.
Drop the segment if the lost contribution margin is less than avoided fixed costs.
EXAMPLE: DIFFERENTIATING AVOIDABLE AND UNAVOIDABLE COST
Chowderhead Industries
Analysis of Fixed Costs by Product
The executives at Chowderhead Industries are evaluating each of their product lines. The analysis of contribution
margin by product appears to show that the company's Clam and Corn chowder products are profitable while their Conch
Chowder product shows a disappointing loss.
Chowderhead Industries
Summary Statement of Contribution Margin by Product
Description Clam Conch Corn Total
Sales $125,000 $75,000 $50,000 $250,000
Variable costs 90,000 60,000 25,000 175,000
Contribution margin 35,000 15,000 25,000 75,000
1 1<
Fixed costs V 1
20,000 20,000 20,000 60,000
N t I l.\4lI\VOl 4lI\b e
$ 15,000 $(5,000) $ 5,000 $ 15,000 e ncome
Should Chowderhead eliminate their Conch Chowder product line?
The following analysis, projecting the impact of eliminating the Conch chowder product line, shows that Chowderhead
should keep all three product lines.
Chowderhead Industries
Summary Statement of Contribution Margin by Product Elimination of Conch
Description Clam Conch Corn Total
Sales $125,000 $50,000 $175,000 Lost CM
Variable costs 90,000 -

25,000 115,000
It Contribution margin 35,000 25,000 60,000::- 75 -
Fixed costs ::- -rot4ll\1 Sl.\l.\\c. 20,000 20,000 N/C 20,000 60,000 N/C
Net Income $ 15,000 $(20,000) $ 5,000
-rot4ll\1 Nl lowev
Elimination of the Conch chowder product line would serve to eliminate company-wide profits since that segment makes a
positive contribution to fixed costs. - Appe4ll\vs 4lI\S COl.\Ch be \c.ept
-+ Further analysis of the cost components shows that fixed costs are comprised of both avoidable and unavoidable elements.
Covvect 4lI\l.\4lI\1ysis
Relev4lI\l.\t
Description
Fixed costs
Unavoidable fixed costs
costs: advertising
Net Income
Clam
$15,000
5,000
$20,000
$4,000
U6,000)
$20,000
Corn
$16,000
4,000
$20,000
Total
$35,000
25,000
$60,000
- 'Sil.\ce lost CM is 15/000 bl.\t costs
4lI\ve 1'/000 -
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EX AMP L E: D IFF ERE N T I A TIN G A V 0 I DAB LEA N DUN A V 0 I DAB LEe 0 ST (continued)
Advertising is a significant avoidable fixed cost. In fact, direct advertising costs associated with the conch product line are
significantly higher than the other product lines.
Given these new facts, should Chowderhead Industries eliminate their Conch chowder product line?
The following analysis shows the elimination of the Conch chowder product line along with related avoidable fixed costs.
Chowderhead Industries
Summary Statement of Contribution Margin along with Avoidable
and Unavoidable Fixed Costs by Product line, Elimination of Conch
Description
Sales
Variable costs
Contribution margin
Fixed costs
Unavoidable fixed costs
Avoided fixed costs: advertising
Net Income
Clam
$125,000
90,000
35,000
15,000
5,000
$ 15,000
Conch
4,000
$14,000)
Corn
$50,000
25,000
25,000
16,000
Total
$175,000 Lost CM
115,000 t
~ 60,000 ::- 75 - \ 5
35,000] \
44::- '0 - ,
9,000 ~
$ 16,000 t Sd\VetA
FC
Elimination of the Conch chowder product line and avoidable fixed costs improves overall productivity from $15,000 to
$16,000.
The Chowderhead executives should eliminate their Conch product line!
c. Qualitative Factors
Managers must consider qualitative and strategic factors in addition to relevant cost analysis
in evaluating the alternatives to add or drop a segment. Qualitative factors include:
Bs-36
1.
2.
3.
4.
The complementary character of products and their relationship to the sales of other
products. Manufacturers might produce and price certain product accessories as loss
leaders to promote sales of more profitable products.
The impact of product addition or deletion on employee morale.
The growth potential of each product regardless of individual profitability.
Opportunity costs associated with available capacity.
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x. ECONOMIC VALUE ADDED
Business 5
The economic value added (EVA) method of performance evaluation is similar to the residual
income method (described in lecture B-3). While the residual income method computes required
return based upon a hurdle rate determined by management, the EVA measures the excess of
income after taxes earned by an investment over the return rate defined by the company's cost of
capital. Economic value added ensures that performance is measured in comparison to changes
associated with all capital, debt, and equity. EVA is expressed as an amount and is considered a
form of economic profit.
A. Computation and Interpretation
1. Formula
The steps for the formula for economic value added are as follows:
a. Step 1: Calculate the required amount of return and income after taxes.
Investment
x Cost of capital
Required return I ~ $
b. Step 2: Compare income to the required return.
Income after taxes - Required return = Economic value added
2. Interpretation
a. Positive EVA
A positive EVA indicates that performance is meeting standards.
b. Negative EVA
A negative EVA indicates that performance is not meeting standards.
B. Economic Value Added Component Issues
Economic value added can be refined using any number of investment or income
adjustments to produce a more accurate analysis of economic profit (value added).
1. Investment Valuation Issues
a. Capitalization of Research and Development
The organization will capitalize research and development costs as part of its
asset base along with other value adding investments in advertising and training.
b. Current Valuation of the Balance Sheet
Balance sheet accounts are revalued to represent current cost.
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Business 5
2.
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Income Determination
Income may be adjusted to eliminate the impact of certain transactions and thereby
create a nearly cash basis income statement.
a. Adjustments to the balance sheet impact the income statement.
b. Deferred taxes are ignored.
EXAMPLE
Question:
Instafab Manufacturing has an investment in its southeast regional plant with an investment of
($300,000)after adjustments for capitalization of research and development costs and revaluation of
certain assets. The company's cost of capital is(12 percenQand their division produces a net income of
{$50,000)after adjustments for current year research and development, asset revaluations, and other
accounting considerations. Calculate the economic value added.
Solution:
After tax income
Investment
Cost of capital
Required return
Economic value added
$300,000
12%
$50,000
Instafab's economic value added is positive. Instafab has added to shareholder value.
XI. FORECASTING AND PROJECTION TECHNIQUES
Forecasting and projection techniques contemplate the institutional measures taken to develop
policies and standards as well as specific data driven techniques for projecting future results.
XII. (BUDGET)POLICIES
Establishment of effective budget policies is an organizational technique for developing forecasts
and budgets. The following outline summarizes the key features of budget policies relative to
budget projection.
A. Management Participation
Typically, a budget will extend for a period of one year and involve numerous individuals
through organizations of significant size. The budget process normally involves a budget
committee, which includes members of senior management. The budget committee is
charged with resolving disputes and making final decisions regarding major budget changes.
B. Budget Guidelines
(Top managemenOprovides a number of guidelines relative to budget preparation based on its
strategic goals and long-term plan. These guidelines include:
1. Evaluation of Current Conditions
Bs-38
a.
b.
c.
Consideration of the changes to the environment since the adoption of the
strategic plan.
Organizational goals for the coming period.
Operating results year-to-date.
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2. Management Instructions
a. Setting the tone for the budget (e.g., cost containment, innovation, etc.).
b. Corporate policies (e.g., mandated downsizing).
Business 5
XIII.
Mc:l\ l.\-Pc:l\Ctl.\Vl
STANDARDS AND BENCHMARKING(.,...

Budgets frequently revolve around the development of standards. Standards have been referred to
as per unit budgets and are integral to the development of flexible budgets. It is frequently these
standards that are used to forecast results based on prior performance or project financial
performance based on assumptions.
A. Ideal and Currently Attainable Standards
Standards are often set below expectations to(motivate productivity and efficienc0 but those
standard costs must be revised periodically (generally once per year) to reflect changes in
previously determined standards.
1.
Ideal standards represent the costs that result from perfect efficiency and effectiveness
in job performance. Ideal standards are generally not historical; they are forward
looking. No provision is made for normal spoilage or down time.
a. Advantage
An advantage of using ideal standards is the implied emphasis on continuous
quality improvement (COl) to meet the ideal.
b. Disadvantages
Disadvantages include demotivation of employees by the use of{unattainable}
standards and the inability to use standards in standard cost of goods sold.
2. Currently(Attainable)Standards GR: with -Ple)Cible
Currently attainable standards represent costs that result from work performed by
employees with appropriate training and experience but(withouDextraordinary effort.
Provisions are made for normal spoilage and down time.
a. Advantage
Fosters the perception that standards are reasonable.
b. Disadvantages
Required use of judgment and potential manipulation.
3. Standard Selection
No one standard is absolutely right in all situations. The best standard is the standard
that leads to accomplishment of strategic goals.
B. Authoritative and Participative Standards
1. Authoritative Standards
Authoritative standards are set exclusively by management.
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a.
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Advantages
Authoritative standards can be implemented quickly and will likely include all
costs.
b. Disadvantage
Workers might not accept imposed standards.
2. Participative Standards
Participative standards are set by both managers and the individuals that are held
accountable to those standards.
a. Advantage
Workers are more likely to accept participative standards.
b. Disadvantage
Participative standards are slower to implement.
C. Setting Standards with Benchmarks
(Benchmarking)nvolves adopting the best practices of different firms to establish standards.
1. Purpose
By adopting best practices, the attainment of the standard promotes achievement of
competitive advantage.
2. Sources
Benchmarks are often available from trade associations for particular industries. Some
organizations, dissatisfied with the benchmarks for their industry, adopt benchmarks by
function, regardless of industry.
XIV. DATA DRIVEN TECHNIQUES PROJECTION
Data driven decision-making models such as forecasting and sensitivity analysis allow for a formal
depiction of the objective, the constraints, and the steps in a process. They may even point to the
best solution among tested alternatives.
AD" A-re
A. Sensitivity Analysis 'Slope AI" A"ol",\o\o\e
Sensitivity analysis is the process of experimenting with different parameters and
assumptions regarding a model and cataloging the range of results to view the possible
consequences of a decision. Sensitivity models often use probabilities to approximate reality.
B. Forecasting Analysis
Forecasting (probabilitylrisk) analysis is an extension of sensitivity analysis.
Bs-40
1.
2.
Purpose -r L 1 L
Or4l'\ COSr
Forecasting involves predicting future values of a dependent variable (the variable one
is trying to explain) using information from previous time periods.
Application
Various quantitative methods (including regression analysis) are used in forecasting.
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xv. REGRESSION ANALYSIS - -rvy t() t()t4l'\l C()sts
Linear regression is a method for studying the relationship between two or more variables. One
use of linear regression is to predict the value of a dependent variable (e.g., total cost [y])
corresponding to given values of the independent variables (e.g., fixed costs [A], variable cost per
unit [8], and production expressed in units [x]).
A. Simple Linear Regression Model
Regression analysis explains variation in a dependent variable as a linear function of one or
more independent variables. Simple regression involves only(one)independent variable.
Multiple regressions involve more than one independent variable. \I()ll.\"",e
1. Components of the Simple Linear Regression Model
The simple linear regression model takes the following form:
-rC FC + NC fey l.\l.\it)C l.\l.\its)
y=A+Bx
where:
v = the dependent variable or the variable we are trying to explain. For example, Vmight be total
costs measured in dollars for a cost function.
x the independent variable (the regressor). The variable that explains V. For example, in a cost
function, x would be total activity (or output).
A the v-intercept of the regression line. For example, if Vis total costs, A would measure total fixed
costs.
B the slope of the regression line. For example, if Vis total costs, and x is output, Bmeasures the
change in total costs due to a one-unit change in output (variable cost per unit).
2. Application
If y is total costs and x is total activity or output, one goal of regression analysis would
be to predict total costs (the dependent variable, y) based on observed total activity or
output. (Questions on the CPA Exam expect you to predict total cost.)
B. Statistical Measures to Evaluate Regression Analysis
1. The Coefficient of Correlation (r)
a. Definition
The coefficient of correlation measures the strength of the linear relationship
between the independent variable (x) and the dependent variable (y). In
standard notation, the coefficient of correlation is "r."
b. Interpretation
The range of "r" is from -1.0 to +1.0, as follows:
-1.0 0 +1.0
Perfect inverse No Perfect direct
relationship relationship relationship
111\1
11
- Whel.\ C()st ch()()se the ()l.\e
with the v/v
2
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Business 5
2.
Becker Professional Education I CPA Exam Review
The Coefficient of Determination (R
2
)
a. Definition
The coefficient of determination (R
2
) may be defined as the proportion of the total
variation in the dependent variable (y) explained by the independent variable (x).
Its value lies between zero and one.
b. Interpretation
The higher the R
2
, the greater is the proportion of the total variation in y that is
explained by the variation in x. That is, the higher the R
2
, the better the fit of the
regression line.
XVI. LEARNING CURVE
A. Learning cUlve analysis is a step-by-step method of logically projecting costs when learning
is a variable, often for repetitive tasks.
B. The learning rate is a percentage expression of the decrease in average time (or total time)
as production doubles.
EXAMPLE
If a single aircraft takes 20 hours to build yet two aircraft take 32 hours to assemble, then the learning rate is
80% 32/40 (Year 2). Assuming demand in excess of capacity, minimal spoilage and full utilization, an 80%
learning rate will increase requirements for components.
XVII. HIGH-LOW METHOD 'See f ~ . 2S
The high-low method is a simple technique that is used to estimate the fixed and variable portions
of cost, usually production costs. The method is to compare the high and low volumes and the high
and low costs. It assumes that the differences are due directly to variable costs.
A. Procedures
1. Gather Data
Compare the high and low volumes and costs (ignoring any obvious aberrations).
Outliers, which are unusually high or low volumes, are eliminated.
2. Analyze Data
a. Divide the difference between the high and low dollar total costs by the difference
in high and low volumes to obtain the variable cost per unit.
b. Use either the high volume or the low volume to calculate the variable costs by
multiplying the volume times the variable cost per unit.
c. Subtract the total calculated variable cost from total costs to obtain fixed costs.
3. Formulate Results
';:The result enables preparation of a flexible/performance budget (see item B, below) by
identifying total fixed costs and variable costs per unit. This may be used to estimate
total costs at any volume.
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B. Flexible Budget Formula
The result of the high-low method is called a total cost formula and, sometimes, a flexible
budget formula (or equation).
1. Flexible Budget
A flexible budget (covered in detail below) is a series of budgets that are prepared for a
range of activity levels rather than a single activity (in which variable costs are adjusted
to the level of activity and fixed costs are held constant).
2. Formula
This formula defines total costs as equal to the fixed costs plus the variable costs per
unit times the units. The flexible budget formula is then used to estimate total cost at
any volume.
'I A I i
. lvariable cost Number J
Total cost = Fixed cost + . x f .
per unit 0 units
(B) ()<)
C. Concept Exercise - High-Low Method
IV EXAMPLE
DV
Difference between high and low -----..4.QQ
'Step \
Period
January
,---{FebruaryJ Low
March
April
J \ . H ~ h
June
High
4Low
UnitsNolume
1,200
1,000
l'050)AIV
1,130 400
1,400
1,200
1,400
(1,000)
Cost
9,000
8,450
8'600)ADV
8,750 \, \ 00
9,550
9,000
9,550
(8,450)
1,100
'Step 2.
ADV AIV
Variable cost per unit = $1,100/400 Units =($2.75/unit):= COl.\st4l'\l.\t
Cost Voll.\\r\r\e
Using either the high or low will produce the same Total Fixed Cost result:
'Step 4
Units
Total cost of units
Variable costs @ $2.75/unit
Total fixed costs )C \,400
TC = FC + [VC/unit x # units]
ITC = $5,700 + [$2.75 x # unitsJI
(8Ji)
1,400
$9,550
(3,850)
$5,700
"
Low
1,000
$8,450
(2,750)
$5,700
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PLANNING TECHNIQUES: BUDGET AND ANALYSIS
I. OPERATIONAL AND TACTICAL PLANNING
Operational and tactical planning is the process of determining the specific objectives and means
by which strategic plans will be achieved (strategic planning was covered in detail in chapter B-2).
Tactical plans are short-term and cover periods up to eighteen (18) months.
A.
B.
Single-Use Plans
(Tacticallans are also called single-use plans because they are developed to apply to
specific circumstances during a specific timeframe.
Annual Budget
An annual budget is a (type of) single-use tactical plan. Budgets translate the strategic plan
and implementation into a period-specific operational guide. Placing responsibility for
achievement of strategic goals in the hands of managers promotes routine accomplishment
of strategy as part of the manager's job function.
II. (MASTERpUDGETS
A master budget (or "annual business plan") documents specific short-term operating performance
goals for a period of time, normally one year or less. The plan normally includes an operating (non-
financial) budget as well as a financial budget that outlines the sources of funds and detailed plans
for their expenditure.
A. General
1. Purpose
Annual business plans are prepared to provide comprehensive and coordinated budget
guidance for an organization consistent with overall strategic objectives.
a. Control Objective
The master budget serves to communicate the criteria for performance over the
period covered by the budget.
b.
Terminologyit ~ ( o ~ e level)
IMaster budgetslare alternatively referred to aslstatic budgetsl annual business
plans, profit planning, or targeting budgets.
c.
Bs-44
2.
Use M-P8. & SeVVlCe
Annual business plans are appropriate fo(most industries b u t ~ particularly
useful in manufacturing settings that require coordination of financial and
operating budgets.
Components
A master bud et is generally comprised of operating budgets and financial budgets
prepared in nticipation of achieving a single level of sales volume for a specified
period of time.
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a. Pro-forma Financial Statements
The ultimate output of the annual business plan is a series of pro-forma financial
statements, including a balance sheet, an income statement, and a statement of
cash flows.
b. Assumptions
Pro-forma financial statements are supported by schedules that reflect the
underlying operating assumptions that produce those statements.
Limitations of the Annual Plan 3.
a.
-rl-\l.\S tl-\e -Pov
-Ple)Clble
see fc:l\8e , 1
-ta -ta
Master BudgetCConfined)o One Year at a Single Level of Activity
C
Budget amounts may be much different from actual results, even though the
relationship between expenses and revenues is consistent. An annual static
budget divided by 12 (to establish a monthly budget) may exaggerate variances
due to seasonal or volume fluctuations.
B.
\
b. Reporting Output
The product of the process is a set of pro-forma financial statements. Although
familiar, pro-forma financial statements may not provide the type of management
information most useful to decision-making.
Mechanics of Master Budgeting - Overview
1. Sales Budget
.La II II
"'X" The annual plan is driven by the sales budget.
a. Unit Sales Drives Unit Production
Sales revenue anticipates the unit volume that must be available to sell and,
therefore, drives the unit production required to sustain the budget.
b. Sales Volume Drives Support Cost
Budgeted sales revenue is also a product of actions taken to stimulate sales.
The selling and administrative budgets anticipate the expenses necessary to
produce or sustain current sales.
2. Budget Reports
The annual business plan process produces the following budgets and reports:
a. Operating Budgets
Operating budgets are established to describe the resources needed and the
manner in which those resources will be acquired. Operating budgets include:
(1 )
(2)
(3)
(4)
Sales budgets.
Production budgets.
Selling and administrative bUdgets]
<Sl.\ffovt Cc:l\st
Personnel budgets.
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Business 5
b.
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Financial Budgets
Financial budgets define the detail sources and uses of funds to be used in
operations. Financial budgets include:
(1) Pro-forma financial statements.
(2) Cash budgets.
3. Annual Plan Overview
The following flowchart provides an overview of the relationships between annual plan
components.
Mission I Strategy
+
Short-term Objectives

+
<Step 1
Capital Budget
./
-
(Sales Budget J
1
Production Budget
Selling and Administrative
Expense Budget
+
I

Direct
Direct Labor
Factory
Materials
Budget
Overhead
Budget Budget
+

Cost of Goods
-
Sold Budget
L
-
]
Cash Budget
Pro-Forma Financial Statements
OPERATING
BUDGETS
FINANCIAL
BUDGETS
Bs-46
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AN elL LA RY MAT ER I A L (for Independent Review)
Business 5
III. OPERATING BUDGETS - Sales Budget
Sales budgets represent the anticipated sales of the organization in both units and dollars. Sales
budgets (particularly units) are the foundation of the entire budget process. Inventory levels,
purchases, and operating expenses are coordinated with sales levels. Sales budgets are the first
budgets prepared, and they drive the development of most other components of the master budget.
Sales budget units drive the number of units required by the production budget. Sales budget
dollars drive the anticipated cash and revenue figures.
/'
'"
-
Sales Budget
~
~
Production
"-
..I
Selling and
Budget
Admi nistrative
Expense Budget

..

Direct Direct Factory
Materials Labor Overhead
Budget Budget Budget

-
Cost of Goods
--
Sold Budget
-
OPERATING
BUDGETS
A. Sales Forecasting and Budgeting
Sales budgets are the result of decisions to create conditions that will generate a desired
level of sales. Sales forecasts are predictions of sales under given sets of conditions.
Management develops guidelines specific to sales forecasting, including defining the sales
planning process and responsibilities.
1. Sales Forecasts
Sales forecasts are derived from input received from numerous organizational
resources, including the opinions of sales staff, statistical analysis of correlation
between sales and economic indicators, and opinions of line management.
a. Sales forecasts are developed after consideration of the following factors:
(1) Past patterns of sales.
(2) Sales force estimates.
(3) General economic conditions.
(4) Competitors' actions.
(5) Changes in the firm's prices.
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Business 5
(6)
(7)
(8)
Becker Professional Education I CPA Exam Review
Changes in product mix.
Results of market research studies.
Advertising and sales promotions plans.
2. Sales Budgets
Sales budgets represent the sales forecast associated with planned or anticipated
conditions. Sales budgets are based upon and selected from sales forecasts. The
sales forecast becomes the sales budget after revision and after acceptance by
management as an objective.
EXAMPLE
Blanchforte Stereo is a retailer of audio equipment. Blanchforte's sales manager is working with the controller to develop
the sales budget for the next year. Blanchforte's sales manager knows that sales volume is seasonal and that it can be
influenced by price and by promotions. The sales manager has come up with several scenarios to forecast sales
performance based on both units to be sold and average selling price.
Assumptions for Forecasts
First quarter sales are often weak. The sales manager projects the following sales volumes for aggregate units and average
prices.
2,000 units at full retail of $75
2,500 units assuming discounts down to $60
Second quarter sales strengthen somewhat for both graduation and Father's Day promotions. Agreater volume and ability
to collect full retail can be anticipated based on promotions.
3,000 units at full retail of $75
4,000 units assuming discounts down to $60
Third quarter sales historically decline despite both summer vacation and back-to-school promotions.
1,500 units at full retail of $75
2,000 assuming discounts down to $50
Fourth quarter sales spike in response to holiday spending.
7,000 units at full retail of $75
10,000 units at discounts down to $60
Blancheforte's sales manager and controller will develop the sales budget from the sales forecasts. Selection of the forecast
to be used for the budget will be based on the guidance the two have received with regard to the mission and strategy of
the company.
Assuming the company's financial mission is to build its resources and that it has selected a cost leadership strategy, we can
assume that Blancheforte's sales manager and controller will come up with a sales budget that focuses on discounts and
volume as follows:
Q1 Q2 Q3 Q4 Total
Sales (units) 2,500 4,000 2,000 10,000
Average price
~ ~ ~ ~
Total 150,000 + 240,000 + 100,000 + 600,000 = 1.090,000
Adjusting the sales budget to accomplish the sales forecasts assumed at full retail might result in greater sales dollars, but
that approach does not fit with the company's strategies. Ultimately Blancheforte is seeking to capture market share and
drive out competitors. The budget consistently selects the discounted sales price. Switching approaches throughout the
year may not be feasible if Blancheforte seeks to be the low cost leader for stereo equipment. Customers need to hear a
consistent message regardless of the time of year they shop and buy.
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IV. OPERATING BUDGETS - Production Budget
Production/inventory budgets are prepared for each product or each department and anticipate the
amount that will be produced, stated in units. The production budget anticipates the accumulation
and coordination of resources necessary to sustain manufacturing operations and fulfill budgeted
sales goals. The production budget is comprised of the amounts spent for direct labor, direct
materials, and factory overhead. The amount of the production budget is primarily defined by the
amounts of inventory on hand and the planned inventory amounts necessary to sustain sales.
Sales Budget
I
1
.,
Production
Selling and
Admi nistrative
Budget
Expense Budget
t
I

Direct Direct Factory
Materials Labor Overhead
Budget Budget Budget

-
Cost of Goods
--
Sold Budget
OPERATING
BUDGETS
A. Establishing Required Levels of Production
1. Production/inventory budgets are prepared in a manner consistent with the production
and inventory levels anticipated by the sales budget, with modifications for increases or
decreases in inventory levels.
2. The relationship between production, sales, and inventory levels is displayed in the
following formula:
Budgeted sales
+ Desired ending inventory
- Beginning inventory
Budgeted production
3. Desired levels of inventory are normally a function of sales volume and seek to balance
the risk of stockouts with the cost of maintaining inventory.
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EXAMPLE
Carlisle Manufacturing is trying to estimate the amount of production required for the month of June. Carlisle
will estimate production based on various estimates of monthly sales, beginning inventory amounts from
month to month, and safety stock amounts.
Assume that Carlisle wants safety stock of 30 percent of estimated sales and that estimated sales for the
months of June and July are as follows:
June ~ 40,000
July ~ 30,000
#1 Compute estimated inventory amounts:
June
M'i
Sales 40,000 30,000
Safety stock percent ~ % ~ %
Beginning inventory "required" 12.000 9.000
#2 Compute the estimated production for June:
Budgeted sales for June 40,000
Desired ending inventory + 9,000
Estimated beginning inventory -12.000
Budgeted production 37.000
Carlisle would anticipate producing 37,000 units to support its anticipated sales effort. Production of those
37,000 units would impact the manner in which direct labor, direct material, and overhead was budgeted.
BS-SO
4. Other Factors Impacting the Production Budget
a. Company policies regarding stable production.
b. Condition of production equipment.
c. Availability of productive resources.
d. Experience with production yields and quality.
B. Direct Materials Budget
The direct materials required to support the production budget are defined by the direct
materials usage budget and the direct materials purchases budget.
1. Direct Materials Purchases Budget
The direct materials purchases budget represents the dollar amount of purchases of
direct material required to sustain production requirements. Amounts for direct
materials purchased include consideration of amounts needed for production, amounts
available in inventory, and the amount anticipated or required for ending inventory.
a. Number of Units to be Purchased
The number of units of direct materials to purchase is calculated from the
production budget. The units of the direct materials needed to sustain the
production budget are derived from the production budget. The formula is as
follows:
Units of direct materials needed for a production period
+ Desired ending inventory at the end of the period
- Beginning inventory at the start of the period
= Units of direct materials to be purchased for the period
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b. Cost of Direct Materials to Be Purchased
The cost of direct materials purchased is calculated by applying the anticipated
cost per unit of direct materials to the computed amount of direct materials to be
purchased.
Units of direct materials to be purchased for the period
x Cost per unit
Cost of direct materials to be purchased for the period
2. Direct Materials Usage Budget (Cost of direct materials used)
The direct materials usage budget represents the number of units of direct materials
required to sustain production requirements along with the related cost of those direct
materials. Amount of direct materials used are comprised of amounts from inventory
and amounts purchased.
a. The extended costs associated with direct materials are derived as follows:
Beginning inventory at cost
+ Purchases at cost
- Ending inventory at cost
Direct materials usage (cost of materials used)
3. Impact of Purchasing Policies
Purchases budgets are influenced by management's philosophy regarding required
inventory levels, including safety stock and stockout decisions.
C. Direct Labor Budget
Direct labor budgets anticipate the hours and rates associated with workers directly involved
in meeting production requirements.
1. Computation
Direct labor hours are computed based upon the hours necessary to produce each unit
of finished goods. Direct labor costs are equal to the total hour required to meet
production budget times the hourly rate applicable to each hour worked. Computations
are as follows:
Budgeted production (in units)
x Hours (or fractions of hours) required to produce each unit
Total number of hours needed
x Hourly wage rate
Total wages
2. Direct Labor Budget Factors
Development of a direct labor budget involves consideration of several factors,
including skill levels required and labor contracts or hiring policies.
a. Skill
Different skill levels normally command different rates of pay. Organizations
often prepare direct labor budgets for each level of skill necessary for conversion
of direct materials into finished goods.
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b.
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Union Contracts and Hiring Policies
A pure direct labor budget anticipates the cost of the hours needed to produce
finished products. Work required by production rarely directly coincides with
worker availability. Often, workers are available for longer than absolutely
necessary. Labor contracts and hiring policies often preclude management from
staffing and laying off personnel in direct proportion to work required. Direct
labor budgets consider the impact of unused but compensated hours.
c. Pro-forma Statement of Employee Benefit Costs
The pro-forma statement of employee benefit costs is calculated by projecting
the cost of employee benefits using direct labor as the cost driver. If employee
benefits are assigned to direct expenses, they are included as part of costs of
goods manufactured. If benefits are assigned to overhead, only the applied
portion of benefits would be charged to cost of goods manufactured. Inclusion of
benefits in overhead would have the tendency to understate net income relative
to applying benefits to direct labor.
EXAMPLE
Carlisle Manufacturing computed its budgeted production at 37,000 units to sustain budgeted sales of
40,000 units in the month of June. We assume we need 4 pounds of direct material to produce each
unit of finished product. We assume that new direct materials cost $10 per pound and that they were
previously acquired for $9 per pound. We also assume we use 2 hours of direct labor to convert the
direct materials to finished goods at $20 per hour. What are the Direct Materials and Direct Labor
Budgets for the month of June?
DIRECT MATERIAL PURCHASES
Units of direct materials neededfor a production period
Budgeted production
Pounds of direct material per unit
Total pounds needed
+ Desired ending inventory at the end of the period
Pounds of direct material (given)
- Beginning inventory at the start of the period
Pounds of direct material
Direct material to be purchased
Cost per pound
Direct material purchases
DIRE CT MAT ERI A LSUS AGE BUD GET (cost of direct materials used)
Beginning inventory at cost (48,000 x $9)
+ Purchases at cost
- Ending inventory at cost (36,000 x $10)
= Direct materials usage (cost of materials used)
DIRECT LABOR BUDGET
Budgeted production
Hours of direct labor per unit
Total hours needed
Rate per hour
Direct labor budget
37,000 units
___24 pounds
148,000 pounds
36,000 pounds
(48,000) pounds
136,000 pounds
x $10
$1.360,000
$ 432,000
1,360,000
(360,000)
$1.432,000
37,000 units
x 2 hours
74,000 hours
x $20
$1.480,000
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D. Factory Overhead Budget
Factory overhead represents the cost pool of all costs that are not direct labor or direct
materials. Some overhead items vary directly with production while other overhead items do
not. Overhead that varies directly with production is identified as variable while overhead that
does not vary directly is identified as fixed.
1. Applied Based on a Representative Statistic
Factory overhead is applied to inventory (cost of goods manufactured and sold, below)
based on a representative statistic. Frequently, the rate is applied using direct labor
hours.
EXAMPLE
Carlisle Manufacturing is budgeting the application of its factory overhead to its cost of goods
manufactured. Carlisle has identified direct labor hours as the appropriate basis for applying variable
factory overhead and has determined that its variable overhead rate is $5 per hour. How much
variable overhead would Carlisle budget to be applied to cost of goods manufactured in the month of
June if the company used 74,000 direct labor hours according to the direct labor?
The application rate is the direct labor hour, the application amount is $5 per hour, and the budgeted
direct labor hours anticipated for June, inferred from the production budget, is 74,000 hours.
Budgeted overhead is the product of the rate times the base, in this case, direct labor hours as follows:
74,000 direct labor hours x $5 per hour = $370,000
2. Components of Factory Overhead Budget
a. Variable Factory Overhead
Variable factory overhead is comprised of the following items:
(1 ) Supplies
(2) Indirect labor (e.g., quality assurance)
(3) Fringe benefits related to indirect labor
(4) Power (related to increases or decreases in production)
(5) Maintenance (related to increases or decreases in production)
b. Fixed Factory Overhead
Fixed factory overhead is comprised of the following items:
(1 ) Depreciation
(2) Insurance and taxes
(3) Indirect Labor (e.g., supervision)
(4) Fringe benefits related to indirect labor
(5) Power (related to maintaining capacity)
(6) Maintenance (related to maintaining capacity)
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Business 5
E.
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Cost of Goods Manufactured and Sold Budget
The cost of goods manufactured and sold budget is prepared in a manner consistent with
planned sales and the changes in various inventory levels (e.g., direct material, work-in-
process, and finished goods). Cost of goods manufactured and sold logically accumulates
the information from the direct labor, direct material, and factory overhead budgets for
matching the cost to budgeted sales.
1. Components of the Costs of Goods Manufactured and Sold Budget
a. The cost of goods manufactured represents the sum of the budgets for each
element of manufacturing as follows:
(1) Direct labor
(2) Direct material
(3) Factory overhead
b. Cost of goods sold considers cost of goods manufactured in relation to beginning
and ending inventories of finished goods as follows:
Cost of goods manufactured
+ Beginning finished goods inventory
- Ending finished goods inventory
= Cost of goods sold
EXAMPLE - COST OF GOODS MANUFACTURED AND SOLD
Carlisle Manufacturing is preparing its budgeted cost of goods manufactured and budgeted cost of
goods sold schedules for the month of June. It has developed the following statistics:
Direct material used
Direct labor
Factory overhea d (variable)
Factory overhea d (fixed)
Finished goods (beginning)
Finished goods (ending)
Compute the cost of goods manufactured
Direct material used
Direct labor
Factory overhea d (variable)
Factory overhea d (fixed)
Total cost of goods manufactured
Plus finished goods, beginning
Goods available
Less finished goods, ending
Cost of goods sold
$1,432,000
1,480,000
370,000
300,000 (given)
1,000,000 (given)
750,000 (given)
$1,432,000
1,480,000
370,000
300,000
3,582,000
1,000,000
4,582,000
(750,000)
$3.832.000
Bs-54
2. Cost of Goods Sold and the Pro-forma Financial Statements
The budgeted cost of goods sold amount feeds directly into the pro-forma income
statement. Budgeted cost of goods sold is matched with budgeted sales as a basis for
budgeting gross margin. Cost of goods sold is also consistent with inventory
computations displayed on the pro-forma balance sheet. Budgeted purchases are
derived from the following relationship:
Desired ending Cost of Beginning Budgeted
inventory +goods sold - inventory =purchases
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V. OPERATING BUDGETS - Selling and Administrative Expense Budget
Selling and administrative expenses represent the non-manufacturing expense anticipated during
the budget period. Portions of selling and administrative expenses are variable while others are
fixed. Selling and administrative expense budgets are prepared by various departments in a
manner consistent with either planned sales volume or the fixed character of the expenses. The
selling and administrative budget needs to be detailed so that the key assumptions associated with
it can be better understood.
-
Sales Budget
1 1
Production
Selling and
Budget
Admi nistrative
Expense Budget

.. ..
'-
Direct Direct Factory
Materials Labor Overhead
Budget Budget Budget
+
-
Cost of Goods
~
Sold Budget
-
OPERATING
BUDGETS
A. Components of Selling and General Administration Expense
1. Variable Selling Expenses
a. Sales commissions
b. Delivery expenses
c. Bad debt expenses
2. Fixed Selling Expenses
a. Sales salaries
b. Advertising
c. Depreciation
3. General Administrative Expenses (all fixed)
a. Administrative salaries
b. Accounting and data processing
c. Depreciation
d. Other administrative expenses
B. Selling and Administrative Expenses and the Pro-forma Financial Statements
Selling and administrative expenses are not inventoried and are budgeted as period costs.
Budgeted selling and administrative expenses are matched in their entirety against budgeted
sales.
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Business 5
VI. CONTRIBUTION MARGIN
Becker Professional Education I CPA Exam Review
Management accounting reporting formats, particularly profit center strategic business units, is
often reflected on contribution margin basis (also referred to as variable costing or directing costing
basis). Variable cost formats clearly show the relationship between sales and variable costs to
derive contribution margin, the contribution to fixed costs.
A. Production Budget Components
Production budget components can be developed using a variable costing format that
segregates fixed and variable costs. Particular care must be taken when developing the
overhead budget to segregate fixed and variable costs.
B. Selling and Administrative Expenses
Selling and administrative expenses can be segregated between fixed and variable costs to
facilitate variable costing displays.
C. Profit Planning
Contribution margin per unit displays are used to reflect earnings on each additional unit of
sales. The product of contribution margin and budgeted sales, in units, displays contribution
margin in total.
VII. FINANCIAL BUDGETS (cash budgets and pro-forma financial statements)
Pro-forma financial statements (also known as budgeted, estimated, or targeted financial
statements or profit plans) describe the organization's goals and objectives in financial, quantitative,
and qualitative terms. The pro-forma income statement is a result of the operating budgets. The
pro-forma balance sheet and statement of cash flows are the results of the pro-forma income
statement plus financing decisions and capital purchase decisions. Pro-forma financial statements
are subject to analysis in the same way that historical statements are analyzed. Ratio analysis can
be performed on the balance sheet or the income statement. Cash shortfalls or loan covenant
violations can generally be anticipated. The cash budget, which displays the cash receipts and
disbursements of the organization, is one of the last budgets to be prepared in a normal budget
process since it is derived from accrual based information prepared as part of pro-forma financial
statements. Cash budget data, however, is used to derive cash balance data displayed in the pro-
forma balance sheet.
I
Mission I Strategy I
..
IShort-term Objectives I
..
I
Sales Budget
I
..
Operati ng Budgets
I
,
Financial Budgets
..
[ Cash Budgets
1
Pro-forma Financial Statements
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Becker Professional Education I CPA Exam Review Business 5
VIII. FINANCIAL BUDGETS - Cash Budgets
Cash budgets represent detailed projections of cash receipts and disbursements. Cash is the most
critical resource of an organization. Even profitable organizations can go bankrupt because of lack
of liquidity. The cash budget is derived from other budgets based on cash collection and
disbursement assumptions. A significant portion of cash budgeting is to convert accrual
assumptions to cash basis assumptions. Cash budgets provide management with information
regarding the availability of funds for distribution to owners, for repayment of debt and investment.
Managers use this information to maximize returns on idle cash and minimize the costs associated
with interim financing. Cash budgets are generally divided into three major sections:
Cash available
Cash disbursements
Financing
A. Cash Available
Cash available represents the cash available for use by the organization. Cash available is
normally associated with both balances available at the beginning of the period and cash
collections.
1. Cash Balances
Cash balances are summarized by the amounts of cash on hand that can be used to
liquidate expenses. Cash balances that are available are subject to both management
policies relative to minimum amounts of cash on hand and any agreements relative to
compensating balances.
2. Cash Collections (cash collection budgets)
Cash collection budgets commonly specify the amounts of cash that will be received
from sales, based on the sales budget and from anticipated loan proceeds.
a. Cash collection budgets set standards for collections based on current period
sales (usually monthly) and prior period sales (also usually monthly).
b. Cash collection budgets make assumptions regarding the percentage of credit
sales and the speed at which those collections will occur.
B. Cash Disbursements
Cash disbursements budgets represent the cash outlays associated with purchases and with
operating expenses.
1. Purchases
Cash disbursement budgets (for purchases) indicate the anticipated amount that will be
paid for purchases.
a. Cash disbursement budgets anticipate:
(1) Cash purchases for the current period (generally the current month);
(2) Credit purchases (accounts payable) for the current period; and
(3) Cash disbursements required to repay accounts payable during the current
period.
b. Cash disbursements budgets anticipate such figures as the percentage of goods
bought on credit, the age of payables liquidated, and the percentage of goods
purchased for cash.
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Business 5
2.
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Operating Expenses
Cash disbursements budgets (for operating expenses) specify the amounts paid out to
defray the costs of operating expenses.
a. Cash disbursements budgets eliminate non-cash operating expenses (such as
depreciation).
b. Cash disbursements budgets consider each of the following:
(1) Percentage of prior month expenses to be paid in the current month;
(2) Current month expenses for which disbursement is deferred until the
following month; and
(3) Current month expenses paid in cash in the current month.
c. Cash disbursements consider the impact of accounts payable (other operating
expenses) and accrued payroll (wages).
B5-58
C. Financing
Financing budgets consider the manner in which operating (line of credit) financing will be
used to maintain minimum cash balances or the manner in which excess or idle cash will be
invested to ensure both liquidity and adequate returns.
D. Cash Budget Formats
Cash budgets represent statements of planned cash receipts and disbursements and are
primarily affected by the amounts used in the budgeted income statement. Cash budgets
consider:
1. Beginning cash.
2. Cash collections from sales (add).
3. Cash disbursements for purchases and operating expenses (subtract).
4. Computed ending cash.
5. Cash requirements to sustain operations (subtract).
6. Working capital loans to maintain cash requirements.
I Mission I Strategy I
..
IShort-term Objectives I
I Sales Budget I
,
Operati ng Budgets
..
Financial Budgets
..
Cash Budgets
[pro-Forma Financial Statements I
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Becker Professional Education I CPA Exam Review Business 5
IX. FINANCIAL BUDGETS - Pro-forma Financial Statements (income statement)
Budgeted income statements are budgeted amounts formatted in a manner similar to an income
statement. Key components of the budgeted income statement include the assembly of data
described in the operating budgets, including:
A sales budget;
A cost of goods sold budget (derived from the purchases budget);
A selling and administrative expense budget; and
An interest expense budget (taken from the cash budget).
X. FINANCIAL BUDGETS - Pro-forma Financial Statements (balance sheet)
Budgeted balance sheets display the balances of each balance sheet account in a manner
consistent with the income statement and cash budget plans developed above.
A. Relationship to Cash Budget
Balance sheet accounts are adjusted for the cash collections and disbursements associated
with the cash budget.
B. Relationship to Pro-forma Income Statement
Balance sheet accounts are adjusted for the non-cash transactions accounted for in the
income statement.
XI. FINANCIAL BUDGETS - Pro-forma Financial Statements (statement of cash flows)
The budgeted statement of cash flows anticipates the manner in which cash flows would be
reported if budgetary amounts materialize as projected. The budgeted statement of cash flows
would be derived from the budgeted income statement, the current and previous budgeted balance
sheets, and then be reconciled to the cash budget. Cash budgeting has the benefits of displaying
the cash effects of the master budget on actual cash flows, assisting in the determination of
whether additional sources of financing are required, and evaluating the optimal use of trade credit.
XII. CAPITAL BUDGETS
Capital purchases budgets identify and allow management to evaluate the capital additions of the
organization, often over a multi-year period. Financing is a significant component of the capital
purchases budget. Capital budgets detail the planned expenditures for capital items (e.g., facilities,
equipment, new products, and other long-term investments). Capital budgets are highly dependent
upon the availability of cash or credit, and they generally involve long-term commitments by the
organization.
A. Pro-forma Balance Sheet
Planned additions of capital equipment and related debt from the capital budget are added to
the balance sheet.
B. Pro-forma Income Statement
Planned additions of capital equipment are considered in developing budgeted depreciation
expense while interest expense associated with planned financing is included as an expense.
C. Cash Budget
Planned financing expenses and principal repayments are included as disbursements on the
cash budget.
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Business 5
XIII. OTHER BUDGETS
Becker Professional Education I CPA Exam Review
Research and development budgets represent the planned expenses of the organization on
product development, and they are sometimes based on a percentage of sales.
XIV. MASTER BUDGET
The following flowchart shows an alternative view of the master budget and the interrelationships
between elements. Although this approach is more detailed than our teaching model, it is
consistent in concept.
MASTER BUDGET
~
Sales
~
Budget
~
_ Ca ital
Marketing Administrative Production
Projected p u r ~ a s e s
Budget Budget Budget "-
\ Inventory B d
u get
~
+
~
-
Material
Labor
Factory Receivables
Purchases
Budget
Overhead and Payables
Budget Budget Projections
"" Cost O:GOOdS I /
~ Manufactured 1/
Budget
Research and
Development
Budget
L..--------.I Cash Budget I..,---------J
Accrual
Trial
Balance
Pro Forma:
Balance Sheet
Income Statement
Statement of Cash Flows
Analysis of
Pro-Forma
Results
END OF ANCILLARY MATERIAL
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xv. FLEXIBLE BUDGETING wHl-\ 'MOst & 'MOst
A flexible budget is a financial plan prepared in a manner that allows for adjustments for changes in
production or sales and accurately reflects expected costs for the adjusted output. Analysis
focuses on substantive variances from standards rather than simple changes in volume or activity.
A. General
Flexible budgets represent adjustable economic models that are designed to predict
-ta outcomes and accommodate changes in actual activity. Revenues and expenses are
adjusted to display anticipated levels for achieved outputs.
1. Assumptions and Uses VC fe
v
totc:l\l FC
Flexible budgets include consideration of revenue per unit, variable costs per unit, and
fixed costs over the relevant range where the relationship between revenues and
variable costs will remain unchanged and fixed costs will remain stable.
a. Yield
Flexible budgets consider the amount of cost per unit allowed for units of output.
b.
Variance Analysis "Actl.\c:l\l"
Flexible budgets derive the expenses and revenues allowed from the output
achieved for purposes of comparison to actual activity and performance
evaluation.
2. Benefits and Limitations of the Flexible Budget
a. Benefits
Flexible budgets can be displayed on any number of volume levels within the
relevant range to pinpoint areas where efficiencies have been achieved or where
waste has occurred.
b. Limitations
Flexible budgets are highly dependent on the accurate identification of fixed and
variable costs and the determination of the relevant range.
B. Mechanics of Flexible Budgeting
1. Identify Cost Behavior and Unit Costs
a. Segregate the fixed and variable portions of expenses.
b. Convert variable expenses to per unit amounts.
c. Increases or decreases in volume anticipate identical relationships between
variable costs and revenues.
2. Use the Budget Formula to Produce a Flexible Budget
3. Apply Actual Volume to Flexible Budget Formula (model)
Based on the flexible budget formula, determine the amount of allowed expenses or
required revenues associated with achieved levels of activity.
a. Determine the actual volume of the revenue and cost driver;
b. Multiply variable revenue and cost by the appropriate revenue and cost
drivers; and
c. Place variable costs and fixed costs in the flexible budget formula.
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Business 5
EXAMPLE
Becker Professional Education I CPA Exam Review
$360,000
(240,000)
120,000
(100,000)
$ 20.000
S"",OOO )< \ .20 ==- ',000
120% of
Master
The Flex-o-matic Corporation produces the Flex-o-matic, a piece of exercise equipment. Corporate controller
Felix Flexmeister is developing a flexible budget. Felix has already developed a master budget but estimates
that the relevant range extends 20 percent above and below the master budget. What is the relevant range
in dollars assuming a selling price of $60 per unit, variable costs of $40 per unit, fixed costs of $100,000 and
anticipated output according to the master budget 0 5,000 units?
'300 -:- S"" ==- '0 .gO )C S"",OOO ==- 4,000
80% of Master
200 -:- S"" ==- <,40;> Master Budget
-20 Sales $240,000 $300,000
CM Variable costs (160,000) (200,000)
Contribution margin 80,000 100,000
Fixed costs (100,000) (100,000)
Operating income $(20,000) $ 0
-ta
XVI. BUDGET VARIANCE ANALYSIS
Comparison of actual results to the annual business plan is the first and most basic level o(control)
and evaluation of operations. Budget variance analysis becomes progressively more sophisticated
as managers are able to review either flexible budget comparisons or variances from operating
standards. The use of budget variances is an application of the concept of management by
exception.
A. Performance Report
Actual results may be easily compared to budgeted results; however, usefulness is limited by
the existence of variances from budget that may be strictly related to(volume) -r",l.\S AAjl.\St IMAstev
to cveAte -P1e)<ib1e
EXAMPLE
Neostar Corporation has prepared its annual business plan for the year-ended 20X1. The organization
anticipated that it would sell 10,000 units of its product at $15 a piece, that its contribution margin percentage
would be 20 percent, and that its fixed costs would be $25,000. Actual units sold numbered only 8,000
(totaling $112,000 in revenues); variable expenses materialized at $100,800, and fixed costs materialized at
$24,000.
You have been asked to prepare a performance report.
Revenue
Variable expenses
Contribution margin
Fixed costs
Net income (loss)
Neostar Corporation
\0,000 Performance Report
Mt:'\stev December
Budget Actual
$150,000 $112,000
(120,000) (100,800)
30,000 11,200
(25,000) (24,000)
$ 5,000 $ (12,800)
Variance 1 "1
($38,000) Unfavorable Re AweA
19,200 Al.\e vo1l.\lMe
(18,800) Unfavorable
1,000 Favorable
$(17,800) Unfavorable
Bs-62
Variances need significant analysis before they are useful. The favorable variance in variable expenses, for
example, does not represent efficiencies. Budgeted contribution margin ratios are 20 percent; actual
contribution margin ratios are 10 percent. Sales in units were off budget by 20 percent, yet revenues are
down by 25 percent! Something is very wrong at Neostar, but what? Performance reports based on annual
business plans do not produce effective management by exception data.
Be-Pove VAV. - AAj. IMAstev -Pov
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B. Use o(Flexible BUdgets)to Analyze Performance
Flexible budgets are based on a cause and effect relationship. The identified driver is the
cause, and the variable cost or revenue is the effect. The flexible budget allows managers to
identify how an individual change in a cost or revenue driver affects the overall cost of a
process.
EXAMPLE
Management at Neostar has heard that flexible budgeting can provide more meaningful information. They have asked you
to prepare a flexible budget using the same information described in our original concept example.
\)
f,OOO
Neostar Corporation
Flexible Budget Performance Report 0> 000
For the year ended December 31, Year 1 l ;J 0,
Flexible Sales
Actual Flexible Budget @ Activity
Results @ Budget Actual (Volume)
QictiiGj) Variances (Planned Cost) Variances
Master
Budget
(6.000)
Units
Sales V
Variable costs V
Contribution margin V
Fixed costs
Operating income
Flexible budget variances
Sales activity (volume) variances
Total master budget variances
*24,000/120,000 = 20%
30,000/150,000 =20%
8,000 8,000
112,000 V (8,000) 120,000 )( 1S"(30,000)
(100,800) V (4,800) )( 12 24,000
11,200 V (12,800) 24,000* (6,000)
(24,000) f 1,000 (25,000)
(12,800) (11.800) (1.000)
(11,800)
(6,000)
10,000
150,000 1S"O ..;-
(120,000) 12.0 ..;-
30,000*
(25,000)
5.000
(17,800)
10
10
Flexible budget variances show that revenue per unit was less than expected, while variable costs per unit were greater than
expected. The company has performed $11,800 worse than expected. Meanwhile, differences in volume produced a $6,000
unfavorable variance, yielding a total variance from budget of $17,800.
Although we still don't know what's wrong with Neostar, we know where to look. Revenues are not materializing as
expected despite efforts to discount our selling price (producing an unfavorable sales price variance of $8,000). and
expenses are over budget (producing an unfavorable variable cost variance of $4,800 despite a favorable fixed cost variance
of $1,000).
XVII. VARIANCE ANALYSIS USING STANDARDS
Variance analysis becomes increasingly sophisticated as the investigation of differences between
budgeted and actual performance moves from the aggregate examinations associated with either
performance reporting or flexible budget analysis to the computation of per unit variances normally
associated with the use of standard cost systems.
Computation of variances can be complex and CPA candidates often find different ways to
memorize, understand and apply these concepts to exam questions. We have presented the
traditional trough method and we have also presented other alternatives as supplementary
information. All methods produce the same results.
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Business 5 Becker Professional Education I CPA Exam Review
A. Variance Calculations Using Standards
1. (Standard);ost Objectives
The objective of using a standard cost system is to attain a realistic predetermined or
budgeted cost for use in planning and decision making. It also greatly simplifies
bookkeeping procedures.
2. Evaluating Variances from Standard
The differences between actual amounts and standard amounts are called variances.
a. Evaluating Results
An actual cost lower than standard cost is called a favorable variance, and an
actual cost higher than standard cost is called an unfavorable variance.
vc
DM
D\..
Evaluating Control
If a variance from standard could have been prevented, it is called a controllable
variance; if not, the variance is known as an uncontrollable variance.
4 Most . p l ) C e ~ costs
b.
Product Costs Subject to Variance Analysis
Product costs generally consist of direct material, direct labor, and manufacturing
overhead. A favorable or unfavorable variance in total is a composite of a number of
variances. Variances are typically calculated for the following cost elements:
3.
a. Direct material (DM)
b. Direct labor (DL)
c. Variable manufacturing overhead (VOH)
d. Fixed manufacturing overhead (FOH)
Direct Materials and Direct Labor Variance
For direct materials and direct labor, two variances are typically calculated: a price (or rate)
variance and a quantity (or efficiency) variance. The variance calculations may be
approached in either an equation or tabular format. Both are presented below:
1. Equation Format
OM price variance
OM quantity usage variance
OL rate variance
OL efficiency variance
Actual quantity purchased x (Actual price - Standard price)
Standard price x (Actual quantity used - Standard quantity allowed)
Actual hours worked x (Actual rate - Standard rate)
Standard rate x (Actual hours worked - Standard hours allowed)
Materials and price variances are expense variances. When actual pricelrate or actual
quantitylhours exceed standards, variances are unfavorable. If standards exceed
actuals, variances are favorable.
2. Tabular Format
The variance is computed by comparing two totals. If a figure on the left (actual) is
larger than a figure on the right (standard), then the variance is unfavorable; if the
figure on the left is smaller, the variance is favorable.
Bs-64
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ctl.\c:l\l Ol.\tpl.\t
fev
ctl.\c:l\l Ol.\tfl.\t
fev
Becker Professional Education I CPA Exam Review
The specific variances follow below:
TABULAR FORMAT
1 Direct;1

A
Materials
Actual quantity Actual quantity Standard quantity
)<:
purchased x Actual purchased x Standard allowed x Standard
price 4

price
/
price
I
Price variance
I
Actual
Standard price
I
Quantity usage variance
I
I Direct Labor I
J
Actual hours x Actual hours x standard Standard hours allowed x
)Ii
actual rate 4

rate standard rate


I
Rate variance
1
Efficiency variance
I
Business 5
EXAMPLE - MATERIALS VARIANCES USING EQUATION AND TABULAR FORMATS
Actual quantit(purchased)
Actual quantity used
Units standard quantity
Actual price paid
Standard price
200 units
110 units., V
100 units.-J
$8 per unit.,
$10 per unit.-J F
DM price variance = AQpurchased x (AP - SP)
= 200 units x ($8/unit - $10/unit)
= $400 Favorable
DM quantity variance = SP X (AQused - SQallowed)
= $10/unit x (110 units -100 units)
= $100 Unfavorable
IDirect Materialsl
Actual quantity Actual quantity Standard quantity
purchased x Actual price purchased x Standard price allowed x Standard price
200 x $8 = $1,600 20
1
0 x $10 = $2,00/ 100 x $10 = $1,000
I
Price variance
= $400 F
Actual quantity used x
Standard price
Quantity usage variance
110 x $10 = $1,100
= $100 U
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Business 5 Becker Professional Education I CPA Exam Review
EXAMPLE - LABOR VARIANCES USING EQUATION AND TABULAR FORMATS
Actual hours worked
Standard hours
Actual paid rate
Standard rate
DL rate variance
DL efficiency variance
450 hours .,F
500 hours .-J
$20 per hour" V
$15 per hour .-J
AHworked x (AR - SR)
450 hours worked x ($20/hour - $15/hour)
$2,250 Unfavorable
SR x (AHworked - SHaliowed)
$15/hour x (450 hours worked - 500 hours allowed)
$750 Favorable
I Direct Labor I
Actual hours x Actual hours x Standard Standard hours allowed x
Actual rate.. rate .-J Standard rate
450 x $20 = $9,000 450 x $15 = $6,750 500 x $15 = $7,500
I
Rate variance I Efficiency variance I E)C+vc:l\ Vc:l\te
L-__ -=--U__...L.- =
l,S'OO V
ANCILLARY MATERIAL (for Independent Review)
PASS KEY
In addition to the equation and tabular formats, try our SAD and PURE mnemonics to get you through
this tricky area of the exam
1. To determine how the "Difference" is calculated in variance analysis, the DIFFERENCE is always
Standard minus Actual-ALWAYS!! It would be "SAD" if you forgot this:
Standard - Actual = Difference
2. Recognize the main four types of variances (not the overhead variances) for raw materials and
direct labor:
P Price variance (for DM)
U Usage (quantity) variance (for DM)
R Rate variance (for DL)
E Efficiency variance (for DL)
3. Memorize how these variances are calculated - Remember your dad always gave you advice about
life, and memorizing variance formulas is easy if you remember him! Apply "DADS" twice to set up
a schedule you cannot forget!
DA Difference x Actual
DS Difference x Standard
DA Difference x Actual
DS Difference x Standard
Line up your DADS with PURE:
P D xA
U D x 5
R Dx A
E DxS
And, remember, it would be SAD if you forgot how the "difference" amount was calculated!
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PASS KEY APPLICATION
Business 5
Facts:
Direct materials (3 pounds per unit @ $2.50 per pound)
Direct labor (5 hours @ $7.50 per hour)
Normal volume per month
January produced
$7.50
$37.50
40,000 hours
7,800 units
Januaryactuals:
Direct materials purchased
Direct materials used
Direct labor
Factory overhead
25,000 pounds @ $2.60 per pound
23,100 pounds
40,100 hours @ $7.30
$300,000
5 $ 2.50 D x A
P A $ 2.60 ($0.10) $25,000 ($2,500)
D ($ 0.10) actual units purchased purchase price variance
Total Material = ($1,750)
5 $23,400 D x S
U* A $23,100 $300 $2.50 $750
D $ 300 usage variance
5 $7.50 D x A
R A $7.30 $0.20 $40,100 $8,020
D $0.20 actual hours worked rate variance
Total Labor = ($230)
5 $39,000 D x S
E* A 40,100 ($1,100) $7.50 ($8,250)
D ($1,100) standard rate per hour
*Must use actual units produced to get standards:
Usage: 7,800 x 3 pounds per units = 23,400
Labor: 7,800 x 5 hours per units = 39,000
END OF ANCILLARY MATERIAL
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<Step t <SQA
1
24
/0001
Actl.\c:l\l )C pev
t2/000 )C 2
Business 5
<Step 2
Becker Professional Education I CPA Exam Review
EXAMPLE
24/000
)C 2.S'"
$'0/000
12,000 units.
12,500 units.
24,000 units.
25,000 units.
a.
V 2,S'"00

Solution: Choice "d" is correct. Units of material used in November = 25,000 units.
ChemKing uses a standard costing system in the manufacture of its single product. The 35,000 units of raw material in
inventory were purchased for $105,000, anc(two raw material are required to produce one unit of final product. In
November, the company producec(12,000)mits of product. The standard allowed for material wa($60,000) and there was
an unfavorable quantity variance of $2,500. The units of material used to produce November output totaled:
AQV 2S'",000
2.S'" StA. )C 25"
('0,000 + $'2,S'"00
to be b.
c.
..f)
24
The facts for the question tell us that the quantity (usage) variance is an unfavorable $2,500. How is the materials usage
variance calculated? Remember PURE with DADS twice, and don't forget the difference is SAD!!!
U=DxS
Usage variance = Difference in usage x Standard price
The standard price is $2.50/unit. The standard allowed for the material was $60,000, and 12,000 units were produced in
November. Therefore, the materials cost on "standard" was $5.00 per unit [$60,000/12,000 units]. However, we are told
that it takes two units of raw material to make one unit of completed goods. So, the standard price for one unit of material
is $2.50 [$5.00/2].
We also know that the usage variance is unfavorable $2,500. So, we solve for the "difference in usage" as follows:
U = D x 5
($2,500) = D x $2.50
($2,500) / $2.50 = D
(1,000) = D
CD o/H. 0 <SHA
Manufacturing Overhead Variance Actl.\c:l\l I
The analysis of manufacturing overhead is the analysis of the debit or credit balance in the (<sHA )C Rc:l\te)
overhead account. A net debit balance (underapplied) is an unfavorable variance while a net
credit balance (overapplied) is a favorable variance.
c.
So, the unfavorable units used amounted to 1,000. The facts of the question tell us that 12,000 units were produced in Actl.\c:l\l
November. At two units of raw materials per unit produced, that's a standard of 24,000 units of raw materials. Actual units
used (S - A = OJ are then 25,000 units to produce the unfavorable usage variance of $2,500 (alternatively, 24,000 standard )C hv
units plus 1,000 unfavorable units used = 25,000 units used).
pev
1. Overview
Three different overhead variance models are:
a. Net Overhead Variance (one-way variance) - Actl.\c:l\l F
Net debit or credit balance in the overhead account.
IIChec"-ll

b. Two-way Variance
(1) Budgetcontrollable)variance - FoCl.\S Vc:l\v. o/H A B F
- Focl.\S o/H A '> B F

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Bs-68
MelMOVlz.e!
A
2)
c:l\ctl.\c:l\1
hvs.
BA
'3)
hvs.
4)
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Becker Professional Education I CPA Exam Review Business 5
c.
1vs.2
2 vs. '3
'3 vs. 4
Three-way Variance
(1) Spending variance -rl-\e less we tl-\e bettev
(2) Efficiency variance -rl-\e less l-\OI.\Vs tl-\e bettev
(3) (Volume)(uncontrollable) variance -rl-\e 'Move tl-\e bettev
The tabular format that follows highlights the differences between models. Notice the
net overhead variance may be broken down into a budget variance component and a
volume variance component (volume variances are fixed). Further notice that the
budget variance may be broken down into a spending (either fixed or variable) and an
efficiency variance (efficiency variances are variable).
2. Establishing Overhead Application Rates to o/H -r
Overhead rates are applied using various cost drivers that most appropriately assign
the components of overhead cost pools to production. Predetermined fixed and
variable overhead rates are established by dividing planned fixed and variable
overhead amounts by a suitable cost driver.
3. (Application)of Overhead
Overhead is applied to production based on the predetermined rate per cost driver
times the achieved volume identified by the cost driver (hours worked, units produced,
etc.).
EXAMPLE
PICTORIAL SUMMARY OF OVERHEAD VARIANCES
Budget
(controllable)
'Step 4
A F applied to WIP 'SHA )C R""te
Net overhead variance I
"------------
'3 4-
Budget amount CO'Mpc:l\ve c:l\Ctlii c:l\l
based on standard
hours allowed for Ol.\tPl.\t to
production (units) Overhead
achieved (output) applied to WIP
I I
Actual
I
Actual
One-way Variance:
(Overapplied or Underapplied)
Two-way Variance:
4- Move Ol.\tf l.\t
tl-\e beHev
Overhead
applied to WIP )

I
Volume
Budget amount
based on standard
hours allowed for
production (units)
achieved (output)
2
Actual overhead costs incurred
Budgeted FOH + (Actual DLH worked x Standard VOH rate per DLH)
Budgeted FOH + (Standard DLH allowed x Standard VOH rate per DLH)
Standard (total) OH rate/DLH x Standard DLH allowed
Three-way Variance:
Budget amount
------------....... based on actual
Actual hours worked
(inputs)

I Spending I Efficiency I
I =
2 =
'3 =
4- =
<Step 4
Standard hours allowed = Standard DLH per unit x Actual units produced
Standard (total) OH rate/DLH = Standard VOH rate per DLH + Standard FOH rate/DLH
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F loP t:'\dl.\t:'\llowev H,\l.\S CR .....
4. Interpretation
Overhead variances represent the analysis of balance in the overhead account after
overhead has been applied. Overapplied (more credit) is favorable. Underapplied
(more debit) is unfavorable. Each component of the variance computation follows the
same logic.
a. If the number on the right is greater than the number on the left (more credit),
then the variance is favorable.
b. If the number on the left is greater than the number on the right (more debit),
then the variance is unfavorable.
(TABULAR FORMAT) EXAMPLE -
c. The sum of all three variances equals the net balance in the overhead account.
#1
Lucy, Inc. produces widgets. Actual overhead totale 16800 In January, Lucy manufactured 3,800 widgets. Each unit
requires one direct labor hour. Overhead is applied based on direct labor hours. Information for the month of January ,8'00
follows: )C 1hv. fey
'3 800J
Actual direct labor hours worked ","'its V (3,900 hours) .... 1------------........ '3,8'00 <5HA
Budgeted fixed overhead (based or{4,000 units) vol",\o\o\e $12,000 ($3.00 per unit/hour)
Standard variable rate $1.50 per hour
Standard total (application) rate (;4.50 per hour)
4
$300F
4 V se
Applied ...-L"
$17,100.
b",
Budget based on Budget based on Applied
actual hours worked Standard hours allowed
$17,100
[12,000 + (3,8'00 )C 15)]
"3
Budget based on standard hours allowed
A B $17,700 /
$900 F I $600 U
Budget variance Volume variance
$1,050 F $600 U
Spending Volume $300F
[\ 2,000 + (3,'00 )C \ 5)]
2 "3
Using the tabular format, calculate the variances under the one-way, two-way, and three-way <5HA
# 1 )C 450 vt:'\te #4
One-way Variance: 1 40 Net Variance
Actual Applied bt:'\1. - oveV
$16,800 Actl.\t:'\l $17,100
$300overapplied F
Net overhead variance
Two-way Variance:
1vs. '3
Not-e: wit-h t-he
Actual
voll.\'Me ol.\.ly +-lAe $16,800
.f'i",eA cost-s ch"'''je.
'3 VS.
$12,000 - $11,400 $'00
1VS.
Three-way Variance:
Not-e: wit-h t-he Actual
e#icl.e",C)' v&'\Yi",,,,"ce,
[ill'!
2 VS. '3
o"ly t-he v"'Yi",,,le cos\-s
$16,800
ch"'''je.
$s-,gS-O - $S",700 $1 s-o
'3 VS.
(continued)
Actl.\t:'\l hOl.\vS wOV (3/100)
8vet:'\tev <5HA (3,8'00) thl.\S V
Bs-70
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Actual costs incurred = $16,800
EXAMPLE (continued)
Business 5
2 Budget based on actual hours = budget FOH + (actual DLH x standard VOH rate)
($12,000 budgeted fixed overhead = $12,000) + ($1.50 per hour of standard variable costs x 3,900 actual DLH
$5,850) = I$17,850 I
'3 Budget based on standard hours = budget FOH + (standard DLH* x standard VOH rate)
($12,000 budgeted fixed overhead = $12,000) + ($1.50 per hour of standard variable costs x 3,800 standard DLH
$5,700) = I$17,700 I
4 Applied overhead = standard (total) overhead rate x standard DLH*
$4.50 x 3,800 hours = $17,100 ($3.00 per hour of standard fixed costs x 3,800 standard DLH
$11,400) + ($1.50 per hour of standard variable costs x 3,800 standard DLH
$5,700) = $17,100
'Standard direct labor hours = Standard direct labor hours allowed per unit x Actual units = 1 hour per unit x 3,800 units = 3,800 direct labor hours
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Business 5 Becker Professional Education I CPA Exam Review
PLANNING TECHNIQUES
Coordinating Information From Various Sources For Integrated Planning
AN elL LA RY MAT ER I A L (for Independent Review)
Coordinating information from various sources for integrated planning involves identification, capture and communication of
information in a form and within a time period to be useful and relevant. The major components of this effort include
information and communication.
I. INFORMATION
A. Strategic and Integrated Systems
Information systems are designed to support business strategy. Internal and external
communications have become more integrated as enterprises increase their collaboration
with customers, suppliers and business partners.
B. Integration with Operations
1. Data Typically Comes in Two Forms
a. Historical data
Historical data is used to track actual performance against targets.
b. Present data
Present data is used to determine if results indicated by the information are
within established tolerances.
2. Integration
Web and web based applications assist with the integration of knowledge and
information with the entire enterprise. Transaction data may be developed in real time
and deployed throughout the organization enabling managers to use data timely and
achieve information quality objectives.
C. Depth and Timeliness of Information
Information must be captured in the level of detail and in time for the entity to identify, assess
and respond to risk. Risk response is significant for the entity to stay within risk tolerances.
D. Information Quality
1. Information quality is defined by a number of characteristics:
a. Appropriate content (relevant)
b. Timely presentation
c. Current (most recent)
d. Accuracy
e. Accessibility
2. Enterprise wide data management systems ensure data quality and to ensure that
information does not overwhelm its users.
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3. Challenges to information quality include:
a. Conflicting functional needs
b. System constraints
c. Non-integrated processes
II. COMMUNICATION
A. Internal
Business 5
Management provides specific communication regarding expectations and includes
statement of both risk management philosophy and delegation.
1. Personnel understand acceptable and unacceptable behavior.
2. Channels of communication exist and employees are encouraged to use them.
3. Communications outside normal reporting lines exist which employees can use without
fear of reprisal.
B. External
1. External communications allow customers and suppliers to provide input.
2. Regulatory bodies receive appropriate mandated communication.
C. Means of Communication
Communication can happen in any number of forms, including policy manuals, memoranda,
e-mails, webcasts, etc.
END OF ANCILLARY MATERIAL
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Business 5
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NOTES
Becker Professional Education I CPA Exam Review
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Becker Professional Education I CPA Exam Review Business 5
TERMINOLOGY
Definitions of the following terms that relate to topics presented in this lecture are provided in the comprehensive glossary
located at the end of this textbook.
Absorption costing
Avoidable costs
Balanced scorecard
Breakeven point
Budget (controllable) variance
Ca rryi ng costs
Coefficient of correlation
Coefficient of determination
Committed costs
Common cost
Contribution margin
Contribution margin ratio
Conversion costs (and conversion
cost pricing)
Cost-volume-profit analysis
Currently attainable standards
Depreciation tax shield
Differential costs
Direct labor
Direct labor efficiency variance
Direct labor rate variance
Direct material
Direct material price variance
Direct material usage variance
Discretionary costs
Economic value added (EVA)
Economies of scale
Efficiency variance
Engineered costs
Events
Fixed costs
Flexible budget
Full product costing
High-low method
Ideal standards
Indirect costs
Infrastructure costs
Inherent risk
Interval measurements
IFRS adoption
IFRS conversion
Inventoriable costs
Learning curve
Management by objective
Manufacturing overhead
Margin of safety
Market share variance
Market size variance
Master budget
Mixed costs
Nominal measurements
Operational costing
Opportunity costs
Ordinal measurements
Overa pplied overhead
Overhead
Period costs
Practical capacity
Prime costs
Product costs
Relevant costs
Relevant range
Residual income
Residual risk
Responsibility accounting
Risk appetite
Risk tolerance
Sales mix variance
Sales quantity variance
Sales volume variance
Selling price variance
Sensitivity analysis
Spending variance
Standard costs
Standard error of the estimate
Statistical quality control
Strategic business unit (SBU)
Step-variable costs
Sunk costs
Target costs
Transfer price
Unexpired costs
Underapplied overhead
Value engineering
Variable cost ratio
Variable costs
Variable (direct) costing
Variance analysis
Volume variance
Zero-based budget
Experience curve Ratio measurements
Expired costs Regression analysis
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