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Management Accounting Concepts and Techniques

Dennis Caplan, Oregon State University


capland@busoregonstateedu
http!""denniscaplan#atco$com"TOChtm
Table o# Contents
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/art %! 0ntroduction
Management accounting de#ined, described, and compared to #inancial accounting
1elevant concepts #rom management and operations management, and a brie# history o# management
accounting
/art &! Microeconomic #oundations o# management accounting
1elevant cost analysis
Cost behavior
Cost2volume2pro#it
3le4ible budgeting
Cost variances #or direct materials and labor

/art '! /roduct costing and cost allocations
/roduct costing
5ormal costing
Standard costing
Activity2based costing
Allocation o# service department costs
The role o# cost in setting prices

/art (! Determining the cost o# inventory
6or72in2process
Alternative inventory valuation methods
3i4ed manu#acturing overhead
Cost variances #or variable and #i4ed overhead
8oint products

/art )! /lanning tools and per#ormance measures #or pro9ects and divisions
Capital budgeting
Operating budgets
:udgetary incentive schemes
Divisional per#ormance measures
Trans#er pricing
Corporate social responsibility

3ive2page summary o# 7ey concepts
;lossary
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C<A/T=1 %! Management Accounting De#ined, Described, and Compared to 3inancial Accounting

/rologue!
We all face the fundamental economic problem of how to allocate scarce resources. This is a problem that confronts every
company, every government, and us as a society. It is a problem that we each face in our families and as individuals.

In the United States and throughout most of the world, there are institutions that facilitate this allocation of scarce resources. The
New Yor Stoc !"change is one such institution, as is the #ondon Stoc !"change, the $hicago %oard of Trade, and all other
stoc, bond and commodity marets. These financial marets are sophisticated and apparently efficient mechanisms for
channeling resources from investors to those companies that investors believe will use those resources most profitably.

%ans and other lending institutions also allocate scarce resources across companies, through their credit and lending decisions.
&overnments allocate scarce resources across segments of society. They collect ta"es from companies and individuals, and
allocate resources to achieve social and economic goals.
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'll of these institutions use #inancial accounting as a primary source of information for these allocation decisions. Investors and
stoc analysts review corporate financial statements prepared in accordance with ;enerally Accepted Accounting /rinciples.
%ans review financial statements as well as pro(ections of cash flows and financial performance. The Internal )evenue Service
ta"es income that is calculated only slightly differently from income for financial reporting purposes. In effect, the same set of
financial accounting rules is used by these different users, with only minor modifications.

*owever, this is only part of the story, because when I buy stoc in +icrosoft, whether my investment turns out to be profitable
depends largely on the operational, mareting and strategic decisions that +icrosoft,s managers mae during the time that I hold
my investment. 'nd when +icrosoft,s management team sits down to decide what products to develop, which marets to enter,
and how to source production, they are not, almost certainly, looing at the company,s most recent annual report or any other
financial accounting report. %y the time the annual report is available, the information is too old, and in any case, it is too highly
summari-ed. there is not enough detail and not enough forward/looing data. )ather, when +icrosoft,s management team maes
decisions, it bases these decisions on management accounting information. This is definitional. By definition, management
accounting is the information that managers use for decision/maing. By definition, financial accounting is information provided
to e"ternal users.

*ence, both financial accounting and management accounting are all about allocating scarce resources. 0inancial accounting is the
principle source of information for decisions of how to allocate resources among companies, and management accounting is the
principle source of information for decisions of how to allocate resources within a company. +anagement accounting provides
information that helps managers control activities within the firm, and to decide what products to sell, where to sell them, how to
source those products, and which managers to entrust with the company,s resources.

> > > > > >

In other news, General Motors common stock rose $1.10 today following the announcement that the company has
successfully installed an improved management accounting system.

> > > > > >

If management accounting so important, why are we not liely to see a headline lie the fictional announcement shown above1
There are two reasons. 0irst, management accounting information is proprietary. public companies are generally not re2uired to
disclose management accounting data nor much detail about the systems that generate this information. Typically, companies
disclose very little management accounting information to investors and analysts beyond what is imbedded in financial reporting
re2uirements. !ven very basic information, such as unit sales by ma(or product category, or product costs by product type, is
seldom reported, and when it is reported one can be sure that management believes voluntary disclosure of this information will
be viewed as 3good news4 by the maretplace.

The second reason we are not liely to see a headline lie the one above is that most management accounting systems seem to
wor reasonably well most of the time. *ence, it is difficult for a company to gain a competitive advantage by installing a better
management accounting system than its competitors. *owever, this observation does not imply that management accounting
systems are not important. 5n the contrary, as the following news story indicates, poor management accounting systems can
significantly affect the investment community,s perception of a company,s prospects.


5=6 ?O1@ T0M=S
OCTO:=1 &,, %--+

O4#ord <ealth /lans said yesterday that it had been losing money because it #ell behind in sending bills to customers and
underestimated ho$ much it o$ed doctors and hospitals Shares #ell *&A Stephen 6iggins, chairman o# O4#ord, said the
company had belatedly discovered that many customers $ere not paying premiums, o#ten because the company $as late in
sending bills

O4#ord ac7no$ledged that it had #allen behind in payments to hospitals and doctors as it struggled $ith a ne$ computer
system 6ith incomplete in#ormation in its computers, it had to advance money to doctors and hospitals $ithout veri#ying
that they $ere obeying O4#ordBs rules Mr 6iggins said O4#ord $ould add about .)A to spending on administration ne4t
year in an e##ort to insure there are no similar problems CThe important thing,D he added, Dis $eBre the same company $e
$ere on 3riday, e4cept our mar7et value has dropped by hal#E


*ealth insurance is a relatively stable industry. 6778 was the middle of a strong bull maret. What was the problem with 5"ford
such that in this environment it should lose half its stoc value almost overnight1 The answer is that its management accounting
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system was broen, big time. +anagement accounting is something lie indoor plumbing. When it functions properly, we tend to
tae it for granted, but when it breas down, we 2uicly develop a greater appreciation for it.


De#inition and Scope o# Management Accounting!
+anagement accounting is the process of measuring and reporting information about economic activity within organi-ations, for
use by managers in planning, performance evaluation, and operational control9

/ :lanning9 0or e"ample, deciding what products to mae, and where and when to mae them. ;etermining the materials,
labor, and other resources that are needed to achieve desired output. In not/for/profit organi-ations, deciding which programs to
fund.

/ :erformance evaluation9 !valuating the profitability of individual products and product lines. ;etermining the relative
contribution of different managers and different parts of the organi-ation. In not/for/profit organi-ations, evaluating the
effectiveness of managers, departments and programs.

/ 5perational control9 0or e"ample, nowing how much wor/in/process is on the factory floor, and at what stages of
completion, to assist the line manager in identifying bottlenecs and maintaining a smooth flow of production.

'lso, the management accounting system usually feeds into the financial accounting system. In particular, the product costing
system is usually used to help determine inventory balance sheet amounts, and the cost of sales for the income statement.

+anagement accounting information is usually financial in nature and dollar/denominated, although increasingly, management
accounting systems collect and report nonfinancial information as well.

The mechanical process of collecting and processing information poses substantial and interesting challenges to large
organi-ations. 'lso, there are important conceptual issues about how to aggregate information in order to measure, report, and
analy-e costs. Issues of how to allocate costs across products, services, customers, subunits of the organi-ation, and time periods,
raise 2uestions of substantial intellectual content, to which there are often no clear answers.

+anagement accounting is used by businesses, not/for/profit organi-ations, government, and individuals9

/ %usinesses can be categori-ed by the sector of the economy in which they operate. +anufacturing firms turn raw materials into
finished goods, and we also include in this category agricultural and natural resource companies. +erchandising firms buy
finished goods for resale. Service sector companies sell services such as legal advice, hairstyling and cable television, and carry
little if any inventory. %usinesses can also be categori-ed by their legal structure9 corporation, partnership, proprietorship. 0inally,
businesses can be categori-ed by their si-e.

/ Not/for/profit organi-ations include charitable organi-ations, not/for/profit health care providers, credit unions, and most private
institutions of higher education.

/ &overnment includes 0ederal, state and local governments, and governmental agencies such as the post office and N.'.S.'.

'll of these organi-ations use management accounting e"tensively. 'lso, individuals use the economic concepts that form the
foundation of management accounting in their personal lives, to assist in decisions large and small9 home and automobile
purchases, retirement planning, and splitting the cost of a vacation rental with friends.


Management Accounting and 3inancial Accounting Compared!
The field of accounting consists of three broad subfields9 financial accounting, management accounting, and auditing. This
classification is user/oriented. 0inancial accounting is concerned with communicating accounting information to e"ternal parties.
+anagement accounting is concerned with generating accounting information for managers and other employees to assist them in
performing their (obs. 'uditing refers to e"amining the authenticity and usefulness of all types of accounting information. 5ther
subfields of accounting include ta" and accounting information systems.

%ecause many students taing management accounting have (ust completed a course in financial accounting, it is useful to
e"amine the ways in which management accounting differs from financial accounting.

3inancial Accounting Management Accounting

+andatory for most companies. 0inancial reporting is
re2uired by U.S. securities laws for public companies. :rivate

+ostly optional. *owever, it is inconceivable that a large company
could operate without sophisticated management accounting
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companies with debt are often re2uired by lenders to prepare
audited financial statements in accordance with &'':.

systems. 'lso, legislation such as the Sarbanes/5"ley 'ct of <==<
sets minimum standards for public companies for their internal
reporting systems.

0ollows &enerally 'ccepted 'ccounting :rinciples >&'':?
in the U.S., and other uniform standards in other countries.

No general principles. $ompanies often develop management
accounting systems and measurement rules that are uni2ue and
company/specific.

%acward/looing9 focuses mostly on reporting past
performance.

0orward/looing9 includes estimates and predictions of future
events and transactions.

!mphasis on reliability of the information

$an include many sub(ective estimates.
:rovides general purpose information. Investors, stoc
analysts, and regulators use the same information >one si-e
fits all?.

:rovides many reports tailored to specific users.
:rovides a high/level summary of the business

$an provide a great deal of detail.
)eports almost e"clusively in dollar/denominated amounts. '
recent e"ception is the increasing >but still infre2uent? use of
the Triple %ottom #ine.

$ommunicates many nonfinancial measures of performance,
particularly operational data such as units produced and sold by
product type.

These differences are generali-ations, and are not universally true. 0or e"ample, &'': allows some important choices, such as
the 0I05 or #I05 inventory flow assumption. 'lso, &'': uses predictions of future events and transactions to value assets and
liabilities under certain circumstances. Nevertheless, the differences between financial accounting and management accounting
shown above reveal important attributes of financial accounting that are driven by the goal of providing reliable and
understandable information to investors and regulators. These individuals are often far removed from the companies in which they
are interested, so a regulatory and self/regulatory institutional structure e"ists to ensure the 2uality of the information provided to
them.

0or e"ample, financial accounting uses historical information, not because investors are interested in the past, but rather because it
is easier for accountants and auditors to agree on what happened in the past than to agree on management,s predictions about the
future. The past can be 3audited.4 Investors then use this information about the past to mae their own predictions about the
company,s future.

's another e"ample, financial accounting follows a set of rules >&'': in the U.S.? that investors can study. 5nce investors obtain
an understanding of &'':, the fact that all U.S. companies comply with the same rules greatly facilitates investors, ability to
follow multiple companies. 'lso, the fact that financial reporting is mandatory for all public companies ensures that the
information will be available.

+anagement accounting, on the other hand, serves an entirely different audience, with different needs. +anagers need detailed
information about their part of the organi-ation, so management accounting provides detailed information tailored for specific
users. 'lso, managers must mae decisions, sometimes on a daily basis, that affect the future of the business, and they need the
best predictions of the future that are available as input in those decisions, no matter how sub(ective those estimates are.

Management Accounting 0nstitutions!
The most important professional association of management accountants in the U.S. is the 0nstitute o# Management
Accountants >0MA?. There are similar organi-ations in other countries. 0ormerly the 5ational Association o# Accountants, the
I+' has about 6==,=== members. Its head2uarters are in +ontvale, N@, outside of New Yor $ity, and there are local chapters
throughout the country.

The I+' sponsors the $ertified +anagement 'ccountant,s certification program. $ertification re2uires passing the $+'
e"amination, and woring for two years in a field related >at least loosely? to management accounting. The e"am is similar to the
$:' e"am, although it is broader in scope and places less emphasis on financial reporting and auditing. Unlie the $:'
certification, which is re2uired by state laws of accountancy for practicing public accountants, the $+' certification is voluntary.
Ne"t to the $:', the $+' and $I' >$ertified Internal 'uditor? are probably the most widely/recogni-ed certifications of
accountants in the U.S.

The I+' issues a $ode of :rofessional !thics for management accountants, which is mandatory for $+'s. The $ode clearly
indicates that management accountants have responsibilities to the public as well as to organi-ations for which they wor. The
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$ode provides e"plicit guidance on how management accountants should respond to 2uestionable or clearly improper financial or
regulatory reporting practices in their organi-ations, which is probably the most difficult ethical issue that every management
accountant should be prepared to encounter. 'nyone who becomes a management accountant >even if he or she does not become a
$+'?, and anyone who wors with or supervises management accountants, should become familiar with the $+',s ethical
standards.

The I+' supports research on management accounting, sponsors continuing education seminars, publishes materials on
management accounting topics >some of which are available at no charge from the I+' website?, and publishes a monthly
maga-ine called Strategic Finance >prior to +arch 6777, the maga-ine was called Management Accounting?. Strategic Finance is
probably the premier management accounting maga-ine for practitioners in the U.S.

A 5ote on Terminology!
%ecause management accounting developed over many decades in a decentrali-ed fashion, within leading companies of the day
and without the direction of a regulatory or self/regulatory rule/maing body, terminology has evolved that is sometimes
redundant and sometimes inconsistent. ' single concept can go by multiple names, and the same term can refer to multiple
concepts.

0or e"ample, full costing has two meanings, one of which is synonymous with absorption costing. Aariable costing is synonymous
with direct costing, and overhead is synonymous with indirect costs. *owever, direct costs, direct costing, and the direct method
of cost allocation all refer to different concepts and techni2ues.

There is nothing 3normal4 about a normal costing system. ' standard costing system is closely related toBbut not 2uite
synonymous withBthe concept of a standard cost.

+anagement accounting and managerial accounting are synonymous. *owever, the relationship between these terms and cost
accounting is ambiguous. +any accounting practitioners use these terms interchangeably. When cost accounting is distinguished
from management accounting, cost accounting sometimes refers to accounting for inventory, and as such, the term applies
primarily to manufacturing and merchandising firms. In this case, cost accounting would be a large subset of the management
accounting system, because most but not 2uite all of the accounting activity inside manufacturing and merchandising companies
relate to inventory. 'lternatively, cost accounting is sometimes distinguished from management accounting in the following way9
if the answer depends upon the accounting techni2ues employed, the 2uestion is a cost accounting 2uestion. if the answer is
independent of the accounting techni2ues employed, the 2uestion is a management accounting 2uestion. 0or e"ample, the
valuation of ending inventory depends on whether the company uses the #I05 >last in, first out? or 0I05 >first in, first out?
inventory flow assumption. That is cost accounting. *owever, the determination of whether the company would be more
profitable in the long/run by closing the factory and sourcing product from an independent supplier is independent of the
inventory flow assumption or any other accounting choice. That is a management accounting problem.

!ven recent advances in management accounting are sometimes associated with ambiguous or redundant terminology. 0or
e"ample, supervariable costing is synonymous with throughput costing.

Te"tboos usually shelter students from this ambiguity in terminology, by defining terms carefully, avoiding redundancy, and
maintaining consistency. *owever, the ambiguity e"ists out there in practice.
C<A/T=1 &! 1elevant Concepts #rom the 3ields o# Strategy and Operations Management, and a :rie# <istory o#
Management Accounting

This chapter describes some concepts and characteristics from the fields of strategy and operations management that are relevant
to the study of management accounting. %ecause management accounting is a management support function, management
accountants need to be aware of emerging trends, issues and techni2ues in the field of management. 'lso, because many of the
most challenging management accounting problems occur in the manufacturing sector of the economy, management accountants
must have a solid understanding of the terminology and basic characteristics of common manufacturing processes. This chapter
also provides a brief history of the development of management accounting.

Manu#acturing /rocesses!
+anufacturing industries can be categori-ed according to the e"tent to which individual units of output are distinguishable from
each other during and subse2uent to the production process. We describe four points on a continuum.

8ob order! In a (ob order process, each unit of output is uni2ue. !"amples include a custom home builder and a custom furniture/
maer.

:atch process! In a batch process, identical >or very similar? units of output are produced in groups called batches, but the units in
one batch can differ significantly from the units in another batch. The units within each batch usually remain within close physical
pro"imity throughout the production process.
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'pparel factories often use a batch process. 0or e"ample, different styles of pants are produced in separate batches. !ach batch
might consist of C= or several hundred pairs of pants. Within each batch, there might be minor differences, such as different waist
and inseam si-es. 't any one time, the factory might have wor/in/process related to several different styles of pants, and
numerous batches of wor/in/process for each style.

Assembly line! In an assembly/line process, similar units are produced in se2uence, usually in a highly/automated operation. The
automobile industry is a good e"ample. 'n automobile manufacturer maes only one model car on any one assembly line. The
assembly line allows for some product differentiation. 0or e"ample, cars produced on the assembly line can differ from each other
with respect to such features as color and upholstery, and perhaps in more substantive ways such as the si-e of engine, and two/
wheel versus all/wheel drive. *owever, to change an assembly line from one model to another usually re2uires significant
e"pense and down/time.

Continuous process! In a continuous manufacturing environment, the manufacturing facility produces a continuous flow of
product during the operating hours of the facility. ' classic e"ample of a continuous process is an oil drilling operation. The
distinguishing feature of a continuous process is that any grouping of output into individual units is arbitrary. 0or e"ample, oil can
be divided into barrels or gallons or any other measure of li2uid volume. In order to determine the cost of production in a
continuous process, it is necessary to select a period of time, collect costs incurred during that period, determine the amount of
output produced during that same period, and divide total costs by total output.

There is no presumption that a continuous manufacturing process is a one/product facility >drilling operations often e"tract both
crude oil and natural gas?, or that it runs <D hours a day.

Overvie$ o# manu#acturing processes! ;istinguishing manufacturing processes along this continuum is helpful, because where
a process falls on this continuum influences the types of management accounting issues that arise, and the design of the
management accounting system. *owever, it is often difficult and seldom helpful to classify any particular manufacturing process
precisely into one of the four points of the continuum described here. 'lso, any one company might operate over several points on
this continuum.

DecentraliFation!
'n important issue in the management of firms is the e"tent to which decision/maing is centrali-ed or decentrali-ed. +any large
companies operate in a highly decentrali-ed fashion, and have numerous responsibility centers and responsibility/center
managers with considerable autonomy. Important types of responsibility centers include the following9

Cost centers! +anagers of cost centers are responsible for costs only. +ost factories are cost centers.

/ro#it centers! +anagers of profit centers are responsible for revenues and costs. The @eans ;ivision of #evi Strauss E $o. might
be a profit center.

0nvestment centers! +anagers of investment centers are responsible for revenues, e"penses, and invested capital. The $anadian
;ivision of #evi Strauss E $o. might be an investment center.

0ollowing are important benefits of decentrali-ation.

6. ;ecision/maing is delegated to managers who are often in the best position to understand the local economy,
consumer tastes, and labor maret.

<. 'utonomy is inherently rewarding. @ob positions that are characteri-ed by a high degree of responsibility and
autonomy are liely to attract and retain more talented, e"perienced and capable managers than positions that provide
managers minimal decision/maing authority.

F. $ompanies that delegate responsibility deep within the organi-ation create a training ground where managers gain
e"perience and prepare themselves for higher/level positions.

D. ;ecentrali-ation places fewer burdens on top management. *ighly/centrali-ed companies impose on top
management the responsibility for numerous routine decisions.

0ollowing are important costs and riss of decentrali-ation.

6. The incentives of responsibility/center managers do not always align with the incentives of owners or top
management. There is the obvious ris that managers might consume per2uisites at the e"pense of corporate profits >e.g.,
e"pensive business lunches and office furniture?. 'lso, there is evidence that managers will attempt to increase the si-e of
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the units for which they are responsible >called the manager,s span of control?, even if doing so does not increase the
profitability of the company.

<. !conomic theory suggests that managers prefer for the responsibility center under their control to accept less ris
than owners would lie. This theory builds on the observation that higher/ris pro(ects generate higher returns, on
average, reflecting the trade/off between ris and return, which constitutes a building bloc of finance theory.
Shareholders prefer risier pro(ects than managers, because shareholders can diversify their portfolios by owning shares
in numerous companies. *owever, the manager,s career is closely connected with the performance of his or her
responsibility center. $onse2uently, managers of responsibility centers of decentrali-ed companies might re(ect risy
pro(ects that shareholders would favor.

'lthough there are both benefits and costs to decentrali-ation, it would appear that by any ob(ective measure, most large
corporations operate in a highly/decentrali-ed fashion. 's a benchmar, one might wish to compare the e"tent of decentrali-ation
in modern corporations with the e"tent of decentrali-ation in such entities as the military or the former Soviet economy.

The Origins o# Management Accounting!
+anagement accounting first emerged as a significant activity during the early industrial revolution, in the leading industries and
enterprises of the day. 's such, management accounting arose after financial accounting, which can trace its origins to its
stewardship role in !uropean merchant trading ventures beginning in the Italian )enaissance, and to ta" records that governments
apparently have re2uired for as long as governments have e"isted. ;ouble/entry booeeping had been used for more than F==
years by the time management accounting first emerged as a recogni-able field.

Two leading industries of the industrial revolution that played important roles in the early history of management accounting were
te"tiles and railroads. Te"tile mills used raw materials and labor to mae fabrics and associated products, and the mills developed
methods to trac the efficiency with which they used these inputs. )ailroads re2uired significant investments of capital over long
periods of time for the construction of roadbed and trac. 5nce operational, railroads handled large volumes of cash receipts from
numerous customers, and developed both financial and operational measures of efficiency for moving passengers and freight.

%y the end of the 67
th
century, new industries and types of businesses were becoming important to the economies of the United
States, &reat %ritain, and other industriali-ing nations. These enterprises included steel producers, mass producers of consumer
products such as foodstuffs and tobacco, and mass merchandisers such as Sears, )oebuc E $ompany. #eading companies in
these industries developed accounting systems to meet their needs for operational control.

In the first two decades of the <=
th
century, the fields of industrial engineering and management accounting developed in tandem.
;uring this period, industrial engineers developed methods to control production that included a 3scientific4 determination of
standards for inputs of materials, labor and machine time, against which actual results could be compared. This development led
directly to standard costing systems, which are still widely used by manufacturing companies. +anagement accounting concepts
and techni2ues continued to evolve rapidly throughout the rest of the first half of the <=
th
century, and by 67C= most of the ey
elements of management accounting as practiced today were well established.

These developments occurred in a decentrali-ed fashion, inside large companies that were using common sense and commonplace
booeeping and analytical tools to meet their internal reporting re2uirements. $ompanies that business historians have identified
as innovators in management accounting practice during this period include ;u:ont, &eneral +otors and &eneral !lectric.
*owever, an innovator is not necessarily a leader. There appears to have been relatively little communication among companies
regarding the management accounting methods that were developed. :erhaps managers and accountants viewed these accounting
systems and techni2ues as proprietary, a possible source of competitive advantage. 'lso, there was no institutional or regulatory
impetus for sharing information. In the early 67==s, there was no association of management accountants to hold annual meetings
in $hicago or %oston for continuing professional education and revelry. There was no government oversight of management
accounting practice. With very few e"ceptions, management accounting itself was not re2uired for regulatory purposes until the
0oreign $orrupt :ractices 'ct of 6788, which mandated that large companies maintain ade2uate systems of internal control. !ven
today, companies have a great deal of discretion in the design of management accounting systems, and management accounting
loos very different from one company to another even within the same industry.

@ey Developments in the /ast ). ?ears!
The economic, business and technological developments that have probably had the greatest impact on management accounting
over the last C= years are the following9

The in#ormation revolution! Those of us born in the second half of the <=
th
century have difficulty appreciating the enormous
hurdle that the collection and processing of information once posed to management accounting systems, and the impact that the
cost of information had on management in general. Today, information technology maes possible sophisticated database
accounting systems that are both powerful and fle"ible in terms of the accounting information that they can collect, organi-e and
report. !ven today, however, the cost of designing, implementing, and running cost accounting systems is a substantial obstacle in
many organi-ations. a fact probably underrepresented in business schools.
7

/roli#eration o# product lines! If a company maes only one product, many cost accounting issues are moot. When companies
significantly e"panded their product lines beginning in the 67C=s, to gain maret share and increase profits, the difficulty and
importance of obtaining accurate cost information on individual products increased. It is generally agreed that in the 678=s and
67G=s, some U.S. companies were allocating costs among products in a manner that led to poor production and mareting
decisions. ' management accounting tool called activity/based costing was developed to help correct this problem, by improving
the accuracy with which costs are allocated among products.

;lobaliFation o# the economy! &lobali-ation has several implications for management accounting. 0irst, globali-ation has
resulted in a more competitive environment, which encourages the implementation of accounting systems that provide the most
accurate, relevant, and timely information possible. Second, the growth of multinational corporations has increased the importance
of transfer pricing. ' transfer price is the amount one division of a company charges another division for an intermediate product.
Transfer pricing plays a role in ta"ation, international trade negotiations, and production and mareting decisions within
decentrali-ed firms. 0inally, globali-ation has increased the pace of change within the management accounting profession. +any
recent innovations in management accounting, as well as in the fields of strategy and operations management, originated in @apan.
;irect competition between @apanese and U.S. companies has led many U.S. companies to adopt these @apanese management
practices.

0ncreasing importance o# the service sector! :rior to the 678=s, most innovations in management accounting techni2ues, and
the most sophisticated management accounting systems, were found in manufacturing firms >although as discussed above,
railroads played an important role in the early development of management accounting?. 's the service sector became a larger part
of the overall economy, and as competitive pressures within service sector industries increased >in some cases brought about by
deregulation?, many service companies invested substantial resources in management accounting systems tailored to meet their
needs. Service sector industries noted for significant developments in their management accounting systems include
transportation, financial institutions, and health care. $ustomer costing >determining the cost of servicing an individual customer?,
and improving the timeliness of accounting information, are two issues of particular importance to many service sector
companies.

0nnovative Management /ractices!
In addition to the four economic and technological trends described above, the following innovations in the fields of strategy and
operations management have influenced management accounting systems and practices over the past several decades.

Total quality management GTHMI! Huality programs go by several names, including TH+, -ero defect programs, and si" sigma
programs. The focus on 2uality has had a significant impact on many organi-ations in all sectors of the economy, beginning with
the automobile industry and some other industries in the manufacturing sector of the economy about forty years ago. Sophisticated
2uality programs are found today in many areas of government, education and other not/for/profit organi-ations as well as in for/
profit businesses.

The impetus for TH+ programs is the assessment that the cost of defects is greater than the cost of implementing the TH+
program. 'dvocates of TH+ claim that some costs of defects have been underestimated historically, particularly the loss of
customer goodwill and future sales when a defective unit is sold. Some advocates of 2uality programs believe that the most cost/
effective approach to 2uality is to eliminate all defects at the point at which they occur. If successful, these 3-ero defect4 programs
would not only result in higher levels of customer satisfaction, but would also eliminate costs associated with more conventional
2uality control procedures, such as inspection costs that occur at the end of the production line, the cost of reworing units
identified as defective, and costs associated with processing customer returns. The focus is on preventive controls to prevent the
defect from occurring in the first place, as opposed to detective controls to identify and correct the defect after it has occurred.

8ust2in2time G80TI! ;uring the last two decades of the <=
th
century, many companies implemented (ust/in/time programs designed
to minimi-e the amount of inventory on hand. These companies identified significant benefits from reducing all types of
inventoriesBraw materials, wor/in/process, and finished goodsBto the lowest possible levels. These benefits consist principally
of reduced inventory holding costs >such as financing and warehousing costs?, reduced losses due to inventory obsolescence, and
more effective 2uality control.

The relationship between @IT and TH+ is important. +any defects in raw materials or the production process can be ignored
indefinitely if high/2uality materials can be substituted for defective materials, and if additional first/2uality units can be produced
to replace defective units. In a non/@IT environment, defective materials and half/finished units might be set aside in a corner of
the factory. *owever, under a @IT program, if raw materials received at the factory are defective, there might be no first/2uality
materials on hand to substitute for the defective materials. In e"treme cases, the production line might be shut down until first/
2uality materials are received. *ence, a @IT program can focus attention on 2uality control in ways not generally possible in a
non/@IT environment.

8
The challenge in a @IT environment is to avoid stoc/outs. To meet this challenge, some companies have found ways to decrease
production lead times. Shorter production schedules result in less wor/in/process inventory, and also allows companies to
maintain lower levels of finished goods inventory while still maintaining high levels of customer satisfaction.

!arly in the <6
st
century, acts of terrorism >such as the destruction of the World Trade $enter in New Yor $ity? and natural
disasters >such as *urricane Iatrina? prompted some companies to rethin the practice of maintaining e"tremely low levels of
inventories. These companies are concerned that future incidents could result in the disruption of inventory pipelines, particularly
for imported materials. $onse2uently, the advantage of maintaining safety stocs of inventory is receiving renewed interest.

Theory o# constraints! The theory of constraints is an operations management techni2ue that decreases inventory levels and
increase throughput in a manufacturing setting. !liyahu &oldratt, a business consultant, is largely responsible for the development
of the theory of constraints. &oldratt populari-ed his ideas in a business novel that he coauthored with @eff $o" called The Goal:
A Process of Ongoing Improvement. The basis of the theory is to identify bottlenecs in the production process, and to focus all
efforts on increasing the capacity of the bottlenec operations. Typically, bottlenec operations are easy to identify, because large
amounts of inventory bac up at these operations waiting to be processed. The theory of constraints also advocates setting the
speed of the entire production process at the speed of the bottlenec operation, because otherwise e"cess wor/in/process will
inevitably build up. This 3pull4 system should replace traditional 3push4 systems, where every operation processes inventory at its
ma"imum capacity.

#ie most new ideas, the theory of constraints has a basis in earlier techni2ues and ideas. 's early as the 678=s or 67G=s,
engineers and production managers used a tool called critical path analysis to predict the time re2uired to accomplish ma(or new
ob(ectives, such as introducing a new product or bringing a new facility on line. $ritical path analysis involved identifying the
se2uence in which various steps were re2uired, and identifying at what point, and for how long, the entire pro(ect would depend
on the completion of any particular step.

Jean production and the lean enterprise! In recent years, the term 3lean4 has been adopted by some organi-ations to describe
the organi-ation,s comprehensive effort to apply state/of/the/art management practices to improve 2uality and customer
satisfaction, reduce costs and production lead/times, and increase value/creation. 3#ean4 is an umbrella term that includes such
techni2ues as @IT and TH+ as component elements. Some accountants credit Toyota as the originator of lean production. The
term 3lean4 was originally applied to manufacturing settings, such as in the phrases 3lean production4 or 3lean manufacturing.4
%ut the term is now used more broadly, and sometimes describes lean initiatives in the distribution and support functions of a
manufacturing company, lean initiatives in service/sector companies, and even initiatives in other types of organi-ations such as
governmental entities. The term 3lean accounting4 has been coined to describe accounting systems that either support lean
production, or that are, themselves, 3lean.4
C<A/T=1 '! 1elevant Cost Analysis

Chapter Contents!
/ 5verview
/ $osts
/ Sun costs
/ 5pportunity cost
/ )elevant costs
/ +icroeconomic analysis and the matching principle
/ !"ercises and problems


Overvie$!
+anagement accounting uses the following terms from economics9

Costs! )esources sacrificed to achieve a specific ob(ective, such as manufacturing a particular product, or providing a client a
particular service.

Sun7 costs! These are costs that were incurred in the past. Sun costs are irrelevant for decisions, because they cannot be
changed.

Opportunity cost! The profit foregone by selecting one alternative over another. It is the net return that could be reali-ed if a
resource were put to its ne"t best use. It is 3what we give up4 from 3the road not taen.4

1elevant costs! These are costs that are relevant with respect to a particular decision. ' relevant cost for a particular decision is
one that changes if an alternative course of action is taen. )elevant costs are also called di##erential costs.

9
The following discussion elaborates on these definitions9

Costs!
$osts are different from e"penses. $osts are resources sacrificed to achieve an ob(ective. =4penses are the costs charged against
revenue in a particular accounting period. *ence, 3cost4 is an economic concept, while 3e"pense4 is a term that falls within the
domain of accounting. :rofit is calculated as revenues minus e"penses, and hence, profit is generally a function of various
accounting conventions and choices. :rofits can be calculated for the organi-ation as a whole, or for a part of the organi-ation
such as a division, product line, or individual product.

$osts can be classified along the following functional dimensions9

6. The value chain. The value chain is the chronological se2uence of activities that adds value in a company. 0or
e"ample, for a manufacturing firm, the value chain might consist of research E development, design, manufacturing, mareting
and distribution.

<. ;ivision or business segment9 e.g., $hevrolet, 5ldsmobile, &.+.$.

F. &eographic location.

$lassification of costs according to the value chain is particularly important for financial reporting purposes, because for e"ternal
reporting, only manufacturing costs are included in the valuation of inventory on the balance sheet. Non/manufacturing costs are
treated as period e"penses. To some e"tent, traditional management accounting systems have been influenced by e"ternal
reporting re2uirements, and conse2uently, costing systems usually reflect this distinction between manufacturing and non/
manufacturing costs.

Sun7 Costs!
Sun costs are costs that were incurred in the past. Committed costs are costs that will occur in the future, but that cannot be
changed. 's a practical matter, sun costs and committed costs are e2uivalent with respect to their decision/relevance. neither is
relevant with respect to any decision, because neither can be changed. Sometimes, accountants use the term 3sun costs4 to
encompass committed costs as well.

!"periments have been conducted that identify situations in which individuals, including professional managers, incorporate sun
costs in their decisions. 5ne common e"ample from business is that a manager will often continue to support a pro(ect that the
manager initiated, long after any ob(ective e"amination of the pro(ect seems to indicate that the best course of action is to abandon
it. ' possible e"planation for why managers e"hibit this behavior is that there may be negative repercussions to poor decisions,
and the manager might prefer to attempt to mae the pro(ect loo successful, than to admit to a mistae.

Some of us seem inclined to consider sun costs in many personal situations, even though economic theory is clear that it is
irrational to do so. 0or e"ample, if you have purchased a nonrefundable ticet to a concert, and you are feeling ill, you might
attend the concert anyway because you do not want the ticet to go to waste. *owever, the money spent to buy the ticet is sun,
and the cost of the ticet is entirely irrelevant, whether it cost JC or J6==. The only relevant consideration is whether you would
derive more pleasure from attending the concert or staying home on the evening of the concert.

*ere is another e"ample. $onsider a student who is between her (unior and senior year in college, deciding whether to complete
her degree. 0rom a financial point of view >ignoring nonfinancial factors? her situation is as follows. She has paid for three years
of tuition. She can pay for one more year of tuition and earn her degree, or she can drop out of school. If her maret value is
greater with the degree than without the degree, then her decision should depend on the cost of tuition for ne"t year and the
opportunity cost of lost earnings related to one more year of school, on the one hand. and the increased earnings throughout her
career that are made possible by having a college degree, on the other hand. In maing this comparison, the tuition paid for her
first three years is a sun cost, and it is entirely irrelevant to her decision. In fact, consider three individuals who all face this same
decision, but one paid J<D,=== for three years of in/state tuition, one paid JDG,=== for out/of/state tuition, and one paid nothing
because she had a scholarship for three years. Now assume that the student who paid out/of/state tuition 2ualifies for in/state
tuition for her last year, and the student who had the three/year scholarship now must pay in/state tuition for her last year.
'lthough these three students have paid significantly different amounts for three years of college >J=, J<D,=== and JDG,===?, all of
those e"penditures are sun and irrelevant, and they all face e"actly the same decision with respect to whether to attend one more
year to complete their degrees. It would be wrong to reason that the student who paid JDG,=== should be more liely to stay and
finish, than the student who had the scholarship.

Opportunity Cost!
's noted above, opportunity cost is the profit foregone by selecting one alternative over another. 5pportunity costs are relevant
for many decisions, but are sometimes difficult to identify and 2uantify, and are seldom recorded in an organi-ation,s accounting
system.

10
' common and very important type of opportunity cost that arises in all sectors of the economy is the opportunity cost associated
with the limited capacity of an asset. The asset might be a tangible asset such as a machine or a factory, or it might be an
intangible asset that may or may not be recorded in the accounting records, such as human capital. 0or e"ample, in a given period
of time such as a day or month, a machine can run only so many hours, a factory can produce only so many units, and an
employee can wor only so many hours. The appropriate way to analy-e a decision of whether to accept a new client or sales
order, or to produce a new type of product, depends fundamentally on whether the organi-ation has the capacity to service the new
client, fill the sales order, or mae the new product, without displacing e"isting customers, orders or products. If the new client,
sales order, or product can be accommodated without displacing e"isting clients, orders or products, the organi-ation is described
as having sufficient ecess capacity, whereas if the new client, sales order or product will displace e"isting clients, orders or
products, the organi-ation is described as having a capacity constraint. If the organi-ation has a capacity constraint, then the
decision of whether to accept the new client or order, or produce the new product, should consider the opportunity cost of clients,
orders or products that will be displaced. If the organi-ation has e"cess capacity, the decision is typically simpler9 there is no
opportunity cost arising from a capacity constraint, so the appropriate decision depends only on the marginal costs and revenues
from the new client, order or product.

The term opportunity cost is sometimes ambiguous in the following sense. Sometimes it is used to refer to the profit foregone
from the ne"t best alternative, and sometimes it is used to refer to the difference between the profit from the action taen and the
profit foregone from the ne"t best alternative.


=4ample! Tina has JC,=== to invest. She can invest the JC,=== in a certificate of deposit that earns CK annually, for a first/year
return of J<C=. 'lternatively, she can pay off an auto loan on her car, which carries an interest rate of 8K. If she pays off the auto
loan, she will save JFC= >8K of JC,===? in interest e"pense. >In this conte"t, a dollar saved is as good as a dollar earned.?

Huestion! What is Tina,s opportunity cost from investing in the certificate of deposit1

Ans$er! The opportunity cost is the 3profit foregone4 from the best action not taen. The payoff from the action not taen is
clear9 it is the JFC= in interest e"pense avoided by paying off the loan. *owever, there is some ambiguity as to whether the
opportunity cost is this JFC=, or the difference between the JFC=, and the J<C= that would be earned on the certificate of deposit,
which is J6==.


This ambiguity is only a 2uestion of semantics with respect to the definition of opportunity cost. it does not create any ambiguity
with respect to the information provided by the concept of opportunity cost. $learly, the opportunity cost of paying off the auto
loan implies that Tina is better off paying off the loan than investing in the certificate of deposit.

When opportunity cost is defined in terms of the difference between the two profits >the J6== in the above e"ample?, then the
opportunity cost can be either positive or negative, and a negative opportunity cost implies that the action taen is better than all
alternatives.

1elevant Costs!
)elevant costs are costs that change with respect to a particular decision. Sun costs are never relevant. 0uture costs may or may
not be relevant. If the future costs are going to be incurred regardless of the decision that is made, those costs are not relevant.
$ommitted costs are future costs that are not relevant. !ven if the future costs are not committed, if we anticipate incurring those
costs regardless of the decision that we mae, those costs are not relevant. The only costs that are relevant are those that differ as
between the alternatives being considered.

Including sun costs in a decision can lead to a poor choice. *owever, including future irrelevant costs generally will not lead to a
poor choice. it will only complicate the analysis. 0or e"ample, if I am deciding whether to buy a Toyota $amry or a Subaru
#egacy, and if my auto insurance will be the same no matter which car I buy, my consideration of insurance costs will not affect
my decision, although it will add a few numbers to my analysis.

Microeconomic Analysis and the Matching /rinciple!
The matching principle >matching e"penses with the associated revenues? provides useful information, if properly interpreted.
*owever, there are ways in which the matching principle can obscure relevant costs. 0or e"ample, to honor the matching
principle, companies capitali-e assets and depreciate them over their useful lives. In manufacturing companies, depreciation
e"pense in any one year for assets used in production is allocated yet again, to individual products made during the period. The
result is that the cost of each unit of product includes depreciation e"pense that represents the allocation of a cost that was
probably incurred years ago. *owever, e"cept for any ta" implications that arise because depreciation e"pense reduces ta"able
income, depreciation e"pense should be ignored with respect to all decisions.
C<A/T=1 '! =4ercises and /roblems!
11

Discussion Huestion '2%!
/art A! You are a big fan of roc musician ;avid %owie. >There,s no accounting for taste.? You decide to spend J<== for you and
your friend to go to an upcoming ;avid %owie concert, and you buy a pair of ticets. 5n your way to the concert, you reali-e that
you have lost the ticetsL 't first, you panic. Then you reali-e that, most liely, your little sister put the ticets down the itchen
disposal the other day when she was mad at you. 'nyhow, she put something down the disposal, and seemed to derive great
satisfaction from it. You mae a mental note to idnap her beanie baby collection. In the meantime, at the bo" office, you learn
that seats are still available, and you can buy new ticets that are comparable to the ones you lost, for J<==. !valuate the logic, in
terms of the relevant cost concepts of incremental cost, sun cost andMor opportunity cost, with respect to each of the following
responses to the 2uestion of 3What should you do14

'. You should forego the concert, because although the concert was worth J<== to attend, it,s not worth JD== to attend.

%. You should buy the ticets, even though you never would have spent JD== to attend, because at this point, the
incremental cost is only J<==.

$. You should buy the ticets, even though you never would have spent JD== to attend, because at this point, if you
don,t, your friend will be very disappointed in you.

/art :! You decide that it is not worth another J<== to attend the concert, and you and your friend decide to go bowling. 5n the
way out of the lobby, a wealthy and happy/looing couple whom you have never seen before confront you, tell you they have
decided to fly to :aris tonight, and as if you want their ticets. You say 3yes,4 of course, and 3than you.4 ' bystander standing
in line to buy ticets sees this happening, and offers to buy the ticets from you for J<==. !valuate the logic, in terms of relevant
cost concepts, with respect to each of the following responses to the 2uestion of 3What should you do now14

'. You should attend the concert, since you are now in e"actly the same situation you were in when you were driving to
the concert and thought you had the original ticets.

%. You should sell the ticets for J<==, since you had already decided, only a few minutes ago, that you didn,t want to
spend another J<== to buy the ticets.


'2&! 'ssume that last semester you bought a te"tboo new for J88. Today, the same boo sells new for J6==, and used copies in
the boostore now sell for J8C. The boostore offers to buy bac your boo for JDC. You would lie to sell your boo, and a
student who will be taing the course ne"t semester wants to buy your boo directly from you. 't what range of prices should a
sale tae place between you and the other student1

'2'! )oule" has C== watches that cost J6C each to manufacture. The watches are out of fashion and cannot be sold as is. They can
be refitted at a cost of JD per watch, and then sold for J6G each. 'lternatively, the watches can be donated to charity for a net
financial benefit >i.e., a reduction in the company,s ta" liability? of <=K of the original production cost.

AI Identify a sun cost in the scenario described above.
:I What should the company do1
CI Huantify the opportunity cost associated with the course of action you recommended above.


'2(! The Uris ;eli purchased a machine for JN8,===. $urrent accumulated depreciation on the machine is JFF,===. +anagement
is thining about buying a new machine at a cost of JGC,===. The disposal of the old machine would cost J<6,===. Which of the
following choices most accurately describes which costs are sun and which costs are relevant1

>'? Sun costs consist of the JN8,=== purchase price of the old machine, and the JFF,=== accumulated depreciation on the old
machine. )elevant costs consist of the JGC,=== purchase price of the new machine, and the J<6,=== disposal cost of the old
machine.

>%? Sun costs consist of the JN8,=== purchase price of the old machine. )elevant costs consist of the JGC,=== purchase price
of the new machine.

>$? Sun costs consist of the JN8,=== purchase price of the old machine. )elevant costs consist of the JGC,=== purchase price
of the new machine, and the J<6,=== disposal cost of the old machine.

>;? Sun costs consist of the JN8,=== purchase price of the old machine, and the JFD,=== boo value of the old machine.
)elevant costs consist of the JGC,=== purchase price of the new machine, and the J<6,=== disposal cost of the old machine.

12
'2)! The year is <==6. 'rthur 'ndersen has ordered some custom/made furniture from #ane 0urniture $ompany. #ane recently
completed manufacturing ten e"ecutive dess that had the 'rthur 'ndersen logo carved into the front and sides of the des. #ane,s
manufacturing costs were J<,=== per des, which consist of JD== in materials, JN== in labor, and J6,=== of other manufacturing/
related costs. 'rthur 'ndersen had agreed to pay JF,=== per des, but has now informed #ane that it can no longer honor the
agreement. #ane,s options are as follows. #ane can rewor the dess, removing the 'rthur 'ndersen logo at a labor cost of J8C=
per des, and sell each des for J6,C==. 'lternatively, #ane can sell each des, as is, to collectors, for JG==.

Should #ane >6? rewor the dess and sell them. ><? sell them with the logo to collectors. or >F? not sell the dess at all1

'2*! Smith $ompany maes widgets. Newman $ompany has approached Smith with a proposal to sell the company one of the
components used to mae widgets at a price of J6==,=== for C=,=== units. Smith is currently maing these components in its own
factory. The following costs are associated with this part of the process when C=,=== units are produced9

+aterials used to mae the widgets
#abor incurred to mae the widgets
5ther manufacturing costs
Total
JDD,===
<=,===
N=,===
J6<D,===


The category 3other manufacturing costs4 includes J<G,=== of costs that will be eliminated if the components are no longer
produced by Smith. The remaining costs in this category will continue to be incurred, whether or not Smith maes the
components.

1equired! *ow much better off or worse off will Smith be, if Smith buys the components from Newman, versus continuing to
mae the components in/house1 Should Smith mae the components or buy them from Newman1


'2+! Sun0un maes beach e2uipment, including frisbees. The cost to mae each frisbee >assuming 6==,=== are produced each
year? is as follows9 materials of J=.C= per unit. labor of J=.6= per unit, variable overhead >such as factory electricity? of J=.6C per
unit, and allocated fi"ed overhead of J=.<C per unit >an allocation of costs such as factory rent and insurance?. 'n 'ustralian
company approaches Sun0un for a large order in 0ebruary >typically a slow month? and offers to buy 6=,=== frisbees for J=.7=
each. )egular sales would not be affected and capacity is available to produce them. Total fi"ed costs will be unaffected. The
normal selling price is J6.<C each. What will be the effect on profits from accepting the order1

'2,! The @ennie +ae 0rog 0arm incurs production costs of J< each time a frog is produced. In addition, the farm spends a lump/
sum JC,=== each month for e"penditures such as insurance, property ta"es, and e2uipment leases, regardless of how many frogs
are produced. Times are good9 @ennie +ae is operating at capacity, and she is producing and selling 6,=== frogs per month. @ennie
+ae,s usual sales price is J7 per frog. The U.S. 'rmy has approached @ennie +ae and proposed a one/time purchase of F== frogs.

AI What is the lowest price @ennie +ae should be willing to charge the 'rmy per frog1

:I ;isregard your answer to part >'? and assume the 'rmy offers to pay JN per frog. What is the opportunity cost associated
with each frog sold to the 'rmy at this price1

CI Now assume that times are not so good, and @ennie +ae has e"cess capacity to mae C== frogs. The 'rmy offers to buy
F== frogs at JN each. What is the opportunity cost associated with each frog sold to the 'rmy at this price1

'2-! )efer to the previous 2uestion. Now assume that the maret for frogs crashes, and @ennie +ae changes over to maing
platypuses. She has an aging inventory of frogs sufficient to meet maret demand for ten months >F== frogs per month?, but
unfortunately, frogs only have a useful life of five months and her inventory becomes obsolete after that. What is the lowest price
@ennie +ae should accept from the 'rmy for a one/time/only purchase of F== frogs1

'2%.! @oe can stoc his cooler with beer, soda or (uice, and sell everything in it at the beach on a hot Saturday in @une. The beer
costs J6 per bottle, and he can sell beer for J< per bottle. The soda costs J=.<C per can, and he can sell soda for J6.C= per can. The
(uice costs J6.<C per carton, and he can sell each carton for J6.8C. The cooler has a capacity of 6< cubic feet. !ach cubic foot can
hold 6N (uice cartons, si" soda cans, or eight bottles of beer. What should @oe do in order to ma"imi-e his profits1

'2%%! )efer to the previous 2uestion. Now assume that @oe has to pay for paring and for a vendor,s license. *ow will these
lump/sum costs, which do not depend on how @oe stocs his cooler, affect your answer to the previous 2uestion1
CHAPTER 4: Cost Behavior
Chapter Contents:
- Introduction
13
- Variable costs
- Fixed costs
- Relevant rane
- !ixed costs
- "ost be#avior assu$%tions in $anae$ent accountin versus $icroecono$ics
- &xercises and %roble$s

Introduction:
'#e $ost i$%ortant buildin bloc( o) bot# $icroecono$ic anal*sis and cost accountin is t#e
c#aracteri+ation o) #o, costs c#ane as out%ut volu$e c#anes- .ut%ut volu$e can re)er to
%roduction/ sales/ or an* ot#er %rinci%le activit* t#at is a%%ro%riate )or t#e orani+ation under
consideration 0e--1 )or a sc#ool/ nu$ber o) students enrolled2 )or a #ealt# clinic/ nu$ber o) %atient
visits2 )or an airline/ nu$ber o) %assener $iles3- '#e )ollo,in discussion exa$ines t#e volu$e o)
%roduction in a )actor*/ but t#e sa$e %rinci%les a%%l* reardless o) t#e t*%e o) orani+ation and t#e
a%%ro%riate $easure o) activit*-

"osts can be variable/ 4xed/ or $ixed-

Variable Costs:
Variable costs var* in a linear )as#ion ,it# t#e %roduction level- 5o,ever/ ,#en stated on a %er unit
basis/ variable costs re$ain constant across all %roduction levels ,it#in t#e relevant range- '#e
)ollo,in t,o c#arts de%ict t#is relations#i% bet,een variable costs and out%ut volu$e-
6 ood exa$%le o) a variable cost is $aterials- I) one %air o) %ants re7uires 810 o) )abric/ t#en ever*
%air o) %ants re7uires 810 o) )abric/ no $atter #o, $an* %airs are $ade- '#e )abric cost is 810 per
unit at ever* level o) %roduction- I) one %air is $ade/ t#e total )abric cost is 8102 i) t,o %airs are $ade/
t#e total )abric cost is 8202 and i) 1/000 %airs are $ade/ t#e total )abric cost is 810/000- 5ence/ t#e
total cost is increasin and linear in t#e %roduction level-

Fied Costs:
Fied costs do not var* ,it# t#e %roduction level- 'otal 4xed costs re$ain t#e sa$e/ ,it#in t#e
relevant range- 5o,ever/ t#e 4xed cost %er unit decreases as %roduction increases/ because t#e
sa$e 4xed costs are s%read over $ore units- '#e )ollo,in t,o c#arts de%ict t#is relations#i% bet,een
4xed costs and out%ut volu$e-

In t#is exa$%le/ 4xed costs are 850/000- '#e 4rst c#art s#o,s t#at 4xed costs re$ain 850/000 at all
%roduction levels )ro$ 100 units to 1/000 units- '#e second c#art s#o,s t#at t#e 4xed cost %er unit
decreases as %roduction increases- 5ence/ ,#en 100 units are $anu)actured/ t#e 4xed cost %er unit is
8500 0850/000 9 1003- :#en 500 units are $anu)actured/ t#e 4xed cost %er unit is 8100 0850/000 9
5003-

Relevant Range:
'#e relevant range is t#e rane o) activit* 0e--/ %roduction or sales3 over ,#ic# t#ese relations#i%s
are valid- For exa$%le/ i) t#e )actor* is o%eratin at ca%acit*/ increasin %roduction re7uires additional
invest$ent in 4xed costs to ex%and t#e )acilit* or to lease or build anot#er )actor*- 6lternativel*/
%roduction $i#t be reduced belo, a t#res#old at ,#ic# %oint one o) t#e co$%an*;s )actories is no
loner needed/ and t#e 4xed costs associated ,it# t#at )actor* can be avoided- :it# res%ect to variable
costs/ t#e co$%an* $i#t 7uali)* )or a volu$e discount on )abric %urc#ases above so$e %roduction
level- '#e relevant rane )or c#aracteri+in )abric as a variable cost ends at t#at %roduction level/
because t#e )abric cost %er unit o) out%ut is di<erent ,#en t#e )actor* %roduces above t#at t#res#old
t#an ,#en t#e )actor* %roduces belo, t#at t#res#old-

!ied Costs:
14
I)/ ,it#in a relevant rane/ a cost is neit#er 4xed nor variable/ it is called se"i#variable or "ied-
Follo,in are t,o co$$on exa$%les o) $ixed costs-

In t#is exa$%le/ alt#ou# t#e total cost line increases in %roduction/ it does not %ass t#rou# t#e
oriin because t#ere is a 4xed cost co$%onent- 6n exa$%le o) a cost t#at 4ts t#is descri%tion is
electricit*- 6 4xed a$ount o) electricit* is re7uired to run t#e )actor* air conditionin/ co$%uters and
li#ts- '#ere is also a variable cost co$%onent related to runnin t#e $ac#ines on t#e )actor* =oor- '#e
4xed co$%onent in t#is exa$%le is 83/000 %er $ont#- '#e variable cost co$%onent is 810 %er unit o)
out%ut- 5ence/ at a %roduction level o) 500 units/ t#e total electric cost is 88/000 >83/000 ? 0810 x
5003@-

'#e $ixed cost illustrated in t#e above c#art is called a ste% )unction- 6n exa$%le o) suc# cost
be#avior ,ould be t#e total salar* ex%ense )or s#i)t su%ervisors- I) t#e )actor* runs one s#i)t/ onl* one
s#i)t su%ervisor is re7uired- In order )or t#e )actor* to %roduce above t#e $axi$u$ ca%acit* o) a sinle
s#i)t/ t#e )actor* $ust add a second s#i)t and #ire a second s#i)t su%ervisor/ so t#at total s#i)t
su%ervisor salar* ex%ense doubles- I) t#e )actor* runs t#ree s#i)ts/ t#ree s#i)t su%ervisors are re7uired-

Cost Behavior Assu"ptions in !anage"ent Accounting Versus !icroecono"ics:
!icroecono$ic anal*sis usuall* assu$es decreasin $arinal costs o) %roduction/ so$eti$es )ollo,ed
b* increasin $arinal costs o) %roduction be*ond a certain %roduction level- 5ence/ econo$ists;
ra%#s o) t#e total cost o) %roduction and t#e averae %er-unit cost o) %roduction s#o, s$oot#/ curved
)unctions- !anae$ent accountants usuall* assu$e t#e linear relations#i%s de%icted in t#e %revious
ra%#s- Ainearit* is a $ore accurate descri%tion o) $an* situations encountered b* $anae$ent
accountants t#an t#e econo$ists; curves/ and even ,#en linearit* constitutes a si$%li)*in assu$%tion
it is al$ost al,a*s suBcientl* descri%tive )or t#e tas( at #and-

Eercises and Proble"s
$iscussion %uestion 4#&: 6 leadin $anae$ent accountin textboo( 0Cost Accounting: A
Managerial Emphasis/ b* 5ornren/ Catar and Foster/ 12
t#
edition3 %rovides t#e )ollo,in table 0&x#ibit
2-5 in t#at textboo(3 %rovidin exa$%les o) cost classi4cations1
$irect Costs Indirect Costs


Variable Costs:
"ost obDect1 E!: F5s %roduced

&xa$%le1 'ires used in asse$bl* o)
auto$obile
"ost obDect1 E!: F5;s %roduced

&xa$%le1 Go,er costs at
H%artanbur %lant- Go,er usae is
$etered onl* to t#e %lant/ ,#ere
$ulti%le %roducts are asse$bled-



Fied Costs:
"ost obDect1 E!: F5s %roduced

&xa$%le1 Halar* o) su%ervisor on
E!: F5 asse$bl* line
"ost obDect1 E!: F5s %roduced

&xa$%le1 6nnual lease costs at
H%artanbur %lant- Aease is )or
,#ole %lant/ ,#ere $ulti%le %roducts
are %roduced-


Re'uired: &valuate ,#et#er t#e cost obDect is identical in eac# o) t#e )our boxes-

4#(:
AI If a company maes 6== units of product, the allocated fi"ed cost per unit is JC and the variable cost per unit is JN. What
will be the per/unit total cost >fi"ed plus variable cost? if the company maes <== units1
:I 't a production and sales level of 6,=== units, the company,s costs are as follows9

Variable $anu)acturin costs %er unit 820
6llocated 4xed $anu)acturin cost %er unit 810
15
Variable sellin costs %er unit 8 5
6llocated 4xed sellin costs %er unit 8 3

5o, $uc# ,ould t#e co$%an* #ave to s%end in total 0total cas# outla* )or bot# 4xed and
variable costs3/ i) it $a(es 1/200 units and sells 200 units 0so t#at 1/000 units are in endin
inventor* at t#e end o) t#e %eriod3I

4#): Cescribe eac# o) t#e )ollo,in costs as eit#er 4xed/ variable/ or se$i-variable 0i-e-/ $ixed3

AI The cost is JC== per unit at a production level of C= units, and JC== per unit at a production level of 6== units.

:I The cost is JC== in total at a production level of C= units, and J6,=== in total at a production level of 6== units.

CI The cost is JC== in total at a production level of C units, and J6== per unit at a production level of 6= units.

4#4: I) a co$%an* $a(es 100 units o) %roduct/ t#e 4xed cost %er unit is 85 and t#e variable cost %er
unit is 86- 5o, $uc# ,ill t#e co$%an* #ave to s%end in total to $a(e 200 unitsI

(2)! Identify the following cost as either fi"ed, variable or mi"ed >semi/variable?. The hori-ontal a"is refers to the number of units
produced. The vertical a"is refers to the cost per unit at that level of production.

4#*: Identi)* t#e )ollo,in cost as eit#er 4xed/ variable or $ixed 0se$i-variable3- '#e #ori+ontal axis
re)ers to t#e nu$ber o) units %roduced- '#e vertical axis re)ers to t#e total cost incurred )or all o) t#e
units %roduced-

(2+! Identify the following cost as either fi"ed, variable or mi"ed >semi/variable?. The hori-ontal a"is refers to the number of units
produced. The vertical a"is refers to the total cost incurred for all of the units produced.

4#+: 'ur7uoise "o$%an* $anu)actures ,idets and ot#er ood stu<- :#en 12/000 ,idets are
%roduced/ t#e total cost %er ,idet is 840/ calculated as )ollo,s1

+aterials >a variable cost? J6=
#abor >another variable cost? 6C
Aariable overhead >yet another variable cost? 6=
0i"ed overhead >not a variable cost? C

The company is considering buying its widgets, instead of maing them >hence, the company would become a widget wholesaler,
but will still manufacture other good stuff?. The company can buy widgets from another company for JD< per widget. If the
company stops maing widgets, total fi"ed costs will not change, although some of the facilities currently being used to mae
widgets can be rented out, resulting in JC=,=== in rental income to the Tur2uoise $ompany. What would be the incremental cost or
benefit to the Tur2uoise $ompany from becoming a widget wholesaler instead of a widget manufacturer1

(2-! ' particular cost is J6=,=== in total when C= units are made.

AI $omplete the following table, indicating what the cost would be if production is increased to <== units9

$ost per Unit $ost in total
If this cost is a variable cost
If this cost is a fi"ed cost

:I $omplete the following table, indicating what the cost would be if production is reduced to <= units9

$ost per Unit $ost in total
If this cost is a variable cost
If this cost is a fi"ed cost

(2%.! ;escribe in two or three >no more than four? complete, well/written sentences the difference between fi"ed costs and
variable costs.

16
(2%%! In general, and within the relevant range, as production increases9

>'? :er unit fi"ed costs and per unit variable costs both stay the same.

>%? :er unit variable costs go down, and per unit fi"ed costs stay the same.

>$? :er unit fi"ed costs go down, and per unit variable costs stay the same.

>;? :er unit fi"ed costs and total variable costs both stay the same.

(2%&! ' particular cost is a semi/variable >or mi"ed? cost, within a relevant range of 6== to <== units of production. This cost is
J6,=== in total when 6== units are manufactured >i.e., J6= per unit, when 6== units are manufactured?. If production is doubled to
<== units, which of the following is the most liely amount incurred for this particular cost1

>'? J 77=

>%? J6,===

>$? J6,6==

>;? J<,===

(2%'! If production doubles, what will happen to variable costs1

>'? Total variable costs and the variable cost per unit will both double.

>%? Total variable costs will stay the same, and the variable cost per unit will decrease

>$? Total variable costs will stay the same, and the variable cost per unit will double.

>;? Total variable costs will double, and the variable cost per unit will stay the same.

(2%(! 't a production level of <== units, total costs for the factory are J7,===, consisting of JG,=== in variable costs and J6,=== in
fi"ed costs. $alculate total factory costs if production increases <CK.

(2%) GThe Matching /rinciple and cost behaviorI! 'ssume that the #ittle )oc $ompany calculates income in the following
manner9 'll manufacturing costs >variable and fi"ed? are treated as a cost of inventory, and the 3matching principle4 is honored
for these costs, such that the cost to mae inventory appears on the Income Statement as $ost of &oods Sold when the inventory is
sold. 'll non/manufacturing costs are e"pensed >appear on the Income Statement? when incurred >i.e., the matching principle is
not honored for these costs?.

In <==F, the #ittle )oc $ompany incurred fi"ed manufacturing costs of JC==,=== and fi"ed non/manufacturing costs of
JF==,===. The $ompany made 6=,=== units and sold C,===. Aariable manufacturing cost was J6C= per unit. Aariable non/
manufacturing cost was JF= for every unit sold >this was a sales commission?. )evenue was JF,===,===.

1equired! $alculate income for <==F.
C<A/T=1 )! Cost2Kolume2/ro#it

Chapter Contents!
/ The %asic :rofit !2uation
/ 'ssumptions in $A: analysis
/ Target costing
/ #everage
/ $onstrained resources
/ !"amples
/ !"ercises and problems

The :asic /ro#it =quation!
$ost/Aolume/:rofit analysis >$A:? relates the firm,s cost structure to sales volume and profitability. ' formula that facilitates
$A: analysis can be easily derived as follows9

17
/ro#it L Sales M =4penses

O :rofit P Sales Q >Aariable $osts R 0i"ed $osts?

O :rofit R 0i"ed $osts P Sales Q Aariable $osts

O :rofit R 0i"ed $osts P Units Sold " >Unit Sales :rice Q Unit Aariable $ost?


This formula is henceforth called the :asic /ro#it =quation and is abbreviated9

/ N 3C L H 4 GS/ M KCI

Contribution margin is defined as

Sales M Kariable Costs

The unit contribution margin is defined as

Unit Sales /rice M Unit Kariable Cost

Typically, the %asic :rofit !2uation is used to solve one e2uation in one unnown, where the unnown can be any of the elements
of the e2uation. 0or e"ample, given an understanding of the firm,s cost structure and an estimate of sales volume for the coming
period, the e2uation predicts profits for the period. 's another e"ample, given the firm,s cost structure, the e2uation indicates the
re2uired sales volume H to achieve a targeted level of profits /. If targeted profits are -ero, the e2uation simplifies to

H L 3C O Unit Contribution Margin

In this case, H indicates the re2uired sales volume to brea even, and the e"ercise is called brea7even analysis.

$:A analysis can be depicted graphically. The graph below shows total revenue >S: " H? as a function of sales volume >H?, when
the unit sales price >S:? is J6<.


The following graph shows the total cost function when fi"ed costs >0$? are JD,=== and the variable cost per unit >A$? is JC.
The following graph combines the revenue and cost functions depicted in the previous two graphs into a single graph.

The intersection of the revenue line and the total cost line indicates the breaeven volume, which in this e"ample, occurs between
C86 and C8< units. To the left of this point, the company incurs a loss. To the right of this point, the company generates profits.
The amount of profit or loss can be measured as the vertical distance between the revenue line and the total cost line.

Assumptions in CK/ Analysis!
The %asic :rofit !2uation relies on a number of simplifying assumptions.

6. 5nly one product is sold. *owever, multiple products can be accommodated by using an average sales mi" and restating
H, S/ and KC in terms of a representative bundle of products. 0or e"ample, a hot dog vendor might calculate that the
3average4 customer buys two hot dogs, one bag of chips, and two/thirds of a beverage. H is the number of customers,
and S/ and KC refer to the sales price and variable cost for this 3average4 customer order.

<. If the e2uation is applied to a manufacturer, beginning inventory is assumed e2ual to -ero, and production is assumed
e2ual to sales. )ela"ing these assumptions re2uires additional structure on the e2uation, including specifying an
inventory flow assumption >e.g., 0I05 or #I05? and the e"tent to which the matching principle is honored for
manufacturing costs.

3- The analysis is confined to the relevant range. In other words, fi"ed costs remain unchanged in total, and variable costs
remain unchanged per unit, over the range of H under consideration.

Target Costing!
' relatively recent innovation in product planning and design is called target costing. In the conte"t of the %asic :rofit !2uation,
target costing sets a goal for profits, and solves for the unit variable cost re2uired to achieve those profits. The design and
manufacturing engineers are then assigned the tas of building the product for a unit cost not to e"ceed the target. This approach
differs from a more traditional product design approach, in which design engineers >possibly with input from merchandisers?
18
design innovative products, manufacturing engineers then determine how to mae the products, cost accountants then determine
the manufacturing costs, and finally, merchandisers and sales personnel set sales prices. *ence, setting the sales price comes last
in the traditional approach, but it comes first in target costing.

Target costing is appropriate when S/ and H are predictable, but are not choice variables, such as might occur in well/established
competitive marets. In such a setting, merchandisers might now the price that they want to charge for the product, and can
probably estimate the sales volume that will be achieved at that price. Target costing has been used successfully by a number of
companies including Toyota, which redesigned the $amry around the turn of the century as part of a target costing strategy.

Constrained 1esources!
$ontribution margin analysis plays an important role when a multi/product organi-ation has a binding resource constraint. The
resource constraint can tae many forms, such as production throughput on a critical machine, free-er space, or silled labor hours
in a particular function. In the presence of a resource constraint, the optimal production decision is to ma"imi-e the contribution
margin per unit of the constraint.

0or e"ample, assume that a company maes small widgets and large widgets. Small widgets incur JC in variable manufacturing
and non/manufacturing costs, and sell for J6=. #arge widgets incur J66 in variable manufacturing and non/manufacturing costs,
and sell for J6C. If production throughput is constrained by the capacity of a particular machine, and both small and large widgets
re2uire one hour of processing time on that machine, then the company should mae only small widgets, because small widgets
provide a contribution margin of JC per unit, whereas large widgets provide a contribution margin of JD per unit. 5n the other
hand, if each small widget re2uires two hours of processing time on the machine, and large widgets re2uire only one hour, then the
company should mae only large widgets, calculated as follows9

Small widgets9 contribution margin per machine hour P >J6= JC? S < P J<.C= per hour

#arge widgets9 contribution margin per machine hour P >J6C J66? S 6 P JD.== per hour

The company ma"imi-es profits by maing large widgets, even though large widgets have a lower contribution margin per unit
than small widgets, because large widgets re2uire less machine time and hence, are more efficient with respect to the limited
resource. In other words, the large widgets generate a higher contribution margin per hour on the machine that constitutes the
capacity constraint of the factory.

Jeverage!
There is often a trade/off between fi"ed cost inputs and variable cost inputs. 0or e"ample, in the manufacturing sector, a company
can build its own factory >thereby operating with relatively high fi"ed costs but relatively low variable costs? or outsource
production >operating with relatively low fi"ed costs but relatively high variable costs?. ' merchandising company can pay its
sales force a flat salary >relatively higher fi"ed costs? or rely to some e"tent on sales commissions >relatively higher variable
costs?. ' restaurant can purchase the e2uipment to launder table cloths and towels, or it can hire a laundry service.

' company that has relatively high fi"ed costs is more highly leveraged than a company with relatively high variable costs.
*igher fi"ed costs result in greater downside ris9 as H falls below the breaeven point, the company loses money more 2uicly
than a company with less leverage. 5n the other hand, the company,s lower variable costs result in a higher unit contribution
margin, which means that as H rises above the breaeven point, the more highly/leveraged company is more profitable.

There is an ongoing trend for companies to outsource support functions and other 3non/core4 activities to third party suppliers and
providers. Usually, outsourcing reduces the leverage of the company by eliminating the fi"ed costs associated with conducting
those activities inside the firm. When the activities are outsourced, the contractual payments to the outsource providers usually
contain a large variable cost component and a relatively small or no fi"ed cost component.

=4amples!
:rea7even! Steve :oplac owns a service station in Walnut $ree. Steve is considering leasing a machine that will allow him to
offer customers the mandatory $alifornia emissions test. !very car in the state must be tested every two years. The machine costs
JN,=== per month to lease. The variable cost per test >i.e., per car inspected? is J6=. The amount that Steve can charge each
customer is set by state law, and is currently JD=.

*ow many inspections would Steve have to perform monthly to brea even from this part of his business1

H P 0$ S Unit $ontribution +argin
H P JN,=== S >JD= J6=? P <== inspections

Targeted pro#its, solving #or volume! )efer to the information in the previous 2uestion. *ow many inspections would Steve
have to perform monthly to generate a profit of JF,=== from this part of his business1

19
: R 0$ P H " >S: Q A$?
JF,=== R JN,=== P H " >JD= J6=?
H P F== inspections

Targeted pro#its, solving #or sales price! 'lice Waters >age 7? runs a lemonade stand in the summer in :alo 'lto, $alifornia. *er
daily fi"ed costs are J<=. *er variable costs are J< per glass of ice/cold, refreshing, lemonade. 'lice sells an average of 6==
glasses per day. What price would 'lice have to charge per glass, in order to generate profits of J<== per day1

: R 0$ P H " >S: Q A$?
J<== R J<= P 6== " >S: J<?
S: P JD.<= per glass

Contribution margin! )efer to the previous 2uestion. What price would 'lice have to charge per glass, in order to generate a
total contribution margin of J<== per day1

Total $+ P H " >S: Q A$?
J<== P 6== " >S: J<.==?
S: P JD.== per glass

Target costing! )efer to the information about 'lice, but now assume that 'lice wants to charge JF per glass of lemonade, and at
this price, 'lice can sell 66= glasses of lemonade daily. 'pplying target costing, what would the variable cost per glass have to be,
in order to generate profits of J<== per day1

: R 0$ P H " >S: Q A$?
J<== R J<= P 66= " >JF Q A$?
A$ P J6

=4ercises and /roblems!

)2%! Sara, Sarah, Shara and 'ssociates want to earn a total contribution margin of J6=,=== on sales of 6,=== units. Their sales
price is J6C per unit, and their fi"ed costs are JC,===. What variable cost per unit is necessary to achieve their goal1

)2&! &eorge and &racie both mae the same product, and sell it for the same sales price. &racie has a higher variable cost per unit
than &eorge. &eorge has higher fi"ed costs than &racie. Who has the higher breaeven point, in terms of number of units sold1

>'? &racie has a higher breaeven point than &eorge.

>%? &eorge has a higher breaeven point than &racie.

>$? &racie and &eorge have the same breaeven point.

>;? Impossible to ascertain, from the information given.

)2'! The Airginia $ompany has fi"ed costs of J6==,=== per month, and variable costs of JF= per unit of output. The sales price is
JC= per unit of output. *ow many units would the company have to sell per month, to generate profits of JF=,=== per month1

)2(! The $harleston $ompany has fi"ed costs of J<=,=== per month, and variable costs of J6C per unit of output. The company
would lie to earn profits of JD,=== per month. 't a sales volume of 6<,=== units per month, what sales price per unit would the
company have to charge in order to achieve its targeted monthly profit1

)2)! The ;elaware $ompany has fi"ed costs of J6==,=== per year and variable costs of J6= per unit of output. The :ennsylvania
$ompany has fi"ed costs of J6<=,=== per year and variable costs of J7 per unit of output. The sales price per unit is the same for
both companies. Identify a sales price at which both companies will have the same brea/even point in terms of number of units
sold.

)2*! The %ilo"i $ompany has the following cost structure9 fi"ed costs of J8=,=== per month and variable costs of JC= per unit.
The %irmingham $ompany has the following cost structure9 fi"ed costs of JN=,=== per month and variable costs of JN= per unit.
%oth companies mae the same product, which sells for J6== per unit. There is a sales level at which these two companies earn
the same profits. What is that sales level1 Which company is more profitable as sales volume e"ceeds this sales level1

)2+! $ompany T and $ompany Y sell the same product for the same price. $ompany T has fi"ed costs of J6== and variable costs
of J6= per unit. $ompany Y has fi"ed costs of J<== and variable costs of JG. What is the unit sales price at which these companies
will have the same brea/even point in terms of unit sales1
20

)2,! !li-a sells flowers in $ovent &arden. *er fi"ed costs are JC= per day. *er average sales price is JD per flower. She is
currently selling D== flowers per day. *er current variable cost is JF per flower. !li-a anticipates that her daily sales will increase
to C== flowers per day. *ow much could her variable cost per flower increase for her to still earn the same daily profits as before1

)2-! The following information is available for the publisher of 30ran the $ow ;og4 $hildren,s %oos9

Aariable cost9 J6=.== per boo
Sales price9 J6C.== per boo
0i"ed costs9 JFC,=== per year

These costs apply over a relevant range of the production of one boo to the production of D=,=== boos.
AI What is the contribution margin per unit1
:I What would operating income be at a sales level of 6C,=== boos1
CI What is the breaeven point in units1
DI Ignore the sales price of J6C per boo. What would the sales price have to be for the publisher to earn operating
income of J6NC,=== on sales of <C,=== boos1

)2%.! The !merald Street Ice $ream Shop sells ice cream cones. The store,s cost structure is as follows9 fi"ed costs per month are
J<,===. Aariable costs are J6.C= for a single scoop cone and J6.8C for a double scoop cone.

1equired!
AI If !merald Street only sells double scoop cones, and sells them for JD.<C per cone, what is the brea/even point in units1

:I If !merald Street only sells single scoop cones, and charges JF.C= per cone, how many ice cream cones would !merald Street
have to sell to mae a profit of JF,=== per month1

CI 'ssume that !merald Street wants to sell only double scoop cones, and believes it can sell G,=== cones per month at JD.<C per
cone. What would the variable cost per cone have to be for !merald Street to mae a profit of JG,=== per month1

DI Ignore :art >$? and refer to the original information. If !merald Street only sells single scoop cones, and sells C,=== cones per
month for JF.N= per cone, what is the contribution margin per unit1

)2%%! Teddy %ear 0udge $ompany maes two types of fudge9 plain fudge and fudge with nuts. 0ollowing is information about the
company,s cost structure when 6,=== pounds of fudge are produced. There is no direct labor.

Overhead /lain 3udge 3udge $ith 5uts
:er unit information9
Sales price per pound
;irect materials per pound
Sales commission per pound

Aariable overhead

0i"ed costs9
0i"ed manufacturing overhead
0i"ed non/manufacturing overhead





JC==


J<,===
JF==

JG.==
J<.==
J=.C=




JG.==
J<.<C
J=.C=

1equired! 'ssuming that variable overhead costs are linear in the 2uantity of production >i.e., pounds of fudge?, and assuming
that C=K of sales are plain fudge, and C=K of sales are fudge with nuts, calculate the breaeven point in pounds of fudge.
C<A/T=1 *! 3le4ible :udgeting

Chapter Contents:
- Introduction
- Gro )or$a anal*sis at Juess :#o Keans
- Htatic budet variance at Juess :#o Keans
- Flexible budet variance at Juess :#o Keans
- &xercises and %roble$s

Introduction:
21
6 budet is a %lan )or t#e )uture- 5ence/ budets are %lannin tools/ and t#e* are usuall* %re%ared %rior
to t#e start o) t#e %eriod bein budeted- 5o,ever/ t#e co$%arison o) t#e budet to actual results
%rovides valuable in)or$ation about %er)or$ance- '#ere)ore/ budets are bot# %lannin tools and
%er)or$ance evaluation tools-

Lsuall*/ t#e sinle $ost i$%ortant in%ut in t#e budet is so$e $easure o) antici%ated out%ut- For a
)actor*/ t#is $easure o) out%ut is t#e nu$ber o) units o) eac# %roduct %roduced- For a retailer/ it $i#t
be t#e nu$ber o) units o) eac# %roduct sold- For a #os%ital/ it is t#e nu$ber o) %atient da*s 0t#e
nu$ber o) %atient ad$issions $ulti%lied b* t#e averae lent# o) sta*3-

'#e static budget is t#e budet t#at is based on t#is %roDected level o) out%ut/ %rior to t#e start o) t#e
%eriod- In ot#er ,ords/ t#e static budet is t#e MoriinalN budet- '#e static budget variance is t#e
di<erence bet,een an* line-ite$ in t#is oriinal budet and t#e corres%ondin line-ite$ )ro$ t#e
state$ent o) actual results- .)ten/ t#e line-ite$ o) $ost interest is t#e Mbotto$ lineN1 total cost o)
%roduction )or t#e )actor* and ot#er cost centers2 inco$e )or %ro4t centers-

'#e ,eible budget is a %er)or$ance evaluation tool- It cannot be %re%ared be)ore t#e end o) t#e
%eriod- 6 =exible budet adDusts t#e static budet )or t#e actual level o) out%ut- '#e =exible budet
as(s t#e 7uestion1 If I had known at the beginning of the period what my output volume (units
produced or units sold would be! what would my budget have looked like"N '#e $otivation )or t#e
=exible budet is to co$%are a%%les to a%%les- I) t#e )actor* actuall* %roduced 10/000 units/ t#en
$anae$ent s#ould co$%are actual )actor* costs )or 10/000 units to ,#at t#e )actor* s#ould #ave
s%ent to $a(e 10/000 units/ not to ,#at t#e )actor* s#ould #ave s%ent to $a(e 9/000 units or 11/000
units or an* ot#er %roduction level-

'#e ,eible budget variance is t#e di<erence bet,een an* line-ite$ in t#e =exible budet and t#e
corres%ondin line-ite$ )ro$ t#e state$ent o) actual results-

'#e )ollo,in ste%s are used to %re%are a =exible budet1

1- Ceter$ine t#e budeted variable cost %er unit o) out%ut- 6lso deter$ine t#e budeted
sales %rice %er unit o) out%ut/ i) t#e entit* to ,#ic# t#e budet a%%lies enerates revenue 0e--/ t#e
retailer or t#e #os%ital3-
2- Ceter$ine t#e budeted level o) 4xed costs-
3- Ceter$ine t#e actual volu$e o) out%ut ac#ieved 0e--/ units %roduced )or a )actor*/ units
sold )or a retailer/ %atient da*s )or a #os%ital3-
4- Euild t#e =exible budet based on t#e budeted cost in)or$ation )ro$ ste%s 1 and 2/ and
t#e actual volu$e o) out%ut )ro$ ste% 3-

Flexible budets are %re%ared at t#e end o) t#e %eriod/ ,#en actual out%ut is (no,n- 5o,ever/ t#e
sa$e ste%s described above )or creatin t#e =exible budet can be used %rior to t#e start o) t#e %eriod
to antici%ate costs and revenues )or an* %roDected level o) out%ut/ ,#ere t#e %roDected level o) out%ut is
incor%orated at ste% 3- I) t#ese ste%s are a%%lied to various antici%ated levels o) out%ut/ t#e anal*sis is
called pro -or"a anal*sis- Gro )or$a anal*sis is use)ul )or %lannin %ur%oses- For exa$%le/ i) next
*ear;s sales are double t#is *ear;s sales/ ,#at ,ill be t#e co$%an*;s cas#/ $aterials/ and labor
re7uire$ents in order to $eet %roduction needsI
Pro For"a Anal.sis at /uess 0ho 1eans:
Follo,in are %ro )or$a $ont#l* inco$e state$ents )or Juess :#o Keans/ a s$all/ start-u% )as#ion
Deans $anu)acturer- '#e %ro )or$a anal*sis ,as %re%ared at t#e beinnin o) t#e $ont# and considered
t#ree alternative sales levels- '#e co$%an* #as no variable $ar(etin costs-
GUESS WHO JEANS
PRO FORMA ANALYSIS
FOR THE UPCOMING MONTH
Inco"e Budgeted Pro For"a Anal.sis -or
22
2tate"ent
line#ite"
a"ount per
unit
Alternative 3utput 4evels
&56555 units (56555 units )56555 units
Revenue
Variable costs1
!aterials
Aabor
.ver#ead
'otal

"ontribution $arin

Fixed costs1
!anu)acturin
.ver#ead
!ar(etin costs
'otal 4xed costs

.%eratin inco$e
840

15
10
5
30

810
8400/000

150/000
100/000
50/000
300/000

100/000



100/000
50/000
150/000

0850/0003
8800/000

300/000
200/000
100/000
600/000

200/000



100/000
50/000
150/000

850/000
81/200/000

450/000
300/000
150/000
900/000

300/000



100/000
50/000
150/000

8150/000
Hince b* de4nition/ 4xed costs are not ex%ected to c#ane as volu$e o) out%ut c#anes ,it#in t#e
relevant rane/ 4xed costs re$ain t#e sa$e at all t#ree %roDected levels o) out%ut- Revenue and
variable costs var* ,it# out%ut in a linear )as#ion- 5ence/ ,#en out%ut increases 100O )ro$ 10/000
units to 20/000 units/ revenue/ eac# line-ite$ )or variable costs/ and contribution $arin all increase
100O-
2tatic Budget Variance at /uess 0ho 1eans:
Juess :#o $anae$ent decides t#at 10/000 units is t#e $ost li(el* out%ut volu$e/ and sets t#e static
budet based on t#is sales and %roduction level- 6)ter t#e end o) t#e $ont#/ co$%an* %ersonnel
%re%are t#e )ollo,in table/ s#o,in t#e static budet/ actual results/ and t#e static budet variance-
GUESS WHO JEANS
STATIC BUDGET VARIANCE
FOR THE MONTH JUST ENDED
Inco"e
2tate"ent
line#ite"
Budgeted
a"ount per
unit
2tatic
Budget
7A8
&56555 units
Actual
Results
7B8
&*6555 units
2tatic
Budget Variance
7A8 9 7B8
Revenue
Variable costs1
!aterials
Aabor
.ver#ead
'otal

"ontribution $arin
Fixed costs1
!anu)acturin
.ver#ead
!ar(etin costs
'otal 4xed costs

.%eratin inco$e
840
15
10
5
30

810
8400/000

150/000
100/000
50/000
300/000

100/000


100/000
50/000
150/000

0850/0003
8670/000

230/000
167/000
84/000
481/000

189/000


105/000
49/000
154/000

835/000
8270/000

080/0003
067/0003
034/0003
0181/0003

89/000


05/0003
1/000 -
04/0003

885/000

In t#e variance colu$n/ %ositive nu$bers are )avorable variances 0ood ne,s3/ and neative nu$bers
are un)avorable 0bad ne,s3-

'#e static budet variance s#o,s a lare )avorable variance )or revenue/ and lare un)avorable
variances )or variable costs- '#ese lare variances are due %ri$aril* to t#e )act t#at t#e static budet
,as built on an out%ut level o) 10/000 units/ ,#ile t#e co$%an* actuall* $ade and sold 16/000 units-
'#e revenue variance $i#t also be due to an averae unit sales %rice t#at di<ered )ro$ budet- '#e
variable cost variances $i#t also be due to in%ut %rices t#at di<ered )ro$ budet 0e--/ t#e %rice o)
)abric3/ or in%ut 7uantities t#at di<ered )ro$ t#e %er-unit budeted a$ounts 0e--/ *ards o) )abric %er
%air o) %ants3-
23

'#ere are also s$all variances )or 4xed costs- '#ese costs s#ould not var* ,it# t#e level o) out%ut 0at
least ,it#in t#e relevant rane3- 5o,ever/ $an* )actors can cause actual 4xed costs to di<er )ro$
budeted 4xed costs t#at are unrelated to out%ut volu$e- For exa$%le/ %ro%ert* tax rates and t#e 4xed
salaries o) )ront oBce %ersonnel can c#ane/ and de%reciation ex%ense can c#ane i) unex%ected
ca%ital ac7uisitions or dis%ositions occur-

The Fleible Budget Variance at /uess 0ho 1eans:
In order to better understand t#e causes o) t#e lare revenue and variable cost variances in t#e static
budet variance colu$n/ Juess :#o %ersonnel %re%are t#e )ollo,in =exible budet-
GUESS WHO JEANS
FLEXIBLE BUDGET VARIANCE
FOR THE MONTH JUST ENDED
Inco"e
2tate"ent
line#ite"
Budgeted
a"ount per
unit
Fleible Budget
7A8
&*6555 units
Actual
Results
7B8
&*6555 units
Fleible Budget
Variance
7A8 9 7B8
Revenue

Variable costs1
!aterials
Aabor
.ver#ead
'otal

"ontribution $arin

Fixed costs1
!anu)acturin
.ver#ead
!ar(etin costs
'otal 4xed costs

.%eratin inco$e
840


15
10
5
30

810
8640/000


240/000
160/000
80/000
480/000

160/000



100/000
50/000
150/000

810/000
8670/000


230/000
167/000
84/000
481/000

189/000



105/000
49/000
154/000

835/000
830/000


10/000-
07/0003
04/0003
01/0003

29/000



05/0003
1/000 -
04/0003

825/000

.nce aain/ %ositive variances are )avorable 0ood ne,s3/ and neative variances are un)avorable 0bad
ne,s3-

Fro$ t#is table/ Juess :#o $anae$ent sees t#at even a)ter adDustin )or sales volu$e/ revenue ,as
#i#er t#an ,ould #ave been ex%ected- '#e )avorable 830/000 variance $ust be due entirel* to an
averae sales %rice t#at ,as #i#er t#an %lanned 0al$ost 842 %er %air co$%ared to t#e oriinal budet
o) 840 %er %air3-

!aterials costs ,ere lo,er t#an ,ould #ave been ex%ected )or a sales volu$e o) 16/000 units- '#is
)avorable variance could be due to lo,er )abric %rices/ or to $ore eBcient utili+ation o) )abric 0less
,aste t#an ex%ected3/ or a co$bination o) t#ese t,o )actors- Aabor and over#ead ,ere #i#er t#an
ex%ected/ even a)ter adDustin )or t#e sales volu$e o) 16/000 units- '#is un)avorable =exible budet
variance i$%lies t#at eit#er ,ae rates ,ere #i#er t#an %lanned/ or labor ,as not as eBcient as
%lanned/ or bot#- Hi$ilarl*/ t#e co$%onents o) variable over#ead ,ere eit#er $ore ex%ensive t#an
budeted/ or ,ere used $ore intensivel* t#an budeted- For exa$%le/ electric rates $i#t #ave been
#i#er t#an %lanned/ or $ore electricit* ,as used t#an %lanned %er unit o) out%ut-

'#e 4xed cost variances are identical in t#is table to t#e %revious table- In ot#er ,ords/ t#e =exible
budet and =exible budet variance %rovide no additional in)or$ation about 4xed costs be*ond ,#at
can be learned )ro$ t#e static budet variance-

24
Eercises and Proble"s:

*#&: '#e Hilver "o$%an* %lanned to $a(e 10/000 units o) %roduct in Kul*- Eudeted costs ,ere
8110/000 in variable costs and 8220/000 in 4xed costs- '#e co$%an* actuall* $ade 11/000 units-
6ctual costs incurred ,ere 8110/000 in variable costs and 8210/000 in 4xed costs- "alculate t#e =exible
budet variance )or Kul*- Is it )avorable or un)avorableI

*#(: '#e Caven%ort 4-5 "lub %lans to s%end 85/000 to send 20 o) its $e$bers to t#e Htate Fair in Ces
!oines- 82/000 o) t#e 85/000 are 4xed costs- ',ent*-4ve $e$bers actuall* attend t#e )air/ at a cost o)
86/000- "alculate t#e =exible budet variance- Is it )avorable or un)avorableI

*#): 6 %iano teac#er #as budeted 4xed costs o) 81/250 %er $ont#/ and budeted variable costs o)
81/200 %er $ont#/ ,#ere variable costs are a linear )unction o) t#e nu$ber o) one-#our %iano lessons-
'#e %iano teac#er ex%ected to ive 120 one-#our %iano lessons in 6%ril/ but actuall* ave 150 one-#our
%iano lessons in 6%ril- 6ctual 4xed costs ,ere 81/000 and actual variable costs ,ere 81/500- :#at is
t#e =exible budet variance )or 6%rilI Is it )avorable or un)avorableI

*2(! The 'mber $ompany planned to mae 6,=== units of product in @une. The static budget showed a per/unit cost of J6=, which
consisted of JF for variable costs and J8 for allocated fi"ed overhead. The company actually made 6,6== units. The actual per/unit
cost was J6=, which consisted of JF for variable costs and J8 for allocated fi"ed overhead. $alculate the total fle"ible budget
variance for @une. Is it favorable or unfavorable1

*#:: '#e static budet 0i-e-/ t#e oriinal budet3 o) t#e 'a$-'a#a "or%oration s#o,ed a %roduction cost
o) 810 %er unit at a %roduction level o) 100 units- '#is 810 included 82 o) 4xed costs- 6ctual %roduction
,as 200 units/ and actual costs ,ere 89 %er unit/ ,#ic# included 81 o) 4xed costs- "alculate t#e =exible
budet variance- Is it )avorable or un)avorableI

*2*! +;$ company plans to mae 8,=== units, and at this level of production, the cost per unit would be JC=. This JC= consists of
JF= in variable costs and J<= in allocated fi"ed overhead. What would the fle"ible budget show for total costs, if the company
maes N,=== units1

*#;: Pinne*-Eorst antici%ates %roduction and sales o) 100 units/ total variable costs o) 86/000/ and total
4xed costs o) 83/000- 6ctual %roduction and sales ,ere 200 units- "alculate a =exible budet-

*2,! 't the beginning of the year, a company budgets variable costs of J<,=== and fi"ed costs of J6,C== at a production level of
6== units. The company actually produces 66= units, and incurs variable costs of J<,=== and fi"ed costs of J6,G==. What is the
fle"ible budget variance1 Is it favorable or unfavorable1

*2-! $W$ company planned to mae <,6== units in <==C, and budgeted J7==,=== in fi"ed costs and J6F= per unit for variable
costs. $W$ actually made <,=== units in <==C, and incurred total costs of J6,<==,===. What is the fle"ible budget variance for
<==C1 Is it favorable or unfavorable1

*#&5: Iron Eutter=*/ Inc-/ $anu)actures a sinle $odel o) a deluxe %ortable ca$%in stove- In)or$ation
)or 6uust %roduction is as )ollo,s1



Eudeted

6ctual

Variable "osts/ %er unit

850-00

852-00
Fixed "osts )or 6uust

Groduction )or 6uust
82/500/000

40/000 units
82/150/000

38/000 units

Re'uired: :#at is t#e =exible budet variance )or 6uustI

*#&&: '#e Gretenders/ Inc-/ %roduces exercise e7ui%$ent )or dos- '#e )ollo,in in)or$ation %ertains to
variable $anu)acturin over#ead/ ,#ic# is allocated usin $ac#ine #ours-

25
Budget Actual
Lnits %roduced
!ac#ine #ours
Variable $anu)acturin over#ead
15/000
5/000
8161/250
22/000
7/500
8242/000

Re'uired: "alculate t#e =exible budet variance-

*#&(: '#e Eee Jees cultivate and sell #one*- '#e* %rovide *ou t#e )ollo,in data ,it# res%ect to t#e
u%co$in *ear-

Eudeted variable costs 0%er Dar31
"ost o) t#e Dar and label
Aabor
First aid su%%lies

81-50
2-40
-25


Eudeted 4xed costs1
Halaries
Aease ex%ense
.t#er 4xed costs

850/000
10/000
15/000

Relevant rane over ,#ic# t#ese cost relations#i%s are ex%ected to #old1 +ero to 50/000 Dars- 6verae
sales %rice %er Dar is 87-00-

Re'uired: Gre%are t#ree =exible budets/ s#o,in o%eratin inco$e/ )or t#e )ollo,in levels o) sales
0assu$e sales e7uals %roduction31

A8 20/000 Dars

B8 40/000 Dars

C8 50/000 Dars

*#&): '#e Vanilla Fude "o$%an* runs a c#ain o) ice crea$ stands in t#e Gaci4c Qort#,est- Follo,in
is data )or location R37 )or Kune- '#is location sells onl* one %roduct1 a lare si+e double-scoo% ice
crea$ cone/ in one =avor1 vanilla )ude-

"ost %er allon o) %re$iu$ ice crea$ 85-00
Hcoo%s %er allon 20
"ost )or t#e ,aSe cone -25
Ga%er %roducts 0a variable cost3 8500 )or t#e $ont#
Fixed costs )or t#e $ont# 0salaries/
rent/ insurance/ etc-3 81-00 %er cone
"ones sold in Kune1 5/000
Hales %rice %er cone1 82-35

'#e co$%an* ex%ects t#e sa$e cost relations#i%s to #old )or Kul*-

Re'uired: Gre%are t,o %ro )or$a budets )or Kul*/ derivin %roDected o%eratin inco$e2 one based on
sales o) 7/500 cones/ and one based on sales o) 10/000 cones-

*#&4: 6ssu$e t#e )ollo,in in)or$ation )or t#e "#estnut Ride Co Pennel )or 20041

Budget Actual
26
Qu$ber o) dos cared )or

Fixed "osts
Variable "osts1
Food
Hu%%lies
'otal "osts

50

840/000

820/000
810/000
870/000
60

845/000

821/000
813/200
879/200

Variable costs are linear in t#e nu$ber o) dos cared )or-
Re'uired:
A8 "alculate a =exible budet )or 2004-

B8 "alculate t#e =exible budet variance )or eac# o) t#e t#ree ex%ense line-ite$s )or 2004/ and
indicate ,#et#er t#e variance is )avorable or un)avorable-

C8 6ssu$e t#at t#e actual results )or 2004 are used as t#e basis )or buildin t#e 2005 static
budet/ exce%t t#at t#e (ennel believes it ,ill care )or 50 dos in 2005- Cevelo% a static budet
)or 2005-

*#&:: '#e "onvent at Qe, H(eet runs an or%#anae- Hister Hara# $anaes t#e or%#anae and Hister
Rac#el is res%onsible )or t#e accountin records- Hister Rac#el %re%ared t#e )ollo,in su$$ar* o) costs
)or 2001/ includin a colu$n s#o,in t#e oriinal budet )or 2001-

The <e= 2>eet 3rphanage # Cost Anal.sis

2001 Eudet

2001 6ctual

Qu$ber o) c#ildren 0all aes3

Fixed costs1
Ltilities
Kanitorial Hervices
Re%airs and !aintenance
Halaries )or non-"onvent e$%lo*ees
'otal 4xed costs

Variable costs1
Food
"lot#in
Aaundr* T Ainen Hervice
&ducational "osts
6llo,ances
'otal variable costs

'otal costs

80


8 25/000
14/000
17/500
85/000
141/500


438/000
40/000
14/000
26/000
20/000
538/000

8679/500

72


8 27/250
15/500
14/300
92/000
149/050


409/968
39/600
13/040
25/480
25/000
513/088

8662/138
Hister Hara# is ver* concerned t#at t#e or%#anae uses its )unds eBcientl*- H#e is %leased t#at total
costs ,ere belo, budet )or t#e *ear/ but s#e ,onders i) t#is is %artl* due to t#e )act t#at t#e
or%#anae #oused )e,er c#ildren t#an ex%ected )or t#e *ear-

Re'uired:

A8 Gre%are a =exible budet )or 2001/ based 0i-e-/ M=exedN3 on t#e nu$ber o) c#ildren
actuall* #oused in 2001-

B8 H#ould Hister Hara# be satis4ed ,it# t#e or%#anae;s cost $anae$ent in 2001I
Erie=* ex%lain-
27
CHAPTER ;: Cost Variances -or $irect !aterials and 4abor

Chapter Contents:
- Introduction
- Qotation
- Cerivation o) t#e direct $aterials variances
- Jeo$etric re%resentation o) t#e direct $aterials variances
- 'i$in o) reconition o) t#e %rice variance
- "ost variances and external re%ortin
- "ost variances )or direct labor
- '#e Elue !oose restaurant
- &xercises and %roble$s

Introduction:
In t#e %revious c#a%ter/ ,e sa, t#at t#e static budget variance $easures t#e di<erence bet,een
budeted costs and actual costs 0or budeted revenues and actual revenues3- :e also sa, t#at ,#en
t#e actual volu$e o) out%ut 0sales or %roduction3 di<ers )ro$ t#e budeted volu$e o) out%ut/ t#is
di<erence contributes to t#e static budet variance- :e sa, t#at a fexible budget adDusts t#e static
budet to re=ect ,#at t#e budet ,ould #ave loo(ed li(e/ i) t#e actual out%ut volu$e could #ave been
(no,n in advance- '#e fexible budget variance $easures t#e di<erence bet,een t#e =exible
budet and actual results-

6s stated in t#e %revious c#a%ter/ t#ere can be onl* t,o ex%lanations )or t#e =exible budet variance
)or variable costs- First/ t#ere can be a di<erence bet,een budeted in%ut %rices and actual in%ut
%rices1 t#e co$%an* %aid $ore %er *ard o) )abric/ or less %er %ound o) steel/ t#an %lanned- Hecond/
t#ere can be an eBcienc* %iece1 t#e co$%an* used $ore )abric %er %air o) %ants/ or )e,er %ounds o)
steel %er ,idet/ t#an %lanned- In t#is c#a%ter/ ,e se%arate t#e =exible budet variance )or direct
$aterials into t#ese t,o %ieces1 t#e M%riceN %iece/ and t#e MeBcienc*N %iece- 6t t#e end o) t#e c#a%ter/
,e extend t#e discussion to ot#er variable costs1 direct labor and variable over#ead-
<otation:
'#e )ollo,in conce%ts and abbreviations are used1

In%uts are t#e $aterials used in t#e %roduction %rocess 0)abric or steel3-
.ut%uts are t#e units o) 4nis#ed %roduct 0%airs o) %ants/ or ,idets3-

Abbreviatio
n
$e?nition Eplanation
U



G

6G

HG

6U

HU
Uuantit*



Grice

6ctual Grice

Htandard Grice

6ctual Uuantit*

Htandard Uuantit*
'#e total 7uantit* o) inputs used in %roduction
0t#e in%uts )or all out%ut units/ not t#e in%uts )or
one unit o) out%ut3

'#e %rice %er unit o) in%ut

'#e actual %rice %aid %er unit o) in%ut

'#e budeted %rice %aid %er unit o) in%ut

'#e actual 7uantit* o) in%uts used in %roduction

'#e 7uantit* o) in%uts t#at Ms#ould #ave been
usedN )or t#e actual out%ut %roduced

Ho$eti$es U re)ers to t#e total 7uantit* o) in%uts purchased/ not used in %roduction- :e ,ill return to
t#is %ossibilit* later in t#is c#a%ter/ but )or no,/ U re)ers to t#e 7uantit* used in %roduction-

28
'#e $ost i$%ortant conce%t identi4ed above is t#e 2tandard %uantit. 72%8- HU is a fexible
budget conce%t1 it is t#e 7uantit* o) in%uts t#at ,ould #ave been budeted #ad t#e budet correctl*
antici%ated t#e actual volu$e o) out%ut-

$erivation o- the $irect !aterials Variances:
Jiven t#ese de4nitions/ t#e =exible budet can be ex%ressed as

HU x HG2

and t#e =exible budet variance can be ex%ressed as

06U x 6G3 V 0HU x HG3 013

E* introducin t#e )ollo,in ex%ression/ ,e can se%arate t#e =exible budet variance into t,o %ieces-

6U x HG

'#is ex%ression $easures ,#at t#e co$%an* Ms#ould #ave s%entN )or t#e actual 7uantit* o) in%uts
used- :e insert t#is ex%ression into &7uation 013 )or t#e =exible budet variance1

06U x 6G3 V 06U x HG3 V 0HU x HG3 023

'#e 4rst di<erence in &7uation 023 can be re,ritten as )ollo,s1

06U x 6G3 V 06U x HG3 W 6U x 06G V HG3

'#is ex%ression is t#e price variance- It is t#e actual in%uts used in %roduction 06U3 $ulti%lied b* t#e
di<erence bet,een t#e budeted %rice 0HG3 and t#e actual %rice 06G3 %aid %er unit o) in%ut- '#e %rice
variance is abbreviated GV- 5ence1

GV W 6U x 06G V HG3

I) t#e ter$ in %arent#esis is %ositive/ t#e )actor* %aid $ore %er unit o) in%ut t#an budeted/ and t#e
%rice variance is un)avorable- I) t#e ter$ in %arent#esis is neative/ t#e )actor* %aid less %er unit o)
in%ut t#an budeted/ and t#e %rice variance is )avorable- In eit#er case/ t#e %rice variance can be
inter%reted as ans,erin t#e )ollo,in 7uestion1 #hat was the total impact on the cost of production
caused by the fact that the actual price per unit of input di$ered from the budgeted price%

'#e second di<erence in &7uation 023 can be re,ritten as )ollo,s1

06U x HG3 V 0HU x HG3 W HG x 06U V HU3

'#is ex%ression is t#e 'uantit. variance 0also called t#e usage variance3- It is t#e budeted %rice
%er unit o) in%ut 0HG3 $ulti%lied b* t#e di<erence bet,een t#e 7uantit* o) in%uts t#at s#ould #ave been
used )or t#e out%ut units %roduced 0HU3 and t#e 7uantit* o) in%uts actuall* used 06U3- '#e 7uantit*
variance is abbreviated UV- 5ence1

UV W HG x 06U V HU3

I) t#e ter$ in %arent#esis is %ositive/ t#e )actor* used $ore in%uts t#an it s#ould #ave used )or t#e
a$ount o) out%ut units %roduced/ and t#e 7uantit* variance is un)avorable- I) t#e ter$ in %arent#esis is
neative/ t#e )actor* used )e,er in%uts t#an it s#ould #ave used )or t#e a$ount o) out%ut units
%roduced/ and t#e 7uantit* variance is )avorable- In eit#er case/ t#e 7uantit* variance can be
29
inter%reted as ans,erin t#e )ollo,in 7uestion1 #hat was the total impact on the cost of production
caused by the fact that the &uantity of inputs used to make each unit of output di$ered from budget-

/eo"etric Representation o- the $irect !aterials Variances:
'#e )ollo,in table s#o,s t#e %rice and 7uantit* variances ra%#icall*/ ,#en bot# variances are
neative- '#e area o) t#e *ello, box re%resents t#e =exible budet- '#e area o) t#e MouterN box 0t#e
union o) t#e t#ree colored boxes3 re%resents t#e actual a$ount incurred )or direct $aterials- '#e %rice
variance is t#e area o) t#e orane box/ and t#e 7uantit* variance is t#e area o) t#e reen box- It is eas*
to see )ro$ t#is eo$etric re%resentation t#at t#e di<erence bet,een t#e =exible budet and actual
costs consists o) t,o variances1 t#e %rice variance and t#e 7uantit* variance-

AP
Price Variance
2P
Fleible
Budget



%uantit.
Variance
2% A%

'#e )ollo,in table is identical to t#e one s#o,n above exce%t )or t#e u%%er ri#t-#and corner- '#is
table s#o,s t#at t#e )or$ula )or t#e %rice variance includes an MinteractiveN variance t#at onl* exists
,#en both 6G HG and 6U HU- I) 6U W HU/ t#is interactive variance box colla%ses )ro$ t#e ri#t- I)
6G W HG/ t#is box colla%ses )ro$ t#e to%-

AP
Price Variance
Interactive
Price@%uantit.
Variance
2P
Fleible
Budget



%uantit.
Variance
2% A%

'#ere is no t#eoretical Dusti4cation )or treatin t#is interactive variance as %art o) t#e %rice variance
instead o) %art o) t#e 7uantit* variance/ but it is custo$aril* assined to t#e %rice variance or else
re%orted se%aratel*-

Ti"ing o- Recognition o- the Price Variance:
Ho$e 4r$s reconi+e t#e %rice variance )or direct $aterials ,#en t#e ra, $aterials are %urc#ased/
rat#er t#an ,aitin until t#e ra, $aterials are %ut into %roduction- In t#is case/ t#e 6U in t#e %rice
variance ,ill enerall* di<er )ro$ t#e 6U in t#e 7uantit* variance/ ,#ic# is denoted in t#e )ollo,in
ex%ressions )or t#ese variances1

GV W 6U
Gurc#ased
x 06G V HG3

UV W HG x 06U
Lsed
V HU3

:#ere usuall*/ 6U
Gurc#ased
6U
Lsed

Reconi+in t#e %rice variance ,#en ra, $aterials are %urc#ased %rovides $ore ti$el* in)or$ation to
$anae$ent about t#e cost o) direct $aterials and t#e %er)or$ance o) t#e %urc#asin de%art$ent-
5ence/ t#is $et#od )or calculatin t#e %rice variance #as $uc# to co$$end it- 5o,ever/ in t#is
30
situation/ t#e su$ o) t#e %rice variance and 7uantit* variance ,ill not e7ual t#e =exible budet
variance/ exce%t b* coincidence or ,#en beinnin and endin 7uantities o) ra, $aterials are +ero-

Cost Variances and Eternal Reporting:
"ost variances are not re%orted se%aratel* in t#e external 4nancial state$ents o) a 4r$/ but are
i$%licitl* incor%orated in one or $ore line-ite$s on t#e balance s#eet and inco$e state$ent/ suc# as
"ost o) Joods Hold and endin Finis#ed Joods Inventor*- 5o,ever/ )or internal re%ortin/ cost variances
are )re7uentl* re%orted as se%arate line-ite$s on divisional inco$e state$ents and %roduct-s%eci4c
%ro4t state$ents-

Cost Variances -or $irect 4abor:
'#e )or$ulas )or s%littin t#e =exible budet variance into a M%riceN variance and M7uantit*N variance
are t#e sa$e )or direct labor as direct $aterials- 5o,ever/ t#e ter$inolo* di<ers sli#tl*- :#at is
called t#e %rice variance )or direct $aterials is called t#e rate variance or =age rate variance )or
direct labor- 5o,ever/ ,e retain t#e sa$e abbreviations1

GV W 6U x 06G V HG3

,#ere 6U is t#e actual labor #ours used in %roduction/ 6G is t#e actual ,ae rate/ and HG is t#e
budeted ,ae rate-

:#at is called t#e 7uantit* or usae variance )or direct $aterials is called t#e eAcienc. variance )or
direct labor- :e abbreviate t#is variance as &V1

&V W HG x 06U V HU3

,#ere HG and 6U are t#e sa$e as above/ and HU is t#e =exible budet 7uantit* o) labor #ours 0t#e
labor #ours t#e )actor* s#ould #ave used )or t#e volu$e o) out%ut units %roduced3-

'#e issue discussed earlier in t#is c#a%ter reardin t#e ti$in o) t#e reconition o) t#e %rice variance
)or direct $aterials does not arise )or direct labor- "onse7uentl*/ )or direct labor/ t#e su$ o) t#e ,ae
rate variance and eBcienc* variance al,a*s e7uals t#e =exible budet variance-

The Blue !oose Restaurant:
'#e Elue !oose Restaurant $a(es and sells sand,ic#es- '#e Restaurant $a(es and sells a lot o)
sand,ic#es- Follo,in is t#e restaurant;s budet )or $a(in a %eanut butter and Dell* sand,ic#1

Cirect !aterials1
Eread1
Uuantit*1 2 slices o) bread 0*ou %robabl* (ne, t#is3
Grice1 80-10 %er slice o) bread

Geanut butter1
Uuantit*1 3 tables%oons
Grice1 80-05 %er tables%oon

Kell*1
Uuantit*1 4 tables%oons
Grice1 80-03 %er tables%oon

Cirect labor1
Uuantit*1 t,o $inutes o) labor
:ae rate1 812 %er #our 080-20 %er $inute3

31
'#e static budet )or !a* indicated a %roduction and sales level o) 1/100 %eanut butter and Dell*
sand,ic#es- In )act/ t#e restaurant $ade and sold 1/000 %eanut butter and Dell* sand,ic#es- '#e total
cost in direct $aterials and labor to $a(e t#ese 1/000 sand,ic#es ,as 8520 )or inredients and 8450
)or labor-

Re'uired:
&B :#at is t#e budeted cost %er unit )or $a(in a %eanut butter and Dell* sand,ic#I

(B :#at ,ould t#e static budet s#o,/ in total/ )or t#e cost o) %roduction )or all %eanut butter and
Dell* sand,ic#esI

)B :#at ,ould t#e =exible budet s#o,/ in total/ )or t#e cost o) %roduction )or all %eanut butter
and Dell* sand,ic#esI H#o, $aterials se%aratel* )ro$ labor-

4B :#at is t#e =exible budet varianceI H#o, t#is variance se%aratel* )or $aterials and labor- Is
t#e =exible budet variance )avorable or un)avorableI

:B &ac# loa) o) bread contains 20 slices o) bread- 105 loa)s o) bread ,ere used to $a(e all o) t#e
%eanut butter and Dell* sand,ic#es- '#e actual %rice %aid %er loa) ,as 82-20- "alculate t#e
7uantit* 0usae3 variance )or bread- Grovide a %ossible ex%lanation )or t#is variance-

*B :#at is t#e %rice variance )or breadI Is it )avorable or un)avorableI

;B 30 labor #ours ,ere s%ent $a(in %eanut butter and Dell* sand,ic#es/ at an averae ,ae rate
o) 815 %er #our- :#at is t#e eBcienc* variance )or laborI

+B :#at is t#e ,ae rate varianceI

2olutions:
&B :#at is t#e budeted cost %er unit )or $a(in a %eanut butter and Dell* sand,ic#I
Eread
Geanut butter
Kell*
Aabor
80-20
80-15
80-12
80-40
80-87

(B :#at ,ould t#e static budet s#o,/ in total/ )or t#e cost o) %roduction )or all %eanut butter and
Dell* sand,ic#esI
80-87 %er sand,ic# x 1/100 sand,ic#es W 8957-

)B :#at ,ould t#e =exible budet s#o,/ in total/ )or t#e cost o) %roduction )or all %eanut butter
and Dell* sand,ic#esI H#o, $aterials se%aratel* )ro$ labor-
Inredients
Aabor
'otal
80-47 x 1/000 W
80-40 x 1/000 W
8470
8400
8870


4B :#at is t#e =exible budet varianceI H#o, t#is variance se%aratel* )or $aterials and labor- Is
t#e =exible budet variance )avorable or un)avorableI

Inredient
s
Aabor
'otal
8520 actual 8470 budeted W
8450 actual 8400 budeted W
8 50 un)avorable
8 50 un)avorable
8100 un)avorable

32
:B &ac# loa) o) bread contains 20 slices o) bread- 105 loa)s o) bread ,ere used to $a(e all o) t#e
%eanut butter and Dell* sand,ic#es- '#e actual %rice %aid %er loa) ,as 82-20- "alculate t#e
7uantit* 0usae3 variance )or bread- Grovide a %ossible ex%lanation )or t#is variance-
HG x 06U V HU3
W 80-10 %er slice x 02/100 actual slices V 2/000 =exible budet slices3
W 810 un)avorable
Gossible reasons )or t#e un)avorable usae variance )or bread include t#e )ollo,in1

1- Ho$e o) t#e bread ,as stale-
2- Ho$e bread ,as dro%%ed on t#e =oor and not used
3- '#e 20 slices %er loa) includes t#e #eels/ ,#ic# are not used-

*B :#at is t#e %rice variance )or breadI Is it )avorable or un)avorableI

6U x 06G V HG3
W 2/100 slices o) bread x 080-11 %er slice 80-10 %er slice3 W
821 un)avorable

;B 30 labor #ours ,ere s%ent $a(in %eanut butter and Dell* sand,ic#es/ at an averae ,ae rate
o) 815 %er #our- :#at is t#e eBcienc* variance )or laborI

HG x 06U V HU3
W 812 %er #our x 030-00 actual #ours V 33-33 =exible budet #ours3
W 840 )avorable

+B :#at is t#e ,ae rate varianceI

6U x 06G V HG3
W 30 actual #ours x 0815 actual ,ae rate V 812 budeted ,ae rate3
W 890 un)avorable

Eercises and Proble"s:

+2%! 0ollowing is selected information about the *opi :opcorn company. 'll information represents total amounts, not per unit
amounts.

Static :udget Actual 1esults
Units made and sold
;irect materials costs
;irect materials used in production
6==
JC,===
6,=== pounds
C=
J<,8==
DC= pounds

*opi had no beginning or ending inventory of either finished product or raw materials.

AI $alculate the direct materials price variance. Indicate whether it is favorable or unfavorable.

:I $alculate the direct materials usage >2uantity? variance. Indicate whether it is favorable or unfavorable.

;#(: 6ssu$e t#e )ollo,in in)or$ation )or t#e *ear1

Budget Actual
:ae rate
Cirect labor #ours %er unit
Lnits %roduced
810
5
100
812
7
110

Re'uired:
33
A8 "alculate t#e direct labor ,ae rate variance 0i-e-/ t#e %rice variance3- Is it )avorable or
un)avorableI

B8 "alculate t#e direct labor eBcienc* variance- Is it )avorable or un)avorableI

C8 "alculate t#e =exible budet variance )or direct labor- Is it )avorable or un)avorableI

;#): '#e Glutoniu$ Fruitca(e "o$%an*;s %roduction level 0units o) out%ut3 and direct $aterials %rices
0cost %er %ound3 in 1957 ,ere exactl* as %lanned in t#e static budet )or t#at *ear/ but t#e co$%an*
used $ore %ounds o) direct $aterials %er unit t#an %lanned-

Jiven t#is set o) circu$stances/ ,#ic# o) t#e )ollo,in t,o state$ents can be $ade ,it# certaint*I

0I3 '#ere ,as an un)avorable =exible budet variance )or direct $aterials-

0II3 '#ere ,as an un)avorable static budet variance )or direct $aterials-

063 bot# 0I3 and 0II3

0E3 0I3 onl*

0"3 0II3 onl*

0C3 neit#er 0I3 nor 0II3

;#4: 6 co$%an* t#at $anu)actures a sinle %roduct #as a )avorable =exible budet variance )or direct
$aterials/ an un)avorable 7uantit* variance )or direct $aterials/ and an un)avorable %rice variance )or
direct $aterials- :#ic# o) t#e )ollo,in state$ents is $ost li(el* trueI

063 '#e co$%an* reconi+es t#e %rice variance )or direct $aterials at t#e ti$e t#e $aterials are
%urc#ased/ not at t#e ti$e t#e $aterials are %ut into %roduct-

0E3 '#e co$%an* used less direct $aterials %er out%ut unit t#an %lanned-

0"3 '#e co$%an* $ade )e,er units t#an %lanned-

0C3 '#e co$%an* $ade $ore units t#an %lanned-

;#:: Follo,in are data )or t#e Van Qess s#irt )actor* in Han 6nelo/ 'exas/ )or t#e $ont# o) !arc#-



Budget

Actual

Lnits !anu)actured

500/000

400/000

Fabric1
%rice %er *ard
total *ards used


82-50
1/000/000

2-60
800/000
Cirect Aabor1
,ae rate %er #our
total #ours used


810-00
250/000

812-00
220/000
1equired! $ompute the price and 2uantity >usage? variances for fabric, and the wage rate and efficiency variances for labor.

;#*: Follo,in is in)or$ation )or !a* )or t#e o%erations o) Gin(/ Inc-/ ,#ic# $a(es re%roductions o)
)a$ous %aintins in various s#ades and #ues o) %in(/ $ostl* )or t#e $otel industr*-
34



Budget

Actual

Groduction in units1

Ra, $aterials1


Cirect labor1


1/000

3 %ounds %er unit
at 824 %er %ound

20 $inutes %er unit
at 817 %er #our

1/100

4 %ounds %er unit
at 818 %er %ound

15 $inutes %er unit
at 817 %er #our

Re'uired:
AI $alculate the fle"ible budget variance for raw materials.

:I $alculate the direct labor wage rate variance.

CI *ow much of the total fle"ible budget variance for materials and labor is due to the fact that the company produced
more units than planned1

+2+! #i, #ee and #evy Industries maes widgets in its factory located in the +arina Shores district of Seattle. 0ollowing is
budgeted and actual information for the month.

Static :udget 0n#ormation
Actual 1esults
Widgets produced

;irect materials9 copper fibers


;irect labor


Aariable overhead
>allocated based on machine hours?

0i"ed costs
6,===

6C,=== pounds for a total cost
of JF6,C==

6,=== hours for a total cost of
J7,===

J6G,===


JCN,===
7==

6<,N== pounds for a total
cost of J<C,<==

7C= hours for a total cost of
JG,=8C

J6D,CCF


JC8,===

AI $ompute the fle"ible budget variance for the month. Show separate line/items for direct materials, direct labor, variable
overhead and fi"ed overhead.

:I $alculate the direct materials price variance. Is it favorable or unfavorable1

CI $alculate the direct materials 2uantity variance. Is it favorable or unfavorable1

DI $alculate the direct labor wage rate variance. Is it favorable or unfavorable1

=I $alculate the direct labor efficiency variance. Is it favorable or unfavorable1

;#+: Hilverstrea$ "o$%an* $a(es travel trailers- '#e )ollo,in in)or$ation %ertains to t#e co$%an*;s
.#io Civision/ ,#ic# $anu)actures and $ar(ets onl* one $odel o) trailer1 t#e 32-)oot 6$bassador
trailer- Follo,in is budeted and actual in)or$ation )or t#e .#io Civision )or 20041

Budgeted Actual


'railers $anu)actured in 2004
'railers sold in 2004
Hales %rice %er trailer

Cirect $aterials costs 0all variable
Ger Lnit






'otal

1/000
1/000
845/000




800
600
845/000


35
costs31
6lu$inu$
Hteel
.t#er
'otal $aterials costs

Cirect labor costs 0all variable costs3
Variable over#ead $anu)acturin costs
Fixed over#ead costs1
!anu)acturin 4xed over#ead
Qon-$anu)acturin 4xed
over#ead

84/000
82/000
84/000
810/000

85/000
88/000
84/000/000
82/000/000
84/000/000
810/000/000

85/000/000
88/000/000

810/000/000
82/000/000
83/400/000
81/600/000
83/800/000
88/800/000

83/800/000
86/400/000

811/000/000
82/100/000

Additional in-or"ation:
'#e co$%an* started t#e *ear ,it# no inventor* o) 4nis#ed trailers or direct $aterials-

Cirect labor standard1 250 #ours %er trailer
6ctual direct labor #ours incurred1 195/000 #ours
'#e budeted 7uantit* o) alu$inu$1 100 lbs- %er trailer
'#e budeted cost o) alu$inu$1 840 %er lb-
'#e actual 7uantit* o) alu$inu$ %urc#ased 84/000 lbs-
'#e actual 7uantit* o) alu$inu$ used 82/927 lbs-

Calculate the -ollo=ing:

A8 '#e alu$inu$ usae variance-

B8 '#e alu$inu$ %rice variance/ i) t#e %rice variance is calculated at t#e ti$e t#e alu$inu$ is
%urc#ased-

C8 '#e alu$inu$ %rice variance/ i) t#e %rice variance is calculated at t#e ti$e t#e alu$inu$ is %ut
into %roduction-

$8 '#e =exible budet variance )or alu$inu$-

E8 '#e =exible budet variance )or steel-

F8 '#e direct labor ,ae rate variance-

/8 '#e direct labor eBcienc* variance-

H8 '#e =exible budet variance )or direct labor-

+2-! The ;urango $lothing $ompany reports the following costs for one of its products.

The /laid 3roc7 Static :udget Actual 1esults
Units produced
+aterials9
Yards of fabric per unit
$ost per yard
#abor9
*ours per unit
Wage rate per hour
0i"ed costs
C,N==

<.<
JC.6=

D.C
J6C
J6<C,===
N,C==

<.=
JC.==

C.=
J6D
J6C<,===

'ctual 2uantity of fabric purchased was 6C,=== yards.

1equired!
AI $omplete the fle"ible budget in the table below for production costs9

36
3le4ible :udget
Units produced
+aterials cost
#abor cost
0i"ed costs
Total costs
N,C== units


:I $alculate the fle"ible budget variance for direct labor.

CI $alculate the 2uantity >usage? variance for direct materials.

DI What is the direct labor efficiency variance1

=I What is the direct labor wage rate variance1

3I $alculate the price variance for direct materials, assuming the company recogni-es the price variance at the time the materials
are put into production.

+2%.! 'rden %rothers reports the following cost information for one of its products.

/roduct Model P82%& Static :udget Actual 1esults
Units produced
+aterials9
:ounds of materials per unit
$ost per pound of materials
#abor9
*ours per unit
Wage rate per hour

0i"ed costs
7==

F
J8.==

6.=
J6F

JDC,===
GC=

D
JN.C=

6.<
J6=

JF7,===

'ctual 2uantity of materials purchased was D,=== pounds.

AI $alculate the fle"ible budget variance for direct labor.

:I $alculate the price variance for direct materials, assuming the company recogni-es the price variance at the time the materials
are purchased.

CI $alculate the 2uantity >usage? variance for direct materials.

DI What is the direct labor wage rate variance1

=I What is the direct labor efficiency variance1

+2%%! :reparation of a bo" of $he" :arty +i" is budgeted to re2uire 6.= pound of Wheat $he", 6.C pounds of )ice $he", and =.G
pounds of $orn $he". 5n Tuesday, the manager,s five/year/old son sat at the control panel of the highly/automated factory and
made C= bo"es of :arty +i". The following information pertains to material variances for that dayUs production, analy-ed by
ingredient9



:#eat "#ex

Rice "#ex

"orn "#ex

Grice variance

816 Ln)avorable

812 Favorable

819 Ln)avorable

Lsae variance

820 Ln)avorable

825 Favorable

810 Favorable

'#e actual %rices ,ere 80-30 $ore %er %ound o) :#eat "#ex/ 80-20 less %er %ound o) Rice "#ex/ and
80-50 $ore %er %ound o) "orn "#ex/ t#an t#eir standard %rices-

Re'uired:
A8 Ceter$ine t#e standard %rice %er %ound o) eac# inredient-
37

B8 Ceter$ine t#e nu$ber o) %ounds used o) eac# inredient-

+2%&! %illy %ones, your long/time business partner in the rum/maing business, dies une"pectedly from natural causes. >It,s
une"pected because nobody e"pected %illy to live long enough to die from natural causes.? You now discover that he was not
always so honest in his business dealings, and the company,s silent partners are becoming not/so/silent about the return on their
investment. The silent partners demand to now the company,s revenue for the year (ust ended.

You now that the financial statements that %illy prepared before his death were a hoa". %ut you also now that the company,s
rum recipe calls for one barrel of molasses to produce <= pints of rum, and that the company had no beginning or ending inventory
of either molasses or rum. 'lso, you find among %illy,s private papers the following information, which you believe is reliable.
The company,s fi"ed costs are J<,CF= per year. The company budgeted J< per barrel of molasses, but paid J=.6= more per barrel
of molasses than budgeted, resulting in an unfavorable price variance for molasses of J66C for the year. 'lso, the company had an
unfavorable 2uantity variance for molasses of J8D for the year. >Somehow, under %illy,s supervision, all variances were always
negative.? 'lso, a few days before he died, %illy scribbled a note to himself that at the sales price that the company has had in
place for over two years now, and at the current variable cost per pint of J=.F= >which includes molasses and all other variable
costs?, the company,s breaeven volume was 66,C== pints of rum.

AI *ow many pints of rum were produced and sold during the year1

:I $alculate the company,s revenue for the year.
CHAPTER +: Product Costing

Chapter Contents:
- Ho$e use)ul de4nitions
- .vervie, o) %roduct costin
- "ost obDects
- Cirect costs
- .ver#ead costs
- "ost allocation bases
- .ver#ead rates
- XFQ 6%%arel "o$%an*/ exa$%le o) 6ctual "ostin
- &xercises and %roble$s

2o"e Cse-ul $e?nitions:
Cost obDect: 6 cost obDect is an*t#in t#at ,e ,ant to (no, t#e cost o)- :e $i#t ,ant to (no, t#e
cost o) $a(in one unit o) %roduct/ or a batc# o) %roduct/ or all o) 'uesda*;s %roduction/ in ,#ic# case
t#e cost obDects are one unit o) %roduct/ a batc# o) %roduct/ or 'uesda*;s %roduction/ res%ectivel*- :e
$i#t ,ant to (no, t#e cost o) o%eratin a de%art$ent or a )actor*/ in ,#ic# case t#e cost obDect is t#e
de%art$ent or )actor*- In a service sector co$%an*/ ,e $i#t ,ant to (no, t#e cost o) treatin a
%atient in a #os%ital/ or t#e cost o) conductin an audit/ in ,#ic# case t#e cost obDect is t#e %atient or
t#e audit client- In a overn$ent settin/ a cost obDect $i#t be a %rora$ suc# as M!eals on :#eels-N

Product costs: 6 %roduct cost is an* cost t#at is associated ,it# units o) %roduct )or a %articular
%ur%ose- 5ence/ t#e identi4cation o) %roduct costs de%ends on t#e %ur%ose )or ,#ic# it is done- For
exa$%le/ t#e )actor* $anaer is interested in $anu)acturin costs/ ,#ereas t#e $erc#andisin
$anaer $i#t be interested in bot# $anu)acturin and non$anu)acturin costs/ includin researc#
and develo%$ent/ $ar(etin/ and advertisin costs-

Inventoriable costs: '#ese are costs t#at are debited to inventor* )or eit#er external or internal
re%ortin %ur%oses- For $anu)acturin 4r$s/ all inventoriable costs are $anu)acturin costs/ but t#e
reverse is not necessaril* true- In ot#er ,ords/ inventoriable costs are eit#er t#e co$%lete set or a
subset o) $anu)acturin costs/ and non-$anu)acturin costs are never included as inventoriable costs-
For $erc#andisin 4r$s/ inventoriable cost is usuall* t#e %urc#ase %rice o) inventor*-

38
Period costs: '#ese are costs t#at are ex%ensed ,#en incurred/ usuall* because t#e* are not
associated ,it# t#e $anu)acture o) %roducts- &xa$%les include advertisin costs and researc# and
develo%$ent costs- Geriod costs are distinuis#ed )ro$ inventoriable costs-

$irect costs and overhead costs1 In relation to a iven cost obDect/ all costs are eit#er direct costs or
over#ead costs- Cirect costs can be traced to t#e cost obDect in an econo$icall* )easible ,a*- .ver#ead
costs 0also called indirect costs3 are associated ,it# t#e cost obDect/ but cannot be traced to t#e cost
obDect in an econo$icall* )easible ,a*- '#ese ter$s a%%l* to co$%anies in all sectors o) t#e econo$*
and to all t*%es o) orani+ations-

Cost driver: 6 cost driver is an* )actor t#at a<ects costs- 6 c#ane in t#e cost driver ,ill cause a
c#ane in t#e total cost o) a related cost obDect- 6n* one cost obDect al$ost al,a*s #as nu$erous cost
drivers- '#is ter$ a%%lies to co$%anies in all sectors o) t#e econo$* and to all t*%es o) orani+ations-

Cost allocation: '#e assin$ent o) over#ead costs to t#e cost obDect- '#is ter$ a%%lies to co$%anies
in all sectors o) t#e econo$* and to all t*%es o) orani+ations-

Cost allocation base: 6 7uantitative c#aracteristic s#ared b* $ulti%le cost obDects t#at is used to
allocate over#ead costs a$on t#e cost obDects- 6 cost allocation base can be a 4nancial $easure
0suc# as t#e ra, $aterial cost o) eac# unit o) %roduct3 or a non4nancial $easure 0suc# as direct labor
#ours incurred in t#e $anu)acture o) eac# unit o) %roduct3- '#e si$%lest cost allocation base is si$%l*
t#e nu$ber o) cost obDects 0e--/ t#e nu$ber o) units %roduced b* t#e )actor* durin a %eriod o) ti$e3-

'#e distinction bet,een a cost driver and a cost allocation base can be su$$ari+ed as )ollo,s- 6 cost
driver is an econo$ic conce%t2 it relates to t#e econo$ic realit* o) t#e business- 6 cost allocation base
is an accountin c#oice t#at is $ade b* accountants and $anaers- Lsuall*/ t#e best c#oice )or a cost
allocation base is a cost driver-

Conversion costs: 6ll $anu)acturin costs ot#er t#an direct $aterials-

3vervie= o- Product Costing:
Groduct costin )ollo,s t#ese ste%s1

1- Identi)* t#e cost obDect2
2- Identi)* t#e direct costs associated ,it# t#e cost obDect2
3- Identi)* t#e overhead costs2
4- Helect t#e cost allocation base to use in assinin over#ead costs to t#e cost obDect2
5- Cevelo% t#e overhead rate )or allocatin over#ead to t#e cost obDect-

'#e cost accountin s*ste$ Mbuilds u%N t#e cost o) %roduct 0or ot#er cost obDect3 b* recordin to a Dob
cost s#eet/ a ,or(-in-%rocess account/ or so$e ot#er a%%ro%riate leder/ t#e direct costs t#at can be
traced to t#e %roduct/ and a s#are o) t#e over#ead costs/ ,#ic# are allocated to t#e %roduct b*
$ulti%l*in t#e over#ead rate b* t#e a$ount o) t#e allocation base identi4ed ,it# t#e cost obDect-

Cost 3bDects:
Recall t#at a cost obDect is an*t#in t#at ,e ,ant to (no, t#e cost o)/ suc# as a %roduct or service-

'#ere is a co$$on convention t#at can be con)usin- :e o)ten tal( about t#e cost obDect 0t#e t#in ,e
,ant to (no, t#e cost o)3 as one unit o) %roduct/ because )actor* $anaers and %roduct $anaers
s%ea( in ter$s o) unit costs- '#ese $anaers ,ant to (no, t#e unit cost )or %roduct %ricin/ %roduct
sourcin/ and %er)or$ance evaluation %ur%oses- '#e* do not ,ant to tal( about t#e cost o) $a(in 620
units/ even i) t#at is t#e batc# si+e- 5o,ever/ in $ost batc# %rocesses/ t#ere ,ould be ver* little bene4t
and enor$ous additional ex%ense in deter$inin t#e cost o) eac# unit o) %roduct individuall*- Rat#er/
t#e accountin s*ste$ treats t#e batc# as t#e cost obDect/ and to derive a unit cost/ ,e divide t#e cost
39
o) t#e batc# b* t#e nu$ber o) units in t#e batc#- 5ence/ loosel* s%ea(in/ ,e tal( as i) a unit o) %roduct
is t#e cost obDect/ but $ore %recisel*/ it is t#e batc# 0or t#e %roduction run in an asse$bl*-line %rocess/
or %er#a%s one da*;s %roduction in a continuous $anu)acturin %rocess3 t#at constitutes t#e cost
obDect-

$irect Costs:
!anae$ent accountin classi4es %roduct costs as eit#er direct costs or over#ead costs 0indirect
costs3- '#is distinction is i$%ortant because costin s*ste$s #andle t#ese t,o t*%es o) costs ver*
di<erentl*- '#e distinction is so$eti$es subtle/ because ,#et#er a cost is direct or over#ead is a
)unction o) t#e cost obDect/ and also %artl* a $atter o) c#oice on t#e %art o) $anaers and accountants-

Follo,in are t#ree de4nitions o) direct costs )ro$ di<erent accountin textboo(s1

Cirect costs o) a cost obDect are costs t#at are related to t#e cost obDect and can be traced to it
in an econo$icall* )easible ,a*-

Cirect costs are costs t#at can be directl* attac#ed to t#e unit under consideration-

Cirect costs are costs t#at can be traced easil* to s%eci4c %roducts-

Cirect costs are also called pri"e costs- For $anu)acturin co$%anies/ direct costs usuall* can be
cateori+ed as eit#er $aterials or labor-

$irect "aterials: $aterials t#at beco$e %art o) t#e 4nis#ed %roduct and t#at can be convenientl*
and econo$icall* traced to s%eci4c units 0or batc#es3 or %roduct-

&xa$%le o) direct $aterials )or an a%%arel $anu)acturer1 )abric- 6ll ot#er $aterials/ suc# as t#read and
+i%%ers/ are %robabl* indirect-

$irect labor: costs )or labor t#at can be convenientl* and econo$icall* traced to a unit 0or batc#3 o)
%roduct- '#e )ollo,in exa$%les s#o, #o, t#e deter$ination o) ,#et#er a cost is direct or over#ead
de%ends on t#e identi4cation o) t#e cost obDect1

&xa$%les o) direct labor )or an a%%arel $anu)acturer1

13 I) t#e cost obDect is a sinle %air o) %ants/ in a batc# o) several do+en %airs1

Grobabl* no labor is direct-

23 I) t#e cost obDect is a batc# o) several do+en %airs o) %ants1

Grobabl*/ se,in o%erators; ,aes are direct-

33 I) t#e cost obDect is a %roduction line in t#e )actor*/ add1

'#e line $anaer;s salar*/ and %ossibl* ,aes incurred in t#e cuttin roo$ 0,#ere rolls o) )abric
are cut into %anels and %ieces t#at are t#en se,n toet#er3-

43 I) t#e cost obDect is t#e entire )actor*/ add1

'#e )actor* $anaer;s salar*/ ,aes o) $aintenance and Danitorial ,or(ers/ and salaries o) )ront
oBce %ersonnel-

40
&ven t#ou# %robabl* no labor is direct ,it# res%ect to a sinle %air o) %ants/ i) labor is direct ,it#
res%ect to a batc# o) 50 or 100 units/ cost accountants ,ould usuall* 0and loosel*3 call labor a direct
cost ,it# res%ect to units o) %roduct/ and divide t#e direct labor cost )or t#e batc# b* t#e nu$ber o)
units %er batc# to derive t#e direct labor cost %er unit-

3verhead Costs:
.ver#ead costs are costs t#at are related to t#e cost obDect/ but cannot be traced to t#e cost obDect in
an econo$icall* )easible ,a*- .ver#ead costs are not directl* traceable to s%eci4c units o) %roduction-
&xa$%les o) over#ead costs incurred at an a%%arel $anu)acturer/ ,#en t#e cost obDect is a batc# o)
%roduct/ %robabl* include t#e )ollo,in1

- &lectricit*
- Factor* oBce salaries
- Euildin and $ac#ine $aintenance
- Factor* de%reciation

'#e distinction bet,een direct costs and over#ead costs relate/ in so$e $easure/ to t#e ,a* t#e
accountin s*ste$ treats t#e cost- For exa$%le/ one a%%arel $anu)acturer $i#t trac( t#read usin t#e
sa$e $et#ods t#at are used to trac( )abric/ t#us treatin t#read as a direct $aterial- 6not#er a%%arel
$anu)acturer $i#t decide t#at t#e cost o) t#read is i$$aterial/ and does not ,arrant t#e cost and
e<ort to trac( it as a direct cost- For t#is co$%an*/ t#read is an over#ead cost- '#ere)ore/ ,#et#er
so$e costs are direct or over#ead de%end on a c#oice $ade b* t#e $anaer and t#e cost accountant-

'#ere are t#ree ,a*s over#ead costs can be treated in an* decision-$a(in context1 013 t#e* can be
inored/ 023 t#e* can be treated as a lu$%-su$/ or 033 t#e* can be allocated to t#e %roducts and
services 0i-e-/ to t#e cost obDects3 to ,#ic# t#e* relate- &ac# o) t#ese t#ree alternatives is a%%ro%riate/
de%endin on t#e circu$stances and t#e %ur%ose )or ,#ic# t#e accountin is done- 5o,ever/ in t#is
c#a%ter and t#rou#out $uc# o) t#is boo(/ ,e are concerned ,it# t#e t#ird alternative1 #o, to allocate
over#ead costs to %roducts and services-

Cost Allocation Bases
'#e allocation base is t#e Mlin(N t#at is used to attac# over#ead costs to t#e cost obDect- In a
$anu)acturin settin/ t#e si$%lest allocation base is t#e nu$ber o) units %roduced- For exa$%le/ i) t#e
)actor* $a(es 15/000 units/ t#e accountin s*ste$ can si$%l* Ms%readN t#e over#ead costs evenl* over
all 15/000 units- '#e %roble$ ,it# usin units as an allocation base/ #o,ever/ is t#at i) t#e )actor*
$a(es a rane o) di<erent %roducts/ t#ose %roducts $i#t di<er sini4cantl* in t#eir resource
utili+ation- 6 deluxe ,idet $i#t re7uire t,ice as $uc# labor and 20O $ore $aterials t#an a standard
,idet/ and one $i#t in)er t#at t#e deluxe ,idet also re7uires $ore resources t#at are re%resented
b* over#ead costs-

:#atever cost allocation base is c#osen/ it $ust be a Mco$$on deno$inatorN across all cost obDects-
For exa$%le/ a )urniture )actor* could allocate over#ead costs across all %roducts usin direct labor
#ours/ because direct labor is incurred b* all %roducts $ade at t#e )actor*- 5o,ever/ it ,ould not see$
a%%ro%riate to allocate )actor* over#ead based on t#e 7uantit* o) ,ood used in eac# unit/ i) t#e )actor*
$a(es bot# ,ood )urniture and a line o) %lastic-$olded/ because no over#ead ,ould be allocated to t#e
%lastic c#airs-

3verhead Rates:
'#e over#ead rate is t#e ratio o) cost %ool over#ead dollars in t#e nu$erator/ and t#e total 7uantit* o)
t#e allocation base in t#e deno$inator1

.ver#ead
rate

.ver#ead costs in t#e cost %ool W
41
'otal 7uantit* o) t#e allocation
base

'#e result re%resents dollars o) over#ead %er unit o) t#e allocation base- For exa$%le/ i) an a%%arel
)actor* allocates over#ead based on direct labor #ours/ t#e over#ead rate re%resents dollars o)
over#ead %er direct labor #our- 6ssu$e t#e over#ead rate is 820 %er direct labor #our- '#en )or ever*
#our t#at a se,in o%erator s%ends ,or(in on %roduct/ 820 ,ill be allocated to t#e %roducts t#at t#e
se,in o%erator asse$bles durin t#at #our-

EF< Apparel Co"pan.6 Ea"ple o- Actual Costing:
'#e XFQ a%%arel co$%an* in 6lbu7uer7ue/ Qe, !exico $a(es Deans and %re$iu$ c#inos- &ac# %roduct
line #as its o,n asse$bl* line on t#e )actor* =oor- .ver#ead costs )or t#e )actor* )or 2005 ,ere
83/300/000- 500/000 Deans and 400/000 c#inos ,ere %roduced durin t#e *ear- 500/000 direct labor
#ours ,ere used1 200/000 )or Deans/ and 300/000 )or c#inos- '#e averae direct labor ,ae rate ,as
t#e sa$e on bot# asse$bl* lines/ and ,as 814 %er #our- Ceni$ )abric is used to $a(e Deans/ and
c#inos are $ade )ro$ a cotton t,ill )abric- .ver#ead is allocated usin direct labor #ours-

'#e )ollo,in Dournal entries and '-accounts illustrate #o, t#e accountin s*ste$ records t#e
$anu)acturin activities o) t#e )actor* in order to derive %roduct cost in)or$ation )or Deans and c#inos-
Kournal entr* 063 to debit over#ead to ,or(-in-%rocess is based on an over#ead rate calculated as
)ollo,s-

83/300/000 9 500/000 direct labor #ours W 86-60 %er direct labor #our-

In %ractice/ t#e )actor* ,ould trac( costs b* batc#/ or %er#a%s ,ee(l*/ but to si$%li)* our exa$%le/ ,e
record onl* one Dournal entr* )or eac# t*%e o) transaction- :e also $a(e t#e unrealistic assu$%tion t#at
t#ere is no ,or(-in-%rocess at t#e end o) t#e %eriod- 'o )ocus t#e %resentation on inventor*-related
accounts/ '-accounts )or so$e non-inventor* accounts/ and t#e entr* to debit accounts receivable and
credit revenue/ are o$itted-
013 Ra, !aterials1 deni$ )abric 83/000/000
Ra, !aterials1 cotton t,ill 2/250/000
6ccounts Ga*able 85/250/000

0'o record t#e %urc#ase o) 600/000 *ards o) deni$ )abric at 85-00 %er *ard/ and
500/000 *ards o) cotton t,ill )abric at 84-50 %er *ard-3

023 :or(-in-%rocess1 Keans 82/500/000
Ra, !aterials1 deni$ )abric 82/500/000

0'o record $aterials re7uisitions )or 500/000 *ards/ )or t#e $ove$ent o) deni$
)ro$ t#e receivin de%art$ent to t#e cuttin roo$-3

033 :or(-in-%rocess1 "#inos 82/160/000
Ra, !aterials1 cotton t,ill 82/160/000

0'o record $aterials re7uisitions )or 480/000 *ards/ )or t#e $ove$ent o) cotton
t,ill )ro$ t#e receivin de%art$ent to t#e cuttin roo$-3

043 :or(-in-%rocess1 Keans 82/800/000
:or(-in-%rocess1 "#inos 4/200/000
6ccrued He,in .%erator :aes 87/000/000

0'o record se,in o%erator ,aes )or t#e *ear1 200/000 #ours )or Deans/ and
300/000 #ours )or c#inos/ at 814 %er #our-3

42
053 Factor* .ver#ead 83/300/000
6ccounts Ga*able 81/800/000
6ccrued :aes )or Indirect Aabor 900/000
6ccu$ulated Ce%reciation 600/000

0'o record over#ead costs incurred durin t#e *ear/ includin utilities/
de%reciation/ re%airs and $aintenance/ and indirect ,aes and salaries-3

063 :or(-in-%rocess1 Keans 81/320/000
:or(-in-%rocess1 "#inos 1/980/000
Factor* .ver#ead 83/300/000

0'o allocate )actor* over#ead to %roduction/ usin an over#ead rate o) 86-60 %er
direct labor #our-3

073 Finis#ed Joods1 Keans 86/620/000
:or(-in-%rocess1 Keans 86/620/000

0'o record t#e co$%letion o) all 500/000 Deans/ at 813-24 %er %air-3

083 Finis#ed Joods1 "#inos 88/340/000
:or(-in-%rocess1 "#inos 88/340/000

0'o record t#e co$%letion o) all 400/000 c#inos/ at 820-85 %er %air-3
093 "ost o) Joods Hold1 Keans 85/296/000
"ost o) Joods Hold1 "#inos 87/297/500
Finis#ed Joods1 Keans 85/296/000
Finis#ed Joods1 "#inos 87/297/500

0'o record t#e sale o) 400/000 Deans and 350/000 c#inos-3


Ra, !aterials1
Ceni$ Fabric

Ra, !aterials1
"otton ',ill

013 83/000/000

8 500/000
82/500/000



023 013 82/250/000

8 90/000
82/160/000 033


6ccrued He,in
.%erator :aes

Factor* .ver#ead

87/000/000



043 053 83/300/000


80
83/300/000 063


:or(-in-Grocess1 Keans :or(-in-Grocess1 "#inos
023
043
063
82/500/000
2/800/000
1/320/000
80
86/620/000




073 033
043
063
82/160/000
4/200/000
1/980/000
80
88/340/000 083


Finis#ed Joods1 Keans Finis#ed Joods1 "#inos
43
073 86/620/000


81/324/000
85/296/000




093 083 88/340/000


81/042/500
87/297/500 093


"ost o) Joods Hold1
Keans
"ost o) Joods Hold1 "#inos

093 85/296/000


093 87/297/500



6ccounts Ga*able
85/250/000
1/800/000

013
053




'#e %er-unit inventor* cost is calculated as )ollo,s1

Keans1 86/620/000 9 500/000 %airs W 813-24 %er %air
"#inos1 88/340/000 9 400/000 %airs W 820-85 %er %air

'#ese a$ounts/ ,#ic# are used in Dournal entr* 093/ can be detailed as )ollo,s1

Input 1eans Chinos
Fabric
Cirect labor
.ver#ead
'otal
1 *ardYDean x 85Y*ard W 85-00
0-4 #rsYDean x 814Y#r W 85-60
0-4 #rsYDean x 86-60Y#r W 82-64
813-24
1-2 *ardsYc#ino x 84-50Y*ard W 85-40
0-75 #rsYc#ino x 814Y#r W 810-50
0-75 #rsYc#ino x 86-60Y#r W 84-95
820-85


In t#e above table/ t#e direct labor #ours %er Dean and %er c#ino a%%ear in t#e lines )or bot# t#e %er-unit
direct labor cost and t#e %er-unit over#ead cost/ because over#ead is allocated based on direct labor
#ours- I) t#e allocation base #ad been so$et#in else/ suc# as $ac#ine #ours/ t#e #ours %er unit ,ould
onl* a%%ear in t#e calculation o) t#e direct labor cost-

!ore over#ead is allocated to eac# %air o) c#inos t#an to eac# %air o) %ants 084-95 versus 82-643
because direct labor #ours #as been c#osen as t#e allocation base/ and eac# c#ino re7uires $ore direct
labor ti$e t#an eac# %air o) Deans 00-75 #ours versus 0-40 #ours3- "#anin t#e allocation base cannot
c#ane t#e total a$ount o) over#ead incurred/ but it ,ill usuall* s#i)t costs )ro$ so$e %roducts to
ot#ers- For exa$%le/ i) t#e allocation base ,ere units o) %roduction instead o) direct labor #ours/ t#e
over#ead rate ,ould be1

83/300/000 9 900/000 units W 83-67 %er unit-

In t#is case/ t#e total cost %er %air o) Deans ,ould increase )ro$ 813-24 to 814-27/ and t#e total cost %er
%air o) c#inos ,ould decrease )ro$ 820-85 to 819-57-

Eecause t#e c#oice o) allocation base deter$ines #o, over#ead is allocated across %roducts/ %roduct
$anaers usuall* #ave %re)erences over t#is c#oice 0because a lo,er re%orted %roduct cost results in
#i#er re%orted %roduct %ro4tabilit*3- 5o,ever/ t#e co$%an*;s c#oice o) allocation base s#ould be
uided/ i) %ossible/ b* t#e cause-and-e<ect relations#i% bet,een activit* on t#e )actor* =oor and t#e
incurrence o) over#ead resources- For exa$%le/ direct labor #ours is a sensible allocation base i) t#e
44
sini4cant co$%onents o) over#ead increase as direct labor #ours increase- !ore direct labor i$%lies
$ore indirect labor b* #u$an resources and accountin %ersonnel/ Danitorial sta< and ot#er su%%ort
sta<- 6lso/ $ore direct labor i$%lies $ore $ac#ine ti$e/ ,#ic# i$%lies $ore electricit* usae/ and
$ore re%airs and $aintenance ex%ense- For t#ese reasons/ direct labor #ours is %robabl* a better
c#oice o) allocation base t#an units o) %roduct-

Eercises and Proble"s:

+#&: 6 co$%an* allocates over#ead based on direct labor cost 0dollars3- '#e rate is 160O o) t#e direct
labor cost- 6 Dob #as direct $aterials cost o) 812/000 and direct labor cost o) 814/000 0700 labor #ours3-
:#at is t#e total cost o) t#e DobI

063 826/000

0E3 834/400

0"3 848/400

0C3 827/120

+#(: 6 $ulti-%roduct $anu)acturin co$%an* uses $an* di<erent $ac#ines and e$%lo*s a labor )orce
,it# ,idel*-var*in s(ill levels and %a* rates- Jenerall*/ t#e #i#er %aid and $ore s(illed e$%lo*ees
o%erate t#e $ore co$%lex and ex%ensive $ac#iner*- I) all over#ead is oin to be a%%lied usin a
sinle over#ead rate/ based on t#e in)or$ation %rovided/ ,#ic# allocation base ,ould ,or( best in t#is
environ$entI

063 !ac#ine #ours

0E3 Cirect labor #ours

0"3 Cirect labor dollars

0C3 Cirect $aterial dollars

,2'! The Huad $ity $andy $ompany uses a budgeted overhead rate, and allocates variable overhead based on direct material costs
>i.e., direct materials dollars?. The company only allocates variable overhead. the company does not allocate fi"ed overhead.
0ollowing is information for the year <==C9

:udget Actual
%o"es of candy >this is output?
Aariable overhead
0i"ed overhead
;irect labor9
*ours per bo"
*ourly wage rate
;irect materials9
:ounds per bo"
$ost per pound
6=,===
J<=,===
J6=,===

=.C
J6=

<
JC
66,===
J<<,===
J6F,<==

=.D
J6<

<
JD

1equired! $alculate the overhead rate for applying overhead9

+#4: '#e Hanta Fe "and* "o$%an* ex%ects to incur over#ead o) 860/000- 6lso/ t#e co$%an* ex%ects to
incur 300 direct labor #ours 0,#ic# is %aid an averae o) 820 %er #our3 and 200 $ac#ine #ours/ in order
to %roduce 30/000 %ounds o) cand*- Lsin t#e in)or$ation %rovided/ calculate )our di<erent over#ead
rates usin )our di<erent allocation bases- In eac# case/ be sure to identi)* t#e allocation base-


45
+#:: '#e Eernalillo )actor* o) :inroc( and 6ssociates $a(es t,o $odels o) a %ortable %neu$atic
co$%ressor1 !odel R6567 and !odel RE234- In)or$ation about t#e *ear 1967 )ollo,s1

Model QA)*+ Model Q:&'(
Units produced
;irect materials costs
;irect labor hours
C==
JD=,===
C,===
C==
JN=,===
C,===

0actory overhead for the year was J6G=,===. The average wage rate for worers on the +odel V'CN8 production line is J6= per
hour. The average wage rate for worers on the +odel V%<FD production line is J<= per hour.

AI 'ssume the company allocates overhead based on direct labor hours. What is the overhead rate1

:I What is the total cost per unit for the +odel V%<FD1

CI 'ssume the company changes the allocation base from direct labor hours to direct labor costs >i.e., direct labor dollars?. What
is the new overhead rate1

DI Using this new overhead rate, what is the new cost per unit for the +odel V%<FD1


+#*: Follo,in is in)or$ation about 6+tec# Industries/ ,#ic# $a(es t#ree t*%es o) %ortable #eaters1

!odel A !odel B !odel C Total
Lnits %roduced
Cirect $aterials 0%er unit3
Cirect labor 0%er unit3

Cost driver in-or"ation:
R o) %arts 0%er unit3
direct labor #ours 0%er unit3
s7uare )eet 0in total3

3verhead cost pools:
Aabor Hu%%ort
!aterials Hu%%ort
Facilit* "ost
'otal over#ead
300
850
820


20
3
400


500
875
850


42
4-60
600



200
8100
840


30
4
1/000

1/000









822/000
833/000
890/000
8145/000

A8 6llocatin Facilit* "ost usin s7uare )eet as t#e allocation base/ #o, $uc# Facilit* "ost over#ead
,ould be allocated to eac# !odel 6 #eaterI

B8 I) Aabor Hu%%ort is allocated usin direct labor #ours as t#e allocation base/ ,#at is t#e over#ead
rate )or allocatin Aabor Hu%%ortI

C8 I) all over#ead is allocated usin direct $aterials dollars as t#e allocation base/ ,#at is t#e total cost
o) $anu)acturin eac# !odel " #eaterI


+#;: '#e Aobaton "oo(ie "o$%an* $a(es t#ree t*%es o) coo(ies1 suar coo(ies/ oat$eal coo(ies/ and
c#ocolate c#i% coo(ies- Follo,in is in)or$ation )or Cece$ber1

2ugar
Coo>ies
3at"eal
Coo>ies
Chocolate Chip
Coo>ies
Gounds o) coo(ies %roduced
!ac#ine #ours
Cirect labor #ours
700 %ounds
20 #ours
7 #ours
300 %ounds
10 #ours
6 #ours
400 %ounds
10 #ours
8 #ours
46
6verae ,ae %er #our 810 %er #our 812 %er #our 89 %er #our

'otal over#ead incurred in Cece$ber ,as 88/400-

A8 "alculate t#e over#ead a%%lied %er %ound o) .at$eal "oo(ies/ ,#en all over#ead is a%%lied usin
$ac#ine #ours as t#e allocation base-

B8 Qo, assu$e t#at 84/000 o) t#e over#ead is 4xed/ and t#e re$ainder is variable- "alculate t#e
over#ead a%%lied %er %ound o) Huar "oo(ies/ usin $ac#ine #ours to allocate 4xed over#ead and
direct labor dollars to allocate variable over#ead-


+#+: '#e Hvendsaard .ranic "ereal "o$%an* $a(es 20 brands o) cereal/ includin ,#eat s7uares/
corn s7uares/ and rice s7uares- Follo,in is in)or$ation )or Cece$ber1

0heat 2'uares Corn 2'uares Rice 2'uares
Gounds o) cereal %roduced
!ac#ine #ours
Cirect labor #ours
800 %ounds
40 #ours
45 #ours
600 %ounds
30 #ours
60 #ours
500 %ounds
30 #ours
40 #ours

'otal over#ead incurred in Cece$ber ,as 810/000- 'otal $ac#ine #ours incurred ,ere 500-

A8 "alculate t#e over#ead rate usin $ac#ine #ours as t#e allocation base-

B8 "alculate t#e over#ead a%%lied %er %ound o) corn s7uares usin $ac#ine #ours as t#e allocation
base-


,2-! Teddy %ear 0udge $ompany maes two types of fudge9 plain fudge and fudge with nuts. 0ollowing is information for
operations in the month of 0ebruary. 'll 2uantities are e"pressed in pounds. There is no direct labor.

Total /lain 3udge 3udge $ith 5uts
%eginning inventory
:roduction
Sales

:er unit information9
Sales price per pound
;irect materials
Sales commission

Aariable manufacturing overhead

0i"ed costs9
0i"ed manufacturing overhead
0i"ed non/manufacturing overhead
=
6,===
GC=






JC==


J<,===
JF==
=
N==
C==


JG.==
J<.==
J=.C=



=
D==
FC=


JG.==
J<.<C
J=.C=

1equired! What is the manufacturing cost for each type of fudge, assuming the company allocates overhead based on direct
materials dollars1
CHAPTER F: <or"al Costing

Chapter Contents:
- Introduction
- Qor$al "ostin
- 6dvantaes o) usin budeted over#ead rates
- !isa%%lied over#ead
47
- XFQ 6%%arel "o$%an*/ Qor$al "ostin exa$%le
- &xercises and %roble$s

Introduction:
Recall t#e discussion )ro$ t#e %revious c#a%ter on over#ead rates- '#e over#ead rate is t#e ratio o)
cost %ool over#ead dollars in t#e nu$erator/ and t#e total 7uantit* o) t#e allocation base in t#e
deno$inator1

.ver#ead rate

.ver#ead costs in t#e cost %ool
W
'otal 7uantit* o) t#e allocation
base

'#e result re%resents dollars o) over#ead %er unit o) t#e allocation base- For exa$%le/ i) an a%%arel
)actor* allocates over#ead based on direct labor #ours/ t#e over#ead rate re%resents dollars o)
over#ead %er direct labor #our-

<or"al costing:
!an* co$%anies calculate and a%%l* t#is over#ead rate usin/ not actual over#ead costs and t#e actual
7uantit* o) t#e allocation base/ but rat#er budeted over#ead costs and t#e budeted 7uantit* o) t#e
allocation base- :#en a co$%an* uses budeted over#ead rates in its costin s*ste$/ but all ot#er
in)or$ation in t#e costin s*ste$ is based on actual costs/ t#e co$%an* is usin ,#at is called a
nor"al costing s.ste"-

It is i$%ortant to re$e$ber t#at alt#ou# t#ere are no rules in $anae$ent accountin/ co$%anies
al,a*s/ as a $atter o) %ractice/ use eit#er budeted nu$bers in both the numerator and the
denominator o) t#e over#ead rate/ or actual nu$bers in both the numerator and the denominator o)
t#e over#ead rate- "o$%anies never use budeted over#ead divided b* t#e actual 7uantit* o) t#e
allocation base/ or actual over#ead divided b* t#e budeted 7uantit* o) t#e allocation base-

It is also i$%ortant to re$e$ber t#at in a nor$al costin s*ste$/ t#e budeted over#ead rate is
$ulti%lied b* t#e actual 7uantit* o) t#e allocation base incurred- In "#a%ter 10/ ,e ,ill discuss anot#er
t*%e o) accountin s*ste$/ called a standard costing s.ste"/ t#at $ulti%lies t#e budeted over#ead
rate b* a =exible budet 7uantit* )or t#e allocation base1 t#e a$ount o) t#e allocation base t#at s#ould
#ave been used )or t#e a$ount o) out%ut ac#ieved- 5o,ever/ in a nor$al costin s*ste$/ t#e onl*
budeted nu$ber is t#e over#ead rate2 direct costs are recorded at t#eir actual cost/ and t#e over#ead
rate is $ulti%lied b* t#e actual 7uantit* o) t#e allocation base used durin t#e %eriod-

Advantages o- Csing Budgeted 3verhead Rates:
'#ere are t#ree %rinci%al reasons t#at $an* co$%anies in all sectors o) t#e econo$* use budeted
over#ead rates/ eit#er as %art o) a nor$al costin s*ste$ or as %art o) a standard costin s*ste$-

Actual overhead rates are not >no=n in a ti"el. "anner: Factor* $anaers o)ten use %roduction
cost in)or$ation in t#eir $onitorin o) t#e $anu)acturin %rocess- "ontrol o) $anu)acturin activities is
a dail* or ,ee(l* %rocess/ not a $ont#l* or 7uarterl* %rocess- '#e c#allene o) collectin and re%ortin
actual direct costsZt#e cost o) $aterials and labor used in %roductionZ,it#in one or t,o da*s o) actual
%roduction is diBcult/ but increasinl* %ossible- For exa$%le/ all $aterials used in %roduction #ave
alread* been %urc#ased/ and t#e cost o) t#ose $aterials can be ascertained- 6lso/ so%#isticated data
collection s*ste$s/ o)ten called real-ti$e s*ste$s/ can trac( t#e $ove$ent o) inventor*/ and trac(
labor resources incurred at various ,or( stations/ as %roduction occurs- &ven t#e 7uantit* o) t#e
over#ead cost allocation base used in %roduction can %robabl* be ascertained/ because t#e allocation
base is usuall* a $easure o) a direct in%ut- 5o,ever/ $an* o) t#e co$%onents t#at $a(e u% over#ead
are not %aid dail* or even ,ee(l*- Ltilities and %ro%ert* taxes are o)ten %aid $ont#l* or 7uarterl*- '#e
)actor* $anaer ,#o ,ants to (no, t#e cost o) %roduction on Kanuar* 3 )or t#e %ur%ose o) controllin
o%erations on t#e )actor* =oor ,ill not ,ant to ,ait until t#e boo(s are closed on Kanuar* 31 )or t#at
48
in)or$ation- Lsuall*/ budeted over#ead rates are suBcientl* close to actual over#ead rates so t#at
nor$al costin s*ste$s %rovide reasonabl* accurate cost in)or$ation )or $anae$ent control
%ur%oses/ and nor$al costin can %rovide t#is in)or$ation in a ti$el* $anner-

3verhead rates are subDect to short#run ,uctuations: For an a%%arel )actor* in &l Gaso/ electric
costs are sini4cantl* #i#er in Kul* t#an in Kanuar* due to t#e cost o) air conditionin- H#ould over#ead
rates be calculated and a%%lied se%aratel* )or eac# $ont#/ or s#ould over#ead rates be averaed over
t#e entire *earI '#e ans,er to t#is 7uestion is not clear/ because it de%ends on t#e t*%es o) decisions
)or ,#ic# $anae$ent ,ill use )actor* cost in)or$ation as an in%ut- For exa$%le/ i) t#e )actor* #as
excess ca%acit* and $anae$ent is considerin sus%endin )actor* o%erations )or t,o ,ee(s/ $ont#l*
cost data ,ill assist in sc#edulin t#e do,n-ti$e to $axi$i+e cost savins 0i-e-/ close t#e )actor* )or
t,o ,ee(s in Kul*/ not Kanuar*3- .n t#e ot#er #and/ i) several %roduct $anaers are sc#edulin
%roduction )or t#e co$in *ear/ it ,ould see$ counter%roductive to %rovide t#ese $anaers incentives
to co$%ete ,it# eac# ot#er )or Kanuar* )actor* ti$e/ )or t#e sa(e o) obtainin t#e lo,er %er-unit
%roduction cost/ i) so$e o) t#e$ ,ill #ave to sc#edule %roduction in Kul* in an* case- Lsin an over#ead
rate t#at averaes over t#e entire *ear $i#t be $ore reasonable )or %roduction costin %ur%oses li(e
t#is one- In )act/ $an* co$%anies %re)er to averae over#ead rates over a 7uarter or an entire *ear/
and t#ese co$%anies usuall* %re)er usin budeted over#ead rates instead o) ,aitin until actual
over#ead is (no,n at t#e end o) t#e %eriod-
0hen actual overhead rates are used6 production volu"e o- each product aGects the
reported costs o- all other products: '#is issue arises because t#e %roduction volu$e o) eac#
%roduct a<ects t#e total 7uantit* o) t#e allocation base in t#e deno$inator o) t#e over#ead rate/
,#ereas an i$%ortant co$%onent o) t#e nu$eratorZ4xed over#eadZis invariant to c#anes in
%roduction volu$e- 5ence/ as %roduction volu$e o) one %roduct decreases belo, budet/ t#e over#ead
rate 0,#ic# is co$$on across all %roducts3 increases/ and ,#en t#at over#ead rate is a%%lied to ot#er
%roducts/ t#ose %roducts absorb $ore over#ead 0and so #ave #i#er re%orted costs3 t#an ,as
budeted- '#e i$%ortant %oint #ere is t#at t#e direct costs and %roduction activit* related to t#ose
ot#er %roducts could be exactl* as %lanned/ but t#e re%orted costs o) t#ose %roducts ,ill be #i#er t#an
%lanned/ due entirel* to t#e %roduction activities o) anot#er %roduct- In a )actor* t#at $a(es Deans and
c#inos/ one $i#t i$aine t#e reaction o) t#e Deans %roduct $anaer ,#en a decline in c#inos
%roduction increases t#e re%orted cost o) eac# %air o) Deans-

!isapplied 3verhead:
:#en budeted over#ead rates are used/ it is ver* li(el* t#at t#e a$ount o) over#ead a%%lied to
%roduction 0t#e debits to ,or(-in-%rocess3 ,ill di<er )ro$ t#e actual over#ead incurred 0credits to cas#/
accounts %a*able/ and various ot#er accounts3 durin t#e %eriod- '#is di<erence/ ,#ic# ,ill occur
,#enever t#e budeted over#ead rate di<ers )ro$ t#e actual over#ead rate/ is called $isa%%lied
over#ead- I) less over#ead is a%%lied to inventor* t#an is actuall* incurred/ t#en t#e di<erence is called
undera%%lied over#ead 0it is also called underallocated over#ead or underabsorbed over#ead3- I) $ore
over#ead is a%%lied to inventor* t#an is actuall* incurred/ t#en t#e di<erence is called overa%%lied
over#ead 0it is also called overallocated over#ead or overabsorbed over#ead3-

!ec#anicall*/ $isa%%lied over#ead is accu$ulated in one or $ore te$%orar* accounts t#at are closed
out at t#e end o) t#e %eriod 0$ont#/ 7uarter or *ear3- '#ese accounts collect t#e $isa%%lied over#ead
because ,#en over#ead is debited to inventor*/ t#e corres%ondin credits are %osted to t#ese
te$%orar* accounts/ and ,#en over#ead is %aid 0or accrued3/ t#e corres%ondin debits are also %osted
to t#ese te$%orar* accounts- '#e net di<erence bet,een t#ese debits and credits re%resents
$isa%%lied over#ead- I) t,o te$%orar* accounts are used/ t#e* are called so$et#in li(e Mover#ead
a%%liedN and Mover#ead incurred-N

'#e nature o) t#e closin entr* to +ero-out t#ese accounts de%ends on t#e $aterialit* o) t#e $isa%%lied
over#ead- I) t#e a$ount is s$all/ $anae$ent $i#t ta(e t#e ex%edient a%%roac# o) closin out all
$isa%%lied over#ead to a line-ite$ on t#e inco$e state$ent )or t#e %eriod- '#e $isa%%lied over#ead
49
$i#t be %osted to cost-o)-oods-sold/ or $i#t be treated as a %eriod ex%ense/ but in eit#er case/ t#e
e<ect is to increase or decrease inco$e b* t#e total a$ount o) $isa%%lied over#ead-

I) t#e a$ount o) $isa%%lied over#ead is $aterial/ $anae$ent s#ould consider ,#et#er t#e entr* to
close out $isa%%lied over#ead s#ould be $ade in suc# a ,a* as to a%%roxi$ate t#e balances in t#e
balance s#eet and inco$e state$ent inventor* accounts t#at ,ould #ave occurred #ad an actual
costin s*ste$ been used- I) so/ t#en t#e entr* to close out $isa%%lied over#ead s#ould include t#e
inventor* balance s#eet accounts o) ,or(-in-%rocess and 4nis#ed oods inventor*/ as ,ell as cost-o)-
oods-sold on t#e inco$e state$ent- .ne tec#ni7ue t#at a%%roxi$ates t#is obDective is to %ro-rate
$isa%%lied over#ead based on t#e endin balances in ,or(-in-%rocess/ 4nis#ed oods inventor*/ and
cost-o)-oods-sold- 6 $ore accurate tec#ni7ue is to %ro-rate $isa%%lied over#ead based on t#e a$ount
o) over#ead in eac# o) t#ese t#ree accounts-

I) over#ead is undera%%lied/ so$e $anaers close out t#e entire a$ount to t#e inco$e state$ent
0t#ereb* decreasin inco$e3 even i) t#e a$ount is $aterial- "onservatis$ is o)ten t#e Dusti4cation )or
t#is a%%roac#-

EF< Apparel Co"pan.6 <or"al Costing Ea"ple:
'#e XFQ a%%arel co$%an* in 6lbu7uer7ue/ Qe, !exico $a(es Deans and %re$iu$ c#inos- &ac# %roduct
line #as its o,n asse$bl* line on t#e )actor* =oor- .ver#ead costs )or t#e )actor* )or 2005 ,ere
budeted )or 83/600/000/ but ca$e in belo, budet at 83/300/000- Eudeted %roduction )or t#e *ear
,as 500/000 Deans and 500/000 c#inos- 6ctual %roduction ,as 500/000 Deans and 400/000 c#inos- '#e
reduction in c#inos out%ut relative to %lan ,as due to unex%ected slac( in t#e de$and )or casual
slac(s- '#e budeted direct labor #ours %er Dean is 0-5/ and %er c#ino is 0-7- In )act/ 500/000 direct
labor #ours ,ere used1 200/000 )or Deans/ and 300/000 )or c#inos- '#e averae direct labor ,ae rate
,as t#e sa$e on bot# asse$bl* lines/ and ,as 814 %er #our- Ceni$ )abric is used to $a(e Deans/ and
c#inos are $ade )ro$ a cotton t,ill )abric- .ver#ead is allocated usin direct labor #ours-

'#e )ollo,in Dournal entries and '-accounts illustrate #o, a nor$al costin s*ste$ records t#e
$anu)acturin activities o) t#e )actor* in order to derive %roduct cost in)or$ation )or Deans and c#inos-

'#e 4rst 4ve entries are identical to t#e XFQ exa$%le in t#e %revious c#a%ter- '#e 4rst entr* t#at di<ers
as t#e result o) usin nor$al costin instead o) actual costin is 063- '#is entr* to debit over#ead to
,or(-in-%rocess is based on an over#ead rate calculated as1

Eudeted Groduction Eudeted #ours %er unit Eudeted labor #ours
Keans
"#inos
'otal
500/000 units x
500/000 units x
0-5 #ours %er unit W
0-7 #ours %er unit W
250/000
350/000
600/000

'#e budeted over#ead rate W

83/600/000 9 600/000 direct labor #ours W 86-00 %er direct labor #our-

In %ractice/ t#e )actor* ,ould trac( costs b* batc#/ or %er#a%s ,ee(l*/ but to si$%li)* our exa$%le/ ,e
record onl* one Dournal entr* )or eac# t*%e o) transaction- :e also $a(e t#e unrealistic assu$%tion t#at
t#ere is no ,or(-in-%rocess at t#e end o) t#e %eriod- 'o )ocus t#e %resentation on inventor*-related
accounts/ '-accounts )or so$e non-inventor* accounts are o$itted- !an* co$%anies ,ould use t,o
se%arate accounts instead o) one account to trac( )actor* over#ead2 one account )or )actor* over#ead
incurred/ and t#e ot#er account )or )actor* over#ead allocated-

013 Ra, !aterials1 deni$ )abric 83/000/000
Ra, !aterials1 cotton t,ill 2/250/000
6ccounts Ga*able 85/250/000

50
0'o record t#e %urc#ase o) 600/000 *ards o) deni$ )abric at 85-00 %er *ard/ and
500/000 *ards o) cotton t,ill )abric at 84-50 %er *ard-3

023 :or(-in-%rocess1 Keans 82/500/000
Ra, !aterials1 deni$ )abric 82/500/000

0'o record $aterials re7uisitions )or 500/000 *ards/ )or t#e $ove$ent o) deni$
)ro$ t#e receivin de%art$ent to t#e cuttin roo$-3

033 :or(-in-%rocess1 "#inos 82/160/000
Ra, !aterials1 cotton t,ill 82/160/000

0'o record $aterials re7uisitions )or 480/000 *ards/ )or t#e $ove$ent o) cotton
t,ill )ro$ t#e receivin de%art$ent to t#e cuttin roo$-3

043 :or(-in-%rocess1 Keans 82/800/000
:or(-in-%rocess1 "#inos 4/200/000
6ccrued He,in .%erator :aes 87/000/000

0'o record se,in o%erator ,aes )or t#e *ear1 200/000 #ours )or Deans/ and
300/000 #ours )or c#inos/ at 814 %er #our-3

053 Factor* .ver#ead 83/300/000
6ccounts Ga*able 81/800/000
6ccrued :aes )or Indirect Aabor 900/000
6ccu$ulated Ce%reciation 600/000

0'o record over#ead costs incurred durin t#e *ear-3

063 :or(-in-%rocess1 Keans 81/200/000
:or(-in-%rocess1 "#inos 1/800/000
Factor* .ver#ead 83/000/000

0'o allocate over#ead to %roduction/ usin a budeted over#ead rate o) 86 %er
direct labor #our/ $ulti%lied b* actual #ours used in %roduction-3

073 Finis#ed Joods1 Keans 86/500/000
:or(-in-%rocess1 Keans 86/500/000

0'o record t#e co$%letion o) all 500/000 Deans/ at 813-00 %er %air-3
083 Finis#ed Joods1 "#inos 88/160/000
:or(-in-%rocess1 "#inos 88/160/000

0'o record t#e co$%letion o) all 400/000 c#inos/ at 820-40 %er %air-3

093 "ost o) Joods Hold1 Keans 85/200/000
"ost o) Joods Hold1 "#inos 87/140/000
Finis#ed Joods1 Keans 85/200/000
Finis#ed Joods1 "#inos 87/140/000

0'o record t#e sale o) 400/000 Deans and 350/000 c#inos-3

0103 "ost o) Joods Hold1 $isa%%lied over#ead 8300/000
Factor* .ver#ead 8300/000
51

0'o close out undera%%lied over#ead to ".JH- '#e total a$ount is ta(en to ".JH
because t#e result is not $ateriall* di<erent )ro$ allocatin $isa%%lied over#ead
to ".JH and 4nis#ed oods inventor*3

Ra, !aterials1
Ceni$ Fabric

Ra, !aterials1
"otton ',ill

01
3
83/000/000


8 500/000
82/500/000




023 013 82/250/000


8 90/000
82/160/000 033



6ccrued He,in
.%erator :aes

Factor* .ver#ead

87/000/000




043 053 83/300/000


80
83/000/000
300/000
063
0103




:or(-in-Grocess1 Keans :or(-in-Grocess1 "#inos
02
3
04
3
06
3
82/500/000
2/800/000
1/200/000
80
86/500/000




073 033
043
063
82/160/000
4/200/000
1/800/000
80
88/160/000 083



Finis#ed Joods1 Keans Finis#ed Joods1 "#inos
07
3
86/500/000


81/300/000
85/200/000




093 083 88/160/000


81/020/500
87/140/000 093



"ost o) Joods Hold1
Keans
"ost o) Joods Hold1 "#inos

093
85/200/000



093 87/140/000



6ccounts Ga*able ".JH1 $isa%%lied over#ead
85/250/000
1/800/000


013
053
0103 8300/000


'#e %er-unit cost o) 4nis#ed oods inventor* is calculated as )ollo,s1

52
Keans1 86/500/000 9 500/000 %airs W 813-00 %er %air
"#inos1 88/160/000 9 400/000 %airs W 820-40 %er %air

'#ese a$ounts can be detailed as )ollo,s1

Input 1eans Chinos
Fabric
Cirect labor
.ver#ead
'otal
1 *ardYDean x 85Y*ard W 85-00
0-4 #rsYDean x 814Y#r W 85-60
0-4 #rsYDean x 86-00Y#r W 82-40
813-00
1-2 *ardsYc#ino x 84-50Y*ard W 85-40
0-75 #rsYc#ino x 814Y#r W 810-50
0-75 #rsYc#ino x 86-00Y#r W 84-50
820-40


.ver#ead is a%%lied usin t#e budeted over#ead rate o) 86-00 %er #our- 5o,ever/ t#is budeted
over#ead rate is $ulti%lied b* t#e actual direct labor #ours used b* eac# %roduct- '#ere)ore/ t#e onl*
reason t#at $ore over#ead or less over#ead is allocated to eac# unit o) %roduct t#an budeted is
because eac# %roduct used $ore o) t#e allocation base or less o) t#e allocation base 0in t#is case/
direct labor #ours3 t#an %lanned- Keans used less over#ead %er unit t#an %lanned 00-4 versus 0-53/ so
less over#ead is allocated to eac# %air o) Deans t#an %lanned- "#inos used $ore over#ead t#an %lanned
00-75 versus 0-73/ so $ore over#ead is allocated to eac# %air o) c#inos t#an %lanned-

'#e total $isa%%lied over#ead is a )unction o) t,o )actors1 013 t#e nu$erator in t#e budeted over#ead
rate di<erin )ro$ actual over#ead incurred2 and 023/ t#e deno$inator in t#e budeted over#ead rate
di<erin )ro$ t#e actual 7uantit* o) t#e allocation base incurred- In t#e next t,o %arara%#s/ ,e
consider eac# o) t#ese t,o )actors-

Aess over#ead ,as incurred t#an %lanned1 83/300/000 versus 83/600/000- It is %robable t#at one reason
actual over#ead incurred ,as less t#an budeted is t#at )e,er units ,ere %roduced t#an %lanned-
Lnless all over#ead is 4xed/ a reduction in out%ut s#ould decrease t#e total over#ead incurred-

'#e deno$inator in t#e budeted over#ead rate can di<er )ro$ t#e actual 7uantit* o) t#e allocation
base incurred )or t,o reasons- First/ t#e a$ount o) t#e allocation base used %er unit o) %roduct 0in t#is
case/ direct labor #ours %er unit3 can di<er )ro$ %lan- Keans used less direct labor #ours %er unit t#an
%lanned/ but c#inos used $ore direct labor #ours t#an %lan- Hecond/ t#e level o) %roduction can di<er
)ro$ %lan 0eit#er total %roduction or %roduct $ix3- Eecause )e,er units ,ere $ade t#an %lanned
0900/000 units versus 1/000/000 units3/ less over#ead ,as allocated t#an ot#er,ise ,ould #ave been
t#e case-

Eercises and Proble"s:

F#&: 6 co$%an* uses a Qor$al "ostin H*ste$/ and allocated over#ead usin direct labor #ours- 6t t#e
beinnin o) t#e *ear/ t#e co$%an* esti$ated t#at t#ere ,ould be 8960/000 in over#ead and 40/000
direct labor #ours ,or(ed- 6t t#e end o) t#e *ear/ t#e co$%an* #ad ,or(ed 39/000 #ours and incurred
8949/000 in over#ead- :#at is t#e undera%%lied or overa%%lied over#ead )or t#e *earI

063 '#ere is not enou# in)or$ation to deter$ine t#is-

0E3 813/000 undera%%lied

0"3 811/000 overa%%lied

0C3 811/000 undera%%lied

-2&! ;)& $ompany maes three products9 cypress, silius, and sibelius. ;)& e"pects to incur J7==,=== in overhead, and e"pects
to use F== machine hours to mae C== units of cypress, <== machine hours to mae 6== units of silius, and 6== machine hours to
mae C= units of sibelius. ;)& uses a Normal $osting System, and uses machines hours as the allocation base.
53

AI If ;)& uses C= machine hours to mae <= units of sibelius, and actually incurs overhead of J6,666,===, how much overhead
will be allocated to each unit of sibelius1

:I If ;)& uses <== machine hours to mae D== units of cypress, D== machine hours to mae 6C= units of silius, and C= machine
hours to mae <= units of sibelius, what is the amount of overapplied or underapplied overhead1

F#): '#e not-)or-%ro)it #ealt# clinic H#ots-[-Ls %rovides various t*%es o) vaccinations and ot#er s#ots/
es%eciall* =u s#ots/ to t#e %ublic )or )ree or )or a no$inal )ee- '#e clinic is )unded b* several local
overn$ental aencies as ,ell as b* a nu$ber o) c#aritable orani+ations- Hince di<erent donors ,is#
to )und di<erent t*%es o) s#ots/ t#e clinic deter$ines t#e )ull cost o) eac# t*%e o) s#ot/ b* addin
over#ead to t#e direct costs/ and t#en %rovides t#is in)or$ation to current and %ros%ective donors-

Follo,in are actual and budeted costs )or H#ots-[-Ls )or 20031

Actual Budgeted
Qu$ber o) %atient visits
Qu$ber o) s#ots ad$inistered

Fixed over#ead1 salaries/ rent )or t#e )acilit*/
insurance/ de%reciation-

Variable over#ead1 nursin sta< #oursl* ,aes/
utilities/ dis%osable su%%lies-

"ost o) #*%oder$ics 0a direct cost3

"ost o) $edications 0a direct cost3
5/000
6/000


894/000


866/000

81/000

830/000
4/000
4/500


8110/000


840/500

8750

820/000

AI Under normal costing, the variable cost per shot is

>'? J7 per shot

>%? J6F.N6 per shot

>$? J6D.68 per shot

>;? JFG.=N per shot

:I Which of the following might help e"plain the increase in total variable overhead, from budget to actual1

>I? The increase in the number of shots given, from budget to actual.

>II? ' misclassification of some fi"ed costs as variable >i.e., the costs are actually fi"ed, but are included under
variable overhead, in both the budget and the actual columns?.

>III? 'n increase in the average hourly wages for the nursing staff, from budget to actual.

>'? I only

>%? III only

>$? I and III, but not II

>;? I, II and III

-2(! The Santa $ru- $andy $ompany e"pects to incur overhead of J<D,===. 'lso, the company e"pects to incur F== direct labor
hours >which is paid an average of J6= per hour? and <== machine hours, in order to produce <,=== pounds of candy. Using the
information provided, calculate three different overhead rates using three different allocation bases. In each case, be sure to
identify the allocation base.
54

-2)! The Santa $ru- +achine Shop allocates overhead based on machine hours, using a budgeted overhead rate. The budgeted
overhead rate is calculated using an estimate of N,=== machine hours in the denominator, and JN=,=== in the numerator. 'ctual
overhead was JC== less than budgeted. 'ctual machine hours were 6,C== more than budgeted. $alculate the misapplied overhead.
%e sure to indicate whether this misapplied overhead is underapplied or overapplied.

F#*: Follo,in is in)or$ation )or Gen7uo/ Inc-/ ,#ic# $a(es cra*ons in its Eillins/ !' )actor*1

Budget Actual
Groduction 0R o) boxes o) cra*ons3
'otal Cirect "osts 0$aterials T labor3
'otal !ac#ine 5ours
.ver#ead 04xed and variable3
1/000
8 2/000
140
82/800
800
8 2/400
100
83/000

Gen7uo allocates over#ead usin a budeted over#ead rate/ usin $ac#ine #ours as t#e allocation
base- '#e over#ead rate is t#en a%%lied to %roduct based on actual $ac#ine #ours incurred- In ot#er
,ords/ t#e co$%an* uses a Qor$al "ostin s*ste$-

Re'uired:
A8 :#at is t#e over#ead rateI

B8 5o, $uc# over#ead ,ould be a%%lied to each box o) cra*onsI

C8 :#at is t#e actual direct cost o) eac# box o) cra*onsI

F#;: '#e Rio Jrande 'ile "o$%an* uses a budeted over#ead rate/ and direct labor costs 0i-e-/ direct
labor dollars3 as t#e allocation base- .ver#ead is a%%lied usin actual labor costs incurred- Follo,in is
in)or$ation )or Kanuar* 2005- '#e labor ,ae rate ,as budeted at 86 %er #our/ but ,as actuall* 88
%er #our- .ver#ead ,as budeted at 842/000/ but ,as actuall* 849/000-

Ceramic Tiles Slate Tiles Total
:roduction9
%udgeted
'ctual

Total ;irect labor hours9
%udgeted
'ctual

D,===
F,===


C==
D==

<,===
D,===


<==
F==

N,===
8,===


8==
8==

AI $alculate the overhead rate. *ow much overhead would be allocated to all D,=== slate tiles1

:I Now assume the company uses a budgeted overhead rate, direct labor hours as the allocation base, and applies overhead based
on actual direct labor hours incurred. *ow much overhead would be applied to each ceramic tile1

CI Now assume the company allocates overhead using direct labor hours as in part >%?. What is the misapplied overhead1 Is
overhead overapplied or underapplied1

F#+: '#e Hvendsaard .ranic "ereal "o$%an* $a(es cereal- Follo,in is in)or$ation )or Qove$ber1

Actual In-or"ation Budgeted In-or"ation
Gounds o) cereal
%roduced
'otal direct $aterials
'otal direct labor
'otal $ac#ine #ours
'otal direct labor #ours
'otal over#ead
800 %ounds
83/200
8800
60 #ours
45 #ours
830/000
800 %ounds
82/600
8800
50 #ours
40 #ours
830/000

55
A8 "alculate t#e over#ead rate usin Qor$al "ostin and $ac#ine #ours as t#e allocation base-

B8 Lsin Qor$al "ostin/ #o, $uc# over#ead ,ill be a%%lied to eac# %ound o) cerealI

C8 "o$%ute t#e a$ount o) $isa%%lied over#ead-

-2-! 0ollowing is information for the @ames Woods $ompany, and one of the products made by the company. The factory has the
capacity to produce 6.C million s2uare feet of wood product.

:udget #or the
Company
Actual #or the
Company
:udget #or
Mahogany
Jaminate
Actual #or
mahogany
Jaminate
:roduction
>in s2uare feet?

;irect :roduct $osts
Aariable 5verhead
0i"ed 5verhead
6,===,===


J<,C==,===
J<,===,===
J6,C==,===
6,<==,===


J<,GG=,===
J<,D==,===
J6,<==,===
C=,===


J6C=,===
D=,===


J6<G,===

AI $alculate the amount of overhead allocated to all of the mahogany laminate if the company uses a budgeted overhead rate,
s2uare feet of product as the allocation base, and applies the overhead rate based on actual s2uare feet produced.

:I $alculate the amount of overhead allocated to all of the mahogany laminate if the company uses a budgeted overhead rate,
direct product cost as the allocation base, and applies the overhead rate based on actual direct product costs incurred.

CI $alculate the amount of overhead allocated to all of the mahogany laminate if the company uses a budgeted overhead rate,
s2uare feet of product as the allocation base, and applies the overhead rate based on actual s2uare feet produced. *owever, the
company allocates variable overhead and fi"ed overhead separately. The denominator for the overhead rate for variable overhead
is budgeted s2uare feet, and the denominator for the overhead rate for fi"ed overhead is factory capacity >in terms of s2uare feet?.

-2%.! ' factory maes (eans and chinos. 5verhead was budgeted at J6C=,===, but was actually J6F<,===. %udgeted production
was 6=,=== (eans and C,=== chinos. 'ctual production was 6=,=== (eans and <,=== chinos. 5verhead is applied using a budgeted
overhead rate, and the allocation base is units of output.

AI $alculate the overhead rate.

:I *ow much overhead would be applied to the chinos production line1

CI What is the misapplied overhead1 Is it underapplied or overapplied1
C<A/T=1 %.! Standard Costing

Chapter Contents!
/ Introduction
/ Standard costs
/ !"ample of a Standard $ost Sheet
/ Standard $osting Systems
/ Standard $osting Systems and fle"ible budgeting
/ W0N 'pparel $ompany, Standard $osting e"ample
/ )easons for using a Standard $osting System
/ Summary of 'ctual $osting, Normal $osting and Standard $osting
/ !"ercises and problems

0ntroduction!
If you were to design a cost accounting system with no accounting education other than financial accounting courses, you would
probably design an accounting system that collects, summari-es, and reports actual costs. This approach would be consistent with
the implicit assumption throughout every financial accounting course that when financial statements report historical cost data,
such as would normally be the case for cost/of/goods/sold and ending inventory, that the information reported represents actual
costs. Therefore, it comes as a surprise to most students that the initial (ournal entries to record the production and movement of
inventory in the costing systems of most manufacturing firms are not based on actual costs at all, but rather are based on budgeted
per/unit costs.

56
In most manufacturing firms, the initial (ournal entries to debit wor/in/process, finished goods and cost/of/goods/sold are based
on the actual 2uantity of output produced, multiplied by budgeted data about the inputs necessary to produce those outputs, and
the budgeted costs of those inputs. Then, at the end of the month >or possibly 2uarterly?, an 3ad(usting4 or 3closing4 entry is made
to record in the inventory accounts the difference between actual costs incurred, and the budgeted information that has formed the
basis for the (ournal entries during the month. The nature of this ad(usting entry depends on the materiality of the amounts
involved. If the differences between actual costs and budgeted costs are small, this ad(usting entry might be made in an e"pedient
manner, involving only cost/of/goods/sold, but if the differences are large, the ad(usting entry might also involve wor/in/process
and finished goods inventory accounts.

The accounting system described above is called a standard costing system, and it is widely/used by companies in the
manufacturing sector of the economy. This chapter describes standard costing systems, and e"plains why companies use them. %ut
first we discuss a related concept, standard costs, which constitutes an important component of standard costing systems.

Standard Costs!
' standard, as the term is usually used in management accounting, is a budgeted amount for a single unit of output. ' standard
cost for one unit of output is the budgeted production cost for that unit. Standard costs are calculated using engineering estimates
of standard 2uantities of inputs, and budgeted prices of those inputs. 0or e"ample, for an apparel manufacturer, standard 2uantities
of inputs are re2uired yards of fabric per (ean and re2uired hours of sewing operator labor per (ean. %udgeted prices for those
inputs are the budgeted cost per yard of fabric and the budgeted labor wage rate.

Standard 2uantities of inputs can be established based on ideal performance, or on e"pected performance, but are usually based on
efficient and attaina!le performance. )esearch in psychology has determined that most people will e"ert the greatest effort when
goals are somewhat difficult to attain, but not e"tremely difficult. If goals are easily attained, managers and employees might not
wor as hard as they would if goals are challenging. %ut also, if goals appear out of reach, managers and employees might resign
themselves to falling short of the goal, and might not wor as hard as they otherwise would. 0or this reason, standards are often
established based on efficient and attaina!le performance.

*ence, a standard is a type of budgeted number. one characteri-ed by a certain amount of rigor in its determination, and by its
ability to motivate managers and employees to wor towards the company,s ob(ectives for production efficiency and cost control.

There is an important distinction between standard costs and a standard costing system. Standard costs are a component in a
standard costing system. *owever, even companies that do not use standard costing systems can utili-e standards for budgeting,
planning, and variance analysis.

=4ample o# a Standard Cost Sheet!
The following e"ample shows a standard cost sheet for a delu"e widget. It is a fictional e"ample, yet provides a realistic picture of
the level of detail involved in setting standard costs. +any manufacturing companies would have a standard cost sheet for each
product, and would revise these cost sheets periodically, perhaps annually or once every three to five years, to incorporate changes
in prices of inputs and manufacturing processes.

Inter/5ffice +emorandum
60D;=TS U5J0M0T=D, JTD


To! +a" ;avid
Date! @uly G
3rom Iris %renner
/ro9ect! ;elu"e Widget

'ttached is a sample of a cost model I did for the ;elu"e Widget. 's discussed at the last meeting, we probably want to use a
model such as this to eep trac of our standard costs as they change over time. We may want to have separate models for the
motor and the housing. :lease review the model and let me now of any changes that you feel would be helpful.


Distribution!
*ayden ;ubinsi
#ouis ;u:uis
$laire %rown
Thea Iimber
'llison Iirstuas
Woe :ritchard

Segments! 's $ast
57













Jining!















Sleeve!










Closure!








1ing!


















+achining

$oating


Total #or * segments
>based on 2ty of C==?

+aterials9





+olding9






Total #or * Jinings


+aterial >tubing?


+achining

$oating


Total #or * Sleeves
3or * Jinings R Sleeves

+aterial


+achining

Total! * Closures



+aterial9





+olding9





Total #or 1ing

6== pieces
C== pieces
6=== pieces
material overhead X



material overhead X






)esin
'dhesive
:repreg
material overhead X


Winding
Tool 'ssembly
In(ection
;ecouple
;emold





material overhead X




material overhead X





material overhead X







$arbon
)esin
:repreg
material overhead X


Winding
Tool 'ssembly
)esin Transfer
;emolding




C.== ea
D.== ea.
F.== ea
<<K

=.6 hrs X

6=K









<<K


=.<= hrs X
=.6C hrs X
=.6= hrs X
=.=6 hrs X
=.<C hrs X
=.86 hrs




<<K

=.<C hrs X


6=K





<<K

=.6N hrs X









<<K


=.F= hrs X
=.<= hrs X
=.6= hrs X
=.6= hrs X
=.8= hrs X







7<.D=







<C.==
6.==
=.8C
<.==
N.FF
FC.=G

GC.==
GC.==
GC.==
GC.==
GC.==







7<.D=










7<.D=












GC.==
GC.==
GC.==
GC.==




D.==

=.GG

7.<D

6.==
=.6=











68.==
6<.8C
G.C=
=.GC
<6.<C
N=.FC



C.==
6.6=

<F.6=

<.==
=.<=




7.==
6.7G

6D.DG






6==.==
D.==
7.==
<D.GN
6F8.GN

<C.C=
68.==
G.C=
G.C=
C7.C=












76.F<















C8<.CC










6GG.D=
8N=.7C






6C<.8N















678.FN

58
Core!







Top!






6indo$!





Misc Jabor!
+aterial


+achining

Total #or Core
>!ngineering !stimate?

Top from Aendor

'nodi-e


Total #or Top

Window from Aendor

'nodi-e

Total #or 6indo$

'ssembly and %alancing

Spin

Total #or Misc Jabor

material overhead X







material overhead X

material overhead X




material overhead X

material overhead X

<<K

=.= hrs X





<<K

6=K




<<K

6=K


=.8C hrs X

=.C= hrs X



7<.D=

















7<.D=

7<.D=

=.==
=.==

=.==




6C.==
F.F=
C.==
=.C=



G=.==
68.N=
G.==
=.G=


N7.F=

DN.<=





<==.==







<F.G=





6=N.D=





66C.C=
Total Delu4e 6idget Standard Cost >based on 2uantity of C==?

Total Delu4e 6idget Standard Cost $"o Sleeves and Closures
J6,NDG.=G

J6,F=N.7F

Standard Costing Systems!
' standard costing system initially records the cost of production at standard. Units of inventory flow through the inventory
accounts >from wor/in/process to finished goods to cost of goods sold? at their per/unit standard cost. When actual costs become
nown, ad(usting entries are made that restate each account balance from standard to actual >or to appro"imate such a
restatement?. The components of this ad(usting entry provide information about the company,s performance for the period,
particularly with regard to production efficiency and cost control.

Standard Costing Systems and 3le4ible :udgeting!
There is an important connection between fle"ible budgeting, which was discussed in $hapter N, and standard costing. In fact, a
standard costing system tracs inventory during the period at the fle"ible budget amount. )ecall that the fle"ible budget is the
budgeted per/unit cost multiplied by the actual number of units. *ence, a standard costing system answers the 2uestion9 what
would the income statement and balance sheet loo lie, if costs and per/unit input re2uirements were e"actly as planned, given
the actual output achieved >units made and units sold?.

&iven the point made in the previous paragraph, it follows that the ad(ustment made at period/end to restate the inventory
accounts for the difference between the standard cost account balance and the actual cost account balance constitutes the
difference between the fle"ible budget amount and actual costs. 0or direct costs, such as materials and labor, this ad(usting entry
represents the sum of the price >or labor wage rate? variance and the efficiency >or 2uantity? variance. 0or overhead costs, this
ad(usting entry represents misapplied overhead. 0or variable overhead, misapplied overhead consists of the sum of the spending
variance and the efficiency variance. 0or fi"ed overhead, misapplied overhead consists of the sum of the spending variance and
the volume variance. These overhead variances are discussed in $hapter 68.

*ence, standard costing systems trac inventory at fle"ible budget amounts during the period, and post ad(usting entries at the end
of the period that provide variance information that managers use for performance evaluation and control.

S35 Apparel Company, Standard Costing =4ample!
We continue with the W0N e"ample from the previous two chapters. The W0N apparel company in 'lbu2uer2ue, New +e"ico
maes (eans and premium chinos. !ach product line has its own assembly line on the factory floor. The following table shows
actual and budgeted information for the year. There was no beginning or ending wor/in/process.
:udgeted 0n#ormation Actual
1esults
59
Units produced
@eans
$hinos
Total

Direct Costs!
@eans9
+aterials >denim?
:rice per yard
Yards per (ean
+aterial cost per (ean

;irect labor
Wage rate
*ours per (ean
#abor cost per (ean

$hinos9
+aterials >cotton twill?
:rice per yard
Yards per chino
+aterial cost per chino

;irect labor
Wage rate
*ours per chino
#abor cost per chino

3actory Overhead

C==,===
C==,===
6,===,===




J D.G=
" 6.6=
J C.<G


J6C.==
" =.C=
J 8.C=



J D.D=
" 6.6=
J D.GD


J6C.==
" =.8=
J6=.C=

JF,N==,===

C==,===
D==,===
7==,===




J C.==
" 6.==
J C.==


J6D.==
" =.D=
J C.N=



J D.C=
" 6.<=
J C.D=


J6D.==
" =.8C
J6=.C=

JF,F==,===

+ost of this information is available from the previous chapter. 'lso, the W0N e"ample in the previous chapter derived the
budgeted overhead rate of JN.== per direct labor hour, and that same overhead rate is used by the standard costing system. %ased
on this information, the standard costing system would debit the finished goods inventory account as follows9
60

8eans Chinos
Standard cost per unit9
+aterials
#abor
5verhead

'ctual units produced
Total

JC.<G
J8.C=
JN.== " =.C= P JF.==
J6C.8G
" C==,===
J8,G7=,===


JD.GD
J6=.C=
JN.== " =.8= P JD.<=
J67.CD
" D==,===
J8,G6N,===

)ecall from the previous chapter that D==,=== (eans and FC=,=== chinos were sold. The entries to record the movement of
inventory from the finished goods inventory account into the cost/of/goods/sold account would multiply these sales volumes by
J6C.8G per (ean and J67.CD per chino.

1easons #or using a Standard Costing System!
There are several reasons for using a standard costing system9

Cost Control! The most fre2uent reason cited by companies for using standard costing systems is cost control. 5ne might initially
thin that standard costing provides less information than actual costing, because a standard costing system tracs inventory using
budgeted amounts that were nown before the first day of the period, and fails to incorporate valuable information about how
actual costs have differed from budget during the period. *owever, this reasoning is not correct, because actual costs are traced
by the accounting system in (ournal entries to accrue liabilities for the purchase of materials and the payment of labor, entries to
record accumulated depreciation, and entries to record other costs related to production. *ence, a standard costing system records
!oth budgeted amounts >via debits to wor/in/process, finished goods, and cost/of/goods/sold? and actual costs incurred. The
difference between these budgeted amounts and actual amounts provides important information about cost control. This
information could be available to a company that uses an actual costing system or a normal costing system, but the analysis would
not be an integral part of the general ledger system. )ather, it might be done, for e"ample, on a spreadsheet program on a personal
computer. The advantage of a standard costing system is that the general ledger system itself tracs the information necessary to
provide detailed performance reports showing cost variances.

Smooth out short2term #luctuations in direct costs! Similar to the reasons given in the previous chapter for using normal
costing to average the overhead rate over time, there are reasons to average direct costs. 0or e"ample, if an apparel manufacturer
purchases denim fabric from different te"tile mills at slightly different prices, should these differences be traced through finished
goods inventory and into cost/of/goods/sold1 In other words, should the accounting system trac the fact that (eans production on
Tuesday cost a few cents more per unit than production on Wednesday, because the fabric used on Tuesday came from a different
mill, and the negotiated fabric price with that mill was slightly higher1 +any companies prefer to average out these small
differences in direct costs.

6hen actual overhead rates are used, production volume o# each product a##ects the reported costs o# all other products!
This reason, which was discussed in the previous chapter on normal costing, represents an advantage of standard costing over
actual costing, but does not represent an advantage of standard costing over normal costing.

Costing systems that use budgeted data are economical! 'ccounting systems should satisfy a cost/benefit test9 more
sophisticated accounting systems are more costly to design, implement and operate. If the alternative to a standard costing system
is an actual costing system that tracs actual costs in a more timely >and more e"pensive? manner, then management should assess
whether the improvement in the 2uality of the decisions that will be made using that information is worth the additional cost. In
many cases, standard costing systems provide highly reliable information, and the additional cost of operating an actual costing
system is not warranted.

Summary o# Actual Costing, 5ormal Costing and Standard Costing!
The following table summari-es and compares three commonly/used costing systems.




Actual Costing System

5ormal Costing System

Direct
Costs!

>Actual prices or rates " actual 2uantity of inputs per
output? " actual outputs

>Actual prices or rates " actual 2uantity of inputs per output? "
actual outputs

Overhead
Costs!

Actual overhead rates " actual 2uantity of the allocation
base incurred.

:udgeted overhead rates " actual 2uantity of the allocation base
incurred.

The following points are worth noting9
61

6. 'll three costing systems record the cost of inventory based on actual output units produced. The static budget
level of production does not appear anywhere in this table.

<. 'ctual costing and normal costing are identical with respect to how direct costs are treated.

F. With respect to overhead costs, actual costing and normal costing use different overhead rates, but both costing
systems multiply the overhead rate by the same amount9 the actual 2uantity of the allocation base incurred.

D. Normal costing and standard costing use the same overhead rate.

C. Standard costing records the cost of inventory using a fle"ible budget concept9 the inputs 3that should have been
used4 for the output achieved.

There are costing systems other than these three. 0or e"ample, some service sector companies apply direct costs using budgeted
prices multiplied by actual 2uantities of inputs. 0or e"ample, many accounting firms trac professional labor costs using budgeted
professional staff hourly rates multiplied by actual staff time incurred on each (ob.

=4ercises and /roblems!

Discussion Huestion %.2%!
)efer to the Standard $ost Sheet for the ;elu"e Widget.

6. Where does this cost information come from1

<. What components of the widget are outsourced1

F. What is going on with the costing of the 3core41

D. *ow is manufacturing overhead applied1 What are the allocation bases1

%.2&! ' factory maes only one product. Which of the following circumstances ensures that the amount of variable overhead
recorded as part of the cost of inventory is the same under Normal $osting as under Standard $osting, when direct labor dollars is
used as the allocation base, and the factory maes e"actly the number of units as were budgeted.

>I? The actual overhead rate is the same as the budgeted overhead rate.

>II? The actual direct labor dollars is the same as the budgeted direct labor dollars.

>'? >I? is sufficient.

>%? >II? is sufficient.

>$? >I? and >II? are sufficient together, although neither is sufficient by itself.

>;? The amount recorded for variable overhead is always the same under Normal $osting as under Standard $osting.
The only difference between these two costing systems pertains to direct costs.

%.2'! The @aramillo Tortilla 0actory manufactures two products9 corn tortillas, and flour tortillas. %oth types of tortillas are made
in the same factory, but on different machinery, and each type of tortilla has its own production line. 5verhead includes variable
and fi"ed costs, and is allocated based on machine hours. Which of the following costing methods is liely to result in
underapplied overhead, if the demand and production of corn tortillas drops relative to plan >i.e., relative to the static budget?1

>I? The use of an 'ctual $osting System.

>II? The use of a Normal $osting System.

>III? The use of a Standard $osting System.

>'? >I? only

>%? >III? only

62
>$? >II? and >III?, but not >I?

>;? Neither >I?, >II? nor >III?

%.2(! ' company uses a Standard $osting System, and allocated overhead using direct labor hours. 't the beginning of the year,
the company estimated that there would be J7N=,=== in overhead and D=,=== direct labor hours wored. 't the end of the year, the
company had wored F7,=== hours and incurred J7D7,=== in overhead. What is the underapplied or overapplied overhead for the
year1

>'? There is not enough information to determine this.

>%? J6F,=== underapplied

>$? J66,=== overapplied

>;? J66,=== underapplied

%.2)! The )esistol $ompany manufactures hats. The company uses a Standard $osting System. :roduction of one hat is budgeted
at J6= of direct materials, and < hours of direct labor at J<= per hour. 5verhead is budgeted at JC==,===, and is allocated based on
direct labor hours. The static budget calls for production of 6=,=== hats in <==C. 'ctual costs per hat in <==C were J6< of direct
materials, and <.< hours of direct labor at J67 per hour. 'ctual overhead was JD==,===. 'ctual production was 6=,C== hats.
$alculate the cost of goods manufactured at standard.

%.2*! The following information applies to the manufacture of horseshoes by the town blacsmith9

:udget Actual
;irect +aterials9
$ost per pound
:ounds per unit

;irect #abor9
Wage rate per hour
*ours per unit

+anufacturing 5verhead9
)ate per labor hour

JC.==
F


J<=.==
=.C


JC.==

JC.6F
<.8G


J67.FN
=.C<N


JC.6D

The blacsmith uses a standard costing system. 5n @anuary 6
st
she has no inventory. She manufactures 6<= horseshoes during
@anuary, and sells 6== during the month. Aariances are written off to $ost of &oods Sold. What is the cost of ending inventory,
rounded to the nearest dollar1

>'? JCDF

>%? JCC=

>$? JCF7

>;? JCD6

%.2+! #incoln Trains manufactures model railroad e2uipment. The company uses a standard costing system. The following information
pertains to the #incoln Steam !ngine ;ivision for <==D.

%udgeted output units 6D,=== engines
%udgeted fi"ed manufacturing overhead J66,<==
%udgeted variable manufacturing overhead J6.C= per direct labor hour
%udgeted direct manufacturing labor hours =.< hours per engine
0i"ed manufacturing costs incurred J6<,===
;irect manufacturing labor hours used D,=== hours
Aariable manufacturing costs incurred JC,C==
'ctual units manufactured 6C,=== engines

1equired! $alculate the fle"ible budget variance for variable overhead.

63
%.2,! The *opi :opcorn 0actory maes and sells two inds of popcorn9 plain, and cheese/flavored. The only direct materials used
for the plain popcorn is corn. The company allocates all overhead >fi"ed and variable? based on pounds of direct materials >i.e.,
pounds of popcorn?.



:udget Actual

bo"es of plain popcorn
bo"es of cheese/flavored
capacity of the facility >bo"es?

;irect materials >corn?9
for plain popcorn9
cost per pound
pounds per bo"
for cheese/flavored popcorn9
cost per pound
pounds per bo"

;irect labor9
>for plain popcorn only?
wage rate
hours per bo"

Total variable overhead
Total fi"ed overhead

6,===
C==
<,===



J=.<C per pound
6.== pounds

J=.<C per pound
6.== pounds



J6= per hour
=.6= hours

J6C,===
J6=,===

6,<==
C==
<,===



J=.F= per pound
6.6= pounds

J=.F= per pound
=.7= pounds



J6< per hour
=.66 hours

J6G,===
J6<,C==

GAI $alculate the cost of producing one bo" of plain popcorn, and also all of the plain popcorn, assuming the company uses
an 'ctual $osting System.

G:I $alculate the cost of producing one bo" of plain popcorn, and also all of the plain popcorn, assuming the company uses a
Normal $osting System.

GCI $alculate the cost of producing one bo" of plain popcorn, and also all of the plain popcorn, assuming the company uses a
Standard $osting System. ;o not consider any ad(usting entries at the end of the period.

%.2-! The %aed 'pple is a baery speciali-ing in pies. The %aery uses a Standard $osting System. 0ollowing are the standards
for the direct costs for maing an apple pie9

;irect +aterials9
0lour9
Huantity9 < cups
:rice9 J=.D= per cup

Shortening9
Huantity9 <MFrds cup
:rice9 J=.N= per cup

'pples9
Huantity9 8 apples
:rice9 J=.F= per apple

;irect labor9
Huantity9 <= minutes of labor
Wage rate9 J6< per hour

The company does not apply overhead to its products. The static budget for +ay indicated a production and sales level of 6C=
apple pies. In fact, the restaurant made and sold 6N= apple pies.

AI What is the standard cost per unit for maing an apple pie1

:I What would the static budget show for the cost of production for all apple pies1

64
CI The actual cost in direct materials and labor to mae all 6N= pies was J7N=. What is the fle"ible budget variance for apple
pies1

DI FF= cups of flour were used to mae all of the apple pies. The actual price paid per cup of flour was J=.FC. $alculate the
2uantity and price variances for flour. :rovide a possible e"planation for the 2uantity variance.

=I C= labor hours were spent maing apple pies, at an average wage rate of J66 per hour. $alculate the efficiency and wage rate
variances for labor. 'lso calculate the fle"ible budget variance for labor.

%.2%.! Silverstream $ompany maes travel trailers. The following information pertains to the company,s 5hio ;ivision, which
manufactures and marets only one model of trailer9 the F</foot 'mbassador trailer. 0ollowing is budgeted and actual information
for the 5hio ;ivision for <==D9

:udgeted Actual


Trailers manufactured in <==D
Trailers sold in <==D
Sales price per trailer

;irect materials costs >all variable costs?9
'luminum
Steel
5ther
Total materials costs

;irect labor costs >all variable costs?
Aariable overhead manufacturing costs
0i"ed overhead costs9
+anufacturing fi"ed overhead
Non/manufacturing fi"ed overhead

:er Unit






JD,===
J<,===
JD,===
J6=,===

JC,===
JG,===
Total

6,===
6,===
JDC,===


JD,===,===
J<,===,===
JD,===,===
J6=,===,===

JC,===,===
JG,===,===

J6=,===,===
J<,===,===


G==
N==
JDC,===


JF,D==,===
J6,N==,===
JF,G==,===
JG,G==,===

JF,G==,===
JN,D==,===

J66,===,===
J<,6==,===

Additional in#ormation!
The company started the year with no inventory of finished trailers or direct materials.

;irect labor standard9 <C= hours per trailer
'ctual direct labor hours incurred9 67C,=== hours
The budgeted 2uantity of aluminum9 6== lbs. per trailer
The budgeted cost of aluminum9 JD= per lb.
The actual 2uantity of aluminum purchased GD,=== lbs.
The actual 2uantity of aluminum used G<,7<8 lbs.

The division allocates overhead based on direct labor hours. The only non/manufacturing costs are certain fi"ed overhead costs, as
shown above.

Calculate the #ollo$ing!
GAI The overhead rate to use for all manufacturing costs under Standard $osting.

G:I The overhead rate to use for all manufacturing costs under Normal $osting.

GCI The total manufacturing cost per trailer under Standard $osting.

GDI The total manufacturing cost per trailer under 'ctual $osting.

G=I The total manufacturing cost per trailer under Normal $osting.
CHAPTER &&: Activit.#Based Costing

Chapter Contents:
- Eac(round
- 6%%arel )actor* exa$%le o) t,o-stae 6E" allocations
65
- "ost #ierarc#*
- !il,ood !ills
- 6E" in t#e service sector
- 6E" i$%le$entation issues
- &xercises and %roble$s

Bac>ground:
Activit.#based costing 0ABC3 is a better/ $ore accurate ,a* o) allocatin over#ead-

Recall t#e ste%s to %roduct costin1

1- Identi)* t#e cost obDect2
2- Identi)* t#e direct costs associated ,it# t#e cost obDect2
3- Identi)* overhead costs2
4- Helect t#e cost allocation base )or assinin over#ead costs to t#e cost obDect2
5- Cevelo% t#e overhead rate %er unit )or allocatin over#ead to t#e cost obDect-

6ctivit*-based costin re4nes ste%s R3 and R4 b* dividin lare #eteroeneous cost %ools into $ulti%le
s$aller/ #o$oeneous cost %ools- 6E" t#en atte$%ts to select/ as t#e cost allocation base )or eac#
over#ead cost %ool/ a cost driver t#at best ca%tures t#e cause and efect relationship bet,een t#e
cost obDect and t#e incurrence o) over#ead costs- .)ten/ t#e best cost driver is a non4nancial variable-

6E" can beco$e 7uite elaborate- For exa$%le/ it is o)ten bene4cial to e$%lo* a t,o-stae allocation
%rocess ,#ereb* over#ead costs are allocated to inter$ediate cost %ools in t#e 4rst stae/ and t#en
allocated )ro$ t#ese inter$ediate cost %ools to %roducts in t#e second stae- :#* is t#is inter$ediate
ste% use)ulI Eecause it allo,s t#e introduction o) multiple cost drivers )or a sinle over#ead cost
ite$- '#is t,o-stae allocation %rocess is illustrated in t#e exa$%le o) t#e a%%arel )actor* belo,-

6E" )ocuses on activities- 6 (e* assu$%tion in activit*-based costin is t#at over#ead costs are caused
b* a variet* o) activities/ and t#at di<erent %roducts utili+e t#ese activities in a non-#o$oeneous
)as#ion- Lsuall*/ costin t#e activit* is an inter$ediate ste% in t#e allocation o) over#ead costs to
%roducts/ in order to obtain $ore accurate %roduct cost in)or$ation- Ho$eti$es/ #o,ever/ t#e activit*
itsel) is t#e cost obDect o) interest- For exa$%le/ $anaers at Aevi Htrauss T "o- $i#t ,ant to (no,
#o, $uc# t#e co$%an* s%ends to ac7uire deni$ )abric/ as in%ut in a sourcin decision- '#e Mactivit*N
o) ac7uirin )abric incurs costs associated ,it# neotiatin %rices ,it# su%%liers/ issuin %urc#ase
orders/ receivin )abric/ ins%ectin )abric/ and %rocessin %a*$ents and returns-

Apparel Factor. Ea"ple o- T=o#2tage ABC Allocations:
6ssu$e t#at an a%%arel )actor* uses )or(li)ts in onl* t,o de%art$ents1

'#e 4rst de%art$ent is Receivin/ ,#ere lare rolls o) )abric are unloaded )ro$ se$i-trailers and
$oved into storae/ and later $oved )ro$ storae to t#e cuttin roo$-

'#e second de%art$ent is H#i%%in/ ,#ere cartons o) 4nis#ed %ants are staed and t#en loaded
onto se$i-trailers )or s#i%$ent to t#e ,are#ouse-

"osts associated ,it# o%eratin t#ese )or(li)ts consist o) t#e )ollo,in1

For(li)t costs1
.%erator salaries
!aintenance
Ce%reciation ex%ense
.t#er
'otal )or(li)t costs
6ll ot#er over#ead

8 80/000
8/000
7/500
2/500
8 98/000
1/400/000
66
'otal over#ead )or t#e )actor* 81/498/000


'#e )actor* o%erates t,o %roduction lines- .ne line is )or Deans/ ,#ic# are $ade )ro$ deni$ )abric- '#e
ot#er %roduction line is )or casual slac(s/ ,#ic# are $ade )ro$ a cotton-t,ill )abric- .%erational data )or
t#e $ont# is as )ollo,s1

1eans Casual 2lac>s Total
Lnits %roduced
Cirect labor #ours
Rolls o) )abric
"artons s#i%%ed
420/000
70/000
1/750
52/500
200/000
40/000
640
20/000
620/000
110/000
2/390
72/500

'#e )actor* s#i%s %roduct to t#e co$%an*;s ,are#ouse/ not directl* to custo$ers- 5ence/ to )acilitate
stoc(in at t#e ,are#ouse/ eac# carton is %ac(ed ,it# Deans or casual slac(s/ but not bot#- 6n
exa$ination o) t#e in)or$ation in t#e above table reveals t#at a carton #olds $ore slac(s t#an Deans/
and t#at )e,er %ants are cut )ro$ a roll o) deni$ )abric t#an )ro$ a roll o) cotton-t,ill- '#ese
o%erational statistics are driven b* t#e )act t#at deni$ is a #eavier-,ei#t )abric t#an cotton-t,ill/ and
#ence/ it is bul(ier- '#e data also indicate t#at $ore direct labor $inutes are re7uired )or a %air o)
slac(s t#an )or a %air o) Deans/ ,#ic# re=ects reater auto$ation on t#e Deans %roduction line-

Traditional costing
Lnder a traditional costin s*ste$/ )or(li)t costs are %ooled ,it# all ot#er over#ead costs )or t#e )actor*
0electricit*/ %ro%ert* taxes/ )ront oBce salaries/ etc-3/ and t#en allocated to %roduct based on direct
labor #ours 0se,in o%erator ti$e3 )or eac# %roduct-

.ver#ead rate under traditional costin1

'otal over#ead costs
Uuantit* o) allocation base 0direct labor #ours3
.ver#ead rate %er direct labor #our

o) ,#ic# t#e )ollo,in is due to )or(li)t costs1
For(li)t over#ead
Uuantit* o) allocation base 0direct labor #ours3
.ver#ead rate )or )or(li)t costs %er direct labor
#our
8 1/498/000
9 110/000
8 13-62


8 98/000
9 110/000
8 0-8909

For(li)t over#ead a%%lied to %roduct usin traditional costin1

1eans 2lac>s
.ver#ead rate
Uuantit* o) allocation base 0direct labor #ours3
For(li)t costs allocated
Lnits %roduced
6%%roxi$ate cost %er unit
8 0-8909
x 70/000
8 62/363
420/000
80-15
8 0-8909
x 40/000
8 35/636
200/000
80-18

Qote t#at all )or(li)t over#ead is allocated1 862/363 ? 835/636 W 897/999 0t#e di<erence due to
roundin o) t#e over#ead rate3-

I) t#e casual slac(s %roduct $anaer as(s ,#* #er %roduct incurs $ore )or(li)t costs on a %er-unit basis
t#an Deans/ even t#ou# casual slac(s use a li#ter-,ei#t )abric/ t#e ans,er is t#at #er %roduct uses
$ore direct labor %er unit/ ,#ic# %er#a%s is not a ver* satis)*in ex%lanation )ro$ #er %ers%ective-

Activit.#based costing
67
6n 6E" s*ste$ $i#t 4rst allocate )or(li)t costs into t,o cost %ools1 one )or t#e Receivin Ce%art$ent
and one )or t#e H#i%%in Ce%art$ent- '#en costs )ro$ eac# o) t#ese t,o de%art$ents ,ould be
allocated to t#e t,o %roduct lines-

ABC ?rst#stage allocation
'#e 4rst-stae allocation $i#t use an esti$ate o) t#e a$ount o) ti$e t#e )or(li)ts s%end in eac#
de%art$ent- 6 one-ti$e stud* indicates t#at )or(li)ts s%end a%%roxi$atel* 70O o) t#eir ti$e in t#e
H#i%%in Ce%art$ent and 30O o) t#eir ti$e in t#e Receivin Ce%art$ent- 6n additional bene4t o) 6E"
is t#at i) t#is in)or$ation ,ere collected %eriodicall*/ t#e $anaers o) t#ese t,o de%art$ents $i#t be
$ore ,illin to s#are t#e )or(li)ts ,it# eac# ot#er/ since t#e re%orted costs o) eac# de%art$ent ,ould
t#en de%end on t#e ti$e t#e )or(li)ts s%end in t#at de%art$ent- In an* case/ t#e 70Y30 allocation results
in t#e )ollo,in 4rst-stae allocation1

30O o) 898/000 W 829/400 is allocated to t#e Receivin Ce%art$ent
70O o) 898/000 W 868/600 is allocated to t#e H#i%%in Ce%art$ent


ABC second#stage allocation
Receiving 2hipping
'otal costs
Uuantit* o) allocation base
.ver#ead rate

6llocation to Keans
.ver#ead rate
Uuantit* o) allocation
base

6llocation to Hlac(s
.ver#ead rate
Uuantit* o) allocation
base
829/400
9 2/390 rolls
812-30 %er roll


812-30 %er roll
x 1/750 rolls
821/525

812-30 %er roll
x 640 rolls
87/872
868/600
9 72/500 cartons
80-946 %er carton


80-946 %er carton
x 52/500 cartons
849/665

80-946 %er carton
x 20/000 cartons
818/920

'otal )or(li)t costs allocated to eac# %roduct1

1eans 2lac>s Total
Fro$ Receivin 821/525 8 7/872 829/397
Fro$ H#i%%in 49/665 18/920 68/585
'otal 871/190 826/792 897/982
Lnits Groduced 420/000 200/000
6%%roxi$ate "ost %er unit 80-17 80-13

'#e 818 di<erence bet,een total costs allocated o) 897/982 and t#e oriinal costs o) 898/000 is due to
roundin-

'#e 4rst-stae allocation allo,s t#e second-stae to allocate )or(li)t costs to %roduct usin rolls o) )abric
as t#e allocation base in Receivin/ and cartons o) %ants as t#e allocation base in H#i%%in- Hince t#ere
are no rolls o) )abric in t#e s#i%%in de%art$ent/ and no cartons in t#e Receivin Ce%art$ent/ ,it#out
t#e 4rst stae allocation/ t#ere ,ould be no obvious c#oice o) an allocation base t#at ,ould ca%ture t#e
cause-and-e<ect relations#i% bet,een t#e costs o) o%eratin t#e )or(li)ts/ and t#e utili+ation o) )or(li)t
resources b* eac# %roduct in t#e t,o de%art$ents-

Conclusion
'#e traditional costin $et#od allocates $ore )or(li)t costs to slac(s t#an to Deans on a %er-unit basis
because casual slac(s re7uire $ore se,in e<ort- 6E" allocates $ore )or(li)t costs to Deans t#an to
68
casual slac(s/ on a %er-unit basis/ ,#ic# is intuitive because deni$ is a #eavier-,ei#t )abric t#an
cotton t,ill-

Cost Hierarch.:
In 6E"/ cost %ools are o)ten establis#ed )or eac# level in a #ierarc#* o) costs- For $anu)acturin 4r$s/
t#e )ollo,in cost hierarch. is co$$onl* identi4ed1

Cnit#level costs: For an* iven %roduct/ t#ese costs c#ane in a $ore-or-less linear )as#ion
,it# t#e nu$ber o) units %roduced- For exa$%le/ )abric and t#read are unit-level costs )or an
a%%arel $anu)acturer1 i) t#e co$%an* ,ants to double %roduction/ it ,ill need t,ice as $uc#
)abric and t#read-

Batch#level costs: '#ese costs c#ane in a $ore-or-less linear )as#ion ,it# t#e nu$ber o)
batc#es run- !ac#ine setu% costs are o)ten batc#-level costs- '#e ti$e re7uired to %re%are a
$ac#ine to run one batc# o) %roduct is usuall* inde%endent o) t#e nu$ber o) units in t#e batc#1
t#e sa$e ti$e is re7uired to %re%are t#e $ac#ine to run a batc# o) 100 units as a batc# o) 50
units- 5ence/ batc#-level costs do not necessaril* var* in a linear )as#ion ,it# t#e nu$ber o)
units %roduced-

Product#level costs: '#ese costs are usuall* 4xed and direct ,it# res%ect to a iven %roduct-
6n exa$%le is t#e salar* o) a %roduct $anaer ,it# res%onsibilit* )or onl* one %roduct- '#e
%roduct $anaer;s salar* is a 4xed cost to t#e co$%an* )or a ,ide rane o) %roduction volu$e
levels- 5o,ever/ i) t#e co$%an* dro%s t#e %roduct entirel*/ t#e %roduct $anaer is no loner
needed-

Facilit.#level costs: '#ese costs are usuall* 4xed and direct ,it# res%ect to t#e )acilit*- 6n
exa$%le is %ro%ert* taxes on t#e )acilit*/ or t#e salaries o) )ront oBce %ersonnel suc# as t#e
rece%tionist and oBce $anaer-

.ne reason ,#* 6E" %rovides $ore accurate %roduct cost in)or$ation is t#at traditional costin
s*ste$s )re7uentl* allocate all over#ead/ includin batc#-level/ %roduct-level/ and )acilit*-level
over#ead/ usin an allocation base t#at is a%%ro%riate onl* )or unit-level costs- '#e better in)or$ation
obtained )ro$ ex%licitl* incor%oratin t#e cost #ierarc#* is illustrated in t#e )ollo,in exa$%le1

!il=ood !ills:
!il,ood !ills $a(es decorative ,oodcut %rints )or sale to restaurants- Its Eillins/ !ontana )actor*
$a(es t,o o) t#e co$%an*;s $ore %o%ular desins1 'ull and Matador and (ogs )laying )oker- Follo,in
is selected in)or$ation )or a t*%ical $ont#1

'ull (ogs *otal
Qu$ber o) ,oodcuts %roduced
Cirect $aterials costs
Cirect labor costs
Qu$ber o) batc#es
'otal over#ead
Eatc# setu% costs 0included in total
over#ead3
500
82/500
81/400
10
1/500
83/300
81/600
30
2/000
85/800
83/000
40
842/000
812/000

'#e traditional costin s*ste$ allocates all over#ead based on nu$ber o) units %roduced- '#is $et#od
allocates over#ead o) 821 0842/000 9 2/000 units3 to eac# 'ull and Matador ,oodcut and to eac# (ogs
)laying )oker ,oodcut/ o) ,#ic# 86 0812/000 9 2/000 units3 re%resents batc# setu% costs-

'#e $anaer o) t#e 'ull and Matador %roduction line develo%s a tec#ni7ue )or doublin t#e batc# si+e
on #er line ,it#out incurrin an* additional costs- 5ence/ s#e can no, $a(e 500 ,oodcuts %er $ont#
usin onl* 5 setu%s- H#e t#in(s t#is s#ould cut #er batc# setu% costs in #al)- H#e reasons as )ollo,s1
69

:#at MdrivesN batc# setu% costsI It is t#e nu$ber o) batc#es- '#e cost %er batc# is 8300- 08300
%er batc# x 40 batc#es W 812/000/ ,#ic# arees to t#e $ont#l* in)or$ation %rovided above-3
Lsin t#e ne, batc# si+e/ t#e batc# setu% cost is still 8300/ but instead o) s%readin t#is 8300
over 50 units/ t#e 8300 ,ill be s%read over 100 units/ lo,erin $* %er-unit batc# setu% cost
)ro$ 86 to 83/ and lo,erin $* total unit cost b* 83-

5o,ever/ t#e )ollo,in $ont#/ a)ter i$%le$entation o) t#e $anaer;s increased batc# si+e/ re%orted
costs are as )ollo,s1 'otal over#ead dro%s b* 81/500/ ,#ic# re%resents t#e cost savins )ro$
eli$inatin 4ve batc# setu%s )or t#e 'ull and Matador %roduction line- 5ence/ total over#ead dro%s
)ro$ 842/000 to 840/500- '#e traditional costin s*ste$ allocates t#is 840/500 to 2/000 units as 820-25
%er unit- '#is ne, over#ead rate re%resents a savins o) 80-75 %er unit )or ever* ,oodcut1 ever* 'ull
and Matador ,oodcut/ and ever* (ogs )laying )oker ,oodcut- '#e $anaer o) t#e 'ull and Matador
%roduction line is disa%%ointed- 5er re%orted costs did not decrease b* as $uc# as s#e #ad antici%ated/
because $ost o) t#e bene4t )ro$ t#e reduction in batc# setu%s #as been allocated to t#e (ogs )laying
)oker %roduction line-

6n 6E" s*ste$ t#at ex%licitl* reconi+es t#e cost #ierarc#* ,ould correct t#is %roble$- Lnder t#e old
%roduction %rocess/ 6E" ,ould #ave allocated costs as )ollo,s1 '#e cost %ool )or batc# setu% costs ,as
%reviousl* 812/000/ ,#ic# ,ould #ave been allocated to t#e t,o %roduct lines based on t#e nu$ber o)
batc#es run b* eac# line1

.ver#ead rate W total batc# setu% costs 9 total nu$ber o) batc#es
W 812/000 9 40 batc#es W 8300 %er batc#

Eatc# setu% costs o) 8300 %er batc#
x 10 batc#es W 83/000 ,ould #ave been allocated to 'ull/
x 30 batc#es W 89/000 ,ould #ave been allocated to (ogs-

In a second-stae allocation/ t#e 83/000 allocated to t#e 'ull and Matador %roduction line ,ould #ave
been allocated to 500 units )or a cost o) 86 %er ,oodcut- '#is allocation is t#e sa$e as under t#e
traditional costin s*ste$ onl* because t#e batc# si+e o) 50 ,oodcuts %er batc# ,as oriinall* t#e
sa$e on bot# %roduction lines-

6)ter t#e batc# si+e is increased )or 'ull and Matador/ %roduction in)or$ation is as )ollo,s1
'ull (ogs *otal
Qu$ber o) ,oodcuts %roduced
Cirect $aterials costs
Cirect labor costs
Qu$ber o) batc#es
'otal over#ead
Eatc# setu% costs 0included in total
over#ead3
500
82/500
81/400
5
1/500
83/300
81/600
30
2/000
85/800
83/000
35
840/500
810/500

Qo, 6E" ,ould allocate costs as )ollo,s1

In t#e 4rst stae1 810/500 9 35 batc#es W 8300 %er batc# 0sa$e as be)ore3-

8300 %er batc# x 5 batc#es W 81/500 to 'ull and Matador 050O less t#an be)ore3/
8300 %er batc# x 30 batc#es W 89/000 to (ogs )laying )oker 0sa$e as be)ore3-

In t#e second stae/ t#e 81/500 is allocated to t#e 500 'ull and Matador ,oodcuts/ )or 83 %er ,oodcut-
'#is 83 %er ,oodcut re=ects t#e cost savins oriinall* antici%ated b* t#e $anaer o) t#e 'ull and
Matador %roduction line- '#e cost %er ,oodcut )or (ogs )laying )oker re$ains unc#aned 089/000 9
70
1/500 units W 863/ ,#ic# is a%%ro%riate because not#in #as c#aned on t#e (ogs )laying )oker
%roduction line-

ABC in the 2ervice 2ector:
6E" is as i$%ortant to co$%anies in t#e $erc#andisin and service sectors as to $anu)acturin
co$%anies- In )act/ alt#ou# t#e oriination o) 6E" is enerall* ascribed to $anu)acturin co$%anies in
t#e 1980s/ b* t#en #os%itals ,ere alread* allocatin over#ead costs to de%art$ents and t#en to %atient
services usin $et#ods si$ilar to 6E"- 5os%itals ,ere re7uired to i$%le$ent relativel* so%#isticated
allocation %rocesses in order to co$%l* ,it# !edicare rei$burse$ent rules- 6)ter its ince%tion in t#e
1960s/ !edicare establis#ed detailed rules reardin #o, over#ead costs s#ould be rou%ed into cost
%ools/ and t#e c#oice o) a%%ro%riate allocation bases )or allocatin over#ead costs to de%art$ents and
t#en to %atients- :it#in t#ese rules/ #os%itals ,ere able to $axi$i+e revenues b* s#i)tin costs )ro$
areas suc# as %ediatrics/ labor and deliver*/ and $aternit* 0,#ic# #ave lo, rates o) !edicare
utili+ation3 to t#e intensive care unit/ t#e critical care unit/ and surer* 0,#ic# #ave #i#er rates o)
!edicare utili+ation3- .t#er non-$anu)acturin industries t#at #ave bene4ted )ro$ 6E" include
4nancial services 4r$s and retailers-

ABC I"ple"entation Issues:
6not#er re4ne$ent in %roduct costin t#at o)ten acco$%anies i$%le$entation o) 6E" )ocuses on ste%
R2 o) t#e 4ve-ste% %roduct costin se7uence1 Midenti)* t#e direct costs associated ,it# t#e cost obDect-N
'#e re4ne$ent involves t#e )ollo,in- For a iven cost obDect/ t#e co$%an* atte$%ts to identi)* costs
currentl* treated as over#ead t#at #ave not beenZbut can beZtraced directl* to t#e cost obDect- In
ot#er ,ords/ costs are $oved )ro$ t#e over#ead cost %ool to t#e direct cost cateor*- For exa$%le/ an
accountin 4r$ $i#t ta(e certain oBce-su%%ort ex%enses )or$erl* treated as over#ead/ suc# as
%rintin and co%*in/ and start trac(in and assinin t#ese costs to s%eci4c Dobs 0audits/ tax
enae$ents/ etc-3 )or internal re%ortin and %ro4tabilit* anal*sis 0but not necessaril* )or client billin
%ur%oses3-

'#e success)ul i$%le$entation o) 6E" usuall* re7uires %artici%ation b* $anaers )ro$ non-accountin
)unctions/ suc# as %roduction and $ar(etin- Eecause 6E" )ocuses on activities/ and activities o)ten cut
across de%art$ents and )unctional areas/ i$%le$entin 6E" can i$%rove lines o) co$$unication and
coo%eration ,it#in t#e co$%an*- .n t#e ot#er #and/ $ore accurate cost allocation does not/ b* itsel)/
reduce costs- '#e initial $ove )ro$ a traditional costin s*ste$ to 6E" usuall* s#i)ts over#ead costs
)ro$ so$e %roducts to ot#er %roducts/ ,it# so$e $anaers M,inninN and so$e Mlosin-N Ho$e
co$%anies #ave )ound t#at #irin an outside consultin 4r$ to assist ,it# t#e 6E" ado%tion )acilitates
obtainin Mbu*-inN b* $anaers and e$%lo*ees t#rou#out t#e co$%an*- Ger#a%s %artl* )or t#is reason/
6E" i$%le$entation #as beco$e an i$%ortant consultin %roduct )or accountin 4r$s and )or $an*
consultin 4r$s-

6lt#ou# 6E" s#ould %rovide t#e co$%an* $ore accurate in)or$ation/ it is not a %anacea2 so$e
co$%anies t#at invested ti$e and $one* i$%le$entin 6E" did not reali+e t#e bene4ts t#e* ex%ected-
Ho$e o) t#ese co$%anies #ave reverted to si$%ler/ $ore traditional costin s*ste$s-

Eercises and Proble"s

$iscussion %uestion &&#&1 "olorado 6irlines is o%eratin at ca%acit* on its Cenver to Qe, \or( route/
o<erin t#ree =i#ts eac# da* on t#is route/ usin Eoein 737;s/ eac# ,it# a ca%acit* o) 120
%asseners- 6irline $anae$ent ,ants to deter$ine t#e least ex%ensive ,a* to increase dail* ca%acit*
)ro$ 360 %asseners to 480 %asseners- .ne %ossibilit* is to add one $ore Eoein 737 %er da*- '#e
ot#er %ossibilit* is to re%lace t#e current e7ui%$ent ,it# Eoein 727;s/ ,#ic# #old 160 %asseners
eac#- In eit#er case/ $anae$ent believes t#e %lanes ,ill continue to o%erate at ca%acit*-

'o ascertain t#e least ex%ensive ,a* to increase %assener ca%acit* on t#e Cenver-to-Qe, \or( route/
$anae$ent #as as(ed *ou to deter$ine ,#at MdrivesN t#e airline;s o%eratin costs-
71

Re'uired:
"onsider t#e )ollo,in cost drivers1

a3 Qu$ber o) =i#ts %er da*
b3 Qu$ber o) $iles =o,n %er da*
c3 Qu$ber o) %asseners served %er da*
d3 Qu$ber o) %assener $iles 0$iles =o,n %er da* $ulti%lied b* nu$ber o) %asseners3

For eac# o) t#e )ollo,in costs/ identi)* t#e $ost a%%ro%riate cost driver )ro$ t#e above list-

1- Gassener $eals
2- 6ir%lane )uel
3- Jround %ersonnel ,#o re)uel t#e %lane/ and $ec#anics on t#e round
4- Jround %ersonnel ,#o serve %asseners at t#e tic(et counter and at t#e ate-
5- "oc(%it cre, salaries 0Federal 6viation 6d$inistration reulations li$it %ilots to =*
no $ore t#an a certain nu$ber o) #ours %er $ont#3-
6- Fli#t attendant salaries 0assu$e t#at Federal 6viation 6d$inistration reulations
li$it =i#t attendants to =* no $ore t#an a certain nu$ber o) #ours %er $ont#/ and
re7uire one =i#t attendant )or ever* 40 %asseners3-
7- &cono$ic de%reciation o) t#e air%lane 0i-e-/ ,it#out reard to t#e de%reciation
$et#od c#osen )or accountin %ur%oses/ c#oose t#e cost driver t#at best ca%tures t#e
,ear and tear on t#e e7ui%$ent/ and deter$ines t#e econo$ic li)e o) t#e %lane3-
8- Gersonnel ,#o #andle baae

%%2&! You are the $hief 0inancial 5fficer of a large New Yor hospital that has decided to implement activity/based costing.
Which of the following would you choose as the allocation base for allocating the costs of the #inen and #aundry ;epartment to
the four patient wards that utili-e linen and laundry services, if your ob(ective is to generate the most accurate cost information
possible1 The four wards are9 >6? surgery, ><? adolescent care, >F? maternity and nursery, and >D? pediatric care.

>'? :atient occupancy rates >i.e., patient days? in each ward.

>%? The number of washing machines in the #aundry and #inen ;epartment

>$? The number of +edicare patients in each ward.

>;? The number of patient admissions to each ward.

%%2'! In which of the following situations are the techni2ues of activity/based costing most liely to lead to improved production
or mareting decisions.

>I? The 'll/;irect $ompany, which incurs significant direct costs, but no overhead costs, to manufacture its e"tensive and
ever/changing product line.

>II? The 5ne/Si-e/0its/'ll *at $ompany, which maes a single product that is sold to many different inds of retailers, in
varying volumes, through various mareting channels, in many different geographic regions.

>III? The Iowa Wind Turbine !lectric $ooperative, which has direct costs and fi"ed overhead, but no variable overhead.

>'? >I? and >II?, but not >III?

>%? >I? and >III?, but not >II?

>$? >I? only

0C3 0II3 onl*

&&#4: For a eneric $anu)acturin )acilit* 0i-e-/ ,it#out bein told ,#at t#e )actor* $a(es31

72
AI &ive two e"amples of overhead e"penses for which direct labor hours is a more appropriate allocation base than machine time.

:I &ive two e"amples of overhead e"penses for which machine time is a more appropriate allocation base than direct labor hours.

&&#:: '#e Hilver "it* !inin "o$%an* $ines co%%er and alu$inu$ in Hout#,estern Qe, !exico-
'raditionall*/ over#ead costs ,ere allocated to t#e t,o $etals based on direct labor #ours- Lsin t#is
$et#od in 2005/ over#ead costs %er ton are 850 )or alu$inu$ and 860 )or co%%er-

The company switched to activity/based costing, using multiple cost pools, and allocating each cost pool using an allocation base
that more accurately captures the cause and effect relationship between the mining operations and overhead costs. 'lso, several
overhead cost categories were reclassified as direct costs. The company had used an 'ctual $osting system prior to implementing
'%$ >i.e., overhead rates were calculated at the end of the year, when actual amounts were nown?, and continued to use 'ctual
$osting after implementation of '%$. To study the effect of the new '%$ system, it was retroactively applied to <==C, in order to
compare the results to the old method. Which of the following outcomes under the new system suggests that an error was made in
the calculation of overhead rates1

>'? The new overhead rates were JDC per ton of aluminum and JN< per ton of copper.

>%? The new overhead rates were JDC per ton of aluminum and JCG per ton of copper.

>$? The new overhead rates were JCC per ton of aluminum and JCG per ton of copper.

>;? The new overhead rates were JCC per ton of aluminum and JN< per ton of copper.

&&#*: '#e Hanta "ru+ "and* "o$%an* $a(es 4ve t*%es o) candies in its sole )actor*/ includin
c#ocolate truSes and c#ocolate $ints- 'ruSes are #and-di%%ed/ so $a(in truSes is labor-intensive/
and )urt#er$ore/ onl* t#e $ost ex%erienced 0and #i#est %aid3 e$%lo*ees can $a(e truSes-
Groduction o) $ints is #i#l* auto$ated1 t#e* don;t re7uire $uc# labor/ but t#e $ac#ine o%erators are
also #i#l*-s(illed and #i#l*-%aid- '#e $anaer o) truSes %roduction 0"and* Ao,ens(i3 and t#e
$anaer o) $ints %roduction 0"oco 5ernande+3 are discussin t#eir %re)erences )or #o, )actor*
over#ead s#ould be allocated to t#eir %roducts- '#e t#ree c#oices are direct labor dollars/ direct labor
#ours/ and $ac#ine #ours- .) course/ eac# $anaer ,ould li(e to re%ort t#e #i#est %ro4ts %ossible
)ro$ #er %roduct line-

Re'uired: In one/ t,o or t#ree 0no $ore t#an t#ree3 co$%lete sentences 0eac# sentence $ust #ave a
verb and a %eriod/ a$on ot#er ra$$atical co$%onents3/ %redict ,#at %osition eac# $anaer ,ill
ta(e ,it# res%ect to #er %re)erred allocation base/ and ex%lain *our reasonin-

&&#;: '#e Eraintree Furniture "o$%an* $anu)actures t,o lines o) )urniture1 an u%scale/ #andcra)ted
line called Ric#leau/ ,#ic# is %roduced in s$all 7uantities2 and a $ass-%roduced/ inex%ensive line
called Garticleboard- Eot# lines are $ade in t#e sa$e )actor*- Ric#leau is ver* labor intensive relative to
Garticleboard- Eraintree Dust s,itc#ed )ro$ a traditional costin $et#od t#at allocated over#ead based
on direct labor #ours to an activit*-based costin s*ste$- Lnder activit*-based costin/ t#e a$ount o)
over#ead allocated to Ric#leau ,ill be

063 #i#er t#an under t#e traditional costin $et#od-

0E3 lo,er t#an under t#e traditional costin $et#od-

0"3 eit#er #i#er or lo,er t#an under t#e traditional costin $et#od/ de%endin on t#e
underl*in econo$ics o) t#e business-

0C3 lo,er t#an under traditional costin/ as lon as activit*-based costin is i$%le$ented in
a ,a* t#at %rovides $ore accurate cost in)or$ation-

&&#+: '#e not-)or-%ro)it #ealt# clinic H#ots-[-Ls %rovides various t*%es o) vaccinations and ot#er s#ots/
es%eciall* =u s#ots/ to t#e %ublic )or )ree or )or a no$inal )ee- '#e clinic is )unded b* several local
overn$ental aencies as ,ell as b* a nu$ber o) c#aritable orani+ations- Hince di<erent donors ,is#
73
to )und di<erent t*%es o) s#ots/ t#e clinic deter$ines t#e )ull cost o) eac# t*%e o) s#ot/ b* addin
over#ead to t#e direct costs/ and t#en %rovides t#is in)or$ation to current and %ros%ective donors-

Follo,in are actual and budeted costs )or H#ots-[-Ls )or 20031
Actual Budgeted
Qu$ber o) %atient visits
Qu$ber o) s#ots ad$inistered

Fixed over#ead1 salaries/ rent )or t#e )acilit*/
insurance/ de%reciation-

Variable over#ead1 nursin sta< #oursl*
,aes/ utilities/ dis%osable su%%lies-

"ost o) #*%oder$ics 0a direct cost3

"ost o) $edications 0a direct cost3
5/000
6/000


894/000


866/000

81/000

830/000
4/000
4/500


8110/000


840/500

8750

820/000

:#ic# o) t#e )ollo,in is %robabl* not a sini4cant cost driver )or variable over#ead/ and #ence/ ,ould
%robabl* be a %oor c#oice as t#e cost allocation base )or allocatin variable over#eadI

063 '#e nu$ber o) s#ots ad$inistered

0E3 '#e dollar value o) t#e $edication ad$inistered

0"3 '#e nu$ber o) %atient visits

0C3 '#e a$ount o) nursin sta< ti$e s%ent ad$inisterin eac# t*%e o) s#ot

%%2-! :in In, Inc. has two products and two overhead cost pools9

Product A Product B In Total
Lnits %roduced
Cirect "osts 0%er unit31
!aterials
Aabor 0%aid 820 %er #our3
!aterials 5andlin cost %ool
&ver*t#in &lse cost %ool
200

810
820
50

820
840




824/000
876/000

A8 Lsin direct labor #ours as t#e allocation base/ ,#at is t#e over#ead rate )or !aterials 5andlin
over#eadI

B8 :#at is t#e total cost to $a(e eac# unit o) Groduct E/ i) all over#ead is allocated based on units
%roducedI

C8 5o, $uc# &ver*t#in &lse over#ead ,ould be a%%lied to eac# unit o) %roduct 6/ i) t#is cost %ool
is allocated to %roduct usin direct $aterials dollars as t#e allocation baseI

&&#&5: Follo,in is in)or$ation about 6+tec# Industries1

!odel A !odel B !odel C Total
Lnits %roduced
Cirect $aterials 0%er unit3
Cirect labor 0%er unit3

Cost driver in-or"ation:
300
850
820


500
875
850


200
8100
840


1/000




74
nu$ber o) %arts 0%er unit3
direct labor #ours 0%er unit3
s7uare )eet 0in total )or all units3

3verhead costs:
Aabor Hu%%ort
!aterials Hu%%ort
Facilit* "ost
'otal over#ead
20
3
400


42
4-60
600



30
4
1/000






822/000
833/000
890/000
8145/000

Lse activit*-based costin to calculate t#e total cost )or eac# !odel " #eater- 6llocate Aabor Hu%%ort
usin direct labor #ours/ !aterials Hu%%ort usin nu$ber o) %arts/ and Facilit* "ost usin s7uare )eet-

&&#&&: '#e "rouse 'ravel "o$%an* a%%lies over#ead to its international ca$%in tours usin activit*-
based costin- Follo,in is in)or$ation about t#e t#ree over#ead cost %ools1


Total $osts

'llocation %ase
Total Huantity of the 'llocation
%ase Incurred
'dministration
5perations
+areting
J<==,===
N==,===
6G=,===
Number of tours
Tourist travel daysY
Number of tourists
D=
N,===
N==

> 0or any given tour, the number of tourist travel days is the number of tourists multiplied by the number of days in the
tour. 0or e"ample, 6= tourists on a seven/day tour would constitute 8= tourist travel days.

AI $alculate the overhead rates.

:I 0ive of the D= tours were 6=/day trips to :atagonia. These tours averaged 6< tourists per trip. *ow much overhead would be
applied to these five :atagonia tours1

&&#&( 7A continuation o- *#&:8: Hister Rac#el recentl* attended a se$inar on activit*-based costin
#eld in Aas Veas- '#e ot#er sisters ,ere so$e,#at s(e%tical about Hister Rac#el;s attendance at t#is
%articular se$inar/ and s#e is eaer to %ut to use ,#at s#e learned t#ere- H#e suests t#at t#e
or%#anae i$%le$ent a re4ned costin s*ste$/ and s#e develo%s t#e )ollo,in in)or$ation-

"osts var* ,it# t#e ae o) t#e c#ildren- '#e nu$ber and aes o) c#ildren ,ere as )ollo,s1



(555

(55&

Gre-sc#ool
0aes 0 - 53

30

15

Gre-teen
0aes 6 - 123

30

32

'eenaers
0aes 13 - 183

'otal

20


80

25


72

&ver*one arees t#at 2000 ,as a ver* success)ul *ear )or t#e .r%#anae/ so t#e 2001 budet ,as
based on 2000 actual costs- '#e )ollo,in in)or$ation %ertains to 20001

2 Food costs %er $eal ,ere 84 )or %re-sc#oolers/ 85 )or %re-teens/ and 86-50 )or teenaers- 3
$eals are served %er da*/ 365 da*s %er *ear-
2 '#e cost o) clot#in is t,ice as $uc# 0%er c#ild3 )or teenaers as )or t#e ot#er t,o ae rou%s-
75
2 Aaundr* and linen costs %er c#ild do not var* ,it# t#e ae o) t#e c#ild- 5o,ever/ t#is cateor*
also includes t#e cost o) a dia%er service- 1Y3 o) %re-sc#ool c#ildren are in dia%ers/ and t#e cost
is 815 %er ,ee(/ 52 ,ee(s %er *ear-
2 &ducational costs do not a%%l* to %re-sc#ool c#ildren-
2 .nl* teenaers receive an allo,ance- '#e allo,ance is 820 %er ,ee(/ 50 ,ee(s %er *ear-

Re'uired:
A8 Identi)* t#e cost drivers )or t#e )ollo,in ex%enses1
063 Cia%er service
0E3 &ducational costs
0"3 6llo,ances

B8 Gre%are a =exible budet )or 2001/ $a(in use o) t#e in)or$ation co$%iled b* Hister Rac#el/ as
,ell as in)or$ation about 4xed costs )ro$ t#e oriinal 2001 budet-

C8 H#ould Hister Hara# be satis4ed ,it# t#e or%#anae;s 4nancial results and e<orts to control
costs in 2001I Erie=* ex%lain-

&&#&): '#e 601 Elue Kean "o$%an* #as decided to allocate t#e cost o) its :are#ouse and Cistribution
"enter to its custo$ers usin activit*-based costin/ in order to better assess %ro4tabilit* b* custo$er-
'#e ,are#ouse $anaer deter$ines t#at t#e onl* costs t#at are econo$icall* )easible to trace directl*
to t#e custo$er are outbound )rei#t costs- '#e $anaer t#en decides t#at t#e )ollo,in over#ead cost
%ools s#ould be allocated to custo$ers usin t#e )ollo,in cost drivers1

Overhead Cost /ool Cost Driver GAllocation :aseI
5rder :rocessing ;epartment
5rder 0illing ;epartment
Huality $ontrol ;epartment
Shipping ;epartment
Number of individual orders processed for that customer
Number of line items on all pull/ticets for that customer
Number of cartons shipped to that customer
Number of cartons shipped to that customer

0ollowing are relevant data for each overhead cost pool9

Order /rocessing Department
Total costs for this department
Total number of orders processed

Order 3illing Department
Total costs for this department
Total number of line/items on all pull ticets
Huality Control Department
Total costs for this department
Total number of cartons shipped

Shipping Department
Total costs for this department
Total number of cartons shipped

JF,===,===
<==,===


JD,===,===
D,===,===


JC==,===
<,===,===


J8,C==,===
<,===,===

3ollo$ing is in#ormation pertaining to t$o customers!

+2-2%% Stores!
Sales revenue for the year
Number of orders
Number of pull ticet line/items
Number of cartons
5utbound freight costs

MenTs Jarge and :ig Stores!
Sales revenue for the year

J<,D==,===
C==
6==,===
C=,===
J8C,===


J6,C==,===
76
Number of orders
Number of pull ticet line/items
Number of cartons
5utbound freight costs
<C=
<=,===
D=,===
JCN,===

1equired!
AI $ompute the overhead rates for each of the four overhead cost pools.

:I $alculate the amount of overhead that would be applied to 8/7/66 Stores

CI $alculate the amount of overhead that would be applied to +en,s #arge E %ig Stores

DI !"plain >in one or two sentences? or show >by calculation? how your answers to :arts >%? and >$? would change if the
company combined Huality $ontrol and Shipping into one overhead cost pool, and allocated overhead for this cost pool to
customers based on the number of cartons shipped to that customer.
C<A/T=1 %&! Allocation o# Service Department Costs

Chapter Contents!
/ Introduction
/ The ;irect +ethod
/ The Step/;own +ethod
/ The )eciprocal +ethod
/ Summary of service department cost allocation methods
/ ;ysfunctional incentives from service department cost allocations
/ !"ercises and problems

0ntroduction!
+any companies in all sectors of the economy, and not/for/profit and governmental organi-ations as well, allocate service
department costs to 3production4 or user departments, and ultimately to the products and services that they provide. 0or e"ample,
hospitals use sophisticated methods for allocating costs of service departments such as *ouseeeping, :atient 'dmissions, and
+edical )ecords to patient wards and outpatient services, and then to individual patients. *istorically, these allocations were
important to hospitals because +edicare reimbursement was based on actual costs. To the e"tent that the hospital allocated service
department costs to +edicare patients, +edicare covered these costs.

$ompanies that allocate service department costs do so for one or more of the following reasons9

6. To provide more accurate product cost information. 'llocating service department costs to production
departments, and then to products, recogni-es that these services constitute an input in the production process.

<. To improve decisions about resource utili-ation. %y imposing on division managers the cost of the service
department resources that they use, division managers are encouraged to use these resources only to the e"tent that
their benefit e"ceeds their cost.

F. To ration limited resources. When production departments have some discretion over their utili-ation of a service
department resource, charging production departments for the resource usually results in less demand for it than if
the resource were 3free4 to the production departments.

The motivation for the first reason, to provide more accurate product cost information, can be to improve decision/maing within
the organi-ation, to improve the 2uality of e"ternal financial reporting, or to comply with contractual agreements in regulatory
settings where cost/based pricing is used. 's discussed above, +edicare was historically a cost/based reimbursement scheme. 's
another e"ample, defense contractors that provide the U.S. military 3big ticet4 items such as airplanes and ships often operate
under cost/plus contracts, under which they are reimbursed for their production costs plus a guaranteed profit. In such settings, the
calculation of cost includes a reasonable allocation of overhead, including overhead from service departments.

The distinction between the second and third reasons is important in the conte"t of fi"ed versus variable costs. In connection with
the second reason, to improve decisions about resource utili-ation, from the company,s perspective, a division manager maing a
short/term decision about whether to utili-e service department resources should incorporate into that decision the service
department,s marginal costs, which are usually the variable costs. The manager should ignore the service department,s fi"ed costs
if these costs will not be affected by the manager,s decision. This reasoning suggests that only the service department,s variable
costs should be charged out.

77
*owever, in connection with the third reason, to ration a scarce resource, if the service department controls a fi"ed asset, and if
demand for the asset e"ceeds capacity, charging users a fee for the asset allows the service department to balance demand with
supply. The fee need not relate to the cost of obtaining the asset. rather, it is a mechanism for managing demand. !"amples would
be charging departments a 3rental fee4 for their use of vehicles from the motor pool, or for their use of a corporate conference
facility.

Service department costs can be allocated based on actual rates or budgeted rates. 'ctual rates ensure that all service department
costs are allocated. %udgeted rates provide service department managers incentives to control costs, and also provide user
departments more accurate information about service department billing rates for planning purposes. In either case, service
department costs should be allocated using an allocation base that reflects a cause/and/effect relationship, whenever possible.
*ere are some e"amples9

/ 'llocate building maintenance costs based on s2uare footage.
/ 'llocate costs of the company airplane based on miles flown.
/ 'llocate costs of the data processing department based on $:U time.

In some cases, companies benefit from allocating fi"ed costs using a different allocation base than variable costs. 0or e"ample,
fi"ed costs might be allocated based on an estimate of long/term usage by the production departments.

*istorically, there have been three alternative methods for allocating service department costs. These methods differ in the e"tent
to which they recogni-e that service departments provide services to other service departments as well as to production
departments. 'll three methods ultimately allocate all service department costs to production departments. no costs remain in the
service departments under any of the three methods.

The Direct Method!
The direct method is the most widely/used method. This method allocates each service department,s total costs directly to the
production departments, and ignores the fact that service departments may also provide services to other service departments.

=4ample! *uman )esources >*.).?, ;ata :rocessing >;.:.?, and )is +anagement >).+.? provide services to the +achining and
'ssembly production departments, and in some cases, the service departments also provide services to each other, as reflected in
the following table9

Total Cost Service
Dept
K of services provided by the service department listed at left to9
<1 D/ 1M Machining Assembly
J G=,=== <1 // <=K 6=K D=K F=K
6<=,=== D/ GK // 8K F=K CCK
D=,=== 1M // // // C=K C=K
J<D=,===

The amounts in the far left column are the costs incurred by each service department. The percentages in the other columns are the
percentage of each service department,s services provided to each department that utili-es the services of that service department.
These percentages are derived from some relevant measure of service department activity. 0or e"ample, the percentages for
human resources might be based on the number of employees in each department, or the number of new hires in each department.
The percentages for data processing might be based on the number of computers in each department. 'ny services that a
department provides to itself are ignored, so the intersection of the row and column for each service department shows -ero. The
rows sum to 6==K, so that all services provided by each service department to the other departments are accounted for.

Under the direct method, each service department is allocated separately, and the order in which the service departments are
allocated does not matter. Taing one row at a time, the percentages of the production departments are normali-ed, so that they
add up to 6==K while still reflecting the relative usage by the production departments >relative to all of the other production
departments?. 0or e"ample, in applying the direct method for the costs of human resources, +achining and 'ssembly are the only
production departments that used the services of the *uman )esources ;epartment in +arch, so the percentages in the columns
for machining and assembly are the only percentages that are relevant >the <=K for data processing and the 6=K for ris
management are ignored?. The denominator in the normali-ation process is the sum of the percentages of all of the production
departments. 0or e"ample, for the human resources row in the table below, the 8=K is the sum of D=K for machining and F=K for
assembly in the table above.

Total Cost Service
Dept
Normali-ed percentage of services provided by the service department listed at
left to the production departments9
<1 D/ 1M Machining Assembly
J G=,=== <1 // // // D=K S 8=K P C8K F=K S 8=K P DFK
6<=,=== D/ // // // F=K S GCK P FCK CCK S GCK P NCK
D=,=== 1M // // // C=K C=K
78
J<D=,===

The ris management service department percentages do not re2uire normali-ation, because this service department provided
services only to the production departments, it did not provide any services to the other service departments. The normali-ed per /
centages are then used to allocate each service department,s total costs to the production departments9

Total cost Service dept Machining Assembly
J G=,=== <1 C8K " JG=,=== P JDC,N== DFK " JG=,=== P JFD,D==
6<=,=== D/ FCK " J6<=,=== P JD<,=== NCK " J6<=,=== P J8G,===
D=,=== 1M C=K " JD=,=== P J<=,=== C=K " JD=,=== P J<=,===
J<D=,=== J6=8,N== J6F<,D==

The normali-ation process ensures that the sum of the costs allocated to the production departments e2uals the total costs incurred
by each service department, even though service/department/to/service/department services are ignored. 0or e"ample, JD<,=== of
data processing costs are allocated to machining and J8G,=== are allocated to assembly, and these two amounts sum to J6<=,===,
the total costs incurred by data processing.

The Step2Do$n Method!
The step2do$n method is also called the sequential method. This method allocates the costs of some service departments to
other service departments, but once a service department,s costs have been allocated, no subse2uent costs are allocated bac to it.

The choice of which department to start with is important. The se2uence in which the service departments are allocated usually
effects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose
when the se2uence is changed. *ence, production department managers usually have preferences over the se2uence. The most
defensible se2uence is to start with the service department that provides the highest percentage of its total services to other service
departments, or the service department that provides services to the most number of service departments, or the service
department with the highest costs, or some similar criterion.

=4ample! *uman )esources >*.).?, ;ata :rocessing >;.:.?, and )is +anagement >).+.? provide services to the +achining and
'ssembly production departments, and in some cases, the service departments also provide services to each other9

Total Cost Service
Dept
K of services provided by the service department listed at left to9
<1 D/ 1M Machining Assembly
J G=,=== <1 // <=K 6=K D=K F=K
6<=,=== D/ GK // 8K F=K CCK
D=,=== 1M // // // C=K C=K
J<D=,===

The amounts in the far left column are the costs incurred by each service department. 'ny services that a department provides to
itself are ignored, so the intersection of the row and column for each service department shows -ero. The rows sum to 6==K, so
that all services provided by each service department are charged out.

The company decides to allocate the costs of *uman )esources first, because it provides services to two other service
departments, and provides a greater percentage of its services to other service departments. *owever, a case could be made to
allocate ;ata :rocessing first, because it has greater total costs than either of the other two service departments. In any case, the
company decides to allocate ;ata :rocessing second.

In the table below, the row for each service department allocates the total costs in that department >the original costs incurred by
the department plus any costs allocated to it from the previous allocation of other service departments? to the production
departments as well as to any service departments that have not yet been allocated.

<1 D/ 1M Machining Assembly
$osts prior to allocation J G=,=== J6<=,=== JD=,=== // //
'llocation of *.). >J G=,===? 6N,=== G,=== JF<,=== J<D,===
'llocation of ;.:. >6FN,===? 6=,FDG DD,FDG G6,F=D
'llocation of ).+. >CG,FDG? <7,68D <7,68D
= = = J6=C,C<< J6FD,D8G

'fter the first service department has been allocated, in order to derive the percentages to apply to the production departments and
any remaining service departments, it is necessary to 3normali-e4 these percentages so that they sum to 6==K. 0or e"ample, after
*.). has been allocated, no costs from ;.:. can be allocated bac to *.). The percentages for the remaining service and
production departments sum to 7<K >8K R F=K R CCK?, not 6==K. Therefore, these percentages are normali-ed as follows9

79
)is +anagement9 8K S 7<K P 8.N6K
+achining9 F=K S 7<K P F<.N6K
'ssembly9 CCK S 7<K P C7.8GK
Total9 6==.==K

0or e"ample, in the table above, C7.8GK of J6FN,=== >P JG6,F=D? is allocated to 'ssembly, not CCK.

The characteristic feature of the step/down method is that once the costs of a service department have been allocated, no costs are
allocated bac to that service department. 's can be seen by adding J6=C,C<< and J6FD,D8G, all J<D=,=== incurred by the service
departments are ultimately allocated to the two production departments. The intermediate allocations from service department to
service department improve the accuracy of those final allocations.

The 1eciprocal Method!
The reciprocal method is the most accurate of the three methods for allocating service department costs, because it recogni-es
reciprocal services among service departments. It is also the most complicated method, because it re2uires solving a set of
simultaneous linear e2uations.

Using the data from the step/down method e"ample, the simultaneous e2uations are9

*.). P J G=,=== R >=.=G " ;.:.?
;.:. P J6<=,=== R >=.<= " *.).?
).+. P J D=,=== R >=.6= " *.).? R >=.=8 " ;.:.?

Where the variables *.)., ;.:. and ).+. represent the total costs to allocate from each of these service departments. 0or e"ample,
*uman )esources receives services from ;ata :rocessing, but not from )is +anagement. GK of the services that ;ata
:rocessing provides, it provides to *uman )esources. Therefore, the total costs allocated from *uman )esources should include
not only the JG=,=== incurred in that department, but also GK of the costs incurred by ;ata :rocessing. Solving for the three
unnowns >which can be performed using spreadsheet software?9

*.). P U -%,.)+
;.:. P U%',,&%%
).+. P U ),,+,%

*ence, costs are allocated as follows9

<1 D/ 1M Machining Assembly
$osts prior to allocation JG=,=== J6<=,===JD=,=== // //
'llocation of *.). GU-%,.)+I 6G,<66 7,6=N JFN,D<F J <8,F68
'llocation of ;.:. 66,=C8 G%',,&%%I 7,N8C D6,DNF 8N,=6N
'llocation of ).+. G),,+,%I <7,F7= <7,F7=
J = J =J = J6=8,<8N J6F<,8<F

To illustrate the derivation of the amounts in this table, the JFN,D<F that is allocated from *uman )esources to +achining is D=K
of *.).,s total cost of J76,=C8.

Summary o# Service Department Cost Allocation Methods!
The direct method and step/down method have no advantages over the reciprocal method e"cept for their simplicity, and the step/
down method is sometimes not very simple. Nevertheless, the reciprocal method is not widely used. &iven advances in computing
power, the reciprocal method would seem to be accessible to many companies that are not using it. :resumably, these companies
believe that the benefits obtained from more accurate service department cost allocations do not (ustify the costs re2uired to
implement the reciprocal method. In fact, many companies do not allocate service department costs at all, either because they do
not thin these allocations are beneficial, or because they do not believe that the benefits (ustify the costs.
Dys#unctional 0ncentives #rom Service Department Cost Allocations!
The incentives that service department cost allocations impose on managers and employees should be carefully considered. In
some cases, these allocations have unintended and undesirable conse2uences. 0or e"ample9

6. 't one university, professors are 3charged4 for office telephone usage, which includes a fi"ed monthly fee similar to
the flat fee that is charged for residential telephone service. The 3charge4 comes out of the professor,s 3research
allowance,4 which can otherwise be used for professional e"penses such as (ournal subscriptions, professional
organi-ation dues, and travel to conferences. Since the flat fee >as opposed to the long distance charges? is unavoidable, it
does not affect the professors, behavior, but it is viewed negatively, because the research allowance is effectively several
hundred dollars a year less than 3advertised4 by the administration.
80

<. 't another university, state/of/the/art computer e2uipment in the classrooms is purchased out of student fees.
$onse2uently, this e2uipment is readily available and 3free4 to the faculty when they teach. *owever, when a professor
reserves a room for a non/teaching purpose, such as a research presentation to fellow faculty, the Instructional
Technology service center 3charges4 the professor,s department appro"imately JC= to use the e2uipment, which is far in
e"cess of the e2uipment,s marginal cost >the depreciation on the bulb in the pro(ector?. The JC= charge is sufficient to
dissuade many departments from using the e2uipment for non/instructional purposes, so the e2uipment sits idle, and the
professors use a 3low tech4 solution9 an overhead pro(ector and transparencies.

=4ercises and /roblems

%&2%! The %ola Tie $ompany has two service departments >;epartments ' and %? and three production departments >;epartments
T, Y and W?. Service ;epartment ' provides services to all three production departments as well as to Service ;epartment %.
*owever, Service ;epartment % only provides services to the other service department >;epartment '?. In other words, Service
;epartment % provides no services directly to the production departments. Which of the following methods for allocating service
department costs maes the most sense in this situation1

>'? The direct method.

>%? The step/down method, beginning with Service ;epartment '.

>$? The step/down method, beginning with Service ;epartment %.

>;? We would want to now the costs incurred by each service department before determining which allocation method maes
the most sense.

%&2&! The 3%ig 5ne4 accounting firm has three divisions9 audit, ta" and consulting. two support departments9 administration and
human resources. The following table shows the utili-ation of support department services by the user departments9

'dministration *uman )esources 'udit Ta" $onsulting
'dministration 6=K F=K <CK FCK
*uman
)esources
6=K F=K FCK <CK

Which of the following allocation methods will result in the smallest allocation of support department costs to the $onsulting
;ivision1

>'? The direct method.

>%? The step/down method, beginning with 'dministration.

>$? The step/down method, beginning with *uman )esources.

>;? $annot be determined from the information given.

%&2'! 5ne advantage of the step/down method of allocating service department costs to production departments, over the direct
method, is the following9

>'? Some interaction among service departments >i.e., service departments providing services to other service
departments? is accounted for.

>%? The step/down method is easier to apply >i.e., it is less complicated?.

>$? 'll service department costs are eventually allocated to production departments.

>;? 'll interaction among service departments >i.e., service departments providing services to other service
departments? is accounted for.

%&2(! The +IS department of $oldwater Industries provides services to two other service departments >'ccounting and
:ersonnel? and two factories. The cost of operating the +IS department is J6==,=== annually. The volume of services provided to
'ccounting, :ersonnel, and the factories is measured by the number of computer terminals in each area.

0actory T 0actory Y 'ccounting :ersonnel
81
Number of terminals9 F= 6= D= <=

Using the direct method of service department allocation, calculate the allocation of +IS costs to 0actory T.

%&2)! 'mber Industries has two service departments9 *uman )esources >*.).? and 'ccounting. These two service departments
provide services to each other, and to three factories, as shown in the following table9



Service
;epartment
Service
;epartment
5perating $osts
:ercentage of services provided by
the service department indicated in the
far left column to each of the factories and
service departments
<1 Accounting 3actory A 3actory : 3actory C
*.). JFC=,=== 6CK FCK D=K 6=K
'ccounting JGG=,=== <CK <CK 6CK FCK


1equired! $alculate the amount of service department costs that will be allocated to each of the factories, using the ;irect
+ethod of service department cost allocation.

%&2*! &lobal/+ega/$orp allocates the costs of three service departments to its three production departments. The following table
shows the percentage of services that each service department provides to each production department and to the other two service
departments9
*uman
)esources
;ata
:rocessing
#egal
;epartment
:roduction
;ept 6
:roduction
;ept <
:roduction
;ept F
*uman )esources 6CK 6CK FCK 6CK <=K
;ata :rocessing 6CK 6=K <CK F=K <=K
#egal ;epartment 6CK <CK <CK <=K 6CK

The following table shows the costs incurred by each service department, prior to the allocation of any service department costs to
the other service departments9

*uman )esources
;ata :rocessing
#egal ;epartment
J6=6,===
JF<D,===
J<CF,===

1equired! Using the ;irect +ethod of service department cost allocation, calculate the total service department costs that are
allocated to each production department.

%&2+! ' company has three service departments that provide services to each other and to four production departments. ;etails for
<==C are shown below9

<uman 1esources
Accounting
Data /rocessing
$osts incurred to run the department9 J8==,=== J6,<==,=== J6,D==,===
'llocation base used to allocate costs of the service
department to the four production departments9
0T!,s >full/time
employee
e2uivalents?
Invoices
processed
V of computers
'mount of services provided by the service
department to itself and to each of the recipient
departments, as measured by the 2uantity of the
allocation base incurred in each department9

*uman )esources 7 DN8 6F
'ccounting <F 668 <C
;ata :rocessing F< GF D=
:roduction ;epartment ' 6=6 <<F F<
:roduction ;epartment % 6C8 F67 DD
:roduction ;epartment $ FF DDD F8
:roduction ;epartment ; N7 67= 68
Total 2uantity of the allocation base

D<D 6,GDF <=G

82
1equired! Using the ;irect +ethod of service department cost allocation, what are the total service department costs from the
three service departments that will be allocated to production department %1

%&2,! The 0ranlin $orporation allocates the costs of three service departments to its three production departments. The following
table shows the percentage of services that each service department provides to each production department and to the other two
service departments9

Service ;ept
'
Service ;ept
%
Service ;ept
$
:roduction
;ept 6
:roduction
;ept <
:roduction
;ept F
Service ;ept ' <=K <=K F=K 6=K <=K
Service ;ept % 6CK 6=K <CK F=K <=K
Service ;ept $ 6CK <CK F=K <=K 6=K

The following table shows the costs incurred by each service department, prior to the allocation of any service department costs to
the other service departments9

Service ;ept '
Service ;ept %
Service ;ept $
J G=,===
J6<D,===
J6CF,===

1equired!
AI Using the ;irect +ethod of service department cost allocation, calculate the total service department costs that are
allocated to each production department.

:I Use the Step/;own +ethod of service department cost allocation, and calculate the total service department costs
allocated to :roduction ;epartment 6. 'ssume that Service ;epartment ' is allocated first, then Service ;epartment $,
and finally Service ;epartment %.

%&2-! State 0armers Insurance $ompany has three revenue/generating divisions9 :roperty Insurance, #ife Insurance, and
'utomobile Insurance. The #egal ;epartment is a service department that provides services to these three revenue/generating
divisions, and not to any other department. To allocate legal department costs to the user departments, the lawyers in the #egal
;epartment trac the hours they spend providing services to each department. >These hours are called 3lawyer/billed4 hours.?
)elevant information about lawyer/billed hours is as follows9

/ea7 Demand Average Demand Actual May Usage
:roperty Insurance ;ivision
#ife Insurance ;ivision
'utomobile Insurance ;ivision
N== hours
<== hours
<== hours
F== hours
6G= hours
6G= hours
D<= hours
68= hours
6G= hours

The #egal ;epartment budgets fi"ed costs at J6==,=== monthly, and variable costs at J6N per lawyer/billed hour. ;uring +ay,
actual costs incurred were as follows9 J8=,=== in fi"ed costs, and J8,=== in variable costs.

1equired!
AI What is the actual cost per lawyer/billed hour, using actual costs >fi"ed and variable? and the actual level of activity for the
month1

:I 'llocate +ay legal costs to the 'uto ;ivision, using the rate calculated in :art >'?, based on actual usage.

CI What amount of legal costs for +ay will be allocated to the #ife ;ivision if a dual allocation rate is used, in which budgeted
fi"ed costs are allocated based on pea usage re2uirements, and budgeted variable costs are allocated based on actual usage1
C<A/T=1 %'! The 1ole o# Cost in Setting /rices

Chapter Contents!
/ Introduction
/ Short/run pricing decisions
/ Intermediate/run pricing decisions
/ #ong/run pricing decisions
/ :ricing decisions when the demand function is unnown
/ )egulated monopolies
/ $ost/plus contracts
/ ;isputes under cost/plus contracts
83
/ Intra/company sales
/ The role of cost in the legal resolution of disputes over pricing
/ The downward demand spiral
/ !"ercises and problems

0ntroduction!
This chapter discusses the role that product costs play in setting sales prices. 0or most companies operating in competitive
marets, as well as for unregulated monopolies >such as a pharmaceutical company that has a drug under patent with no close
substitutes?, the most important factor in setting the profit/ma"imi-ing sales price is the elasticity of demand >the sales demand as
a function of price?. The elasticity of demand is affected by such factors as competitors, prices, consumers, preferences, and the
availability of substitute goods. Ignoring the elasticity of demand, and setting the sales price based on cost of production >such as
full cost plus F=K? is generally a really bad idea.

Nevertheless, production costs do play a supporting role in setting prices generally, and for a relatively small number of products
and marets, production costs play the lead role.

Short21un /ricing Decisions!
5ccasionally, a company faces a sales opportunity for which the only relevant costs and revenues are the incremental costs and
revenues for that one transaction. In this situation, accurate information about marginal costs are important, because the company
should be willing to set the sales price at any amount in e"cess of marginal cost >marginal production cost plus any marginal non/
manufacturing costs such as distribution and mareting costs?. Typically, marginal production costs consist of all variable
production costs.

These opportunities probably occur relatively infre2uently >certainly less often, for e"ample, than one might infer from !liyahu
&oldratt,s popular business novel The Goal?. 'mong the conditions that are typically re2uired for the optimal sales price to
depend only on the variable costs of the one transaction the company now faces are9 >6? e"cess production capacity >so that the
sales order does not displace e"isting orders?. ><? a one/time customer >since the price the customer is willing to pay in the future
might depend on the price the customer pays today?. and >F? a customer not in the company,s normal sales channels >because if
other customers learn that the company has given another customer a price brea, they are liely to demand similar concessions?.

0ntermediate21un /ricing Decisions!
5ver the course of several months to a year or two, costs associated with many fi"ed assets are unavoidable, but the company can
mae meaningful decisions about product prices, production levels and product mi". 0or these decisions, microeconomics
provides analytical tools for (ointly determining the optimal sales price and production level to ma"imi-e profits. The solution to
this problem depends on the elasticity of demand and also on variable production costs >marginal production cost, in the
terminology of economics?.

Jong21un /ricing Decisions!
In the long/run, all fi"ed costs become relevant costs. 0actories and warehouses can be built, rebuilt, purchased or sold. Salaried
employees can be hired, fired, reassigned, or given incentives to resign or retire. #ong/term leases and other contracts come up for
renewal. In the long/run, the company,s revenues must e"ceed its costs, if it is to survive. Therefore, the management accounting
system should provide managers information about whether sales prices for products are sufficiently in e"cess of their full cost of
production to cover non/manufacturing costs and still provide the company a reasonable rate of return. +anagement should
consider dropping products that are unable to cover their full costs >manufacturing costs plus non/manufacturing costs?, unless
there are e"tenuating circumstances such as a product that serves as a 3loss leader4 >e.g., sell the in(et printer at or near cost, and
mae high profit margins on sales of in cartridges?. The timing for eliminating unprofitable products might depend on when the
costs of fi"ed assets associated with those products can be avoided.

/ricing Decisions $hen the Demand 3unction is Un7no$n!
0or new products, the demand function is often unpredictable. 'lso, important macro/economic, political and technological
changes can create significant uncertainty about the demand function. In these situations, the sales price might be based on cost of
production. 's better information about the demand function becomes nown over time, this information should then be
incorporated into pricing decisions.

1egulated Monopolies!
Natural monopolies that provide essential services are usually regulated. Traditionally, utility companies that provide electricity,
natural gas and telephone service have been natural monopolies in their local service areas. When these services are provided by a
for/profit company, as opposed to a municipality or cooperative, a regulatory agency determines the rates that the company is
allowed to charge customers, in order to cover its costs and earn a reasonable return on its investment. *ence, rate/setting re2uires
the determination of the utility company,s cost of providing the service. In effect, sales prices for the utility company are based on
its costs.

84
In the telecommunications industry, changes in technology have created competition that did not e"ist before. 0or e"ample, one
can easily purchase cellular phone service from one of a number of providers, and entirely avoid the company that provides local
land/line telephone service. $hanges in laws and technology permit customers to purchase long distance telephone service from
any of a number of providers. 'ttempts have been made to deregulate the electric and natural gas marets, although the results
have been mi"ed with respect to consumer welfare. When an industry that was previously a natural monopoly becomes a
competitive maret, regulatory rate/setting is no longer necessary.

Cost2/lus Contracts!
In a few speciali-ed marets, sales prices are often based on cost. The U.S. ;efense ;epartment fre2uently contracts with
companies for the design and manufacture of military e2uipment using cost/plus contracts9 the contractor receives reimbursement
for production costs plus a negotiated profit. $ost/plus contracts are useful when it is difficult for the manufacturer to predict
production costs, when product specifications may have to change after the contract is signed, or when there is only one logical
supplier. +ilitary e2uipment with long design and production lead/times, such as comple" weapons systems and aircraft, often
meet one or more of these criteria.

'n important purpose of cost/plus contracts is to transfer ris from the seller to the buyer. 0or e"ample, given the uncertainty
surrounding the cost of building the ne"t/generation Navy submarine, it is possible that no company capable of undertaing the
pro(ect would be willing to do so, if the company were re2uired to commit to a price beforehand. ' significant cost overrun could
banrupt the company. $onversely, if the contracted price significantly e"ceeded actual cost, the large profits that would be earned
by the defense contractor could cause the military considerable political embarrassment. $ost/plus contracts avoid both issues by
ensuring that the defense contractor earns a reasonable profit.

+edicare, which was discussed earlier, is another government program that originally used a cost/plus reimbursement scheme.
'nother e"ample is 0ederal support of scientific research. National Science 0oundation grants usually allow grant money to be
used to cover the direct costs of the research as well as a share of institutional overhead. The indirect cost reimbursement rate is
based on estimates of the indirect costs of the grant recipient. In other words, the indirect cost reimbursement rate is institution/
specific. When the researcher is employed by a university, which is often the case, these indirect costs can include general and
administrative e"penses that sometimes appear far removed from the researcher and department that receives the grant.

In the entertainment industry, actors and writers sometimes sign contracts that provide them a percentage of the profits from a
movie or television show. These contracts are not cost/plus contracts, but they do incorporate cost in the determination of the
amount to be received by the actor or writer. )is sharing in this situation does not apply so much to uncertainty about the cost of
production, as to uncertainty about revenue. These contracts allow the actor or writer to share in the upside potential of the pro(ect.
Disputes under Cost2/lus Contracts!
There are fairly comple" guidelines for how government contractors can allocate overhead. These rules have been promulgated by
the $ost 'ccounting Standards %oard. Within these guidelines, contractors that are woring on a mi" of cost/plus contracts and
traditional fi"ed fee contracts have incentives to allocate as much overhead as possible to the cost/plus contracts and away from
fi"ed fee contracts. The fi"ed fee contracts could represent sales to government agencies or to commercial enterprises. To the
e"tent that overhead is allocated to the cost/plus contracts, the contractor will be reimbursed for those overhead costs. *eadlines
sometimes report apparently e"cessive charges under cost/plus contracts, such as JC== toilet seats for military airplanes. Usually,
these amounts reflect the allocation of large amounts of overhead, including research and design, to a relatively small production
run and they are not improper.

5n the other hand, contractors also have incentives to shift direct costs from fi"ed fee contracts to cost/plus contracts, and this
type of cost/shifting constitutes fraud. Several cases have arisen over the past few decades in which defense contractors have been
accused of this practice, as well as other practices involving the improper treatment of overhead.

In the 677=s, Stanford University came under public scrutiny for allegedly including in its indirect cost pool, for the purpose of
determining reimbursement rates on 0ederal grants, the cost of depreciation on a yacht that had been donated to the University,
and the cost of e"pensive linen at the University :resident,s house. The inclusion of these costs was apparently not a concerted
effort to increase the reimbursement rate. In point of fact, however, Stanford had one of the highest reimbursement rates of any
university in the nation, and Stanford put on seminars, attended by personnel from other universities, on how to ma"imi-e
reimbursement under 0ederal grants. 't one point, University :resident ;onald Iennedy remared 3I e"pect our controllers to do
their best on behalf of the university.4 There were $ongressional hearings, and the scandal prompted Iennedy to resign.

There have been so many public allegations over the years by actors and writers that film and television studios overstate costs,
and thus significantly reduce or completely eliminate the incentive component of the actor,s or writer,s contract, that it is difficult
to understand why artists continue to sign these contracts. Stan #ee, creator of Spiderman, sued +arvel in <==<, claiming that his
contract entitled him to 6=K of +arvel,s profits whenever his characters were used in film or television. The lawsuit asserted that
the first Spiderman movie had grossed more than JD== million, that +arvel had reported millions of dollars in earnings from the
movie, but that #ee had not received a penny. +arvel issued a statement that Stan #ee was well/compensated for his contributions
85
to the industry, and that +arvel was in compliance with its contract with #ee, which probably meant that there were no 3profits4
from the movie as 3profits4 are defined in the company,s contract with #ee.

'ctors and writers would be on surer ground signing contracts based on a percentage of revenues, which are less susceptible to
manipulation than profits.

0ntra2Company Sales!
The cost of production is often used as the basis for setting the sales price for internal sales of product that sometimes occur from
one part of a company to another part of the same company. These internal sales are called transfers, and the topic is referred to as
transfer pricing. $hapter <F discusses transfer pricing. +ost companies that use a cost/based transfer price include an allocation of
fi"ed costs in the determination of cost.

The role o# cost in the legal resolution o# disputes over pricing!
0or the most part, aside from the e"ceptions noted above, most companies conducting business in the U.S. are free to charge
whatever they want for their products. There are, however, laws that prevent certain types of price discrimination and predatory
pricing practices. :rice discrimination consists of charging different customers different amounts for the same product. :redatory
pricing consists of charging low prices in an attempt to drive a competitor out of business >or out of the local maret?.

The Sherman 'ct of 6G7= prohibits companies from monopoli-ing trade, conspiring in restraint of trade, or engaging in predatory
pricing. The $layton 'ct of 676D elaborated on the Sherman 'ct, and made price discrimination illegal. The concern at that time
was that manufacturers were granting lower prices to large customers, and the purpose of the $layton 'ct was to encourage
competition among retailers by allowing small retailers to buy merchandise at the same price as large retailers. In effect, the
concern that $ongress was addressing at the beginning of the last century mirrors the concern of many people today about the
proliferation of large, national retail chains lie Wal/+art at the e"pense of small, locally/owned 3+ain Street4 stores.

The $layton 'ct was amended by the )obinson/:atman 'ct in 67FN. This 'ct delineates three defenses against a charge of price
discrimination. The first defense is that the manufacturer is allowed to offer volume discounts. This defense gives large retailers a
great advantage. The second defense is that price can reflect differences in manufacturing costs, which might arise, for e"ample,
from different product specifications by different customers. The third defense is that manufacturers are allowed to meet
competitors, prices, even if doing so results in charging lower prices in one geographic maret >where the competitor has a
presence? than in other locations.

The resolution of disputes that arise under these laws usually involves a determination of the manufacturer,s costs. *owever, the
$ongressional 'cts identified above do not specify how cost is to be determined. *ence, this issue was left to the courts. $ase law
has resulted in a determination that marginal cost is to be used.

$onsidering the three defenses specified in the )obinson/:atman 'ct, the courts, determination of how costs are to be calculated,
and the fact that price discrimination applies only to manufacturing companies >not to service sector companies?, it would seem
very difficult for any plaintiff to prevail in a lawsuit alleging either price discrimination or predatory pricing. )ecently, the
Supreme $ourt defined predatory pricing as a situation in which a company sets prices below average variable cost, with plans to
raise prices later to recover the temporary losses >Brooe Group "td# vs# Bro$n % &illiamson To!acco 'orp#, 677F?. The Supreme
$ourt then interpreted economic theory as indicating that predatory pricing does not wor. In effect, the $ourt appears to have
asserted that predatory pricing cannot succeed, and that therefore, it is unreasonable to assert that any company would engage in
it. In the subse2uent F8 predatory pricing cases, the defendants prevailed. In <==6, a 0ederal (udge threw out a high/profile legal
action brought by the @ustice ;epartment against 'merican 'irlines that alleged predatory pricing in the ;allasM0ort Worth
maret.

:redatory pricing also applies to international trade. 'nti/dumping laws preclude foreign companies from dumping product onto
domestic marets, which refers to selling large 2uantities of product at unusually low prices. Such actions by foreign competitors
can drive domestic industries out of business, and in fact, there are fre2uent accusations that this is the intent of dumping. U.S.
anti/dumping laws stipulate that the import price into the U.S. cannot be lower than the cost of production. The World Trade
5rgani-ation found that the number of cases brought under anti/dumping laws increased FCK from 677C to <===.

The Do$n$ard Demand Spiral!
If sales price is established based on cost of production, and if cost of production includes an allocation of fi"ed costs, then the
cost/based price will be a decreasing function of sales volume. Thus, if sales volume increases, the per/unit sales price decreases.
and if sales volume decreases, the per/unit sales price increases. If in addition, the demand function is decreasing in price, which
normally would be the case, then this situation can result in something called the do$n$ard demand spiral >occasionally called
the death spiral. we accountants are so dramatic?.

Start with either a decrease in demand for the product, or an increase in fi"ed costs. The downward demand spiral refers to the
reduction in demand that can occur if prices are raised to recover the higher fi"ed cost per unit of product, which in turn induces
86
another price increase, because fi"ed costs must be recovered from a smaller customer base, which leads to another drop in
demand, etc., etc.

The downward demand spiral does not occur often, and when it does, it probably occurs most fre2uently for 3internal sales4 by
service departments. In this setting, service departments might view demand as relatively inelastic, when in fact, user departments
might be surprisingly creative in finding either less costly e"ternal service providers, or alternative in/house solutions. 0or
e"ample, there is a story about a downward demand spiral that supposedly occurred in the typing pool of a high/tech company in
the 678=s or 67G=s. The typing pool charged out its services on a per/page basis at a time when managers were becoming
increasingly proficient with destop computers and word/processing software. 's managers became more proficient with the
technology, their demand for the typing pool decreased, which resulted in higher per/page costs, which prompted more managers
to avoid the typing pool, to the point where the cost/per/page was ridiculously high.

=4ercises and /roblems!

%'2%! In a controversial decision, $ongress withdraws funding from the ne"t generation of aircraft carriers and reassigns the
money to public schools, particularly for improving education in art history and comparative literature.

In a move that stuns the nation, the Secretary of the Navy taes advice from a bumper sticer and announces that the Navy will
hold a bae sale to fund the new aircraft carrier. Navy personnel have minimal training in baing, so the Navy decides to
outsource some production, including the purchase of C8=,=== lemon bars from Nabisco.

The Navy is accustomed to buying e2uipment lie (et fighters and missiles under cost/plus contracts. Under a cost/plus contract,
the Navy pays the defense contractor for the cost of production plus a predetermined profit. $ost/plus contracts have the
advantage of encouraging defense contractors to accept pro(ects for which there is a great deal of uncertainty about the cost. In
other words, cost/plus contracts minimi-e ris to the contractor.

Not nowing any better, the Navy,s procurement officer signs a cost/plus contract with Nabisco on +arch 6
st
for the lemon bars.
The Navy agrees to pay Nabisco the full cost >variable plus fi"ed? of manufacturing each lemon bar, plus <= cents. These costs are
based on actual costs >not budgeted costs?. Nabisco must manufacture all of the lemon bars by +arch F6
st
. %ecause each lemon
bar has powdered sugar on top forming the outline of an anchor, none of Nabisco,s current inventory of lemon bars can be used
for the contract.

Nabisco will manufacture the lemon bars in its factory in !urea, $alifornia. This factory is already dedicated to lemon bar
production. It is currently producing D==,=== lemon bars per month for supermarets. >This satisfies demand. lemon bars are not
as popular as they once were.? 't this production level, variable manufacturing costs >mostly ingredients, utilities and factory
labor? total JF==,=== per month. The factory,s fi"ed costs are JC==,=== per month >mostly depreciation e"pense on building and
e2uipment, administrative costs and managerial salaries?. 0actory capacity is one million lemon bars per month, so the factory has
sufficient unused capacity to meet current demand and also fulfill the Navy contract. The variable manufacturing cost per bar
should be the same for the Navy contract as for current production. Aariable mareting and selling costs are 6= cents per lemon
bar for sales to supermarets, but these costs are not incurred in connection with lemon bars produced for the navy contract.
Nabisco sells lemon bars to supermarets at an average sales price of J6.C= per bar.

1equired!
AI $alculate the total price per lemon bar that the Navy will pay Nabisco.

:I $alculate the total profits that the contract will generate for Nabisco.

CI Now assume that the factory stops manufacturing lemon bars for its usual customers, and only maes lemon bars for the Navy
>so production is reduced to C8=,=== bars?. Now calculate the total price per lemon bar that the Navy will pay Nabisco.

%'2&! The $hildrenUs $arousel in the municipal par in #ae Wobegon is evaluating its ticet prices and operating hours. It is open
0riday through Tuesday during the summer months for 6C wees. The following information pertains to last yearUs summer
season. $osts are e"pected to remain the same for this year.

'verage riders per day
Aariable operating costs per day when open
>e.g., operator,s salary, ticet taer,s salary, electricity,
fee assessed by the city for par security and maintenance?
0i"ed overhead costs per year
+areting costs per year
$ustomer service costs per year
Ticet sales price
<C=
JG<=


JFN,===
6<,C==
6,===
N.C=

87
1equired!
AI What is the unit cost basis >i.e., cost per rider? for establishing a long/run price for ride ticets1

:I It is 'pril, and the carousel has not yet opened for the year. The manager, *illary &rover $leveland $linton, wants to open
the carousel all wee, including Wednesdays and Thursdays. She is willing to do this as long as it doesnUt decrease her
overall profits for this year. ' study suggests that attendance on these two days would average <== riders daily, but that
attendance on the other days of the wee would drop by C= per wee. ' special one/time promotion to advertise the
Wednesday and Thursday hours will cost J6=C=. *ow much should the manager charge per ticet for Wednesdays and
Thursdays this summer if she wants to brea even from the decision to e"pand the hours of the carousel1 In other words,
her incremental profits this year from the e"pansion should be -ero. *ow much should she charge on Wednesdays and
Thursdays, if she eeps the current JN.C= ticet price for the other days of the wee1

CI 'ssume *illary decides to open on Wednesdays and Thursdays and charges the price you calculated in :art % plus J=.<C
more. She has e"cess capacity on Wednesdays of on average 6== rides. ' tour operator, $larence %unsen, offers *illary
J<.== per ride for F= rides each Wednesday for ne"t season. Should *illary accept the offer1 What are her relevant costs
for maing this decision1

DI ;espite taing $ost 'ccounting as an undergraduate, *illary is confused by your answer to :art $, and puts off her
decision about the tour operatorUs offer until the end of the month. In the meantime, the new 0ederal 'ssistance :rogram
Z:or for ToddlersZ offers to contract with the carousel for C= rides per wee. The :rogram will pay *illary the carouselUs
full cost per ride plus <=K >i.e., 6<=K of full cost?. %eing socially progressive, and believing she wonUt lose money on
the program, she immediately accepts the government contract. Now it is the end of the month, and she has to decide
about the tour operatorUs offer >see :art $?. Now what are the relevant costs and revenues for deciding whether to accept
the tour operatorUs offer1

%'2'! @eff Wong is an entrepreneur on a small island in the South :acific. 0ollowing is the demand function for cell phone service
on the island, which is a new service that @eff is going to introduce on the island. The table shows the elasticity of demand9 the
number of residents who would subscribe if the monthly fee were as indicated. 0or e"ample, if @eff charges J6D= per month
>actually, any amount between J6<N and J6D=?, he will have 6D subscribers. If he lowers the price to J6<C, he will have 6G
subscribers, and he will continue to have 6G subscribers until he gets down to J66C, at which point he will have <= subscribers. *e
will never have more than <= subscribers.

/rice V of customers willing to pay up to the
amount indicated in the left/hand
column for the service
J66C
J6<C
J6D=
J6CC
J68=
J<6=
JF==
JD==
<=
6G
6D
6<
66
6=
C
<

@eff has the following cost function for providing the service. 0irst, he must pay a flat fee of J6,=== per month to rent the
transmission e2uipment and to act as an authori-ed dealer for the cell phone carrier. 'fter that, he pays JC= per month per
subscriber to the carrier for the service. 0or e"ample, if he has 6= subscribers, he will pay J6,C==9 the J6,=== fi"ed cost, plus JC==
>JC= " 6=? in variable costs.

@eff does not now the information about the demand function presented in the above table. @eff mistaenly believes that at a sales
price of J66C per subscriber, demand will be << subscribers. *e then estimates his profits as follows9

<< " >J66C JC=? J6,=== P JDF=.

3&reatL4 @eff says to himself. 3I can mae over JD== per month.4 @eff then sets the price at J66C. *owever, at the end of the
month, he only maes JF== for the month, calculated as follows9

<= " >J66C JC=? J6,=== P JF==.

3That,s no good,4 @eff says to himself. 3I want to earn JD== per month.4 @eff then decides to raise his sales price (ust enough to
mae e"actly JD== per month, under the assumption that he is not going to lose any e"isting customers. >)emember, @eff does not
now the demand function shown above.? 0urthermore, @eff decides that if he loses customers, he will eep raising the sales price
88
to mae up for the loss in customer base, to plan to mae JD== in profit at the new sales price. In other words, @eff always fails to
anticipate that he will lose additional customers as he raises his price. %ut @eff is mistaen, because he is ignoring the elasticity of
demand, and because whenever he raises his monthly fee, customers are allowed to cancel their contracts.

1equired! &iven @eff,s pricing strategy, and the demand function that @eff does not now but that you do now, derive each
successive price that @eff will charge for phone service. Is there an e2uilibrium sales price that @eff will attain >i.e., a sales price
that gives @eff JD== profit that he will arrive at given his pricing strategy?. If so, what is that final sales price1

%'2(! +any people support the concept of school voucher programs. The general idea of school vouchers is that a family that
enrolls a child in a private school instead of the public school system receives a voucher. The family gives the voucher to the
private school to help pay the child,s tuition. The private school is then reimbursed by the government for the amount of the
voucher. The philosophy of the program is that families that use private schools are not utili-ing public school resources, so they
should receive a partial refund of ta"es that support the public schools. The vouchers constitute this refund.

'nother goal of voucher programs is to provide public schools incentives at the local level to improve the 2uality of education.
Under most voucher programs, each school,s funding is based on enrollment. If the public school attracts more students, its
funding is increased. If public school enrollment drops, its funding is cut. This aspect of the program is similar to cost/plus
contracting, e"cept that 3cost4 is determined using a 3base/line4 year, and the 3plus4 component does not constitute corporate
profits, but rather constitutes additional resources for the school to improve the 2uality of its programs.

%riefly discuss how effective each of the following reimbursement schemes would be in

>6? providing incentives and resources for the local public schools to improve 2uality, and

><? minimi-ing the ris that public school funding, and hence, 2uality, will decline in the short/run.

In each case, 3base/line4 refers to information for the year immediately prior to the first year of the voucher program.

AI !ach public school receives funding e2ual to its base/line fi"ed costs, plus an amount calculated as follows9 the school,s
base/line variable cost per student plus a small increment, multiplied by the number of students enrolled after the voucher
program is initiated.

:I !ach public school receives funding e2ual to its base/line fi"ed costs, plus its base/line variable cost per student
multiplied by the number of students enrolled after the voucher program is initiated.

CI !ach public school receives funding e2ual to the number of students enrolled after the voucher program is initiated,
multiplied by its base/line full cost per student. %ase/line full cost refers to base/line variable cost per student plus an
allocation of fi"ed costs calculated by dividing base/line fi"ed costs by the base/line number of students.

DI !ach public school receives funding e2ual to the sum of its base/line fi"ed and variable costs, plus a small variable
amount for each student in e"cess of its base/line enrollment.
89