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CHAPTER VII

BUDGETING PROCESS
A budget is a detailed plan that shows how resources are expected to be acquired and used
during a specified time period. In other words budget is a quantitative expression of management
objectives and means of monitoring progress towards achievement of the same. An effective
budget must be well coordinated with related management and accounting system.

Initially, budgeting identifies certain financial and operating targets that become management’s
goals for the future. These targets which provide direction for the entity’s activities and
transactions, is expected to lead to satisfactory profitable results. As the actual performance
occurs, it is monitored and checked against the related targets for control purposes. If significant
variances between the actual and planned performance are found, they are investigated and
corrected whenever possible using the concept of management by exception.

Benefits of Budgeting

An entity’s financial performance must be planned and controlled through sound budgeting
procedures in order to achieve and maintain acceptable profit results. To ensure that budgets are
effectively used, both their benefits and limitations must be carefully considered. The benefits of
budgeting are:

1. Planning : Budgeting forces management to plan ahead and systematically anticipate the
future. Since managers are mostly preoccupied in their day-to-day business operations,
they avoid formalized plans unless budgeting is part of their job. The budgeting forces
managers to formalize their thinking about the future and participate in the firm’s goals
setting activities.
2. Organization. Budgeting assist in (1) placing economic and human resources in the most
financially rewarding areas and (2) making the various managers aware of the scarcity of
resources.
3. Controlling: Budgeting provides managers with realistic performance targets against
which actual results can be compared. Management by exception is performed by
identifying significant variances that require corrective action if the firm is to achieve its
goals.
4. Coordination: Budgeting coordinates the various segments of the organization and makes
each manager aware of how the different activities fit together. Goal congruence of an
organization can be achieved by the unifying efforts through budgeting.
5. Communication: Budgeting serves as a communication device that the various managers
use to (1) exchange information concerning goals, ideas, and achievements and (2)
interact and develop an awareness of how their activities contributes to the firm’s overall
operation.
6. Motivation: Budgeting provides managerial motivation in the form of goals. Few people
work for the sheer joy of it; most of us need some form of stimulus to work hard and
maintain an enthusiastic attitude towards our jobs. Budget goals and periodic reports
comparing actual performance with the goals serve as an important stimulus whenever
budgeting is properly used.

Limitations of Budget

1. In many cases, a budget tends to oversimplify the facts of a real world situation and does
not truly represent the complexities faced by management.
2. A budget may emphasize results (actual net income compared with amount budgeted) but
not reasons (e.g. explanations for why marketing costs were higher than expected), when
both are important.
3. The participative theme of budgeting demands complete management support and
involvement. If managers are not convinced of budgeting’s benefits they are not likely to
spend the time required to use it successfully.
4. The budget may undermine management’s initiative by discouraging new developments
and actions not covered in the budget.
5. If excess pressure is applied to individual managers for the achievement of budget goals,
the managers may react with decisions that adversely affect organizational goals.
6. The budgeting process is not an exact science and good judgment plays an essential role.
Thus, budgeting is somewhat subjective and is based on best information available.
Constant revision is needed as new facts become known.

Master Budget

The master budge is a set of separate but closely interrelated budget representing a
comprehensive plan of action for a specified time period. This budget is typically prepared for
the 12 month period representing a firm’s calendar or fiscal year. It is then subdivided into
shorter periods (such as month or quarters) to facilitate time comparisons of actual and budgeted
results.
The master budget consists of two components (1) the operating budget and (2) the financial
budget. The operating budget is a detailed description of the revenues and costs required to
achieve satisfactory profit results. The financial budget shows the cash flows and financial
position expected with the planned operations. The master budget for a manufacturing firm
would contain the following budgets:

Master Budget

Operating budget Financial budget


Sales budget Capital Expenditures budget
Production budget Budgeted Balance Sheet
Direct material budget Budgeted statement of cash flows
Manufacturing overhead budget
Cost of goods sold budget
Selling Expenses Budget
Administrative expenses budget
Budgeted Income statement

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Types of Budgets

Functional Budget
A functional budget relates to any of the functions of an undertaking. Functional budgets are
subsidiary to the master budget. The operating budgets listed above are examples of functional
budgets.

Zero Based Budget


Zero Based budgeting can be defined as a planning and budgeting process which requires each
manger to justify his entire budget request in detail from scratch (hence the zero based) and shifts
the burden of proof to each manager to justify why he should spend any money at all i.e. taking
zero as the base and the budget is based on the basis of likely activities for the future period.

Fixed Budget (Static Budget)


When a budget is drawn for one level of activity and one set of conditions on the assumption that
there will no change in the budget level of activity, it is called a fixed budget.

Flexible Budget
A flexible budget gives different budget costs for different levels of activity. It is a budget
designed to change in accordance with the level of activity actually attained. It is a tool that is
extremely useful in cost control. The flexible budget is characterized as follows:

1. It is geared toward a range of activity rather than a single level of activity.


2. It is dynamic in nature rather than static. By using the cost volume formula, a series of
budgets can be easily developed for various levels of activity.

The basic steps used to prepare a flexible budget are:

1. Select the measure of activity to be used to prepare the budget, e.g. units of production.
2. Define the relevant range of activity for the budgeted performance based on the measure
of activity selected in step 1.
3. Identify the cost items to be included in the budget.
4. Determine the cost behavior of each cost item over the relevant range.
5. Separate the cost items into variable and fixed cost categories (a mix cost is split between
the two).
6. Select the specific levels of activity to be budgeted.
7. Use the cost behavior patterns identified in step 4 to estimate the budgeted amounts for
each cost item.

Control Aspects of Budgeting

The control aspect of budgeting consists of three major steps:


1. Comparing the actual financial performance results with the budget estimates.
2. Identifying any significant variances (differences between the actual performance and
budget estimates).
3. Deciding what management action should be taken – corrective or adaptive.

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The Complete Periodic Budget

A complete set of budget generally consists of:


1. Sales estimates by:
a. Territory and product or
b. Territory, customer group, and product.
2. Estimates of inventory, production, labour, and factory overhead combined into a cost
of goods sold schedule.
3. Estimates of materials, labour and factory overhead combined into a cost of goods
sold schedule.
4. Detailed expense budget for marketing and administrative expenses.
5. A budget of major repairs, replacements, and improvements of plant and machinery,
and research and development expenditures.
6. A cash budget showing cash receipts and disbursements.
7. A forecast income statement.
8. A forecast balance sheet showing the estimated financial position of the company at
the end of the budget period.

Budgeting in Service Firms like Banks

The absence of inventory in a service firm does not eliminate the need for budgeting but it does
alter the focus of its applications. Service firms such as banks, accounting firms, legal
practitioners, medical clinic, architectural firm, etc. are typically labour intensive because their
most important resources are the people who perform the revenue producing services. These
people often engage in numerous non-repetitive activities because no two jobs are exactly alike.
The lack of similarity of the services to be performed complicates the projection of the revenues
and costs associated with the services.

The primary financial consideration is ensuring that the professional staff is kept busying,
thereby generating enough revenue to support the operation. Consequently, the budgeting
emphasis is on the labour budget to provide an adequate but not excessive amount of labour to
satisfy the demand for services being performed.

The budget of a service firm is usually developed on the basis of a “bottom-up approach”,
unlikely manufacturing firms which use “top-down procedure”. In case of manufacturing
concern the forecast of sales demand is the first step in the development of master budget, which
in turn determines the resources needed to produce and sell the products involved. Thus, the
budgeting process flows from revenues to costs and is referred to as “top down approach”. In
contrast the size and composition of the professional staff of a service firm are relatively fixed
for a particular budget period. The basic concern is an efficient and effective utilization of the
professional staff in the performance of the services offered. The total labour cost is the starting
point for determining how much revenue must be earned from the labour capacity available to
absorb all costs and return an acceptable amount of profit to the owners of the firm. Thus we
have a “bottom-up approach” as the budget process flows from costs to revenue.

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Multiple Choice Questions

1. Budgetary control is a system designed:


a) To plan and control all quantifiable aspects of business activity
b) To budget and control cash flows of a business
c) To monitor results of business
d) None of above

2. Production budget comprises:


a) Plant capacity and utilization plan
b) Production plan (quantities)
c) Production cost budget
d) All of the above

3. Unabosorbed or over absorbed cost means:


a) Under charging or over charging of overheads costs to cost of products manufactured.
b) Less or excess overhead cost incurred as compared to last year.
c) Less or excess overhead cost incurred as compared to budget.

4. Starting point for budgeting is:


a) Production forecast
b) Capacity forecast
c) Sales forecast
d) Manpower level forecast

5. A flexible budget is also called:


a) A variable budget
b) A seasonal budget
c) A budget with loose controls
d) A document yet to be finalized

6. A flexible budget is:


a) Not appropriate when costs and expenses are affected by fluctuation in volume limits.
b) Appropriate for any relevant level of activity.
c) Appropriate for control of FOH but not for control of direct material and direct labour
d) Appropriate for control of direct material and direct labour but not for control of FOH

7. A flexible budget is:


a) In which monthly variations are accommodated
b) Having a technique to adjust itself to current conditions
c) Various bases and cost allocations used by different departments of a company
d) None of the above

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8. A standard cost system may be used in:
a) Job order but not process costing.
b) Either job order costing or process costing.
c) Process costing but not job order costing.
d) Neither process costing nor job order costing

9. A budget in which a responsibility centre manager must justify each planned activity and
its estimated total cost is called a:
a) Conventional budget
b) Master budget
c) Program planning and budget system
d) Zero based budget

10. Standard costs provide the building blocks for a:


a) Variable cost
b) Unit cost
c) Budgeted cost
d) Overhead cost

11. In responsibility accounting system each cost must be assigned to:


a) A division
b) An individual
c) A profit centre

12. The important reason for measuring performance of a division can be associated with:
a) Motivating personal managers
b) Public reporting
c) Determining divisional contribution to net earnings

13. The situation when the goals of a division or an individual are in harmony with the broad
goals of the company is known as:
a) Management by exception
b) Goal congruence
c) Division goal analysis

14. In divisional performance analysis, the sum of earnings of all the divisions of a company:
a) Will be the same as the net earnings of the enterprise as a whole.
b) Probably will not be the same as the net earnings of the enterprise as a whole.
c) Is called the return on investment.

15. Modern divisional performance reporting system give attention to:


a) Costs
b) Costs and revenues
c) Costs, revenues and investment

16. The use of responsibility accounting focuses attention on:

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a) Management by objective
b) Management by domination
c) Management by exception

Answer 1(a), 2 (b), 3 (c), 4 (c), 5 (a), 6(b), 7(b), 8(b), 9(d), 10(c), 11(b), 12(c), 13(b),
14(b), 15(c), 16(a)

Additional Multiple Choice Questions

1. A major weakness of static budgets is that:


a) They are geared only to a single level of activity.
b) They cannot be used to assess whether variable costs are under control.
c) They force the manager to compare actual costs at one level of activity to budgeted
costs at a different level of activity.
d) All of the above.

Answer (d)

2. The budget or schedule that provides necessary input data for the direct materials budget
is the :
a) Cash Budget c) Production budget
b) Raw materials purchase budget d) Schedule of cash collection

Answer (c). The compilation of direct material budget is based on production budget.

3. Turkey Company uses an accounting system that charges costs to the manager who has
been delegated the authority to make decisions concerning the costs. For example, if the
sales manager accepts a rush order that will result in higher than normal shipping costs,
these additional costs are charged to the sales manager because the authority to accept or
decline the rush order was given to the sales manager. This type of accounting system is
known as:
a) Absorption accounting c) Operation budgeting
b) Contribution accounting d) Responsibility accounting

Answer (d)
4. Marker company’s sales are 50% cash and 50% on credit. Seventy percent of the credit
sales are collected in the month of sale, 20% in the month following sale, and 5% in the
second month following sale. The remainder is uncollectible. The following are budget
sales data:
September October November December
Total Sales $ 50,000 $ 70,000 $ 60,000 $ 80,000
Total cash receipts in December would be budgeted to be:
a) $28,000 b) $ 68,000 c) $ 75,750 d) $ 83,500

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5. Leonardo Co. plans to sell 24,000 units during the month of August. If the company has
5,000 units on hand at the start of the month, and plans to have 4,000 units on hand at the
end of the month, how many units must be produced during the month?
a) 23,000 b) 24,000 c) 25,000 d) 28,000

6. Champion Co. produces and sells volleyballs. To guard against out of stock situations,
the company requires that 20% of the next month’s sales be on hand at the end of each
month. Budgeted sales of volleyballs over the next four months are:

January February March April


Budgeted sales in units 60,000 80,000 120,000 100,000

Budgeted production for March would be:

a) 100,000 units b) 116,000 units c) 124,000 units 140,000 units

7. Corner Company plans the following beginning and ending inventory levels (in units) for
July:

July 1 July 30
Raw material 80,000 100,000
Work in Process 20,000 20,000
Finished goods 160,000 100,000

Two units of raw materials are needed to produce each unit of finished product. If Corner
Co. plans to sell 960,000 units during July, the number of units it would have to
manufacture during July would be:

a) 880,000 units b) 900,000 units c) 960,000 d) 1,020,000 units

8. The Kentucky Co. has budgeted production for next year as follows:
First Second Third Fourth
Quarter Quarter Quarter Quarter
Production in units 20,000 24,000 32,000 28,000

Five pounds of raw materials are required for each unit produced. Raw materials on hand
at the start of the year totals 5,000 lbs. The raw materials inventory at the end of each
quarter should equal 10% of the next quarter’s production needs. Budgeted purchases of
raw materials in the second quarter would be:

a) 24,800 lbs. b) 116,000 lbs. c) 124,000 lbs. d) 160,000 lbs.

9. The Johnson Co. makes and sells a single product. Each unit of product requires 2.6
hours of labour at a labour rate of $ 9.10 per hour. The company needs to prepare a direct
labour budget for the second quarter of the next year. The budgeted direct labour cost per
unit of product would be:

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a) $ 14.00 b) $ 18.20 c) $ 20.80 d) $ 23.66

10. Robert Company has a cash balance of $ 18,000 on April 1. The company is required to
maintain a minimum cash balance of $ 12,000. During April expected cash receipts are $
90,000. Expected cash disbursement during the month total $ 104,000. During April the
company need to borrow:

a) $ 4,000 b) $ 6,000 c) $ 8,000 d) $ 14,000

11. The Alpha Company makes and sells a single product. Budgeted sales for April are $
600,000. Gross margin is budgeted at 30% of sales. If the net income for April is
budgeted at $ 80,000, budgeted selling and administrative expenses must be:

a) $ 100,000 b) $156,000 c) 204,000 d) $ 266,666

12. Roma Restaurant compares monthly operating results with a static budget prepared at the
beginning of the year. When actual sales are less than budget, would the restaurant
usually report favour variances on fixed supervisory salaries and variable food costs?
Supervisory salaries Food costs
a) Yes Yes
b) Yes No
c) No Yes
d) No No

a) Answer A b) Answer B c) Answer C d) Answer D

Exercise 32

The following data on production, materials required for products X and Y, and inventory pertain
to the budget of Pioneer Company.

Product X Product Y
Production Units 2,000 3,000
Materials (per Unit)
A 3.00 1.00
B 4.00 6.50

Beginning Desired Price/Unit


Ending (Rs.)
Material Inventory
A 2,000 3,000 2.00
B 6,000 6,000 1.20

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Required :
a) Determine the number of units needed to produce products X and Y.
b) Calculate the cost of materials used for production.
c) Determine the number of material units to be purchased.
d) Calculate the cost of materials to be purchased.

Answer 32
Material A Material B
a) Number of units product X to be produced 2,000 2,000
Units needed to produce X 3 4
Total 6,000 8,000

Number of units product Y to be produced 3,000 3,000


Units needed to produce Y 1 6.5
Total 3,000 19,500

Total number of material units needed to 9,000 27,500


Produce product X and Y (6,000+3,000)

Material A Material B
b) Total number of material units 9,000 27,500
Unit price 2 1.20
Cost of materials used for production 18,000 33,000

Material A Material B
c) Total number of units needed for production 9,000 27,500
Add desired ending inventory 3,000 6,000
Total material needed 12,000 33,500
Less beginning inventory 2,000 6,000
Materials to be purchased 10,000 27,500

Material A Material B
d) Material to be purchased 10,000 27,500
Unit Price 2 1.20
Cost of material to be purchased 20,000 33,000

Exercise 33

M/s Saima Corporation manufactures and sells products that has peak sales in the third quarter of
the year. The following information concerns operations for Year 2 and the first quarter of the 3rd
year.
a) The company’s single product sells for $ 8 per unit. Budgeted sales in units for the next
six quarters are as follows:

Year 2 (Quarter) Year 3 (Quarter)

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1 2 3 4 1 2
Budgeted unit sales 40,000 60,000 100,000 50,000 70,000 80,000

b) Sales are collected in the following pattern: 75% in the quarter the sales are made and the
remaining 25% in the following quarter. On January 1, Year 2, the company’s balance
sheet showed $ 65,000 in accounts receivable, all of which will be collected in the first
quarter of the year. Bad debts are negligible and can be ignored.
c) The company desires as ending finished goods inventory at the end of each quarter equal
to 30% of the budgeted unit sales for the next quarter. On December 31, Year 1, the
company has 12,000 units on hand.
d) Five pounds of raw materials are required to complete one unit of product. The company
requires ending raw materials inventory at the end of each quarter equal to 10% of the
following quarter’s production needs. On December 31, Year 1 the company had 23,000
pounds of raw material on hand.
e) The raw material costs $ 0.80 per pound. Raw material purchases are paid for in the
following pattern. 60% paid in the quarter the purchases are made, and the remaining
40% paid in the following quarter. On January 1, Year 2, the company’s balance sheet
showed $81,500 in accounts payable for raw material purchases, all of which will be
paid for in the first quarter of the year.

Required:
Prepare the following budgets and schedule for the year, showing both quarterly and total
figures.
1. A sales budget and a schedule of expected cash collections.
2. A production budget.
3. A direct material budget and schedule of expected cash payments for purchases of
materials.

Answer 33

1. The sales budget is prepared as follows :

Year 2 Quarter
1 2 3 4 Year
Budgeted unit sales 40,000 60,000 100,000 50,000 250,000
Selling Price per unit x $8 x $8 x $8 x $8 x $8
Total sales $320,000 480,000 $800,000 $400,000 $2,000,000

Based on the budgeted sales above, the schedule of expected cash collection is prepared
as follows:
2 Quarter
1 2 3 4 Year
Accounts receivable, beginning balance $65,000 $ 65,000
First quarter sales ($320,000 x 75%, 25%) 240,000 $80,000 320,000
Second quarter sales ($480,000x75%,25%) 360,000 $120,000 480,000
Third sales ($800,000 x 75%, 25%) 600,000 200,000 800,000

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Fourth quarter sales ($400,000 x75%) 300,000 300,000
Total cash collections 305,000 440,000 720,000 500,000 1,965,000

2. Based on the sales budget in units, the production budget is prepared as follows:
Year 2 Quarter Year 3 Quarter
1 2 3 4 Total 1 2
Budgeted units in sales 40,000 60,000 100,000 50,000 250,000 70,000 80,000
Add desired ending inventory 18,000 30,000 15,000 21,000 21,000 24,000
Total inventory needed 58,000 90,000 115,000 71,000 271,000 94,000
Less beginning inventory 12,000 18,000 30,000 15,000 12,000 21,000
Required Production 46,000 72,000 85,000 56,000 259,000 73,000

Note : Ending inventory 30% of the following quarter’s sales in units

4th quarter ending inventory is computed from the sales of 1st quarter of the third year’s sale
Beginning inventory of 1st quarter is based on the ending inventory of the previous year which is
given in the question.

Beginning inventory of subsequent quarter is based on the closing inventory of the previous
quarter.

3. Based on the production budget, raw materials will needed to be purchased during the
year as follows:

Year 2 Quarter Year 3 Quarter


1 2 3 4 Total 1
Required production (units) 46,000 72,000 85,000 56,000 259,000 70,000
Quantity per unit x 5 x 5 x 5 x 5 x 5 x 5
Product needs in Pounds 230,000 360,000 425,000 280,000 1,295,000 35,000
Add desired ending inventory 36,000 42,500 28,000 35,000 35,000
Total inventory needed 266,000 402,500 453,000 315,000 1,330,000
Less beginning inventory 23,000 36,000 42,500 28,000 23,000
Raw material to be purchased 243,000 366,500 410,500 287,000 1,307,000

Ending inventory is equivalent to 10% of the following quarter’s demand.


4th quarter ending inventory is computed on the data of 1 quarter of 3rd year.
Beginning inventory of the first quarter is based on the closing inventory of the previous quarter.

Based on the raw material purchases above, expected cash payments are as follows:

Year 2 Quarter
1 2 3 4 Total
Raw materials to be purchased 243,000 366,500 410,500 287,000 1,307,000

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Cost per unit x $0.80 x $0.80 x $0.80 x $0.80 x $0.80
Cost of raw material $ 194,400 293,200 328,400 229,600 1,045,600

Accounts Payable (Beg.) 81,500 81,500


First quarter purchases
($194,400x60%, 40%) 116,640 77,760 194,400
2nd quarter purchases
($293,200x60%, 40%) 175,920 117,280 293,200
3rd quarter purchases
($328,400x60%, 40%) 197,040 131,360 328,400
4th quarter purchases
($229,600 x60%) 137,760 137,760
Total cash requirements $ 198,140 253,680 314,320 269,120 1,035,260

Exercise 34

A cash budget, by quarters, is given below for a retail company in thousands. The company
requires a minimum cash balance of at least $ 5,000 to start each quarter.

Cash Balance, beginning $ 6 $ ? $ ? $ ? $ ?


Add collections from customers ? ? 96 ? 323
Total cash available 71 ? ? ? ?

Less Disbursements
Purchase of inventory 35 45 ? 35 ?
Operating expenses ? 30 30 ? 113
Equipment purchases 8 8 10 ? 36
Dividends 2 2 2 2 ?
Total disbursements ? 85 ? ? ?

Exces(deficiency) of cash
Available over disbursements (2) ? 11 ? ?

Financing
Borrowings ? 15 - - ?
Repayments (including interest) - - (?) (17) (?)
Total financing ? ? ? ? ?
Cash balance, ending ? ? ? ? ?

Answer 34

Cash Balance, beginning $ 6 $ 5 $ 5 $ 5 $ 6


Add collections from customers 65 70 96 92 323

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Total cash available 71 75 101 97 329

Less Disbursements
Purchase of inventory 35 45 48 35 163
Operating expenses 28 30 30 25 113
Equipment purchases 8 8 10 10 36
Dividends 2 2 2 2 8
Total disbursements 73 85 90 72 320

Exces(deficiency) of cash
Available over disbursements (2) (10) 11 25 9

Financing
Borrowings 7 15 - - 22
Repayments (including interest) - - (6) (17) (23)
Total financing 7 15 (6) (17) (1)
Cash balance, ending 5 5 5 8 8

Exercise 35

Pearl Product Ltd. manufactures and exports toys. Three cubic centimeters (cc) of solvent H300
are required to manufacture each unit of Supermix, one of the company’s products. The company
is now planning raw materials need for the third quarter, the quarter in which peak sales of
Supermix occur. To keep production and sales moving smoothly, the company has the following
inventory requirements.
a) The finished goods inventory on hand at the end of each month must be equal to 3,000
units of supermix plus 20% of the next month’s sales. The finished goods inventory on
June 30 is budgeted to be 10,000 units.
b) The raw materials inventory on hand at the end of each month must be equal to one half
of the following month’s production needs for raw materials. The raw materials inventory
on June 30 is budgeted to be 54,000 cc of solvent H300.
c) The company maintains no work in process inventories.
A sale budget for Supermix for the last six months of the year follows:

Budgeted sales in Units


July 35,000
August 40,000
September 50,000

October 30,000
November 20,000
December 10,000

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Required:
1. Prepare a production budget for Supermix for the month July, August, September and
October.
2. 2. Examine the production budget that you prepared. Why will the company produce
more units than it sells in July and August, and less than it sells in September and
October?
3. Prepare a direct material budgets budget showing the quantity of solvent H300 to be
purchased for July, August, September and for the quarter in total.

Answer 35

1. Production Budget

July August September October November December


Sales 35,000 40,000 50,000 30,000 20,000 10,000
Ending Inventory 11,000 13,000 9,000 7,000 5,000
46,000 53,000 59,000 37,000 25,000
Less beginning
Inventory 10,000 11,000 13,000 9,000 7,000
Required Prod. 36,000 42,000 46,000 28,000 18,000

2. Ending Inventory 3,000 units plus 20% of next months sales


3. The entity is producing more in July and August to build inventory to match the higher
level of sale in September and produces less in September because reduced demand in
October.

Direct Material Budget

July August September October November December


Required Prod 36,000 42,000 46,000 28,000 18,000 10,000
Quantity per unit x 3 x 3 x 3 x 3 x 3
Production
Requirements 108,000 126,000 138,000 84,000 54,000
Add End. Inventory 63,000 69,000 42,000 27,000
Total material needed 171,000 195,000 180,000 111,000
Less beginning
Inventory 54,000 63,000 69,000 42,000
Material Purchased 117,000 132,000 111,000 69,000

Total Purchases = 117,000 + 132,000 + 111,000 = 360,000

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Exercise 36

Modern Company is a wholesale distributor of Swiss chocolates. The company’s balance sheet
as of April 30 is given below:

Modern Company
Balance Sheet
April 30
Assets
Cash $ 9,000
Accounts Receivable 54,000
Inventory 30,000
Building and equipment, net of depreciation 207,000
Total Assets 300,000
Liabilities and Stockholder’s Equity
Accounts Payable $ 63,000
Notes Payable 14,500
Capital stock, no par 180,000
Retained earning 42,500
Total liabilities and stockholder’s equity 300,000

The company is in the process of preparing budget data for May. A number of budget items have
already been prepared as stated below:

1. Sales are budgeted at $200,000 for May. Of these sales, $60,000 will be for cash, the
reminder will be credit sales. One half of a month’s credit sales are collected in the month
the sales are made, and the reminder is collected in the following month. All of the April
30 accounts received will be collected in May.
2. Purchases of inventory are expected to total $120,000 during May. These purchases will
all be on account. Fifty per cent of all purchases are paid for in the month of purchase, the
reminder are paid in the following month. All of the April 30 accounts payable to
suppliers will be paid during May.
3. The May 31 inventory balance is budgeted at $40,000.
4. Operating expenses for May are budgeted at $72,000, exclusive of depreciation. These
expenses will be paid in cash. Depreciation is budgeted at $ 2,000 for the month.
5. The note payable on the April 30 balance sheet will be paid during May, with $100 in
interest (All of the interest relates to May).
6. New refrigerating equipment costing $6,500 will be purchased for cash during May.
7. During May, the company will borrow $20,000 from its bank by giving a new note
payable to the bank for the amount. The new note will be due in one year.
Required :
1. Prepare a cash budget for May. Support your budget with a schedule of expected cash
collections from sales and schedule of expected cash disbursements for merchandise
purchases.

16
2. Prepare a budgeted income statement for May. Use the absorption costing income
statement format.
3. Prepare a budgeted balance sheet of May 31.

Answer 36

Schedule of Cash Receipts


Collection of Accounts Receivable (April 30) 54,000
Cash Sales for May 60,000
Credit Sales (50% of 140,000) 70,000
Total Cash collection 184,000

Schedule of Cash Payments


Payment of Accounts Payable 63,000
Purchase of Inventory (50% down payment) 60,000
Total Cash Payments 123,000

Cash Budget for the month of May


Cash Balance opening 9,000
Add cash receipts from customers 184,000
Total cash available 193,000
Less disbursements during the month
Payment to suppliers 123,000
Payment of expenses 72,000
Payment of refrigerator 6,500 (201,500)
Excess/shortfall of cash - 8,500

Financing
Payment of note payable - 14,500
Interest on note payable - 100
Borrowing from Bank 20,000 5,400
Balance (Shortfall) 3,100

Budgeted Income Statement


Sales 200,000
Cost of goods sold
Opening Inventory 30,000
Purchases 120,000
Goods available for sale 150,000
Less closing inventory 40,000 110,000
Gross Margin 90,000
Operating Expenses
Selling & Adm. 72,000

17
Depreciation 2,000
Interest 100 74,100
Net Income 15,900

Budgeted Balance Sheet


Assets
Accounts Receivable 70,000
Inventory 40,000
Building & Equipment 205,000
Office Equipment 6,500 321,500
Liabilities
Bank Balance (Cr.) 3,100
Accounts Payable 60,000
Notes Payable (Bank Loan) 20,000
Capital Stock 180,000
Retained Earning 58,400
Total Liabilities & Owner’s Equity 321,500

Exercise 37

M/s Modern Garment is ready to begin its third quarter in which peak sales occur. The company
has requested a $40,000, 90 days loan from its bank to help meet cash requirements during the
quarter. Since the company has experienced difficulty in paying off its loan in the past, the loan
officer at the bank has asked the company to prepare a cash budget for the quarter. In response to
the bank’s requirement the following data have been assembled.

a. On July 1, the beginning of the third quarter the following will have a cash balance of
$44,500.
b. Actual sales for the last two months and budgeted sales for the third quarter follow (all
sales are on account).
May (actual) $ 250,000
June (actual) 300,000
July (budgeted) 400,000
August (budgeted) 600,000
September (budgeted) 320,000

Past experience shows that 25% of a month’s sales are collected in the month of sale,
70% in the month following sale, and 3% in the second month following sale. The
reminder is uncollectable.
a. Budgeted merchandise purchases and budgeted expenses for the third quarter are
given below:

Merchandise purchases $ 240,000 $ 250,000 $ 175,000

18
Salaries and wages 45,000 50,000 40,000
Advertising 130,000 145,000 80,000
Rent payments 9,000 9,000 9,000
Depreciation 10,000 10,000 10,000

Merchandise purchases are paid in full during the month following purchase. Accounts
payable for merchandise purchase on June 30, which will be paid during July, total
$180,000.
b. Equipment costing $10,000 will be purchased for cash during July.
c. In preparing the cash budget, assume that the $40,000 loan will be made in July and
repaid in September. Interest on the loan will total $1,200.
Required:
1. Prepare a schedule of expected cash collections for July, August and September and
for quarter in total.
2. Prepare a cash a cash budget, by month and in total for the third quarter.
3. If the company needs a minimum cash balance of $ 20,000 to start each month can
the loan be repaid as planned?

Answer 37

Schedule of Cash Collections


July August September
Accounts Receivable
May 3% 250,000 7,500
June 70%, 3% 300,000 210,000 9,000
Sale for July (25%, 70%, 3%) 400,000 100,000 280,000 12,000
Sale for August 600,000 150,000 420,000
Sale for September 320,000 80,000
Total Cash collections 317,500 439,000 512,000

Cash Budget Month


July August September
Cash Balance – Opening 44,500 28,000 23,000
Add collections during the month 317,500 439,000 512,000
Total cash available 362,000 467,000 535,000

Less Cash disbursement


Payment for Accounts Payable for June 180,000
Payment for purchases 240,000 350,000
Salaries and Wages 45,000 50,000 40,000
Advertising 130,000 145,000 80,000
Rent Payments 9,000 9,000 9,000
Purchase of Equipments 10,000 - -
Total Cash disbursements 374,000 444,000 479,000
Excess / Shortfall of cash -12,000 23,000 56,000

19
Financing
Bank Loan 40,000
Repayment
Total Financing 40,000 - -41,200
Cash Balance Closing 28,000 23,000 14,800

Exercise 38

Hero Cycle Co. has prepared the following incomplete flexible budget:

Standard Direct Labour Hours


Manufacturing overhead Rate per hour 20,000 24,000 28,000 32,000
Variable Costs
Indirect labour $ 45,000
Maintenance 64,200
Utilities 30,800
Total 140,000

Fixed Costs
Supervisory salaries 52,000
Rent 32,000
Insurance 14,500
Depreciation 48,500
Total 147,000

Total manufacturing overhead 287.000


Required:
Complete the flexible budget

Answer 38
Standard Direct Labour Hours
Manufacturing overhead Rate per hour 20,000 24,000 28,000 32,000
Variable Costs
Indirect labour $ 2.25 $ 45,000 54,000 63,000 72,000
Maintenance 3.21 64,200 77,040 89,880 102,720
Utilities 1.54 30,800 36,960 43,120 49,280
Total 140,000 168,000 196,000 224,000

Fixed Costs
Supervisory salaries 52,000 52,000 52,000 52,000
Rent 32,000 32,000 32,000 32,000
Insurance 14,500 14,500 14,500 14,500
Depreciation 48,500 48,500 48,500 48,500
Total 147,000 147,000 147,000 147,000

20
Total manufacturing overhead 287.000 315,000 343,000 371,000

Note
Rate computation variable cost = $ 45,000/20,000, 64,200/20,000, 30,800/20,000
Fixed cost will remain unchanged for all the three levels of production unless additional fixed
cost is needed for additional level.

Exercise 39

M/s Burns Food Co. produces special Beryani pack for lunch. The firm uses flexible budget for
planning and controlling costs. Below are budget and actual production data for the previous
year.
Budgeted Budgeted Actual
Number of packs 70,000 90,000 82,500
Supervision $30,000 $38,000 $73,500
Materials 28,000 36,000 33,500
Maintenance 9,000 11,000 11,000
Depreciation 18,000 18,000 18,000
Utilities 7,000 9,000 8,500
Required :
c. Determine the cost behavior pattern for each mixed cost.
d. Prepare a flexible budget performance report for the last year.

Answer 39

By using high and low method variable and fixed cost is segregated as under.

Supervision = 38,000 – 30,000/(90,000 – 70,000) = $0.40 variable cost rate


Fixed cost = 38,000 – 90,000 (0.40) = $ 2,000

Materials = 36,000 - 28,000/(90,000 – 70,000) = $0.40 variable cost rate


Fixed cost = 36,000 – 90,000(0.40) = 0

Maintenance = 11,000 – 9,000 /(90,000 – 70,000) = 0.10 variable cost rate


Fixed cost = 11,000 – 90,000(0.10) = $ 2,000

Utilities = 9,000 - 7,000/(90,000 – 70,000) = 0.10 variable cost rate


Fixed cost = 9,000 – 90,000(0.10) = 0

Burns Food Company


Flexible Overhead Budget

Cost Variable cost Fixed


Supervision $ 0.40 $ 2,000
Materials 0.40 -0-

21
Maintenance 0.10 2,000
Depreciation -0- 18,000
Utilities 0.10 -0-

Burns Food Company


Flexible Budget Report
Budgeted Actual Variance
Number of Packs 82,500 82,500
Costs
Supervision $35,000 73,500 $ 38,500 U
Material $ 33,000 33,500 500 U
Maintenance 10,250 11,000 750 U
Depreciation 18,000 18,000 -0-
Utilities 8,250 8,500 250 U

Computation :
Supervision (82,500 x 0.40) + 2,000 = $35,000
Material (82,500 x 0.40) + 0 = $33,000
Maintenance (82,500 x 0.10) + 2,000 = $10,250
Utilities (82,500 x 0.10) + 0 = $8,250

Exercise 40

M/s Gold Company provides the following budget that were prepared at the beginning of the
year. Budgeted capacity was set at 20,000 units.
20,000 units 27,500 units
Direct materials $30,000 $41,250
Direct labour 22,000 30,250
Factory utilities 60,000 82,500
Sales Promotion 10,000 13,750
Production supervision salaries 12,000 12,000
Marketing Manager’s salary 8,000 8,000
Administration salaries 32,000 32,000
Total 174,000 219,750

At the end of the month, analysis of the cost record reveals that Gold incurred the following costs
and expenses for producing and selling 21,600 units.

Direct materials $ 33,000


Direct labour 25,100
Factory utilities 64,900
Production supervisor salaries 12,500
Sales Promotion 11,300
Marketing manager salary 7,800

22
Administrative salaries 32,700
Total 187,300
Required :
a. Determine the flexible budget formula for all expenses, expressing variable cost on per
unit basis.
b. Compute the factory overhead application rate.
c. Determine variances for each line item using a flexible budget, indicating whether the
variances are favourable or unfavourable.

Answer 40

Fixed cost
Production Supervisor’s salary $ 12,000
Marketing Manager’s salary 8,000
Administrative salaries 32,000
Total fixed cost 52,000

Variable cost
Direct material ($30,000/20,000 = $ 1.50)
Direct labour ($22,000/20,000 = $ 1.10)
Factory utilities ($60,000/20,000 = $ 3.00)
Sales Promotion ($10,000/20,000 = $ 0.50)
Total variable cost $ 6.10

b. Flexible budget formula = $ 6.10 per unit Fixed cost $ 52,000

c.
Actual cost Budget for 21,600 units Variance
Direct material $ 33,000 32,400 ($1.50 x 21,600) $ 600 U
Direct labour 25,100 23,760 ($1.10 x 21,600) $ 1,340 U
Factory Utilities 64,900 64,800 ($3.00 x 21,600) $ 100 U
Production Supervisor 12,500 12,000 $ 500 U
Sales Promotion 11,300 10,800 ($0.50 x 21,600) $ 500 U

Market Manager’s S. 7,800 8,000 $ 200 F


Administrative Sal. 32,700 32,000 $ 700 U
Total 187,300 183,760 3,540 U

Exercise 40
In the first quarter of 2006, Griffin Manufacturing Company projects its sales in units to be as
follow:
January 3,270
February 2,965
March 3,315
In addition, it desires to have the following units of finished goods inventory in hand:
January 1 2,975

23
January 31 2,705
February 2,650
March 3,000

Required : Prepare a production budget for the first quarter 2006.

Answer 40

Production Budget
Griffin Manufacturing Co.

January February March


Sales $ 3,270 2,965 3,315
Add Ending Inventory 2,705 2,650 3,000
Total production 5,975 5,615 6,315
Less Beginning Inventory 2,975 2,705 2,650
Required Production 3,000 2,910 3,665

Exercise 41

The Pelican Company provided the following information from their annual budget for 2003.

Products Expected Sales Estimated Sale Required material


Price Per unit Per unit
A B
Tribolite 80,000 $ 1.80 1 kg 2 kg
Polycal 40,000 2.00 2 kg -
Power X 100,000 0.80 - 1 kg

Estimated inventories at the beginning and desired quantities at the end of the year :

Material Beginning Ending Purchase Price


Per Kg
A 10,000 kg 12,000 kg $ 0.20
B 12,000 kg 15,000 kg $ 0.10

Product Beginning Ending Direct labour hours


Per 1,000 units
Tribolite 5,000 6,000 50
Polycal 4,000 2,000 125
Power X 10,000 8,000 12.5

The direct labour cost is budgeted as $ 8 per hour and variable factory overhead at $ 6.00 per
hour of direct labour. Fixed factory overhead, estimated to be $ 40,000, is a common cost and is

24
not allocated to specific products in developing the manufacturing budget for internal
management use.

Required :
1. Prepare a production Budget.
2. Prepare a purchase budget for each material.
3. Prepare a budget of manufacturing costs by products and in total.

Answer 41
Production Budget

Tribolite Polycal Power X


Budgeted Sales 80,000 40,000 100,000
Add ending inventory 6,000 2,000 8,000
Total units required 86,000 42,000 108,000
Less beginning inventory 5,000 4,000 10,000
Required Production 81,000 38,000 98,000

Purchase Budget – Material A


Tribolite Polycal Power X
Required Production 81,000 38,000 98,000
Required material per unit x 1 kg x 2 kg -
Required material 81,000 kg 76,000 kg -
Total material required 81,000 + 76,000 = 157,000 kg
Add ending inventory 12,000
169,000
Less beginning inventory 10,000
Material to be purchased 159,000
Rate per kg $ 0.20
Budgeted purchased Price $ 31,800

Purchase Budget – Material B


Tribolite Polycal Power X
Required Production 81,000 38,000 98,000
Required material per unit x 2 kg - x 1 kg
Required material 162,000 kg - 98,000
Total material required 162,000 + 98,000 = 260,000 kg
Add ending inventory 15,000
275,000
Less beginning inventory 12,000
Material to be purchased 263,000
Rate per kg $ 0.10

25
Budgeted purchased Price $ 26,300

Manufacturing Budget
Material A (81,000 x 1 x 0.20) $ 16,200
(38,000 x 2 x 0.20) 15,200 $ 31,400
Material B (81,000 x 2 x $0.10) 16,200
(98,000 x 1 x $0.10) 9,800 26,000 $ 57,400
Direct labour
Tribolite 81 x 50 hr x $8 = 32,400
Polycal 38 x 125 hr x $8 = 38,000
Power X 98 x 12.5 hr x $8 = 9,800 80,200
Manufacturing overhead
Variable 81 x 50 hr x $6 = 24,300
38 x 125 hr x $6 = 28,500
98 x 12.5 hr x $6 = 7,350
60,150
Fixed Manufacturing overhead 40,000 100,150
Total manufacturing cost 237,750

Note : For Manufacturing budget actual material required for production is taken into account to
compute the total manufacturing cost.

Exercise 42

Karen Vance is a highly successful attorney specializing in automobile insurance claims


settlements. She has a staff consisting of four attorneys and three clerical workers. The staff
attorneys are paid $ 4,000 per month and the clerical workers are paid $1,400. Other operating
expenses are fixed at $ 9,800 per month. Ms. Vance charges her clients based on the number of
hours worked. The fee structure is as follows:

Charges per hour


K. Vance $ 90.00
Staff attorneys 60.00
Clerical Staff 16.00

Ms. Vance’s practice has been seasonal in the past. Due to snow and ice during the winter, a
dramatic increase in automobile accidents occurs from November to February. Below is an
analysis of the average hours charged to clients per month.

November – February March – October


K. Vance 160 hrs 100 hrs each
Staff attorneys 170 hrs each 110 hrs each
Clerical staff 150 hrs each 80 hrs each

Required :

26
Prepare an annual budget of revenue and expenses for the law firm. Separate the budget into
quarter periods and summarize the result in annual budget.

Answer 42

Karen Vance, Attorney at Law


Schedule for Annual Budget

Revenue
1st Quarter 2th Quarter
Jan Feb Mar Total April May June
K. Vance 160 160 100 420 100 100 100 300
Charges per hr. $ 90 $ 90
$37,800 $27,000

3rd Quarter 4th Quarter


July Aug Spt. Total Oct. Nov. Dec. Total
100 100 100 300 100 160 160 420
$ 90 $ 90
$27,000 $ 37,800
Total = $37,800 + 27,000 + 27,000 + 37,800 = $ 129,600

Staff Attorney (4) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Hours 1,800 1,320 1,320 1.800
Rate $ 60 $ 60 $ 60 $ 60
$ 108,000 $79,200 $79,200 $108,000
Total $ 108,000 + 79,200 + 79,200 + 108,000 = $ 374,400

Attorney hours = 1st quarter 170 + 170 + 100 = 450 x 4 = 1,800 hrs
Rest may be calculated in the same way

Clerical Staff (4) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Hours 1,140 720 720 1.140
Rate $ 16 $ 16 $ 16 $ 16
$ 18,240 $11,520 $11,520 $18,240
Total $ 18,240 + 11,520 + 11,520 + 18,240 = $ 59,520

Staff hours = 1st quarter 150 + 150 + 80 = 380 x 3 = 1,140 hrs


Rest may be calculated in the same way

Expenses

27
Salaries
Attorneys 4 x $ 4,000 x 4 = $ 64,000
Clerical Staff 3 x $ 1,400 x 4 = $ 16,800
Operating Expenses $ 9,800 x 4 = $ 39,200

Karen Vance Attorney At Law


Annual Budget of Revenue and Expenses

1st 2nd 3rd 4th Total


Revenue
Karen Vance $37,800 27,000 27,000 37,800 129,600
Staff Attorney 108,000 79,200 79,200 108,000 374,400
Clerical Staff 18,240 11,520 11,520 18,240 59,520
Total Revenue 164,040 117,720 117,720 164,040 563,520

Expenses
Salaries
Attorneys 16,000 16,000 16,000 16,000 64,000
Clerical Staff 4,200 4,200 4,200 4,200 16,800
Operating Expenses 9,800 9,800 9,800 9,800 39,200
Total expenses 30,000 30,000 30,000 30,000 120,000

Net Income 134,040 87,720 87,720 134,040 443.520

28
CHAPTER VIII
STANDARD COST AND ANALYSIS OF VARIANCES

A standard is a benchmark for measuring performances. Standards are observed everywhere. In


manufacturing and service institutions standards are set for each major input such as raw
materials and labour time. The performance thereafter is evaluated by comparing the actual
results with the predetermined standards. If either the quantity or price or other inputs departs
significantly from the standards, managers investigate the discrepancy to find out the cause of
the problem and eliminate it. This process is called management by exception.

Ideal versus Practical Standards

Ideal Standards can be defined as a standard which can be attained only under the best
circumstances. They allow for no machine break down or any other work interruptions, and they
call for a level of effort that can be attained only by the most skilled and efficient employees
working at peak effort 100% of the time.

Practical Standards are standards that are “tight but attainable”. They allow for normal machine
downtime and employee rest periods and they can be attained through reasonable though highly
efficient, efforts by the average workers. In real life ideal standards cannot be used for practical
applications, because they do not allow for normal inefficiencies and result in unrealistic
forecasts.

Standard cost system have a number of advantages.

1. Standard costs are a key element in a management by exception approach. If costs


conform to the standards, managers can focus on other issues. When costs are
significantly outside the standards, managers investigate the causes for that problem. This
approach helps them to focus on important issues.
2. Standards that are viewed as reasonable by employees can promote economy and
efficiency in the working.
3. Standard costs can greatly simplify bookkeeping. Instead of recording actual costs for
each job, the standard costs for direct materials, direct labour and factory overhead can be
charged to jobs.
4. Standard costs fit naturally in an integrated system of “responsibility accounting”.

Material Variance

Material variance comprises of two components. i) Material Price Variance. It evaluates the
actual unit price paid for an item and the standard price, multiplied by the quantity purchased. ii)
Material quantity variance. The difference between the actual quantity of material used in
production and the standard quantity allowed for the actual output, multiplied by the standard
price per unit of materials.

29
(1) (2) (3)
Actual Quantity Actual Quantity Standard Quantity
of input in put allowed for actual output
at actual price at standard price at standard price
(AQ x AP) (AQ x SP) (SQ x SP)
│ │ │
│ Price Variance │ Quantity Variance │
│ (1) - (2) │ (2) - (3) │
│ │ │
│ │ │

The above working can be presented with the help of the following equation.

Material Price Variance = (AQ x AP) – (AQ x SP) = AQ (AP – SP)


Material Quantity Variance = (AQ x SP) - (SQ x SP) = SP (AQ – SQ)

Labour Variance

Another important variance is termed as labour variance. The labour rate variance measures any
deviation from standard in the average hourly rate paid to direct labour workers. The labour
efficiency variance attempts to measure the productivity of direct labour. The management,
therefore, keenly watches these variances because they believe that increasing direct labour
productivity is vital to reducing cost.

(1) (2) (3)


Actual Hours Actual Hours Standard Hours
of input in put allowed for actual output
at actual Rate at standard rate at standard rate
(AH x AR) (AH x SR) (SH x SR)
│ │ │
│ Rate Variance │ Efficiency Variance │
│ (1) - (2) │ (2) - (3) │
│ │ │
│ │ │

The equation for the labour rate variance and labour efficiency variance is expressed as follows:

Labour Rate Variance = (AH x AR) – (AH x SR) = AH (AR - SR)


Labour Efficiency Variance = (AH x SR) - (SH x SR) = SR (AH - SH)

30
Variable Manufacturing Overhead Variance

The variable portion of manufacturing overhead can also be analyzed using the same basic
formula as direct material variance and direct labour variance. The variances are, however,
termed as variable overhead spending variance and variable overhead efficiency variance.

(1) (2) (3)


Actual Hours Actual Hours Standard Hours
of input in put allowed for actual output
at actual Rate at standard rate at standard rate
(AH x AR) (AH x SR) (SH x SR)
│ │ │
│ Spending Variance │ Efficiency Variance │
│ (1) - (2) │ (2) - (3) │
│ │ │
│ │ │

Variable Overhead Spending Variance = (AH x AR) – (AH x SR) = AH (AR - SR)
Variable Overhead Efficiency Variance = (AH x SR) - (SH x SR) = SR (AH - SH)

Other Variances (Formula):

The undernoted variances are helpful in computing variances relating to sales volume, selling
price variance and variable volume variance in order assess the operating performance of an
entity.

Sale Volume Variance (Actual Sales in units - Budgeted Sales in units) x


Budgeted variable margin

Selling Price Variance (Actual Selling Price - Budgeted Selling Price) x


Actual Units Sold

Variable Volume Variance Actual Cost per Unit - Budgeted Cost per Unit) x
Actual units sold

Multiple Choice Questions

1. A basic objective of standard costing is to:


a) Determine the breakeven production level.
b) Control costs.
c) Eliminate the need for subjective decision by management.
d) Allocate cost more accurately.

2. In standard costing standard hours allowed is a mean of measuring:

31
a) Standard output at standard hours
b) Actual output at standard hours
c) Standard hours at actual hours
d) Actual output at actual hours.

3. Material price variance is:


a) (Actual quantity – Standard quantity) x Actual price
b) (Actual quantity – Standard quantity) x Standard Price
c) (Actual price – Standard price) x Standard quantity
d) (Actual price – Standard price) x Actual quantity

4. Labour rate variance:


a) (Actual hours – Standard hours) x Actual rate
b) (Actual hours – Standard hours) x Standard rate
c) (Actual rate – Standard rate) x Standard hours
d) (Actual rate – Standard rate) x Actual hours

5. In standard costing when FOH are applied to the production:


a) FOH applied is debited and WIP is credited
b) FOH applied is credited and WIP is debited
c) FOH control is debited and cost of goods sold is credited
d) None of the above

6. Standard is an important tool for:


a) Cost control
b) Pricing
c) Price regulation
d) None of the above

7. Managerial cost includes the discussion on:


a) Cost volume profit analysis
b) Breakeven analysis
c) Both of the above two
d) None of the above.

8. Internal financial control methods include:


a) Internal check
b) Internal audit
c) Internal check as well as internal audit
d) None of the above

9. The type of cost presented to management for elimination of a product line should be
limited to:
a) Relevant costs
b) Standard costs
c) Controllable costs

32
d) Conversion costs

10. An understatement of work in process inventory at the end of a period will:


a) Understate cost of goods manufactured in that period.
b) Overstate current assets.
c) Overstate goods profit from sales in that period.
d) Understate income for that period.

Understatement of work in process inventory will increase the cost of goods


manufactured which in turn will increase the cost of finished goods ending inventory. An
increase in cost of goods ending inventory will reduce cost of goods sold and increase the
profit of the entity.

Answers :

1 (b), 2(b), 3(d), 4(d), 5(b), 6(a), 7(c), 8(c), 9(a), 10(b)(c)

Additional Multiple Choice Questions

1. Which of the following variances would be used in calling attention to possible problems
in the control of spending on overhead items?
Variable Fixed Fixed
Overhead Overhead Overhead
Spending Budget Volume
Variance Variance Variance
a) No No No
b) No Yes Yes
c) Yes No No
d) Yes Yes Yes

a) Answer A b) Answer B c) Answer C d) Answer D

2. The higher the denominator level of activity:

a) The more profitable operations likely will be.


b) The less likely is the occurrence of a volume variance.
c) The lower the unit product cost.
d) The higher the unit product cost.

3. An increase in denominator level of activity will:


a) Decrease the fixed portion of the predetermined overhead rate.
b) Increase the fixed portion of the predetermined overhead rate.
c) Decrease the variable portion of the predetermined overhead rate.
d) Increase the variable portion of the predetermined overhead rate.

33
4. Which of the following variances is caused by a difference between the denominator
activity in the predetermined overhead rate and the standard hours allowed for the actual
production of the period?
a) Fixed overhead budget variance.
b) Fixed overhead volume variance.
c) Variable overhead efficiency variance.
d) Variable overhead spending variance.

5. The fresh company applies manufacturing overhead costs to products on the basis of
direct labour hours. The standard cost card shows that 6 direct labour hours are required
per unit of product. For August, the company budgeted to work 180,000 direct labour
hours and to incur the following total manufacturing overhead costs:
Total variable overhead costs $ 198,000
Total fixed overhead costs $ 237,600
During August, the company completed 28,000 units of product, worked 172,000 direct
labour hours and incurred the following total manufacturing overhead costs:
Total variable overhead costs $ 197,800
Total fixed overhead costs $ 230,600
The denominator activity in the predetermined overhead rate is 180,000 direct labour
hours. The variable overhead spending variance for August is :
a) $ 8,600 F b) $ 8,600 U c) $ 13,000 F d) $ 13,000 U

6. The fresh company applies manufacturing overhead costs to products on the basis of
direct labour hours. The standard cost card shows that 6 direct labour hours are required
per unit of product. For August, the company budgeted to work 180,000 direct labour
hours and to incur the following total manufacturing overhead costs:
Total variable overhead costs $ 198,000
Total fixed overhead costs $ 237,600
During August, the company completed 28,000 units of product, worked 172,000 direct
labour hours and incurred the following total manufacturing overhead costs:
Total variable overhead costs $ 197,800
Total fixed overhead costs $ 230,600
The denominator activity in the predetermined overhead rate is 180,000 direct labour
hours. The variable overhead efficiency variance for August is :
a) $ 0 b) $ 3,600F c) $ 4,400F d) $ 4,400 U

7. The fresh company applies manufacturing overhead costs to products on the basis of
direct labour hours. The standard cost card shows that 6 direct labour hours are required
per unit of product. For August, the company budgeted to work 180,000 direct labour
hours and to incur the following total manufacturing overhead costs:
Total variable overhead costs $ 198,000
Total fixed overhead costs $ 237,600
During August, the company completed 28,000 units of product, worked 172,000 direct
labour hours and incurred the following total manufacturing overhead costs:
Total variable overhead costs $ 197,800
Total fixed overhead costs $ 230,600

34
The denominator activity in the predetermined overhead rate is 180,000 direct labour
hours. The fixed overhead budget variance for August is :

a) $ 7,000F b) $ 7,000 U c) $ 6,400 F d) $ 6,400 U

8. The fresh company applies manufacturing overhead costs to products on the basis of
direct labour hours. The standard cost card shows that 6 direct labour hours are required
per unit of product. For August, the company budgeted to work 180,000 direct labour
hours and to incur the following total manufacturing overhead costs:
Total variable overhead costs $ 198,000
Total fixed overhead costs $ 237,600
During August, the company completed 28,000 units of product, worked 172,000 direct
labour hours and incurred the following total manufacturing overhead costs:
Total variable overhead costs $ 197,800
Total fixed overhead costs $ 230,600
The denominator activity in the predetermined overhead rate is 180,000 direct labour
hours. The fixed overhead volume variance for August is :

a) $ 8,600 U b) $ 9,960 F c) $ 9,960 U d) $ 15,840 U

Exercise 43

M/s X Company produces a single product. Variable manufacturing overhead is applied to


products on the basis of direct labour hours. The standard costs for one unit of product are as
follows:

Direct material 6 ounces at $0.50 per ounce $ 3


Direct labour 1.8 hours at $ 10 18
Variable manufacturing ovherad 1.8 hours at $ 5 per hr. 9
Total standard variable cost per unit $30

During June, 2000 units were produced. The costs associated with June’s operations were as
follow:

Material purchased 18,000 ounces at $ 0.60 per ounce $ 10,800


Material used in production 14,000 oz
Direct labour 4,000 hours at $9.75 per hours $ 39,000
Variable manufacturing overhead costs incurred $ 20,800

Required : Compute the direct materials, direct labour and variable manufacturing overhead
variances.

35
Answer 43

Direct material Variance

(1) (2) (3)


Actual Quantity Actual Quantity Standard Quantity
of input in put allowed for actual output
at actual price at standard price at standard price
(AQ x AP) (AQ x SP) (SQ x SP)
18,000 x $0.60 18,000 x $0.50 12,000 x $ 0.50
= $10,800 = $ 9,000 = $ 6,000
│ │ │
│ Price Variance │ Quantity Variance │
│ (1) - (2) │ (2) - (3) │
│$10,800 – 9,000 = 1,800U │ │
│ │ │
14,000 x $ 0.50 = 7,000 │
│ │
│ │
│$ 7,000 – 6,000 = 1,000 U │
│Quantity variance │

Standard quantity = 6 ounce x 2,000 units = 12,000 ounce

Using the formula the material variance can be computed as follows:

Material price variance = AQ (AP – SP)


18,000 ($0.60 – $0.50) = $ 1,800 U

Material quantity variance = SP(AQ - SQ)


$0.50 (14,000 – 12,000) = $ 1,000 U

Note : While computing quantity variance, actual quantity consumed is used and not actual
quantity purchased.

36
Direct Labour Variance
(1) (2) (3)
Actual Hours Actual Hours Standard Hours
of input in put allowed for actual output
at actual Rate at standard rate at standard rate
(AH x AR) (AH x SR) (SH x SR)
4,000 hrs x $ 9.75 4,000 hrs x $10.00 3,600 hrs x $ 10.00
= $39,000 = $40,000 $ 36,000
│ │ │
│ Rate Variance │ Efficiency Variance │
│ (1) - (2) │ (2) - (3) │
│ $1,000 F │ $4,000 U │
│ │ │

The formula for the labour rate variance and efficiency variance is expressed as follows:

Labour Rate Variance = AH (AR - SR)


4,000 ($9.75 - $10.00)
$ 1,000 F

Labour Efficiency Variance = SR(AH - SH)


$10.00 (4,000 – 3,600)
$4,000 U

Total units produced = 2,000 units


Actual hours used 4,000 hrs.
Actual hours per unit 4,000/2,000 = 2 hr per unit
Standard hours per unit 1.8 hrs (given)
Permissible standard hours 2,000 x 1.8 = 3,600 hrs

Variable Manufacturing Overhead Variance

(1) (2) (3)


Actual Hours Actual Hours Standard Hours
of input in put allowed for actual output
at actual Rate at standard rate at standard rate
(AH x AR) (AH x SR) (SH x SR)
4,000 x $5.2 4,000 x $ 5 3,600 x $ 5
=$ 20,800 $20,000 $18,000

│ │ │
│ Spending Variance │ Efficiency Variance │
│ (1) - (2) │ (2) - (3) │
│ $ 800 U │ $ 2,000 U │
│ │ │

37
Using the formulas the variable manufacturing overhead variance would be computed as follows:

Variable overhead spending variance = AH (AR – SR)


4,000 ($5.20 - $5.00) = $ 800 U
Variable overhead efficiency variance = SR (AH – SH)
$ 5.00 (4,000 hrs – 3,600 hrs) = 2,000 U

Actual hours used 4,000


Variable manufacturing cost incurred $20,800
Actual variable manufacturing rate $20,800/4,000 = $5.2

Exercise 44

Wales Ice Cream Ltd. makes premium handcrafted chocolates. The owner of the company is
setting up a standard cost system and has collected the following data for one of the company’s
products, Chocolate Brand. This product is made with the fine white chocolate and various
fillings. The data below pertain only to the white chocolate used in the product.

Material requirements, kilograms of white chocolate per dozen 0.70 kilograms


Allowance for waste, kilograms of white chocolate per dozen 0.03 kilograms
Allowance for rejections, kilograms of white chocolate per dozen 0.02 kilograms
Purchase price, finest grade white chocolate $ 7.50 per kilograms
Purchase discount 8% of purchase price
Shipping cost from the supplier $0.30 per kilogram
Receiving and handling cost $0.04 per kilogram

Required :
1. Determine the standard price of a kilogram of white chocolate.
2. Determine the standard quantity of white chocolate for a dozen pack.
3. Determine the standard cost of the white chocolate in a dozen pack.

Answer 44

Standard Price of a kilogram white chocolate


Material $ 7.50
Less discount @ 8% 0.60
Net material cost 6.90
Shipping cost 0.30
Receiving and handling cost 0.04
Standard Price per kg. $ 7.24

Standard Quantity for a dozen pack

Material 0.70 kg
Allowance for wastage 0.03

38
Allowance for rejection 0.02
Standard Quantity for a dozen pack 0.75 kg

Standard Cost per dozen pack

Standard Price x Standard Quantity


$ 7.24 x $ 0.75 = $ 5.43

Exercise 45

Fuji toys Ltd. produces toys. The company has recently established a standard cost system to
help control costs and has established the following standards for the manufacture of a new
series of toys:

Direct materials 6 microns per toy @ $0.50 per micron


Direct labour 1.3 hours per toy at $ 8 per hour

During July, the company produced 3,000 toys. Production data for the month on the toy
follows:

Direct material : 25,000 microns were purchased at a cost of $ 0.48 per micron. 5,000 of these
microns were still in inventory at the end of the month.
Direct labour: 4,000 direct labour hours were worked at a cost of $36,000.

Required
1. Compue the following variances for July:
a. Direct materials price and quantity variances.
b. Direct labour rate and efficiency variances.
2. Prepare a brief explanation of the possible cause of each variance.

Answer 45

a. Material Price variance


AQ (AP - SP)
25,000 ($0.48 – $0.50) = $ 500 F
Material Quantity variance
SP (AQ – SQ)
$0.50 (20,000 – 18,000) = $ 1,000 U

Total material variance


$ 500 F - $1,000 U = $ 500 U

Note : While calculating material price variance, the entire quantity purchased is taken for
computation of variance. While computing quantity variance, the quantity actually consumed is
considered for computing the variance.
Standard quantity = 3,000 toys x 6 microns per toy = 18,000 microns

39
b. Direct labour variance
AH (AR – SR)
4,000 ($9 - $8) = $4,000 U
SR (AH – SH)
$8 (4,000 – 3,900) = $ 800 U

Total labour variance


$4,000 U + $800 U = $4,800 U

2. The manufacturing department could not achieve the standards both in respect of material as
well as for labour. As for as material variance, the quantity consumed was higher than the
specified standard. However, the variance was low. Whereas in case of labour the actual hours
used as well as the rate for hiring the labour was unfavourable from the approved standard. The
unfavour variance of the labour must be investigated to control the high level of inefficiency or it
should be revised to an attainable level.

Exercise 46

Bell Corporation has decided to accumulate standard costs, in addition to actual costs, for the
next accounting period (Year 2010). The following data have been collected:

Projected Production for 2010 – 30,000 units direct materials, required to produce one unit 2
tons. Price per ton of direct materials based on annual order of:

1 – 25,000 tons $ 200 per ton


25,000 – 50,000 tons $ 190 per ton
50,000 – 74,000 tons $ 185 per ton

Direct labour requirements


Shaping time per ton 3 hours
Welding time per ton 10 hours

Average rate per hour for:


Shaper $ 11
Welders $ 15
Factory overhead is applied on direct labours:
Budgeted variable overhead $120,000
Budgeted fixed overhead 57,600
Bell Corporation uses a process cost system to accumulate costs.

Required :
a. Calculate the following standards
1. Direct material price per unit
2. Direct materials efficiency per unit

40
3. Direct labour price per hour
4. Direct labour efficiency per unit
5. Variable factory overhead application rate per direct labour hours.
6. Fixed factory overhead application rate per direct labour hour.
b. Complete the total standard cost per unit.

Answer 45

a.1 Standard Direct material


30,000 units x 2 tons per pound = 60,000 tons
Per ton unit price as the basis of annual purchase of 60,000 tons falls in the
range 50,000 – 75,000 tons at the rate of $ 185 per ton.
Direct material price per unit = $ 185 per ton x 2 = $370

a.2 Direct material efficiency per ton


Required material per unit = 2 Tons
Required material = 2 x 30,000 units = 6,000 tons

a.3 Direct labour price per standard hr


Shaping 3 hrs x 2 tons @ $ 11 = $ 66
Welding 10 hrs x 2 tons @ $ 15 300
Total labour cost per unit 366
Total hours 26 hrs**
Rate per standard hour 366/26 = $ 14.07

a.4 Direct efficiency labour per unit


Shaping per unit (3 hr x 2 tons) 6 hours
Welding (10 hrs x 2 tons) 20 hours
Total 26 hours**

a.5 Variable factory overhead application rate:


Shaping (30,000 units x 2tons x 3 hrs) 180,000 hrs
Welding (30,000 units x 2 tons x 10) 600,000 hrs
Total 780,000 hrs
Budgeted variable overhead $120,000
Standard Rate 120,000/780,000 hrs = $ 0.154 per hour
Fixed factory overhead $ 57,600
Standard Rate per unit 57,600/780,000 = $ 0.07

b. Total Standard cost per unit


Direct material ($ 185 x 2) $ 370.00
Direct labour ($14.07 x 26 hrs) 365.82
Factory overhead
Variable ( $ 0.154 x 26 hrs) 4.00
Fixed Factory overhead ($0.07 x 26) 1.82
Total Standard price 741.64

41
CHAPTER IX
DECISION MAKING BASED ON RELEVANT INFORMATION

Managers at different levels of an organization make decisions continuously as they plan


activities, organize resources, direct operations and control performance. Decision making
involves a choice between alternative courses of actions, and that choice is usually made on the
basis of some measure of profitability or cost savings. Examples of management decisions are:

What product to produce?


How to produce them?
How to sell them?
What prices to charge?
Where to buy raw materials?
When to replace equipment?
How to allocate scarce resources?
Whether to expand production capacity?

In the normal course, the quality of decision making depends on the quality of the information
available for the decision making. Good information typically leads to correct decisions and
therefore, leads to desired results. In contrast, incomplete information usually leads to incorrect
decisions and undesirable results.

Use of Differential Analysis

Differential analysis, or incremental analysis, is a decision model that can be used to evaluate the
differences in costs and revenues associated with alternative courses of action. The costs
considered in differential analysis are not necessarily those used in conventional financial
reporting. For decision making purposes, relevant costs, differential costs, unavoidable costs,
sunk costs and opportunity costs are important factors that needed consideration.

Costs Relevant to Decision Making

Relevant costs are the expected future costs that will differ between the alternatives being
considered in decision making. The difference between the relevant costs of two or more
alternative is called differential costs. For example if a manager is deciding which of the two
generators to buy if they carry same price tag, the amount of fuel consumption and maintenance
cost of each generators is the relevant cost factor that should be considered. A comparison of
relevant cost shall help to make the correct decision in selection of the equipment.

Similarly sunk costs are not relevant in decision making because they already have been incurred
and cannot be changed. An example of a sunk cost is the book value of a machine that a business
considering to replace. Assume that the machine does not have any residual value. If it is
replaced, its book value will be written off in the period of the disposal. If it is kept, the same
amount will be depreciated over the remaining life of the asset. In either event, the book value
will be expensed out, so it is sunk cost that is irrelevant.

42
An opportunity cost is the benefit forfeited by rejecting one alternative while accepting another.
Opportunity costs are not found in the general ledger, but they are considered either formally or
informally when most decisions are made. For example, if a student decides to attend summer
school instead of accepting a job that will pay $ 2,400, the true cost of attending school is more
than just books, tuition, meals and conveyance. The opportunity cost of $2,400 must be added to
these costs to determine the true costs of making the decision to attend the summer school.

Joint Processing cost. A joint production is one in which the processing of a common input
results in two or more distinct products known as joint products. A special decision that
commonly arises in the context of the joint process is the decision whether or not to process
further one of the joint products into a different product. The proper approach for making this
type of decision is the compute the incremental benefits from further processing with the
incremental costs.

The allocated joint processing costs are irrelevant when making a decision as to whether a joint
product should be sold at the split off point or processed further. The total joint cost will not
change as a result of the decision to process further, and therefore it is irrelevant to the decision.

The proper approach to making a production decision when limited resources are involved is to
maximize production of the product that has the highest contribution margin per unit of scarce
resource.

The contribution margin per unit of scarce resource is a producer’s unit contribution margin
divided by the number of units of the scarce resource required to produce one unit of the product.
For example, if a product’s contribution margin per unit is Rs.5 and it requires two hours of
labour to produce one unit, the contribution margin per direct labour hour is Rs. 2.50.

Multiple Choice Questions

1. Which of the following to income measurement is an extremely useful tool for selecting
the best source of action in a non-routine decision problem?
a. The contribution approach c) Book keeping
b. Depreciation d) Job costing

2. There are three primary approaches to alternative choice problems. They are the total
project approach, the opportunity cost approach and;
a. The process cost c) Incremental (differential) cost approach
b. The unit cost d) The cost of goods sold

3. Which of the following in a decision are expected future costs that differ between the
alternatives being considered?
a. Relevant costs c) Total cost
b. Sunk costs d) Joint cost

43
4. A sunk cost is___________________in alternative choice problems.
a. Relevant c) Future cost
b. Irrelevant d) None of the above

5. The contribution approach to pricing or the variable pricing model is:


a) Method of total product cost c) Method of inventory valuation
b) Method of pricing special orders d) None of the above

6. Make-or-buy decisions depend on both qualitative factor and:


a) Quantitative factors c) Political factors
b) Internal factors d) None of the above

7. It is the stage of production at which the different joint product are individually
recognized.
a) Work in process c) Split off point
b) Selling point d) All of the above

8. _____________is irrelevant in the sell or process further decision.


a) Joint cost c) Variable cost
b) Total cost d) None of the above

9. When there are two or more products with limited capacity, the way to maximize total
contribution margin of a firm is to manufacture the product.
a) With the lowest contribution margin per unit of that limited capacity.
b) With the highest contribution margin per unit of that limited capacity.
c) With the highest total cost.
d) All of the above.

10. It will always be profitable to process joint products beyond the split off point as long as:
a. The incremental revenue from such processing exceeds of the incremental costs.
b. The incremental cost from such processing exceeds the incremental revenue.
c. The incremental revenue from such processing equals the incremental costs.
d. None of the above.

11. The final decision as to whether to keep an old product line depends primarily on the
impact the decision will have on the incremental revenue:
a. True
b. False
c. None of the above

12. The book value of old equipment is irrelevant for future replacement decisions:
a. True
b. False
c. None of the above.

44
13. Fixed costs are always irrelevant, whereas variable costs are relevant.
a. True
b. False
c. None of the above.

14. An avoidable cost is the same as a sunk cost:


a. True
b. False
c. None of the above

15. Which of the following is a fixed cost which results from decisions of prior period? The
amount of committed cost is fixed by decisions which are made in the past and is not
subject to managerial control in the present on a short run basis. Example of committed
cost are depreciation, insurance premium, rent etc.
a) Future costs c) Opportunity cost
b) Committed cost d) Variable cost

16. This is the specific costs of an activity or sector of a business which would be avoided if
that activity or section did not exist.
a) Avoidable cost c) Joint cost
b) Indirect cost d) Direct cost

17. This the cost of one unit of product or service which would be avoided if that unit were
not produced or provided.
a) Marginal cost c) Estimated cost
b) Prime cost d) Conversion cost

18. This is the cost of ensuring and assuring quality, as well as loss incurred when quality is
not achieved. Quality costs are classified as prevention cost, appraisal cost, internal
failure cost and external failure cost.
a) Historical costs c) Quality related cost
b) Replacement cost d) Standard cost

19. It is “costs appropriate to a specific management decision”.


a) Production costs c) Product cost
b) Joint cost d) Relevant costs

20. It is “tangible and intangible costs and losses sustained by third parties or the general
public as a result of economic activity, e.g. pollution by industrial effluent.”
a) Conversion costs c) Social Responsibility cost
b) Replacement cost d) Prime cost

Answers
1 (a), 2 (c), 3(a), 4(b), 5(d), 6(a), 7(c), 8(a), 9(b), 10(a), 11(b), 12(a), 13(b),
14 (b), 15(b), 16(a), 17(a), 18(c), 19(d), 20(c)

45
Additional Multiple Choice Questions
1. Costs that are always relevant in decision making are :
a) Avoidable costs
b) Fixed costs
c) Sunk costs
d) Variable costs

2. The managers of a firm are in the process of deciding whether to accept or reject a special
offer for one of its products. A cost that is not relevant is their decision is the :
a) Common fixed overhead that will continue if the special offer is not accepted.
b) Direct materials.
c) Fixed overhead that will be avoided if the special offer is accepted.
d) Variable overhead.

3. The Empire Corporation has 2,000 obsolete units of a product that are carried in
inventory at a manufacturing cost of $ 40,000. If the units are remachined for $ 10,000,
they could be sold for $ 18,000. Alternatively, the units could be sold for scrap for $
2,000. Which alternative is more desirable and what are the total relevant cost for that
alternative?
a) Remachine: 10,000 b) Remachine $ 50,000 c) Scrap $ 40,000 d) Scrap $40,000

4. The Calculex Company has 800 obsolete calculators that are carried in inventory at a
total cost of $ 53,400. If these calculators are upgraded at a total cost of $ 20,000, they
can be sold for a total of $ 60,000. As an alternative can be sold in their present
conditions for $ 22,400. The sunk cost in this situation is:
a) $ -0- b) $20,000 c) $22,400 d) $53,400

5. A study has been conducted to determine if one of the department of Lucy Company
should be discontinued. The contribution margin in the department is $100,000 per year.
Fixed expenses charged to the department are $ 130,000 per year. It is estimated that $
80,000 of these fixed expenses could be eliminated if the department is discontinued.
These data indicates that if the department is discontinued, Lucy’s overall net operating
income would:
a) Decrease by $ 20,000 per year.
b) Increase by $ 20,000 per year.
c) Decrease by $ 50,000 per year.
d) Increase by $ 50,000 per year.

6. Brown Company produces parts per year, which are used in the assembly of one of its
products. The unit product cost of these parts is:
Variable manufacturing cost $ 24
Fixed manufacturing cost 18
Unit product cost 42
The part can be purchased from an outside supplier at $ 40 per unit. If the part is
purchased from the outside supplier, two thirds of the fixed manufacturing costs can be

46
eliminated. The annual impact on Brown’s net operating income as a result of buying the
part from the outside supplier would:
a) $ 4,000 increase c) $ 8,000 increase
b) $ 4,000 decrease d) $ 8,000 decrease

7. The following are the Goodluck Company’s unit costs of making and selling an item at a
volume of 20,000 units per month (which represents the company’s capacity):
Manufacturing:
Direct materials $ 2.00
Direct labour 4.00
Variable overhead 1.00
Fixed overhead 1.80
Selling and administrative
Variable 3.00
Fixed 1.20
Assume the company has 100 units left over from last year which have small defects and
which will have to be sold at a reduced price as scrap. This would have no effect on the
company’s other sales. The variable selling and administrative costs would have to be
incurred to sell the defective units. What cost is relevant as a guide for setting a minimum
price on these defective units?
a) $ 3.00 b) $ 7.00 c) $ 10.00 d) $ 13.00

8. Rolling Corporation manufactures coolers. The company can manufacture 600,000


coolers a year at a variable cost of $ 1,500,000 and a fixed cost of $ 900,000. Based on
management’s predictions for next year, 480,000 coolers will be sold at the regular price
of $ 10.00 each. In addition, a special order was placed for 120,000 coolers to be sold at a
40% discount off the regular price. Total fixed costs would be unaffected by this order.
By what amount would the company’s net operating income be increased as a result of
the special order?
a) $240,000 b) $300,000 c) $420,000 d) 720,000

9. Chapman Company sells its products for $ 42 per unit. The Company’s unit product cost
based on the full capacity of 400,000 units is as follows:
Direct materials $ 8.00
Direct labour 10.00
Manufacturing overhead 12.00
Unit product cost 30.00
A special order offering to buy 40,000 units has been received from a foreign distributor.
The only selling costs that would be incurred on this order would be $ 6 per unit for
shipping. The company has sufficient idle capacity to manufacture the additional units.
Two thirds of the manufacturing overhead is fixed and would not be affected by this
order. Assume that direct labour is an avoidable cost in this decision. In negotiating a
price for the special order, the minimum acceptable selling price per unit should be:
a) $ 28 b) $ 30 c) $ 32 d) $ 36

47
10. Consider the following production and cost data for two products, A and B :
Product A Product B
Contribution margin per unit $ 260 $ 240
Machine set ups needed per unit 20 set ups 16 set ups
The company can only perform 130,000 machine set ups each period due to limited
skilled labour and there is unlimited demand for each product. What is the largest
possible total contribution margin that can be realized each period?
a) $ 1,690,000 b) $1,950,000 c) 1,820,000 d) $ 3,640,000

Exercise 46

Troy Engine Ltd., manufactures a variety of engines for use in heavy equipment. The company
always produced all the necessary parts for its engines, including carburetors. An outside
supplier has offered to sell one type of carburetor to Troy Engine Ltd. at a cost of $35 per unit.
To evaluate this offer, Troy Engines Ltd., has gathered the following information relating to its
own cost of producing the carburetor internally:

Per Unit 15,000 units


per year
Direct materials $ 14 $ 210,000
Direct labour 10 150,000
Variable manufacturing overhead 3 45,000
Fixed manufacturing overhead 6** 90,000
Fixed manufacturing
overhead allocated 9 135,000

**One third supervisory salaries, two thirds depreciation of special equipment (no resale value)

Required :
1. Assuming that the company has no alternative use for the facilities that are now being
used to produce the carburetors, should outside supplier’s offer be accepted. Show
computation.
2. Suppose that if the carburetors were purchased. Troy Engines Ltd., could use the freed
capacity to launch a new product. The segment margin of the new product would be
$150,000 per year. Should Troy Engines Ltd. accept the offer to buy the carburetors for
$35 per unit? Show all computations.

Answer 46

Produce Buy
Cost of buying carburetors (15,000 x $35) $ 525,000
Cost of Manufacturing carburetors
Direct material (15,000 x 14) $ 210,000
Direct labour (15,000 x 10) 150,000
Variable MOH (15,000 x 3) 45,000
Fixed manufacturing Overhead

48
(1/3 supervisor’s salary) 30,000
Total cost 435,000
Difference in favour of producing internally 90,000 _______
Total 525,000 525,000

Only supervisor’s salary is avoidable. Depreciation is a sunk cost and is not relevant for decision
making. Therefore depreciation is not considered as product cost.

Produce Buy
Cost of buying carburetors (15,000 x $35) $ 525,000
Cost of Manufacturing carburetors $435,000
Add opportunity cost 150,000
Saving from purchases from outside source _______ 60,000
Total cost 585,000 585,000

Exercise 47

The XYZ Company requires 10 machine hours per unit in the cutting department. The following
costs are assumed to be related to the operating of a cutting machine at a normal capacity of
10,000 units per year (with a maximum capacity of 12,000 units per year).

Variable Costs
Electricity (10,000 units x 10 MH x $ 5 per MH) $500,000
Repairs and maintenance (10,000 units x $ 2 per 10 MH) 200,000
Depreciation ($2,000,000/5 years) 400,000
Insurance 100,000
Total costs 1,200,000
(Note MH represents machine hours)

Required:
a) What are the variable and fixed costs per unit if the normal production of 10,000 units per
year is achieved.
b) What are the variable, fixed and total costs per unit if only 8,000 units are produced?
c) What are the implications of producing fewer units (8,000 units) than normal capacity
(10,000 units) for decision making?
d) Which costs are relevant and which costs are irrelevant to a decision to expand
production from normal capacity (10,000 units) to maximum capacity (12,000 units)?
e) Suppose a second cutting machine, identical in every respect to the first one, is under
consideration for possible purchase. Total production for the year is expected tto be equal
to normal capacity (10,000 units) with the first cutting machine accounting for 6,000
units and the second cutting machine accounting for 4,000 units.
1. What is the total cost of operating two machines?
2. What are the variable, fixed and total costs per unit of each machine?

49
3. What costs are relevant and what costs are irrelevant to the decision to acquire a
second cutting machine?
4. Under what condition would both the variable cost and fixed costs be relevant in a
decision to require a second machine.

Answer 47
Per unit
a) Variable cost
Electricity (10 MH x $ 5 per MH) $ 50.00
Repairs & Maintenance ($2 per 10 MH) 20.00
Total variable cost 70.00

Fixed Cost
Depreciation $ 400,000
Insurance 100,000
Total fixed cost 500,000
No. of units produced 10,000
Fixed cost per unit ($500,000/10,000) $ 50.00
Total cost per unit ($70.00 + 50.00) $ 120.00

b) Variable cost
Electricity (10 MH x $ 5 per MH) $ 50.00
Repairs & Maintenance ($2 per MH) 20.00
Total variable cost per unit 70.00

Fixed cost
Depreciation $ 400,000
Insurance 100,000
Total 500,000
No. of units produced 8,000
Fixed cost per unit ($500,000/8,000) $ 62.50
Total cost per unit ($70.00 + 62.50) $132.50

c) If few than 10,000 units are produced, the variable constant per unit will remain constant
but the fixed cost per unit will increase from $ 50 to $62.50. The company will either
have to settle for lesser profit or increase its selling price. Increase in selling price will
affect the sale volume which in turn will result in lesser profit.

d) The variable cost i.e. electricity, repair and maintenance costs are relevant for decision
making. The increase in production by additional 2,000 units will increase the
profitability because the fixed cost has already been covered by the existing production.
The profit will increase be the amount of contribution margin per unit multiplied with the
additional number of units produced.

50
e) 1. Machine 1 Machine 2
Electricity
6,000 units x 10 MH x $ 5 MH $300,000
4,000 units x 10 MH x $ 5 MH $200,000
Repair & Maintenance
6,000 units x 10 MH units x $2 MH 120,000
4,000 units x 10 MH units x $2 MH 80,000
Depreciation 400,000 400,000
Insurance 100,000 100,000
Total cost of operating two machines 920,000 780,000

2.
Variable cost per unit $ 70.00 $ 70.00
($420,000/6,000 units)
($280,000/4,000 units)
Fixed cost per unit
($500,000/6,000 units) 83.33 125.00
($500,000/4,000 units) __ ______
Total cost per unit 153.33 195.00

3.
If the second machine is not purchased, the additional fixed cost of $ 500,000 can be
avoided. In this situation the fixed cost of the new machine is relevant because total fixed
cost is increasing without any corresponding increase in production, thereby decreasing
profitability.

4.
If the first machine would have been working at full capacity, the second machine would
have been viable. Again the new machine must be utilized for production above the
breakeven level to add to the profitability of the firm.

Exercise 48

Woodside Company part No. 347 uses in one of its main product. Normal annual production for
part 347 is 100,000 units. The cost per 100 unit is as follows:

Direct materials $ 260


Direct labour 100
Manufacturing Overhead
Variable 120
Fixed 160
Total cost per 100 units 640

Caesar Company has offered to sell Woodside all 100,000 units if needed during the company
year for $ 600 per 100 units. If Woodside accepts the offer from Caesar, the facilities used to
produce part 347 could be used to produce 483. This change would save Woodside $90,000 in

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relevant costs. Also a $100,000 cost item included in the fixed factory overhead that is
significantly related to part 347 would be eliminated. Should Woodside accept the offer from
Caesar Company.

Answer 48

Make Buy
Purchase Price
(100,000 units @ 600 per unit $600,000
Cost of Production
Variable production cost
(100,000 units @ 480 per 100 units) $ 480,000
Fixed Cost 100,000
Total Mfg. Cost 580,000
Add opportunity cost 90,000
Net saving in purchasing the parts 70,000
Total cost 670,000 670,000

Variable cost
Direct material $ 260
Direct labour 100
Factory overhead 120
Total 480

In this case fixed cost amounting to $ 100,000 is relevant in decision making because it directly
relates to the part being produced and as stated in the question will be eliminated if the product is
purchased from outside.

Exercise 49

Imperial Jewelers is considering a special order for 20 handcrafted gold bracelets to be given as
gifts to members of a wedding party. The normal selling price of a gold bracelet is $189.95 and
its unit price cost is $149.00 as show below:

Direct materials $ 84.00


Direct labour 45.00
Manufacturing overhead 20.00
Unit product cost 149.00

Most of the manufacturing overhead is fixed and unaffected by variations in how much jewelry
is produced in any given period. However, $ 4 of the overhead is variable with respect to the
number of bracelets produced. The customer who is interested in the special bracelet order would
like special monogram applied to the bracelets. This monogram would require additional
materials costing $ 2.00 per bracelet and would also require acquisition of a special tool costing
$ 250 that would have no other use once the special order is completed. This order would have

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no effect on the company’s regular sales and the order could be fulfilled using the company’s
existing capacity without affecting any order.

Required :

What effect would accepting this order have on the company’s net operating income if a special
price of $169.95 per bracelet is offered for this order? Should the special order be accepted at
this price?

Answer 49

Incremental Cost Incremental Revenue


Incremental revenue (20 x $169.95) $ 3,399
Incremental cost
Direct material (20 x $84) $ 1,680
Direct labour (20 x $45) 900
Mfg.overhead variable (20 x $4) 80
Special material (20 x $2) 40
Cost of special equipment 250
Total cost 2,950
Net increase in income 449
($3,399 – 2,950)

Special order should be accepted.

Exercise 50

Barron Co. manufactures three products: A, B, and C. The selling price, variable costs, and
contribution margin for one unit of each product follow:

Product
A B C
Selling Price $180 $270 $240
Less variable expenses
Direct materials 24 72 32
Other variable expenses 102 90 148
Total variable expenses 126 162 180
Contribution Margin 54 108 60
Contribution margin 30% 40% 25%

The same raw material is used in all three products. Barron company only 5,000 pounds of raw
material on hand and will not be able to obtained any more of it for several weeks due to a strike
in its supplier’s plant. Management is trying to decide which product(s) to concentrate on ext
week in filling its backlog of orders. The material costs $ 8 per pound.

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Required:
1. Compute the amount of contribution margin that will be obtained per pound of material
used in each product.
2. Which orders would you recommend that the company work on next week – the orders
for product A, product B, or product C? Show computation.
3. A foreign supplier could furnish Barron with additional stocks of raw material at a
substantial premium over the usual price. If there is unfilled demand for all three product,
what is the highest price that Barron Company should be willing to pay for an additional
pound of materials. Explain.

Answer 50

a) Product
A B C
Contribution per unit 54 108 60
Direct material cost per unit 24 72 32
Direct material rate per pound 8 8 8
Direct material per unit (24/8, 72/8, 32/8) 3 9 4
Contribution margin per pound of material
(54/3, 108/9, 60/4) 18 12 15

b)
Contribution margin on 5,000 pounds 90,000 60,000 75,000
(5,000 x 18, 5,000 x 21, 5,000 x 15)

In view of highest contribution margin of product ‘A’, product ‘A’ should be produced.

c)
Material cost per pound 8 8 8
Add contribution margin 18 12 15
Total maximum price acceptable 26 20 23

The maximum price which the company will be willing to pay for one pound of material is $26.

Exercise 51

Maqbool Company manufactures three products from a common input in a joint processing
operation. Joint processing costs up to the split-off point total $350,000 per quarter. The
company allocates these costs to be joint products on the basis of their relative sales value at the
split off point. Unit selling price and total output at the split off point are as follows:

Product Selling Price Quarterly Output


A $16 per pound 15,000 pounds
B $ 8 per pound 20,000 pounds
C $ 25 per gallon 4,000 gallons

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Each product can be processed further after the split off point. Additional processing requires no
special facilities. The additional processing costs (per quarter) and unit selling prices after further
processing are given below:
Additional
Product Processing Cost Selling Price
A $ 63,000 $20 per pound
B $ 80,000 $13 per pound
C $ 36,000 $32 per pound
Required :
Which product or products should be sold at split off point and which product or products should
be processed further? Show computation.

Answer 51
A B C
Sales revenue after additional processing $ 300,000 $ 260,000 $ 128,000
Sales revenue before additional processing 240,000 160,000 100,000
Increase in revenue 60,000 100,000 28,000
Increase in cost 63,000 80,000 36,000
Additional revenue - 3,000 20,000 - 8,000

Computation
Sales revenue after processing A, 15,000 x $20, B 20,000 x $13, C 4,000 x $32
Sales revenue before processing A 15,000 x 16, B 20,000 x 8, C 4,000 x $25

Product B should be processed further, whereas product A and C should be sold before
additional processing to maximize revenue.

Exercise 52

For many years Modern Company purchased the starters that it installs in its farm tractors. Due
to a reduction in output, the company has idle capacity that could be used to produce starters.
The chief engineer has recommended against this move, however, pointing out that the cost to
produce the starters would be greater than the current $ 8.40 per unit purchase price.

Per Unit Total


Direct materials $ 3.10
Direct labour 2.70
Supervision 1.50 $ 60,000
Depreciation 1.00 40,000
Variable manufacturing overhead 0.60
Rent 0.30 12,000
Total production cost 9.20

A supervisor would have to be hired to oversee production of the starter. However, the company
has sufficient idle tools and machinery that no new equipment would have to be purchased. The

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rent charge above is based on space utilized in the plant. The total rent on the plant is $ 80,000
per period. Depreciation is due to obsolescence rather than wear and tear.

Required :
Prepare computations showing how much profit will increase or decrease as a result of making
the starter rather than purchasing them.

Answer 52

Cost of producing one starter


Direct material $ 3.10
Direct labour 2.70
Supervisor’s salary 1.50
Variable Mfg. overhead 0.60
Depreciation -
Rent -
____
Total cost per unit 7.90
Cost of purchasing 8.40
Saving per unit 0.50

Rent is an allocated cost and has no impact on production cost of the starter. Similarly
depreciation is a sunk cost and the machinery must be depreciated in the usual way irrespective
of the company’s decision to opt for production or otherwise.
The company should produce the starter at its own facility.

Exercise 53

Mighty Company that manufactures sneakers has enough idle capacity available to accept a
special order of 20,000 pairs of sneakers at $ 6 a pair. The normal selling price is $ 10.00 per a
pair. Variable manufacturing costs are $ 4.50 a pair, and fixed manufacturing costs are $ 1.50 a
pair. Mighty will not incur any selling expenses as a result of the special order. What would be
the effect on net income if Mighty accepts the special order?

Answer 53

Incremental revenue (20,000 x $6) $120,000


Incremental cost (variable)
Manufacturing cost (20,000 x $4.50) $ 90,000
Incremental Revenue 30,000

The fixed manufacturing cost of $ 1.50 is not relevant for accepting the special order. Since
special order is adding $ 30,000 to the firm’s revenue, it should be accepted.

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Exercise 54

Rice Corporation currently operates two divisions. The operating results of both the units for the
year ended December 31, 2011 are as follows:

West Division East Division


Sales $ 600,000 $ 300,000
Variable costs 310,000 200,000
Contribution margin 290,000 100,000
Fixed costs for the division 110,000 70,000
Operating margin 180,000 30,000
Allocated corporate costs 90,000 45,000
Operating income 90,000 (15,000)

Since East Division has sustained a loss of $15,000, the Rice President is considering the
elimination of this division. If East Division is eliminated from January, 2012 what would have
been Rice Corporation’s operating income for the year 2012.

Answer 54

Rice Corporation
East Division

Forgone revenue $ 300,000


Cost saving
Variable costs $200,000
Fixed Cost 70,000 270,000
Decrease in operating income 30,000

Exercise 55

The Morris Meat Company produces three joint products, hamburger, steak and roast beef from a
joint process. Total joint costs equal to $ 43,000. Each of three joint products can be (1) sold at
the split off point to a competing meat company or (2) further processed at Morris Company and
sold to the retailers.

Relevant costs and revenue appear below:

Total Sales Total additional Total


Product Value at Split off Processing cost Final Sales Value
Hamburger $ 10,000 $ 2,000 $ 14,000
Steak 14,000 3,000 20,000
Roast beef 13,000 6,000 17,000

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Which product should be sold at the split off point and which product should be processed
further?

Answer 55

Hamburger Steak Roast Beef


Incremental Revenue $ 4,000 $ 6,000 $ 4,000
Incremental cost 2,000 3,000 6,000
Increase/decrease in income 2,000 3,000 (2,000)

Hamburger and Steak should be processed further. Roast Beef should be sold at split off point.

Working of incremental Revenue

Hamburger Steak Roast Beef


Revised Revenue $ 14,000 $ 20,000 $ 17,000
Original Revenue (10,000) (14,000) (13,000)
Incremental Revenue 4,000 6,000 4,000

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