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AFM102

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Chapter 10
Good to Know…
-‐  DM, DL, VMO, FMO variances
-‐  Overhead Cost Analysis
Management by Exception
DefiniFon
•  System of management in which
standards are set for various
operaFng acFviFes which are
periodically compared to actual
results
•  Significant differences (variances)
= “excepFons”
Variance Analysis Cycle
1)  Prepare standard cost
performance report
2)  Analyze variances
3)  IdenFfy QuesFons
4)  Receive explanaFons
5)  Take correcFve acFons
6)  Conduct next period’s operaFons
! Goal is to improve operaFons, not
assign blame
Ideal vs. Practical Standards
Ideal Standards
• Allows for no machine breakdowns
or other work interrupFon
• Require peak efficiency
PROS
• MoFvaFonal value
CONS
• Discourages most diligent workers
• Variances have liale meaning
Ideal vs. Practical Standards
PracFcal Standards
• Allows for normal machine breakdowns
and other work interrupFon
• Aaained through reasonable but highly
efficient efforts by average employees
PROS
• Used to forecast cash flows and plan
inventory
• Standard used for purposes of chapter
CONS
• Variances need management aaenFon
Direct Materials Standards
Standard Price per Unit (SP) – price
paid for single unit of material
•  Includes allowances for quality, shipping, net of
discounts
Standard QuanFty per Product (SQ) –
amount of materials required to
complete single unit of product
•  Includes allowances for waste, spoilage, rejects
Standard Cost of Material per Product
= SP x SQ
Direct Labour Standards
Standard Rate per Hour (SR) – labour
rate that should be incurred per hour
•  Includes employment tax, employee benefits
Standard Hours per Product (SH) –
amount of labour Fme required to
•  Includes allowances for breaks, machine
downFme, clean up
Standard Labour Cost per Product
= SR x SH
Variable Manuf. O’head Standards
Standard Rate per Hour (SR) –
variable porFon of predetermined
overhead rate
Standard Hours per Product (SH) –
amount of labour Fme required to
•  SH same as in DL Variance
Standard VMO per Product
= SR x SH
Variance Analysis
• Variance – Difference between
standard price and quanFFes and
actual price and quanFFes
Variance Analysis
Actual Standard
Actual QuanFty
QuanFty QuanFty
At
At At
Standard Price
Actual Price Standard Price
AQ x AP AQ x SP SQ x SP
QuanFty
Price Variance
Variance
Total Flexible Budget Variance

Variance Analysis
Actual Standard
Actual QuanFty
QuanFty QuanFty
At
At At
Standard Price
QuanFty
Price Variance
Variance

Direct Materials Variance
Materials Price Variance
= AQ (AP – SP)
• Measure of difference
between actual unit price and
standard unit price
Responsibility
• Purchasing manager
Variance Analysis
Actual Standard
Actual QuanFty
QuanFty QuanFty
At
At At
Standard Price
QuanOty
Price Variance
Variance

Direct Materials Variance
Materials QuanFty Variance
= SP (AQ – SQ)
• Measure of difference between
actual quanFty used and standard
quanFty allowed
• Best isolated when materials placed
into producFon (early control)
• Excess result of faulty machine,
untrained workers, poor supervision
Responsibility
• ProducFon department
Variance Analysis
Actual Standard
Actual QuanFty
QuanFty QuanFty
At
At At
Standard Price
QuanFty
Price Variance
Variance

Direct Labour Variance
Labour Rate Variance
= AH(AR – SR)
• Measure of diff. b/w actual rate and
standard rate
• Can arise from way labour used ie.
High-‐skilled worker doing duty of
low skill or v.v.
• Unfavourable variance from
overFme work @ premium rate
Responsibility
• ProducFon supervisors
Variance Analysis
Actual Standard
Actual QuanFty
QuanFty QuanFty
At
At At
Standard Price
QuanOty
Price Variance
Variance

Direct Labour Variance
Labour Efficiency Variance
= SR(AH – SH)
• Measure of diff. b/w actual hours and
standard hours allowed (measures
producFvity)
• Most important to management
• Unfavourable variance from untrained
workers, poor-‐quality materials,
breakdowns, insufficient demand
Responsibility
• Managers in charge of producFon
Variance Analysis
Actual Standard
Actual QuanFty
QuanFty QuanFty
At
At At
Standard Price
QuanFty
Price Variance
Variance

Variable Manuf. O’head Variance
VMO Spending Variance
= AH(AR – SR)
• Measure of diff. b/w actual VMO cost
and standard cost
• Can occur if:
a) Actual purchase price different from
standard price
b) Actual quanFty different from std.
Responsibility
• Purchasers of overhead items
Variance Analysis
Actual Standard
Actual QuanFty
QuanFty QuanFty
At
At At
Standard Price
QuanOty
Price Variance
Variance

Variable Manuf. O’head Variance
VMO Efficiency Variance
= SR(AH – SH)
• Measure of diff. b/w actual acFvity
and standard acFvity allowed
• Indirectly measures efficiency of
acFvity base
Responsibility
• Whoever is responsible for acFvity
base
Variance Analysis
QuanOty
Price Variance
Variance
Favourable Favourable
AP < SP AQ < SQ
Unfavourable Unfavourable
AP > SP AQ > SQ

Further Analysis
Actual QuanFty At
Std. Mix & Std. Price
AQ x AP AQ x SP M x SP SQ x SP
Mix Yield
Variance Variance
Price
Variance QuanOty Variance

Quantity Variance
Mix Variance
= SP(AQ – M)
= SP(AQ – Budgeted% x Total Input)
• Difference between actual mix of
materials and budgeted mix of materials
ie. Mix of Materials A & B, Mix of Skilled
and Unskilled Labour Types
• Favourable: AQ < M
• Unfavourable: AQ > M
Quantity Variance
Yield Variance
= SP(M – SQ)
= Mix Variance – QuanOty Variance
• Favourable: Mix Var. < QuanFty Var.
• Unfavourable: Mix Var > QuanFty Var.
Quantity Variance
Process:
• Calculate a Mix Variance and Yield
Variance for every type of material,
labour, etc…
• Total Mix Variance = Sum of Mix
Variances
• Total Yield Variance = Sum of Yield
Variances
Overhead Rates
• Predetermined overhead rate
Estimated Total Manuf. O'head Cost
=
Estimated Total Units in Base
• Variable Element
Estimated Total Variable O'head Cost
=
! SR used in VMO variance calculaFons
• Fixed Element
Estimated Total Fixed O'head Cost
=
• EsFmates are from flexible budget
Overhead Cost Application
• In a standard cost system, total
overhead cost applied based on
standard hours, not actual hours
• Total Overhead Cost
= Predet. O’head Rate x Standard Hours
• Keeps unit costs from being
affected by variaFons in efficiency
Fixed Manuf. O’head Variance
Budget Variance
= Actual FMO cost
– Flexible budget FMO cost
•  Represents difference between
how much should have been
spent and how much actually
spent
• Favourable: Actual < Flexible
• Unfavourable: Actual > Flexible
Fixed Manuf. O’head Variance
Volume Variance
= Fixed PorFon of Predet. O’head Rate x
(Denominator Hours – Std. Hours
Allowed)
•  Measures uFlizaFon of plant faciliFes
• Arises when std. hours allowed differs
from denominator acFvity level
planned
• Favourable: Denom. < Standard
• Unfavourable: Denom. > Standard
Graphic Analysis of FMO Variance
Denom.
Fixed O’head Cost Hours Std. Hours
Applied
Volume Variance (F)
Actual
Budget Variance (U)
Budget
Applied
Budgeted
Applied-‐Cost Line
Variable O’head Cost
Cautions in FMO Analysis
• Total fixed cost is not a variable
cost, but we act as if it is
• Volume variance expressed in
units as opposed to $ to avoid
confusion
Under/Overapplied O’head Cost
Sum of:
• VMO Spending Variance
• VMO Efficiency Variance
• FMO Budget Variance
• FMO Volume Variance
= Total Overhead Variance
• Favourable Variance: Overapplied
• Unfavourable Variance: Underapplied
Management by Exception
• If Actual close to Budget/Standards
! Managers can focus on other
issues
• If Variance occurs
! Managers alerted of “excepFon”
Evaluation of Standard Costs
Advantages
1.  Key element in management by
excepFon.
2.  Reasonable standards can
promote economy and efficiency.
3.  Greatly simplifies bookkeeping;
standard costs are consistent.
4.  Fits naturally in “responsibility
accounFng”.
Evaluation of Standard Costs
Disadvantages
1.  Variance reports oqen outdated.
2.  Morale may suffer if reports used to lay blame.
3.  Assumes output is labour-‐paced (but oqen
depends on speed of machine).
4.  Assumes labour hours are variable; in fact, fixed.
5.  In some cases, favourable is actually
“unfavourable”; ie. Harvey’s: less meat =
substandard burger
6.  Emphasizes meeFng standards; excludes other
important objecFves ie. Quality
Question
• Which of the following is not a possible cause
of an unfavourable variable overhead
spending variance
A)  Paying higher hourly wages for indirect
labour than planned
B)  Paying more for indirect supplies than
planned
C)  Using more indirect supplies than planned
D)  Paying more for insurance on factory
equipment than planned
Question
• Which of the following is not a possible cause
of an unfavourable variable overhead
spending variance
A)  Paying higher hourly wages for indirect
labour than planned
B)  Paying more for indirect supplies than
planned
C)  Using more indirect supplies than planned
D)  Paying more for insurance on factory
equipment than planned
Question 10-‐26
Haliburton Mills Inc. is a large producer of men’s and women’s clothing.
The company uses standard costs for all of its products .The standard
costs and actual costs for a recent period are given:
Direct Materials: Standard Actual
Standard: 4.0m at $3.60 /m $14.40
Actual: 4.4m at $3.35/m $14.74
Direct Labour:
Standard: 1.6hr at $4.50/hr $7.20
Actual: 1.4hr at $4.85/hr $6.79
Variable Manufacturing Overhead:
Actual: 1.4hr at $2.15/hr $3.01
Fixed Manufacturing Overhead:
Actual: 1.4hr at $3.05/hr $4.27
Total Cost per unit $29.28 $28.81

Question 10-‐26
During this period, the company produced 4,800 units of
product.
There was no inventory of materials on hand to start the
period. During the period, 21,120 metres of materials
were purchased and used in producFon. The
denominator level of acFvity for the period was 6,860
hours.
1.  For direct materials:
a)  Compute the price and quanFty variances for the
period.
b)  Prepare journal entries to record all acFvity
relaFng to direct materials for the period.
3.  Compute the fixed overhead budget and volume
variances.
2006 Final Question
Analysts at Spring Break Ltd. have gathered
the following data:
Budgeted direct labour mix at standard
rate, for actual output achieved:
Skilled labour 7,650 hours at $32 per hr
Unskilled labour 2,550 hours at $24 per hr
Actual results:
• Skilled labour 8,000 hours at $38 per hr
• Unskilled labour 2,000 hours at $18 per hr
2006 Final Question cont’d

Required
Calculate the mix and yield variances for
direct labour. (8 marks)
Chapter 11
Good to Know…
-‐  NegoFated Transfer Pricing
-‐  ROI/RI calculaFons
-‐  4 Cost of Quality Groups
Responsibility Centre
DefiniFon
• Any part of an organizaFon
whose manager has control
over and is accountable for
cost, profit or investments
Responsibility Centre
3 types of responsibility centres
1)  Cost Centre
• Evaluated using standard cost and
flexible budget variances
2) Profit Centre
• Evaluated by comparing actual
profit to target/budget
3) Investment Centre
• Evaluated using ROI or RI
Transfer Pricing
DefiniFon
•  Price charged when division
provides good or service to
another division of
organizaFon
Transfer Pricing
3 common approaches:
1)  Allow managers to negoFate.
2)  Set at cost using variable/full
absorpFon cosFng.
3)  Set at market price.
! Fundamental objecOve:
Act in best interest of overall
company
Negotiated Transfer Price
Advantages
• Preserves autonomy of division.
• Managers have beaer
informaFon about costs and
benefits
Selling Transfer Purchasing
Division ≤ Price ≤ Division
Upper Limit (Purchasing Division)
Transfer Price
≤ Cost of buying from Supplier

• If no outside suppliers,
purchasing division should be
willing to pay expected revenue
per unit – excluding transfer
price
Lower Limit (Selling Division)
Transfer Price
Total CM on Lost Sales
≥ VC/unit +
# of Units Transferred
3 scenarios:
1)  Selling Division with Idle Capacity
2)  Selling Division with no Idle
Capacity
3)  Selling Division with some Idle
Capacity
Selling Division with Idle Capacity
Transfer Price
≥ VC/unit +

0
≥ VC/unit +

≥ VC/unit
Selling Division with no Idle Capacity
Transfer Price
≥ VC/unit + # of Units Transferred

≥ VC/unit + ( Selling Price − VC / unit ) × # of units

≥ Selling Price per unit
Selling Division with some Idle Capacity
Transfer Price
≥ VC/unit + # of Units Transferred

≥ VC/unit
+ ( Selling Price ‐ VC/unit ) × # of sales lost
Evaluation of Negotiated Transfer Prices
• If transfer results in higher overall
profits, there will always be a range
of acceptable transfer prices
• SomeFmes managers aren’t
cooperaFve
• Most companies set transfer prices
using other methods
!  Set transfer price at:
1) Cost or 2) Market Price
Transfers to Selling Division at Cost
• Set price at variable cost or full absorpFon
cost incurred by selling division.
Major defects:
• May lead to subopFmizaFon.
• Selling division will never show profit.
• No incenFves to control costs.
Advantage:
• Easily understood and convenient.
! cost-‐based transfer prices common used.
Transfers to Selling Division at MV
• Set price to match price charged on
open market.
• Appropriate when no idle capacity.
Major defects:
• When idle capacity present,
purchasing division might regard
market price as cost
! might make bad pricing decision
(end product priced too high)
Evaluation of Investment Centre
•  2 methods:
1)  Return on Investment
2)  Residual Income
1) Return on Investment
Operating Income
ROI =
Average Operating Assets
OperaFng Income
• Earnings before Interest and Tax (EBIT)
Average OperaFng Assets
• Includes cash, A/R, inventory, P&E
• Doesn’t include land, investments,
rented-‐out buildings
! Higher ROI = Greater Profit per $
invested in operaFng assets
Side Note
Advantage of calculaFng P&E using:
• Net Book Value
! Consistent with balance sheet value
• Gross Cost
! Eliminates depreciaFon factor
(ROI" as NBV# due to depreciaFon)
ROI = Margin x Turnover
Operating Income Sales
= ×
Sales Average Operating Assets
• Increase in ROI must involve at least
one of following:
1) Increased Sales
2) Reduced operaFng expenses
3) Reduced operaFng assets
CriFcisms
1)  Increasing ROI inconsistent with
company strategy.
!  May increase ROI in short run but harm
in long run ie. cut R&D costs.
2)  Managers may inherit commiaed costs
with no control
!  Difficult to assess manager against other
managers.
3)  Managers evaluated based on ROI may
reject profitable investment
opportuniFes.
2) Residual Income
Residual Income
= OperaFng Income
– (Average OperaFng Assets
x Minimum Required Rate of Return)
2) Residual Income
Advantage
• Encourages manager to make
investment that is profitable for
enOre company but rejected by
managers evaluated with ROI.
Disadvantage
• Can’t be used to compare
performance of division of
different size.
2) Residual Income
CriFcisms
1)  Based on historical data.
2)  Doesn’t indicate what earnings
should be for business unit.
! Must compare to compeFtor/past
performance.
3)  Requires adjustments to GAAP
that increases cost of preparing
informaFon.
4)  Doesn’t incorporate non-‐financial
indicators ie. Employee moFvaFon
Balanced Scorecard
3 Strategic Approaches to
Outperforming CompeOtors:
1)  Cost Leadership
2)  DifferenFaFon
3)  Focus/Niche
Balanced Scorecard
•  Illustrates theory of how company
can aaain desired outcome with
concrete acFons.
Advantage
•  Can be used conFnually to test
theories underlying manager’s
strategy
!  Needs feedback
Balanced Scorecard
Advantages of Timely Feedback
•  Cause can be tracked down and
acFon taken quickly.
•  Managers can focus on trends.
!  Emphasize improvement rather
than standard.
Measures of Internal Business
Process Performance
Delivery Cycle Time
•  Amount of Fme required from receipt of
order to shipment of good
Throughput (Manufacturing Cycle) Time
• Amount of Fme required to turn raw
material to complete product
• Process Ome = value-‐added acFvity
• InspecOon, Move, Queue Ome – should be
eliminated as much as possible
Manufacturing Cycle Efficiency
= Value-‐Added Time / Throughput Time
Cost of Quality
Quality of Conformance
• Degree to which product/service
meets design specificaFons and is
free of defects
! ObjecOve:
High Quality of Conformance
Cost of Quality
4 Groupings:
1)  PrevenOon Costs – incurred to keep
defects from occurring
2)  Appraisal Costs – incurred to idenFfy
defecFve products before shipping
3)  Internal Failure Costs – costs incurred
as result of idenFfying defecFve
product before shipping
4)  External Failure Costs – costs incurred
when defect product delivered
Cost of Quality
• When quality of conformance
low, cost of quality high.
• Reduce cost of quality by focusing
on appraisal and prevenFon costs.
International Standards Organization
ISO 9000 Standards

•  Quality control requirements
issued by the ISO.
ISO 4000 Standards
•  Requirements for environmental
management system.
Question
Which of the following statements is true?
A) If a division’s net operaFng income is
posiFve, it’s residual income will also be
posiFve.
B) Residual income should be used to
evaluate profit center managers.
C) ROI can be used to compare divisions of
different sizes.
Question
Which of the following statements is true?
A) If a division’s net operaFng income is
posiFve, it’s residual income will also be
posiFve.
B) Residual income should be used to
evaluate profit center managers.
C)  ROI can be used to compare divisions
of different sizes.
Question
Vision Inc. reported actual return on
investment of 24% and average operaFng
assets of $1,500,000 for the month of
September. If the required rate of return is
20%, what was Vision’s residual income in
September?
A)  $360,000
B)  $300,000
C)  $60,000
D)  $0
Question
Vision Inc. reported actual return on
investment of 24% and average operaFng
assets of $1,500,000 for the month of
September. If the required rate of return is
20%, what was Vision’s residual income in
September?
A)  $360,000
B)  $300,000
C)  $60,000
D)  $0
11-‐24
GalaF Products Inc. has just purchased a small company
that specializes in the manufacture of electronic tuners
that are used as component part of TV sets. GalaF
Products Inc. is a decentralized company and it will treat
the newly acquired company as an autonomous division
with full profit responsibility. The new division called
Tuner Division has the following revenue and costs
associated with each tuner that it manufactures and
sells:
•  Selling Price $20
•  Expenses:
•  Variable $11
•  Fixed (based on 100,000 tuners) $6 $17
•  OperaFng income $3
11-‐24
GalaF Products also has an Assembly Division that
assembles TV sets. This division is currently purchasing
30,000 tuners per year from an overseas supplier at a
cost of $20 per tuner, less a 10% purchase discount. The
president of GalaF Products is anxious to have the
Assembly Division begin purchasing its tuners from the
newly acquired Tuner Division in order to “keep the
profits within the corporate family.”
11-‐24
Assume the Tuner Division can sell all of its output to
outside TV manufacturers for $20.
1.  Are the managers of the Tuner and Assembly
Division likely to voluntarily agree to a transfer price
for 30,000 tuners each year? Why or why not?
2.  If the Tuner Division meets the price that the
Assembly Division is currently paying to its overseas
supplier and sells 30,000 tuners to the Assembly
Divison each year, what will be the effect on the
profits of the Tuner Division, the Assembly Division
and the company as a whole?
11-‐24
Assume the Tuner Division is currently selling only
60,000 tuners to outside TV manufacturers.
3.  Are the managers of the Tuner and Assembly
Divisions likely to voluntarily agree to a transfer price
for 30,000 tuners each year? Why or why not.
2006 Final Question
Folk Company’s Audio Division (AD) produces a
speaker used by manufacturers of various audio
products. Sales and cost data on the speaker are as
follows:
•  Selling price per unit to external customers $60
•  Variable manufacturing costs per unit $40
•  Fixed overhead per unit (based on capacity) $ 2
•  Variable selling costs per unit $ 2
•  Fixed selling and administraFve costs per unit $ 8
•  Total capacity 25,000 units
The Home Theatre Division (HTD) of Folk Company
could use this speaker in one of its products. They
require 5,000 speakers per year and are currently
paying $57 per speaker from an external supplier.
2006 Final Question
•  Selling price per unit to external customers $60
•  Variable manufacturing costs per unit $40
•  Fixed overhead per unit (based on capacity) $ 2
•  Fixed selling and administraFve costs per unit $ 8
•  Total capacity 25,000 units
•  HTD requires 5000 speakers.
•  HTD current pays external supplier $57 per speaker.
Required
Assuming the AD is currently selling 20,000 speakers per
year to external customers, what would be the overall
effect on company profits if they were to sell 5,000
speakers per year to the HTD? (4 marks)
2006 Final Question
Assume now that the AD is currently selling 25,000 speakers
per year to external customers. Further assume that the HTD
will use the speaker in a product with the following details:
•  Selling price per unit $400
•  Direct material costs per unit $300 (excl. speaker cost)
•  Direct labour costs per unit $ 20
•  Variable overhead costs per unit $ 10
•  Fixed overhead costs per unit $ 8
Also assume that the HTD can only manufacture and sell this
product if they are able to buy the speaker from the AD (i.e.,
there is no external supplier). What would be the overall
effect on company profits if the AD sells 5,000 speakers per
year to the HTD? (5 marks)
Chapter 12
Good to Know…
-‐  Relevant vs. Irrelevant Costs
-‐  Various Decision Analyses
-‐  Cost-‐Plus Pricing
Relevant vs. Irrelevant Costs
Relevant Costs
• Avoidable Costs – any cost that can be
eliminated by choosing one alternaFve
over another
(aka relevant cost, differenFal cost)
Irrelevant Costs
• Sunk Costs – any cost already incurred
that can’t be changed by decision
• Future Costs that don’t differ between
alternaFves
Why Isolate Relevant Costs?
1)  Only rarely will enough
informaFon be available for
detailed income statement.
2)  Combining R and IR costs
may cause confusion and
distract from criFcal
informaFon (relevant costs).
Analysis of Decisions
1)  Add or Drop Product Line
2)  Make or Buy
3)  Accept or Reject Special Order
4)  Sell or Process Further
1) Adding/Dropping Product Lines
Add product line if:
• Avoidable Fixed Costs
< ContribuFon Margin
Drop product line if:
• Avoidable Fixed Costs
> ContribuFon Margin
2) Make or Buy Decision
Advantages of Making
• Less dependent on suppliers.
• Smooth flow of parts and materials
for producFon.
• Control quality beaer.
Advantages of External Suppliers
• Suppliers enjoy economies of scale.
Consider:
1)  Avoidable Costs
2)  Opportunity Costs
Avoidable Costs
Make if:
• Avoidable Costs < Purchase Price
Buy if:
• Avoidable Costs > Purchase Price
Opportunity Costs
• If space idle, opportunity cost = 0
!  Make
• If space used for something else,
opportunity cost = CM from best
alternaFve use of space.
• Make: Opp. Cost < Make/Buy Difference
• Buy: Opp. Cost > Make/Buy Difference
3) Special Orders
Take special order if:
• Idle Space:
•  Incremental Revenue >
Incremental Costs
• No Idle Space:
• Incremental Revenue >
Incremental Costs + CM forgone
4) Sell or Process Further
Keep Processing if:
•  Incremental Revenue >
Incremental Processing Cost
Maximizing CM with
Constrained Resources
Without Boaleneck
•  Choose products that have highest
unit CM.
With Boaleneck
•  Choose products with highest
profitability index.
• Profitability Index
= Unit CM/QuanFty of Constraint
Cost-‐Plus Pricing
Selling Price
= Cost + (Markup % x Cost)
2 Approaches:
1)  AbsorpFon CosFng Approach
2)  Variable CosFng Approach
1) Absorption Costing Approach
1)  Compute Unit Product Cost
= DM + DL + VMO + FMO
2)  Markup Percentage
(
=
Req'dROI × Investment) + SG& A Expenses
Unit Sales × Unit Product Cost
Problems
• Relies on forecast of unit sales.
2) Variable Costing Approach
1)  Compute Unit Variable Cost
= DM + DL + VMO
2)  Markup Percentage
(
=
Req'dROI × Investment) + Total Fixed Cost
Unit Sales × Total Unit Variable Cost
Advantages
1)  Consistent with CVP Analysis
2)  Avoids need to arbitrarily
allocate common fixed costs.
Target Costing
• Process of determining maximum
allowable cost for developing new
product.
Target Cost
= AnFcipated Sell Price – Desired Profit
Reasoning
•  Many companies have liale control
over price.
•  Most of the cost of a product
determined in the design stage.
Question
Which of the following items will not be
relevant when deciding whether to keep
or drop a product line?
A) ContribuFon margin of the product line
B) Avoidable fixed costs of the product line
C) DepreciaFon on equipment used to
manufacture the product
D) All of the above are relevant
Question
Which of the following items will not be
relevant when deciding whether to keep
or drop a product line?
A) ContribuFon margin of the product line
B) Avoidable fixed costs of the product line
C)  DepreciaOon on equipment used to
manufacture the product
D) All of the above are relevant
2006 Final Question
Tanner CompuFng, a retailing company, has two departments,
Hardware and Soqware. Results from the most recent month of
operaFons are as follows:
Total Hardware Soqware
Total Hardware Sorware
•  Sales $4,000,000 $3,000,000 $1,000,000
•  Variable expenses 1,300,000 900,000 400,000
•  ContribuFon margin 2,700,000 2,100,000 600,000
•  Fixed expenses 2,200,000 1,400,000 800,000
•  OperaFng income $500,000 $700,000 $(200,000)
Analysis shows that 40% of the fixed costs in the Soqware
department are common costs that will conFnue even if the
department is dropped. Of the remaining fixed costs, $50,000
relates to the Soqware department manager, who if the
department is dropped, will be assigned other duFes in Tanner
CompuFng at her exisFng salary. If the Soqware department is
dropped, sales in the Hardware department will drop by 10% with
no change to Hardware’s fixed costs.
2006 Final Question
•  Sales $4,000,000 $3,000,000 $1,000,000
•  Variable expenses 1,300,000 900,000 400,000
•  CM 2,700,000 2,100,000 600,000
•  Fixed expenses 2,200,000 1,400,000 800,000
•  OperaFng income $500,000 $700,000 $(200,000)
•  40% of the Soqware Dept. fixed costs are common costs
•  $50,000 relates to Soqware Manager, who will be transferred
•  If the Soqware department is dropped, sales in the Hardware
department will drop by 10% with no change to Hardware’s
fixed costs.
Required:
If the Soqware department is dropped, what will be the effect on
operaFng income for the company as a whole? Should the
department be dropped? (7 marks)
Chapter 13
Good to Know…
-‐  3 Screening Decisions
-‐  2 Preference Decisions
-‐  CCA tax shield calculaFon
Capital Budgeting
2 Broad Categories of
Capital BudgeFng Decisions:
1)  Screening Decision – decision as
to whether proposed
investment meets standard.
2)  Preference Decision – decision
as to which of several
compeFng acceptable
investment proposals is best.
Capital Budgeting Decisions
3 Screen Decision Approaches:
1)  The Payback Method
2)  The Simple Rate of Return
3)  Discounted Cash Flows
1)  Net Present Value
2)  Internal Rate of Return
1) The Payback Method
Investment Required
Payback Period =
Advantages Net Annual Cash Inflow
•  Used in industries where product
obsolete quickly
• Important for “cash poor” companies
Disadvantages
• Doesn’t adequately consider Fme
value of money
• Prefer return sooner rather than later
2) The Simple Rate of Return
Simple Rate of Return
= IncrementalRevenue − IncrementalCost
InitialInvestment
• Accept: Simple Rate > Target Rate
• Reject: Simple Rate < Target Rate
Advantage
• InformaFon is consistent with ROI
Disadvantage
• Doesn’t adequately consider Fme
value of money.
3) Discounted Cash Flows
= PV of Cash Inflows – PV of Cash Ou|lows
• If NPV is PosiFve ! Accept Project
• If NPV is Zero ! Accept Project
• If NPV is NegaFve ! Reject Project
1) Net Present Value
• Cash Inflows:
• Incremental revenues
• ReducFon in costs
• Salvage value
• Release of working capital
1) Net Present Value
• Cash Ouslows:
• IniFal investment
(depreciaFon not deducted)
• Increased working capital
(=current assets – current liabiliFes)
• Repairs and maintenance
• Incremental operaFng costs
•  Discount rate that makes NPV = 0
•  Can only be calculated through
trial-‐and-‐error or financial
calculator
• IRR compared to Required Rate of
Return:
• If IRR ≥ Required ! Accept
• If IRR < Required ! Reject
NPV Advantages over IRR
• NPV simpler to calculate
• IRR assumes internal rate is rate of
return (whereas it should be the
discount rate)
! If NPV and IRR disagree, use NPV
IRR Advantage over NPV
• IRR used for comparing projects of
different sizes
Capital Budgeting Decisions
2 Preference Decisions:
1) Net Present Value
•  NPV can’t be compared unless
investments are of equal size
•  Profitability Index
PV of CashInflows
=
Investment Req'd
•  Higher PI ! More desirable project
2) Internal Rate of Return
•  Higher IRR
! More Desirable Project
Comparing Preference Rules
•  Profitability Index preferred
because it always gives the
correct signal as to relaFve
desirability of alternaFves, even
if different lives/paaerns of
earning
•  IRR preferred for short-‐term
decisions (4-‐5 years)
After-‐tax Cost and Bene[it
Arer-‐Tax Cost
= Tax DeducFble Cash Expense
x (1 – tax rate)
Arer-‐Tax Benefit
= Taxable Cash Receipt
x (1 – tax rate)
Capital Cost Allowance
•  Amount of depreciaFon allowed by
Canada Revenue Agency for tax
purposes
• Undepreciated Capital Cost (UCC) –
remaining book value of asset under
CCA
• Maximum amount that can be
deducted as depreciaFon expense
= UCC x CCA rate
CCA Tax Shield
• Present value of infinite stream of
tax savings from CCA
Cdt 1 + 0.5k
CCA Tax Shield = ×
where: d + k 1 + k
C = the capital cost of the asset
d = CCA rate
t = firm’s tax rate
k = Cost of Capital
Adjustment for Salvage Value
Sdt −n
Salvage Value =
d + k
× 1+k ( )
where:
S = salvage value
d = CCA rate
t = firm’s tax rate
k = Cost of Capital

PV of CCA tax shield
PV of CCA tax shield
Cdt 1 + 0.5k Sdt −n
(
= × −
d+k 1+k d+k
× 1+k )
Question
Which of the following indicates an
UNACCEPTABLE capital project?
A) The internal rate of return exceeds the
cost of capital.
B) The net present value of a project is 10.
C) The profitability index of a project is
0.97.
D) The simple rate of return exceeds the
target rate of return.
Question
Which of the following indicates an
UNACCEPTABLE capital project?
A) The internal rate of return exceeds the
cost of capital.
B) The net present value of a project is 10.
C)  The profitability index of a project is
0.97.
D) The simple rate of return exceeds the
target rate of return.
Question
Project A:
Periods 0 1 2 3 4
Cash flows (50) 0 0 0 100

If Project B has an IRR of 10%,
which project would you prefer
using the IRR method?

Good Luck!
Roanna
roanna.shen@gmail.com

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• Since 2004, SOS has raised

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Total Flexible Budget Variance

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