N. Cruz-Course Material For Strategic Cost Management

Subject Code: BACOSTMX
Subject Title: STRATEGIC COST MANAGEMENT
Subject Description: This course is designed to acquaint students with the role of the
accountant in the management team by analyzing, interpreting and
reporting cost information to help the management develop and
identify superior strategies that will produce a sustainable competitive
advantage. It covers the discussion of the objectives, role and scope of
management accounting; management accounting concepts and
techniques for planning and control which includes cost terms,
concepts and behavior, CVP analysis, variable costing and absorption
costing, financial planning and budgets, capital budgeting, strategic
cost management; and management accounting concepts and
techniques for performance measurement which includes
responsibility accounting and transfer pricing and balance scorecard.
No. of Units: 3
REFERENCES:
Strategic Cost Management by Elenita Balatbat Cabrera, Gilbert Anthony B. Cabrera, and Bernadette
Ann B. Cabrera (2021)
A Closer Look on Cost Accounting by Paul Anthony Dela Fuente De Jesus (2021)
Cost Accounting by Guillermo M. De Leon Jr. and Normal D. De Leon (2012)
Cost Accounting by Horngren, Datar, and Rajan (14th Edition)
Topics:
MODULE 1: PROCESS COSTING

A. Definition
B. Characteristics of Process Costing
C. Cost of Production Report
D. Product Flow
E. Differences between FIFO and Average
F. Characteristics of FIFO Costing Method
G. Characteristics of Average Costing Method
H. Computation of Equivalent Unit Cost
I. Computation of Cost Allocation
MODULE 2: STANDARD COSTING

A. Definition
B. Nature of Standard Costs
C. Purposes of Standard Cost
D. Types of Variances
E. Computation of Variances
F. Entries to Record Different Variances
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MODULE 3: COST VOLUME PROFIT ANALYSIS
A. Explain the features of cost-volume-profit (CVP) analysis.
B. Determine the breakeven point and output level needed to achieve a
target operating income.
C. Explain how managers use CVP analysis in decision making.
D. Explain how sensitivity analysis helps managers cope with uncertainty.
E. Use CVP analysis to plan variable and fixed costs.
F. Apply CVP Analysis to a company producing multiple products.
MODULE 4: ABSORPTION AND VARIABLE COSTING

A. Determine the Cost of Goods Sold and Income under Absorption
Costing
B. Determine the Cost of Goods Sold and Income under Variable Costing
C. Identify Differences between Absorption and Variable Costing Methods
D. Learn the Reconciliation of Absorption and Variable Costing Income
Figures
E. Understand the Standard Costs Report under Absorption and Variable
Costing
MODULE 5: RELEVANT INFORMATION FOR DECISION MAKING

A. Use the five-step decision-making process to make decisions
B. Distinguish relevant from irrelevant information in decision situations
C. Explain the opportunity-cost concept and why it is used in decision
making
D. Know how to choose which products to produce when there are capacity
constraints
E. Explain why book value of equipment is irrelevant in equipment
replacement decisions
F. Explain how conflicts can arise between the decision model used by a
manager and the performance evaluation model used to evaluate the
manager
MODULE 6: BUDGETING FOR PLANNING AND CONTROL

A. Define budgeting, and discuss its role in planning, controlling, and
decision making.
B. Prepare the operating budget, identify its major components, and explain
the interrelationships of the various components.
C. Identify the components of the financial budget, and prepare a cash
budget.
D. Define flexible budgeting, and discuss its role in planning, control, and
decision making.
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DISLAIMER: The information content provided in this course material is designed to provide helpful information on
the subjects discussed. Some information’s are compiled from different materials and summarized from different books.
Some information’s are based on contributors' perspective and understanding. References are provided for
informational purposes only and do not constitute endorsement of websites or other sources. Readers should be aware
that the websites/electronic references listed in this course material may change. Hence, the contributors do not claim
any information presented in the materials and do not reflect their own work.
MODULE 1:
PROCESS COSTING
I. LEARNING OBJECTIVES
At the end of this module the students should be able to:
1. Define the characteristics of a process cost system
2. Compute for the equivalent production
3. Discuss and prepare a cost of production report
4. Discuss the effect of beginning work in process inventories
5. Discuss the differences between the weighted average and FIFO methods used to account for
beginning work in process inventories
6. Discuss how to deal with spoiled units in a process cost system
7. Discuss how scrap and waste materials are handles in a process cost system.
II. CONTENT
The basic purpose of cost accounting is the accumulation of data designed to provide management
with accurate information on the cost of manufacturing a product. The appropriate cost accounting
system for a particular entity depends on the nature of manufacturing operations.
When a manufacturing process involves the continuous production of identical units rather than
distinguishable job lots, there can be no job orientation. When there is no obvious start or finish,
we use a process-costing system to accumulate and allocate manufacturing costs. In using process
costing all manufacturing costs are allocated to units of product as unit are completed. Instead of
using job-cost sheets, the costs associated with each department are summarized on a cost-of-
production report, with one report per department for period of time. At the end of each period,
the costs accumulated on each such report will be allocated between end of period work in process
and units transferred to the next process, or, in the case of the final process, to finished goods.
A process cost system determines how manufacturing costs incurred during each period will be
allocated. The allocation of costs within a department is only an information step, the ultimate
goal is to compute total cost per unit for income determination. During a period some units will
be started but will not be completed by the end of the period. Consequently each department must
determine how much of the total costs incurred by the department is distributed to units still in
process and how much is attributable to completed units.
PROCESS COSTING METHOD ARE USED BY THE FOLLOWING:

1. Industries producing chemicals, petroleum, textiles, steel, rubber, cement flour,
pharmaceuticals, shoes, plastics, sugar, and coal.
2. Firms manufacturing items such as rivets, screws, bolts, and small electrical parts.
Page 3 of 134
3. Assembly-type industry which manufactures typewriters, automobiles, airplanes, and
household electric appliances.
4. Service industries such as gas, water, and heat.
CHARACTERISTICS OF A PROCESS COST SYSTEM

1. Costs are accumulated by department or cost center
2. Each department has its own general ledger Work in Process Inventory account. This account
is debited with the processing costs incurred by the department and credited with the cost of
completed units transferred to another department or to finished goods inventory.
3. Equivalent units are used to restate – work in process inventory to terms of completed units
at the end of a period.
4. Completed units and their corresponding costs are transferred to the last department or to
finished goods inventory. By the time units leave the last processing department, total costs
for the period have been accumulated and can be used to determine the unit cost of each and
total finished goods.
5. Total costs and unit costs for each department are periodically calculated and analysed with
the use of department cost of production report.
PRODUCTION BY DEPARTMENT
In a process cost system, when units are completed in one department, they are transferred to the
next processing department accompanied by their corresponding costs. A compete unit of one
department becomes the raw materials of the next department until the units reach finished goods.
Thus the output of Department 1 becomes the input of Department 2. Department 2 receives both
the units produced by Department 1 and the costs carried by such units. When department 2
completes its processing, it transfers out the units and the costs it received from Department 1
plus any cost it incurred while working on the units. The costs of a unit grow larger as it progresses
along the assembly line from one department to the next. For example, Sunbloc manufactures
chairs and uses three departments to produce one chair. Department 1 cuts and cleans the wood
at an average cost of P45 per unit. The wood are then moved to Department 2, where they are
assembled and put together at an average cost of P15. The next stop is Department 2, where they
are assembled and put together at an average cost of P15. The next stop is Department 3, where
they are painted at an average cost of P25 per unit. The completed chairs are transferred from
Department 3 to finished goods inventory. The total unit cost of one finished chair is P85,
computed as follows:
 Department 1 P45
 Department 2 15
 Department 3 25
Total Unit Cost Added P85
Generally, the cost per unit increases as units flow through each department. The unit cost can
decrease when units pass through a department if volume is added to the product.
SYSTEM FLOW
Units and costs flow together through a process cost system, the following equation summarizes
the physical flow of units in a department.
Page 4 of 134
UNITS TO ACCOUNT FOR UNITS ACCOUNTED FOR
Beginning units in process Unit Completed and Transferred
+ +
Units Started in Process OR Units Completed and On Hand
=
Received from Previous Department +
+ Units in Process, End
Increase in units due to addition of
Materials
PRODUCT FLOW
A product can flow through a factory in three different ways. These product formats associated
with process costing are:
1. Sequential Product Flow – the initial raw materials are placed into process in the first
department and flow through every department in the factory. Additional materials may or
may not be added in the subsequent departments. All items purchased go through the same
processes in the same sequence.
Department 1
Department 2
Department 3
Finished Goods Inventory
2. Parallel Product Flow – certain portions of the work are done at the same time and then
brought together for the final process and upon completion transferred to finished goods
inventory.
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Cutting Department 1 Writing Department 3
Staining Department 2 Resting Department 4
Combining Department 5
Packaging Department 6
Finished Goods Inventory
3. Selective – the product moves to different departments within the factory, depending upon the
desired final product. Several products are produced from the same initial raw materials.
Crude Oil
Department 1
Gasoline Heating Oil Kerosene

Department 2 Department 3 Department 4
Finished Goods Finished Goods Finished Goods

Inventory Inventory Inventory
Page 6 of 134
PROCEDURES – DIRECT MATERIALS, DIRECT LABOR AND FACTORY
OVERHEAD.
The use of a process cost system does not alter the manner of accumulating direct materials, direct
labor and factory overhead costs. The normal procedures of cost accounting are used to
accumulated the three product cost elements. Process costing is concerned however with the
assignment of these costs to the appropriate departmental Work In Process Inventory Account
Direct Materials
The entry to record the issuance of direct materials to Department 1 during the period is as
follows:
Work in Process – Department 1 xxx
Materials xxx
Direct materials are always added in the first processing department, but they are also usually
added in other departments. The journal entry would be the same for adding direct material costs
in later processing departments. The accumulation of direct material cost is much simpler in a
process cost system than in a job order cost system. Fewer journal entries are generally required
under process cost system. The number of departments using direct materials is usually less than
the number of jobs requiring direct materials in a job order cost accumulation system.
Direct Labor
The amounts to be charged to each department are determined by the gross earnings of the
employees assigned to each department. The entry to distribute direct labor costs is as follows:
Payroll xxx
Factory Overhead
In a process cost system, factory overhead costs may be applied using either of the following two
methods. The first method, which is similar to that used in job order costing, applies factory
overhead to work-in-process inventory at a predetermined application rate. A predetermined
factory overhead application rate based on normal capacity is appropriate when production
volume or factory overhead costs fluctuate substantially from month to month, as it eliminates
distortion in monthly unit costs caused by such fluctuations.
Factory Overhead Applied xxx
The second method charges actual factory costs incurred to work in process inventory. In the
event that production volume and factory overhead costs remain relatively constant from month
to month, expected capacity is appropriate as the denominator activity level. In a process cost
system, where there is continuous production, either method maybe used.
Page 7 of 134
COST OF PRODUCTION REPORT
The cost of production report is an analysis of the activity in the department or cost center for the
period. All costs chargeable to a department or cost center are presented according to cost
elements.
Total and unit costs are determined and summarized on a cost of production report. Either each
cost center or department makes such a report, or the individual reports of several departments
are summarized. There are a number of useful formats in preparing the cost of production report.
However, only one format is illustrated in this material. Regardless of the format used, the
important thing to emphasize is that process costing requires an orderly approach to assigning
costs to products. The following steps provide a uniform approach in preparing the cost of
production report.
Step 1 – Quantity Schedule

This schedule accounts for the physical flow of units into and out of departments. All units started
in the department must be accounted for and also the disposition of these units, that is, whether
they are transferred to the next department, lost, or remain in the department (complete or
incomplete). This schedule is concerned only with whole units, regardless of their stages of
completion.
Step 2 – Calculate Equivalent Units and Unit Costs

The concept of equivalent production is basic to process costing. In most cases, not all units are
completed during the period. Thus, there are units still in process at varying stages of completion
at the end of the period. All units must be expressed in terms of completed units in order to
determine unit costs. Equivalent production equals total units completed plus incomplete units
restated in terms of completed units. Completed units do not create a problem when equivalent
production is computed because they are always 100% complete as to direct materials, direct
labor, and factory overhead.
The problem lies in the restatement of incomplete units in terms of completed units. Incomplete
units are accounted for in work in process inventory until they are completed and transferred to
finished goods inventory. Therefore, to compute equivalent production, an analysis must be made
of the stage of completion of work in process inventory, subdivided into direct materials, direct
labor, and factory overhead. For example, direct materials may be added at one specific point in
production, such as at the beginning or at the end of the process. If direct materials are added at
the beginning, all work in process units will have complete direct material costs. When direct
materials are added at the end of the process, work in process inventory will not have any direct
materials from that department. Direct materials may also be added continuously, in this case the
work in process inventory will have direct materials equal to the stage of completion of the work
in process. The unit cost in the department is computed by dividing the cost incurred in the
department. For each element, by the equivalent production. The formula is:
FIRST-IN FIRST-OUT METHOD

Equivalent Unit Cost = Costs added during the period/Equivalent Units (Work done this period)
Page 8 of 134
WEIGHTED AVERAGE METHOD
Equivalent Unit Cost = (Cost from last period plus cost added during the period)/Equivalent Units
(Work done last period plus work done this period)
Step 3 – Determine the costs to be accounted for (cost charged to the department)
The cost that a department is responsible for may come from several sources. For one thing, there
may be some units in beginning inventory that maybe partially complete, and the costs of direct
materials, direct labor, and factory overhead that were assigned to these units last period will
become the cost of the beginning inventory and must be accounted for. Also, if the department is
not the first department in the production process, it will receive costs from other departments
when the units from these departments are received in its operations. In addition, each department
will incur direct materials, direct labor, and factory overhead in its own processing. The total of
these costs must be determined so that they can be accounted for.
Step 4 – Account for all costs

After the costs for which the department is responsible for are determined, an accounting for the
disposition of these costs must be made. Some of the costs are assigned to cost centres receiving
units transferred out of the department. The remaining costs are assigned to the units remaining
in the department and in some cases, to any units lost.
METHODS OF APPLICATION OF ELEMENTS OF COST TO PRODUCTION
1. Even application – under this method, it is considered that at any stage during the process of
production, the introduction of the three elements of cost are equal with one another. Only
one computation of equivalent production should be made.
2. Uneven application – under this method, the introduction of the elements of cost to production
varies at any stage of the process, hence, there should be as many computations of equivalent
as the elements of cost that are unevenly applied.
COMPUTATION OF EQUIVALENT PRODUCTION
Illustrative Problem 1
Units received from preceding department 10,000 Units
Units completed and transferred 8,000 Units
Units in Process, End (60% Completed) 2,000 Units
Materials are added 100% at the beginning of
the process
Solution
Materials Labor and Overhead
Actual
Work Done EUP Work Done EUP
Units Received 10,000
Units Completed 8,000 100% 8,000 100% 8,000

Units In Process 2,000 100% 2,000 60% 1,200
10,000 10,000 9,200
Page 9 of 134
Since materials are added at the beginning of process, then all units started during the period will get
100% materials. The percentage of completion is always the work done for labor and sometimes
overhead.
Materials are added 100% at the end of the
process
Solution
Actual
Units Completed 8,000 100% 8,000 100% 8,000

Units In Process 2,000 - - 60% 1,200
10,000 8,000 9,200
In this department, the units will get the materials upon reaching the end of the process in the
department. The units in process at the end are only 60%, hence no materials were added to these
units.
50% of Materials are added at the beginning
of the process and the remaining when the units
are 40% completed
Solution
Actual
Units Completed 8,000 100% 8,000 100% 8,000

Units In Process 2,000 100% 2,000 60% 1,200
10,000 10,000 9,200
The units in process at the end are 60% completed, therefore the units have passed the second addition
of materials which is done at 40% stage of completion.
Page 10 of 134
50% of Materials are added at the beginning of
the process, 30% when the units are 20% complete.
and the remaining at the end of the process
Solution
Actual
Units Completed 8,000 100% 8,000 100% 8,000

Units In Process 2,000 80% 1,600 60% 1,200
10,000 9,600 9,200
In this department, materials are added 50% at the beginning, so the in process end will get the first
50%, the second addition is at 20% stage of completion and because the units in process end are 60%
it means they have passed the second addition of materials and this will make their materials 80%
complete.
ILLUSTRATIVE PROBLEM
The following data were taken from the books of Michelle Cruz Company for the month of July
Department 1 Department 2
Units
Started 25,000
Completed and Transferred 20,000 18,000
In Process, End 5,000 2,000
Stage of Completion 40% 50%
Costs
Materials P100,000 P54,000
Labor 66,000 38,000
Overhead 44,000 19,000
In Department 1, materials are added at the beginning of the process while in Department 2,
materials are added at the end of the process.
Page 11 of 134
Michelle Cruz Company
Cost of Production Report
July 31, 2021
(Department 1)

Actual
Units Completed 20,000 100% 20,000 100% 20,000

Units In Process 5,000 100% 5,000 40% 2,000
25,000 25,000 22,000
Cost Charged to the Department

Cost Added in the Department
Materials P 100,000 P 4 *
Labor 66,000 3 **
Overhead 44,000 2 ***
Total added 210,000 9
Total Cost to be Accounted For P 210,000 P 9
Cost Accounted for As Follows:

Completed and Transferred (20,000 x 9) P180,000
In Process, End
Materials (5,000x4) P20,000
Labor (2,000x3) 6,000
Overhead (2,000x2) 4,000 30,000
Total Costs as Accounted For P210,000
*100,000/25,000 = 4
**66,000/22,000 = 3
***44,000/22,000 = 2
Page 12 of 134
July 31, 2021
(Department 2)

Actual
Units Completed 18,000 100% 18,000 100% 18,000

Units In Process 2,000 - - 50% 1,000
20,000 18,000 19,000

Cost from Preceding Department P 180,000 P 9
Materials
Labor 54,000 3 *
Overhead 38,000 2 **
Total added 19,000 1 ***
Total Cost to be Accounted For P 291,000 P 15

Completed and Transferred (18,000 x 15) P270,000
In Process, End
Cost from Preceding Department (2,000x9) P18,000
Materials -
Labor (1,000x2) 2,000
Overhead (1,000x1) 1,000 21,000
*54,000/18,000 = 3
**38,000/19,000 = 2
***19,000/19,000 = 1
JOURNAL ENTRIES
1. Materials Issued
Work in Process – Department 1 100,000
Materials 154,000
2. Labor Cost
Payroll 104,000
Page 13 of 134
3. Overhead Applied to Production
Factory Overhead Applied 63,000
4. Interdepartmental Transfer of Cost

5. Completion of Products
Finished Goods Inventory 270,000

Cost of Goods Manufactured Statement
For the Month of July 31, 2021
Direct Materials P 154,000

Direct Labor 104.000
Factory Overhead 63,000
Total Manufacturing Cost P 321,000
Less: Work in Process, July 31 51,000
Cost of Goods Manufactured P 270,000
METHODS OF COSTING UNDER PROCESS COSTING

1. FIFO Method
Under this method there is an assumed flow of manufacturing operations and as such it is
considered that those units which are first placed in process are presumed to be the first
ones completed and those that are first completed are the one transferred out. Under this
method:
a. The work in process beginning in the department will require a separate computation
for its equivalent production.
b. The units started, completed and transferred will have its own computation for
equivalent production.
2. Weighted Average Method

Under this method, there is no assumed flow of manufacturing operations. It involves the
merging of the departmental costs, by elements, of the initial work in process inventory
with the costs incurred in the current month and securing a representative average unit
costs by dividing the total element of costs by the equivalent production based upon the
sum of the units in the initial work in process inventory and the units placed production
during the period. Under this method, in the computation of the equivalent production, the
stage of completion of the work in process beginning is ignored and the total units
completed and transferred during the period is considered to have 100% completion.
Page 14 of 134
DIFFERENCES BETWEEN FIFO AND AVERAGE
1. Computation of equivalent production
a. FIFO – work done last month on the units in process, beginning is considered. The
work done needed to make the work in process 100% is the work done assigned for
the current month. (100% less work done last month).
b. Average – work done last month on the units in process, beginning is ignored and not
considered in the computation of the equivalent production.
2. Computation of Unit Cost

a. FIFO = Current Period Costs/Equivalent Units of Current Work Done
b. Average = (Cost of Beginning Inventory + Current Period Costs)/(Equivalent Units
in Beginning Inventory + Equivalent Units of Current Work Done)
3. Computation of the Cost of Goods Transferred Out

a. FIFO – the cost of goods transferred out equals the sum of the following three items:
 The cost incurred in the beginning inventory at the beginning of the period.
 The current period costs to complete beginning inventory, which equals the
equivalent units to complete beginning inventory times the current period unit cost
computed for FIFO.
 The cost to start and complete units, calculated by multiplying the number times
the current units cost computed.
b. Average – the cost of goods transferred out equals the total units transferred out times
the weighted average unit cost.
4. Computation of the Cost of Ending Inventory

a. FIFO – the cost of goods in ending inventory equals the equivalent units in ending
inventory times the unit current cost.
b. Average – the cost of goods ending inventory equals the equivalent units in ending
inventory times the weighted average unit cost.
STEPS FOR ASSIGNING PROCESS COSTS TO UNITS

1. Summarize the flow of physical units
2. Compute the equivalent units produced
a. Using FIFO, this means adding the equivalent units of work done to:
 Complete units in beginning inventory
 Start and complete units
 Work on units still in ending inventory
b. Using Average, this means adding the equivalent units of work done in the current
period to the equivalent units of work already done in the beginning inventory from
the previous period.
3. Summarize the total costs to be accounted for
The total costs to be accounted for are the costs in the beginning work in process inventory
and current period costs.
4. Compute costs per equivalent unit.
Page 15 of 134
ILLUSTRATIE PROBLEM 1
Units in Process, Beginning (40% complete) 5,000 Units
Units Started 20,000 Units
Units Completed 18,000 Units
Materials are added at the beginning of the process.
AVERAGE
Actual Work Done EUP Work Done EUP
Units Completed 18,000 100% 18,000 100% 18,000
Units In Process 7,000 100% 7,000 80% 5,600
25,000 25,000 23,600
FIFO
Actual Work Done EUP Work Done EUP
Units Completed
In Process, Beginning 5,000 - - 60% 3,000
Started and Completed 13,000 100% 13,000 100% 13,000
Units In Process 7,000 100% 7,000 80% 5,600
25,000 20,000 21,600
Note that no material was added to the units in process, beginning during the month because as of the
end of last month, all materials were added.
ILLUSTRATIE PROBLEM 2
The following information relates to the operations of Natalie Jillienne Company for the month of
November 2021.
Department 2
Units
In Process, November 1(40% complete) 1,000
Received from Department 1 8,000
Completed and Transferred 8,200
In Process, November 30 (20% complete) 800
Costs
In Process, 11/1 Cost during the Month
Materials P13,500 P81,000
Labor 9,000 72,000
Overhead 5,036 83,580
Materials are added at the beginning of the process.
Page 16 of 134
Natalie Jillienne Company
November 30, 2021
(AVERAGE METHOD)

Actual
Units in Process, Beg. 1,000
9,000
Units Completed 8,200 100% 8,200 100% 8,200

Units In Process 800 100% 800 40% 160
9,000 9,000 8,360

Cost from Preceding Department
In Process, November 1 P 13,500
Transferred-in during mo. 81,000
P 94,500 P 10.50 *
In Process, November 1
Materials P 9,000
Labor and Overhead 5,036
During the Month
Materials 72,000 9 **
Labor and Overhead 83,580 10.60 ***
Total Cost to be Accounted For P 169,616 P 30.10

Completed and Transferred (8,200 x 30.10) P246,820
In Process, End
Cost from Preceding Department (800x10.50) P8,400
Materials (800x9) 7,200
Labor and Overhead (160x10.60) 1,696 17,296
*(13,500+81,000)/9,000 = 10.50
** (9,000+72,000)/9,000 = 9
*** (5,036+83,580)/8,360 = 10.60
JOURNAL ENTRIES – AVERAGE METHOD

1. Work in Process – Department 2 81,000
Page 17 of 134
Materials 72,000
Payroll/Factory Overhead Applied 83,580
3. Finished Goods 246,820

Natalie Jillienne Company

November 30, 2021
(FIFO METHOD)

Actual
Units in Process, Beg. 1,000
9,000
Units Completed
In Process, Beginning 1,000 - - 60% 600
Received and Completed 7,200 100% 7,200 100% 7,200
In Process, End 800 100% 800 40% 160
9,000 8,000 7,960

Cost in Process, November 1 P 27,536
Cost from Preceding
81,000 P 10.125 *
Department

Cost Added During the Month
Materials P 72,000 9 **
Labor and Overhead 83,580 10.60 ***
Total Cost to be Accounted For 155,580 P 30.10
Total Cost to be Accounted For P 264,116 P 29.625

Started and Transferred (7,200 x 29.625) P213,300
From In Process, November 1 P27,536
Cost added During the Month
Materials -
In Process, End
Cost from Preceding Department P8,100
Materials (800x9) 7,200
Page 18 of 134
*81,000/8,000 = 10.125
**72,000/8,000 = 9
***83,580/7,960 = 10.50
JOURNAL ENTRIES – AVERAGE METHOD


Materials 72,000
Payroll/Factory Overhead Applied 83,580
3. Finished Goods 246,820

III. ACTIVITY
TRUE OR FALSE
1. Process costing is used when identical units are produced through an ongoing series of
uniform steps. TRUE
2. In a process costing system, the cost of production report takes the place of the job cost sheet.
TRUE
3. Process and job-order costing are similar in that costs are accumulated (and units costs are
computed) for each separate customer order. FALSE
4. In a process costing system, a Work in Process account is maintained for each department
TRUE
5. Since costs are accumulated by department, there is no need for Finished Goods inventory
account in a process costing system. FALSE
6. In a process costing system, costs incurred in one department remain there rather than being
transferred on to the next department. FALSE
7. Using the FIFO method, if for any period, the beginning Finished Goods Inventory is zero,
then the average ending unit cost in Finished Goods Inventory is either a number between the
unit cost in the beginning Work in Process inventory and the current period units costs, or it
is equal to the current period unit cost. TRUE
8. Using the FIFO method, if the units transferred out exceed the equivalent units in Work in
Process beginning inventory, then the unit cost of the ending Work in Process inventory will
equal the current period units cost. TRUE
9. Using the FIFO method, the number of units transferred out equals the number of units started
and completed plus the equivalent units in the beginning inventory times one minus the degree
of completion. FALSE
10. Using the FIFO method, if the beginning work in process inventory is zero, then the unit cost
of units transferred out will always equal the unit costs of the unit sin ending Work in Process.
TRUE
Page 19 of 134
MULTIPLE CHOICE
1. Which of the following characteristics applies in process costing but not to job order costing?
a. Identifiable batches of production
b. Equivalent units of production
c. Averaging process
d. Use of standard cost
2. An equivalent unit of material or conversion cost is equal to
a. The amount of material or conversion cost necessary to complete one unit of production
b. A unit of work in process inventory
c. The amount of material or conversion cost necessary to start a unit of production into
work in process
d. Fifty percent of the material or conversion cost of a unit of finished goods inventory
3. Assuming that there was no beginning in process inventory and the ending work in process
inventory is 100% complete as to material costs, the number of equivalent units as to materials
costs would be
a. The same as units placed in process
b. The same as the units completed
c. Less than the units placed in process
d. Less than the units completed
4. What are transferred-in costs as used in a process costing system?
a. Labor that is transferred from another department within the same plant instead if hiring
temporary workers from the outside
b. Cost of the production of a previous internal process that is subsequently used in a
succeeding internal process
c. Supervisory salaries that are transferred from an overhead cost center to a production
cost center
d. Ending work in process inventory of a previous process that will be used in a succeeding
process
5. In the computation of manufacturing cost per equivalent unit, the weighted average method
of process costing considers
a. Current costs only
b. Current cost plus cost of ending work in process inventory
c. Current cost plus cost of beginning work in process inventory
d. Current cost less cost of beginning work in process inventory
6. Which of the following statements are true?
Statement 1 – The weighted average method or process costing is computationally simpler
than the FIFO method of process costing
Statement 2 – Manufacturing companies that use process costing would usually, have more
products than manufacturing companies that use job-order costing.
Statement 3 – The production report prepared by companies using process costing will
indicate the cost and quantity of materials purchased during the period.
a. I only
b. II only
c. I and III only
d. I, II, and III
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7. Which of the following are needed to calculate the cost assigned to ending work in process
under the FIFO method of process costing?
a. Cost of In Process Beginning Only
b. Unit Cost Only
c. Unit Cost and Equivalent Units
d. Unit Cost, Equivalent Units, and Cost of In Process Beginning
8. The units transferred in from the first department to the second department should be included
in the computation of the equivalent units for the second department for which of the
following methods of process costing
a. FIFO Method and Weighted Average Method
b. FIFO Method
c. Weighted Average Method
d. Neither FIFO Method and Weighted Average Method
9. Armando Cruz, Inc. uses a process costing system. The following data are available for on
department for April:
PERCENTAGE OF COMPLETION
UNITS MATERIALS CONVERSION COST
Work in Process, April 1 10,000 60% 30%
Work in Process, April 30 5,000 80% 70%
The department started 45,000 units into production during the month and completed and
transferred 50,000 units to the next department. Assuming that weighted-average method of
accounting for units and costs, the equivalent units of material for April would be
a. 54,000 units
b. 50,000 units
c. 48,000 units
d. 44,000 units
10. Using the above information, except that, FIFO method of accounting for units and costs, the
equivalent units for conversion costs for April would be
a. 50,500 units
b. 46,500 units
c. 44,500 units
d. 48,000 units
11. The following information pertains to the month of July for Michelle Company:
 Beginning work in process inventory – P17,500 (10,000 units; 100% complete for
materials, and 60% complete for conversion cost)
 Units completed – 60,000 units
 Cost per equivalent units; Materials – P2.50; Conversion Cost, P2
Based on the above information, the cost of units transferred out during the July is
a. P260,000
b. P242,500
c. P254,500
d. P250,500
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12. Department L is the first stage of Liberty Company’s production cycle, the following
information is available for conversion costs for the month of January:
 Work in process, January 1 (75% incomplete) 8,000 units
 Started in January 40,000 units
 Completed in January and Transferred to Department M 38,000 units
 Work in process, January 1 (60% complete) 10,000 units
Using the FIFO method, the equivalent units for conversion costs for the month
a. 42,000 units
b. 38,000 units
c. 44,000 units
d. 36,000 units
13. The Allen Company has a process cost system and uses the weighted-average method. The
following information is applicable for the month of August
Units
 In process, August 1 (100% complete as to materials,
30% complete as to Labor and Overhead) 5,000
 Started in August 25,000
 Completed in August and Transferred to Department C 22,000
 Work in process, August 31 (60% complete) 8,000
Costs
In Process, August 1
Materials P10,000
 Added during the month
Materials P47,000
Based on this information, the cost of the units completed is
a. P135,000
b. P113,600
c. P107,800
d. P120,250
14. Using the above information, the cost of the ending Work in Process is?
a. P27,200
b. P39,200
c. P21,400
d. P32,400
15. The equivalent units for conversion costs is 47,500 units. The beginning inventory consisted
of 15,000 units, 60% complete. The ending inventory consisted of 10,000 units, 75%
complete. Assuming a FIFO basis of computing equivalent units, the number of units started
during the month was
a. 41,500 units
b. 31,000 units
c. 44,000 units
d. 34,000 units
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16. Che Company uses the weighted average method. It had P8,000 of conversion cost in the
beginning Work in Process Inventory and added P64,000 of conversion cost during the year.
The company completed 40,000 equivalent units for conversion costs during the year. The
Company had 10,000 units in the Ending Work in Process Inventory that were 30% complete
as to conversion. The amount of conversion cost assigned to the unit in process
a. P12,600
b. P5,400
c. P11,200
d. P4,800
Using the following information for questions 17 to 20

Beginning Inventory
Prior Department Costs P 4,800 3,000 units
Materials 1,080 20% complete
Conversion Costs 600 25% complete
Current Work
Prior Department Costs P 9,600 8,000 units
Materials 20,460
Conversion Costs 7,640
8,000 units were started this period
The ending inventory has 2,000 units, which are 45% complete as to materials, 65% complete
with respect to conversion costs. FIFO costing is used
17. What are the total units to be accounted for?
a. 8,000 units
b. 10,000 units
c. 11,000 units
d. 13,000 units
18. How many units were started and completed this period?
a. 6,000 units
b. 8,000 units
c. 10,000 units
d. 11,000 units
19. What are the equivalent units produced for materials?
a. 6,000 units
b. 8,000 units
c. 9,300 units
d. 9,900 units
20. What are the equivalent units produced for conversion costs?
a. 8,000 units
b. 9,300 units
c. 9,550 units
d. 10,300 units
IV. EVALUATION/ASSESSMENT
Evaluation/Assessment will be posted on MS Teams.
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MODULE 2:
STANDARD COSTING
1. Define Standard Costing and its uses
2. Distinguish actual, normal, and standard costing
3. Learn the Establishment of Standards for Direct Materials, Direct Labor, and Factory
Overhead.
4. Compute the Direct Material, Direct Labor, and Factory Overhead Variances
II. CONTENT
In an actual cost system, product costs are only recorded when they are incurred. This technique
is usually acceptable for the recording of direct materials, and direct labor because they can be
easily traced to specific jobs (job order costing) or departments (process costing). Factory
overhead, the indirect cost components of a product, usually cannot be easily traced to a specific
job or department. Since overhead is not a direct cost of production, a modification of an actual
cost system called normal costing, is commonly used. Under normal costing, direct materials and
direct labor costs are accumulated as they are incurred with one exception factory overhead is
applied to production, on the basis of actual input (hours, units, costs, etc. multiplied by a
predetermined factory overhead application rate). Under standard costing, all costs attached to
products are based on standard or predetermined accounts. Standard costs represent the “planned”
costs of production and are generally established well before production begins. The
establishment of standards thus provide management with goals to attain (i.e. – planning) and
bases for comparison with actual results (i.e. – control).
Standard costs are those expected to be achieved in a particular production process under normal
conditions. Standard costing is concerned with cost per unit and serves basically the same purpose
as a budget. Budgets, however, quantify management expectations in terms of total costs rather
than in terms of per unit costs. Standard costs do not replace actual costs in a costing accumulation
system. Instead, standard costs and actual costs are both accumulated.
Standard costs are also known as planned costs predicted costs, scheduled costs, and specification
costs. Estimated costs are different from standard costs because estimated costs have historically
been used a projections of what per unit costs will be for a period, while standard costs are what
a unit cost of a product should be.
The purpose of standard cost accounting is to control costs and promote efficiency. This system
is not a third cost accounting method, but is used with either job order or process costing to
manufacture a product and the subsequent comparison of the actual costs with the established
standard. Any deviation from the standard can be quickly detected and responsibility pinpointed
so that appropriate action can be taken to eliminate inefficiencies or to take advantage of
efficiencies.
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Comparison of Actual, Normal, and Standard Costing
Actual Costing Normal Costing Standard Costing
Cost of a product
Direct Materials Actual Actual Standard
Direct Labor Actual Actual Standard
Factory Overhead Actual Applied Standard
Standard costs are usually determined for a period of one year and are revised annually. However,
if cost analyses during the year indicate that a standard is incorrect, or if a significant change has
occurred in costs or other related factors management should not hesitate to adjust the standard
accordingly,
Uses of Standard Costs

Cost information may be used for many different purposes. It should be noted that cost
information which serves one purpose may not be appropriate for another. Therefore, the purpose
for which cost information is to be used should be clearly defined before procedures are developed
to accumulate cost data. Standard costs may be used for
1. Cost control
This refers to identifying a cost with its related benefits and making sure that the cost is
justified given the benefits derived. Standard costs provide a very useful tool for cost control.
The standard costs of a product is usually computed on a per unit basis. This standard cost is
then used to determine the cost of manufacturing any number of units by simply multiplying
the total units produced by the standard unit cost. Actual costs can be compared with standard
costs as frequently as necessary, whether monthly, weekly, and daily or for a single work
shift. With time performance, reporting, management can take action quickly to control
problems as they arise. Unnecessary high costs could go undetected without standard costs.
2. Pricing decisions
Prices are established by business firms to cover the cost of a product and at the same time
provide for profit. Accurate cost information is needed not only by profit organizations but
also by not-for-profit organizations to price their products or services fairly and within
regulatory guidelines. While actual costs reflect accurately the costs involved in producing
goods or services, they do not always provide consistent and timely information for pricing.
Standard costs provide a measure of consistency by eliminating fluctuations in actual costs,
such as seasonal costs for some raw materials or random fluctuations such as unexpected cost
changes in world markets. Since consistent and timely cost information in pricing its products
or services. Standard costs provide this timely information.
3. Performance appraisal
When standards are established for performance appraisal, they provide measurements that
can be applied uniformly to all personnel being evaluated. Standards provide one of the few
objective means of performance evaluation. For the standards to work well, they must be
understood by the people being evaluated. The employee should also know how the standards
are used in employee evaluation and reward system.
4. Cost awareness
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The primary concern of many managers are usually increasing production, improving product
quality, and reducing absenteeism. Although these are important goals each has specific cost
consequences which managers may not be aware of. Standard cost performance reports inform
managers of the cost implications of these actions and as a result make them take steps to
effectively control costs.
5. Management By Objectives (MBO)

MBO means that specific objectives are established for each business activity and the manager
responsible for that activity works to achieve the objectives. When an activity fails with the
acceptable performance levels, little managerial action is necessary other than routine
supervision. When performance varies significantly from acceptable levels, the manager tries
to correct the problem by taking appropriate actions. A standard cost system facilitates MBO
because it provides a quick reference for identifying and reporting differences between
standard and actual performance.
Establishment of Standards
An integral part of any standard cost system is the setting of standards for direct materials, direct
labor and factory overhead.
Direct Materials Standard

1. Direct Materials Price Standards
Price standards are the unit price at which direct materials should purchase. Even though
material costs are stated on a per unit basis, management must still estimate total sales for
next period before individual standards can be set. The sales forecast is of utmost importance
because it will first determine the total quantity of direct materials that will have to be
purchased during the next period. Most suppliers will offer substantive quantity to be ordered
for the entire period. Once the quantity to be purchased has been determined, the net purchase
price can be established by the supplier.
2. Direct Materials Usage (Efficiency) Standards

Efficiency (quantity or usage) standards are predetermined specifications of the quantity of
direct materials that should go into the production of one finished unit. If more than one direct
material is required to complete a unit individual standards must be computed for each direct
material. The number of different direct materials and the related quantities of each required
to complete one unit can be developed from engineering studies, analysis of past experiment
using descriptive statistics, and/or test runs under controlled conditions.
The engineering department, because it designs the production process is in the best position
to set realistically attainable material standards.
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Direct Labor Standards
1. Direct Labor Price Standards
Price (rate) standards are predetermined rates for a period. The standard rate of pay that an
individual will receive is usually based on the type of job being performed and the experience
that the person has had on the job. The wage rate of most manufacturing companies is usually
set forth in the union contract. If a non-union shop exists, the wage rate will usually be
determined by management in consultation with the human resources (HR) department. Items
like vacation pay and sick pay are usually not included in the standard rate of pay because
they are normally accounted for as part of factory overhead.
2. Direct Labor Efficiency Standards

Efficiency standards are predetermined performance standards for the amount of direct labor
hours that should go into the production of one finished unit. Time and motion studies are
helpful in developing direct labor efficiency standards. In these studies, an analysis is made
of the procedures followed by workers and the conditions (space), temperature, equipoment,
tools, lighting, etc. under which workers must perform their assigned tasks.
Studies have shown that average time (hours) required to complete one unit will decrease at
a constant percentage rate from the first job or unit, until complete processing had taken place.
The amount of direct labor hours required to produce one unit will usually decrease as workers
become more familiar with the process.
Factory Overhead Standards

The concept of standard setting for factor overhead is similar to standard setting for direct
materials and direct labor. However, although the basic concept is similar, the procedures used to
compute standard costs for factory overhead are quite different. One reason for the difference in
procedures is the variety of items comprising the factory overhead cost pool. Factory overhead
includes indirect materials, indirect labor, and all other indirect manufacturing costs such as
factory rent, depreciation of factory equipment, etc. The individual costs that make up total factory
overhead are effected differently by increases or decreases in plant activity. Depending on the
cost item, plant activity may cause a proportionate change (variable factory overhead costs) a
disproportionate change (mixed factory overhead costs), or no change (fixed factory overhead
cost) on total factor overhead costs.
When preparing factory overhead cost estimates for the next period assumption must be also be
made about changes in costs as a result of inflation, technology advances, and policy decisions
regarding production standards or objectives. Budgeting factory overhead costs requires careful
analysis of past experience, expected economic conditions, and other pertinent data in order to
arrive at the best possible prediction of next period’s factory overhead.
When determining a standard product cost, the amount representing factory overhead cost is
separated into variable and fixed costs. Although the total variable factory overhead costs will
vary in direct proportion with the production level, the variable factory overhead per unit will
remain constant within the relevant range. The total fixed overhead cost will remain constant over
different activity levels within the relevant range, while fixed overhead cost per unit will decrease
as production increases and increase as production decreases. Because of this cost-behavior
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characteristic, the application of a standard fixed factory overhead cost to each product becomes
a problem when production levels vary.
Budgets are commonly used in controlling factory overhead costs. Prior to the period in question
a budget that shows anticipated factory overhead costs is prepared. Actual factory overhead costs
are later compared with those budgeted as a means of evaluating managerial performance.
Budgets may either be static or flexible. Static budgets show anticipated costs at one level of
activity only. Flexible budgets show anticipated costs at different activity levels. This preparation
of flexible budgets eliminated the problems associated with static budgets in terms of fluctuations
in productive activity.
Variance Analysis
One of the major purpose of using a standard cost system is to aid management in controlling the
costs of production. Standards enable management to make periodic comparison of actual results
with standard (or planned) results. Differences that arise between actual results and planned
results are called variances. Variance analysis is a technique that can be used by management to
measure performance, correct inefficiencies, and deal with the “accountability function”. Cost
center managers’ report to the production supervisor who delegated authority to them.
Before accountability can be required of managers, responsibility for costs must be clearly
defined. Responsibility for costs should be assigned only to the department or cost center having
authority to incur the cost. When authority is delegated by upper level management to middle or
lower level managers, they will be held accountable for their performance.
DIRECT MATERIALS VARIANCES

1. Direct Material Price Variance – the difference between actual price per unit of direct
materials purchased and standard price per unit of direct materials results in the direct
materials price variance per unit, and if multiplied by the actual quantity purchased, the results
is the total direct material price variance. This is preferred method of computing the direct
material price variance because the variances are recorded when purchases are made. If the
problem does not give the quantity purchased, then quantity put into production may be used.
Most companies assign the responsibility for prior variances to the purchasing department.
Formula
Actual Quantity x Actual Price xx
Actual Quantity x Standard Price xx
Materials Price Variance xx
Possible causes of material price variance are as follows:

a. Fluctuations in market prices of materials
b. Purchasing from distant suppliers resulting in additional transportation costs
c. Failure to avail cash discounts
d. Purchasing materials of inferior quality
2. Direct Material Efficiency (Usage) Variance – the difference between actual quantity of
direct materials and standard quantity allowed multiplied by the standard price per unit equals
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the direct material efficiency variance. Standard quantity allowed is equal to the standard
quantity of direct materials per unit multiplied by equivalent production (FIFO Method) or
units completed during the period. As a result of using the standard price per unit and not the
actual price per unit, the effect of price changes has been eliminated. The direct material
efficiency variance computed can be solely attributed to differences in the quantity of input
unaffected by purchasing department price efficiencies or inefficiencies. The production
department or cost center that controls the input of direct materials into the production process
is assigned the responsibility for this variance.
Formula
Actual Quantity x Standard Price xx
Standard Quantity x Standard Price xx
Materials Efficiency (Usage) Variance xx
Possible causes of material efficiency variance are as follows:

a. Loss of materials due to poor handling
b. Use of defective or substandard materials
c. Lack of proper tools or machines
d. Spoilage or waste due to use of inferior quality of materials
DIRECT LABOR VARIANCES

1. Direct Labor Rate (Price) Variance – the difference between the actual hourly wage rate
and the standard hourly wage rate results in the direct labor price variance per hour, when
multiplied by the actual direct labor hours worked, the outcome is the total direct labor price
variance. The actual number of direct labor hours worked as opposed to the standard direct
labor hours allowed is used because we are analysing the cost difference between the payroll
that should have been incurred and the actual payroll that was incurred. Both payrolls are
based on the actual number of direct labor hours worked. The supervisor of the department or
cost center where the work is performed is held accountable for a direct labor price variance.
Formula
Actual Hours x Actual Rate xx
Actual Hours x Standard Rate xx
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Labor Rate Variance xx
Possible causes of labor rate variance are as follows:

a. Hiring of inexperienced workers
b. Change in labor rate
c. Hiring of workers with pay higher than that assumed when the standard for a job was set.
2. Direct Labor Efficiency Variance – the difference between the actual direct labor hours
worked and the standard direct labor hours allowed, multiplied by the standard hourly wage
rate, and equals the direct labor efficiency variance. Standard direct labor hours allowed is
equal to the standard number of direct labor hours per unit multiplied by equivalent production
(FIFO) or units completed during the period. As a result of using the standard wage rate per
direct labor hours, the effect of price changes has been eliminated. The direct labor efficiency
variance can be solely attributed to worker’s efficiencies or inefficiencies. The supervisor of
the department or cost center in which the work is performed are accountable for direct labor
efficiency variances in that it is their responsibility to oversee production and exercise right
control over the number of direct labor hours worked.
Formula
Actual Hours x Standard Rate xx
Standard Hours x Standard Rate xx
Labor Effieciency Variance xx
Possible causes of labor efficiency variance are as follows:

a. Lack of training for workers
b. Poor scheduling of work
c. Lack of supervision
d. Faulty equipment
FACTORY OVERHEAD VARIANCES

Factory overhead control under standard costing is similar to the control of direct materials and
direct labor. To evaluate performance predetermined standard costs are compared with actual
costs incurred. The analysis of factory overhead requires more detail than the variance analysis
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for direct materials and direct labor. A volume variance must be considered in addition to the
price (rate for labor) and efficiency variances that were computed when the direct cost (materials
and labor) were analysed. Different methods have been developed over the years to compute
factory overhead variances. Factory overhead variances may be determined using the two-factor
analysis, three-factor analysis, and four-factor analysis. Whatever method we use the amount of
total factory overhead variance will be the same. The total factory overhead variance is
determined by getting the difference between actual factory overhead and standard factory
overhead applied to production.
1. One-Factor Analysis
The difference between actual factory overhead and standard factory overhead applied to
production equals the one-factory analysis variance. Standard factory overhead is applied to
production by multiplying the standard hours by the standard factory overhead application
rate. The one-factor analysis technique is limited in its usefulness because although it shows
that a variance exists, it does not help in pinpointing the possible causes. It simply shows that
total factory overhead variance.
Formula
Actual Factory Overhead xx
Less: Standard Hours x Standard FO Rate xx
Total Factory Overhead Variance xx
2. Two-Factor Analysis
Two-factory analysis of factory overhead variances is divided into (1) controllable (budget)
variance and production volume (idle capacity) variance.
Controllable (budget) variance. The difference between actual factory overhead and
budgeted overhead on the basis of standard direct labor hours allowed equals the controllable
(budget) variance. A variance will occur if a company actually spends more or less on factory
overhead than expected and/or uses more or less than the number of direct labor hours
allowed. This variance is called controllable variance because it is believed that the manager
or supervisor has some control over this combined (spending and efficiency) variance.
Formula
Actual Factory Overhead Incurred ₱ xxx
Less: Budget Allowance based on Standard Hours
Budgeted Fixed Factory Overhead ₱ xxx
Variable Standard Rate x Standard Hours xxx xxx
Controllable (Budget) Variance ₱ xxx
Production Volume (idle capacity) variance. The difference between budgeted overhead on
the basis of standard direct labor hours allowed and standard factory overhead applied to
production. It may be computed also by getting the difference between the denominator
activity level (usually normal capacity) used to determine the fixed factory overhead
application rate and standard direct labor hours allowed then multiply the difference by the
standard fixed factory overhead application rate. A production volume variance only relates
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to fixed factory overhead because, in order to determine a product’s cost, fixed factory
overhead is applied to production as if it were a variable cost.
Formula
Budget Allowed Based on Standard Hours ₱ xxx
Less: Standard Hours x Standard Overhead Rate xxx
Volume Variance ₱ xxx
3. Three-Factor Analysis
Three-factor analysis of factory overhead variance may be divided into (1) price (spending)
variance, (2) efficiency variance, and (3) production (volume) variance.
Spending variance. The difference between actual factory overhead and budgeted factory
overhead on the basis of actual direct labor hours worked equals the price (spending) variance.
Take note that the only difference between the computation of controllable (budget) variance
and the spending (price) variance is the number of hours used to compute the budgeted factory
overhead. Under controllable variance, we use standard hours allowed and under spending
variance we use actual hours worked. The price variance is also known as the spending
variance because in many situations the variance results from price changes (as in direct
materials and direct labor price variances) and from temporary changes in operating
conditions. A factory overhead spending variance is usually not controllable by management
it is results from external forces (example MERALCO increasing its rate); however, it is
controllable if the variance is the results of internal factors such as changes I operating
conditions.
Formula
Actual Factory Overhead Incurred ₱ xxx
Less: Budget Allowance based on Actual Hours
Budgeted Fixed Factory Overhead ₱ xxx
Variable Standard Rate x Actual Hours xxx xxx
Spending Variance ₱ xxx
Efficiency Variance. The difference between actual direct labor hours worked and standard
direct labor hours allowed multiplied by the standard variable factory overhead application
rate equals the efficiency variance. A variance will occur if workers are more or less efficient
than planned. If workers are efficient, actual labor hours worked will be less than standard
direct labor hours worked and the variance will be favorable. On the other hand, if workers
are inefficient, actual labor hours worked will be more than standard direct labor hours worked
and the variance will be unfavourable.
Formula
Budget Allowed Based on Actual Hours ₱ xxx
Less: Budget Allowed Based on Standard Hours xxx
Variable Efficiency Variance ₱ xxx
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Production Volume (idle capacity) variance. Same as the volume variance computed under
the two-factor analysis. This variance is also known as the denominator variance because the
variance is the result of production of an activity level different from that used as denominator
to calculate the fixed factory overhead application rate. If production falls below (or rises
above) the denominator level used in computing the fixed factory overhead application, fixed
factory overhead costs are being under absorbed (or over absorbed). Volume variance is also
called the idle capacity variance because it deals with the utilization of the plant and the effect
of such utilization of the factory overhead cost of the finished product.
Formula
4. Four-Factor Analysis
Variable Overhead Spending Variance – the difference between actual variable spending
and budgeted variable overhead on actual hours is the variable overhead spending variance.
The variable overhead spending variance is caused by both price and volume differences.
Variable overhead spending variances associated with price difference can occur because,
over time, changes in variable overhead prices have not been included in the standard rate.
Variable overhead spending variance associated with volume differences can be caused by
waste or shrinkage or production inputs such as indirect materials.
Formula
Actual Variable Factory Overhead ₱ xxx
Less: Actual Hours x Standard Variable Overhead Rate xxx
Variable Spending Variance ₱ xxx
Fixed Overhead Spending Variance – the difference between actual fixed factory overhead
and the budgeted fixed overhead is the fixed overhead spending variance. This amount
normally represents the differences between budgeted and actual costs for the numerous fixed
factory overhead components.
Formula
Actual Fixed Factory Overhead ₱ xxx
Less: Budgeted Fixed Overhead at Normal Capacity xxx
Fixed Spending Variance ₱ xxx
Variable Overhead Efficiency Variance – the difference between budgeted variable

overhead for actual hours and applied variable overhead is the variable efficiency variance.
This variance quantifies the effect of using more or less of the activity which is used as the
base for the applied variable overhead.
Formula
Budget Allowed Based on Actual Hours ₱ xxx
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Less: Budget Allowed Based on Standard Hours xxx
Variable Efficiency Variance ₱ xxx
Production Volume (idle capacity) variance – This is just the same as the volume variance
computed under the two-factor and three-factor analysis.
Formula
Possible causes of volume variance are as follows:

a. Poor production scheduling
b. Unusual machine breakdowns
c. Shortage of skilled workers
d. Decrease in demand from customers
e. Unused plant capacity
Illustrative Problem
The following information were provided by Natalie Company:
a. Produced 50,000 plastic microcomputer cases
b. Standard variable costs per unit (per case)
 Direct Materials; 2 pounds at P1.00 P2.00
 Direct Labor; 0.10 hours at P15 1.50
 Variable Manufacturing Overhead, 0.10 Hrs. at P5 0.50
c. Fixed Manufacturing Overhead Cost
 Monthly Budget – 40,000 cases or 4,000 standard hours P80,000
d. Actual Production Costs
 Direct Materials purchased 200,000 lbs. at P1.20 P240,000
 Direct Materials Used – 110,000 lbs. at P1.20 132,000
 Direct Labor – 6,000 hours at P14 84,000
 Factory Overhead (Variable – P36,000) 111,000
Requirements:
1. Compute the materials, labor, and overhead variances.
2. Journal entries to record the given information.
SOLUTION
1. Materials Variances
a. Material Price (Purchase) Variance
Actual Price P1.20
Less: Standard Price 1.00
Difference 0.20
x Actual Quantity Purchased 200,000
Material Price Variance – Unfavorable P40,000
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b. Material Quantity Variance
Actual Quantity Used 110,000
Less: Standard Quantity Allowed (50,000 x 2) 100,000
Difference in Quantity 10,000
x Standard Price P 1.00
Material Quantity Variance – Unfavorable P10,000
2. Labor Variances
a. Labor Rate Variance
Actual Rate per Hour P14.00
Less: Standard Rate per Hour 15.00
Difference 1.00
x Actual Hours Used 6,000
Labor Rate Variance – Favorable P6,000
b. Labor Efficiency Variance

Actual Hours Used 6,000
Less: Standard Quantity Allowed (50,000 x 0.10) 5,000
Difference in Quantity 1,000
x Standard Price P 15.00
Labor Efficiency Variance – Unfavorable P15,000
3. Factory Overhead Variances

a. Two-Way Method
Actual Factory Overhead ₱ 111,000
Less: Budget Allowance based on Standard Hours
Budgeted Fixed Factory Overhead ₱ 80,000
Variable Standard Rate x Standard Hours (50,000 x 0.10 x 5) 25,000 105,000
Controllable (Budget) Variance - Unfavorable ₱ 6,000
Budget Allowance based on Standard Hours P105,000

Less: Standard Hours x Factory Overhead Rate (50,000 x 0.10 x 25) 125,000
Volume Variance – Favorable P 20,000
b. Three-Way Method
Actual Factory Overhead ₱ 111,000
Less: Budget Allowance based on Actual Hours
Budgeted Fixed Factory Overhead ₱ 80,000
Variable Standard Rate x Actual Hours (6,000 x 5) 30,000 110,000
Spending Variance - Unfavorable ₱ 1,000
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Budget Allowance based on Actual Hours P110,000
Less: Budget Allowance based on Actual Hours 105,000
Variable Efficiency Variance – Unfavorable P 5,000

c. Four-Way Method
Actual Variable Factory Overhead ₱ 36,000
Less: Actual Hours x Variable Factory Overhead Rate (6,000 x P5) 30,000
Spending Variance - Unfavorable ₱ 6,000
Actual Fixed Factory Overhead ₱ 75,000

Less: Budgeted Fixed Factory Overhead 80,000
Spending Variance - Favorable ₱ 5,000
Budget Allowance based on Actual Hours P110,000

Less: Budget Allowance based on Actual Hours 105,000
Variable Efficiency Variance – Unfavorable P 5,000

Journal Entries
1. Materials Inventory 200,000
Material Price Variance 40,000
Accounts Payable 240,000
2. Work in Process 100,000

Materials Efficiency Variance 10,000
Materials Inventory 110,000
3. Payroll 84,000
Accrued Payroll 84,000

Labor Efficiency Variance 15,000
Labor Rate Variance 6,000
Payroll 84,000
5. Factory Overhead Control 111,000

Various Credit Accounts 111,000
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Factory Overhead Applied 125,000
7. Factory Overhead Applied 125,000

Factory Overhead Controllable Variance 6,000
Factory Overhead Volume Variance 20,000
Factory Overhead Control 111,000
III. ACTIVITY
MULTIPLE CHOICE
1. Which of the following variances is least helpful for control purposes?
a. Material efficiency variance
b. Production volume variance
c. Variable overhead controllable variance
d. Labor rate variance
2. Which of the following is true of standard costing?
a. It uses predetermined overhead rates times a standard base
b. It uses actual rates times a standard base
c. It uses an actual base times a predetermined rate
d. It uses actual rates exclusively
3. What type of direct material variances for price and efficiency result if actual number of
pounds of material used exceeds overhead pounds allowed but actual cost per pound was less
than standard cost per pound?
a. Efficiency – Favorable; Price – Favorable
b. Efficiency – Favorable; Price – Unfavorable
c. Efficiency – Unfavorable; Price – Favorable
d. Efficiency – Unfavorable; Price – Unfavorable
4. Standard costing will produce the same results as actual or conventional costing when
standard costs variances are allocated to
a. Cost of goods sold and inventories
b. A balance sheet account
c. An income and expense account
d. None of the above
5. When computing variances from standard costs, the difference between actual and standard
price multiplied by the actual quantity yields a
a. Combined price-quantity variance
b. Price variance
c. Volume variance
d. Mix variance
6. What does a credit balance in a direct labor efficiency variance account indicate?
a. The average wage rate paid to direct labor employees was less than the standard rate
b. The standard hours allowed for the units produced were greater than actual direct labor
hours used.
c. Actual total direct labor costs incurred were less than standard direct labor costs allowed
for the units produced
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d. The number of units produced was less than the number of units budgeted for the period.
7. If raw materials are carried in the raw materials inventory at standard costs, then it is
reasonable to assume that
a. The price variance is recognized when materials are purchased
b. The price variance is recognized when materials are placed into production
c. The company does not follow generally accepted accounting principles
d. The raw materials inventory account is overvalued
8. In a standard cost system, when production is greater than the estimated unit or denominator
level, there will be
a. An unfavorable capacity variance
b. A favorable materials and labor usage variance
c. A favorable volume variance
d. A favorable budget variance
9. Suppose a standard cost system is being used. What do you call the various in the use of
materials which can be calculated by comparing the record of materials withdrawn with the
standard consumption?
a. Volume variance
b. Quantity variance
c. Efficiency variance
d. Price variance
10. Which department is customarily held responsible for a material usage variance?
a. Quality control
b. Purchasing
c. Engineering
d. Production
PROBLEM SOLVING
Problem 1
Michelle Corporation provided the following information for the month of July
 Actual labor hours used 3,150 Hours
 Standard materials price P2.50 per unit
 Actual labor rate per hour P3
 Standard quantity of materials used 4,050 Units
 Standard labor hours used 3,000 Hours
 Actual materials price P2.52 per unit
 Standard labor rate per hour P3.10
 Actual quantity of materials purchased and used 4,450 Units
Required: Compute for the Materials and Labor Variances
1. Actual price P 2.52 2/. Actual qty. used 4.450

Std. price ( 2.50) Std. qty. (4,050)
Difference 0.02 Difference 400
X Act. Qty. 4,450 x Std. price x 2.50
MPV 89.00 U MQV 1.000 U
3 Actual rate P 3.00 4. Actual hours 3,150
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Std. rate ( 3.10) Std. hours ( 3,000)
Difference ( 0.10) Difference 150
X Actual Hrs. 3,150 x Std. rate 3.10
Labor rate var. ( 315) F LEV 465 U
Problem 2
Oninz Company manufactures one product and provides you with the following information for
the year 2022:
 Normal direct labor hour 155,000
 Standard fixed overhead rate P4
 Standard fixed overhead cost per unit P10
 Actual Units Manufactured 60,000
 Actual direct labor hours 148,000
 Actual Variable Overhead P475,000
 Actual Fixed Overhead P632,500
 Total Budgeted Overhead P1,085,000
Required: Compute for the Overhead Variances using 2-way, 3-way and 4-way Methods.
155,000 DLHrs.
Total Per DLHr
Fixed 620,000 4.00 (4 x 155,000) Std. hrs./unit = 10.00/4
Variable 465,000 3.00 (465,000/155,000) = 2.5 Hrs.
Total 1,085,000 7.00
1. Actual variable overhead 475,000

Less: AH x Variable rate ( 148,000 x 3) 444,000
Variable spending variance 31,000 U
AH x Variable rate 444,000

Less: Std. hrs. x V rate ( 60,000 x 2.5 x 3) 450,000
Variable efficiency variance ( 6,000) F
2. Actual fixed overhead 632,500

Less: Fixed overhead at normal capacity 620,000
Fixed spending variance 12,500 U
Fixed overhead at normal capacity 620,000

Less: Std. hrs. x fixed rate (150,000 x 4) 600,000
Fixed volume variance 20,000 U
3. Actual factory overhead (475,000 + 632,500) 1,107,500

Less: Budget allowed on std. hrs.
Fixed 620,000
Variable ( 150,000 x 3) 450,000 1,070,000
Controllable variance 37,500 U
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Budget allowed on std. hrs 1,070,000
Less: Std. hrs. x OH rate (150,000 x 7) 1,050,000
Volume variance 20,000 U
4. Actual factory overhead 1,107,500

Less: Budget allowed on actual hrs.
Fixed 620,000
Variable (148,000 x 3) 444,000 1,064,000
Spending variance 43,500 U
Budget allowed on actual hrs. 1,064,000

Less: Budget allowed on std. hrs. 1,070,000
Efficiency variance ( 6,000) F
Budget allowed on std. hrs. 1,070,000

Less: Std. hrs. x FO rate (150,000 x 7) 1,050,000
5. Actual Variable Factory Overhead P475,000

Less: Variable Rate x Actual Hrs (3 x 148,000) 444,000
Fixed Spending variance 31,000 U
Actual fixed factory overhead P632,500

Less: Fixed overhead at normal capacity 620,000
Fixed Spending variance 12,500 U
Variable efficiency variance ( 6,000) F
Page 40 of 134
MODULE 3:
COST VOLUME PROFIT ANALYSIS
1. Explain the features of cost-volume-profit (CVP) analysis.
2. Determine the breakeven point and output level needed to achieve a target operating income.
3. Explain how managers use CVP analysis in decision making.
4. Explain how sensitivity analysis helps managers cope with uncertainty.
5. Use CVP analysis to plan variable and fixed costs.
6. Apply CVP Analysis to a company producing multiple products.
II. CONTENT
Cost-Volume-Profit
(CVP) analysis studies the behavior and relationship among these elements as changes occur in the
units sold, the selling price, the variable cost per unit, or the fixed costs of a product. Let’s consider
an example to illustrate CVP analysis. Example: Oninz Zurc is considering selling UPCAT Success,
a book for the business school admission test, at a college fair in UP. Oninz knows he can purchase
this package from a wholesaler at P120 per book, with the privilege of returning all unsold books and
receiving a full P120 refund per book. He also knows that he must pay P2,000 to the organizers for
the booth rental at the fair. He will incur no other costs. He must decide whether she should rent a
booth.
Oninz, like most managers who face such a situation, works through a series of steps.
1. Identify the problem and uncertainties. The decision to rent the booth hinges critically on
how Oninz resolves two important uncertainties—the price he can charge and the number of
books he can sell at that price. Every decision deals with selecting a course of action. Oninz
must decide knowing that the outcome of the chosen action is uncertain and will only be known
in the future. The more confident Oninz is about selling a large number of books at a good price,
the more willing he will be to rent the booth.
2. Obtain information. When faced with uncertainty, managers obtain information that might
help them understand the uncertainties better. For example, Oninz gathers information about the
type of individuals likely to attend the fair and other test-prep books that might be sold at the
fair. He also gathers data on her past experiences selling UPCAT Success at fairs very much
like the UP fair.
3. Make predictions about the future. Using all the information available to them, managers
make predictions. Oninz predicts that he can charge a price of P200 for UPCAT Success. At that
price he is reasonably confident that he will be able to sell at least 30 books and possibly as
many as 60. In making these predictions, Oninz like most managers, must be realistic and
exercise careful judgment. If his predictions are excessively optimistic, Oninz will rent the booth
when he should not. If they are unduly pessimistic, Oninz will not rent the booth when he should.
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Oninz’s predictions rest on the belief that her experience at the UP fair will be similar to his
experience at the ADMU fair four months earlier. Yet, Oninz is uncertain about several aspects
of his prediction. Is the comparison between ADMU and UP appropriate? Have conditions and
circumstances changed over the last four months? Are there any biases creeping into her
thinking? He is keen on selling at the UP fair because sales in the last couple of months have
been lower than expected. Is this experience making her predictions overly optimistic? Has he
ignored some of the competitive risks? Will the other test prep vendors at the fair reduce their
prices? Oninz reviews his thinking. He retests her assumptions. He also explores these questions
with John Doe, a close friend, who has extensive experience selling test books like UPCAT
Success. In the end, he feels quite confident that her predictions are reasonable, accurate, and
carefully thought through.
4. Make decisions by choosing among alternatives. Oninz uses the CVP analysis that follows,
and decides to rent the booth at the UP Fair.
5. Implement the decision, evaluate performance, and learn. Thoughtful managers never stop
learning. They compare their actual performance to predicted performance to understand why
things worked out the way they did and what they might learn. At the end of the UP fair, for
example, Oninz would want to evaluate whether her predictions about price and the number of
books he could sell were correct. Such feedback would be very helpful to Oninz as he makes
decisions about renting booths at subsequent fairs.
How does Oninz use CVP analysis in Step 4 to make her decision? Oninz begins by identifying
which costs are fixed and which costs are variable and then calculates contribution margin.
Contribution Margins
The booth-rental cost of P2,000 is a fixed cost because it will not change no matter how many books
Oninz sells. The cost of the book itself is a variable cost because it increases in proportion to the
number of books sold. Oninz will incur a cost of P120 for each book that he sells. To get an idea of
how operating income will change as a result of selling different quantities of books, Oninz calculates
operating income if sales are 5 books and if sales are 40 books.
5 Books Sold 40 Books Sold

Revenues P1000 (200x5) P8000 (200x40)
Variable Cost 600 (120x5) 4800 (120x40)
Fixed Cost 2000 2000
Operating Income (P1,600) P1,200
The only numbers that change from selling different quantities of packages are total revenues and
total variable costs. The difference between total revenues and total variable costs is called
contribution margin. That is,
Contribution margin = Total revenues - Total variable costs
Contribution margin indicates why operating income changes as the number of units sold changes.
The contribution margin when Oninz sells 5 books is P400 (P1,000 in total revenues minus P600 in
total variable costs); the contribution margin when Oninz sells 40 books is P3,200 (P8,000 in total
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revenues minus P4,800 in total variable costs). When calculating the contribution margin, be sure to
subtract all variable costs. For example, if Oninz had variable selling costs because he paid a
commission to salespeople for each book he sold at the fair, variable costs would include the cost of
each book plus the sales commission.
Contribution margin per unit is a useful tool for calculating contribution margin and operating
income. It is defined as,
Contribution margin per unit = Selling price - Variable cost per unit
In the UPCAT Success example, contribution margin per book, or per unit, is P200 – P120 = P80.
Contribution margin per unit recognizes the tight coupling of selling price and variable cost per unit.
Unlike fixed costs, Oninz will only incur the variable cost per unit of P120 when he sells a unit of
UPCAT Success for P200. Contribution margin per unit provides a second way to calculate
contribution margin:
Contribution margin = Contribution margin per unit * Number of units sold
For example, when 40 packages are sold, contribution margin P80 per unit 40 units P3,200.
Even before He gets to the fair, Oninz incurs P2,000 in fixed costs. Because the contribution margin
per unit is P80, Oninz will recover P80 for each package that He sells at the fair. Oninz hopes to sell
enough packages to fully recover the P2,000 He spent for renting the booth and to then start making
a profit.
Exhibit 3.1 presents contribution margins for different quantities of packages sold. The income
statement in Exhibit 3.1 is called a contribution income statement because it groups costs into variable
costs and fixed costs to highlight contribution margin. Each additional package sold from 0 to 1 to 5
increases contribution margin by P80 per package, recovering more of the fixed costs and reducing
the operating loss. If Oninz sells 25 packages, contribution margin equals P2,000 (P80 per package
25 packages), exactly recovering fixed costs and resulting in P0 operating income. If Oninz sells 40
packages, contribution margin increases by another P1,200 (P3,200 P2,000), all of which becomes
operating income. As you look across Exhibit 3.1 from left to right, you see that the increase in
contribution margin exactly equals the increase in operating income (or the decrease in operating
loss). Instead of expressing contribution margin as a dollar amount per unit, we can express it as a
percentage called contribution margin percentage (or contribution margin ratio): In our example,
Contribution margin percentage is the contribution margin per dollar of revenue. Oninz earns 40% of
each dollar of revenue (equal to 40 cents). Contribution margin ratio = P80/P200 = 0.40, or 40%
Contribution margin ratio = Contribution margin per unit/ Selling price
In our example, Contribution margin ratio = P80/P200 = 0.40, or 40%
Page 43 of 134
Exhibit 3.1 – Contribution Income Statement for Different Quantities of UPCAT Success Books
Sold
No. of Books Sold
0 1 5 25 40
Revenues P200/Book 0 P200 P1,000 P5,000 P8,000
Variable Cost P120/Book 0 120 600 3,000 4,800
Contribution Margin P 80/Book 0 80 400 2,000 3,200
Fixed Cost P2,000 2,000 2,000 2,000 2,000 2,000
Operating Income (Loss) P (2,000) P (1,920) P (1,600) P – 0 - P 1,200
Most companies have multiple products. As we shall see later in this module, calculating contribution
margin per unit when there are multiple products is more cumbersome. In practice, companies
routinely use contribution margin percentage as a handy way to calculate contribution margin for
different dollar amounts of revenue: For example, in Exhibit 3.1, if Oninz sells 40 packages, revenues
will be P8,000 and contribution margin will equal 40% of P8,000, or 0.40 P8,000 P3,200. Oninz earns
operating income of P1,200 (P3,200 Fixed costs, P2,000) by selling 40 packages for P8,000.
Expressing CVP Relationships

How was the Excel spreadsheet in Exhibit 3-1 constructed? Underlying the Exhibit are some
equations that express the CVP relationships. To make good decisions using CVP analysis, we must
understand these relationships and the structure of the contribution income statement in Exhibit 3.1.
There are three related ways (we will call them methods) to think more deeply about and model CVP
relationships:
1. The equation method
2. The contribution margin method
3. The graph method
The equation method and the contribution margin method are most useful when managers want to
determine operating income at few specific levels of sales (for example 5, 15, 25, and 40 units sold).
The graph method helps managers visualize the relationship between units sold and operating income
over a wide range of quantities of units sold. As we shall see later in the chapter, different methods
are useful for different decisions.
Equation Method
Each column in Exhibit 3-1 is expressed as an equation.
How are revenues in each column calculated?

Revenues = Selling price (SP) x Quantity of units sold (Q)
How are variable costs in each column calculated?

Variable costs = Variable cost per unit (VCU) x Quantity of units sold (Q)
Page 44 of 134
So,
Equation 1 becomes the basis for calculating operating income for different quantities of units sold.
For example, based on Exhibit 3-1, the calculation of operating income when Oninz sells 5 packages
is
(P200 * 5) - (P120 * 5) - P2,000 = P1,000 - P600 - P2,000 = -P1,600
Contribution Margin Method

Rearranging equation 1,
In our UPCAT Success example, contribution margin per unit is P80 (P200 P120), so when Oninz
sells 5 packages,
Operating income = (P80 * 5) - P2,000 = -P1,600
Equation 2 expresses the basic idea we described earlier—each unit sold helps Oninz recover P80 (in
contribution margin) of the P2,000 in fixed costs.
Graph Method
In the graph method, we represent total costs and total revenues graphically. Each is shown as a line
on a graph. Exhibit 3-2 illustrates the graph method for UPCAT Success. Because we have assumed
that total costs and total revenues behave in a linear fashion, we need only two points to plot the line
representing each of them.
1. Total costs line. The total costs line is the sum of fixed costs and variable costs. Fixed costs
are P2,000 for all quantities of units sold within the relevant range. To plot the total costs line,
use as one point the P2,000 fixed costs at zero units sold (point A) because variable costs are
P0 when no units are sold. Select a second point by choosing any other convenient output
level (say, 40 units sold) and determine the corresponding total costs. Total variable costs at
this output level are P4,800 (40 units x P120 per unit). Remember, fixed costs are P2,000 at
all quantities of units sold within the relevant range, so total costs at 40 units sold equal P6,800
(P2,000 + P4,800), which is point B in Exhibit 3-2. The total costs line is the straight line from
point A through point B.
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2. Total revenues line. One convenient starting point is P0 revenues at 0 units sold, which is
point C in Exhibit 3.2. Select a second point by choosing any other convenient output level
and determining the corresponding total revenues. At 40 units sold, total revenues are P8,000
(P200 per unit x 40 units), which is point D in Exhibit 3.2. The total revenues line is the
straight line from point C through point D. Profit or loss at any sales level can be determined
by the vertical distance between the two lines at that level in Exhibit 3.2. For quantities fewer
than 25 units sold, total costs exceed total revenues, and the purple area indicates operating
losses. For quantities greater than 25 units sold, total revenues exceed total costs, and the blue-
green area indicates operating incomes. At 25 units sold, total revenues equal total costs.
Oninz will break even by selling 25 packages.
Exhibit 3.2 – Cost-Volume Graph for UPCAT Success
**Slope of the total revenues line is the selling price = P200

*Slope of the total costs line is the variable cost per unit = P120
Cost Volume Profit Assumptions

Now that you have seen how CVP analysis works, think about the following assumptions we made
during the analysis:
1. Changes in the levels of revenues and costs arise only because of changes in the number of product
(or service) units sold. The number of units sold is the only revenue driver and the only cost driver.
Just as a cost driver is any factor that affects costs, a revenue driver is a variable, such as volume,
that causally affects revenues.
2. Total costs can be separated into two components: a fixed component that does not vary with
units sold and a variable component that changes with respect to units sold.
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3. When represented graphically, the behaviors of total revenues and total costs are linear (meaning
they can be represented as a straight line) in relation to units sold within a relevant range (and
time period).
4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and time period)
are known and constant.
As the CVP assumptions make clear, an important feature of CVP analysis is distinguishing fixed
from variable costs. Always keep in mind, however, that whether a cost is variable or fixed depends
on the time period for a decision.
The shorter the time horizon, the higher the percentage of total costs considered fixed. For example,
suppose a Philippine Airlines plane will depart from its gate in the next hour and currently has 20
seats unsold. A potential passenger arrives with a transferable ticket from a competing airline. The
variable costs (such as one more meal) to Filipino of placing one more passenger in an otherwise
empty seat is negligible At the time of this decision, with only an hour to go before the flight departs,
virtually all costs (such as crew costs and baggage-handling costs) are fixed.
Alternatively, suppose Philippine Airlines must decide whether to keep this flight in its flight
schedule. This decision will have a one-year planning horizon. If Philippine Airlines decides to cancel
this flight because very few passengers during the last year have taken this flight, many more costs,
including crew costs, baggage-handling costs, and airport fees, would be considered variable. That’s
because over this longer horizon, these costs would not have to be incurred if the flight were no longer
operating. Always consider the relevant range, the length of the time horizon, and the specific
decision situation when classifying costs as variable or fixed.
Breakeven Point and Target Operating Income

Managers and entrepreneurs like Oninz always want to know how much they must sell to earn a given
amount of income. Equally important, they want to know how much they must sell to avoid a loss.
Breakeven Point
The breakeven point (BEP) is that quantity of output sold at which total revenues equal total costs—
that is, the quantity of output sold that results in P0 of operating income. We have already seen how
to use the graph method to calculate the breakeven point. Recall from Exhibit 3.1 that operating
income was P0 when Oninz sold 25 units, the breakeven point. But by understanding the equations
underlying the calculations in Exhibit 3.1, we can calculate the breakeven point directly for UPCAT
Success rather than trying out different quantities and checking when operating income equals P0.
Recall the equation method (equation 1):
Setting operating income equal to P0 and denoting quantity of output units that must be sold by Q,
(P200 * Q) - (P120 * Q) - P2,000 = P0
P80 * Q = P2,000
Q = P2,000 , P80 per unit = 25 units
Page 47 of 134
If Oninz sells fewer than 25 units, she will incur a loss; if she sells 25 units, she will break even; and
if she sells more than 25 units, she will make a profit. While this breakeven point is expressed in
units, it can also be expressed in revenues: 25 units x P200 selling price = P5,000.
Recall the contribution margin method (equation 2):
At the breakeven point, operating income is by definition P0 and so,
Contribution margin per unit * Breakeven number of units = Fixed cost (Equation 3)
Rearranging equation 3 and entering the data,

Breakeven number of units = Fixed costs/Contribution margin per unit
= P2,000/P80
= 25 units
Breakeven revenues = Breakeven number of units * Selling price
In practice (because they have multiple products), companies usually calculate breakeven point
directly in terms of revenues using contribution margin percentages. Recall that in the UPCAT
Success example,
Contribution margin ratio = Contribution margin per unit/ Selling price

=P80/P200
=40%
That is, 40% of each dollar of revenue, or 40 cents, is contribution margin. To break even, contribution
margin must equal fixed costs of P2,000. To earn P2,000 of contribution margin, when P1 of revenue
earns P0.40 of contribution margin, revenues must equal P2,000/0.40 = P5,000.
Breakeven revenues = Fixed costs/Contribution Margin Ratio

=P2,000/40%
While the breakeven point tells managers how much he must sell to avoid a loss, managers are equally
interested in how they will achieve the operating income targets underlying their strategies and plans.
In our example, selling 25 units at a price of P200 assures Oninz that she will not lose money if he
rents the booth. This news is comforting, but we next describe how Oninz determines how much he
needs to sell to achieve a targeted amount of operating income.
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Target Net Income and Income Taxes
Net income is operating income plus non-operating revenues (such as interest revenue) minus non-
operating costs (such as interest cost) minus income taxes. For simplicity, throughout this chapter we
assume non-operating revenues and non-operating costs are zero. Thus,
Net income = Operating income – Income taxes
Until now, we have ignored the effect of income taxes in our CVP analysis. In many companies, the
income targets for managers in their strategic plans are expressed in terms of net income.
Exhibit 3.3 – Profit-Volume Graph for UPCAT Success
That’s because top management wants subordinate managers to take into account the effects their
decisions have on operating income after income taxes. Some decisions may not result in large
operating incomes, but they may have favorable tax consequences, making them attractive on a net
income basis—the measure that drives shareholders’ dividends and returns.
To make net income evaluations, CVP calculations for target income must be stated in terms of target
net income instead of target operating income. For example, Oninz may be interested in knowing the
quantity of units he must sell to earn a net income of P960, assuming an income tax rate of 40%.
Page 49 of 134
In other words, to earn a target net income of P960, Oninz’s target operating income is P1,600.
 Target operating income P1,600
 Tax at 40% (0.40xP1,600) 640
Target net income P 960
The key step is to take the target net income number and convert it into the corresponding target
operating income number. We can then use equation 1 for target operating income and substitute
numbers from our UPCAT Success example.
Alternatively we can calculate the number of units Oninz must sell by using the contribution margin
method and equation 4:
 Revenues (P200 per unit * 45 units) P9,000

 Variable costs, P120 per unit * 45 units (5,400)
 Contribution margin 3,600
 Fixed costs (2,000)
 Operating income 1,600
 Income taxes, P1,600 * 0.40 (640)
Net income P 960
Oninz can also use the PV graph in Exhibit 3.3. To earn target operating income of P1,600, Oninz
needs to sell 45 units. Focusing the analysis on target net income instead of target operating income
will not change the breakeven point. That’s because, by definition, operating income at the breakeven
point is P0, and no income taxes are paid when there is no operating income.
Using CVP Analysis for Decision Making

We have seen how CVP analysis is useful for calculating the units that need to be sold to break even,
or to achieve a target operating income or target net income. Managers also use CVP analysis to guide
other decisions, many of them strategic decisions. Consider a decision about choosing additional
Page 50 of 134
features for an existing product. Different choices can affect selling prices, variable cost per unit,
fixed costs, units sold, and operating income. CVP analysis helps managers make product decisions
by estimating the expected profitability of these choices.
Strategic decisions invariably entail risk. CVP analysis can be used to evaluate how operating income
will be affected if the original predicted data are not achieved—say, if sales are 10% lower than
estimated. Evaluating this risk affects other strategic decisions a company might make. For example,
if the probability of a decline in sales seems high, a manager may take actions to change the cost
structure to have more variable costs and fewer fixed costs. We return to our UPCAT Success
example to illustrate how CVP analysis can be used for strategic decisions concerning advertising
and selling price.
Decision to Advertise
Suppose Oninz anticipates selling 40 units at the fair. Exhibit 3.3 indicates that Oninz’s operating
income will be P1,200. Oninz is considering placing an advertisement describing the product and its
features in the fair brochure. The advertisement will be a fixed cost of P500. Oninz thinks that
advertising will increase sales by 10% to 44 packages. Should Oninz advertise? The following table
presents the CVP analysis.
Operating income will decrease from P1,200 to P1,020, so Oninz should not advertise. Note that
Oninz could focus only on the difference column and come to the same conclusion: If Oninz
advertises, contribution margin will increase by P320 (revenues, P800 variable costs, P480), and fixed
costs will increase by P500, resulting in a P180 decrease in operating income.
As you become more familiar with CVP analysis, try evaluating decisions based on differences rather
than mechanically working through the contribution income statement. Analyzing differences gets to
the heart of CVP analysis and sharpens intuition by focusing only on the revenues and costs that will
change as a result of a decision.
Decision to Reduce Selling Price
Having decided not to advertise, Oninz is contemplating whether to reduce the selling price to P175.
At this price, she thinks he will sell 50 units. At this quantity, the test prep package wholesaler who
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supplies UPCAT Success will sell the packages to Oninz for P115 per unit instead of P120. Should
Oninz reduce the selling price?
Contribution margin from lowering price to P175: (P175 - P115) per unit * 50 units P3,000
Contribution margin from maintaining price at P200: (P200 - P120) per unit * 40 units P3,200
Change in contribution margin from lowering price P (200)
Decreasing the price will reduce contribution margin by P200 and, because the fixed costs of P2,000
will not change, it will also reduce operating income by P200. Oninz should not reduce the selling
price.
Determining Target Prices

Oninz could also ask “At what price can I sell 50 units (purchased at P115 per unit) and continue to
earn an operating income of P1,200?” The answer is P179, as the following calculations show.
Oninz should also examine the effects of other decisions, such as simultaneously increasing
advertising costs and lowering prices. In each case, Oninz will compare the changes in contribution
margin (through the effects on selling prices, variable costs, and quantities of units sold) to the
changes in fixed costs, and she will choose the alternative that provides the highest operating income.
Sensitivity Analysis and Margin of Safety

Before choosing strategies and plans about how to implement strategies, managers frequently analyze
the sensitivity of their decisions to changes in underlying assumptions. Sensitivity analysis is a “what-
if” technique that managers use to examine how an outcome will change if the original predicted data
are not achieved or if an underlying assumption changes. In the context of CVP analysis, sensitivity
analysis answers questions such as, “What will operating income be if the quantity of units sold
decreases by 5% from the original prediction?” and “What will operating income be if variable cost
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per unit increases by 10%?” Sensitivity analysis broadens managers’ perspectives to possible
outcomes that might occur before costs are committed.
Electronic spreadsheets, such as Excel, enable managers to conduct CVP-based sensitivity analyses
in a systematic and efficient way. Using spreadsheets, managers can conduct sensitivity analysis to
examine the effect and interaction of changes in selling price, variable cost per unit, fixed costs, and
target operating income. Exhibit 3.4 displays a spreadsheet for the UPCAT Success example. Using
the spreadsheet, Oninz can immediately see how many units she needs to sell to achieve particular
operating-income levels, given alternative levels of fixed costs and variable cost per unit that she may
face. For example, 32 units must be sold to earn an operating income of P1,200 if fixed costs are
P2,000 and variable cost per unit is P100.
Oninz can also use Exhibit 3.4 to determine that she needs to sell 56 units to break even if fixed cost
of the booth rental at the UP fair is raised to P2,800 and if the variable cost per unit charged by the
test-prep package supplier increases to P150. Oninz can use information about costs and sensitivity
analysis, together with realistic predictions about how much she can sell to decide if she should rent
a booth at the fair.
Exhibit 3.4 – Spreadsheet Analysis of CVP Relationships for UPCAT Success
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Operating income of P1,200 if fixed costs are P2,000 and variable cost per unit is P100. Oninz can
also use Exhibit 3-4 to determine that she needs to sell 56 units to break even if fixed cost of the booth
rental at the Chicago fair is raised to P2,800 and if the variable cost per unit charged by the test-prep
package supplier increases to P150. Oninz can use information about costs and sensitivity analysis,
together with realistic predictions about how much she can sell to decide if she should rent a booth at
the fair. Another aspect of sensitivity analysis is margin of safety:
The margin of safety answers the “what-if” question: If budgeted revenues are above breakeven and
drop, how far can they fall below budget before the breakeven point is reached? Sales might decrease
as a result of a competitor introducing a better product, or poorly executed marketing programs, and
so on. Assume that Oninz has fixed costs of P2,000, a selling price of P200, and variable cost per unit
of P120. From Exhibit 3.1, if Oninz sells 40 units, budgeted revenues are P8,000 and budgeted
operating income is P1,200. The breakeven point is 25 units or P5,000 in total revenues.
Sometimes margin of safety is expressed as a percentage:
This result means that revenues would have to decrease substantially, by 37.5%, to reach breakeven
revenues. The high margin of safety gives Oninz confidence that she is unlikely to suffer a loss.
If, however, Oninz expects to sell only 30 units, budgeted revenues would be P6,000 (P200 per unit
x 30 units) and the margin of safety would equal:
The analysis implies that if revenues decrease by more than 16.67%, Oninz would suffer a loss. A
low margin of safety increases the risk of a loss. If Oninz does not have the tolerance for this level of
risk, she will prefer not to rent a booth at the fair. Sensitivity analysis is a simple approach to
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recognizing uncertainty, which is the possibility that an actual amount will deviate from an expected
amount. Sensitivity analysis gives managers a good feel for the risks involved.
Operating Leverage
The risk-return trade-off across alternative cost structures can be measured as operating leverage.
Operating leverage describes the effects that fixed costs have on changes in operating income as
changes occur in units sold and contribution margin.
Degree of operating leverage = Contribution margin/ Operating Income
The following table shows the degree of operating leverage at sales of 40 units for the three rental
options.
These results indicate that, when sales are 40 units, a percentage change in sales and contribution
margin will result in 2.67 times that percentage change in operating income for Option 1, but the
same percentage change (1.00) in operating income for Option 3. Consider, for example, a sales
increase of 50% from 40 to 60 units. Contribution margin will increase by 50% under each option.
Operating income, however, will increase by 2.67 * 50% = 133% from P1,200 to P2,800 in Option
1, but it will increase by only 1.00 x 50% = 50% from P1,200 to P1,800 in Option 3. The degree of
operating leverage at a given level of sales helps managers calculate the effect of sales fluctuations
on operating income. Keep in mind that, in the presence of fixed costs, the degree of operating
leverage is different at different levels of sales. For example, at sales of 60 units, the degree of
operating leverage under each of the three options is as follows:
The degree of operating leverage decreases from 2.67 (at sales of 40 units) to 1.71 (at sales of 60
units) under Option 1 and from 1.67 to 1.36 under Option 2. In general, whenever there are fixed
costs, the degree of operating leverage decreases as the level of sales increases beyond the breakeven
point. If fixed costs are P0 as in Option 3, contribution margin equals operating income, and the
degree of operating leverage equals 1.00 at all sales levels.
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But why must managers monitor operating leverage carefully? Again, consider companies such as
General Motors, Global Crossing, US Airways, United Airlines, and WorldCom. Their high operating
leverage was a major reason for their financial problems. Anticipating high demand for their services,
these companies borrowed money to acquire assets, resulting in high fixed costs. As sales declined,
these companies suffered losses and could not generate sufficient cash to service their interest and
debt, causing them to seek bankruptcy protection. Managers and management accountants should
always evaluate how the level of fixed costs and variable costs they choose will affect the risk-return
trade-off.
What actions are managers taking to reduce their fixed costs? Many companies are moving their
manufacturing facilities from the United States to lower-cost countries, such as Mexico and China.
To substitute high fixed costs with lower variable costs, companies are purchasing products from
lower-cost suppliers instead of manufacturing products themselves. These actions reduce both costs
and operating leverage. More recently, General Electric and Hewlett-Packard began outsourcing
service functions, such as post-sales customer service, by shifting their customer call centers to
countries, such as India, where costs are lower. These decisions by companies are not without
controversy. Some economists argue that outsourcing helps to keep costs, and therefore prices, low
and enables U.S. companies to remain globally competitive.
Effects of Sales Mix on Income

Sales mix is the quantities (or proportion) of various products (or services) that constitute total unit
sales of a company. Suppose Oninz is now budgeting for a subsequent college fair in ADMU. He
plans to sell two different test-prep packages—UPCAT Success and ADMU Success—and budgets
the following:
UPCAT Success ADMU Success Total
Expected sales 60 40 100
Revenues, P200 and P100 per unit P12,000 P4,000 P16,000
Variable costs, P120 and P70 per unit 7,200 2,800 10,000
Contribution margin, P80 and P30 per unit 4,800 1,200 6,000
Fixed costs 4,500
Operating income 1,500
What is the breakeven point? In contrast to the single-product (or service) situation, the total number
of units that must be sold to break even in a multiproduct company depends on the sales mix—the
combination of the number of units of UPCAT Success sold and the number of units of ADMU
Success sold. We assume that the budgeted sales mix (60 units of UPCAT Success sold for every 40
units of ADMU Success sold, that is, a ratio of 3:2) will not change at different levels of total unit
sales. That is, we think of Oninz selling a bundle of 3 units of UPCAT Success and 2 units of ADMU
Success. Each bundle yields a contribution margin of P300 calculated as follows:
Number of Units of UPCAT Contribution Margin per Unit Contribution

Success and ADMU for UPCAT Success and Margin
Success in Each Bundle ADMU Success of the Bundle
UPCAT Success 3 P80 P240
ADMU Success 2 P30 P60
Total P300
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To compute the breakeven point, we calculate the number of bundles Oninz needs to sell.
Breakeven point in bundles = Fixed costs/ Contribution margin per bundle

= P4,500/P300
= 15 Bundles
Breakeven point in units of UPCAT Success and ADMU Success is as follows:
UPCAT Success: 15 bundles * 3 units of UPCAT Success per bundle 45 units

ADMU Success: 15 bundles * 2 units of ADMU Success per bundle 30 units
Total number of units to break even 75 units
Breakeven point in pesos for UPCAT Success and ADMU Success is as follows:
UPCAT Success: 45 units * P200 per unit P 9,000
ADMU Success: 30 units * P100 per unit 3,000
Breakeven revenues P12,000
When there are multiple products, it is often convenient to use contribution margin percentage. Under
this approach, Oninz first calculates the revenues from selling a bundle of 3 units of UPCAT Success
and 2 units of ADMU Success:
Number of Units of UPCAT

Selling Price for UPCAT Revenue
Success and ADMU
Success and ADMU Success of the Bundle
Success in Each Bundle
UPCAT Success 3 P200 P600
ADMU Success 2 P100 P200
Total P800
Contribution margin percentage for the bundle = Contribution margin of the bundle/ Revenue of the
bundle
=P300/800
=37.5%
Breakeven revenues = Fixed costs/ Contribution margin % for the bundle

=P4,500/37.5%
=P12,000
Number of bundles required to be sold to break even = Breakeven revenues/ Revenue per bundle
=P12,000/P800 per bundle
=15 bundles
The breakeven point in units and pesos for UPCAT Success and ADMU Guarantee are as follows:
UPCAT Success:
15 bundles x 3 units of UPCAT Success per bundle 45units x P200 per unit = P9,000
ADMU Success:
15 bundles x 2 units of ADMU Success per bundle 30 units x P100 per unit = P3,000
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III. ACTIVITY
MULTIPLE CHOICE
1. To which function of management is CVP analysis most applicable?
a. Planning
b. Organizing
c. Directing
d. Controlling
2. The systematic examination of the relationships among selling prices, volume of sales and
production, costs, and profits is termed:
a. contribution margin analysis
b. cost-volume-profit analysis
c. budgetary analysis
d. gross profit analysis
3. The term contribution margin is best defined as the:
a. Difference between fixed costs and variable costs.
b. Difference between revenue and fixed costs.
c. Amount available to cover fixed costs and profit.
d. Amount available to cover variable costs.
4. Cost-volume-profit analysis allows management to determine the relative profitability of a
product by
a. Highlighting potential bottlenecks in the production process.
b. Determining the contribution margin per unit and projected profits at various levels of
production.
c. Assigning costs to a product in a manner that maximizes the contribution margin.
d. Keeping fixed costs to an absolute minimum.
5. Cost-volume-profit analysis cannot be used if which of the following occurs?
a. Costs cannot be properly classified into fixed and variable costs.
b. The per unit variable costs change.
c. The total fixed costs change.
d. Per unit sales prices change.
6. The most useful information derived from a breakeven chart is the
a. Amount of sales revenue needed to cover enterprise variable costs.
b.Amount of sales revenue needed to cover enterprise fixed costs.
c. Relationship among revenues, variable costs, and fixed costs at various levels of activity.
d.Volume or output level at which the enterprise breaks even
7. Which of the factors is (are) involved in studying cost-volume-profit relationships?
a. Levels of production
b.Variable costs
c. Fixed costs
d.All of these
8. At the breakeven point, fixed cost is always
a. Less than the contribution margin
b.Equal to the contribution margin.
c. More than the contribution margin
d.More than the variable cost
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9. At the break-even point:
a. Net income will increase by the unit contribution margin for each additional item sold above
break-even.
b.the total contribution margin changes from negative to positive
c. fixed costs are greater than contribution margin
d.the contribution margin ratio begins to increase
10. In cost-volume-profit analysis, the greatest profit will be earned at
a. One hundred percent at normal productive capacity.
b.The production point with the lowest marginal cost.
c. The production point at which average total revenue exceeds average marginal cost.
d.The point at which marginal cost and marginal revenue are equal.
PROBLEM SOLVING
1. Sanderson sells a single product for P50 that has a variable cost of P30. Fixed costs amount
to P5 per unit when anticipated sales targets are met. If the company sells one unit in excess
of its break-even volume, the bottom-line profit will be:
a. P15.
b.P20.
c. P50.
d.None of the Above
2. At a volume of 15,000 units, Boston reported sales revenues of P600,000, variable costs of
P225,000, and fixed costs of P120,000. The company's contribution margin per unit is:
a. P17.
b.P25.
c. P47.
d.P55.
3. A recent income statement of Banks Corporation reported the following data:
 Sales revenue P8,000,000
 Variable costs 5,000,000
 Fixed costs 2,200,000
 If these data are based on the sale of 20,000 units, the contribution margin per unit would
be:
A. P40.
B. P150.
C. P290.
D. P360.
4. A recent income statement of Fox Corporation reported the following data:
 If these data are based on the sale of 10,000 units, the break-even point would be:
A. 2,000 units.
B. 2,778 units.
C. 3,600 units.
D. 5,000 units.
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5. A recent income statement of Yale Corporation reported the following data:
 Fixed costs 800,000
 If these data are based on the sale of 5,000 units, the break-even sales would be:
A. P2,000,000.
B. P2,206,000.
C. P2,500,000.
D. P10,000,000.
6. Lawton, Inc., sells a single product for P12. Variable costs are P8 per unit and fixed costs
total P360,000 at a volume level of 60,000 units. Assuming that fixed costs do not change,
Lawton's break-even point would be:
a. 30,000 units.
b.45,000 units.
c. 90,000 units
d.50,000 units
7. Orion recently reported sales revenues of P800,000, a total contribution margin of P300,000,
and fixed costs of P180,000. If sales volume amounted to 10,000 units, the company's
variable cost per unit must have been:
a. P12.
b. P32.
c. P50.
d. P92.
8. Ribco Co., makes and sells only one product. The unit contribution margin is P6 and the
break-even point in unit sales is 24,000. The company's fixed costs are:
a. P4,000.
b. P14,400.
c. P40,000.
d. P144,000.
9. A recent income statement of Oslo Corporation reported the following data:
 Units sold 8,000
If the company desired to earn a target net profit of P480,000, it would have to sell:
a. 1,200 units.
b.2,800 units.
c. 4,000 units.
d.5,200 units.
10. Yellow, Inc., sells a single product for P10. Variable costs are P4 per unit and fixed costs
total P120,000 at a volume level of 10,000 units. What dollar sales level would Yellow have
to achieve to earn a target net profit of P240,000?
a. P400,000.
b. P500,000.
c. P600,000.
d. P750,000.
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Use the following to answer questions 11-13:
Archie sells a single product for P50. Variable costs are 60% of the selling price, and the company
has fixed costs that amount to P400,000. Current sales total 16,000 units.
11. Archie:
a. will break-even by selling 8,000 units.
b. will break-even by selling 13,333 units.
c. will break-even by selling 20,000 units.
d. will break-even by selling 1,000,000 units.
12. Each unit that the company sells will:
a. increase overall profitability by P20.
b. increase overall profitability by P30.
c. increase overall profitability by P50.
d. increase overall profitability by some other amount.
13. In order to produce a target profit of P22,000, Archie's dollar sales must total:
a. P8,440.
b. P21,100.
c. P1,000,000.
d. P1,055,000.
14. Maxie's budget for the upcoming year revealed the following figures:
 Sales revenue P840,000
 Contribution margin 504,000
 Net income 54,000
If the company's break-even sales total P750,000, Maxie's safety margin would be:
a. P(90,000).
b. P90,000.
c. P246,000.
d. P336,000.
15. Dana sells a single product at P20 per unit. The firm's most recent income statement revealed
unit sales of 100,000, variable costs of P800,000, and fixed costs of P400,000. If a P4 drop
in selling price will boost unit sales volume by 20%, the company will experience:
a. no change in profit because a 20% drop in sales price is balanced by a 20% increase in
volume.
b. an P80,000 drop in profitability.
c. a P240,000 drop in profitability.
d. a P400,000 drop in profitability.
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MODULE 4:
Absorption and Variable Costing
1. Determine the Cost of Goods Sold and Income under Absorption Costing
2. Determine the Cost of Goods Sold and Income under Variable Costing
3. Identify Differences between Absorption and Variable Costing Methods
4. Learn the Reconciliation of Absorption and Variable Costing Income Figures
5. Understand the Standard Costs Report under Absorption and Variable Costing
II. CONTENT
Absorption Costing or Full Costing
A product costing method that includes all the manufacturing costs (direct materials, direct labor, and
both the variable and fixed factory overhead) in the cost of a unit of product. Under the absorption
costing method, fixed factory overhead is treated as a product cost.
Variable Costing or Contribution Margin Reporting

A product costing method that includes only the variable manufacturing costs (direct materials, direct
labor, and variable overhead) in the cost of a unit of product. Under the variable costing method, fixed
factory overhead is treated as a period cost.
Product Cost Components

Absorption Costing Variable Costing
Direct Materials Direct Materials
+ Direct Labor + Direct Labor
+ Variable FOH + Variable FOH
+ Fixed FOH____ -______
Total Product Cost Total Product Cost
Distinction Between Period Costs and Product Costs

Period Cost Product Cost
1. Cost that is charged against current revenue 1. Cost that is included in the computation of
during a time period regardless of the product cost that is apportioned between the
difference between production and sales sold and unsold units.
volumes.
2. Does not form part of the cost of inventory. 2. An inventoriable cost. The portion of the
cost that has been allocated to the unsold
units becomes part of the cost of inventory.
3. Reduces income for the current period by its 3. Reduces current income by the portion
full amount. allocated to the sold units; the portion
allocated to unsold units is treated as an
asset, being part of the cost of inventory.
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Principal Differences between Absorption and Variable Costing Methods
1. Cost Seldom segregates costs into Costs are segregated into variable and
Segregation variable and fixed costs. fixed.
2. Cost of Cost of inventory includes all the Cost of inventory includes only the
Inventory manufacturing costs: materials, variable manufacturing costs: materials,
labor, variable factory overhead, labor, and variable factory overhead.
and fixed factory overhead.
3. Treatment of Fixed factory overhead is treated Fixed factory overhead is treated as
Fixed as product cost. period cost.
Factory
Overhead
4. Income Distinguish between production Distinguish between variable and fixed
Statement and other costs costs
Sales xx Sales xx
COGS (xx) Variable Cost (xx)
Gross Profit xx Contribution Margin xx
Operating Expense (xx) Fixed Cost (xx)
Profit xx Profit xx
5. Net Income Net income between the two methods may differ each other because of the
difference in the amount of fixed overhead costs recognized as expense during
an accounting period. This is due to variations between sales and production.
In the long run, however, both methods give substantially the same results
since sales cannot continuously exceed production, nor production can
continually exceed sales.
Difference in Net Income under Absorption and Variable Costing

Variable and absorption costing methods of accounting for fixed manufacturing overhead result in
different levels of net income in most cases. The differences are timing differences, i.e. when to
recognize the fixed manufacturing overhead as an expense. In variable costing, it is expensed during
the period when the fixed overhead is incurred, while in absorption costing, it is expensed in the
period when the units to which such fixed overhead has been related are sold.
Production Equals Sales
When production is equal to sales, there is no change in inventory. Fixed overhead expensed under
absorption costing equals fixed overhead expensed under variable costing. Therefore, absorption
costing income equals variable costing income.
Production is Greater than Sales

When production is greater than sales, there is an increase in inventory, fixed overhead expensed
under absorption costing is less than fixed overhead expensed under variable costing. Therefore,
absorption income is greater than variable costing income.
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Production is Less Than Sales
When production is less than sales, there is a decrease in inventory. Fixed overhead expensed under
absorption is greater than fixed overhead expensed under variable costing. Therefore, absorption
income is less than variable costing income.
Reconciliation of Absorption and Variable Costing Income Figures

Absorption Costing Income xx
Add: Fixed Overhead in the Beginning Inventory xx
Total xx
Less: Fixed Overhead in the Ending Inventory (xx)
Variable Costing Income xx
Accounting for Difference in Income

Change in Inventory (Production less Sales) xx
X Fixed FOH cost per unit xx
Difference in Income xx
Arguments for the Use of Variable Costing

1. Variable costing reports are simpler and more understandable
2. Data needed for break-even and cost-volume profit analyses are readily available.
3. The problems involved in allocating fixed costs are eliminated.
4. Variable costing is more compatible with the standard cost accounting system.
5. Variable costing reports provide useful information for pricing decisions and other decision-
making problems encountered by management.
Arguments Against of Variable Costing

1. Segregation of costs into fixed and variable might be difficult, particularly in the case of mixed
costs.
2. The matching principle is violated by using variable costing which excludes fixed overhead
from product costs and charges the same to period costs regardless of production and sales.
3. With variable costing, inventory costs and other related accounts, such as working capital,
current ratio, and acid-test ratio are understated because of the exclusion of fixed overhead in
the computation of product cost.
Illustrative Example
During the year 200A, Liberty Corporation’s production was equal to its normal capacity of 1,000
units. It sold 900 units at a price of P50 per unit.
The following costs were incurred during the year:
Total Cost Cost per Unit
Direct Materials 12,000 12
Direct Labor 10,000 10
Variable Factory Overhead 8,000 8
Fixed Factory Overhead 6,000 6
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Variable Selling and 4,500 5*
Administrative
Fixed Selling and 3,000 3
Administrative
*Variable selling and administrative cost per unit = Total/Units Sold = P4,500/900 = P5
Required:
A. Product costs per unit under absorption and variable costing
B. Income under absorption costing
C. Income under variable costing
D. Computation of and accounting for the difference in income
A. Product costs per unit under absorption and variable costing

Product Costs Per Unit
Direct Materials P12 P12
Direct Labor 10 10
Variable Factory Overhead 8 8
Fixed Factory Overhead 6 -
Product Cost Per Unit P36 P30
 The difference between the two product costs per unit is the fixed FOH per unit.
 Under both methods, selling and administrative costs, whether variable or fixed, are treated
as period costs.
B. Income under Absorption Costing

Sales (900 units x P50) P45,000
Less: Cost of Goods Sold (900 x P36) 32,400
Gross Income P12,600
Less: Selling and Administrative Expenses:
Variable (900 x P5) P4,500
Fixed 3,000 7,500
Income – Absorption Costing P5,100
Allocation of Fixed Overhead Cost:

Charged to Cost of Goods Sold (900 units sold x P6 per unit) P5,400
Allocated to Inventory Cost (100 unsold units x P6) 600
Total Fixed Overhead (1,000 units @ P6 per unit) P6,000
Cost of Ending Inventory

Number of Units (1,000 units produced – 900 units sold) 100
X Cost per unit – Absorption P36
Cost of Ending Inventory(Includes Fixed OH Cost of P600) P3,600
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C. Income under Variable Costing
Sales (900 units x P50) P45,000
Less: Variable Costs
Cost of Goods Sold (900xP30) P27,000
Selling and Administrative 4,500 31,500
Contribution Margin P13,500
Less: Fixed Costs
Factory Overhead P6,000
Selling and Administrative 3,000 9,000
Income – Variable Costing P4,500
 The cost of goods sold consists of variable manufacturing costs only. Fixed factory
overhead is not charged to the cost of goods sold.
 The whole amount of fixed factory overhead is charged as a period cost, regardless of
whether all the units produced were sold or not.
 Cost of ending inventory
Number of units 100
X Cost per unit – variable P30
Cost of ending inventory P3,000*
*Consists of variable manufacturing costs only. Fixed factory overhead is not an
inventoriable cost.
D. Computation of and accounting for the difference in income

Absorption costing income P5,100
Variable costing income 4,500
Difference in income P 600
The difference in income represents the amount of fixed factory overhead charged to inventory
(treated as asset)
Accounting:
Change in Inventory (Production – Sales) 100 units
x Fixed FOH cost per unit P 6
Difference in income P600
Standard Costs under Absorption and Variable Costing

When a firm uses the standard costing system and income statements are prepared under the
absorption and variable costing methods:
1. Cost of goods sold are computed at standard.
2. The standard cost of goods sold is adjusted to actual costs by adding unfavorable variances
and/or deducting favourable variances.
3. In absorption costing, both the variable and fixed manufacturing cost variances are used as
adjustment to the standard cost of goods sold.
4. In variable costing, only the variable manufacturing cost variances are used as adjustments
to the standard cost of goods sold
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Illustrative Example:
Armando Corporation uses a standard costing system for a product that it manufactures. For the
year 200A, the following standards were established based on normal production of 1,000 units:
Total Cost
Materials 2 pcs. @ P6 per piece P12
Labor 5 hrs. @ P4 per hour 20
Variable Overhead 5 hrs. @ P3 per hour 15
Fixed Factory Overhead 5 hrs. @ P2 per hour 10
Total Standard Cost Per Unit P57
The following are the actual data for the year 200A:
 Production 1,100 units
 Sales 950 units
 Selling Price P80
 Materials (2,250@P5.80) P13,050
 Labor (5,420 hrs. @ P4.30 per hour) P23,306
 Variable overhead P15,718
 Fixed factory overhead P12,000
 Selling and administrative expenses: Variable P5,700
 Selling and administrative expenses: Fixed P8,000
Required:
1. Variances for each cost element of production
2. Comparative Income Statements – Absorption and Variable Costing
1. Variances For Each Cost Element Of Production

Materials Labor Variable FOH Fixed FOH
Actual Costs P13,050 P23,306 P15,718 P12,000
Standard Costs* 13,200 22,000 16,500 11,000
*Standard Costs = actual production x standard costs per unit

 Materials 1,100 x P12 P13,200
 Labor 1,100 x P20 22,000
 Variable FOH 1,100 x P15 16,500
 Fixed FOH 1,100 x P10 11,000
2. Comparative Income Statements – Absorption and Variable Costing

Sales (950 units x P80) P76,000 P76,000
Cost of Goods Sold/Variable Costs:
Standard Cost of Goods Sold
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(950 x P57) P54,150
(950 x P47) P44,650
Add (Deduct) Variances:
Materials – favourable (150) (150)
Labor – unfavorable 1,306 1,306
Variable OH – favourable (782) (782)
Fixed OH - unfavorable 1,000 -
Actual Cost of Goods Sold P55,524 P45,024
Add: Variable and Selling Administrative Expenses - 5,700
Total Cost of Goods Sold/Variable Costs P55,524 P50,724
Gross Income/Contribution Margin P20,476 P25,276
Less: Operating Expenses/Fixed Costs
Fixed OH - P12,000*
Fixed Selling and Administrative Expenses 8,000 8,000
Variable Selling and Administrative Expenses 5,700 -
Total Operating Expenses/Fixed Costs P13,700 P20,000
Income P6,776 P5,276
*The total actual fixed overhead cost incurred during the period.
Difference in Income (P6,776-P5,276) P 1,500

Accounted for as follows:
Change in Inventory (Production – Sales) (1,100-950) 150 units
x Fixed FOH cost per unit P10
Difference in Income P1,500
The Extremes
1. Super variable Costing or Throughput Costing – treats direct materials as the only variable
costs.
Features:
a. Only materials costs are inventoried, work-in-process or finished goods inventories are
not recorded.
b. Direct labor and manufacturing overhead costs are all treated as period costs,
expensing them as they are incurred.
c. Cost of goods sold is the cost of materials put into process.
d. Sales less cost of goods sold (purely materials) = Throughput
e. Throughput costing results in even lower income than does variable costing when
production exceeds sales
f. Throughput costing penalizes high production and rewards low production. Hence, it is
very much in tune with Just-in-Time and other philosophies that seek lower
inventories.
2. Super absorption costing – treats costs from all links in the value chain as inventoriable costs.
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III. ACTIVITY
MULTIPLE CHOICE
1. Which of the following statements is correct?
a. In a variable costing income statement, sales revenue is typically higher than in
absorption costing income statement.
b. When production is not equal to sales, income under absorption costing differs from
income under variable costing due to the difference in treatment (product cost and
period cost) of the fixed overhead cost under the two costing methods.
c. In a variable costing system, fixed overhead cost is included as part of the cost of
inventory.
d. In an absorption costing system, fixed overhead cost is treated as a period cost.
2. Which of the following statements is true?
a. Depreciation expense is always a product cost
b. Depreciation expense is always a period cost
c. Selling and administrative costs, whether variable or fixed, is always treated as period
costs under both the absorption and variable costing systems.
d. Income under absorption costing is always greater than income under variable costing.
3. If production is less than sales (in units), then absorption costing net income will generally be
a. Greater than variable costing net income
b. Less than variable costing net income
c. Equal to variable costing net income
d. Less than expected
4. If a firm uses variable costing,
a. Its product costs include variable selling and administrative costs
b. Its profit fluctuate with sales
c. It calculates an idle facility variation
d. Its product cost per unit changes because of changes in the number of units produced.
5. The inventory costing method that treats direct manufacturing costs and indirect
manufacturing costs, both variable and fixed, as inventoriable costs is called
a. Variable costing
b. Absorption costing
c. Conversion costing
d. Perpetual inventory
6. Which of the following statements regarding absorption and variable costing is correct?
a. Absorption costing results in higher income when finished goods inventory increases
b. Variable manufacturing costs are lower under absorption costing
c. Overhead costs are treated in the same manner under both variable and absorption
costing methods.
d. Profits are always the same under the two costing methods.
7. Which of the following cost items is not correctly accounted for as a product cost under
absorption and variable costing?
Product Cost Under
Absorption Variable
a. Shipping costs No No
b. Straight line depreciation Yes Yes
c. Factory supplies Yes Yes
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d. Direct materials Yes Yes
8. Which of the following must be known about a production process to institute a variable
costing system?
a. The direct and indirect costs related to production
b. Standard quantities and prices for all production inputs
c. The variable and fixed components of manufacturing costs
d. The capacity level or denominator level to be used in allocating fixed overhead costs
9. What costs are treated as product cost under variable costing?
a. All variable costs
b. All direct costs only
c. All manufacturing costs
d. Only variable production costs
10. Which of the following would most likely decrease the product cost per unit under variable
costing?
a. A decrease in the commission paid to salesperson for each unit sold
b. An increase in the number of units sold
c. A decrease in the remaining useful life of a factory equipment depreciated using the
straight line method
d. An increase in the remaining useful life of a factory equipment depreciated on the
units of production method
11. Which of the following costing methods is not acceptable for both internal and external
reporting?
a. Activity based costing
b. Variable costing
c. Absorption costing
d. Process costing
12. Under variable costing, all fixed costs are expensed during the current period because
a. Fixed costs are usually immaterial in amount.
b. Fixed costs are non-controllable costs.
c. Fixed costs are incurred whether or not there is production, so it is not proper to
allocate these costs to production and defer a current cost of doing business.
d. Allocation of fixed costs is usually done arbitrarily and could lead to erroneous
decision by management.
13. Which of the following statements is incorrect?
a. In a variable costing income statement, variable selling and administrative expenses
are used both in the computation of contribution margin and operating income.
b. When using a variable costing system, the contribution margin discloses the excess of
revenues over variable costs
c. In an income statement prepared as an internal report using the variable costing
method, fixed FOH is used in the computation of operating income and contribution
margin.
d. Using absorption costing, fixed manufacturing overhead costs are best described as
indirect product cost.
14. A company prepares income statement using both absorption and variable costing methods.
At the end of the period, a comparison of actual and budgeted results revealed that the actual
net income was substantially above the budgeted net income, although actual sales, gross
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margin, and contribution margin approximated the budgeted figures. There were no beginning
or ending inventories during the period. The most likely explanation of the increase in net
income is that, compared to budget, actual
a. Selling prices was higher
b. Variable costs was lower
c. Fixed selling and administrative costs was lower.
d. Fixed factory overhead costs was lower.
15. Income under absorption costing may differ from income under variable costing. The
difference in income between the two costing methods is equal to the change in the quantity
of all units
a. Produced multiplied by the variable manufacturing cost per unit.
b. Sold multiplied by the fixed factory overhead cost per unit.
c. In inventory multiplied by the fixed factory overhead cost per unit.
d. Sold multiplied by the selling price per unit.
PROBLEM SOLVING
1. Lone Star has computed the following unit costs for the year just ended:
Direct material used P12

Direct labor 18
Variable manufacturing overhead 25
Fixed manufacturing overhead 29
Variable selling and administrative cost 10
Fixed selling and administrative cost 17
Under variable costing, each unit of the company's inventory would be carried at:
A. P35.
B. P55.
C. P65.
D. P84.
2. Prescott Corporation has computed the following unit costs for the year just ended:
Direct labor 27
Under absorption costing, each unit of the company's inventory would be carried at:
A. P75.
B. P107.
C. P116.
D. P133.
3. Santa Fe Corporation has computed the following unit costs for the year just ended:
Direct labor 19
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Which of the following choices correctly depicts the per-unit cost of inventory under variable
costing and absorption costing?
Variable Absorption
Costing Costing
A. P79 P119
B. P79 P151
C. P96 P119
D. P96 P151
4. Delaware has computed the following unit costs for the year just ended:
Variable manufacturing cost P85

Fixed manufacturing cost 20
Which of the following choices correctly depicts the per-unit cost of inventory under variable costing and
absorption costing?
A. Variable, P85; absorption, P105.
B. Variable, P85; absorption, P116.
C. Variable, P103; absorption, P105.
D. Variable, P103; absorption, P116.

Indiana Company incurred the following costs during the past year when planned production and actual
production each totaled 20,000 units:
Direct materials used P280,000
Direct labor 120,000
Variable manufacturing overhead 160,000
Fixed manufacturing overhead 100,000
Variable selling and administrative costs 60,000
Fixed selling and administrative costs 90,000
5. If Indiana uses variable costing, the total inventoriable costs for the year would be:
A. P400,000.
B. P460,000.
C. P560,000.
D. P620,000.
6. The per-unit inventoriable cost under absorption costing is:
A. P9.50.
B. P25.00.
C. P28.00.
D. P33.00.
7. Roberts, which began business at the start of the current year, had the following data:
Planned and actual production: 40,000 units
Sales: 37,000 units at P15 per unit
Production costs:
Variable: P4 per unit
Fixed: P260,000
Selling and administrative costs:
Fixed: P32,000
The gross margin that the company would disclose on an absorption-costing income statement is:
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A. P97,500.
B. P147,000.
C. P166,500.
D. P370,000.
8. McAfee, which began business at the start of the current year, had the following data:
Production costs:
Fixed: P260,000
Fixed: P32,000
The contribution margin that the company would disclose on an absorption-costing income
statement is:
A. P0.
B. P147,000.
C. P166,500.
D. P370,000.
9. Chicago began business at the start of the current year. The company planned to produce 25,000 units,
and actual production conformed to expectations. Sales totaled 22,000 units at P30 each. Costs
incurred were:
Fixed manufacturing overhead P150,000
Fixed selling and administrative cost 100,000
Variable manufacturing cost per unit 8
Variable selling and administrative cost per unit 2
If there were no variances, the company's absorption-costing net income would be:
A. P190,000.
B. P202,000.
C. P208,000.
D. P220,000.
10. Norton, which began business at the start of the current year, had the following data:
Production costs:
Fixed: P260,000
Fixed: P32,000
The contribution margin that the company would disclose on a variable-costing income statement is:
A. P97,500.
B. P147,000.
C. P166,500.
D. P370,000.
11. Madison began business at the start of the current year. The company planned to produce 30,000 units,
and actual production conformed to expectations. Sales totaled 28,000 units at P32 each. Costs
incurred were:
Fixed manufacturing overhead P150,000
Variable manufacturing cost per unit 11
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Variable selling and administrative cost per unit 2
If there were no variances, the company's variable-costing net income would be:
A. P270,000.
B. P292,000.
C. P308,000.
D. P532,000.
12. The following data relate to Lobo Corporation for the year just ended:
Sales revenue P750,000
Cost of goods sold:
Variable portion 370,000
Fixed portion 110,000
Variable selling and administrative cost 50,000
Which of the following statements is correct?
A. Lobo’s variable-costing income statement would reveal a gross margin of P270,000.
B. Lobo’s variable costing income statement would reveal a contribution margin of P330,000.
C. Lobo’s absorption-costing income statement would reveal a contribution margin of P330,000.
D. Lobo’s absorption costing income statement would reveal a gross margin of P330,000.

Franz began business at the start of this year and had the following costs: variable manufacturing cost per unit,
P9; fixed manufacturing costs, P60,000; variable selling and administrative costs per unit, P2; and fixed selling
and administrative costs, P220,000. The company sells its units for P45 each. Additional data follow.
Planned production in units 10,000
Actual production in units 10,000
Number of units sold 8,500
There were no variances.
13. The net income (loss) under absorption costing is:
A. P(7,500).
B. P9,000.
C. P15,000.
D. P18,000.
14. The net income (loss) under variable costing is:
A. P(7,500).
B. P9,000.
C. P15,000.
D. P18,000.
15. Highline Company reported the following costs for the year just ended:
Throughput manufacturing costs P180,000
Non-throughput manufacturing costs 600,000
Selling and administrative costs 125,000
If Highline uses throughput costing and had sales revenues for the period of P950,000, which of the
following choices correctly depicts the company's cost of goods sold and net income?
Cost of Net
Goods Sold Income
A. P180,000 P45,000
B. P180,000 P645,000
C. P305,000 P45,000
D. P305,000 P645,000
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COMPREHENSIVE PROBLEM (Group Activity)
1. Information taken from Grille Corporation's May accounting records follows.
Direct labor 80,000
Variable selling and administrative costs 51,000
Fixed selling and administrative costs 60,000
Sales revenues 625,000
Required:
A. Assuming the use of variable costing, compute the inventoriable costs for the month.
B. Compute the month's inventoriable costs by using absorption costing.
C. Assume that anticipated and actual production totaled 20,000 units, and that 18,000 units were
sold during May. Determine the amount of fixed manufacturing overhead and fixed selling and
administrative costs that would be expensed for the month under (1) variable costing and (2)
absorption costing.
D. Assume the same data as in requirement "C." Compute the contribution margin that would be
reported on a variable-costing income statement.
2. Sosa, Inc., began operations at the start of the current year, having a production target of 60,000 units.
Actual production totaled 60,000 units, and the company sold 90% of its manufacturing output at P55
per unit. The following costs were incurred:
Manufacturing:
Direct labor 420,000
Selling and administrative:
Variable 120,000
Fixed 630,000
Required:
A. Assuming the use of variable costing, compute the cost of Sosa's ending finished-goods
inventory.
B. Compute the company's contribution margin. Would Sosa disclose the contribution margin on a
variable-costing income statement or an absorption-costing income statement?
C. Assuming the use of absorption costing, how much fixed selling and administrative cost would
Sosa include in the ending finished-goods inventory?
D. Compute the company's gross margin.
3. Kim, Inc., began business at the start of the current year and maintains its accounting records on an
absorption-cost basis. The following selected information appeared on the company's income
statement and end-of-year balance sheet:
Income-statement data:
Sales revenues (35,000 units x P22) P770,000
Gross margin 210,000
Total sales and administrative expenses 160,000
Balance-sheet data:
Ending finished-goods inventory (12,000 units) 192,000
Kim achieved its planned production level for the year. The company's fixed manufacturing overhead
totaled P141,000, and the firm paid a 10% commission based on gross sales dollars to its sales force.
Required:
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A. How many units did Kim plan to produce during the year?
B. How much fixed manufacturing overhead did the company apply to each unit produced?
C. Compute Kim's cost of goods sold.
D. How much variable cost did the company attach to each unit manufactured?
4. Houston Company has per-unit fixed and variable manufacturing costs of P40 and P15, respectively.
Variable selling and administrative costs are P9 per unit. Consider the two cases that follow for the
firm.
Case A: Variable-costing net income, P110,000; sales, 6,000 units; production, 6,000 units
Case B: Variable-costing net income, P178,000; sales, 7,500 units; production, 7,100 units
Required:
A. From a product-costing perspective, what is the basic difference between absorption costing and
variable costing?
B. Compute Houston's absorption-costing net income in Case A.
C. Compute Houston's absorption-costing net income in Case B.
5. Beachcraft Corporation has fixed manufacturing cost of P12 per unit. Consider the three independent
cases that follow.
Case A: Absorption- and variable costing net income each totaled P240,000 in a period when
the firm produced 18,000 units.
Case B: Absorption-costing net income totaled P320,000 in a period when finished-goods
inventory levels rose by 7,000 units.
Case C: Absorption-costing net income and variable-costing net income respectively totaled
P220,000 and P250,000 in a period when the beginning finished-goods inventory
was 14,000 units.
Required:
A. In Case A, how many units were sold during the period?
B. In Case B, how much income would Beachcraft report under variable costing?
C. In Case C, how many units were in the ending finished-goods inventory?
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MODULE 5:
Relevant Information for Decision Making
1. Use the five-step decision-making process to make decisions
2. Distinguish relevant from irrelevant information in decision situations
3. Explain the opportunity-cost concept and why it is used in decision making
4. Know how to choose which products to produce when there are capacity constraints
5. Explain why book value of equipment is irrelevant in equipment replacement decisions
6. Explain how conflicts can arise between the decision model used by a manager and the
performance evaluation model used to evaluate the manager
II. CONTENT
Information and the Decision Process
Managers usually follow a decision model for choosing among different courses of action. A
decision model is a formal method of making a choice that often involves both quantitative and
qualitative analyses. Management accountants analyze and present relevant data to guide
managers’ decisions.
Consider a strategic decision facing management at Precision Sporting Goods, a manufacturer of

golf clubs: Should it reorganize its manufacturing operations to reduce manufacturing labor costs?
Precision Sporting Goods has only two alternatives: Do not reorganize or reorganize.
Reorganization will eliminate all manual handling of materials. Current manufacturing labor
consists of 20 workers—15 workers operate machines, and 5 workers handle materials. The 5
materials-handling workers have been hired on contracts that permit layoffs without additional
payments. Each worker works 2,000 hours annually. Reorganization is predicted to cost P90,000
each year (mostly for new equipment leases). Production output of 25,000 units as well as the
selling price of P250, the direct material cost per unit of P50, manufacturing overhead of
P750,000, and marketing costs of P2,000,000 will be unaffected by the reorganization.
Managers use the five-step decision-making process presented in Exhibit 1.1. Study the sequence
of steps in this exhibit and note how Step 5 evaluates performance to provide feedback about
actions taken in the previous steps. This feedback might affect future predictions, the prediction
methods used, the way choices are made, or the implementation of the decision.
Exhibit 1.1 – Five-Step Decision Making Process for Precision Sporting Goods
Step 1: Should Precision Sporting Goods reorganize its manufacturing
Identify the Problem operations to reduce manufacturing labor costs? An important
and Uncertainties uncertainty is how the reorganization will affect employee morale.
Step 2: Historical hourly wage rates are P14 per hour. However, a recently
Obtain Information negotiated increase in employee benefits of P2 per hour will increase
wages to P16 per hour. The reorganization of manufacturing
operations is expected to reduce the number of workers from 20 to 15
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by eliminating all 5 workers who handle materials. The reorganization
is likely to have negative effects on employee morale.
Step 3: Managers use information from Step 2 as a basis for predicting future
Make Predictions manufacturing labor costs. Under the existing do not reorganize
About the Future alternative, costs are predicted to be P640,000 (20 workers x 2,000
hours per worker per year x P16 per hour), and under the reorganize
alternative, costs are predicted to be P480,000 (15 workers x 2,000
hours per worker per year x P16 per hour). Recall, the reorganization
is predicted to cost P90,000 per year.
Step 4: Managers compare the predicted benefits calculated in Step 3
Make Decisions by (P640,000 - P480,000 = P160,000—that is, savings from eliminating
Choosing Among materials-handling labor costs, 5 workers _ 2,000 hours per worker per
Alternatives year x P16 per hour = P160,000) against the cost of the reorganization
(P90,000) along with other considerations (such as likely negative
effects on employee morale). Management chooses the reorganize
alternative because the financial benefits are significant and the effects
on employee morale are expected to be temporary and relatively small.
Step 5: Evaluating performance after the decision is implemented provides
Implement the critical feedback for managers, and the five-step sequence is then
Decision, Evaluate repeated in whole or in part. Managers learn from actual results that
Performance, and the new manufacturing labor costs are P540,000, rather than the
Learn predicted P480,000, because of lower-than-expected manufacturing
labor productivity. This (now) historical information can help
managers make better subsequent predictions that allow for more
learning time. Alternatively, managers may improve implementation
via employee training and better supervision.
The Concept of Relevance

Much of this module focuses on Step 4 in Exhibit 1.1 and on the concepts of relevant costs and
relevant revenues when choosing among alternatives.
Relevant Costs and Relevant Revenues

Relevant costs are expected future costs, and relevant revenues are expected future revenues that
differ among the alternative courses of action being considered. Revenues and costs that are not
relevant are said to be irrelevant. It is important to recognize that to be relevant costs and relevant
revenues they must:
 Occur in the future—every decision deals with selecting a course of action based on its
expected future results.
 Differ among the alternative courses of action—costs and revenues that do not differ will
not matter and, hence, will have no bearing on the decision being made.
The question is always, “What difference will an action make?”

Exhibit 1.2 presents the financial data underlying the choice between the do not reorganize and
reorganize alternatives for Precision Sporting Goods. There are two ways to analyze the data. The
first considers “All revenues and costs,” while the second considers only “Relevant revenues and
costs.”
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The first two columns describe the first way and present all data. The last two columns describe
the second way and present only relevant costs—the P640,000 and P480,000 expected future
manufacturing labor costs and the P90,000 expected future reorganization costs that differ
between the two alternatives. The revenues, direct materials, manufacturing overhead, and
marketing items can be ignored because they will remain the same whether or not Precision
Sporting Goods reorganizes. They do not differ between the alternatives and, therefore, are
irrelevant.
Note, the past (historical) manufacturing hourly wage rate of P14 and total past (historical)
manufacturing labor costs of P560,000 (20 workers x 2,000 hours per worker per year x P14 per
hour) do not appear in Exhibit 1.2. Although they may be a useful basis for making informed
predictions of the expected future manufacturing labor costs of P640,000 and P480,000, historical
costs themselves are past costs that, therefore, are irrelevant to decision making. Past costs are
also called sunk costs because they are unavoidable and cannot be changed no matter what action
is taken.
The analysis in Exhibit 1.2 indicates that reorganizing the manufacturing operations will increase
predicted operating income by P70,000 each year. Note that the managers at Precision Sporting
Goods reach the same conclusion whether they use all data or include only relevant data in the
analysis. By confining the analysis to only the relevant data, managers can clear away the clutter
of potentially confusing irrelevant data. Focusing on the relevant data is especially helpful when
all the information needed to prepare a detailed income statement is unavailable. Understanding
which costs are relevant and which are irrelevant helps the decision maker concentrate on
obtaining only the pertinent data and is more efficient.
Exhibit 1.2 – Determining Relevant Revenues and Relevant Costs for Precision Sporting Goods
Page 79 of 134
Qualitative and Quantitative Relevant Information
Managers divide the outcomes of decisions into two broad categories: quantitative and qualitative.
Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors
are financial; they can be expressed in monetary terms. Examples include the cost of direct materials,
direct manufacturing labor, and marketing. Other quantitative factors are nonfinancial; they can be
measured numerically, but they are not expressed in monetary terms. Reduction in new product-
development time and the percentage of on-time flight arrivals are examples of quantitative
nonfinancial factors. Qualitative factors are outcomes that are difficult to measure accurately in
numerical terms. Employee morale is an example.
Relevant-cost analysis generally emphasizes quantitative factors that can be expressed in financial
terms. But just because qualitative factors and quantitative nonfinancial factors cannot be measured
easily in financial terms does not make them unimportant. In fact, managers must wisely weigh these
factors. In the Precision Sporting Goods example, managers carefully considered the negative effect
on employee morale of laying-off materials handling workers, a qualitative factor, before choosing
the reorganize alternative. Comparing and trading off nonfinancial and financial considerations is
seldom easy. Exhibit 1.3 summarizes the key features of relevant information.
Exhibit 1.3 Key Features of Relevant Information

 Past (historical) costs may be helpful as a basis for making predictions. However, past costs
themselves are always irrelevant when making decisions.
 Different alternatives can be compared by examining differences in expected total future
revenues and expected total future costs.
 Not all expected future revenues and expected future costs are relevant. Expected future
revenues and expected future costs that do not differ among alternatives are irrelevant and,
hence, can be eliminated from the analysis. The key question is always, “What difference will
an action make?”
 Appropriate weight must be given to qualitative factors and quantitative nonfinancial factors.
One-Time-Only Special Orders

One type of decision that affects output levels is accepting or rejecting special orders when there is
idle production capacity and the special orders have no long-run implications. We use the term one-
time-only special order to describe these conditions. Example 1: Surf Gear manufactures quality
beach towels at its highly automated Burlington, North Carolina, plant. The plant has a production
capacity of 48,000 towels each month. Current monthly production is 30,000 towels. Retail
department stores account for all existing sales. Expected results for the coming month (August) are
shown in Exhibit 11-4. (These amounts are predictions based on past costs.) We assume all costs can
be classified as either fixed or variable with respect to a single cost driver (units of output).
As a result of a strike at its existing towel supplier, Azelia, a luxury hotel chain, has offered to buy
5,000 towels from Surf Gear in August at P11 per towel. No subsequent sales to Azelia are
anticipated. Fixed manufacturing costs are based on the 48,000 towel production capacity. That is,
fixed manufacturing costs relate to the production capacity available and not the actual capacity used.
If Surf Gear accepts the special order, it will use existing idle capacity to produce the 5,000 towels,
and fixed manufacturing costs will not change. No marketing costs will be necessary for the 5,000-
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unit one-time-only special order. Accepting this special order is not expected to affect the selling
price or the quantity of towels sold to regular customers. Should Surf Gear accept Azelia’s offer?
Exhibit 1.4 presents data for this example on an absorption-costing basis (that is, both variable and
fixed manufacturing costs are included in inventoriable costs and cost of goods sold). In this exhibit,
the manufacturing cost of P12 per unit and the marketing cost of P7 per unit include both variable
and fixed costs. The sum of all costs (variable and fixed) in a particular business function of the value
chain, such as manufacturing costs or marketing costs, are called business function costs. Full costs
of the product, in this case P19 per unit, are the sum of all variable and fixed costs in all business
functions of the value chain (R&D, design, production, marketing, distribution, and customer
service). For Surf Gear, full costs of the product consist of costs in manufacturing and marketing
because these are the only business functions. No marketing costs are necessary for the special order,
so the manager of Surf Gear will focus only on manufacturing costs. Based on the manufacturing cost
per unit of P12—which is greater than the P11-per-unit price offered by Azelia—the manager might
decide to reject the offer.
Exhibit 1.4 Budgeted Income Statement for August, Absorption-Costing Format for Surf Gear
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Exhibit 1.5 separates manufacturing and marketing costs into their variable- and fixed-cost
components and presents data in the format of a contribution income statement. The relevant revenues
and costs are the expected future revenues and costs that differ as a result of accepting the special
offer—revenues of P55,000 (P11 per unit x 5,000 units) and variable manufacturing costs of P37,500
(P7.50 per unit x 5,000 units). The fixed manufacturing costs and all marketing costs (including
variable marketing costs) are irrelevant in this case because these costs will not change in total
whether the special order is accepted or rejected. Surf Gear would gain an additional P17,500
(relevant revenues, P55,000 – relevant costs, P37,500) in operating income by accepting the special
order. In this example, comparing total amounts for 30,000 units versus 35,000 units or focusing only
on the relevant amounts in the difference column in Exhibit 1.5 avoids a misleading implication—
the implication that would result from comparing the P11-per-unit selling price against the
manufacturing cost per unit of P12 (Exhibit 1.4), which includes both variable and fixed
manufacturing costs.
Exhibit 1.5 – One-Time-Only Special-Order Decision for Surf Gear: Comparative Contribution
Income Statements
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The assumption of no long-run or strategic implications is crucial to management’s analysis of the
one-time-only special-order decision. Suppose Surf Gear concludes that the retail department stores
(its regular customers) will demand a lower price if it sells towels at P11 apiece to Azelia. In this
case, revenues from regular customers will be relevant. Why? Because the future revenues from
regular customers will differ depending on whether the special order is accepted or rejected. The
relevant-revenue and relevant-cost analysis of the Azelia order would have to be modified to consider
both the short-run benefits from accepting the order and the long-run consequences on profitability if
prices were lowered to all regular customers.
Potential Problems in Relevant-Cost Analysis

Managers should avoid two potential problems in relevant-cost analysis. First, they must watch for
incorrect general assumptions, such as all variable costs are relevant and all fixed costs are irrelevant.
In the Surf Gear example, the variable marketing cost of P5 per unit is irrelevant because Surf Gear
will incur no extra marketing costs by accepting the special order. But fixed manufacturing costs
could be relevant. The extra production of 5,000 towels per month does not affect fixed manufacturing
costs because we assumed that the relevant range is from 30,000 to 48,000 towels per month. In some
cases, however, producing the extra 5,000 towels might increase fixed manufacturing costs. Suppose
Surf Gear would need to run three shifts of 16,000 towels per shift to achieve full capacity of 48,000
towels per month. Increasing the monthly production from 30,000 to 35,000 would require a partial
third shift because two shifts could produce only 32,000 towels. The extra shift would increase fixed
manufacturing costs, thereby making these additional fixed manufacturing costs relevant for this
decision.
Second, unit-cost data can potentially mislead decision makers in two ways:
1. When irrelevant costs are included. Consider the P4.50 of fixed manufacturing cost per unit
(direct manufacturing labor, P1.50 per unit, plus manufacturing overhead, P3.00 per unit)
included in the P12-per-unit manufacturing cost in the one-time-only special-order decision (see
Exhibits 1.4 and 1.5). This P4.50-per-unit cost is irrelevant, given the assumptions in our
example, so it should be excluded.
2. When the same unit costs are used at different output levels. Generally, managers use total costs
rather than unit costs because total costs are easier to work with and reduce the chance for
erroneous conclusions. Then, if desired, the total costs can be unitized. In the Surf Gear example,
total fixed manufacturing costs remain at P135,000 even if Surf Gear accepts the special order
and produces 35,000 towels. Including the fixed manufacturing cost per unit of P4.50 as a cost
of the special order would lead to the erroneous conclusion that total fixed manufacturing costs
would increase to P157,500 (P4.50 per towel 35,000 towels).
The best way for managers to avoid these two potential problems is to keep focusing on (1) total
revenues and total costs (rather than unit revenue and unit cost) and (2) the relevance concept.
Managers should always require all items included in an analysis to be expected total future revenues
and expected total future costs that differ among the alternatives.
Insourcing-versus-Outsourcing and Make-versus-Buy Decisions

We now apply the concept of relevance to another strategic decision: whether a company should
make a component part or buy it from a supplier. We again assume idle capacity.
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Outsourcing and Idle Facilities
Outsourcing is purchasing goods and services from outside vendors rather than producing the same
goods or providing the same services within the organization, which is insourcing. For example,
Kodak prefers to manufacture its own film (insourcing) but has IBM do its data processing
(outsourcing). Honda relies on outside vendors to supply some component parts but chooses to
manufacture other parts internally.
Decisions about whether a producer of goods or services will insource or outsource are also called
make-or-buy decisions. Surveys of companies indicate that managers consider quality, dependability
of suppliers, and costs as the most important factors in the make-or-buy decision. Sometimes,
however, qualitative factors dominate management’s make-or-buy decision. For example, Dell
Computer buys the Pentium chip for its personal computers from Intel because Dell does not have
the know-how and technology to make the chip itself. In contrast, to maintain the secrecy of its
formula, Coca-Cola does not outsource the manufacture of its concentrate.
Example 2: The Soho Company manufactures a two-in-one video system consisting of a DVD player
and a digital media receiver (that downloads movies and video from internet sites such as NetFlix).
Columns 1 and 2 of the following table show the expected total and per-unit costs for manufacturing
the DVD-player of the video system. Soho plans to manufacture the 250,000 units in 2,000 batches
of 125 units each. Variable batch-level costs of P625 per batch vary with the number of batches, not
the total number of units produced. Broadfield, Inc., a manufacturer of DVD players, offers to sell
Soho 250,000 DVD players next year for P64 per unit on Soho’s preferred delivery schedule. Assume
that financial factors will be the basis of this make-or-buy decision. Should Soho make or buy the
DVD player?
Columns 1 and 2 of the preceding table indicate the expected total costs and expected cost per unit of
producing 250,000 DVD players next year. The expected manufacturing cost per unit for next year is
P72. At first glance, it appears that the company should buy DVD players because the expected P72-
per-unit cost of making the DVD player is more than the P64 per unit to buy it. But a make-or-buy
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decision is rarely obvious. To make a decision, management needs to answer the question, “What is
the difference in relevant costs between the alternatives?”
For the moment, suppose (a) the capacity now used to make the DVD players will become idle next
year if the DVD players are purchased and (b) the P3,000,000 of fixed manufacturing overhead will
continue to be incurred next year regardless of the decision made. Assume the P750,000 in fixed
salaries to support materials handling and setup will not be incurred if the manufacture of DVD
players is completely shut down.
Exhibit 1.6 presents the relevant-cost computations. Note that Soho will save P1,000,000 by making
DVD players rather than buying them from Broadfield. Making DVD players is the preferred
alternative.
Exhibit 1.6 – Relevant (Incremental) Items for Make-or-Buy Decision for DVD Players at Soho
Company
Note how the key concepts of relevance presented in Exhibit 1.3 apply here: Exhibit 1.6
 Compares differences in expected total future revenues and expected total future costs. Past
costs are always irrelevant when making decisions.
 Shows P2,000,000 of future materials-handling and setup costs under the make alternative but
not under the buy alternative. Why? Because buying DVD players and not manufacturing them
will save P2,000,000 in future variable costs per batch and avoidable fixed costs. The
P2,000,000 represents future costs that differ between the alternatives and so is relevant to the
make-or-buy decision.
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 Excludes the P3,000,000 of plant-lease, insurance, and administration costs under both
alternatives. Why? Because these future costs will not differ between the alternatives, so they
are irrelevant.
A common term in decision making is incremental cost. An incremental cost is the additional total
cost incurred for an activity. In Exhibit 1.6, the incremental cost of making DVD players is the
additional total cost of P15,000,000 that Soho will incur if it decides to make DVD players. The
P3,000,000 of fixed manufacturing overhead is not an incremental cost because Soho will incur these
costs whether or not it makes DVD players. Similarly, the incremental cost of buying DVD players
from Broadfield is the additional total cost of P16,000,000 that Soho will incur if it decides to buy
DVD players. A differential cost is the difference in total cost between two alternatives. In Exhibit
1.6, the differential cost between the make-DVD players and buy-DVD-players alternatives is
P1,000,000 (P16,000,000 – P15,000,000). Note that incremental cost and differential cost are
sometimes used interchangeably in practice. When faced with these terms, always be sure to clarify
what they mean.
We define incremental revenue and differential revenue similarly to incremental cost and differential
cost. Incremental revenue is the additional total revenue from an activity. Differential revenue is the
difference in total revenue between two alternatives.
Strategic and Qualitative Factors

Strategic and qualitative factors affect outsourcing decisions. For example, Soho may prefer to
manufacture DVD players in-house to retain control over the design, quality, reliability, and delivery
schedules of the DVD players it uses in its video-systems. Conversely, despite the cost advantages
documented in Exhibit 1.6, Soho may prefer to outsource, become a leaner organization, and focus
on areas of its core competencies—the manufacture and sale of video systems. As an example of
focus, advertising companies, such as J. Walter Thompson, only do the creative and planning aspects
of advertising (their core competencies), and outsource production activities, such as film,
photographs, and illustrations.
Outsourcing is not without risks. As a company’s dependence on its suppliers increases, suppliers
could increase prices and let quality and delivery performance slip. To minimize these risks,
companies generally enter into long-run contracts specifying costs, quality, and delivery schedules
with their suppliers. Intelligent managers build close partnerships or alliances with a few key
suppliers. Toyota goes so far as to send its own engineers to improve suppliers’ processes. Suppliers
of companies such as Ford, Hyundai, Panasonic, and Sony have researched and developed innovative
products, met demands for increased quantities, maintained quality and on-time delivery, and lowered
costs— actions that the companies themselves would not have had the competencies to achieve.
Outsourcing decisions invariably have a long-run horizon in which the financial costs and benefits of
outsourcing become more uncertain. Almost always, strategic and qualitative factors such as the ones
described here become important determinants of the outsourcing decision. Weighing all these factors
requires the exercise of considerable management judgment and care.
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Opportunity Costs and Outsourcing
In the simple make-or-buy decision in Exhibit 1.6, we assumed that the capacity currently used to
make DVD players will remain idle if Soho purchases the parts from Broadfield. Often, however, the
released capacity can be used for other, profitable purposes. In this case, the choice Soho’s managers
are faced with is not whether to make or buy; the choice now centers on how best to use available
production capacity.
Example 3: Suppose that if Soho decides to buy DVD players for its video systems from Broadfield,
then Soho’s best use of the capacity that becomes available is to produce 100,000 Digiteks, a portable,
stand-alone DVD player. From a manufacturing standpoint, Digiteks are similar to DVD players
made for the video system. With help from operating managers, Soho’s management accountant
estimates the following future revenues and costs if Soho decides to manufacture and sell Digiteks:
Because of capacity constraints, Soho can make either DVD players for its video-system unit or
Digiteks, but not both. Which of the following two alternatives should Soho choose?
1. Make video-system DVD players and do not make Digiteks
2. Buy video-system DVD players and make Digiteks
Exhibit 1.7, Panel A, summarizes the “total-alternatives” approach—the future costs and revenues
for all products. Alternative 2, buying video-system DVD players and using the available capacity to
make and sell Digiteks, is the preferred alternative. The future incremental costs of buying video-
system DVD players from an outside supplier (P16,000,000) exceed the future incremental costs of
making video-system DVD players in-house (P15,000,000).
Soho can use the capacity freed up by buying video-system DVD players to gain P2,500,000 in
operating income (incremental future revenues of P8,000,000 minus total incremental future costs of
P5,500,000) by making and selling Digiteks. The net relevant costs of buying video-system DVD
players and making and selling Digiteks are P16,000,000 – P2,500,000 = P13,500,000.
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Exhibit 1.7 – Total-Alternatives Approach and Opportunity-Cost Approach to Make-or-Buy
Decisions for Soho Company
The Opportunity-Cost Approach

Deciding to use a resource in a particular way causes a manager to forgo the opportunity to use the
resource in alternative ways. This lost opportunity is a cost that the manager must consider when
making a decision. Opportunity cost is the contribution to operating income that is forgone by not
using a limited resource in its next-best alternative use. For example, the (relevant) cost of going to
school for an MBA degree is not only the cost of tuition, books, lodging, and food, but also the income
sacrificed (opportunity cost) by not working. Presumably, the estimated future benefits of obtaining
an MBA (for example, a higher-paying career) will exceed these costs.
Exhibit 1.7, Panel B, displays the opportunity-cost approach for analyzing the alternatives faced by
Soho. Note that the alternatives are defined differently in the total alternatives approach (1. Make
Video-System DVD Players and Do Not Make Digiteks and 2. Buy Video-System DVD Players and
Make Digiteks) and the opportunity cost approach (1. Make Video-System DVD Players and 2. Buy
Video-System DVD Players), which does not reference Digiteks. Under the opportunity-cost
approach, the cost of each alternative includes (1) the incremental costs and (2) the opportunity cost,
the profit forgone from not making Digiteks. This opportunity cost arises because Digitek is excluded
from formal consideration in the alternatives.
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Consider alternative 1, making video-system DVD players. What are all the costs of making video-
system DVD players? Certainly Soho will incur P15,000,000 of incremental costs to make video-
system DVD players, but is this the entire cost? No, because by deciding to use limited manufacturing
resources to make video-system DVD players, Soho will give up the opportunity to earn P2,500,000
by not using these resources to make Digiteks. Therefore, the relevant costs of making video-system
DVD players are the incremental costs of P15,000,000 plus the opportunity cost of P2,500,000. Next,
consider alternative 2, buy video-system DVD players. The incremental cost of buying video-system
DVD players will be P16,000,000. The opportunity cost is zero.
Why? Because by choosing this alternative, Soho will not forgo the profit it can earn from making
and selling Digiteks.
Panel B leads management to the same conclusion as Panel A: buying video-system DVD players
and making Digiteks is the preferred alternative. Panels A and B of Exhibit 11-7 describe two
consistent approaches to decision making with capacity constraints. The total-alternatives approach
in Panel A includes all future incremental costs and revenues. For example, under alternative 2, the
additional future operating income from using capacity to make and sell Digiteks (P2,500,000) is
subtracted from the future incremental cost of buying video-system DVD players (P16,000,000). The
opportunity-cost analysis in Panel B takes the opposite approach. It focuses only on video-system
DVD players. Whenever capacity is not going to be used to make and sell Digiteks the future forgone
operating income is added as an opportunity cost of making video-system DVD players, as in
alternative 1. (Note that when Digiteks are made, as in alternative 2, there is no “opportunity cost of
not making Digiteks.”)
Therefore, whereas Panel A subtracts P2,500,000 under alternative 2, Panel B adds P2,500,000 under
alternative 1. Panel B highlights the idea that when capacity is constrained, the relevant revenues and
costs of any alternative equal (1) the incremental future revenues and costs plus (2) the opportunity
cost. However, when more than two alternatives are being considered simultaneously, it is generally
easier to use the total alternatives approach.
Opportunity costs are not recorded in financial accounting systems. Why? Because historical record
keeping is limited to transactions involving alternatives that were actually selected, rather than
alternatives that were rejected. Rejected alternatives do not produce transactions and so they are not
recorded. If Soho makes video-system DVD players, it will not make Digiteks, and it will not record
any accounting entries for Digiteks. Yet the opportunity cost of making video-system DVD players,
which equals the operating income that Soho forgoes by not making Digiteks, is a crucial input into
the make-or-buy decision. Consider again Exhibit 1.7, Panel B. On the basis of only the incremental
costs that are systematically recorded in accounting systems, it is less costly for Soho to make rather
than buy video-system DVD players. Recognizing the opportunity cost of P2,500,000 leads to a
different conclusion: Buying video-system DVD players is preferable.
Suppose Soho has sufficient capacity to make Digiteks even if it makes video-system DVD players.
In this case, the opportunity cost of making video-system DVD players is P0 because Soho does not
give up the P2,500,000 operating income from making Digiteks even if it chooses to make video-
system DVD players. The relevant costs are P15,000,000 (incremental costs of P15,000,000 plus
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opportunity cost of P0). Under these conditions, Soho would prefer to make video-system DVD
players, rather than buy them, and also make Digiteks.
Besides quantitative considerations, the make-or-buy decision should also consider strategic and
qualitative factors. If Soho decides to buy video-system DVD players from an outside supplier, it
should consider factors such as the supplier’s reputation for quality and timely delivery. Soho would
also want to consider the strategic consequences of selling Digiteks. For example, will selling
Digiteks take Soho’s focus away from its videosystem business?
Product-Mix Decisions with Capacity Constraints

We now examine how the concept of relevance applies to product-mix decisions—the decisions made
by a company about which products to sell and in what quantities. These decisions usually have only
a short-run focus, because they typically arise in the context of capacity constraints that can be relaxed
in the long run. In the short run, for example, BMW, the German car manufacturer, continually adapts
the mix of its different models of cars (for example, 325i, 525i, and 740i) to fluctuations in selling
prices and demand.
To determine product mix, a company maximizes operating income, subject to constraints such as
capacity and demand. Throughout this section, we assume that as short run changes in product mix
occur, the only costs that change are costs that are variable with respect to the number of units
produced (and sold). Under this assumption, the analysis of individual product contribution margins
provides insight into the product mix that maximizes operating income.
Example 4: Power Recreation assembles two engines, a snowmobile engine and a boat engine, at its
Lexington, Kentucky, plant. Assume that only 600 machine-hours are available daily for assembling
engines. Additional capacity cannot be obtained in the short run. Power Recreation can sell as many
engines as it produces. The constraining resource, then, is machine-hours. It takes two machine-hours
to produce one snowmobile engine and five machine-hours to produce one boat engine. What product
mix should Power Recreation’s managers choose to maximize its operating income?
In terms of contribution margin per unit and contribution margin percentage, boat engines are more
profitable than snowmobile engines. The product that Power Recreation should produce and sell,
however, is not necessarily the product with the higher individual contribution margin per unit or
contribution margin percentage. Managers should choose the product with the highest contribution
margin per unit of the constraining resource (factor). That’s the resource that restricts or limits the
production or sale of products.
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The number of machine-hours is the constraining resource in this example and snowmobile engines
earn more contribution margin per machine-hour (P120/machine-hour) compared to boat engines
(P75/machine-hour). Therefore, choosing to produce and sell snowmobile engines maximizes total
contribution margin (P72,000 versus P45,000 from producing and selling boat engines) and operating
income. Other constraints in manufacturing settings can be the availability of direct materials,
components, or skilled labor, as well as financial and sales factors. In a retail department store, the
constraining resource may be linear feet of display space. Regardless of the specific constraining
resource, managers should always focus on maximizing total contribution margin by choosing
products that give the highest contribution margin per unit of the constraining resource.
In many cases, a manufacturer or retailer has the challenge of trying to maximize total operating
income for a variety of products, each with more than one constraining resource. Some constraints
may require a manufacturer or retailer to stock minimum quantities of products even if these products
are not very profitable. For example, supermarkets must stock less-profitable products because
customers will be willing to shop at a supermarket only if it carries a wide range of products that
customers’ desire. To determine the most profitable production schedule and the most profitable
product mix, the manufacturer or retailer needs to determine the maximum total contribution margin
in the face of many constraints. Optimization techniques, such as linear programming discussed in
the appendix to this chapter, help solve these more-complex problems.
Finally, there is the question of managing the bottleneck constraint to increase output and, therefore,
contribution margin. Can the available machine-hours for assembling engines be increased beyond
600, for example, by reducing idle time? Can the time needed to assemble each snowmobile engine
(two machine-hours) and each boat engine (five machine-hours) be reduced, for example, by reducing
setup time and processing time of assembly? Can quality be improved so that constrained capacity is
used to produce only good units rather than some good and some defective units? Can some of the
assembly operations be outsourced to allow more engines to be built? Implementing any of these
options will likely require Power Recreation to incur incremental costs. Power Recreation will
implement only those options where the increase in contribution margins exceeds the increase in
costs.
Irrelevance of Past Costs and Equipment-Replacement Decisions

At several points in this chapter, when discussing the concept of relevance, we reasoned that past
(historical or sunk) costs are irrelevant to decision making. That’s because a decision cannot change
something that has already happened. We now apply this concept to decisions about replacing
equipment. We stress the idea that book value—original cost minus accumulated depreciation—of
existing equipment is a past cost that is irrelevant.
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Example 6: Toledo Company, a manufacturer of aircraft components, is considering replacing a
metal-cutting machine with a newer model. The new machine is more efficient than the old machine,
but it has a shorter life. Revenues from aircraft parts ($1.1 million per year) will be unaffected by the
replacement decision. Here are the data the management accountant prepares for the existing (old)
machine and the replacement (new) machine:
Toledo Corporation uses straight-line depreciation. To focus on relevance, we ignore the time value
of money and income taxes. Should Toledo replace its old machine?
Exhibit 1.8 presents a cost comparison of the two machines. Consider why each of the four items in
Toledo’s equipment-replacement decision is relevant or irrelevant:
1. Book value of old machine, P400,000. Irrelevant, because it is a past or sunk cost. All past costs
are “down the drain.” Nothing can change what has already been spent or what has already
happened.
2. Current disposal value of old machine, P40,000. Relevant, because it is an expected future
benefit that will only occur if the machine is replaced.
3. Loss on disposal, P360,000. This is the difference between amounts in items 1 and 2. It is a
meaningless combination blurring the distinction between the irrelevant book value and the
relevant disposal value. Each should be considered separately, as was done in items 1 and 2.
4. Cost of new machine, P600,000. Relevant, because it is an expected future cost that will only
occur if the machine is purchased.
Exhibit 1.8 should clarify these four assertions. Column 3 in Exhibit 1.8 shows that the book value
of the old machine does not differ between the alternatives and could be ignored for decision-making
purposes. No matter what the timing of the write-off— whether a lump-sum charge in the current
year or depreciation charges over the next two years—the total amount is still P400,000 because it is
a past (historical) cost. In contrast, the P600,000 cost of the new machine and the current disposal
value of P40,000 for the old machine are relevant because they would not arise if Toledo’s managers
decided not to replace the machine. Note that the operating income from replacing is P120,000 higher
for the two years together.
To provide focus, Exhibit 1.9 concentrates only on relevant items. Note that the same answer—higher
operating income as a result of lower costs of P120,000 by replacing the machine—is obtained even
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though the book value is omitted from the calculations. The only relevant items are the cash operating
costs, the disposal value of the old machine, and the cost of the new machine that is represented as
depreciation in Exhibit 1.9.
Exhibit 1.8 – Operating Income Comparison: Replacement of Machine, Relevant, and

Irrelevant Items for Toledo Company
Exhibit 1.9 – Cost Comparison: Replacement of Machine, Relevant Items Only, for Toledo
Company
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Adding or Dropping Products/Segments
Over time, consumers’ preferences change. Some products become obsolete and are dropped from
product lines, others are developed to replace them. When management is considering dropping a
product line or customer group, the only relevant costs are those that a company would avoid by
dropping the product or customer. An important factor deciding whether to add or drop a product is
the decision’s effect on operating income.
Exhibit 1.10 – Eliminate or Retain a Product Line

Suppose a company furnishes the following recent operating statement for its three product lines, A,
B and C.
A B C Total
Sales P400,000 P360,000 P300,000 P1,060,000
Variable Expenses 280,000 (70%) 216,000 (60%) 240,000 (80%) 736,000
Fixed Expenses:
 Salaries of Product Line 30,000 32,000 40,000 102,000
Supervisors
 Marketing cost allocated 8,000 7,200 6,000 21,200
to product lines on basis of
sales
 Administrative costs 22,000 22,000 22,000 66,000
allocated equally
Total Expenses 340,000 277,200 308,000 925,200
Operating Income (Loss) P60,000 P82,800 P (8,000) P134,800
Management is considering discontinuing Product C operations.
The company can sell assets used in product C operations at book value. They would lay off the
Product C supervisor with no termination pay.
a. Assuming no other changes are expected, should the company drop Product C?
Analysis: Product C has a positive contribution to indirect costs of P20,000 (P300,000-
P240,000-P40,000) and therefore should not be eliminated. Overall income will decrease by
P20,000 if the company will drop Product C.
b. Assuming that in addition to the data given, the following changes are expected
i. Sales of Product A and Product B increase by 10% and 15%, respectively.
ii. Marketing costs will remain unchanged.
iii. Salaries of Product A and B’s product line supervisors would increase by 8% and 10%,
respectively due to the increased sales.
iv. No increase in total assets is required.
Should the company drop Product C?
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Analysis: the following schedule shows the projected operating statement assuming the company
discontinued Product C operations.
A B Total
Sales P440,000 P414,000 P854,000
Variable Expenses 308,000 248,400 556,400
Fixed Expenses:
 Salaries of Product Line Supervisors 32,400 35,200 67,600
 Marketing cost allocated to product lines on 10,923 10,277 21,200
basis of sales
 Administrative costs allocated equally 33,000 33,000 66,000
Total Expenses 384,323 326,877 711,200
Operating Income (Loss) P55,677 P87,123 P142,800
Based on the computations, the company may decide to drop Product C.
As shown above, overall net income will be P142,800. This is slightly higher than the present overall
income of P134,800 with no increase in total assets required. However, management should consider
other factors, such as the future sales of product C and whether the increased sales of Product A and
B will continue or would occur without eliminating Product C operations.
Decisions and Performance Evaluation

Consider our equipment-replacement example in light of the five-step sequence in Exhibit 1.1
The decision model analysis (Step 4), which is presented in Exhibits 1.8 and 1.9, dictates replacing
the machine rather than keeping it. In the real world, however, would the manager replace it? An
important factor in replacement decisions is the manager’s perception of whether the decision model
is consistent with how the manager’s performance will be judged after the decision is implemented
(the performance-evaluation model in Step 5).
From the perspective of their own careers, it is no surprise that managers tend to favor the alternative
that makes their performance look better. If the performance evaluation model conflicts with the
decision model, the performance-evaluation model often prevails in influencing managers’ decisions.
For example, if the promotion or bonus of the manager at Toledo hinges on his or her first year’s
operating income performance under accrual accounting, the manager’s temptation not to replace will
be overwhelming. Why? Because the accrual accounting model for measuring performance will show
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a higher first-year operating income if the old machine is kept rather than replaced (as the following
table shows):
Even though top management’s goals encompass the two-year period (consistent with the decision
model), the manager will focus on first-year results if his or her evaluation is based on short-run
measures such as the first-year’s operating income.
Resolving the conflict between the decision model and the performance-evaluation model is
frequently a baffling problem in practice. In theory, resolving the difficulty seems obvious: Design
models that are consistent. Consider our replacement example. Year-by year effects on operating
income of replacement can be budgeted for the two-year planning horizon. The manager then would
be evaluated on the expectation that the first year would be poor and the next year would be much
better. Doing this for every decision, however, makes the performance evaluation model very
cumbersome. As a result of these practical difficulties, accounting systems rarely track each decision
separately.
Performance evaluation focuses on responsibility centers for a specific period, not on projects or
individual items of equipment over their useful lives. Thus, the impacts of many different decisions
are combined in a single performance report and evaluation measure, say operating income. Lower-
level managers make decisions to maximize operating income, and top management—through the
reporting system—is rarely aware of particular desirable alternatives that were not chosen by lower-
level managers because of conflicts between the decision and performance-evaluation models.
Consider another conflict between the decision model and the performance-evaluation model.
Suppose a manager buys a particular machine only to discover shortly thereafter that a better machine
could have been purchased instead. The decision model may suggest replacing the machine that was
just bought with the better machine, but will the manager do so? Probably not. Why? Because
replacing the machine so soon after its purchase will reflect badly on the manager’s capabilities and
performance. If the manager’s bosses have no knowledge of the better machine, the manager may
prefer to keep the recently purchased machine rather than alert them to the better machine.
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III. ACTIVITY
MULTIPLE CHOICE
1. Which of the following is not a characteristic of relevant costing information? It is
a. Associated with the decision under consideration.
b. Significant to the decision maker.
c. Readily quantifiable.
d. Related to a future endeavour.
2. A fixed cost is relevant if it is
a. A future cost.
b. Avoidable.
c. Sunk.
d. A product cost.
3. Relevant costs are
a. All fixed and variable costs.
b. All costs that would be incurred within the relevant range of production.
c. Past costs that are expected to be different in the future.
d. Anticipated future costs that will differ among various alternatives.
4. Which of the following is the least likely to be a relevant item in deciding whether to replace
an old machine?
a. acquisition cost of the old machine
b. outlay to be made for the new machine
c. annual savings to be enjoyed on the new machine
d. life of the new machine
5. If a cost is irrelevant to a decision, the cost could not be
a. A sunk cost.
b. A future cost.
c. A variable cost.
d. An incremental cost.
6. Which of the following costs would be relevant in short-term decision making?
a. incremental fixed costs
b. all costs of inventory
c. total variable costs that are the same in the considered alternatives
d. the cost of a fixed asset that could be used in all the considered alternatives
7. The term incremental cost refers to
a. The profit foregone by selecting one choice instead of another.
b. The additional cost of producing or selling another product or service.
c. A cost that continues to be incurred in the absence of activity.
d. A cost common to all choices in question and not clearly or feasibly allocable to any of
them.
8. A cost is sunk if it
a. Is not an incremental cost.
b. Is unavoidable.
c. Has already been incurred.
d. Is irrelevant to the decision at hand.
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9. Most___________ are relevant to decisions to acquire capacity, but not to short-run decisions
involving the use of that capacity.
a. sunk costs
b. incremental costs
c. fixed costs
d. prime costs
10. In deciding whether an organization will keep an old machine or purchase a new machine, a
manager would ignore the
a. Estimated disposal value of the old machine.
b. Acquisition cost of the old machine.
c. Operating costs of the new machine.
d. Estimated disposal value of the new machine.
11. The potential rental value of space used for production activities
a. Is a variable cost of production.
b. Represents an opportunity cost of production.
c. Is an unavoidable cost.
d. Is a sunk cost of production.
12. The opportunity cost of making a component part in a factory with excess capacity for which
there is no alternative use is
a. The total manufacturing cost of the component.
b. The total variable cost of the component.
c. The fixed manufacturing cost of the component.
d. Zero.
13. In a make or buy decision, the opportunity cost of capacity could
a. Be considered to decrease the price of units purchased from suppliers.
b. Be considered to decrease the cost of units manufactured by the company.
c. Be considered to increase the price of units purchased from suppliers.
d. Not be considered since opportunity costs are not part of the accounting records.
14. In a make or buy decision, the reliability of a potential supplier is
a. An irrelevant decision factor.
b. Relevant information if it can be quantified.
c. An opportunity cost of continued production.
d. A qualitative decision factor.
15. When a scarce resource, such as space, exists in an organization, the criterion that should be
used to determine production is
a. Contribution margin per unit.
b. Selling price per unit.
c. Contribution margin per unit of scarce resource.
d. Total variable costs of production.
PROBLEM SOLVING
1. Knox Company uses 10,000 units of a part in its production process. The costs to make a part are: direct
material, P12; direct labor, P25; variable overhead, P13; and applied fixed overhead, P30. Knox has
received a quote of P55 from a potential supplier for this part. If Knox buys the part, 70 percent of the
applied fixed overhead would continue. Knox Company would be better off by
a. P50,000 to manufacture the part.
b. P150,000 to buy the part.
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c. P40,000 to buy the part.
d. P160,000 to manufacture the part.
2. Paulson Company has only 25,000 hours of machine time each month to manufacture its two products.
Product X has a contribution margin of P50, and Product Y has a contribution margin of P64. Product X
requires 5 hours of machine time, and Product Y requires 8 hours of machine time. If Paulson Company
wants to dedicate 80 percent of its machine time to the product that will provide the most income, the
company will have a total contribution margin of
a. P250,000.
b. P240,000.
c. P210,000.
d. P200,000.
3. Doyle Company has 3 divisions: R, S, and T. Division R's income statement shows the following for the
year ended December 31:
Sales P1,000,000
Cost of goods sold (800,000)
Gross profit P 200,000
Selling expenses P100,000
Administrative expenses 250,000 (350,000)
Net loss P (150,000)
Cost of goods sold is 75 percent variable and 25 percent fixed. Of the fixed costs, 60 percent are avoidable if
the division is closed. All of the selling expenses relate to the division and would be eliminated if Division R
were eliminated. Of the administrative expenses, 90 percent are applied from corporate costs. If Division R
were eliminated, Doyle’s income would
a. increase by P150,000.
b. decrease by P 75,000.
c. decrease by P155,000.
d. decrease by P215,000.
4. Thomas Company is currently operating at a loss of P15,000. The sales manager has received a special
order for 5,000 units of product, which normally sells for P35 per unit. Costs associated with the product
are: direct material, P6; direct labor, P10; variable overhead, P3; applied fixed overhead, P4; and variable
selling expenses, P2. The special order would allow the use of a slightly lower grade of direct material,
thereby lowering the price per unit by P1.50 and selling expenses would be decreased by P1. If Thomas
wants this special order to increase the total net income for the firm to P10,000, what sales price must be
quoted for each of the 5,000 units?
a. P23.50
b. P24.50
c. P27.50
d. P34.00
5. Quest Company produces a part that has the following costs per unit:
Direct material P 8
Direct labor 3
Variable overhead 1
Fixed overhead 5
Total P17
Zest Corporation can provide the part to Quest for P19 per unit. Quest Company has determined that 60 percent
of its fixed overhead would continue if it purchased the part. However, if Quest no longer produces the part, it
can rent that portion of the plant facilities for P60,000 per year. Quest Company currently produces 10,000
parts per year. Which alternative is preferable and by what margin?
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a. Make-P20,000
b. Make-P50,000
c. Buy-P10,000
d. Buy-P40,000
6. Browning Company has 15,000 units in inventory that had a production cost of P3 per unit. These units
cannot be sold through normal channels due to a significant technology change. These units could be
reworked at a total cost of P23,000 and sold for P28,000. Another alternative is to sell the units to a junk
dealer for P8,500. The relevant cost for Browning to consider in making its decision is
a. P45,000 of original product costs.
b. P23,000 for reworking the units.
c. P68,000 for reworking the units.
d. P28,000 for selling the units to the junk dealer.
Robertson Corporation
Robertson Corporation sells a product for P18 per unit, and the standard cost card for the product shows the
following costs:
Direct material P 1
Direct labor 2
Overhead (80% fixed) 7
Total P10
7. Refer to Robertson Corporation. Robertson received a special order for 1,000 units of the product. The
only additional cost to Robertson would be foreign import taxes of P1 per unit. If Robertson is able to sell
all of the current production domestically, what would be the minimum sales price that Robertson would
consider for this special order?
a. P18.00
b. P11.00
c. P5.40
d. P19.00
8. Refer to Robertson Corporation. Assume that Robertson has sufficient idle capacity to produce the 1,000
units. If Robertson wants to increase its operating profit by P5,600, what would it charge as a per-unit
selling price?
a. P18.00
b. P10.00
c. P11.00
d. P16.60
9. Glamorous Grooming Corporation makes and sells brushes and combs. It can sell all of either product it
can make. The following data are pertinent to each respective product:
Brushes Combs
Units of output per machine hour 8 20
Selling price per unit P12.00 P4.00
Product cost per unit
Direct material P1.00 P1.20
Direct labor 2.00 0.10
Variable overhead 0.50 0.05
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Total fixed overhead is P380,000.
The company has 40,000 machine hours available for production. What sales mix will maximize profits?
a. 320,000 brushes and 0 combs
b. 0 brushes and 800,000 combs
c. 160,000 brushes and 600,000 combs
d. 252,630 brushes and 252,630 combs
10. Houston Footwear Corporation has been asked to submit a bid on supplying 1,000 pairs of military combat
boots to the Armed Forces. The company's costs per pair of boots are as follows:
Direct material P8
Direct labor 6
Variable overhead 3
Variable selling cost (commission) 3
Fixed overhead (allocated) 2
Assuming that there would be no commission on this potential sale, the lowest price the firm can bid is some
price greater than
a. P23.
b. P20.
c. P17.
d. P14.
11. Holt Industries has two sales territories-East and West. Financial information for the two territories is
presented below:
East West
Sales P980,000 P750,000
Direct costs:
Variable (343,000) (225,000)
Fixed (450,000) (325,000)
Allocated common costs (275,000) (175,000)
Net income (loss) P(88,000) P 25,000
Because the company is in a start-up stage, corporate management feels that the East sales territory is creating
too much of a cash drain on the company and it should be eliminated. If the East territory is discontinued, one
sales manager (whose salary is P40,000 per year) will be relocated to the West territory. By how much would
Holt's income change if the East territory is eliminated?
a. increase by P88,000
b. increase by P48,000
c. decrease by P267,000
d. decrease by P227,000
Woodville Motors
Woodville Motors is trying to decide whether it should keep its existing car washing machine or purchase a
new one that has technological advantages (which translate into cost savings) over the existing machine.
Information on each machine follows:
Old machine New machine

Original cost P9,000 P20,000
Accumulated depreciation 5,000 0
Annual cash operating costs 9,000 4,000
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Current salvage value of old machine 2,000
Salvage value in 10 years 500 1,000
Remaining life 10 yrs. 10 yrs.
12. Refer to Woodville Motors. The P4,000 of annual operating costs that are common to both the old and
the new machine are an example of a(n)
a. sunk cost.
b. irrelevant cost.
c. future avoidable cost.
d. opportunity cost.
13. Refer to Woodville Motors. The P9,000 cost of the original machine represents a(n)
a. sunk cost.
b. future relevant cost.
c. historical relevant cost.
14. Refer to Woodville Motors. The P20,000 cost of the new machine represents a(n)
a. sunk cost.
b. future relevant cost.
c. future irrelevant cost.
15. Refer to Woodville Motors. The estimated P500 salvage value of the existing machine in 10 years
represents a(n)
a. sunk cost.
b. opportunity cost of selling the existing machine now.
c. opportunity cost of keeping the existing machine for 10 years.
d. opportunity cost of keeping the existing machine and buying the new machine.
16. Refer to Woodville Motors. The incremental cost to purchase the new machine is
a. P11,000.
b. P20,000.
c. P13,000.
d. P18,000.
Entertainment Solutions Corporation

Entertainment Solutions Corporation manufactures and sells FM radios. Information on the prior year's
operations (sales and production Model A1) is presented below:
Sales price per unit P30
Costs per unit:
Direct material 7
Direct labor 4
Overhead (50% variable) 6
Selling costs (40% variable) 10
Production in units 10,000
Sales in units 9,500
17. Refer to Entertainment Solutions Corporation. The Model B2 radio is currently in production and it
renders the Model A1 radio obsolete. If the remaining 500 units of the Model A1 radio are to be sold
through regular channels, what is the minimum price the company would accept for the radios?
a. P30
b. P27
c. P18
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d. P4
18. Refer to Entertainment Solutions Corporation. Assume that the remaining Model A1 radios can be sold
through normal channels or to a foreign buyer for P6 per unit. If sold through regular channels, the
minimum acceptable price will be
a. P30.
b. P33.
c. P10.
d. P4.
Chip Division of Computer Solutions, Inc.
The Chip Division of Computer Solutions, Inc. produces a high-quality computer chip. Unit production costs
(based on capacity production of 100,000 units per year) follow:
Direct material P50

Direct labor 20
Overhead (20% variable) 10
Other information:
Sales price 100
SG&A costs (40% variable) 15
19. Refer to Chip Division of Computer Solutions, Inc. Assume, for this question only, that the Chip Division
is producing and selling at capacity. What is the minimum selling price that the division would consider
on a "special order" of 1,000 chips on which no variable period costs would be incurred?
a. P100
b. P72
c. P81
d. P94
is operating at a level of 70,000 chips per year. What is the minimum price that the division would consider
on a "special order" of 1,000 chips to be distributed through normal channels?
a. P78
b. P95
c. P100
d. P81
is presently operating at a level of 80,000 chips per year. Accepting a "special order" on 2,000 chips at
P88 will
a. increase total corporate profits by P4,000.
b. increase total corporate profits by P20,000.
c. decrease total corporate profits by P14,000.
d. decrease total corporate profits by P24,000.
Richmond Steel Corporation

The capital budgeting committee of the Richmond Steel Corporation is evaluating the possibility of replacing
its old pipe-bending machine with a more advanced model. Information on the existing machine and the new
model follows:
Existing machine New machine
Original cost P200,000 P400,000
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Market value now 80,000
Market value in year 5 0 20,000
Annual cash operating costs 40,000 10,000
Remaining life 5 yrs. 5 yrs.
22. Refer to Richmond Steel Corporation. The major opportunity cost associated with the continued use of the
existing machine is
a. P30,000 of annual savings in operating costs.
b. P20,000 of salvage in 5 years on the new machine.
c. lost sales resulting from the inefficient existing machine.
d. P400,000 cost of the new machine.
23. Refer to Richmond Steel Corporation. The P80,000 market value of the existing machine is
a. a sunk cost.
b. an opportunity cost of keeping the old machine.
c. irrelevant to the equipment replacement decision.
d. a historical cost.
24. Refer to Richmond Steel Corporation. If the company buys the new machine and disposes of the existing
machine, corporate profit over the five-year life of the new machine will be ____________________ than
the profit that would have been generated had the existing machine been retained for five years.
a. P150,000 lower
b. P170,000 lower
c. P230,000 lower
d. P150,000 higher
25. Emerald Corporation has been manufacturing 5,000 units of Part 10541, which is used in the manufacture
of one of its products. At this level of production, the cost per unit of manufacturing Part 10541 is as
follows:
Direct material P 2
Direct labor 8
Variable overhead 4
Fixed overhead applied 6
Total P20
Hamilton Company has offered to sell Emerald 5,000 units of Part 10541 for P19 a unit. Emerald has
determined that it could use the facilities currently used to manufacture Part 10541 to manufacture Part RAC
and generate an operating profit of P4,000. Emerald has also determined that two-thirds of the fixed overhead
applied will continue even if Part 10541 is purchased from Hamilton. To determine whether to accept
Hamilton’s offer, the net relevant costs to make are
a. P70,000.
b. P84,000.
c. P90,000.
d. P95,000.
26. Harding Corporation manufactures batons. Harding can manufacture 300,000 batons a year at a variable
cost of P750,000 and a fixed cost of P450,000. Based on Harding's predictions, 240,000 batons will be
sold at the regular price of P5.00 each. In addition, a special order was placed for 60,000 batons to be sold
at a 40 percent discount off the regular price. The unit relevant cost per unit for Harding's decision is
a. P1.50.
b. P2.50.
c. P3.00.
d. P4.00.
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Page 105 of 134

MODULE 6:
Budgeting for Planning and Control
1. Define budgeting, and discuss its role in planning, controlling, and decision making.
2. Prepare the operating budget, identify its major components, and explain the interrelationships
of the various components.
3. Identify the components of the financial budget, and prepare a cash budget.
4. Define flexible budgeting, and discuss its role in planning, control, and decision making.
II. CONTENT
Careful planning is vital to the health of any organization. Failure to plan, either formally or
informally, can lead to financial disaster. Managers of businesses, whether small or large, must
know their resource capabilities and have a plan that details the use of these resources. In this
chapter, the basics of budgeting are discussed, and traditional master budgets using functional-
based accounting data are developed. Flexible and activity-based budgeting are also presented,
along with extensive discussion of the behavioural aspects of budgeting and its use in control.
The Role of Budgeting in Planning and Control

Budgeting plays a crucial role in planning and control. Plans identify objectives and the actions
needed to achieve them. Budgets are the quantitative expressions of these plans, stated in either
physical or financial terms or both. When used for planning, a budget is a method for translating
the goals and strategies of an organization into operational terms. Budgets can also be used in
control. Control is the process of setting standards, receiving feedback on actual performance,
and taking corrective action whenever actual performance deviates significantly from planned
performance. Thus, budgets can be used to compare actual outcomes with planned outcomes, and
they can steer operations back on course, if necessary.
Exhibit 6-1 illustrates the relationship of budgets to planning, operating, and control. Budgets
evolve from the long-run objectives of the firm; they form the basis for operations. Actual results
are compared with budgeted amounts through control. This comparison provides feedback both
for operations and for future budgets.
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Exhibit 6-1. Relationship of Budgets to Planning, Operating, and Control
Purposes of Budgeting
Budgets are usually prepared for areas within an organization (departments, plants, divisions, and so
on) and for activities (sales, production, research, and so on). This system of budgets serves as the
comprehensive financial plan for the organization as a whole and gives an organization several
advantages.
1. It forces managers to plan.
2. It provides resource information that can be used to improve decision making.
3. It aids in the use of resources and employees by setting a benchmark that can be used for the
subsequent evaluation of performance.
4. It improves communication and coordination.
Budgeting forces management to plan for the future—to develop an overall direction for the
organization, foresee problems, and develop future policies. When managers plan, they grow to
understand the capabilities of their businesses and where the resources of the business should be used.
All businesses and not-for-profit entities should budget. All large businesses do budget. In fact, the
budgeting activity of a company such as Conoco or IBM consumes significant amounts of time and
involves many managers at a variety of levels. Some small businesses do not budget, and many of
those go out of business in short order.
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Budgets enable managers to make better decisions. For example, a cash budget points out potential
shortfalls. If a company foresees a cash deficiency, it may want to improve accounts receivable
collection or postpone plans to purchase new assets. Budgets set standards that can control the use of
a company’s resources and control and motivate employees. Fundamental to the overall success of a
budgetary system, control ensures that steps are being taken to achieve the objectives outlined in an
organization’s master plan.
Budgets also serve to communicate the plans of the organization to each employee and to coordinate
their efforts. Accordingly, all employees can be aware of their role in achieving those objectives. This
is why explicitly linking the budget to the long-run plans of the organization is so important. The
budget is not a series of vague, rosy scenarios, but a set of specific plans to achieve those objectives.
Budgets encourage coordination because the various areas and activities of the organization must all
work together to achieve the stated objectives. The role of communication and coordination becomes
more important as an organization increases in size.
The Budgeting Process

The budgeting process can range from the fairly informal process undergone by a small firm, to an
elaborately detailed, several-month procedure employed by large firms. Key features of the process
include directing and coordinating the compilation of the budget.
Directing and Coordinating

Every organization must have someone responsible for directing and coordinating the overall
budgeting process. This budget director is usually the controller or someone who reports to the
controller. The budget director works under the direction of the budget committee. The budget
committee has the responsibility to review the budget, provide policy guidelines and budgetary goals,
resolve differences that may arise as the budget is prepared, approve the final budget, and monitor
the actual performance of the organization as the year unfolds. The budget committee is also
responsible for ensuring that the budget is linked to the strategic plan of the organization. The
president of the organization appoints the members of the committee, who are usually the president,
vice presidents, and the controller.
Types of Budgets
The master budget is a comprehensive financial plan for the year made up of various individual
departmental and activity budgets. A master budget can be divided into operating and financial
budgets. Operating budgets are concerned with the income generating activities of a firm: sales,
production, and finished goods inventories. The ultimate outcome of the operating budgets is a pro
forma or budgeted income statement. Note that “pro forma” is synonymous with “budgeted” and
“estimated.” In effect, the pro forma income statement is done “according to form” but with
estimated, not historical, data. Financial budgets are concerned with the inflows and outflows of cash
and with financial position. Planned cash inflows and outflows are detailed in a cash budget, and
expected financial position at the end of the budget period is shown in a budgeted, or pro forma,
balance sheet. Exhibit 6-2 illustrates the components of the master budget.
The master budget is usually prepared for a 1-year period corresponding to the company’s fiscal year.
The yearly budgets are broken down into quarterly and monthly budgets. The use of shorter time
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periods allows managers to compare actual data with budgeted data as the year unfolds and to make
timely corrections. Because progress can be checked more frequently with monthly budgets,
problems are less likely to become too serious.
Exhibit 6-2 Components of the Master Budget
Most organizations prepare the budget for the coming year during the last four or five months of the
current year. However, some organizations have developed a continuous budgeting philosophy. A
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continuous (or rolling) budget is a moving 12- month budget. As a month expires in the budget, an
additional month in the future is added so that the company always has a 12-month plan on hand.
Proponents of continuous budgeting maintain that it forces managers to plan ahead constantly. The
majority of CFOs believe that rolling forecasts are very valuable, and companies that do use them
typically roll the forecasts out for five or six quarters rather than four.
Similar to a continuous budget is a continuously updated budget. The objective of this budget is not
to have 12 months of budgeted information at all times, but instead to update the master budget each
month as new information becomes available. For example, every autumn, Chandler Engineering
prepares a budget for the coming year. Then at the end of each month of the year, the budget is
transformed into a rolling forecast by recording year-to-date results and the forecast for the remainder
of the year. In essence, the budget is continually updated throughout the year.
Gathering Information for Budgeting

At the beginning of the master budgeting process, the budget director alerts all segments of the
company to the need for gathering budget information. The data used to create the budget come from
many sources. Historical data are one possibility. For example, last year’s direct materials costs may
give the production manager a good feel for potential materials costs for next year. Still, historical
data alone cannot tell a company what to expect in the future.
Forecasting Sales
The sales forecast is the basis for the sales budget, which, in turn, is the basis for all of the other
operating budgets and most of the financial budgets. Accordingly, the accuracy of the sales forecast
strongly affects the soundness of the entire master budget. Creating the sales forecast is usually the
responsibility of the marketing department. One approach is for the chief sales executive to have
individual salespeople submit sales predictions, which are aggregated to form a total sales forecast.
The accuracy of this sales forecast may be improved by considering other factors such as the general
economic climate, competition, advertising, pricing policies, and so on. Some companies supplement
the marketing department forecast with more formal approaches, such as time-series analysis,
correlation analysis, econometric modeling, and industry analysis.
To illustrate an actual sales forecasting approach, consider the practices of a company that
manufactures oil field equipment on a job-order basis. Each month, the finance and sales departments’
heads meet to construct a sales forecast based on bookings. A booking is a probable sales order
submitted by sales personnel in the field; it is meant to alert the engineering and manufacturing
departments to a potential job. Past experience has shown that bookings are generally followed by
sales/shipments within 30 to 45 days. Exhibit 6-3, on the following page, shows the short-term
bookings forecast for the company. Notice that the peso amount of each booking is multiplied by its
probability of occurrence to obtain a weighted dollar amount. The sum of weighted amounts is the
forecast for sales for the month. The probability estimate requires additional explanation. The
probability is determined jointly by the salesperson and the controller. Each probability is initially set
at 50 percent. Then, it is adjusted upward or downward based on any additional information about
the sale. The probability is really a prediction of a compound event, the prediction of both getting the
order and determining the month in which it will happen. The sales department tends toward
overconfidence—both in terms of getting the order and in landing it sooner rather than later. As a
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result, the controller takes a more pessimistic view and modifies the forecast. The end result is the
form shown in the exhibit.
Exhibit 6-3 Short Term Bookings Forecast for Oil Field Equipment Company
Forecasting Other Variables

Of course, sales are not the only concern in budgeting. Costs and cash-related items are critical. Many
of the same factors considered in sales forecasting apply to cost forecasting. Here, historical amounts
can be of real value. Managers can adjust past figures based on their knowledge of coming events.
For example, a 3-year union contract takes much of the uncertainty out of wage prediction. (Of course,
if the contract is expiring, the uncertainty returns.) Alert purchasing agents will have an idea of
changing materials prices. In fact, large companies such as Nestlé and The Coca-Cola Company have
entire departments devoted to the forecasting of commodity prices and supplies. They invest in
commodity futures to smooth out price fluctuations, an action that facilitates budgeting. Overhead is
broken down into its component costs; these can be predicted using past data and relevant inflation
figures.
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The cash budget is a critically important part of the master budget, and some of its components,
especially payment of accounts receivable, also require forecasting. This is discussed in more detail
in the section on cash budgeting.
Preparing the Operating Budget

The first section of the master budget is the operating budget. It consists of a series of schedules for
all phases of operations, culminating in a budgeted income statement. The following are the
components of the operating budget.
1. Sales budget
2. Production budget
3. Direct materials purchases budget
4. Direct labor budget
5. Overhead budget
6. Ending finished goods inventory budget
7. Cost of goods sold budget
8. Marketing expense budget
9. Research and development expense budget
10. Administrative expense budget
11. Budgeted income statement
You may want to refer back to Exhibit 6-2 to see how these components of the operating budget fit
into the master budget. The example used to illustrate the components of the operating budget is based
on ABT, Inc., a manufacturer of concrete block and pipe for the construction industry.
For simplicity, we will prepare the operating budget for ABT’s concrete block line. (The budget for
the pipe product line is prepared in the same way and merged into the overall company budget.)
Sales Budget
The sales budget is the projection approved by the budget committee that describes expected sales
for each product in units and pesos.
Schedule 1 illustrates the sales budget for ABT’s concrete block line. (For a multiple-product firm,
the sales budget reflects sales for each product in units and sales pesos.) Notice that the sales budget
reveals that ABT’s sales fluctuate seasonally. Most sales (75 percent) take place in the spring and
summer. Also, note that ABT expects price to increase from P0.70 to P0.80 in the summer quarter.
Because of the price change within the year, an average price must be used for the column that
describes the total year’s activities (P0.75 = P12,000/16,000 units).
Schedule 1 (in thousands)
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Production Budget
The production budget describes how many units must be produced in order to meet sales needs and
satisfy ending inventory requirements. From Schedule 1, we know how many concrete blocks are
needed to satisfy sales demand for each quarter and for the year. If there were no inventories, the
concrete blocks to be produced would just equal the units to be sold. In the JIT firm, for example,
units sold equal units produced, since a customer order triggers production.
Usually, however, the production budget must consider the existence of beginning and ending
inventories. Assume that ABT company policy sets desired ending inventory of concrete blocks for
each quarter as follows.
Quarter Ending Inventory
1 500,000
2 500,000
3 100,000
4 100,000
To compute the units to be produced, we must know both unit sales and units in desired finished
goods inventory.
Units to be Produced = Units, ending inventory + Unit Sales – Units, Beginning Inventory
The formula is the basis for the production budget in Schedule 2. Notice that the production budget
is expressed in terms of units; we do not yet know how much they will cost.
Direct Materials Purchases Budget
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After the production schedule is completed, budgets for direct materials, direct labor, and overhead
can be prepared. The direct materials purchases budget is similar in format to the production budget;
it is based on the amount of materials needed for production and the inventories of direct materials.
Expected direct materials usage is determined by the input-output relationship (the technical
relationship existing between direct materials and output). This relationship is often determined by
the engineering department or the industrial designer. For example, one lightweight concrete block
requires approximately 26 pounds of materials (cement, sand, gravel, shale, pumice, and water). The
relative mix of these ingredients is fixed for a specific kind of concrete block. Thus, it is fairly easy
to determine expected usage for each material from the production budget by multiplying the amount
of material needed per unit of output times the number of units of output.
Once expected usage is computed, the purchases (in units) are computed as follows:
Purchases = Desired Ending Inventory of Direct Materials + Expected Usage – Beginning

Inventory of Direct Materials
The quantity of direct materials in inventory is determined by the firm’s inventory policy. ABT’s
policy is to have 2,500 tons of materials (5 million pounds) in ending inventory for the third and
fourth quarters and 4,000 tons of materials (8 million pounds) in ending inventory for the first and
second quarters. The direct materials purchases budget for ABT is presented in Schedule 3. For
simplicity, all materials are treated jointly (as if there were only one material input). In reality, a
separate schedule would be needed for each kind of material.
*Follows the inventory policy of having 8 million pounds of materials on hand at the end of the first
and second quarters and 5 million pounds on hand at the end of the third and fourth quarters.
Direct Labor Budget

The direct labor budget shows the total direct labor hours needed and the associated cost for the
number of units in the production budget. As with direct materials, the usage of direct labor is
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determined by the technological relationship between labor and output. For example, if a batch of
100 concrete blocks requires 1.5 direct labor hours, then the direct labor time per block is 0.015 hour.
Assuming that the labor is used efficiently, this rate is fixed for the existing technology. The
relationship will change only if a new approach to manufacturing is introduced.
Given the direct labor used per unit of output and the units to be produced from the production budget,
the direct labor budget is computed as shown in Schedule 4. In the direct labor budget, the wage rate
used (P8 per hour in this example) is the average wage paid the direct laborers associated with the
production of the concrete blocks. Since it is an average, it allows for the possibility of differing wage
rates paid to individual laborers.
Overhead Budget
The overhead budget shows the expected cost of all indirect manufacturing items. Unlike direct
materials and direct labor, there is no readily identifiable input-output relationship for overhead items.
Recall, however, that overhead consists of two types of costs: variable and fixed. Past experience can
be used as a guide to determine how overhead varies with activity level. Items that vary with activity
level are identified (e.g., supplies and utilities), and the amount that is expected to be spent for each
item per unit of activity is estimated. Individual rates are then totaled to obtain a variable overhead
rate. For ABT, assume that the variable overhead rate is P8 per direct labor hour.
Since fixed overhead does not vary with the activity level, total fixed overhead is simply the sum of
all amounts budgeted. Assume that fixed overhead is budgeted at P1.28 million (P320,000 per
quarter). Using this information and the budgeted direct labor hours from the direct labor budget, the
overhead budget in Schedule 5 is prepared.
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*Includes P200,000 of depreciation in each quarter.
Ending Finished Goods Inventory Budget

The ending finished goods inventory budget supplies information needed for the balance sheet and
also serves as an important input for the preparation of the cost of goods sold budget. To prepare this
budget, the unit cost of producing each concrete block must be calculated using information from
Schedules 3, 4, and 5. The unit cost of a concrete block and the cost of the planned ending inventory
are shown in Schedule 6.
A – Amounts taken from Schedule 3.

B – Amounts taken from Schedule 4.
C – Amounts taken from Schedule 5.
D – Budgeted fixed overhead (Schedule 5)/Budgeted direct labor hours (Schedule 4) = P1,280/240 =
P5.33.
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Cost of Goods Sold Budget
Assuming that the beginning finished goods inventory is valued at P55,000, the budgeted cost of
goods sold schedule can be prepared using Schedules 3, 4, 5, and 6. The cost of goods sold schedule
(Schedule 7) will be used as an input for the budgeted income statement.
Schedule 7 (In thousands)
*Production needs x P0.01 = 416,000 x P0.01
Marketing Expense Budget

The next budget to be prepared—the marketing expense budget—outlines planned expenditures for
selling and distribution activities. As with overhead, marketing expenses can be broken into fixed and
variable components. Such items as sales commissions, freight, and supplies vary with sales activity.
Salaries of the marketing staff, depreciation on office equipment, and advertising are fixed expenses.
The marketing expense budget is illustrated in Schedule 8.
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Research and Development Expense Budget
ABT, Inc., has a small research and development group that works on product line extensions, for
example, brick and paving tile. The expenditures by this group are estimated for the coming year and
presented in the research and development expense budget. This budget is illustrated, by quarter, in
Schedule 9.
Administrative Expense Budget

The final budget to be developed for operations is the administrative expense budget. Like the
research and development or marketing expense budgets, the administrative expense budget consists
of estimated expenditures for the overall organization and operation of the company. Most
administrative expenses are fixed with respect to sales. They include salaries, depreciation on the
headquarters building and equipment, legal and auditing fees, and so on. The administrative expense
budget is shown in Schedule 10.
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Budgeted Income Statement
With the completion of the administrative expense schedule, ABT has all the operating budgets
needed to prepare an estimate of operating income. This budgeted income statement is shown in
Schedule 11. The 10 schedules already prepared, along with the budgeted income statement, define
the operating budget for ABT.
Operating income is not equivalent to the net income of a firm. To yield net income, interest expense
and taxes must be subtracted from operating income. The interest expense deduction is taken from
the cash budget. The taxes owed depend on the current tax laws.
Preparing the Financial Budget

The remaining budgets found in the master budget are the financial budgets. The typical financial
budgets prepared are the cash budget, the budgeted balance sheet, the budgeted statement of cash
flows, and the budget for capital expenditures.
While the master budget is a plan for one year, the capital expenditures budget is a financial plan
outlining the expected acquisition of long-term assets and typically covers a number of years.
Decision making in regard to capital expenditures will not be discussed in this module. Details on the
budgeted statement of cash flows are appropriately reserved for another course. Accordingly, only
the cash budget and the budgeted balance sheet will be illustrated here.
The Cash Budget

Knowledge of cash flows is critical to managing a business. Often, a business is successful in
producing and selling a product but fails because of timing problems associated with cash inflows
and outflows. By knowing when cash deficiencies and surpluses are likely to occur, a manager can
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plan to borrow cash when needed and to repay the loans during periods of excess cash. Bank loan
officers use a company’s cash budget to document the need for cash, as well as the company’s ability
to repay. Because cash flow is the lifeblood of an organization, the cash budget is one of the most
important budgets in the master budget.
Components of the Cash Budget

The cash budget is the detailed plan that shows all expected sources and uses of cash. The cash budget,
illustrated in Exhibit 6-4, has the following five main sections:
1. Total cash available
2. Cash disbursements
3. Cash excess or deficiency
4. Financing
5. Cash balance
Exhibit 6-4. Cash Budget
The cash available section consists of the beginning cash balance and the expected cash receipts.
Expected cash receipts include all sources of cash for the period being considered. The principal
source of cash is from sales. Because a significant proportion of sales is usually on account, a major
task of an organization is to determine the pattern of collection for its accounts receivable. If a
company has been in business for a while, it can use past experience to create an accounts receivable
aging schedule. In other words, the company can determine, on average, what percentages of its
accounts receivable are paid in the months following the sales.
The cash disbursements section lists all planned cash outlays for the period except for interest
payments on short-term loans (these payments appear in the financing section). All expenses not
resulting in a cash outlay are excluded from the list. (Depreciation, for example, is never included in
the disbursements section.)
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The cash excess or deficiency section compares the cash available with the cash needed. Cash needed
includes the total cash disbursements plus the minimum cash balance required by company policy.
The minimum cash balance is simply the lowest amount of cash on hand that the firm finds acceptable.
Consider your own checking account. You probably try to keep at least some cash in the account,
perhaps because a minimum balance avoids service charges or because it allows you to make an
unplanned purchase. Similarly, companies also require minimum cash balances. The amount varies
from firm to firm and is determined by each company’s particular needs and policies. If the total cash
available is less than the cash needs, a deficiency exists. In such a case, a short-term loan will be
needed. On the other hand, with a cash excess (cash available is greater than the firm’s cash needs),
the firm has the ability to repay loans and perhaps make some temporary investments.
The financing section of the cash budget consists of borrowings and repayments. If there is a
deficiency, the financing section shows the necessary amount to be borrowed. When excess cash is
available, the financing section shows planned repayments, including interest.
The final section of the cash budget is the planned ending cash balance. Remember that the minimum
cash balance was subtracted to find the cash excess or deficiency. However, the minimum cash
balance is not a disbursement, so it must be added back to yield the planned ending balance.
Cash Budgeting Example

To illustrate the cash budget, let’s extend the ABT example by assuming the following:
a. ABT requires a P100,000 minimum cash balance for the end of each quarter. On December 31,
2021, the cash balance was P120,000.
b. Money can be borrowed and repaid in multiples of P100,000. Interest is 12 percent per year.
Interest payments are made only for the amount of the principal being repaid. All borrowing takes
place at the beginning of a quarter, and all repayment takes place at the end of a quarter.
c. Half of all sales are for cash; half are on credit. Of the credit sales, 70 percent are collected in the
quarter of sale, and the remaining 30 percent are collected in the following quarter. The sales for
the fourth quarter of 2021 were P2 million.
d. Purchases of materials are made on account; 80 percent of purchases are paid for in the quarter of
purchase. The remaining 20 percent are paid in the following quarter. The purchases for the fourth
quarter of 2021 were P500,000.
e. Budgeted depreciation is P200,000 per quarter for overhead.
f. The capital budget for 2022 revealed plans to purchase additional equipment to handle increased
demand at a small plant in Nevada. The cash outlay for the equipment, P600,000, will take place
in the first quarter. The company plans to finance the acquisition of the equipment with operating
cash, supplementing it with short-term loans as necessary.
g. Corporate income taxes are approximately P600,000 and will be paid at the end of the fourth
quarter (refer to Schedule 11).
Given the preceding information, the cash budget for ABT is shown in Schedule 12 (all figures are
rounded to the nearest thousand).
Much of the information needed to prepare the cash budget comes from the operating budgets. In
fact, Schedules 1, 3, 4, 5, 8, 9, and 10 all supply essential input. However, these schedules by
themselves do not supply all of the needed information. The collection pattern for revenues and the
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payment pattern for materials must be known before the cash flow for sales and purchases on credit
can be found.
Exhibit 6-5 displays the pattern of cash inflows from both cash and credit sales. Of course, the credit
sales must be adjusted to show how much will be paid in cash during a particular quarter. Let’s look
at the cash receipts for the first quarter of 2022. Cash sales during the quarter are budgeted for
P700,000 (0.5 x P1,400,000). Collections on account for the first quarter relate to credit sales made
during the last quarter of the previous year and the first quarter of 2022. Quarter 4, 2021, credit sales
equaled P1,000,000 (0.5 x P2,000,000), and P300,000 of those sales (0.3 x P1,000,000) remain to be
collected in Quarter 1, 2022. Quarter 1, 2022, credit sales are budgeted at P700,000, and 70 percent
will be collected in that quarter. Therefore, a total of P490,000 will be collected on account for credit
sales made in that quarter. Similar computations are made for the remaining quarters
Exhibit 6.5. Schedule of Cash Receipts
Cash is disbursed for purchases of materials, payment of wages, and payment of other expenses. This
information comes from Schedules 3, 4, 5, 8, 9, and 10. However, all noncash expenses, such as
depreciation, need to be removed from the total amounts reported in the expense budgets. Thus, the
budgeted expenses in Schedules 5, 8, and 10 were reduced by the budgeted depreciation for each
quarter. Overhead expenses in Schedule 5 were reduced by depreciation of P200,000 per quarter.
Marketing expenses and administrative expenses were reduced by P5,000 per quarter and P10,000
per quarter, respectively. The net amounts are what appear in the cash budget.
The cash budget shown in Schedule 12 underscores the importance of breaking down the annual
budget into smaller time periods. The cash budget for the year gives the impression that sufficient
operating cash will be available to finance the acquisition of the new equipment. Quarterly
information, however, shows the need for short-term borrowing because of both the acquisition of
the new equipment and the timing of the firm’s cash flows. Breaking down the annual cash budget
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into quarterly time periods conveys more information. Even smaller time periods often prove to be
useful. Most firms prepare monthly cash budgets, and some even prepare weekly and daily cash
budgets.
Another significant piece of information emerges from ABT’s cash budget. By the end of the third
quarter, the firm holds a considerable amount of cash (P1,334,000). ABT should consider investing
this cash in short-term marketable securities rather than allowing it to sit idly in a bank account. The
management of ABT should consider paying dividends and making long-term investments. At the
very least, the excess cash should be invested in short-term marketable securities. Once plans are
finalized for use of the excess cash, the cash budget should be revised to reflect those plans. Budgeting
is a dynamic process. As the budget is developed, new information becomes available and better plans
can be formulated.
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Flexible Budgets for Planning and Control
Budgets are useful control measures. To be used in performance evaluation, however, two major
considerations must be addressed. The first is to determine how budgeted amounts should be
compared with actual results. The second consideration involves the impact of budgets on human
behavior.
Static Budgets versus Flexible Budgets

Master budget amounts, while vital for planning, are less useful for control. The reason for this is
because the anticipated level of activity rarely equals the actual level of activity. Therefore, the costs
and revenues associated with the anticipated level of activity cannot be readily compared with actual
costs and revenues for a different level of activity.
Static Budgets
Master budgets are developed around a particular level of activity; they are static budgets. Because
the revenues and costs prepared for static budgets depend on a level of activity that rarely equals
actual activity, they are not very useful when it comes to preparing performance reports.
To illustrate, let’s return to the ABT, Inc., example used in developing the master budget. Suppose
that ABT provides quarterly performance reports. Recall that ABT anticipated sales of 2 million in
the first quarter and had budgeted production of 2.4 million units to support that level of sales. Now,
let’s suppose that sales activity was greater than expected in the first quarter; 2.6 million concrete
blocks were sold instead of the 2 million budgeted in the sales budget; and, because of increased sales
activity, production was increased over the planned level. Instead of producing 2.4 million units, ABT
produced 3 million units. A performance report comparing the actual production costs for the first
quarter with the original planned production costs is given in Exhibit 6-6.
Exhibit 6-6. Performance Report
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a. F means the variance is favorable.
b. 2,400,000 units x P0.26.
c. U means the variance is unfavorable.
d. 2,400,000 units x P0.12.
e. Variable overhead equals 2,400,000 units times the unit amounts from Schedule 6. Budgeted
fixed overhead per quarter is given in Schedule 5.
According to the report, unfavorable variances occur for direct materials, direct labor, supplies,
indirect labor, and rent. However, there is something fundamentally wrong with the report. Actual
costs for production of 3 million concrete blocks are being compared with planned costs for
production of 2.4 million. Because direct materials, direct labor, and variable overhead are variable
costs, we would expect them to be greater at a higher activity level. Thus, even if cost control were
perfect for the production of 3 million units, unfavorable variances would be produced for all variable
costs.
To create a meaningful performance report, actual costs and expected costs must be compared at the
same level of activity. Since actual output often differs from planned output, some method is needed
to compute what the costs should have been for the actual output level.
Flexible Budgets
The budget that (1) provides expected costs for a range of activity or (2) provides budgeted costs for
the actual level of activity is called a flexible budget. Flexible budgeting can be used in planning by
showing what costs will be at various levels of activity. When used this way, managers can deal with
uncertainty by examining the expected financial results for a number of plausible scenarios.
Spreadsheets are particularly useful in developing this type of flexible budget.
The flexible budget can be used after the fact, for control, to compute what costs should have been
for the actual level of activity. Once expected costs are known for the actual level of activity, a
performance report that compares those expected costs to actual costs can be prepared. When used
for control, flexible budgets help managers compare “apples to apples” in assessing performance.
To illustrate the power of flexible budgeting, let’s prepare a budget for ABT for three different activity
levels (the number of concrete blocks produced). Since the flexible budget gives the expected cost at
various levels of activity, we must know the cost behavior patterns of each budget item. Recall that
the cost behavior pattern can be expressed as the sum of the fixed cost and a variable rate multiplied
by activity level. The variable rates for direct materials (P0.26 per unit), direct labor (P0.12 per unit),
supplies (P0.03), indirect labor (P0.07), and power (P0.02) are given in Schedule 6. Finally, we know
from Schedule 5 that fixed overhead is budgeted at P320,000 per quarter. Exhibit 6-7 displays a
flexible budget for production costs when 2.4, 3, and 3.6 million concrete blocks are produced.
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Exhibit 6-7. Flexible Production Budget
Notice in Exhibit 6-7 that total budgeted production costs increase as the activity level increases.
Budgeted costs change because of variable costs. Because of this, a flexible budget is sometimes
referred to as a variable budget. Exhibit 8-8 reveals what the costs should have been for the actual
level of activity (3 million blocks). A revised performance report that compares actual and budgeted
costs for the actual level of activity is given in Exhibit 6-8 on the following page.
The revised performance report in Exhibit 6-8 paints a much different picture than the one in Exhibit
6-6. By comparing budgeted costs for the actual level of activity with actual costs for the same level,
flexible budget variances are generated. Managers can locate possible problem areas by examining
these variances. According to the ABT flexible budget variances, expenditures for direct materials
are excessive. (The other unfavorable variances seem relatively small.) With this knowledge,
management can search for the causes of the excess expenditures and prevent the same problems
from occurring in the future.
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Exhibit 6-8. Actual versus Flexible Performance Report
Budgets can be used to examine the efficiency and effectiveness of a company. Efficiency is achieved
when the business process is performed in the best possible way, with little or no waste. The flexible
budget provides an assessment of the efficiency of a manager. This is so because the flexible budget
compares the actual costs for a given level of output with the budgeted costs for the same level.
Effectiveness means that a manager achieves or exceeds the goals described by the static budget.
Thus, efficiency examines how well the work is done, and effectiveness examines whether or not the
right work is being accomplished. Any differences between the flexible budget and the static budget
are attributable to differences in volume. They are called volume variances. A 5-column performance
report that reveals both the flexible budget variances and the volume variances can be used. Exhibit
6-9 provides an example of this report using the ABT data.
As the report in Exhibit 6-9 reveals, production volume was 600,000 units greater than the original
budgeted amount. Thus, the manager exceeded the output goal. This volume variance is labeled
favorable because it exceeds the original production goal. (Recall that the reason for the extra
production was because the demand for the product was greater than expected. Thus, the increase in
production over the original amount was truly favorable.) On the other hand, the budgeted variable
costs are greater than expected because of the increased production. This difference is labeled
unfavorable because the costs are greater than expected; however, the increase in costs is because of
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an increase in production. Thus, it is totally reasonable. For this particular example, the effectiveness
of the manager is not in question; thus, the main issue is how well the manager controlled costs as
revealed by the flexible budget variances.
Exhibit 6-9. Managerial Perforamance Report
III. ACTIVITY
MULTIPLE CHOICE
1. The concept of “management by exception” refers to management’s consideration of
A. only those items that vary materially from expectations.
B. only rare events.
C. samples selected at random.
D. only significant unfavorable deviations.
2. A formal written statement of management’s plans for the future, packaged in financial
terms, is a:
A. Responsibility report. C. Cost of production report.
B. Performance report. D. Budget.
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3. Budgets are related to which of the following management functions?
A. Planning C. Control
B. Performance evaluation D. all of these
4. Budgeting supports the planning process by encouraging all of the following activities
except:
A. Requiring all organizational units to establish their goals for the coming period.
B. Increasing the motivation of managers and employees by providing agreed-upon
expectations.
C. Improving overall decision making by considering all viewpoints, options, and cost control
programs.
D. Directing and coordinating operations during the period.
5. Which of the following advantages does a budget mostly provide?

A. Coordination is increased.
B. Planning is emphasized.
C. Communication is continuous.
D. Comparison of actual versus budgeted data.
6. Which of the following is least likely a reason why a company prepares its budget?
A. To provide a basis for comparison of actual performance
B. To communicate the company’s plans throughout the entire business organization
C. To control income and expenditure in a particular period.
D. To make sure the company expands its operations.
7. Which of the following does not contribute to an effective budgeting?

A. Top management is involved in budgeting.
B. To give each manager a free hand in the preparation of the budget, the data within the master
budget are flexible.
C. The organization is divided into responsibility units.
D. There is communication of results.
8. The budgets that are based on a very high levels of performance, like expected costs using
ideal standards,
A. assist in planning the operations of the company
B. stimulate people to perform better than they ordinarily would
C. are helpful in evaluating the performance of managers
D. can lead to low levels of performance
9. Which of the following statements is incorrect?

A. An imposed budget is the same as a participative budget.
B. Preparation of the budget would be the responsibility of each responsibility unit.
C. Top management’s support is necessary to promote budget participation.
D. The top management should review and approve each responsibility unit’s budget.
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10. The primary role of the budget director and the budgeting department is to
A. Settle disputes among operating executives during the development of the annual operating
plan.
B. Develop the annual profit plan by selecting the alternatives to be adopted form the
suggestions submitted by the various operating segments.
C. Compile the budget and manage the budget process.
D. Justify the budget to the corporate planning committee of the board of directors.
PROBLEMS
1. Management has prepared a graph showing the total costs of operating branch warehouses
throughout the country. The cost line crosses the vertical axis at P400,000. The total cost
of operating one branch is P650,000. The total cost of operating ten branches is P2,900,000.
For purposes of preparing a flexible budget based on the number of branch warehouses in
operation, what formula would be used to determine budgeted costs at various levels of
activity?
A. Y = P400,000 + P250,000X C. Y = P650,000 + P400,000X
B. Y = P400,000 + P290,000X D. Y = P650,000 + P250,000X
2. PTO Company desires an ending inventory of P140,000. It expects sales of P800,000 and has
a beginning inventory of P130,000. Cost of sales is 65% of sales. Budgeted purchases are
A. P 530,000 C. P 810,000
B. P 790,000 D. P1,070,000
3. Calypso Co. has projected sales to be P600,000 in January, P750,000 in February, and
P800,000 in March. Calypso wants to have 50% of next month’s sales needs on hand at the
end of a month. If Calypso has an average gross profit of 40%, what are the February 28
purchases?
A. P465,000 C. P775,000
B. P310,000 D. P428,000
4. Blue Company budgeted purchases of P100,000. Cost of sales was P120,000 and the desired
ending inventory was P42,000. The beginning inventory was
A. P20,000 C. P42,000
B. P32,000 D. P62,000
5. The payment schedule of purchases made on account is: 60% in the time period of purchase,
30% in the following time period, and 10% in the subsequent time period. Total credit
purchases were P200,000 in May, and P100,000 in June. Total payments on credit purchases
were P140,000 in June. What were the credit purchases in the month of April?
A. P200,000 C. P145,000
B. P100,000 D. P215,000
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6. Montalban Company’s sales budget shows the following expected sales for the following
year:
Quarter Units
First 120,000
Second 160,000
Third 90,000
Fourth 110,000
Total 480,000
The inventory at December 31 of the prior year was budgeted at 36,000 units. The quantity of
finished goods inventory at the end of each quarter is to equal 30% of the next quarter’s
budgeted sales of units.
How much should the production budget show for units to be produced during the first quarter?
A. 48,000 C. 132,000
B. 96,000 D. 144,000
7. Lorie Company plans to sell 400,000 units of finished product in July and anticipates a
growth rate in sales of 5% per month. The desired monthly ending inventory in units of
finished product is 80% of the next month’s estimated sales.
There are 300,000 finished units in the inventory on June 30. Each unit of finished product
requires four pounds of direct materials at a cost of P2.50 per pound. There are 800,000
pounds of direct materials in the inventory on June 30.
How many units should be produced for the three-month period ending September 30?
A. 1,260,000 C. 1,331,440
B. 1,328,000 D. 1,424,050
8. If the required direct materials purchases are 8,000 pounds and the direct materials required
for production is three times the direct materials purchases, and the beginning direct
materials are three and a half times the direct materials purchases, what are the desired ending
direct material in pounds?
A. 20,000 C. 12,000
B. 4,000 D. 32,000
9. If there were 30,000 pounds of raw material on hand on January 1, 60,000 pounds are desired
for inventory at December 31, and 180,000 pounds are required for annual production, how
many pounds of raw material should be purchased during the year?
A. 150,000 pounds C. 120,000 pounds
B. 240,000 pounds D. 210,000 pounds
10. Silver Bowl Company manufactures a single product. It keeps its inventory of finished goods
at 75% the coming month’s budgeted sales. It also keeps its inventory of raw materials at 50%
of the coming month’s budgeted production. Each unit of product requires two pounds of
materials. The production budget is, in units: May, 1,000; June, 1,200; July, 1,300; august,
1,600. Raw material purchases in July would be
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11. Each unit of finished product uses 6 kilograms of raw materials. The production and inventory
budgets for May 2007 are as follows:
Beginning Inventory:
Finished goods 15,000 units
Raw materials 21,000 kg.
Budgeted unit sales 18,000 units
Planned ending inventory
Finished goods 11,400 units
Raw materials 24,400 kg.
During the production process, it is usually found that 10% of production units are scrapped as
defective and this loss occurs after the raw materials have been placed in process.
How many kilograms of raw materials should be purchased in June?
A. 89,800 C. 96,000
B. 98,440 D. 99,400
12. Violet Company manufactures a single product. It keeps its inventory of finished goods at
twice the coming month’s budgeted sales, inventory of raw materials at 150% of the coming
month’s budgeted production requirements. Each unit of product requires two pounds of
materials. The production budgets in units consist of the following:.
May 1,000
June 1,200
July 1,300
August 1,600
Raw material purchases in June would be
13. Sales Company is budgeting sales of 300,000 units of its only product for the coming year.
Production of one unit of product requires three pounds of Material Q and 2 pounds of
Material L. Inventory units at the beginning of the year are:
Actual, Jan. 1 Budgeted, Dec 31
Finished goods 60,000 50,000
Material Q 80,000 60,000
Material L 88,000 96,000
How many pounds of Material Q is Sales planning to buy during the coming year?
A. 850,000 C. 862,000
B. 890,000 D. 908,000
14. Strama Company prepares its budgets on annual basis. The following beginning and ending
inventory unit levels are planned for the fiscal year of June 1, 2006 through May 31, 2007.
June 1, 2006 May 31, 2007
Raw material* 40,000 50,000
Work-in-process 10,000 10,000
Finished goods 80,000 50,000
*Two (2) units of raw material are needed to produce each unit of finished product.
If 500,000 finished units were to be manufactured during the 2006-2007 fiscal year by Strama
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Company, the units of raw material needed to be purchased would be
A. 1,000,000 units C. 1,020,000 units
B. 1,010,000 units D. 990,000 units
15. Diliman Corporation includes the following quarterly budget for production:
Quarter Production
First 60,000 units
Second 45,000 units
Third 40,000 units
Fourth 65,000 units
Each unit of product requires 2.5 kilograms of direct materials. The company begins each
quarter with inventory of direct materials equal to 25 percent of the total quarter’s material
requirements.
What is the budgeted purchases of materials for the second quarter?
A. 113,750 C. 46,250
B. 109,375 D. 112,500
16. Namuco, Inc. uses flexible budgeting for cost control. During the month of September,
Namuco, Inc. produced 14,500 units of finished goods with indirect labor costs of P25,375.
Its annual master budget reflects an indirect labor costs, a variable cost, of P360,000 based
on an annual production of 200,000 units. In the preparation of performance analysis for the
month of September, how much flexible budget should be allowed for indirect labor costs?
A. P30,000 C. P25,375
B. P29,167 D. P26,100
17. Generous Company began its operations on January 1 of the current year. Budgeted sales
for the first quarter are P240,000, P300,000, and P420,000, respectively, for January,
February and March. Generous Company expects 20% of its sales cash and the remainder
on account. Of the sales on account, 70% are expected to be collected in the month of sale,
25% in the month following the sale, and the remainder in the following month.
How much should Generous receive from sales in March?
A. P304,800 C. P388,800
B. 294,000 D. P295,200
18. Mendrez Company has a collection schedule of 60% during the month of sales, 15% the
following month, and 15% subsequently. The total credit sales in the current month of
September were P80,000 and total collections in September were P57,000. What were the
credit sales in July?
A. P90,000 C. P45,000
B. P30,000 D. P32,000
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19. The Avelina Company has the following historical pattern on its credit sales.
70 percent collected in month of sale
15 percent collected in the first month after sale
10 percent collected in the second month after sale
4 percent collected in the third month after sale
2 percent uncollectible
The sales on open account have been budgeted for the last six months of 2007 are shown below:
July P 60,000
August 70,000
September 80,000
October 90,000
November 100,000
December 85,000
The estimated total cash collections during the fourth calendar quarter from sales made on open
account during the fourth calendar quarter would be
A. P172,500 C. P265,400
B. P230,000 D. P251,400
20. The Le Amore Company had the following budgeted sales for the first half of the current year:
Cash Sales Credit Sales
January P70,000 P340,000
February 50,000 190,000
March 40,000 135,000
April 35,000 120,000
May 45,000 160,000
June 40,000 140,000
The company is in the process of preparing a cash budget and must determine the expected cash
collections by month. To this end, the following information has been assembled:
Collections on sales: 60% in month of sale

30% in month following sale
10% in second month following sale
The accounts receivable balance on January 1 of the current year was P70,000, of which
P50,000 represents uncollected December sales and P20,000 represents uncollected November
sales.
The total cash collected by Le Amore Company during the month of January would be:
A. P410,000 C. P344,000
B. P254,000 D. P331,500
V. EVALUATION/ASSESSMENT
Page 134 of 134

N. Cruz-Course Material For Strategic Cost Management

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N. Cruz-Course Material For Strategic Cost Management

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Subject Code: BACOSTMX

Subject Title: STRATEGIC COST MANAGEMENT

MODULE 1: PROCESS COSTING

MODULE 2: STANDARD COSTING

MODULE 4: ABSORPTION AND VARIABLE COSTING

MODULE 5: RELEVANT INFORMATION FOR DECISION MAKING

MODULE 6: BUDGETING FOR PLANNING AND CONTROL

PROCESS COSTING METHOD ARE USED BY THE FOLLOWING:

CHARACTERISTICS OF A PROCESS COST SYSTEM

Finished Goods Inventory

Staining Department 2 Resting Department 4

Finished Goods Inventory

Gasoline Heating Oil Kerosene

Finished Goods Finished Goods Finished Goods

Step 1 – Quantity Schedule

Step 2 – Calculate Equivalent Units and Unit Costs

FIRST-IN FIRST-OUT METHOD

Step 4 – Account for all costs

METHODS OF APPLICATION OF ELEMENTS OF COST TO PRODUCTION

COMPUTATION OF EQUIVALENT PRODUCTION

Units Completed 8,000 100% 8,000 100% 8,000

Units Completed 8,000 100% 8,000 100% 8,000

Units Completed 8,000 100% 8,000 100% 8,000

Units Completed 8,000 100% 8,000 100% 8,000

Materials Labor and Overhead

Units Completed 20,000 100% 20,000 100% 20,000

Cost Charged to the Department

Cost Accounted for As Follows:

Materials Labor and Overhead

Units Completed 18,000 100% 18,000 100% 18,000

Cost Charged to the Department

Cost Accounted for As Follows:

4. Interdepartmental Transfer of Cost

Michelle Cruz Company

Direct Materials P 154,000

METHODS OF COSTING UNDER PROCESS COSTING

2. Weighted Average Method

2. Computation of Unit Cost

3. Computation of the Cost of Goods Transferred Out

4. Computation of the Cost of Ending Inventory

STEPS FOR ASSIGNING PROCESS COSTS TO UNITS

Materials Labor and Overhead

Units Completed 8,200 100% 8,200 100% 8,200

Cost Charged to the Department

Cost Accounted for As Follows:

JOURNAL ENTRIES – AVERAGE METHOD

3. Finished Goods 246,820

Natalie Jillienne Company

Materials Labor and Overhead

Cost Charged to the Department

Cost Added in the Department

Cost Accounted for As Follows:

JOURNAL ENTRIES – AVERAGE METHOD

2. Work in Process – Department 2 155,580

3. Finished Goods 246,820

Using the following information for questions 17 to 20

Uses of Standard Costs

5. Management By Objectives (MBO)

Direct Materials Standard

2. Direct Materials Usage (Efficiency) Standards

2. Direct Labor Efficiency Standards

Factory Overhead Standards