CHAPTER FOUR

MANAGEMENT & COST ACCOUNTING

ACCOUNTING FOR MANAGERS

Contents
Introduction

Accounting for Manufacturing Operations

Costing systems
◦ Job Order Costing
◦ Process Costing
◦ Activity Based Costing

Cost Volume Profit Analysis

Decision Making

ACCOUNTING FOR MANAGERS

Introduction
Cost & Management accounting

▪ Cost accounting provides the detailed cost information that management needs to
control current operations and plan for the future.

▪ Cost accounting information is commonly used in financial

accounting information, and by managers to make decisions.

▪ Management accounting is a field of accounting that provides economic and financial

information for managers and other internal users.
➢The development and interpretation of accounting information intended
specifically to assist managing in operating the business

ACCOUNTING FOR MANAGERS

Cost concepts and Cost Behavior
▪ Resources are needed to manufacture products.
▪ Resources need to be properly managed to enhance profitability of the products
or services considered.
▪ How much of the resources consumed for each product need to be known.
▪ That is we need to know:
1.What are the type of resources needed for the product
2.For what purpose resources are used
3.What is the condition of their traceability

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Cost Concepts
➢ Cost: is a resource sacrificed or forgone to achieve a specific objective (usually
measured as the monetary amount)

➢ A Cost object: is anything for which a separate measurement of costs is desired.

Example; product, department, customer, geographical area, process etc.

➢ Cost pool: A cost pool is a grouping of individual cost items possessing identical
nature. Cost pools can range from broad, such as all costs within a manufacturing
plant, to narrow, such as the costs of operating machine.

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➢Cost accumulation: is the collection of costs in some organized way by
means of an accounting system, i.e., by some natural or self descriptive
classification.
Eg. material cost, labor cost, fuel, Advertisement cost etc.
➢Cost assignment: is a general term that includes:
a. Tracing accumulated costs: For direct costs
b. Allocating accumulated costs: For indirect costs
➢ Cost driver is a variable, such as an activity level or volume, the change of
which causally affect costs over a given time span. That is, there is a specific
cause-and-effect relationship between change in level of activity or volume
and change in level of cost.

ACCOUNTING FOR MANAGERS

Classification of costs:
▪ Different cost classifications are used to develop cost information for a given
purpose.
▪ Managers use this information to support product and service decisions,
enables cost control, provide historical data for cost management.
▪ Thus, different classification of costs provide different information that helps
for decision making.
1. By natural element: Direct material, Direct labor & MOH

ACCOUNTING FOR MANAGERS

2. By function/operation/purposes: production(manufacturing); direct
materials, direct labor and manufacturing overhead), and
Non manufacturing costs( selling, distribution, administration, R&D)
3. Based on their traceability to a particular cost object:
Direct: costs that have a relationship with the cost object and can be traced to
that cost object in an economically feasible (cost effective) way. And
Indirect: costs that have a relationship with the cost object but cannot be
traced to that cost object in an economically feasible way.

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4. Based on their behavior pattern :
Fixed: costs that remain constant regardless of the level of activity up to a
certain relevant range but unit costs vary according to the level of activity.
Variable: costs that changes in direct proportion to changes in the level of
activity but unit costs remain constant.
Semi-variable or semi-fixed (Mixed)

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5. By control ability:
Controllable : costs that can be influenced by management action
Uncontrollable: cost beyond the control of management.
6. By normality:
Normal: costs incurred in the normal course of activity for producing normal
level of out put under normal circumstances.
Abnormal: costs incurred on account of abnormal conditions or abnormal
activity.

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7. Based on timing they are charged against revenue
Product costs: are costs that are necessary and integral part of producing
(acquiring) the finished product. They are considered as an asset/inventory
when they are incurred. Under the matching principle, these costs do not
become expenses until the finished goods inventory is sold.
Example: Cost of direct material
Period Costs: are costs of income statement other than cost of goods sold.
They are treated as expense of the period in which they are incurred because
they are expected to benefit revenue in the current period.
Example: Advertising costs

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Accounting for Manufacturing Operations
Steps in the Manufacturing Process:

Buy raw Convert raw materials Sell finished

materials. into finished goods. goods.

Direct Direct labor and

Cost of goods
materials manufacturing
sold.
costs. overhead costs.

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Direct Materials
Raw materials &
component parts Can be traced
that become an directly and
integral part of conveniently to
finished products. products.

If materials cannot be traced directly to products, the materials are

considered indirect and are part of manufacturing overhead.

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Direct Labor
Includes the payroll cost of direct workers.

Those employees who

Direct labor Wage work directly on the
× goods being
hours rate
manufactured.

The cost of employees who do not work directly on the goods is

considered indirect labor and is part of manufacturing overhead.

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Product Cost

The cost to produce a unit of

product includes:
⚫Direct material
⚫Direct labor
⚫Manufacturing overhead

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Product Cost: Manufacturing Overhead

The cost to
produce a unit of
product includes: Manufacturing overhead
⚫Direct material must be mathematically
allocated to each unit of
⚫Direct labor product using a
predetermined overhead
⚫Manufacturing application rate.
overhead

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Product Costs Versus Period Costs
Balance Sheet
Product Costs
(manufacturing Current assets and
costs)
as inventory
incurred
When goods are
sold.
Income Statement

Period Costs Revenue

(operating expenses COGS
and income taxes.) Gross profit
Expenses
as Net income.
incurred
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Inventories of a Manufacturing Business

Raw materials - inventory on Work in process -

hand and available for use. partially completed
goods.

Finished goods- completed goods

awaiting sale.

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Costing systems

Job order costing

Process costing

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Job Order Cost System
◆ Costs are assigned to each job or batch of goods.

◆ Key feature: Each job or batch has its own distinguishing characteristics.

◆ Objective: Compute the cost per job.

◆ Measures costs for each completed job rather than for set time periods.

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ACCOUNTING FOR MANAGERS
 Process Cost System
◆ Used when a large volume of similar products are manufactured (cereal,
refining of petroleum, production of ice cream).

◆ Costs are accumulated for a time period (week or month).

◆ Costs are assigned to departments or processes for a specified period of

time.

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ACCOUNTING FOR MANAGERS
 Job Order Cost Flow
Job order cost accounting parallels the physical flow of the materials as
they are converted into finished goods

◆ Manufacturing costs are assigned to Work in Process (WIP) Inventory

account.

◆ Cost of completed jobs is transferred to Finished Goods Inventory.

◆ When units are sold, the cost is transferred to Cost of Goods Sold.

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Job Order Cost Flow

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 Accumulating Manufacturing Costs

Raw Material Costs

Illustration: Wallace Company purchases 2,000 lithium batteries (Stock No.
AA2746) at $5 per unit ($10,000) and 800 electronic modules (Stock No.
AA2850) at $40 per unit ($32,000) for a total cost of $42,000 ($10,000 +
$32,000) on account. The entry to record this purchase on January 4 is:

Jan. 4 Raw Materials Inventory 42,000

Accounts Payable 42,000

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Factory Labor Costs
Consists of three costs:
1. Gross earnings of factory workers,

2. Employer payroll taxes on these earnings, and

3. Fringe benefits incurred by the employer.

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 Factory Labor Costs
Illustration: Wallace incurs $32,000 of factory labor costs. Of that
amount, $27,000 relates to wages payable and $5,000 relates to
payroll taxes payable in February. The entry to record factory labor for
the month is:

Jan. 31 Factory Labor 32,000

Factory Wages Payable 27,000
Employer Payroll Taxes Payable 5,000

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Manufacturing Overhead Costs

◆ Many types of overhead costs

► For example, property taxes, depreciation, insurance, and

repairs.

◆ Costs unrelated to manufacturing process are expensed.

◆ Costs related to manufacturing process are accumulated

in Manufacturing Overhead.

► Manufacturing overhead subsequently assigned to work in

process.

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 Manufacturing Overhead Costs

Illustration: Using assumed data, the summary entry for manufacturing

overhead in Wallace Manufacturing Company is:

Jan. 31 Manufacturing Overhead 13,800

Utilities Payable 4,800
Prepaid Insurance 2,000
Accounts Payable (for repairs) 2,600
Accumulated Depreciation 3,000
Property Taxes Payable 1,400

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Assigning Manufacturing Costs to Work in Process

Manufacturing costs are assigned to Work in Process with

Debits to: Work in Process Inventory

Credits to: Raw Materials Inventory

Factory Labor
Manufacturing Overhead

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Job Cost Sheet
◆ Used to record
► the costs chargeable to a specific job and

► to determine the total and unit costs of the completed job.

◆ Constitutes the subsidiary ledger for the Work in Process Inventory

account.

◆ Each entry to a Work in Process Inventory must be accompanied by a

corresponding posting to one or more job cost sheets.

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ACCOUNTING FOR MANAGERS
Raw Material Costs

◆ Assigned to a job when materials are issued

◆ Materials requisition slip

► Written authorization for issuing raw materials.

► May be directly issued to use on a job – Work in Process

Inventory account.

► May be considered indirect materials – Manufacturing

Overhead account.

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ACCOUNTING FOR MANAGERS
Assigning Materials to Jobs and Overhead
Illustration: Wallace uses $24,000 of direct materials and $6,000 of
indirect materials in January, the entry is:

Jan. 31 Work in Process Inventory 24,000

Manufacturing Overhead 6,000
Raw Materials Inventory 30,000

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Assigning Raw
Materials Cost
The sum of the direct
materials columns of
the job cost sheets
should equal the direct
materials debited to
Work in Process
Inventory.

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Factory Labor Costs
◆ Assigned to jobs on the basis of time tickets prepared when the work
is performed.

◆ Time tickets indicate

► Employee

► Hours worked

► Account and job charged

► Total labor cost

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ACCOUNTING FOR MANAGERS
Factory Labor Costs
Illustration: Time tickets are sent to the payroll department, which applies the
employee’s hourly wage rate and computes the total labor cost. If the $32,000 total
factory labor cost consists of $28,000 of direct labor and $4,000 of indirect labor, the
entry is:

Jan. 31 Work in Process Inventory 28,000

Manufacturing Overhead 4,000
Factory Labor 32,000

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Factory Labor Costs
Jan. 31 Work in Process Inventory 28,000
Manufacturing Overhead 4,000
Factory Labor 32,000

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 Job Cost Sheets –
Direct Labor
The sum of the direct
labor columns of the job
cost sheets should equal
the direct labor debited to
Work in Process
Inventory.

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Manufacturing Overhead Costs
◆ Relates to production operations as a whole.

◆ Cannot be assigned to specific jobs based on actual costs

incurred.

◆ Companies assign manufacturing overhead to work in process and

to specific jobs on an estimated basis through the use of a …

Predetermined Overhead Rate

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Predetermined Overhead Rate
◆ Based on the relationship between estimated annual overhead costs
and expected annual operating activity
◆ Expressed in terms of an activity base such as
► Direct labor costs

► Direct labor hours

► Machine hours

► Any other activity that is an equitable base for applying overhead costs to
jobs

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Predetermined Overhead Rate
◆ Established at the beginning of the year.

◆ Small companies often use a single, company-wide

predetermined overhead rate.

◆ Large companies often use rates that vary from department

to department.

◆ Formula for a predetermined rate overhead rate is

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 Manufacturing Overhead Costs
Assigned to Work in Process during the period to get timely
information about the cost of a completed job.

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 Manufacturing Overhead Costs
Illustration: Wallace uses direct labor cost as the activity base.
Assuming that the company expects annual overhead costs to be
$280,000 and direct labor costs for the year to be $350,000, compute
the overhead rate.

$280,000 ÷ $350,000 = 80%

This means that for every dollar of direct labor, Wallace will assign
80 cents of manufacturing overhead to a job.
_______

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Manufacturing Overhead Costs
Illustration: Wallace applies manufacturing overhead to work in process when it
assigns direct labor costs. Calculate the amount of applied overhead assuming
direct labor costs were $28,000.

$28,000 x 80% = $22,400

The following entry records this application.

Jan. 31 Work in Process Inventory 22,400

Manufacturing Overhead 22,400

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Manufacturing
Overhead Costs
The balance in Work in
Process Inventory
should equal the sum
of the costs shown on
the job cost sheets of
unfinished jobs.

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 Manufacturing Overhead Costs
At the End of Each Month:
The balance in the Work in Process Inventory should equal the
sum of the costs shown on the job cost sheets of unfinished jobs.

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 Assigning Costs to Finished Goods

When a job is
completed,
Wallace
summarizes the
costs and
completes the
job cost sheet.

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Assigning Costs to Finished Goods

Illustration: When a job is finished, Wallace makes an entry to

transfer its total cost to finished goods inventory.

Jan. 31 Finished Goods Inventory 39,000

Work in Process Inventory 39,000

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 Assigning Costs to Cost of Goods Sold
Illustration: On January 31 Wallace sells on account Job 101. The
job cost $39,000, and it sold for $50,000. The entries to record the sale
and recognize cost of goods sold are:

Jan. 31 Accounts Receivable 50,000

Sales revenue 50,000
Cost of Goods Sold 39,000
Finished Goods Inventory 39,000

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 Job Order Cost Flow
Summary

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Summary

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Advantages of Job Order Costing
◆ More precise in assignment of costs to projects than process costing.

◆ Provides more useful information for determining the profitability of

particular projects and for estimating costs when preparing bids on future
jobs.

Disadvantages of Job Order Costing

◆ Requires a significant amount of data entry.

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 Reporting Job Cost Data

◆ Schedule shows manufacturing overhead applied rather than

actual overhead costs.
◆ Applied overhead is added to direct materials and direct labor to
determine total manufacturing costs

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Partial Income Statement

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Under- or Overapplied Manufacturing Overhead

◆ A debit balance in manufacturing overhead means

that overhead is underapplied.
◆ A credit balance in manufacturing overhead means
that overhead is overapplied.

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Under- or Overapplied Manufacturing Overhead

Any Year-End Balance in manufacturing overhead is eliminated

by adjusting cost of goods sold.

◆ Underapplied overhead is debited to COGS

◆ Overapplied overhead is credited to COGS

Conceptually, some argue, under- or overapplied overhead at the end

of the year should be allocated among ending work in process, finished
goods, and cost of goods sold.

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The Nature of Process Cost Systems
Uses of Process Cost Systems
◆ To apply costs to similar products that are mass-
produced in a continuous fashion

◆ Examples include the production of Cereal, Paint,

Manufacturing Steel, Oil Refining and Soft Drinks
Similarities and Differences Between Job
Order Cost and Process Cost Systems

Job Order Cost Process Cost

◆ Costs assigned to ◆ Costs tracked through a

each job. series of connected
manufacturing processes
◆ Products have unique or departments.
characteristics.
◆ Products are uniform or
relatively homogeneous and
produced in a large
volume.
Illustration 21-3
 Similarities Differences
1. Manufacturing cost 1. Number of work in
elements. process accounts used.

2. Accumulation of the 2. Documents used to track

costs of materials, costs.
labor, and overhead.
3. Point at which costs are
3. Flow of costs. totaled.

4. Unit cost computations.

Job order versus
process cost systems
 Process Cost Flow
Tyler Company manufactures roller blade and skateboard wheels that it
sells to manufacturers and retail outlets. Manufacturing consists of two
processes: machining and assembly. The Machining Department
shapes, hones, and drills the raw materials. The Assembly Department
assembles and packages the parts.
Assigning Manufacturing Costs—Journal Entries
◆ Accumulation of materials, labor, and overhead costs is the same
as in job order costing.
► Debit - Raw Materials Inventory for purchases of raw
materials.
► Debit - Factory Labor for factory labor incurred.
► Debit - Manufacturing Overhead for overhead cost incurred.

◆ Assignment of the three manufacturing cost elements to Work

in Process in a process cost system is different from a job order
cost system
Material Costs
◆ A process cost system requires fewer material
requisition slips than a job order cost system.
► Materials are used for processes and not specific
jobs.

► Requisitions are for larger quantities of materials.

► Journal entry to record materials used:

Factory Labor Costs
◆ Time tickets may be used in both systems.

◆ All labor costs incurred within a production

department are a cost of processing.

◆ The journal entry to record factory labor costs:

Manufacturing Overhead Costs
◆ Objective of assigning overhead is to allocate overhead to
production departments on objective and equitable basis.

◆ Use the activity that “drives” or causes the costs.

◆ Primary driver is machine time used.

◆ Journal entry to allocate overhead:

Transfers
Transfer to next department:

Transfer to Finished Goods:

Transfer to record Cost of Goods sold :

Equivalent Units
Weighted Average Method
◆ Considers the degree of completion (weighting) of units
completed and transferred out and units in ending work in
process.
◆ Beginning work in process not part of computation of
equivalent units.
Illustration: The output of Kori Company’s Packaging Department
during the period consists of 10,000 units completed and transferred
out, and 5,000 units in ending work in process which are 70%
completed.

Calculate the equivalent units of production.

Completed units 10,000

Work in process equivalent units (5,000 x 70%) + 3,500
13,500
Refinements on the Weighted-Average Method
Illustration: Kellogg Company has produced Eggo® Waffles
since 1970. Three departments produce these waffles: Mixing,
Baking, and Freezing/Packaging. The Mixing Department
combines dry ingredients, including flour, salt, and baking
powder, with liquid ingredients, including eggs and vegetable oil,
to make waffle batter.

Illustration on next slide provides information related to the Mixing

Department at the end of June.
Refinements on the Weighted-Average Method
Illustration: Information related to the Mixing Department at the
end of June.
◆ Conversion costs are labor costs plus overhead costs.

◆ Beginning work in process is not part of the equivalent-units-

of-production formula.
Refined Equivalent Units
of Production Formula
Production Cost Report
A production cost report is the
◆ Key document used to understand activities.
◆ Shows Production Quantity and Cost data for each
department.
◆ Four steps in preparation:
Step 1: Compute physical unit flow
Step 2: Compute equivalent units of production
Step 3: Compute unit production costs
Step 4: Prepare a cost reconciliation schedule
Flow of costs in making
Eggo® Waffles
Unit and cost
data—Mixing
Department
Compute the Physical Unit Flow (Step 1)

◆ Physical units - actual units to be accounted for during

a period, irrespective of any work performed.

◆ Total units to be accounted for - units started (or

transferred) into production during the period + units in
production at beginning of period.

◆ Total units accounted for - units transferred out

during period + units in process at end of period.
Compute Equivalent Units of Production (Step 2)
Mixing Department
◆ Department adds materials at beginning of process and
◆ Incurs conversion costs uniformly during the process.
Compute Unit Production Costs (Step 3)
Compute total materials cost related to Eggo® Waffles:
Work in process, June 1
Direct materials costs $ 50,000
Cost added to production during June
Direct material cost 400,000
Total material costs $450,000
Compute Unit Production Costs (Step 3)
Compute total conversion costs related to Eggo® Waffles:
Work in process, June 1
Conversion costs $ 35,000
Costs added to production during June
Conversion costs 170,000
Total conversion costs $205,000
 Compute Unit Production Costs (Step 3)

Compute total manufacturing costs per unit:

Prepare a Cost Reconciliation Schedule (Step 4)

Kellogg charged total costs of $655,000 to the Mixing

Department in June, calculated as follows.

Costs to be accounted for

Work in process, June 1 $ 85,000
Started into production 570,000
Total costs $655,000
Prepare a Cost Reconciliation Schedule (Step 4)
Prepare the
Production
Cost Report
Costing Systems – Final Comments

◆ Companies often use a combination of a process cost and a job

order cost system.

◆ Called operations costing, this hybrid system is similar to

process costing in its assumption that standardized methods
are used to manufacture the product.

◆ At the same time, the product may have some customized,

individual features that require the use of a job order cost
system.
Contemporary Developments
Just-In-Time Processing
A processing system that is dedicated to having the right products
or parts as they are needed.

◆ Objective: To eliminate all manufacturing inventories to make

funds and space available for more productive purposes.

◆ Elements of JIT: Dependable suppliers; Multi-skilled workforce;

Total quality control system.

◆ Benefits of JIT: Reduced inventory; Enhanced product quality;

Reduced rework and storage costs; Savings from improved flow
of goods.

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 Activity-Based Costing

An overhead cost allocation system that focuses on activities performed in

producing a product.

◆ ABC System: More than one basis of allocating activity costs to products is
needed.

◆ Assumptions of ABC: All overhead costs related to the activity

► must be driven by the cost driver used to assign costs to products.
► should respond proportionally to changes in the activity level of the cost
driver.

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Activity-Based Costing Activities and cost
drivers in ABC

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Traditional Costing versus ABC
Production and Cost Data
Illustration: Atlas Company produces two abdominal-training products, the Ab Bench and the
Ab Coaster. The Ab Bench is a high-volume item totaling 25,000 units annually. The Ab
Coaster is a low-volume item totaling only 5,000 units per year. Each product requires one
hour of direct labor for completion. Therefore, total annual direct labor hours are 30,000
(25,000 + 5,000). Expected annual manufacturing overhead costs are $900,000. The
predetermined overhead rate is $30 ($900,000 ÷ 30,000) per direct labor hour. The direct
materials cost per unit is $40 for the Ab Bench and $30 for the Ab Coaster. The direct labor
cost is $12 per unit for each product.
Unit Costs Under Traditional Costing
 Unit Costs Under ABC
Determining Overhead Rates Under ABC
Atlas Company’s expected annual overhead costs of $900,000 relate
to three activities—machine setups, machining, and inspections.
Unit Costs Under ABC

Assigning Overhead Cost to Products Under ABC

Because of its low volume, the Ab Coaster requires more setups
and inspections than the Ab Bench. The expected number of cost
drivers for each product is as follows.
Assigning Overhead Cost to Products Under ABC

Assignment of overhead costs to products follows.

Assigning Overhead Cost to Products Under ABC

The data shows that under ABC, overhead costs are shifted from
the high-volume product (Ab Bench) to the low-volume product
(Ab Coaster). This shift results in more accurate costing for two
reasons.

1. Low-volume products often require more special handling,

such as more machine setups and inspections, than high-
volume products.

2. Assigning overhead using ABC will usually increase the cost

per unit for low-volume products as compared to a traditional
overhead allocation.
 Comparing Unit Costs

The comparison shows that unit costs under traditional costing have
been significantly distorted.
 Benefits of ABC

The primary benefit of ABC is more accurate product costing. Here’s why:
1. ABC leads to more cost pools being used to assign overhead costs to products.

2. ABC leads to enhanced control over overhead costs.

3. ABC leads to better management decisions.

 Limitations of ABC

ABC systems often provide better product cost data than traditional volume-
based systems, there are limitations:
1. ABC can be expensive to use.

2. Some arbitrary allocations continue.

Cost-Volume-Profit Analysis
Cost-volume-profit (CVP) analysis is the study of the effects of changes in
costs and volume on a company’s profits.

◆ Important in profit planning.

◆ Critical factor in management decisions as

► Setting selling prices,

► Determining product mix, and

► Maximizing use of production facilities.

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Basic Components

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 Basic Components - Assumptions
◆ Behavior of both costs and revenues is linear throughout the relevant range of the
activity index.

◆ Costs can be classified accurately as either variable or fixed.

◆ Changes in activity are the only factors that affect costs.

◆ All units produced are sold.

◆ When more than one type of product is sold, the sales mix will remain constant.

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 CVP Income Statement
◆ A statement for internal use.

◆ Classifies costs and expenses as fixed or variable.

◆ Reports contribution margin in the body of the statement.

► Contribution margin – amount of revenue remaining after deducting variable costs.

◆ Reports the same net income as a traditional income statement.

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 CVP Income Statement
Illustration: Vargo Video Company produces a high-definition digital
camcorder with 15x optical zoom and a wide-screen, high-resolution
LCD monitor. Relevant data for the camcorders sold by this company in
June 2014 are as follows.

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CVP Income Statement
Illustration: The CVP income statement for Vargo Video
therefore would be reported as follows.

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Contribution Margin per Unit
◆ Contribution margin is available to cover fixed costs
and to contribute to income.

◆ Formula for contribution margin per unit and the

computation for Vargo Video are:

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 Contribution Margin per Unit
Vargo’s CVP income statement assuming a zero net income.

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Contribution Margin per Unit
Assume that Vargo sold one more camcorder, for a total of 1,001
camcorders sold.

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Contribution Margin Ratio
◆ Shows the percentage of each sales dollar available to
apply toward fixed costs and profits.

◆ Formula for contribution margin ratio and the

computation for Vargo Video are:

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Contribution Margin Ratio

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 Contribution Margin Ratio
Assume Vargo Video’s current sales are $500,000 and it wants to
know the effect of a $100,000 (200-unit) increase in sales.

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Break-Even Analysis
◆ Process of finding the break-even point level of activity at which total revenues
equal total costs (both fixed and variable).

◆ Can be computed or derived

► From a mathematical equation,

► By using contribution margin, or

► From a cost-volume profit (CVP) graph.

◆ Expressed either in sales units or in sales dollars.

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 Mathematical Equation
Break-even occurs where total sales equal variable costs plus
fixed costs; i.e., net income is zero.

Computation of
break-even
point in units.

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Contribution Margin Technique
◆ At the break-even point, contribution margin must equal total
fixed costs

(CM = total revenues – variable costs)

◆ Break-even point can be computed using either contribution

margin per unit or contribution margin ratio.

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Contribution Margin in Units
◆ When the break-even-point in units is desired, contribution
margin per unit is used in the following formula which shows
the computation for Vargo Video:

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Contribution Margin Ratio
◆ When the break-even-point in dollars is desired, contribution
margin ratio is used in the following formula which shows the
computation for Vargo Video:

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 Graphic
Presentation

Because this graph also

shows costs, volume,
and profits, it is
referred to as a cost-
volume-profit (CVP)
graph.

ACCOUNTING FOR MANAGERS

 Target Net Income

◆ Level of sales necessary to achieve a specified income.

◆ Can be determined from each of the approaches used to

determine break-even sales/units:
► from a mathematical equation,

► by using contribution margin technique, or

► from a cost-volume profit (CVP) graph.

◆ Expressed either in sales units or in sales dollars.

ACCOUNTING FOR MANAGERS

Mathematical Equation
Formula for required sales to meet target net income.

ACCOUNTING FOR MANAGERS

Mathematical Equation
Using the formula for the break-even point, simply include the
desired net income as a factor.

ACCOUNTING FOR MANAGERS

Contribution Margin Technique
To determine the required sales in units for Vargo Video:

ACCOUNTING FOR MANAGERS

Contribution Margin Technique
To determine the required sales in dollars for Vargo Video:

ACCOUNTING FOR MANAGERS

Margin of Safety
◆ Difference between actual or expected sales and sales at the
break-even point.
◆ Measures the “cushion” that a particular level of sales
provides.
◆ May be expressed in dollars or as a ratio.
◆ Assuming actual/expected sales are $750,000:

ACCOUNTING FOR MANAGERS

Margin of Safety
◆ Computed by dividing the margin of safety in dollars by the
actual (or expected) sales.

◆ Assuming actual/expected sales are $750,000:

◆ The higher the dollars or percentage, the greater the

margin of safety.

ACCOUNTING FOR MANAGERS

Decision Making
▪ Decision-making is a fundamental part of management.
▪ Managers are constantly faced with problems of deciding
▪ What product to sell,
▪ What production method to use,
▪ Whether to make or buy component parts,
▪ What prices to charge,
▪ What channels of distribution to use,
▪ Whether to accept special orders at special prices, and so forth.
▪ This section covers the role of management accounting information in
a variety of marketing and production decisions.

ACCOUNTING FOR MANAGERS

Identifying Relevant Costs
Costs that can be eliminated (in whole or in part) by choosing one
alternative over another are avoidable costs.
Avoidable costs are relevant costs.
Unavoidable costs are never relevant and include:
Sunk costs.
Future costs that do not differ between the alternatives.

ACCOUNTING FOR MANAGERS

 Adding/Dropping Segments
One of the most important decisions managers make is whether to add or drop a business segment
such as a product or a store.

Let’s see how relevant costs should be used in this

decision.

ACCOUNTING FOR MANAGERS

Adding/Dropping Segments
Discount Drug Company has three major product lines: drugs, cosmetics and
housewares. The last one has not reported a profit for the last two years. An
income statement for last year is shown on the next screen
Segment Income Statement
Housewares
Sales $ 50,000
Less: variable expenses $ 30,000
Contribution margin $ 20,000
Less: fixed expenses
Salaries 8,000
Depreciation of equipment 2,000
Advertising - direct 6,500
Utilities 1,000
Rent 4,000
Insurance 500
General admin. expenses 6,000 28,000
Net operating loss $ (8,000)

ACCOUNTING FOR MANAGERS

Adding/Dropping Segments

• Salaries expense represent direct labor, all employees would be

discharged if the product line is dropped.
• The advertising expense is product-specific.
• Utilities expense is firm-level, allocated based on space used, it is not
avoidable if the segment is dropped.
• The equipment that is being depreciating has no resale value.
• Rent is for the entire building housing the company, allocated to
products based on dollar sales. It is fixed, under a long-term lease.
• Insurance is product-specific.
• General administrative expense would be unaffected by the
discontinuation of any segment.

ACCOUNTING FOR MANAGERS

A Contribution Margin Approach

DECISION RULE
A segment should be discontinued only if the company’s profit would
increase. This would only happen if the fixed cost savings exceed the lost
contribution margin.

ACCOUNTING FOR MANAGERS

A Contribution Margin Approach

Contribution Margin
Solution
Contribution margin lost if the
housewares line is dropped $ (20,000)

Less fixed costs that can be avoided

Salaries $ 8,000
Advertising - direct 6,500
Insurance 500 15,000
Net disadvantage $ (5,000)

ACCOUNTING FOR MANAGERS

The Make or Buy Decision
▪ A decision concerning whether an item should be produced internally or
purchased from an outside supplier is called a “make or buy” decision.
Example
Mountain Goat Cycles manufactures gear shifters used in one of its
products. Direct materials $ 6
Direct labor 4
The unit product cost of this part is: Variable overhead 1
Supervisor's salary 3
Depreciation of special equip. 2
Allocated general overhead 5
Unit product cost $ 21

ACCOUNTING FOR MANAGERS

▪ The special equipment used to manufacture gear-shifters has no resale
value.
▪ The total amount of general factory overhead, which is allocated on the
basis of direct labor hours, would be unaffected by this decision.
▪ The $21 unit product cost is based on 8,000 parts produced each year.
▪ An outside supplier has offered to provide the 8,000 parts at a cost of
$19 per part.
Should we accept the supplier’s offer?
ACCOUNTING FOR MANAGERS
 Make Buy
Outside purchase price $ 19 $ 152,000 DECISION RULE
In deciding whether to accept
Direct materials $ 6 48,000
the outside supplier’s offer,
Direct labor 4 32,000
Variable overhead 1 8,000
Mountain Goat Cycles
Supervisor's salary 3 24,000
isolated the relevant costs of
Depreciation of equip. 2 - making the part by
General factory overhead 5 - eliminating:
Total cost ◦ The sunk costs.
$ 21 $ 112,000 $ 152,000
◦ The future costs that will not differ between
making or buying the parts.

8,000 × $4 per unit = $32,000

ACCOUNTING FOR MANAGERS
Opportunity Cost
▪ The benefits that are foregone as a result of pursuing some course of action.
▪ Opportunity costs are not actual dollar outlays and are not recorded in the
formal accounts of an organization.

ACCOUNTING FOR MANAGERS

 Special Orders
Jet, Inc. makes a single product whose normal Jet, Inc.
selling price is $20 per unit. Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
A foreign distributor offers to purchase 3,000 Variable costs:
units for $10 per unit. Direct materials $ 20,000
Direct labor 5,000
This is a one-time order that would not affect Manufacturing overhead 10,000 $8 variable cost
the company’s regular business. Marketing costs 5,000
Total variable costs 40,000
Annual capacity is 10,000 units, but Jet, Inc. is Contribution margin 60,000
currently producing and selling only 5,000 units. Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Should Jet accept the offer? Total fixed costs
Net operating income
48,000
$ 12,000

ACCOUNTING FOR MANAGERS

 If Jet accepts the offer, net operating income will
increase by $6,000.

Increase in revenue (3,000 × $10) $ 30,000

Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 6,000

Note: This answer assumes that fixed costs are

unaffected by the order and that variable marketing
costs must be incurred on the special order.

ACCOUNTING FOR MANAGERS

 Master Budget and
Responsibility Accounting
Learning Objective 1

Understand what a master budget

is and explain its benefits.
Budgeting Cycle

Performance planning
Providing a frame of reference
Investigating variations
Corrective action
Planning again
The Master Budget

Master Budget

Operating Financial
Decisions Decisions
Learning Objective 2

Describe the advantages

of budgets.
What are the Advantages of Budgets?

#1 Compels strategic planning

Provides a framework
#2 for judging performance
What are the Advantages of Budgets?
Motivates employees
#3 and managers

Promotes coordination
#4 and communication
Strategy, Planning, and Budgets
Long-run Long-run
Planning Budgets
Strategy
Analysis
Short-run Short-run
Planning Budgets
Time Coverage of Budgets
Budgets typically have a set time
period (month, quarter, year).
This time period can itself be broken
into subperiods.
The most frequently used budget
period is one year.
Businesses are increasingly using
rolling budgets.
Learning Objective 3

Prepare the operating budget

and its supporting schedules.
Operating Budget Example
Hawaii Diving expects 1,100 units to be sold
during the month of August 2004.
Selling price is expected to be $240 per unit.
How much are budgeted revenues for the month?
1,100 × $240 = $264,000
Operating Budget Example
Two pounds of direct materials are budgeted per
unit at a cost of $2.00 per pound, $4.00 per unit.
Three direct labor-hours are budgeted per unit
at $7.00 per hour, $21.00 per unit.
Variable overhead is budgeted at $8.00
per direct labor-hour, $24.00 per unit.
Fixed overhead is budgeted at $5,400 per month.
Operating Budget Example

Variable nonmanufacturing costs are

expected to be $0.14 per revenue dollar.
Fixed nonmanufacturing costs are
$7,800 per month.
Production Budget Example

Budgeted sales (units)

+ Target ending finished goods inventory (units)
– Beginning finished goods inventory (units)
= Budgeted production (units)
Production Budget Example

Assume that target ending finished goods

inventory is 80 units.
Beginning finished goods inventory is 100 units.
How many units need to be produced?
Production Budget Example

Hawaii Diving Production Budget

for the Month of August 2004
Units required for sales 1,100
Add ending inv. of finished units 80
Total finished units required 1,180
Less beg. inv. of finished units 100
Units to be produced 1,080
Direct Materials Usage Budget
Each finished unit requires 2 pounds of direct
materials at a cost of $2.00 per pound.
Desired ending inventory equals 15% of the
materials required to produce next month’s sales.
September sales are forecasted to be 1,600 units.
What is the ending inventory in August?
480 pounds
Direct Materials Usage Budget
September sales: 1,600 × 2 pounds per unit
= 3,200 pounds
3,200 × 15% = 480 pounds
(the desired ending inventory)
What is the beginning inventory in August?
1,100 units × 2 × 15% = 330 units
Direct Materials Usage Budget
How many pounds are needed to produce
1,080 units in August?
1,080 × 2 = 2,160 pounds
Material Purchases Budget
Hawaii Diving Direct Material Purchases
Budget for the Month of August 2004
Units needed for production 2,160
Target ending inventory 480
Total material to provide for 2,640
Less beginning inventory 330
Units to be purchased 2,310
Unit purchase price $ 2.00
Total purchase cost $4,620
Direct Manufacturing Labor Budget
Each unit requires 3 direct labor-hours
at $7.00 per hour.
Hawaii Diving Direct Labor Budget
for the Month of August 2004
Units produced: 1,080
Direct labor-hours/unit 3
Total direct labor-hours: 3,240
Total budget @ $7.00/hour: $22,680
Manufacturing Overhead Budget

Variable overhead is budgeted at $8.00

per direct labor-hour.
Fixed overhead is budgeted at $5,400 per month.
Manufacturing Overhead Budget

Hawaii Diving Manufacturing Overhead

Budget for the Month of August 2004
Variable Overhead:
(3,240 × $8.00) $25,920
Fixed Overhead 5,400
Total $31,320
Ending Inventory Budget

Cost per finished unit:

Materials $ 4
Labor 21
Variable manufacturing overhead 24
Fixed manufacturing overhead 5*
Total $54
*$5,400 ÷ 1,080 = $5
Ending Inventory Budget
What is the cost of the target
ending inventory for materials?
480 × $2 = $960
What is the cost of the target
finished goods inventory?
80 × $54 = $4,320
Cost of Goods Sold Budget

Direct materials used:

2,160 × $2.00 $ 4,320
Direct labor 22,680
Total overhead 31,320
Cost of goods manufactured $58,320
Cost of Goods Sold Budget

Assume that the beginning finished

goods inventory is $5,400.
Ending finished goods inventory is $4,320.
What is the cost of goods sold?
Cost of Goods Sold Budget

Beginning finished goods inventory $ 5,400

+ Cost of goods manufactured $58,320
= Goods available for sale $63,720
– Ending finished goods inventory $ 4,320
= Cost of goods sold $59,400
Nonmanufacturing Costs Budget

Hawaii Diving Other Expenses Budget

for the Month of August 2004
Variable Expenses:
($0.14 × $264,000) $36,960
Fixed expenses 7,800
Total $44,760
Cost of Goods Sold Budget

Hawaii Diving has budgeted sales of

$264,000 for the month of August.
Cost of goods sold are budgeted at $59,400.
What is the budgeted gross margin?
Budgeted Statement of Income

Hawaii Diving Budgeted Income Statement

for the Month ending August 31, 2004
Sales $264,000 100%
Less cost of sales 59,400 22%
Gross margin $204,600 78%
Other expenses 44,760 17%
Operating income $159,840 61%
Cash Budget

Hawaii Diving has the following

collection pattern:
In the month of sale: 50%
In the month following sale: 27%
In the second month following sale: 20%
Uncollectible: 3%
Cash Budget

Budgeted charge sales are as follows:

June $200,000
July $250,000
August $264,000
September $260,000
What are the expected cash collections in August?
Cash Budget

Budgeted Cash Receipts

for the Month Ending August 31, 2004
August sales: $264,000 × 50% $132,000
July sales: $250,000 × 27% 67,500
June sales: $200,000 × 20% 40,000
Total $239,500
Cash Budget
Budgeted Cash Disbursements
for the Month Ending August 31, 2004
August purchases $ 4,620
Direct labor 22,680
Total overhead 31,320
Other expenses 9,760*
Total $68,380
*Other expenses exclude depreciation
Cash Budget
Cash Budget
for the Month Ending August 31, 2004
Budgeted receipts $239,500
Budgeted disbursements 68,380
Net increase in cash $171,120
 What is a Responsibility Center?

It is any part, segment, or subunit of a business that needs control.

– production
– service
Types of Responsibility Centers

Cost center

Investment center

Profit center
Learning Objective 8

Explain how controllability

relates to responsibility
accounting.
What is Controllability?

It is the degree of influence that a specific

manager has over costs, revenues,
or other items in question.
A controllable cost is any cost that is
primarily subject to the influence of a
given responsibility center manager
for a given time period.
Controllability

Responsibility accounting focuses on

information and knowledge, not control.
A responsibility accounting system could
exclude all uncontrollable costs from
a manager’s performance report.
In practice, controllability is difficult to pinpoint.
End of Chapter 4