Chapter 5 – Activity Based Costing:
Activity Based Costing- An overhead cost allocation system that allocates overhead to multiple activity cost pools and
assigns the activity cost pools to products or services by means of cost drivers that represent the activities used.
Reasoning: Products consume activities and activities consume resources. ABC systems are more accurate than normal
costing systems. ABC is particularly useful when product lines differ greatly in volume and manufacturing. ABC
emphasizes the cause-and-effect relationship between cost-allocation base and costs in a cost pool. ABC combines small
homogeneous activities that are likely driven by a common cost driver into a single cost pool.
Note: Cost allocation bases assign indirect costs to cost objects.
Note: An under costed product would consume a high level of resources per unit but is reported to have a low cost per
unit, it is underpriced and may lead to sales that result in losses. If a product is underpriced, they would gain market
share because more customers would want to purchase the under-costed product.
Note: Product-cost cross-subsidization indicates that if a company under costs one of its products, it will definitely over-
cost at least one of its other products.
Note: Current Trends in manufacturing include less direct cost and more overhead.
Activity – Any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or
providing a service.
Activity Cost Pool – A distinct type of activity. For example, ordering materials or setting up
machines. Cost Drivers – Any
factors or activities that have a direct cause-effect relationship with the resources consumed.
ABC Allocation of Overhead: ABC allocates overhead costs in 2 stages: (1) Overhead costs are allocated to activity
cost pools, (2) The overhead costs allocated to the cost pools is assigned to products using cost drivers.
**The more complex a products manufacturing operation, the more activities and cost drivers likely to be present.
Advantages of ABC: Elimination of Under Costing and Over costing, more accurate costing, better pricing, enhanced
profitability or enhanced performance through more refined identification of activities and cost drivers, use of more cost
pools to assign overhead costs, and better management decisions.
Activity Level Classification:
1. Unit Level Activities – Performed for each unit of production, Types of Activities: Drilling, cutting, milling,
assembling etc. Examples of Cost Drivers: Machine Hours, Direct labour hours or cost etc. Note: In the ABC costing
system, direct materials used would typically be classified as a unit level cost.
2. Batch Level Activities – Performed for each batch of production. Types of activities: Equipment set-ups, purchase
ordering, inspection, materials handling. Examples of Cost Drivers: Number of set ups, number of purchase orders,
inspection time etc.
3. Product Level Activities – performed in support of an entire product line, but not always performed every time a
new unit or batch is produced. Types of activities: Product design, engineering changes, Product Line Manager Salaries.
Examples of Cost Drivers: Number of product designs, number of changes.
4. Facility Level Activities – required to support or sustain an entire production/process. Types of activities: Plant
management salaries, Plant depreciation. Examples of Cost Drivers: Number of employees managed, square footage,
etc.
Note: Facility Level Costs are the costs of activities that cannot be traced to individual products or services but that
support the organization as a whole.
Value Added Activities – An activity that increases the perceived value for a product or service such as: engineering
design, machining, assembly, performing surgery, legal research services, etc.
Non Value Added Activities – Any activity that adds cost to, or increases the time spent on, a product/service without
increasing its market value such as: Repair of machines, storage of inventory, moving raw materials, taking
appointments, reception, booking/billing etc.
Activity Flow Charts – are often used to help identify the activities that will be used in ABC costing. Allow
accountants to try and reduce time of non value added activities.
Activity Based Management (ABM) – An extension of ABC from a product costing system to a management function
that focuses on reducing costs and improving processes and decision making. Also sometimes referred to as Cost
Engineering or Strategic Cost Management.
Limitations of ABC: Can be expensive to use, some arbitrary allocations continue.
ABC – When to Use: Use ABC when one or more of the following exist:
Products differ greatly in volume/manufacturing complexity. Product lines are: Numerous, Diverse, require different
degrees of support services. Overhead costs are a significant portion of total costs. Significant change in manufacturing
process or number of products and when managers ignore data from existing system and instead use “Bootleg” Costing
Data.
ABC in Service Industries:
Similarities with Manufacturing Firms: Overall objective (Identify key cost generation activities and keep track of
quantity of activities performed for each service provided, general approach is to identify activities, cost pools and cost
drivers, labelling of activities as VA or NVA, and reduction or elimination of NVAs.
Major Difficulty in Implementing ABC in Service Industries: A larger proportion of overhead costs are company
wide costs that cannot be directly traced to specific services.
Note: The Traditional Costing System allocates overhead using a single predetermined rate. This system was
satisfactory when: direct labour was a major portion of total manufacturing costs and when there was a wide acceptance
of a high correlation between direct labour and overhead costs.
Chapter 5 Formula Summary:
Rate = Cost / Total Driver
Cost Assigned = Rate X Driver Units Per Activity
Indirect Manufacturing Costs = Rate X Driver Units
Total Overhead Costs = Rate * Driver Units
Total Cost = DM + DL + OH
Activity Based Costing:
First → Find the Rate (i.e, Average Cost Per Unit)
Second → Find cost assigned per activity = ∑ (Rate * Driver Units per Activity)
Total Amount of Overhead Allocated = ∑ Costs assigned per Activity
Traditional Based Costing:
Traditional costing is based off one input (Plant Wide Rate). We do not use all activities given like we do in ABC
costing.
First ➔ Rate = Total cost of Activity / Activity Cost Driver
Second→ Total Overhead Costs = Rate X Driver Units
Practice Exam Questions:
1. A product that consumes a relatively low level of resources but is reported to have a relatively high cost, may
result in:
Answer: Product Over Costing
2. Provided a single allocation base is used, jobs are typically under costed if:
Answer: Jobs consume relatively more of the resources than the revenue they bring in.
Explanation: If you use a single allocation base, the job in question may consume a high amount of the base that all
overhead is allocated with. If you use ABC costing, however, overhead is allocated using multiple rates calculated with
different allocation bases. Using a single allocation base would under-cost the job compared to the scenario where ABC
costing is used. Because the product is under costed, the company will sell it for a lower selling price and therefore bring
in less revenue than it should.
3. The term used to describe a situation when at least one “Miscosted” product causes other products to be
“Miscosted” in the organization is known as:
Answer: Product Cost Cross Subsidization
4. In ABC costing, an Activity includes all of the following except:
A) An event; B) A unit of work; C) A process; D) A Task; E) An Indirect Cost
5. A costing system which focuses on individual event or tasks as the fundamental cost objects is called:
Answer: Activity Based Costing (ABC)
6. A Four-part cost hierarchy includes all of the following Except
A) Market Sustaining Costs B) Product Sustaining Costs C) Batch level Costs 4) Output Unit Level Costs E) Facility
Sustaining Costs
Use the Information Below to answer the following two questions:
7. How much of the account inquiry cost will be assigned to Department A?
Answer: 40,000
8. How much of the account billing cost will be assigned to Department B?
Answer: 7,000
9. Stanley corp Manufactures two models of its roasting pans, a standard and a deluxe model. Three activities
have been identified as cost drivers. The Related Cost Pools and the Cost Driver Usage are given below:
If
Activity-based Costing is used, then the total amount of overhead allocated to the deluxe model would
be: Answer: $74,330
Use the following information to answert the next two questions:
Scissors Inc. is a manufacturer of scissors. The company has always used a traditional plant-wide rate for allocating
manufacturing overhead to is products. The plant manager believes it is time to change to a better method of cost
allocation. The accounting department has been able to establish some new relationships between production activities
and the manufacturing overhead. They are as follows:
The previous allocation method is based upon direct manufacturing labour hours, and if that method is used the rate is
$400 per labour hour. A batch of 1,000 scissors was produced. The batch requires 2,000 parts, 20 direct manufacturing
labour hours, and 30 minutes of inspection time.
10. What are the indirect manufacturing costs per scissor assuming the traditional method is used?
Answer: $8.00
11. What are the indrect manufactoring costs for a batch of scissors assuming the ABC method is used and a
batch of 1,000 scissors were produced.
Answer: $8,980
Use The Following Information For the Next Two Questions:
Chris has a custom curtain and chair cover shop. The job costing system was designed using an activity-based approach.
There are two direct cost categories (direct materials and direct labor) and three indirect cost pools. These three cost
pools reprsent three activity areas of work at the shop.
In October Chris made and installed five sets of curtains and chair covers for clients. A set includes curtains for two
windows and coverings for three chairs. The direct labor rate is $20.00 per hour. Cost data for curtains and covers is as
follows:
12. The Cost for a set of Curtains and Chair Covers Would be:
Answer: $2,385
13. The Indirect Costs for the shop in October were:
Answer: $4,350
Note: Sets consist of 3 chairs and 2 curtains. There are 5 orders. Chair assembly and chair materials and chair stiching,
are all 6 pieces per unit, also curtain material and sitching are 1 unit per piece and curtain assembly is 3 hours per unit.
Note: Total Cost = Cost* Set*Units *Orders
14. The use of a single Indirect Cost rate is more likely to:
Answer: Under Cost Low Volume Products
15. In a job-order costing system, the incurrence of indirect labor costs would usually be recorded as a debit to:
Answer: Manufacturing Overhead
16. If Overhead is Underapplied then:
Answer: The amount of overhead cost applied to Work in Process is less than the actual overhead cost incurred.
17. Which of the following is a reason for acceleration in the demand for refinement of costing systems?
Answer: An Increase in Indirect Costs a
18. Feinstein, Inc., an appliance manufacturer, is developing a new line of ovens that uses controlled-laser
technology. The reasearch and testing costs associated with the new ovens is said to arise from a:
Answer: Product Sustaining Activity
19. Vex Corporation manufactures a variety of products. In the past, Vex had been using a traditional overhead
allocation system based on machine-hours. For the current year, Vex decided to switch to an activity-based
costing system using machine-hours and the number of inspections as measures of activty. Information on these
measures of activity and related overhead ratea for the current year are as follows:
Job #812 for the current year requred 15 machine hours and 2 inspections. Would this job have been overcosted
or undercosted under the traditional system and by how much?
Answer: Under costed by $44
20. Which of the following choices correctly depicts a cost that arises from a batch-level activity and one that
arises from a facility level activity?
Answer: Option B
21. Jackson manufactures products X and Y, applying overhead on the basis of labour hours. X, A low volume
product, requires a variety of complex manufactruing procedures. Y, on the other hand, is both ahigh volume
product and relatively simplistic in nature. What would an activity based costing system likely disclose about
products X and Y as a result of Jacksons current account procedures?
Answer: X is Undercosted and Y is overcosted. Explanation: When a single allocation base is used usually the simple
designed high volume products are over costed and the complex low volume products are under costed.
22. Alamo’s custoemer service department follows up on customer complaints by telephone inquiry. The
company produces and sells to different types of products: Product A and Product B. At the beginning of the
month the company estimated 10,000 calls with estimated costs of $300,000. During the period, the customer
service department answered 7,000 calls and incured costs of $203,000. If 2,940 of these calls were related to
Product A, the total costs that should be assigned to Product A is:
Answer: 88,200
Use the following information to answer the next two questions:
Riverside Florists uses an activity-based costing system to compute the cost of making floral Bouqets and delivered the
bouqets to its commercial customers. Company personnel who earn $180,000 typically perform both tasks; other firm-
wide overhead is expected to total 70,000. These costs are allocated as follows:
Riverside anticipate making 20,000 bouqets and 4,000 deliveries in the upcoming year.
23. The cost of wages and salaries and other overhead that would be chaged to each bouqet made is:
24. The cost of wages and salaries and other overhead that would be charged to each delivery is closest to:
Chapter 4 - Process Costing
*Process Costing is used when a large volume of similar products are manufactured/produced over a specified time
period. Costs are Accumulated for a specific time period (a week or a month) and Costs are Assigned to departments or
processes for a set period of time. Ex: Cereal, Automobiles, Paint, etc.
Process Cost System Features:
Work in Process Accounts: One for each Process
Documents Used: Production Cost Reports
Determination of Total Manufacturing Costs: Each Period
Unit Cost Calculation: Total Manufacturing Costs / Units Produced During the period
Equivalent Units of Production – A measure of the work done during the period, expressed in fully completed units.
Used to determine the cost per unit of the completed product.
Equivalent Units Example – Calculate the cost of instruction at XYZ College per full-time equivalent student (FTE)
based on the following information: Total Cost of instruction is $9 Million, student population consists of 900 full time
and 1,000 part time students, Part time students take 60% of the classes of a full-time student.
Full Time Students + Equivalent Units of Part Time Students = Full-Time Equivalent Students
= 900 + (60% X 1,000) = 1,500
Cost of Instruction Per Full Time Equivalent Student = 9 Million/1,500 = $6,000
Equivalent Units – Weighted Average Method: Considers the degree of completion (weighting) of units completed
and transferred out and units in ending work in process (EWIP). Most Widely Used Method. Beginning work in process
is NOT separated as part of the calculation of equivalent units.
Equivalent Units of Production = Units Completed and transferred out + Equivalent Units of
EWIP Conversion Costs
– The sum of direct labour costs and manufacturing overhead costs. Production Cost Report – An internal report for
management that shows both the production quantity an cost data for a production department using process costing.
Uses of production cost report: Basis for evaluating productivity of each department, helps asses reasonableness of unit
costs and total costs, and it aids in judging whether planned objectives are met. Four Steps:
1. Calculate Physical Unit Flow:
Physical Units – Actual Units to be accounting for during a period, regardless of work performed.
Total Units to be Accounted for- Units started (or transferred) into production during the period + Units in production at
the beginning of the period.
Total Units Accounted For – Units Transferred out during period + Units in production at the end of the
period
2. Calculate Equivalent Units of Production
Measure of a departments productivity. Two calculations are required: one for materials and one for conversion costs.
Beginning WIP is ignored
3. Calculate Unit Production Costs
Costs expressed in terms of equivalent units of production. When equivalent units of production are different for
materials and for conversion costs, three-unit costs are calculated: Materials, Conversion, and Total Manufacturing
Unit Material Cost = Total Material Cost / Equivalent Units of Materials
Unit Conversion Cost = Total Conversion Cost / Equivalent Units of Conversion Cost
Total Mfg. Cost Per Unit = Unit Material Cost + Unit Conversion Cost
4. Prepare a cost reconciliation Schedule – Determines costs of goods transferred to the next department. Assigns total
costs to units transferred out and to EWIP. Shows that total costs accounted for equal total costs to be accounted for.
Cost Reconciliation Schedule – A schedule that shows that the total costs accounted for equal the total costs to be
accounted for.
Operations Costing- A combination of a process cost and a job order cost system, in which products are manufactured
mainly by standardized methods, with some customization.
Transferred In Costs – A sequential process where goods are transferred from one department to another requires an
additional cost component called transferred in. Features of this cost component: Percentage of completion factor of 1%,
treated the same way as any other cost component in the calculation of equivalent units of production and the cost per
equivalent unit of production.
FIFO Method – A process costing method in which the cost assigned to the beginning work in process inventory is
separated from current-period production costs. The cost per equivalent unit is related to the current period only. Using
the FIFO method, equivalent units are the sum of the 3 following types of work: (1) Work done to finish the units from
beginning work in process inventory (2) Work done to complete the units started into production during the period (3)
Work done to start, but only partially complete the units in EWIP.
Chapter 4: Formula Summary
BB + Units Started = Units C & T + EB
Units S & C = Units C & T – BB
Units S & C = Units Started – EB
Total Cost = BB Cost + Units Started Cost (Divide by units for per unit)
Debited to WIP = Cost of Units Started DM + Cost of Units Started CC
CC Costs assigned to End WIP = (EB WIP X Completion %) X (CC Cost/ Equivalent Units)
Total Cost Per Equivalent Unit Transferred out = Transferred in Cost per unit + DM cost per Unit + CC cost per
unit
WA Method:
Finding Equivalent Units for DM = All Units Started + All Units BB OR = C&T + EB
Finding Equivalent Units for CC = BB (100%) + S&C (100%) + EB (Completion %) OR =C&T + EB
Use the following information to answer the next 5 Questions:
Father Time Clock Shop uses weighted-average process costing. It utilizes two cost categories: Direct Materials and
Conversion Costs. Each product must pass through the Assembly Department and the testing department. The following
data are related to the Assembly department for the month of June:
1. What are the equivalent units for direct materials and conversion costs, respectively?
Answer: 1050 Units; 1012.5 Units
2. What is the total amount debited to the WIP account during the month of June?
Answer: $2,000,000 (Explanation: Debited To the WIP Acct = DM +CC = 1M+1M = 2M
3. What is the Direct Materials Cost Per Equivalent Unit during June?
Answer: $1,123.81
4. What is the conversion cost per equivalent unit in June?
Answer: $1,254.32
W
5. What amount of conversion costs are assigned to EWIP FOR June?
Answer: $141,111 Explanation: (150 Units X 75%) X $1,254.32 = 141,111
Use the following information to answer the next 2 Questions:
Carnival Furniture had 60,000 foam cushions in process at May 1 (70% Converted) and 40,000 cushions in process at
May 31 (50% Converted). During the month, 140,000 cushions were transferred to finished goods.
6. What is the equivalent units for material costs for May using the Weighted Average
method? Answer: 180,000
Cushions
7. What is the equivalent units for conversion costs for may using the weighted average method?
Answer: 160,000 Cushions
8. All production costs have been steadily rising in the Donner company for several periods. The company
maintains large work in process inventories. Which of the following is correct about the companies Cost of Goods
Completed and Transferred out (C&T) and Cost of EWIP computed using the FIFO method as compared with
weighted average (WA) method.
A) Cost of C&T would be higher under FIFO than that computed under WA B) Cost of EWIP would be higher under
FIFO than WA C) Cost of C&T would be lower under FIFO than WA
D) Both B and C are Correct
Explanation: B and C would be correct because if the costs are rising in the period it would get averaged out over the
units using the WA method. This would mean that the rising costs would be offset by the previous lower costs.
Conversely, under the FIFO method, those costs are identified when they are incurred and are not offset by previous
units. Therefore, the previous units that were completed and transferred would have a lower cost than the newer units
that were not finished and left in WIP. Therefore the FIFO method would have a higher EWIP and lower C&T than
WA.
9. The materials are entered into production at the END of the process in the cracking department. Assume there
have been NO changes in input costs for material, labour or overhead items over the past 2 years. Which of the
following statements is TRUE? A) Equivalent units for DM and CC under FIFO and WA are the same
B) Cost of Goods Transferred out under FIFO and WA are the same C) Cost of Ending Balance of WIP under FIFO and
WA are the same D) B and C are Correct
Explanation: This is because the costs have not changed for two years. Since they would be likely turning over their
inventory more than every two years, all the costs would be the same regardless of the costing method. There is no BB
or EB in the process.
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10. On March 1, Atlanta Company had 20,000 units of WIP in Department A, which were 100% complete as to
material costs and 30% complete as to conversion costs. During March,
150,000 units were started in Department A and 160,000 units were completed and
transferred to Department B. WIP on March 31 was 100% complete as to material costs and
W
50% complete as to conversion costs. By what amount would the equivalent units for
conversion costs for the month of March differ if the FIFO method were used instead of the
weighted-average method?
Answer: 6,000 Decrease
W
11. Lucas Company uses the weighted average method in its process costing system. The company adds materials
at the beginning of the process in the Forming Department, which is the first of two stages in its production
process. Information concerning operations in the Forming Department in October are as follows:
Units Completed and Transferred to the next department during October: 44,000. What was the materials cost of
WIP at October 31?
Use the following Information is for the next 3 Questions:
The Rest-a-Lot chair company manufacturers a standard recliner. During February, the firm's Assembly
Department started production of 75,000 chairs. During the month, the firm completed 80,000 chairs, and
transferred them to the Finishing Department. The firm ended the month with 10,000 chairs in ending inventory.
There were 15,000 chairs in beginning inventory. The FIFO method is used. Beginning work in process was 30%
complete as to conversion costs, while ending work in process was 80% complete as to conversion costs.
12. What were the Equivalent Units for Conversion Costs During February?
Answer: (15,000 X 0.7) + 65,000 + 10,000 (0.8) = 83,500
13.What is the amount of direct materials cost assigned to EWIP at the end of February?
Answer: 168,000/75,000 = 2.24 X 10,000 = 22,400
14. What is the Cost of goods transferred out during Feb?
15. Stay Company uses the weighted-average method in its process costing system. The
company's ending work in process inventory consists of 8,000 units, 60% complete with
respect to materials and 80% complete with respect to labor and overhead. If the total cost in this inventory is
$200,000 and if the cost for materials is $16 per equivalent unit for the
period, the cost of labor and overhead per equivalent unit of the production for the period
must be:
%
%
%
Chapter 8 – Alternative Costing Methods
Absorption Costing- A costing approach in which all manufacturing (All variable and fixed) costs are charged to the
product. Required for external reporting.
Product Costs Under Absorption Costing = Prime Costs + VMOH + FMOH
Period Costs Under Absorption Costing = V S&A + F S&A
Variable Costing- A costing approach in which only variable manufacturing costs are product costs (Direct Materials,
Direct Labour, Variable MOH. Fixed Manufacturing costs are period costs (Expenses). Used for Internal Decision
%
Making.
Product Costs Under Variable Costing = Prime Costs + VMOH
%
Period Costs Under Variable Costing = V S&A + F S&A + FMOH
VC Advantages: Consistent with CVP and Incremental Analysis, Net income unaffected by changes in production
levels, net income closely tied to changes in sales levels – not production levels, and its easier to identify fixed and
variable costs and their effect on the company.
Primary Difference: Under variable costing, fixed manufacturing overhead is an expense in the current period, they do
not defer fixed manufacturing overhead to the future i.e., they are not inventoried.
NI Under Absorption Costing Compared to NI under Variable:
*Income is higher for AC when Units Produced > Units Sold, because cost of ending inventory is higher under AC
then VC because of Fixed manufacturing Overhead
%
* Income is Lower for AC when Units Produced < Units Sold
* Income is Equal when Units Produced = Units Sold
%
Note: Total Manufacturing Costs are almost always higher under absorption costing because fixed manufacturing costs
are product costs under Absorption Costing.
Normal Costing – Is a method for allocating overhead costs using an estimated allocation rate and actual quantity of the
allocation base. Normal costing uses an estimated, rather than actual, denominator level for the overhead cost allocation
base. If an actual denominator level is used information is not timely.
Note: We can reconcile the absorption costing net income to the variable costing net income by concentrating on the
fixed manufacturing overhead in ending inventory.
Throughput Costing – a costing approach in which only direct material costs are product costs. Direct Labour and
Variable and fixed manufacturing costs are period costs (Expenses). Throughput costing income statements are used
%
internally only; useful when most manufacturing costs are NOT variable in the short-run.
Throughput Costing Advantages: Reduces build up of excess inventories in order to spread fixed manufacturing costs
over a larger number of units. Encourages managers to reduce operating costs such as direct labour and variable
overhead, which are treated as period and not Product Costs.
Throughput Contribution Margin – The difference between revenues and direct material costs for the units sold.
Through Put Margin = Sales – COGS (Direct Materials Only)
%
Chapter 8 Formula Summary:
Prime Costs = DM +DL
Per Unit Variable Manufacturing Costs = Total VC – VS&A
Per Unit FOH=Total Manufacturing Costs – Variable Manufactu
%
%
ROI Budgeted = Budgeted NI / Budgeted Invested Amount
Absorption Cost Approach
1. Only Include Manufacturing costs in the Cost Base Part
2. Include ROI and S&A Costs in the Markup Part
Manufacturing Costs = DM + DL + FMOH +VMOH
Markup Costs = ROI + VS&A + FS&A
Variable Cost Approach
1. Only Include Variable costs in the cost base.
2. Include ROI and Fixed Costs in the Markup base.
Manufacturing Costs = DM + DL + VMOH + VS&A
Markup Costs = ROI + FMOH + FS&A
Transfer Price:
With no excess capacity → Deciding how much company A will accept, it will be equal or higher then there minimum
transfer price to outside consumers.
Minimum Transfer Price = Selling Price to Outside Buyers
Selling Within excess capacity → Deciding how much company A will accept, it will be equal to the variable
manufacturing cost. (Be cautious about VS&A)
Selling Over our Excess Capacity → Deciding how much company A will accept, follow the two step process (1)
Transfer the remaining excess capacity over to company B ONLY CHARGING VARIABLE COST. (2) Transfer the
used units over to company B CHARGIN BOTH OPPORTUNITY COST AND VARIABLE COST.
Opportunity Cost = Number of Units X CM
CM = Selling Price – Variable Costs (i.e., VS&A +
VMOH)
Practice Questions:
1. In most cases, a company sets the price instead of it being set by the competitive market.
Answer: FALSE → In most cases, a company does not set the prices. Instead, the price is set by the competitive market.
2. In a competitive market, a company is forced to act as a price taker and must emphasize minimizing and
controlling costs.
Answer: TRUE
3. Using the negotiated transfer pricing approach, a minimum transfer price is established by the selling division.
Answer: True
4. There are two approaches for determining a transfer price: Cost-Based and Market-Based.
Answer: False → There are three different approaches for determining a transfer price, which are negotiated, cost-based
and market-based approaches.
5. If a cost-based transfer price is used, the transfer price must be based on variable cost.
Answer: FALSE → If a company uses a cost-based transfer price, the transfer price may be based on variable costs
alone, or on variable costs plus fixed costs.
6. A Problem with a cost-based transfer price is that it does NOT provide adequate incentive for the selling
division to control costs.
Answer: TRUE
7. In Cost-plus pricing, the target selling price is calculated as:
Answer: Total Unit Cost + Desired ROI Per Unit
8. The following per unit information is available for a new product of Blue Ribbon Company: Desired ROI $15,
Fixed Cost $50, Variable Cost $100, Total Cost $150, Selling Price $165. Blue Ribbon Company’s mark-up
percentage would be?
9. Bryson Company has just developed a new product. The following data are available for this product: Desired
ROI Per Unit = $40, Fixed Cost Per Unit =$60, Variable Cost Per Unit = $90, Total cost per unit = $150. The
Target Selling Price for this product is?
10. Hen Company has developed a new product, egg crates that prevent breakage. The cost per crate is $50 and
the company expects to sell 1,000 crates per year. Hen Company has invested $1,000,000 in equipment to produce
the crates and desires a 10% return on investment. What is Hen Company’s selling price for one egg crate?
Use the following Information to answer Questions 11-15 Below:
Division A produces a product that it sells to the outside market. It has compiled the following:
11. Division B of the same company is currently buying an identifcal product from an outside provider for $38
per unit. It wishes to purchase 5,000 units per year from Division A. Division A is currently selling 30,000 units of
the product per year. If the internal transfer is made, Division A will not incur any selling costs. What would be
the minimum transfer price per unit that Division A would be willing to accept?
12. Division B of the same company is currently buying an identical product from an outside provider for $38 per
unit. It wishes to purchase 5,000 units per year from Division A. Division A is currently selling 25,000 units of the
product per year. If the internal transfer is made, Division A will not incur any selling costs. What would be the
minimum transfer price per unit that Division A would be willing to accept?
13. Division B of the same company is currently buying an identical product from an outside provider for $38 per
unit. It wishes to purchase 5,000 units per year from division A. Division A is currently selling 25,000 units of the
product per year. If the internal transfer is made, Division A will not incur any selling costs. What would be the
maximum transfer price per unit that Division B would be willing to accept?
14. Division B of the same company is currently buying an identical product from an outside
provider for $38 per unit. It wishes to purchase 5,000 units per year from Division A. Division Ais currently
selling 25,000 units of the product per year. If the internal transfer is made, Division A will not incur any selling
costs. At what price would the internal transfer occur?
Answer: It depends on the negotiation skills of the division managers
15. Division B of the same company is currently buying an identical product from an outside
provider for $38 per unit. It wishes to purchase 5,000 units per year from Division A. Division A is currently
selling 26,000 units of the product per year. If the internal transfer is made, Division A will not incur any selling
costs. What would be the minimum transfer price per unit that Division A would be willing to accept?
16. The current selling price for the Pluto, a mid-sized car, is $19,000. For next year it is anticipated that Pluto
will have a $12,000 cost base. What is its prospective selling rpice, using cost-plus pricing, if the company desires
a markup component of 15 percent?
Use the Following Information to answer Questions 17-19 Below:
Sheltar’s TV currently sells small televisions for $180. It has costs of $140. A competitor is bringing a new small
television to market that will sell for $150. Management believes it must lower the price to $150 to compete in the
market for small televisions. Makreting velieves that the new price will cause sales to increase by 10% even with a new
competitor in the market. Sheltar’s sales are currently 100,000 televisions per year.
17. What is the Target Cost if Target operating income is 25% of sales?
Answer: $150 – ($150*0.25) = $112.50
18. What is the change in operating income if marketing is correct and only the sales price is changed?
19. What is the target cost if the company wants to maintain its same income level, and marketing is correct
(round to the nearest cent)?
20. Ellingson Company has budgeted sales of $487,500 with the following budgeted costs:
Compute the target profit percentage for setting prices as a percentage of: (a) Total Manufacturing costs (b)
Total variable costs (c)Total Costs
Chapter 10 – Budgeting:
Budget- A formal written statement, in financial terms, of management’s plans for a specified future time period.
Primary way to communicate agreed-upon objectives to all parts of the company. Promotes efficiency. “Control
Device”- important basis for performance evaluations once adopted. The budget and its administration are managements
responsibility.
Budget Committee – A group responsible for coordinating the preparation of the budget.
Benefits of Budgeting: Requires all levels of management to plan ahead and formalize goals on a recurring basis,
provides definite objectives for evaluating performance at each level of responsibility, Creates an early warning system
for potential problems, facilitates coordination of activities within the business, results in greater management awareness
of the entity’s overall operations and the impact of external factors, and motivates personnel throughout the organization
to meet its planned objectives.
Budgeting Basics: A budget is an aid to management NOT a substitute for Management. An Effective Budget depends
on a sound organizational structure with authority and responsibility for all phases of operations clearly defined, is based
on research and analysis with realistic goals and is accepted by all levels of management.
Budget Period: May be prepared for any period of time (most common 1 year). Must be long enough to provide an
attainable goals and minimize seasonal or cyclical fluctuations and short enough for reliable estimates.
Note: The “Continuous 12 Month Budget” is used by dropping the month that just ended and adding a future month.
This keeps management planning for at least one full year ahead.
Budgeting Basics – Process: Base budget goals on past performance. Collect data from organizational units. Begins
several months before end of the current year. Develop budget within the framework of a sales forecast, factors
considered in sales forecasting include: general economic conditions, industry trends, market research studies etc.
Usually informal in small companies. Assigned to a Budget Committee in larger companies.
Participative Budgeting – a budgetary approach that starts with input from lower-level managers and works upward so
that managers at all levels participate. Its goal is to produce a budget considered fair and achievable by managers while
still meeting corporate goals. * There is a risk of unreliable budgets when they are “top-down”.
Advantages: More accurate budget estimates because lower-level manages have more detailed knowledge of their area,
tendency to perceive process as fair due to involvement of lower level management.
Disadvantages: Can be time consuming and costly, can foster budgetary gaming through budgetary slack (a situation
where managers intentionally under-estimate budgeted revenues or overestimate budgeted expenses so that budget goals
are easier to meet.
Budgetary Slack – the amount by which a manager intentionally underestimates budgeted revenues or overestimates
budgeted expenses in order to make it easier to achieve budgetary goals.
Budgeting Vs Long Range Planning:
Budgeting – Short term, usually one year, achievement of short term specific goals, very detailed.
LRP – Usually at least 5 years, identifies goals, select strategies, policies to implement strategies. Less Detailed.
Master Budget – A set of interrelated budgets that constitutes a plan of action for a specified time period. Contains two
Classes of Budgets: (1) Operating Budgets & (2) Financial Budgets.
Operating Budgets - Individual budgets that result in the preparation of the budgeted income statement – Establish
goals for sales and production Personnel. (Sales budget, production budget, direct materials budget, direct labour budget,
MOH budget, and S & A expense budget.
Financial Budgets – The capital expenditures budget, the cash budget, and the budgeted balance sheet - focus primarily
on cash needs to fund operations and capital expenditures.
Note: The Budgeted Balance Sheet is defined as an estimate of the expected profitability of operations for the budget
period. Developed from the Budgeted balance sheet for the preceding year and the budgets for the current year.
Sales Budget – an estimate of the expected sales for the budget period. First Budget prepared, derived from the sales
forecast. **Every Other budget depends on the sales budget.**Prepared by multiplying expected unit sales volume for
each product and anticipated unit selling price.
Production Budget – a projection of the units that must be produced to meet expected sales. Derived from sales budget
plus the desired change in ending finished goods (ending finished goods less the beginning finished goods units).
Required Production units = Budgeted Sales Units + Desired Ending finished goods units – Beginning finished
goods units
Direct Materials Budget – an estimate of the quantity and cost of direct materials to be purchased. Derived from the
direct materials units required for production (from the production budget) plus the desired change in ending direct
materials units.
Required Direct Materials Units to be Purchased = Direct Materials for Units required for production + Desired
Ending Direct Materials Units – Beginning Direct Materials Units
Direct Labour Budget - Shows both the quantity of hours and cost of direct labour necessary to meet production
requirements. Critical in maintaining a labour force that can meet expected production goals.
Total Direct Labour Cost = Units to be Produced X Direct Labour Time Per Unit X Direct Labour Cost Per
Hour
Manufacturing Overhead Budget – An estimate of expected MOH costs for the budget period. Shows the expected
manufacturing overhead costs for the budget period. Distinguishes between fixed and variable overhead costs.
Selling and Administrative budget - A projection of expected selling and administrative expenses for the budget
period. Distinguishes between fixed and variable costs.
Budgeted Income Statement – Important end product of the operating budgets. Indicates expected profitability of
operations. Provides basis for evaluating company performance. Prepared from the operating budgets
Note: To find COGS on the Budgeted IS, determine the total unit cost and multiply it by the units sold.
Cash Budget – A projection of anticipated cash flows. Often considered to be the most important output in preparing
financial budgets. Contributes to more effective cash management, shows managers need for additional financing before
actual need arises, and indicates when excess cash will be available. Shows beginning and ending cash balances. Often
prepared for the year on a monthly basis. Contains three sections that must be prepared in
sequence: (1) Cash
Receipts – Includes expected receipts from the principal sources of revenue – usually cash sales and collections on
credit sales. Shows expected interest and dividend receipts, as well as proceeds from planned sales of investments, plant
assets, and capital stock. (2)
Cash Disbursements - Includes expected cash payments for direct materials and labour, overhead, taxes, dividends ,
plant assets, etc.
(3) Financing – shows expected borrowings and repayments of borrowed funds plus interest.
Note: Ending Cash Balance of one period = Beginning Cash Balance for next Period.
Budgeting – Merchandisers: The sales budget is the starting point and key factor in developing the master budget.
Merchandisers use a purchases budget instead of a production budget. Do NOT use manufacturing budgets (DMs, DL
and MOH). To determine budgeted merchandise purchases:
Required Merchandise Purchases = Budgeted COGS + Desired Ending Merch Inventory – Beginning Merch
Inventory
Budgeting – Service Firms: Critical factor in budgeting is coordinating professional staff needs with expected services.
Problems if Overstaffed: Disproportionately high labour costs, lower profits due to additional salaries, and increased
staff turnover due to no challenging work. Problems if Understaffed: Lost Revenue because existing and prospective
client needs for service cannot be met, and loss of professional staff due to excessive work loads.
Budgeting – Not for Profit Firms: Important process that differs significantly form that of a profit oriented company.
Budget on the basis of cash flows (expenditures and receipts), rather than on a revenue and expense basis. The starting
point is expenditures, not receipts, Significantly different activity index.
Chapter 10 Formula Summary:
Ending Inventory = Beginning Inventory + Produced – Sales
Items Needed = Ending Inventory + Purchases – Sales
Items Produced = Items Needed – Items on Hand
Ending Cash Balance = Begin Balance + Cash in – Cash out
Borrowing Requirement = Minimum Balance – Ending Balance
Finding Direct Materials for a month:
1. Determine the production budget for the month
2. Determine the DM purchase for the month
3. Determine the DM cost for the month.
Practice Questions:
1. For next year Flex Steel company has budgeted sales of 40,000 units, target ending finished goods inventory of
2,000 units, and a beginning finished goods inventory of 1,200 units. All other inventories are zero. How many
units should be produced?
2. Randy Company has budgeted sales of 12,000 units, target ending finished good inventory of 2,000 units and a
beginning finished goods inventory of 600 units. How many units should be produced?
Use the information below to answer the following two questions:
Layne Cedar manufactures cedar chests. The estimated number of chests for the first three months of 2007 is as follows:
Finished Goods inventory at the end of December is 3,000 units. Ending finished goods are equal to 30% of next
month’s sales. April 2007 sales are expected to total 16,000 Units.
3. What will be the number of chests produced in January 2007?
4. How many chest will be produced in the first quarter of 2007?
5. Boone Hobbies, a wholesaler, has a sales budget for next month of $600,000. Cost of units sold is expected to be
40 percent of sales. All units are paid for in the month following purchase. The beginning inventory of units is
$20,000, and an ending amount of $24,000 is desired. Beginning accounts payable is $152,000.
Use the Information Below to Answer the following three questions:
6. Cash Collections for September are:
7. What is the ending balance of accounts receivable for Septemeber assuming uncollectible balance is written off
after the second month?
8. Cash Collections for October Are:
Use the Following Information to answer the next two questions:
Noel Enterprises has budgeted sales in units for the next five months as follows: June → 6800 Units, July → 5400
Units, August → 7200 Units, September→4600 Units , October→ 3800 Units. Past experience has shown that the
ending inventory on May 31 contained 400 units. The company needs to prepare a production budget for the second
quarter of the year.
9. The Total Number of Units to be produced in July is:
10. The Desired Ending Inventory for August is:
Use the following information to answer the next two questions:
Sarter Corporation is in the process of preparing its annual budget. The following beginning and ending inventory levels
are planned for the year.
Each Unit of Finished Goods requires 3 grams of raw material. The company plans to sell 880,000 units during the
year. 11. The number of units the
company would have to manufacture during the year would be:
12. How much of the raw material should the compant purchase during the year?
13. Parlee Company’s sales are 30% in cash and 70% on credit. Sixty percent of the credit sales are collected in
the month of the sale, 25% in the month following sale, and 12% in the second month following the sale. The
remainder is uncollectible. The following are budgeted sales data:
What would be the budgeted total Cash Reciepts in April?
14. The Waverly Company has budgeted sales for next year as follows:
The ending inventory of finished goods for each quarter should equal 25% of the next quarters budgeted sales in
units. The finished goods inventory at the start of the year is 3,000 units. What should be the schedule production
for the third quarter?
15. Looker Hats is Planning to sell 1,000 felt hats, and 800 will be produced during June. Each hat equires 0.75
meters of felt and ½ of direct labour. Felt costs $5.000 per meter and employees of the company are paid $15 per
hour. How much is the total amount of budgeted direct labour for June?
16. Leak Company sells only on credit. It reported the following information for 2016:
Customer amounts on account are collected 45% in the month of the sale and 55% in the following month. How
much is the November 30, 2016 Budgeted Accounts Receivable?
17. Sundy Company provided the following information for the month of August:
Sundy borrowed $15,000 and repaid $16,000 during the month. How much will Sundy’s report on its budgeted
balance sheet at August 31 for cash?
Chapter 11 – Budgetary Control and Responsibility Accounting:
Budgetary Control – the use of budgets to control operations. Takes place by means of budget reports which compare
actual results with planned objectives. Provides management with feedback on operations. Works best when a company
has a formalized reporting system which: identifies the name of the budget report (such as the sales budget or the MOH
budget), states the frequency of the report (weekly or monthly), specifies the purpose of the report, indicates recipient of
the report. FEEDBACK LOOP
Static Budget Reports – A projection of budget data at one level of activity. Ignores data for different levels of activity.
Always compares actual results with the budget data at the activity level used in the master budget. Appropriate for
evaluating a managers effectiveness in controlling costs when: Actual level of activity closely approximates the master
budget activity level and/or behaviour of the costs is fixed in response to changes in activity. Appropriate for Fixed
costs. NOT appropriate for variable costs.
Note: If the difference between the budgeted amount and actual amount is negative it is considered unfavourable and
vice versa. (ex: Actual – Budgeted = Negative → Unfavourable).
Flexible Budget – A project of budget data for various levels of activity. Essentially, a series of static budgets at
different activity levels. This budgetary process is more useful if it is adaptable to changes in operating conditions. Can
be prepared for each type of budget in the master budget.
Steps in Developing the Flexible Budget:
1. Identify the activity index and the relevant range of activity W
2. Identify the variable costs and determine the budgeted variable cost per unit of activity for each cost.
3. Identify the fixed costs and determine the budgeted amount for each cost.
4. Prepare the budget for selected increments of activity within the relevant range.
Total Budgeted Costs = Fixed Costs + (Total VC X Activity Level)
Flexible Budget Report – A type of internal report, consists of two sections (1) production data for a selected activity
index, such as direct labour hours (2) Cost data for variable and fixed reports. Widely used in production and service
departments to evaluate a managers performance in production control and cost control.
Responsibility Accounting – a part of management accounting that involves accumulating and reporting revenues and
costs that relate to the manager who has the authority to make the day-to-day decisions. Managers performance is
evaluated on the matters directly under the managers control “Controllability Principle”. There are different levels of
responsibility. Responsibility accounting is especially valuable in a decentralized company with control of operations
delegated to many managers throughout the organization. Applies to both profit and non-profit entities (Profit:
Maximize Net Income, Not For Profit: Minimize cost of providing service).
Conditions for using responsibility accounting: Costs and revenues can be directly associated with the specific level
of management responsibility. The costs and revenues are controllable at the level of responsibility with which they are
associated. Budget data can be developed for evaluating the manager’s effectiveness in controlling the costs and
revenues.
Responsibility Center – any individual who has control and is accountable for specific decisions.
Controllable Vs Non-Controllable Costs: All costs are controllable by top management but fewer costs are
controllable as one moves down to lower levels of management.
Controllable Costs- Cost incurred directly by a level of responsibility that are controllable at that level; costs that a
manager has the authority to incur withing a specific time period.
Non-Controllable Costs – Costs that are incurred indirectly and are allocated to a responsibility center that cannot
control them.
Responsibility Reporting System: Involves preparation of a report for each level of responsibility in the companies
organization chart. Begins with the lowest level of responsibility and moves upward to higher levels, permits
management by exception at each level of responsibility, permits comparative evaluations, plan manager can rank the
department managers effectiveness in controlling manufacturing costs, and comparative ranking provides incentive for a
manager to control costs.
Types of Responsibility Centers:
1. Cost Centers – responsible for expenses. Example: Production Center or Service Department 2. Profit Centers –
Responsible for Revenue and Expenses. Example: Retail store or Bank Branch 3. Investment Centers – Responsible
for revenue, expenses, and ROI. Ex: Subsidiary Company
Responsibility Accounting – Cost Centers: Based on a managers ability to meet budgeted goals for controllable costs.
Results in responsibility reports which compare actual controllable costs with flexible budget data: Include only
controllable costs in reports, No distinction between variable and fixed costs.
Responsibility Accounting – Profit Centers: Based on detailed information from broth controllable revenues and
controllable costs. Manager controls operating revenues earned, such as sales. Manager controls all variable costs (and
expenses) incurred by the center because they vary with sales. May have both direct and indirect fixed costs.
Note: Direct fixed costs also called traceable costs relate specifically to a responsibility center and are incurred for the
sole benefit of the center and are mostly controllable by the profit center manager, and indirect fixed costs pertain to a
companies overall operating activities and are incurred for the benefit of more than one profit center and they are mostly
not controllable by the profit center manager.
Responsibility Accounting – Investment Centers (ROI): ROI shows the effectiveness of the manager in utilizing the
operating assets at his or her disposal. ROI is calculated as follows:
ROI = Controllable Margin / Avg Operating Assets
Note: Operating Assets include current assets and plant assets used in operations by the center, Exclude non operating
assets such as idle plant assets and land held for future use. Base average operating assets on the beginning and ending
cost or book value of the assets. Performance Evaluation Various Criteria: Net Income
(Overinvestment problem), ROI (Underinvestment Problem), and Residual Income (Scale Problem).
Judgemental Factors in ROI:
Valuation of Operating Assets – may be valued at acquisition cost, book value, appraised value, or market value.
Margin (Income) Measure – May be controllable margin, income from operations or net income.
Improving ROI: Return on Investment can be improved by increasing the controllable margin or reducing average
operating assets.
Expanded Formula for ROI: ROI = (Operating income/sales) X (Sales / Operating Assets) which is essentially ROI =
Profit Margin X Investment Turnover
Disadvantage of Using ROI to evaluate performance: ignores the minimum rate of return on operating assets (rate at
which costs are covered and a profit is earned). ROI can be misleading by rejecting a project that actually increases
income.
Note: Profit margin shows how the operating margin can be improved by increasing the margin on each dollar of sales.
Investment turnover shows how investment turnover can be improved by generating more sales for each dollar invested.
Residual Income – The income that remains after subtracting from controllable margin the minimum rate of return on
average operating assets. Use the residual income approach to evaluate performance using the minimum rate of return.
Residual Income Weakness: attempting to evaluate a company only on maximizing residual income ignores the fact
that one division might use substantially fewer assets to attain the same level of residual income. %
Economic Value Added (EVA) – The after-tax controllable margin minus the weighted average cost of the total capital W
used.
Chapter 11 Formula Summary:
Residual Income = Operating Income – (Total Assets X Min required Rate of Return)
ROI = Operating Income/Total Assets
ROI = Return on Sales X Asset Turnover
ROI = Operating Income / Avg Operating Assets
Return on Sales = Net Income / Sales
Margin = Operating Income / Sales
Investment Turnover = Sales / Average Operating Assets.
Chapter 12 – Standard Costs and Balanced Scorecard: W
Note: Standards are common in business and are often imposed by the government (and called regulations)
Standard Costs – Predetermined unit costs that are used as measures of performance. W
Standards Vs Budgets:
Standards and Budgets are both predetermined costs and a part of management planning and control. **However, A W
standard is a Unit amount whereas a Budget is a Total amount. Budget data is not journalized in cost accounting
systems, Standard costs may be incorporated into a cost accounting system.**
Standards – Advantages: Facilitate management planning, promote greater economy by making employees more
“cost-conscious”, help set selling prices, contribute to management control by providing basis for evaluation of cost
control and help highlight variances in management by exception, and simplify costing of inventories and reduce
clerical costs.
Setting Standard Costs: Requires input from all persons who have responsibility for costs and quantities. Standard
costs need to be current and should be under continuous review. There are two levels of standard costs: (1) Ideal
standards represent optimum levels of performance under perfect operating conditions & (2) Normal standards
represent efficient levels of performance attainable under expected operating conditions (Rigorous but Attainable). W
Direct Materials Price Standard – the cost per unit of direct materials that should be incurred. Based on the
purchasing departments best estimate of the cost of raw materials. Includes related costs such as receiving, storing, and
handling.
Direct Materials Quantity Standard – the quantity of direct materials that should be used per unit of finished goods.
Based on physical measure such as pounds, barrels, etc. Considers both the quantity and quality of materials required. W
Includes allowances for unavoidable waste and normal spoilage.
Standard DM cost per unit = Standard DM Price X Standard DM Quantity
Direct Labour Price Standard – Rate per hour that should be incurred for direct labour. Based on current wage rates
adjusted for anticipated changes, such as cost of living adjustments (COLA). Includes employer payroll taxes, and
benefits such as holidays and paid vacation.
Direct Labour Quantity Standard – Time that should be required to make one unit of the prod
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