ACCCOB3

Term 1, A.Y. 2021 - 2022

1.0 Financial vs. Managerial Accounting

Work of Management
● Planning
○ Establish goals → Specify how goals will be achieved → Develop budgets
● Controlling
○ Gathers feedback to ensure that plans are being followed
○ Feedback in the form of performance reports that compare actual results with the
budget are an essential part of the control function
● Decision Making
○ Involves making a selection among competing alternatives
○ What should we be selling? Who should we be serving?
● Management Accounting focuses on teaching measurement skills that managers use
to support planning, controlling, and decision making activities

Big Data
● Refers to large collections of data that are gathered from inside or outside a company to
provide opportunities for ongoing reporting and analysis
● The 5 V’s of Big Data
○ Variety — data formats in which information is stored
○ Volume — the continuously expanding quantity of data that companies must
gather, cleanse, and organize
○ Velocity — the rate at which data is received and acted on by organizations
○ Value — time and money organizations expand to analyze Big Data
 ○ Veracity — users expect their data to be accurate and trustworthy
Data Analytics
● Process of analyzing data with the aid of specialized system and software to draw
conclusions about the information they contain
● Managers often communicate the findings from their data analysis to others through the
use of data visualization techniques such as graphs, charts, maps, diagrams
● Can be used for descriptive, diagnostic, predictive and prescriptive purposes

Institute of Management Accountant (IMA) Code of Ethics

● Competence
○ Recognize and communicate professional limitations that preclude responsible
judgment and maintain professional competence
○ Provide accurate, clear, concise, and timely decision to support information
○ Follow applicable laws, regulations, and standards
● Confidentiality
○ Not disclosing confidential information unless legally obligated to do so
○ Not using confidential information for unethical or illegal advantage
○ Ensure that subordinates do not disclose such information
● Integrity
○ Mitigate conflicts of interest and advise others of potential conflicts
○ Refrain from conduct that would prejudice carrying out duties ethically
○ Abstain from activities that might discredit the profession
● Credibility
○ Communicate information fairly and objectively
○ Disclose delays or deficiencies in information timeliness, processing, or internal
controls
○ Disclose all relevant information that could influence a user’s understanding of
reports and recommendations

Why have ethical standards?

● Essential for a smooth functioning economy
● Without it, the economy and all of us who depend on it would suffer
● Lead to lower quality of life with less desirable goods and services at higher prices

Strategy
● A game plan that enables a company to attract customers by distinguishing itself
● Focal point of a company’s strategy = target customers

Customer Value Propositions

● Customer Intimacy Strategy — understand and respond to individual customer needs
● Customer Excellence Strategy — delivery products faster and at cheaper prices
● Product Leadership Strategy — offer higher quality products
Enterprise Risk Management
● Used by companies to proactively identify and manage risk
● Common risk management tactic = reduce risk by implementing specific controls

● Internal Controls for Financial Reporting

A Corporate Social Responsibility (CSR) Perspective

● CSR — organizations and firms consider the needs of all stakeholders
● Extends beyond legal compliance to include voluntary actions that satisfy stakeholder
expectations

A Process Management Perspective

● Business Process — series of steps that are followed in order to carry out tasks
● R&D → Design → Manufacturing → Marketing → Distribution → Customer service
● Lean Production or Just-in-Time (JIT) Production
○ Creating products when an order is made
○ Contrast to traditional manufacturing, which produces goods in anticipation of
sales
● Benefits of Lean Production
○ Number of units produce tends to equal number of units sold
○ Results in fewer defects, less wasted effort, quicker customer response
Leadership
● Organization leaders unite the behavior of employees around two common themes:
pursuing strategic goals and making optimal decisions
● Factors that Influence Behavior
○ Intrinsic motivation
○ Extrinsic incentives
○ Cognitive bias
2.1 Cost Concepts

Assigning Costs to Cost Objects

● Direct Cost — costs that can be easily traced to a specified cost object
○ Example: Salary of a sales manager in its Tokyo office
● Indirect Cost — costs that cannot be easily traced to a specific cost object
○ Example: Factory manager’s salary for a particularly variety, like soup
○ Common Cost — cost cost that is incurred to support a number of cost objects
but cannot be traced to them individually
● Particular costs may be direct or indirect, depending on the cost object
● While the factory manager’s salary is an indirect cost of manufacturing chicken noodle
soup, it is a direct cost of the manufacturing department

Costs in Manufacturing Companies

Manufacturing Costs
● Direct Materials — raw materials that go into the final product; costs that can be
conveniently traced to the finished product
○ Example: Seats for a commercial aircraft
● Direct Labor — labor costs that can be easily traced to individual units of product; also
known as touch labor
○ Example: Assembly-line workers at Toyota
● Manufacturing Overhead — all manufacturing costs except direct materials and direct
labor; are indirect costs because they cannot be directly traced
○ Also known as indirect manufacturing cost, factory overhead, etc.
○ Indirect Materials — raw materials; e.g. glue used to assemble a chair
○ Indirect Labor — janitors, maintenance workers, security guards
○ Includes costs such as depreciation, utility costs, property taxes, and insurance
○ Only indirect costs associated with operating the factory are included
● Conversion Cost — sum of direct labor and manufacturing overhead
○ Costs that are incurred to convert direct materials into finished products

Nonmanufacturing Costs
● Also often called selling, general, and administrative (SG&A)
● Selling Costs — costs incurred to secure customer orders and get the finished product
to the customer; also known as order-getting or order-filling
○ Includes advertising, shipping, travel and commissions, salaries, and costs of
finished goods warehouses
○ Direct Selling Costs — advertising campaign for a specific product
○ Indirect Selling Costs — salary of a marketing manager
● Administrative Costs — costs associated with the management of an organization
 ○ Includes executive compensation, accounting, legal counsel, public relation
○ General administration of the organization as a whole
○ Direct Administrative Costs — salary of an accounting manager in a specific
region
○ Indirect Costs — salary of a chief financial officer who oversees all regions with
respect to individual regions

Preparing Financial Statements

Product Costs
● Costs involved in acquiring or making a product; also known as inventoriable costs
● “Attached” to a unit of product; stays attached to each unit of product as long as it
remains in inventory awaiting sale
● When sold, these costs are released from inventory as expenses (cost of goods sold)
● Includes direct materials, direct labor, and manufacturing overhead
● Manufacturing costs are recorded on the balance sheet
● Three Types of Manufacturing Product Costs
○ Raw Materials — any materials that go into the final product
○ Work in Process — only partially complete; require further work
○ Finished Goods — completed units of product that have not yet been sold
● Process of Costs
○ Direct Materials: Raw Materials → Work in Progress
○ Direct Labor & Manufacturing Costs: Work in Progress → Finished Goods
○ Finished Goods: Finished Goods → Cost of Good Sold (CoGS)
● Recorded as expenses in the period the products are sold

Period Costs
● Costs that aren’t product costs; selling and administrative expenses
● Not included as part of the cost of either purchased or manufactured goods
● Expensed on the income statement in the period in which they are incurred
Predicting Cost Behavior
● Cost behavior refers to how a cost reacts to changes in the level of activity
● Cost structure is the relative proportion of fixed, variable, and mixed costs in a business

Variable Cost
● Varies, in total, in direct proportion to changes in the level of activity
○ Example: Cost of goods sold, direct materials and labor, commissions, etc.
● Must be variable with respect to something; something = activity base
○ Activity Base — measure of whatever causes the incurrence of a variable cost;
referred to as a cost driver
■ Example: Direct labor-hours, units produced and sold, etc.
■ Assume that it is the total volume of goods and services
● Remains constant per unit; varies for the total

Fixed Cost
● Cost that remains constant, in total, regardless of changes in the level of activity
○ Example: depreciation, insurance, property taxes, rent, salaries
● The same unless influenced by some outside force
● Remains constant for the total; varies per unit
● Caution against expressing fixed costs on an average per unit basis; creates a false
impression that fixed costs are like variable costs
● Committed Fixed Costs — represent long-term costs that can’t be significantly reduced
even for short periods of time; real estate taxes, insurance, etc.
○ Remain largely unchanged in the short term; costs of restoration are likely to be
far greater than any short-run savings that might be realized
● Discretionary Fixed Costs — managed fixed costs; arise from annual decisions;
includes advertising costs, research, public relations, etc.
○ Can be cut for short periods of time with minimal damage to the long-run goals of
the organization
● Linearity Assumption and the Relevant Range
○ Fixed costs are not always linear
○ Relevant Range — range of activity wherein the assumption is that cost behavior
is said to be linear

Decision Making
● Relevant Costs & Benefits — should be considered in making decisions
● Irrelevant Costs & Benefits — should be ignored in decision making
● Differential Cost & Revenue
○ Differential Cost — incremental cost; always relevant costs; a future cost that
differs between any two alternatives
○ Differential Revenue — future revenue that differs between two choices
 ○ Similar to the economist’s marginal cost and marginal revenue concept
○ Can be either fixed or variable
● Opportunity Cost — the potential benefit that is given up when one alternative is
selected over another
○ Not usually found in accounting records
○ Are relevant costs that must be explicitly considered in every decision made
● Sunk Cost — cost that has already been incurred and that cannot be changed by any
decision made now or in the future
○ Are irrelevant costs and should be ignored
● Controllable Cost — can be influenced by the manager being evaluated
● Uncontrollable Cost — cannot be influenced by the manager being evaluated
● Value-added Cost — increases the value of products and services provided to the
company’s stakeholders,
● Non-value-added Cost — does not provide any benefit to the company’s stakeholders
2.2 Cost Classifications

Traditional Income Statements

● Are prepared primarily for external reporting purposes
● Rely on cost classifications for preparing financial statements (product and period costs)
to depict the financial consequences of past transactions
● Emphasis on recording past performance

Contribution Format Income Statement

● Are prepared for internal management purposes
● Use cost classifications for predicting costs behavior (variable and fixed costs) to better
inform decisions affecting the future
● Emphasis on making predictions and decisions that affect future performance
● Contribution Margin — the amount remaining from sales revenues after all variable
expenses have been deducted

Income Statement Differences

● Traditional Format
○ Divides costs by product costs (cost of goods sold) and period costs (selling and
administrative)
● Contribution Format
○ Divides costs by variable costs (cost of goods sold, selling and administrative)
and fixed costs (selling and administrative)
○ Clearly distinguishes between fixed and variable costs
● Cost of Goods Sold = Beginning Inventory + Purchases - Ending Inventory
3.0 Job-Order Costing

Job-Order Costing vs. Process Costing

● Process Costing
○ Company that produces many units of a single product
○ One unit of product is indistinguishable from another
○ Identical nature of each unit of product enables assigning the same average cost
per unit
○ Example: Paper manufacturing, Coca-Cola
● Job Order Costing
○ Many different products are produced each period
○ Products are typically manufactured to order
○ Unique nature of each order requires tracing and allocating costs to each job
○ Example: Aircraft manufacturing, movie production
■ Not just used in customized or luxury manufacturing but also services

Measuring Direct Materials Cost

● Bill of Materials — document that lists the quantity of each type of direct material
needed to complete a unit of product
● Production Order is issued once an agreement has been made
● Materials Requisition Form — document that specifies the type and quantity of
materials to be drawn from the storeroom and identifies the job that will be charged for
the cost of the materials

Job Cost Sheet

● Records the materials, labor, and manufacturing overhead costs charged to that job
Measuring Direct Labor Cost
● Direct labor consists of labor charges that are easily traced to a particular job
● Charges that cannot be easily traced are treated as part of manufacturing overhead
● Time Ticket — hour-by-hour summary of the employee’s activities

Predetermined Overhead Rates (POHR)

● Allocation Base — a measure such as direct labor-hours (DLH) or machine-hours (MH)
used to assign overhead costs to products and services
○ Examples include direct labor-hours, direct labor costs, machine-hours, and units
of product
● Predetermined Overhead Rates — manufacturing overhead commonly assigned to
products
○ Computed before the period begins
● POHR = Estimated total manufacturing overhead cost / estimated total allocation base

Computing the POHR

● Estimate the total amount of the allocation base (denominator)
● Estimate the total fixed and variable manufacturing overhead cost
● Use the cost formula to estimate the total manufacturing cost
● Cost Formula = Y = a + bX
○ Y = estimated total manufacturing overhead cost
 ○ a = estimated total fixed manufacturing overhead cost
○ b = estimated total variable manufacturing overhead cost
○ X = estimated total amount of allocation base

Applying Manufacturing Overhead

● Overhead Application — process of assigning overhead cost to jobs
● Overhead Applied = POHR x Amount of the allocation base incurred
● Normal Cost System — applies overhead costs to jobs by multiplying a predetermined
overhead rate by the actual amount of the allocation base incurred by jobs
Need for a Predetermined Overhead Rate
● If an actual rate is computed monthly or quarterly, seasonal factors in manufacturing and
allocation can produce fluctuations in the overhead rate
○ Two identical jobs, one completed in the winter and one completed in the spring,
would be assigned different manufacturing overhead costs
● Typically computed usually on an annual basis
○ However, costs would not be known until the end of the year

Job-Order Costing: A Managerial Perspective

● Managers use job cost information to establish plans and make decisions
○ If certain types of jobs appear to be highly profitable, managers may decide to
dedicate future advertising expenditures to growing sales of these types of jobs
● Managers use job cost informed to make pricing decisions
○ Used in established a markup and selling price
○ Cost-Plus Pricing — establishing a markup percentage that managers believe will
generate enough revenue to cover costs and residual profit
● Inaccurately assigning manufacturing costs to jobs adversely influences planning and
decisions made by managers
○ May cause managers to use additional advertising dollars to pursue certain types
of jobs that they believe are profitable, but in actuality are not
● Job-order costing systems can accurately trace direct materials and labor costs to jobs
● However, they often fail to accurately allocate the manufacturing overhead costs used
during the production process to their respective jobs

Choosing an Allocation Base

● The allocation base in the POHR should drive the overhead cost; if it doesn’t, it would
not accurately measure the cost of overhead
● Cost Driver — a factor, such as machine-hours, that causes overhead costs
● Oftentimes, companies use a single POHR or a plantwide overhead rate to allocate all
manufacturing overhead costs to jobs based on their usage of direct-labor hours
 ○ Overly simplistic and incorrect to assume that direct-labor hours is a company’s
only manufacturing overhead cost driver

Multiple Predetermined Overhead Rates

● A cost system that uses more than one overhead rate to apply overhead costs to jobs
● Cost-plus Pricing — a pricing method in which a predetermined markup is applied to a
cost base to determine the target selling price
○ Also known as a departmental approach
● Activity-based Costing — used when a firm creates overhead rates based on the
activities that it performs
○ An alternative approach to developing multiple POHR
Cost-plus Pricing
● Step 1: Calculate the estimated total manufacturing overhead cost for each department
○ Use the Cost Formula
● Step 2: Calculate the POHR in each department
● Step 3: Calculate the amount of overhead applied from both departments
● Step 4: Calculate the total job cost for the job
● Step 5: Calculate the selling price for the job
○ Markup percentage %

External Reporting
● Job-order costing systems are used to create balance sheets and income statements
● Underapplied Overhead — when a company applies less overhead than what it actually
incurs
○ Adjustment for underapplied overhead increases the cost of goods sold and
decreases net income
● Overapplied Overhead — when a company applies more overhead than what it actually
incurs
○ Adjustment for overapplied overhead decreases the costs of good sold and
increases net income
● Subsidiary Ledger — when all job cost sheets are collectively viewed
● Job-order sheets provide an underlying set of financial reports that explain what specific
jobs comprises the amounts in the balance sheet and income statement
4.0 CVP Relationships

Cost-Volume-Profit Analysis
● Assists managers in making important decisions
● Primary purpose is to estimate how profits are affected by five factors: selling price,
sales volume, unit variable costs, total fixed costs, and mix of products sold
● Managers typically adopt the following assumptions:
○ Selling price is constant
○ Costs are linear and can be accurately divided into fixed and variable
○ In multiproduct companies, the mix of products sold remains constant
● The Contribution Income Statement is helpful in judging the impact on profits of changes
in selling price, cost, or volume
○ Emphasis is on cost behavior
● Contribution Margin (CM) is used first to cover fixed expenses
○ Any remaining CM contributes to the net operating income

The Contribution Approach

● The $200 tells us that if the firm sells an additional bicycle, $200 will be the additional
CM or profit generated to cover fixed expenses and profit
● Each month, the company must generate at least $80,000 in the total CM to break-even
● 400 units a month is the break-even point
● If the company sells one more bike (401 bikes), operating income will increase by $200
● Net Operating Income = Units x Contribution margin

CVP Relationships in Equation Form

● Profit = (Sales - Variable expenses) - Fixed expenses
● Profit = (P x Q - V x Q) - Fixed expenses
○ Sales = Quantity sold (Q) x Selling price per unit (P)
○ Variable Expenses = Quantity sold (Q) x Variable expenses per unit (V)
● Profit = Unit CM x Q - Fixed expenses
○ Unit CM = Selling price per unit (P) - Variable expenses per unit (V)
 ● Profit = (P - V) x Q - Fixed expenses
○ Unit CM = P - V

CVP Graph
● Three key figures: Fixed expenses, total expenses, and sales

● Profit Graph — a simpler form of the CVP graph

○ Profit = Unit CM x Q - Fixed costs

CM Ratio
● CM Ratio = Contribution margin / Sales
● CM Ratio = Contribution margin per unit / Selling price per unit
● If the CM Ratio is 40%, then a $1 increase in sales results in a total CM increase of 40c
● Variable Expense Ratio = Variable expenses / Sales
● CM Ratio = 1 - Variable expense ratio
● Profit = (CM ratio x Sales) - Fixed expense

Break-even Analysis
● The Equation Method
○ Profit = Unit CM ratio x Q - Fixed expense
■ Wherein Profit = 0
● The Formula Method
○ Unit Sales to Break-even = Fixed Expenses / Unit CM
○ Dollar Sales to Break-even = Fixed Expenses / CM Ratio

Target Profit Analysis

● The Equation Method
○ Profit = Unit CM ratio x Q - Fixed expense
■ Wherein Q is unknown
○ Profit = CM ratio x Sales - Fixed expense
 ■ Wherein Sales is unknown
● The Formula Method
○ Unit Sales to Attain Profit = (Target profit + Fixed expenses) / CM per unit
○ Dollar Sales to Attain Profit = (Target profit + Fixed expenses) / CM ratio

Margin of Safety
● Excess of budgeted or actual sales dollars over the break-even volume of sales dollars
● Amount by which sales can drop before losses are incurred
● Higher margin of safety = lower risk of not breaking even
● Margin of Safety in Dollars = Total sales - Break-even sales
○ Can also be expressed in percentage and units

Cost Structure and Profit Stability

● Cost Structure — relative proportion of fixed and variable costs in a firm
● Managers often have some latitude in determining their firm’s cost structure
● High fixed costs and low variable costs are more volatile
○ Income will be higher or lower in good and bad years respectively compared to
companies with lower fixed costs
● Low fixed costs and high variable costs enjoy greater stability in income across good and
bad years

Degree of Operating Leverage

● Measure of how sensitive net operating income is to percentage changes in sales
● DOL = Contribution margin (CM) / Net operating income
● With an OL of 5, if a firm increases its sales by 10%, then the net operating income
would increase by 50%

Structuring Sales Commissions

● Commission based on sales dollars can lead to lower profits in a company
● Generally, firms pay salespeople either through commissions based on sales or a salary
plus a sales commission
● Example: Pipeline Unlimited produces two types of surfboards, the XR7 and the Turbo.
The XR7 sells for $100 and generates a contribution margin per unit of $25. The Turbo
sells for $150 and earns a contribution margin per unit of $18.
○ With this, you’d push to sell the Turbo even though XR7 has a higher CM per unit
○ Commissions can also be based on CM rather than selling price alone
5.1 Segment Reporting

Segmented Income Statements

● Segment — any part or activity of an organization about which a manager seeks costs,
revenue, or profit data
○ Example: A service center, individual store, or sales territory
○ Can be done by customer channel, geographic region, etc.
● Keys to Segmented Income Statements
○ The contribution format should be used because it separates fixed from variable
costs to calculate the contribution margin
○ Traceable fixed costs should be separated from common fixed costs to calculate
the segment margin
● Activity-based costing can help identify how costs shared by more than one segment are
traceable to individual segments

Traceable vs. Common Fixed Costs

● Traceable Fixed Costs — arise because of the existence of a particular segment and
would disappear over time if the segment itself disappeared
○ Example: Salary of a Fritos manager at PepsiCo is a traceable fixed costs of
Fritos in PepsiCo;
○ No division = no costs (e.g. salaries)
● Common Fixed Costs — arise because of the overall operation; would not disappear
if any particular segment were eliminated
○ Example: Salary of GM CEO is a common fixed costs across divisions in GM
○ Should not be allocated in the divisions
■ No division = still have that cost
● A traceable fixed cost of one segment can be a common fixed cost of another
○ Example: Landing fees can be traced to a particular flight, but not traceable to the
type of passenger (business class, economy, first class)
● Segment Margin = Contribution margin — Traceable fixed costs
○ Best gauge of the long-run profitability of a segment
● Fixed expenses that are traceable to one segment can become common fixed
expenses if the company is divided into smaller segments
○ Notice how it matches the previous income statement
 ● Contribution format segmented income statement can be used to make decisions and
perform break-even analysis

● Segmented financial data is required in the IFRS and US GAAP

○ Must also report segmented results to shareholders using the same measures
used by the chief operating decision maker
○ Some use the absorption approach to comply with GAAP

Break-even Analysis
● CM Ratio = Contribution margin / Sales
● Break-even Point = Traceable fixed expenses + Common fixed expenses / CM ratio

Costs and Value Chain

● Costs assignment to a segment should include all costs attributable to the segment from
the company’s value chain
● Business Functions that Make up the Value Chain include: Research and development,
product design, manufacturing, marketing, distribution, and customer service

Inappropriate Methods of Allocating Costs

● Failure to Trace Costs Directly
○ Costs that can be traced directly should not be allocated to other segments
○ Should be charged to the responsible segment
● Inappropriate Allocation base
○ Some companies allocate costs to segment using arbitrary bases
○ Costs such be allocated to segments only when the allocation base actually
drives the cost being allocated
 ● Common Costs
○ Should not be arbitrarily allocated to segments based on the belief that “someone
has to cover the common costs”
■ Makes a profitable business appear unprofitable
○ Forces managers to be held accountable for costs out of their control

5.2 Standard Costs and Variances

Standards
● Benchmarks or norms used for measuring performance
● Price Standards — specify how much should be paid for each unit of input
● Quantity Standards — specific how much of an input should be used to make a product
● Setting Direct Materials Standards
○ Standard Price per Unit — final, delivered cost of materials, net of discounts
○ Standard Quantity per Unit — summarized in a Bill of Materials
● Setting Direct Labor Standards
○ Standard Rate per Hour — often a single rate; reflects mix of wages earned
○ Standard Hours per Unit — time and motion studies for each labor operation
● Setting Variable MO Standards
○ Price Standard — rate is the variable portion of the POHR
○ Quantity Standard — quantity is the activity in the allocation base for POH
● Standard Cost Card

Variances
● Standard costs per unit can be used to compute activity and spending variances
● Spending variances become more useful by breaking them down into price and quantity
variances
● General Model for Variance Analysis
● Price and Quantity standards are determined separately
○ The purchasing manager is responsible for raw material purchases, while the
production manager is responsible for the quantity used
○ Buying and using activities occur at different times
■ Raw materials may be held in inventory for a long period
 ● Types of Price Variance
○ Materials Price Variance
○ Labor Rate Variance
○ VOH Rate Variance
● Types of Quantity Variance
○ Materials Quantity Variance
○ Labor Efficiency Variance
○ VOH Efficiency Variance

Variance Analysis

● Actual Quantity — the amount of direct materials, direct labor, and variable MO used
● Standard Quantity — standard quantity allowed for the actual output of the period
● Actual Price — amount actually paid for the input used
● Standard Price — amount that should’ve been paid for the input used
● Material Price Variance (MPV) = (AQ x AP) - (AQ x SP) or AQ(AP - SP)
● Material Quantity Variance (MQV) = (AQ x SP) - (SQ x SP) or SP(AQ - SQ)

Case: Material Variances

● Given: 0.1 kg of fiberfill per parka at $5.00/kg
● Actual: 210kgs, 2,000 parkas, at $1,029 total
● Actual Price = $1,029 / 210 kg = 4.90/kg
● Standard Price = 2,000 x 0.1 kg = 200kg
● MPV = AQ(AP - SP) = 210(4.9 - 5.0) = 210 (-0.1) = $21 F
● MQV = SP(AQ - SQ) = 5(210 - 200) = 5(10) = $50 UF
Note: AQ x AP and SQ x SP are both subtracted from AQ x SP. If MQV is positive, then it’s
unfavorable. If MPV is positive, it’s favorable.

If the quantity variance is greater than the price variance, then the spending variance is
unfavorable.

Responsibility for Materials Variances

● Purchasing Manager = Materials Price Variance
● Production Manager = Materials Quantity Variance
● The standard price is used to compute the quantity variance so that the production
manager is not held responsible for the purchasing manager’s performance

Controllability of Materials Variances

● Not always entirely controllable by a person or department
● Production managers may schedule production in a way that requires express delivery of
raw materials that can result in an unfavorable MPV
● Purchasing managers may purchase lower quality materials, resulting in an unfavorable
MQV for the production manager

Case: Labor Variances

● Given: 1.2 hours per parka at $10/hour
● Actual: 2,500 hours, 2,000 parkas at $26,250
● Actual Rate = $26,250 / 2,500 hours = $10.50/hour
● Standard Hours = 2,000 x 1.2 hours = = 2,400 hours
Note: AH x AH and SH x SR are both subtracted from AH x SR.

If the efficiency variance is greater than the rate variance, then the spending variance is
favorable.

Responsibility for Labor Variances

● Production managers are usually held accountable for labor variances because they can
influence key factors
● Mix of skill levels assigned to work tasks
● Level of employee motivation
● Quality of production supervision
● Quality of training provided to employees

Controllability of Labor Variances

● Not always entirely controllable by a person or department
● Maintenance department managers may do a poor job of maintaining equipment, which
results in an increase in processing time needed per unique, causing an unfavorable
labor efficiency variance
● Purchasing managers may purchase lower quality materials, resulting in an unfavorable
LEV for the production manager

Case: Variable MOH Variances

● Given: 1.2 standard labor hours per parka at $4.00/hour
● Used: 2,500 labor hours, 2,000 hours at $10,500
● Actual Rate = $10,500 / 2,500 hours = $4.2/hour
● Standard Hours = 2,000 x 1.2 hours = = 2,400 hours
Note: AH x AH and SH x SR are both subtracted from AH x SR.

Add the rate variance and efficiency variance to get the spending variance. If they are
both favorable, then the spending variance is also favorable.

Case: Material Variances

● Quantity variance is computed only on the quantity used
● Price variance is computed on the entire quantity purchased
● Given: 0.1 kg of fiberfill per parkata at $5/kg
● Used: 210 kg at $1,029, used 200 kg, 2,000 parkas

Standard Cost Advantages

● Standard costs are key elements of the management by exception approach
● Can provide benchmarks that promote economy and efficiency
● Greatly simplifies bookkeep and responsibility supports accounting systems

Standard Cost Disadvantages

● Standard cost variance reports are often prepared monthly and may be outdated
● Meeting standards is not always sufficient; continuous improvement is needed
● If variances are misused as a club to negatively reinforce employees, morale may suffer
and cause dysfunctional decisions
● Labor variances assume that the production process is labor-paced and is a variable
cost
 ● In some cases, a “favorable” variance can be as bad or worse than unfavorable
● Excessive emphasis on meeting standards may overshadow other important objectives

5.3 Responsibility Accounting Systems

Decentralized Organizations
● Advantages
○ Top management are free to concentrate on strategy
○ Lower-level managers gain experience in decision-making, have access to better
information, and can respond quickly to customers; first-class information
○ Decision-making authority leads to job satisfaction
● Disadvantages
○ Lower-level managers may make decisions without seeing the big picture and
may have objectives not aligned to the organization;s
○ Difficult to spread innovative ideas
○ Lack coordination among autonomous managers
○ Can easily be remedied by the balanced scorecard, design performance
evaluation, effective communication, periodic team building

Responsibility Accounting
● Managers are held responsible only for those items they can control to a significant
extent
● Responsibility Center — organization whose manager has control over cost, profit, and
investments
● Cost Centers — segment whose manager has control over costs
● Profit Center — segment whose manager has control over both costs and revenues
● Investment Center — segment whose manager has control over costs, revenues, and
investments in operating assets

○ Investment Centers — Corporate Headquarters and Operations VP

○ Cost Centers — CFO, General Counsel, VP, Managers
○ Profit Centers — Product Managers
Return on Investment (ROI)
● NBV = Acquisition cost - Accumulated depreciation
○ Most firms use the NBV of depreciable assets to calculate average operating
assets
● ROI = Net operating income / Average operating assets
○ Net Operating Income — Income before interest and taxes (EBIT)
○ Average Operating Assets (AOA) — cash, accounts receivable, inventory, PPE
● Margin = Net operating income / Sales
● Turnover = Sales / Average operating assets
● ROI = Margin x turnover

Criticisms of ROI
● Without a balanced scorecard, management may not know how to increase ROI
● Managers often inherit many committed costs which they have no control over
● Managers who evaluate on ROI may reject profitable investment opportunities

Residual Income
● Rate of Return (RoR) — net gain or loss of an investment over a specified time period
● Differs from ROI in that it measures net operating income earned less than the minimum
required return on average operating assets
○ ROI measures net operating income earned relative to the investment in
average operating assets
● Residual Income = Net Income - (Ave. Operating Assets x Min. Required RoR)
● Encourages managers to make profitable investments that would otherwise be rejected
using ROI

Transfer Price
● Price charged when one segment of a company provides goods or services to another
segment of the company
● Objective is to motivate managers to act in the best interests of the firm
● Three Primary Approaches
○ Negotiated transfer prices
○ Set transfer prices at cost using either variable cost or full (absorption) cost
○ Transfers at market price

Negotiated Transfer Prices

● Results from discussions between the selling and buying divisions
● Upper limit and lower limit is determined by the buying and selling division respectively
● Advantages
○ Preserve the autonomy of the divisions; consistent with decentralization
 ○ Managers are likely to have much better information about the potential costs
and benefits of the transfer than others in the company

Case: Grocery Storehouse

● Transfer Price > VC per unit + (Total CM on Lost sales / Units transferred)
● Transfer Price < Cost of buying from outside suppliers

● If there are sufficient idle crates, the price range would be $15 - $20
○ West Coast > $15, whereas Grocery Mart < $20
● If there are no idle crates, there is no acceptable range
○ West Coast > $25, whereas Grocery Mart < $20
● If there are 500 idle crates, then there is a price range of $17.5 - $20
○ West Coast > $17.5, whereas Grocery Mart < $20
● Evaluation of Transfer Prices
○ If a transfer within a company results in higher profits for the company, there is
always a range of transfer prices wherein both divisions would benefit
● If managers are pitted against each other, a noncooperative atmosphere is guaranteed
● Given the disputes that often follows, most companies rely on other means of setting
transfer prices

Transfer at the Cost to the Selling Division

● Set transfer prices at either the variable cost or full cost incurred by the selling division
● Disadvantages of this Method
○ Using full cost as a transfer price can lead to suboptimization
○ The selling division will never show profit on an internal transfer
○ Cost-based transfer prices doesn’t provide incentives to control costs

Transfers at Market Price

● Market Price — price charged for an item on the open market
○ Often regarded as the best approach to the transfer pricing problem
● Works best when the product or service is sold in present form to outside customers
and the selling division has no idle capacity
○ This approach does not work well when there is idle capacity
Operating vs. Service Departments
● Operating departments carry out central purposes
● Service departments do not directly engage in operating activities
● Service department costs are charged to operating departments
○ Encourages operating department to wisely use service department resources
○ Helps measure profitability and provides more complete cost data for decisions
○ Creates an incentives for service departments to operate efficiently

Charging Costs by Behavior

● Variable and fixed service department costs should be charged to operations separately
● Variable Service Department Costs (VSDC) should charge consuming departments
according to activity or cost driver that caused the incurrence of the cost
● Fixed Service Department Costs (FSDC) should charge consuming departments in
predetermined lump-sum amounts that are based on the department’s peak-period or
long-run average servicing needs
○ Based on amounts of capacity each department requires
○ Should not vary from period to period
● Budgeted, not actual, VSDC and FSDC should be charged to operating departments

Case: Sipco
● Given: $0.6/machine hour, $200,000 fixed costs

Pitfalls in Allocating Fixed Costs

● Allocating a fixed cost using a variable allocation base that fluctuates periodically
● Fixed costs allocated to one department are heavily influenced by external factors
● Using sales dollars as an allocation base
● Sales of one department influence the service department costs allocated to others

5.4 Strategic Performance Management

Balanced Scorecard
● Used to help management translate its strategy into performance measures
● Performance measures include financial, customer, internal business processes, and
learning and growth
 ● Financial
○ Includes sales, profitability ratios, cash flows, profits, trend performance, and
market performance
● Customer
○ Customer satisfaction, acquisition and retention, customer lifetime value, loyalty
and customer service, and value proposition
● Internal Business Processes
○ Innovation, product and service quality, agility, cost and delivery times, etc.
● Learning and Growth
○ May include recruitment, retention rates, job satisfaction, compensation and
advancement opportunities, skill development, etc.
● Financial vs. Nonfinancial Measures
○ This framework rejects the notion that improving process-oriented measures
automatically leads to financial success
○ Including a financial perspective keeps organizations accountable for translating
improvements in nonfinancial performance to bottom-line results
○ If favorable, nonfinancial trends do not translate to financial results, the balanced
scorecard is designed to force the organization to re-examine its strategies

Setting Balanced Scorecard Measures

● The four categories of a balanced scorecard are interrelated to one another
● Company’s employees need to continuously learn and grow to improve internal business
processes
● Improving business processes is necessary to improve customer satisfaction
● Improving customer satisfaction is necessary to improve financial results
● Example: Jaguar
Quality Costs
● Costs incurred to prevent defects or results from defects
● Prevent Costs — support activities whose purpose is to reduce defects
○ Example: Quality training, statistical processes and control activities
● Appraisal Costs — incurred to identify defective products before being shipped
○ Example: Final product testing, inspection, depreciation of testing equipment
● Internal Failure Costs — result of identifying defects before they are shipped
○ Example: Scrap, spoilage, rework
● External Failure Costs — result of defective products being delivered
○ Example: Cost of field servicing and handling complaints, warranty, lost sales
● Quality Cost Reports — provides an estimate of the financial consequences of a
company’s current defect rate

Quality Cost Information

● Uses
○ Help managers see the financial significance of defects
○ Identify the relative importance of the quality problems
○ See whether their quality costs are poorly distributed
● Limitations
○ Simply measuring and reporting does not solve quality problems
○ Results usually lag behind quality improvement programs
○ Lost sales, the most important quality cost, is often omitted

Operating Performance Measures

● Manufacturing Cycle Efficiency (MCE) = Value-added time / Manufacturing cycle time
○ Value-added time = process time
○ Manufacturing cycle time = throughput time
 ● Overall Equipment Effectiveness (OEE) — measures the productivity of a piece of
equipment in terms of utilization, efficiency, and quality
● OEE = Utilization rate x Efficiency rate x Quality rate
○ Utilization Rate = Actual run time / Machine time available
○ Efficiency Rate = Actual run rate / Ideal run rate
○ Quality Rate = Defect-free output / Total output

CSR Performance Measures

● Corporate Social Responsibility (CSR) — when organizations consider the needs of
all stakeholders when making decisions beyond financial results to satisfy stockholders
● Many of the world’s largest companies prepare CSR reports that are shared
● Global Reporting Initiative (GRI) is a leading organization in the field of environmental
and social performance measurement
6.0 Differential Analysis

Differential analysis is the key to decision making.

Relevant vs. Irrelevant

● First step is to define the alternatives being considered
● Relevant costs and benefits should be considered when making decisions
● Irrelevant costs and benefits should be ignored when making decisions
● Differential Analysis — focusing on the future costs and benefits that differ between
the alternatives
● Future costs and benefits that do not differ between alternatives are irrelevant

Types of Costs & Revenues

● Differential Cost — future cost that differs between two alternatives
● Differential Revenue — future revenue that differs between two alternatives
● Incremental Cost — increase in cost between two alternatives
● Avoidable Cost — cost that can be eliminated by choosing one over the other
● Sunk Costs — always irrelevant; already been incurred and cannot be changes
● Opportunity Costs — potential benefit that is given up when one alternative is selected
over the other
○ Needs to be considered when making decisions

Total and Differential Cost Approaches

● Example: Long Version

○ The new machine costs $3,000 but saves $3 per unit in direct labor
○ Here, we see a $12,000 increase in net operating income
● Example: Shortened Version

● Using the differential approach is desirable for two reasons:

 ○ It’s rare that enough information will be available to prepare detailed income
statements for both alternatives
○ Mingling irrelevant costs with relevant costs may cause confusion and distraction

Adding or Dropping Segments

● The decision to drop or add a new or old segment hinges primarily on financial impact
● Example: Lovell Company
○ Decision Rule — drop the digital watch segment only if its profits would increase
○ Done so by comparing the contribution margin that would be lost if the digital
watch was discontinued to the fixed expenses that would be avoided
● Fixed factory overhead and general administrative expenses are not affected
○ Would be reallocated to other product lines
● If equipment has no resale value, do not include in the solution; irrelevant cost
● Contribution Margin Approach

○ If the number is negative, it means that it’s best to keep the product line
○ If the number is positive, it means that it’s best to drop the product line
● Comparative Income Approach

Beware of Allocated Fixed Costs

● Allocated fixed costs can distort the decision-making process
● In the case of Lovell, we know that they are operating at a net loss of $100,000
● Including unavoidable common fixed costs makes the product line seem unprofitable
when dropping the product line would decrease the overall net operating income
Make or Buy Analysis
● Vertically Integrated — when companies are involved in more than one activity in the
entire value chain
● Some companies opt to carry out the activities internally, rather than externally
● Advantages of Vertical Integration
○ Smoother flow of parts and materials
○ Better quality control
○ Realize profits
● Disadvantages of Vertical Integration
○ Fail to take advantage of suppliers who can create economies of scale
○ Need to retain control over activities to maintain competitive position
● Example

○ Avoidable costs include direct materials and labor, variable overhead, and salary
○ Sunk costs include the depreciation of equipment
○ Allocated overhead costs are common to all products; would be unchanged
○ Here, we can see it is cheaper to make the product internally
● Opportunity costs are not actual cash outlays; not recorded formally

Special Orders
● Special Orders — one-time orders that aren’t considered in normal operations
● Only the incremental costs and benefits are relevant
○ Existing fixed manufacturing overhead costs would not be affected by the order
● Example: Jet Inc.’s Special Order

Constrained Resource

Volume Trade-Off Decisions

● Companies are forced to make volume-trade off decisions when they don’t have enough
capacity to produce all the products and sales demand
 ● Sacrifice production of some products in favor of others to maximize profits
● Constraint — limited resource that restricts capacity to satisfy demand
● Bottleneck — machine or process that is limiting overall output; the constraint
● Fixed Costs are usually unaffected
○ Product mix that maximizes the total CM should ordinarily be selected
● Companies should not necessarily promote products that have the highest CMs
● Total CM will be maximized by promoting products or orders that provide the highest CM
in relation to the constraining resource

Contribution Margin per Unit of the Constrained Resource

● CM per Unit of the CR = CM per unit x Time required to produce one unit

Value of a Constrained Resource

● Question to Ask: “How much should you be willing to pay for an additional unit of time?”
● Increasing the capacity of a constrained resource should lead to increased production
● For a two-item resource, it should be less than the lower CM per unit
○ Highest should be $24

Managing Constraints
● Relaxing or Elevating the Constraint — increase the capacity of a bottleneck
● Can be done by:
○ Working overtime on the bottleneck
○ Subcontracting some of the processing
○ Investing in additional machines
○ Shifting workers from non-bottleneck to bottleneck
○ Focusing business process improvement efforts
○ Reducing defective units processed

Joint Product Costs

● Joint Products — two or more products produced from a single raw material input
● Split-Off Point — point where joint products can be recognized as a separate product
● Decisions are made on whether a joint product should be sold at split-off point or
processed further
○ Known as the sell or process further decision
● Example: Petroleum Industry
Pitfalls of Allocation
● Joint costs are traditionally allocated among different products at the split-off point
● Typical approach is to allocate joint costs according to relative sales value of the end
products
○ Allocations of this kind are very dangerous

Sell or Process Further

● Joint costs are irrelevant in decisions regarding what to do with a product from the
split-off point forward; costs are not allocated to end products
● Profitable to continue processing after the split-off point so long as the incremental
revenue exceeds incremental processing costs
● Example: Sawmill’s Company

○ Lumber = Financial Advantage of $80

○ Sawdust = Financial Disadvantage of $10
○ In this case, sawdust should be sold at split-off point for profit maximization

Activity-Based Costing
● Activity-Based Costing can be used to help identify potentially relevant costs
● Managers should exercise caution against reading more into this traceability
● Tendency to assume that if a cost is traceable to a segment, it is automatically avoidable