ACCT 4302 – 5317

Fall-2022
EXAM 1 REVIEW
Chapters 1-4, 9 (pages 329-341)

NANDU J. NAGARAJAN

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 Cost Behavior and Terminology
Chapter 2
• Fixed and variable costs

• Total fixed costs and unit variable costs stay the same over the “Relevant
Range”
• A more refined approach to understanding cost behavior is to understand
that all costs are not driven by volume, i.e., they are not all unit level costs
• Costs can also be batch level (vary depending on number of batches),
product level (vary depending on number of products) and facility level
(exist to support the entire operation)
• Many of these non-unit level costs are fixed in the short term. However,
over longer periods they can vary based on the cost driver

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 More Cost Terminology
• Differential cost
A cost that is different across different alternatives
• Opportunity cost
• Profit foregone by not pursuing next best alternative
• Relevant cost
• A cost that is different across different alternatives
• A cost that is avoidable by not pursuing a particular alternative
• Sunk cost
• A cost that was incurred in the past and is not usually relevant

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 Cost Concepts and Terminology

• Production cost
– Cost of one unit of product or service

• What goes into Cost of Goods Sold (COGS)?

• Components of production cost/product cost - these costs can be inventoried

Prime cost
– Direct materials

– Direct labor
Conversion cost
– Production Overhead

• Selling ,distribution and administrative expenses are period costs – to be expensed in the period in which
these costs are incurred

• There are estimation issues in determining unit product or service cost. This is because overhead costs
cannot be directly traced to the product or service and have to be allocated over several products or
services. This allocation process is not easy because the choice of the allocation base is not straightforward.
We will discuss these issues in greater detail later on in Activity-Based Costing.

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 Product Costing (Chapters 2 and 6)
• Costs move through the accounting system mimicking the physical flow of
products or services
• For manufacturing companies the key account that captures “production”
is the work-in process (WIP) account
• Direct material, direct labor and overhead costs are transferred from the
relevant primary accounts to the WIP account
• Actual overhead costs are rarely used in product or service cost estimation
• Usually, an overhead rate is estimated for each category of overhead at
the beginning of the fiscal period and overhead is “allocated “ or “applied”
to the WIP account for manufacturing companies or to the cost object for
service companies. The allocated overhead is the overhead rate times the
actual consumption of the allocation base.
• The reason this is done is that overhead is a “lumpy” cost and using actual
overhead in cost estimation would distort product and service cost
estimates in some periods

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 Basics of product and service cost
• Recall, the cost flows mimic the production process
• For a manufacturing company, material costs are important (service
companies usually have only labor and overhead costs to worry about).
• The direct material, direct labor and allocated overhead costs are charged
to a Work-in-Process (WIP) account.
• The Cost of Goods Manufactured (COGM) flows out of the WIP account to
the Finished Goods Account.
• When product is sold, the cost of the finished output that is sold is called
Cost of Goods Sold and moves out of the Finished Goods account to the
Income Statement --see next slide
• At the end of the fiscal period, the under or over allocated overhead is
generally adjusted to cost of goods sold (COGS)

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 Cost flows in the accounting system

Beginning
balance of Cost of goods
Direct Finished Goods manufactured
Material during the period
(DM)

Work-in-
Finished Income
Process Statement
Direct Labor (WIP) Goods
(DL) (FG)

Manufacturing
Overhead Cost of goods sold
Ending balance
(MOH) of Finished
(expense):
recognized only at
Goods (asset)
the time of sale
 Product Costing in Manufacturing Companies

• Cost of Goods Manufactured and Cost of Goods Sold

statements are WIP and FG accounts “spread out”,
respectively
• OWIP+DM+DL+ applied OH– EWIP=COGM
• Cost of Goods Sold (COGS) is the balance transferred
from FG account into the income statement
• OFG + COGM - EFG = COGS

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 Question 1
• Refer to sample exam questions for all data:
• Case 1: we are required to calculate the COGS and ending finished
goods inventory.
• We know that Sales – COGS = Gross margin. If we plug in the known
numbers, we get:
• $52000 – A = $18000 => $34000 (COGS)
• To calculate, ending finished good inventory, we need COGM
Because -> OFG + COGM – EFG = COGS ---(1)
To get COGM, we have to go to the WIP A/C =>
OWIP + Manufacturing Costs – EWIP = COGM or,
$3000 + 13000 + 4500 + 9500 – 0 = $30,000 (COGM)
Going back to equation 1, we have $5000 + 30000 – B = 34000, or
(B) Ending Finished Goods = $1000
 Question 1
• Case 2: We are required to calculate Gross margin and
manufacturing overhead costs.
• Sales – COGS = Gross Margin =>
(C) $52,300 - $31,800 = $ 20,500 (Gross margin)
To calculate manufacturing costs, we need COGM from the finished
goods account.
OFG + COGM –EFG = COGS =>
7000 +COGM -7000 = 31,800 => COGM = $31,800
Therefore, manufacturing costs are:
OWIP + Manuf. Costs –EWIP = COGM =>
$1500 + Manuf. Costs – 4700 = 31800 => manuf. costs are
$35,000
Manufacturing OH = 35,000 -19000-8500 = 7500 (D)
 Chapter 7 –Job Order Costing
• Key ideas are that (a) each job has a separate cost sheet by
cost element (DM, DL and OH) (b) WIP account is a summary
account across all job cost sheets.
• Thus, ending WIP balance is the cost charged to unfinished
jobs
• COGM is the cost charged to jobs that are completed.
• There is a correspondence between where the cost shows up
in WIP and the job’s completion status
• Critical thinking problem 6, Text book problems 4-37, 4-38, 4-
42, sample exam problem 1

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 Two Kinds of Income Statements
• Absorption Costing or Gross Margin income statement
- useful for external reporting
- basis for product costing
- long run measure of resource consumption
• Variable Costing or Contribution Margin (CM) income
statement
- useful for decision making
- short run measure of resource consumption
• CM statement with Relevant Costing information
- Footnotes differential cost information to the CM statement
- useful for decision making
- Examples

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Absorption Costing/GAAP/Gross
Margin Income Statement
Sales DM
- COGS --Product costs DL
Gross Margin MOH
- S, G & A --- Period costs –V and F
Operating Income
The Gross Margin income statement does not distinguish between
controllable and non-controllable, fixed and variable and direct and
indirect costs

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 Variable Costing/Contribution
Margin Income Statement
Sales DM

- Variable Costs DL **

Contribution Margin VOH

- Fixed Costs VSG&A

Operating Income FOH & FSG&A

The Contribution Margin income statement does not distinguish

between direct and indirect costs
** DL costs are usually assumed to be variable

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 Absorption and Variable Costing Income
Statements
• The difference between absorption costing and variable costing operating
income arises because not all fixed production overhead for the year is
expensed that year under absorption costing

• The difference between absorption costing and variable costing operating

income equals the difference between production and sales times the
fixed production overhead rate (assuming that the only fixed production
costs are overhead costs and that the FMOH rate in opening inventory is
the same as that in ending inventory)

• More generally the difference in income between absorption costing and

variable costing is equal to the fixed manufacturing cost in ending
inventory minus the fixed manufacturing cost in opening inventory. This is
because of inventory valuation approaches such as FIFO and LIFO.

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 Absorption Costing and Variable Costing
Income Statements (continued)
• Production>Sales => NI (AC) > NI (VC)

• Production=Sales => NI (AC) = NI (VC)

(Assumption sometimes seen in CVP
calculations)

• Production<Sales => NI (AC) < NI (VC)

• CT # 1
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 Implications of Absorption Costing

• The fixed manufacturing costs can be included in the value of

inventories treated as assets in the firm’s balance sheet, but
not fixed selling, general & administrative costs
• When costs can be placed in inventory and when production
exceeds the # units sold, then a portion of the current
period’s fixed manufacturing costs is not expensed in the
current year, thereby affording an opportunity to increase the
reported earnings for the current year.
• Such inventoried costs simply defer expensing the current
year’s fixed manufacturing overhead to a future period.
• Critical Thinking Problem 1–South Asian Electronics

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 QUESTION 3
• Miami, Inc., planned and actually manufactured 250,000 units
of its single product in 2017, its first year of operation.
Variable manufacturing cost was $19 per unit produced.
Variable operating (nonmanufacturing) cost was $13 per unit
sold. Planned and actual fixed manufacturing costs were
$750,000. Planned and actual fixed operating
(nonmanufacturing) costs totaled $420,000. Miami sold
170,000 units of product at $41 per unit.
• 1) What is its operating income using absorption costing?
• 2) What is its operating income using variable costing?

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 Question 3 –part 1

1. Absorption Costing:

Revenuesa $6,970,000

Cost of goods sold:

Variable manufacturing costsb $3,230,000

Allocated fixed manufacturing costs c 510,000 3,740,000

Gross margin 3,230,000

Operating costs:

Variable operatingd 2,210,000

Fixed operating 420,000 2,630,000

Operating income $ 600,000

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 Question 3 –part 2

Revenuese $6,970,000

Variable costs:

Variable manufacturing cost of goods sold f $3,230,000

Variable operating costsg 2,210,000 5,440,000

Contribution margin 1,530,000

Fixed costs:

Fixed manufacturing costs 750,000

Fixed operating costs 420,000 1,170,000

Operating income $ 360,000

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 Question 3-Reconciliation
• Difference in income = $600,000 - $360,000 =
$240,000
• Production –sales = 250,000 -170,000 =
80,000
• FOH rate = $750,000/250,000 = $3/unit
• Difference in income AC- VC = 80,000 x
$3/unit = $240,000

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 CVP Analysis –short term decision
tool
• Analysis
– Unit selling price $P per unit
– Unit variable expense $V per unit
– Total fixed expense $F
– Target profit / income $I
– Target # of units
produced and sold X

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 CVP Analysis (Continued)
• Sales – costs = profit
• Sales – variable expenses = contribution
• Contribution – fixed expenses = profit
• PX – VX – F = I
• (P-V)X – F = I
• X = (F+I)/(P-V)
• I is before tax – I(BT)
• We will also consider I(AT)—after tax income
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 Taxes
• Taxes are an unavoidable cost of doing business
– Single tax rate on income

• Profit after tax (PAT) =

Profit before tax (PBT) – taxes paid

– Taxes paid = tax rate  Profit before tax

– Profit after tax =(1- tax rate)  Profit before tax

– Profit after tax {I(AT)}

= (1- tax rate)  [Contribution margin – fixed cost]
X = {I (AT)/(1-T) + F}/ (P-V)

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 Multi-product CVP Analysis
• For multiple products we cannot use number
of units
• We can calculate the sales revenue required
to achieve a target level of profit
• The sales revenue will depend on the
product/ sales mix--- “fix the mix”
• Key idea is contribution margin ratio
• Margin of safety: The difference between
current revenue and break-even revenue,
usually expressed as a percentage
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 Multi-product CVP Analysis (Continued)
• The contribution margin ratio is always calculated for a
particular mix. So, we will call it the weighted average
contribution margin ratio
• WACMR = Total CM/ Total Sales
• Another definition : WACMR = The sum of the CM ratio of
each product multiplied by its fraction of revenue
• WACMR = CMR (A)*Sales (A)/Total sales + CMR (B)* Sales (B)/Sales + ……
• Single product : X = (F+I)/(P-V) => multiply both sides by P =>
• PX = P[ (F+I)/(P-V)] = (F+I)/[(P-V)/P] = (F+I)/ CM ratio

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 Multi-product CVP Analysis (Continued)
• Target level of revenue equals the target income plus the
fixed expenses divided by the contribution margin ratio

• Because this is the contribution margin ratio for a particular

mix we will call it the weighted average contribution margin
ratio

• Critical Thinking problems 2 and 3, Text book Problems 3-28,

3-35, 3-41, 3-50, 3-51, Sample exam problem 3

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 Question 2
• The Kenosha Company has three product lines
of beer mugs—A, B, and C—with contribution
margins of $5, $4, and $3, respectively. The
president foresees sales of 175,000 units in
the coming period, consisting of 25,000 units
of A, 100,000 units of B, and 50,000 units of C.
The company’s fixed costs for the period are
$351,000.
•
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 Required
1)What is the company’s breakeven point in units, assuming that the
given sales mix is maintained?
2) If the sales mix is maintained, what is the total contribution margin
when 175,000 units are sold? What is the operating income?
3) What would operating income be if the company sold 25,000 units
of A, 75,000 units of B, and 75,000 units of C? What is the new
breakeven point in units if these relationships persist in the next
period?
4) Comparing the breakeven points in requirements 1 and 3, is it
always better for a company to choose the sales mix that yields the
lower breakeven point? Explain.
•

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 Question 2
• Part 1
• Given the ratio => A:B:C is 1: 4:2,
• Let the volume of A at the break-even point be X, the volume of B
would then be 4X and C would be 2X.
• The total CM would be (multiplying the volumes by the unit CMs)
=>
• 5X + 16X + 6X = (fixed cost) at the B/E point
• That is, 27X = 351,000 or X (volume of A) = 13,000
• Then, volume of B is 52000 and volume of C is 26,000 units.
• Part 2
• For total CM, multiply volumes by unit CMs . For operating income,
subtract fixed cost =>
 Question 2
• Part 2
• A: 25,000  $5 $125,000
• B: 100,000  $4 400,000
• C: 50,000  $3 150,000
Contribution margin $675,000
• -FC -$351,000
• Operating Income $324,000

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 Question 2 –part 3
• Contribution margin
• A: 25,000  $5 $125,000
• B: 75,000  $4 300,000
• C: 75,000  $3 225,000
• Contribution margin $650,000
• Fixed costs 351,000
• Operating income $299,000
• Break even point

• Ratio: 1:3:3
• 5X + 12X + 9X = $351,000, X = 13,500
• A= 13,500 units, B= 40,500, C = 40,500
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 Question 2-part 4
• No, it is not always better to choose the sales
mix with the lowest breakeven point because
this calculation ignores the demand for the
various products. The company should look to
and sell as much of each of the three products
as it can to maximize operating income even if
this means that this sales mix results in a
higher breakeven point.
•
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 Question 4
• Genesee Music Society is a not-for-profit organization that
brings guest artists to the community’s greater metropolitan
area. The music society just bought a small concert hall in the
center of town to house its performances. The lease payments
on the concert hall are expected to be $4,000 per month. The
organization pays its guest performers $1,800 per concert and
anticipates corresponding ticket sales to be $4,500 per concert.
The music society also incurs costs of approximately $1,000 per
concert for marketing and advertising. The organization pays its
artistic director $33,000 per year and expects to receive $30,000
in donations in addition to its ticket sales.
•
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 Question 4 -Required
• 1. If the Genesee Music Society just breaks even, how many concerts does
it hold?
• 2. In addition to the organization’s artistic director, the music
society would like to hire a marketing director for $25,500 per year. What
is the breakeven point? The music society anticipates that the addition of
a marketing director would allow the organization to increase the number
of concerts to 41 per year. What is the music society’s operating
income/(loss) if it hires the new marketing director?
• 3. The music society expects to receive a grant that would provide
the organization with an additional $17,000 toward the payment of the
marketing director’s salary. What is the breakeven point if the music
society hires the marketing director and receives the grant?

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 Question 4
• Part 1
• CM per concert: $4500 - $1800 - $1000 = $1700
• Annual fixed costs = (4000 x 12) +33,000 -$ 30,000 =
$51,000
• Break-even # of concerts = 51000/1700 = 30
• Part 2
• New FC = 51,000 + 25,500 = $76,500
• New B/E point = 76,500/ 1700 = 45

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 Question 4
• Part 2 continued
• New CM 41 x 1700 = 69,700
• - New FC -76,500
• Operating income/(loss) (6,800)
• Check ( 45-41) x $1700 = $6800
• Part 3
• New FC = $76,500 - $17,000 = $59,500
• New B/E point 59,500/1700 = 35
• So with 41 concerts, they would make a profit of
• (41-35) x 1700 = $10,200

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 Operating Leverage

• Operating leverage relates to the level of fixed costs in a

firm’s cost structure
• One way of defining operating leverage is the ratio of
contribution margin to operating income .
• Operating Leverage Ratio (OLR)
– OLR x % change in sales = % change in income
– The above relationship should be interpreted with caution
for income close to zero
• Helps us understand the implications of CT 2

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