MODULE IN MAC 302 - MANAGEMENT REPORTING MODULE IN MAC 302 - MANAGEMENT REPORTING

MODULE 1: THE NEED FOR MANAGEMENT ADVISORY SERVICES and good governance. At the end of these business stakeholders would expect to receive reports
on what happened to their money.
Learning Objectives:
In all of these stages of business events, conditions and developments problems arise. Still, the
1. Explain the management services practice standards manager is expected to get through it. The manager therefore must be certain on what he is
2. Identify and explain the management services engagement process doing. He must be certain that he can increase the wealth of the organization and be equally
3. Enumerate the characteristics of management services practices certain that the wealth of the money providers would be protected using his know-how and
4. Rationalize the importance of management services practice in a changing business experience in the fields of business, finance and accountancy.
environment
In many cases, the manager needs the assistance of another expert to help him in running the
Management Advisory Services (MAS) refers to that practice of accounting concerned with business affairs. He may either employ the expert or outsource his services as an outside
providing advice and technical assistance to help management improve the use of resources in professional contractor.
achieving organizational goals. The certified public accountant who practices MAS work is
called an advisor or consultant. The CPA as advisor or consultant

The Manager of the MAS client The practice of management advisory services arise when an independent public accountant is
contracted by a manager to render his professional and business expertise to help define
MAS principally serves the needs of the top management. Management is entrusted with problems and subsequently recommend solutions, save in the fields of auditing and assurance
organizational resources to make more wealth. services, tax services and legal services.
Technically, management is difference from governance. Governance, being the duty of the The job of an advisor is to provide advice and technical assistance to managers. An advisor is an
Board of Directors , is engaged in setting the strategic goals and policies of the enterprise. independent and competent professional accountant who enjoys the trust and confidence of the
Management develop and executes operating standards and systems to deliver the goals of the managers.
business.
The practice of advisory services is essentially consultancy in nature. The end point of the
As a manager endeavors to increase the wealth of the organization by going through the business advisor’s job is to identify the client’s problem and recommend solutions accordingly. The
cycle of making money, cash is converted into so many forms to make it more productive. Cash pattern or format of the practitioner’s business advisory approach from one settings to another,
is converted to machines, materials, men, methods, and market to make goods and services one client to another is not governed by specific standards and processes. This is because clients
which serves as an incredible way of generating sales and, expectedly profit which would have their natural and unique way of being different from each other. Clients have different
eventually end up with more cash. These conversion processes once put into operations and organizational objectives, strategies, core competencies, and structures leading to more
realities would mean complex structures and interconnections of activities towards the differences in the details of their standards and systems.
completion of the business cycle.
Analytical Approach and Processes
These conversion processes expose in wealth of the organizations into so many risks attendant to
the uncertainties of business process, that the cash may not be reverted back to cash. Ergo, as It involves more than an incident report devoted to combination of activities in
organizations strive to make money through the business cycle, it also exposes itself into the determining client objectives, fact-finding opportunity, problem definition, evaluation of
inevitable risk of business where investments may not be recovered in full. Add to it the inherent alternatives, formulation and follow-up. Analytical approach and process also refers to the
and non-controllable risks of market and financial environment and this would surely make systematic, and rational method of solving organizational problems. It involves at a professional
management a discipline of tremendous intellectual challenges. level, the ability to find facts and define the basic problems, identify alternative solutions, and to
adopt the most applicable solution under the circumstances.
In all of these activities, the manager exercises his decision-making power, This is an authority
bestowed to him by those who have entrusted their wealth and given the manager the power to CPAs may also be involved in activities such as:
do whatever he wants to do with their money within the ambit of business expectations, ethics

1 Reference: Franklin Agamata (2019). Management Services 2 Reference: Franklin Agamata (2019). Management Services

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• Operational advice – counseling management in its analysis, planning, organizing, Professional competence means the ability to:
operating and controlling functions.
• Identify and define client’s needs
• Special studies – conducting social studies, proposing plans and programs and providing
guidance and technical assistance in their implementation • Select and supervise appropriate staff
• Organizational analysis – reviewing and suggesting improvement of policies, • Apply an analytical approach and process appropriate to the engagement
procedures, systems, methods, and organizational relationships • Apply knowledge of the subject matter under consideration
• Ideas – introducing new approaches, methods, techniques, and concepts to management • Communicate recommendations effectively, when required, assist in implementing
recommendations.
MAS Standards
3. Due Care- Due care reflects the ability of the practitioner to exercise competence and utmost
A CPA is guided by standards in the performance of his professional practice. care from the date the engagement is being negotiated with the client, to the definition of clients
performance and needs, formation of engagement teams, development of engagement programs,
Moral standards are governed by CPA practitioner’s spiritual laws, canons, societal beliefs, and
supervision of personnel, preparation of reports, presentation of output to the client and up to the
traditions that define acceptable relationship with his creator and his environment.
post-evaluation stage.
Ethical standards relate to the practitioner’s relationship with his client, his colleagues, his
4. Client Benefit – Before accepting an engagement, a practitioner is to notify the client of any
fellowmen, and the society in general. The dynamism of these relationships create expectations,
reservations he has regarding anticipated benefits.
and standards inherently aimed to protect and foster the interest of the society in general, and that
of the profession and the professional practitioners in particular. The practitioner should determine what the client wants to achieve from the engagement before
initiating an engagement. He should notify the client any reservation he has concerning the
Legal standards are meant to promote compliance, fairness, and justice to all men. Professionals
realization of anticipated benefits from the engagements. The notification should be made before
have the Constitution, or equivalent legal document of his country to serve as the primary guide
accepting the engagement. If during the engagement the practitioner comes to know or has a
in respecting legal standards.
belief of knowing that there would be significant change in the anticipated benefits to the client,
MAS Practice Standards he must communicate the same to the client.

Technical Standards set the threshold for the personal quality of the practitioner and serve as 5. Understanding with the Client. Before undertaking an engagement, a practitioner is to
guide in his work. inform the client of all significant matters relating to the engagements. An understanding with
the client should be forged to determine the nature, scope and limitations of the engagements to
1. Personal Characteristics- integrity, objectivity, and independence in mental attitude be performed. After accepting the engagement but before undertaking it, the practitioner should
inform the client on all significant matters relating to the engagement. Either an oral or
• Integrity means that the process applied in the engagement and the corresponding results
understanding with the client is acceptable. The following matters should be well understood
thereof are free from deliberate distortions of information and misstatements.
with the client:
• Objectivity refers to the fairness in approach in the conduct of the engagement and in the
presentation of results. It involves impartially and freedom from bias. • Engagement objectives
• Independence in mental attitude is the practitioner’s ability to maintain impartiality and • Nature of the services to be performed
clarity in performing his task to attain his professional objective. He should not be • Engagement scope, including areas of client operations to be addressed and limitations, if
unnecessarily influenced by his personal and related interests that may impair the any
integrity of his performance but always uphold the interests of his clients and the public • Respective roles, responsibility, and relationships of the practitioner, client and other
in general. parties in the engagement
2. Competence – It refers to the practitioner’s technical qualification to perform the engagement. • Anticipated engagement approaches, major tasks and activities to be performed and
It measures intelligence, expertise and required skills to perform an act. methods to be used
• Work schedule, timing of reports and fee arrangements

3 Reference: Franklin Agamata (2019). Management Services 4 Reference: Franklin Agamata (2019). Management Services
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6. Planning, Supervision and Control 4. Presentation of engagement results

Engagements are to be adequately planned, supervised and controlled. Adequate planning an 5. Implementation of recommendation, if applicable
supervision is required to provide reasonable assurance that the work shall be conducted in
accordance with the objectives of the engagement programs, professional standards and rules of 6. Post-engagement follow-up
conduct. Planning involves preparation of a work program. Proper supervision is need to be EXERCISES:
done. The extent of supervision depends on the quality of the personnel and the complexities of
the assignment. Effective control is to be exercised during the engagement. The quality, quantity Direction: Answer the following questions comprehensively:
and pacing of work is to be monitored with the defined engagement objectives.
1. Explain the need for management advisory services.
7. Sufficient Relevant Data
2. What is a MAS standard?
Sufficient relevant data are needed to provide a reasonable basis in making conclusions and
3. Differentiate the MAS Practice standards.
formulating recommendations to client. The gathering and analysis of data should be
documented to serve as basis in verifying the degree of the evidence obtained and the manner on 4. What are the characteristics of MAS Practice standards?
how these evidences are treated to generate the conclusions being reported.
5. What is a MAS engagement?
8. Communication of Results

All significant matters relating to the result of the engagement are to be communicated to the
client. All significant matters related to the result of the engagement are to be communicated to
the client. Reports may be done at an interim and or at the end of the engagement. Interim reports
are desirable in long or complex engagements.

Reports may be in oral, written or visual form. When no written report is to be issued, the
practitioner should keep a memorandum file documenting the results and processes of the
engagement and all his correspondence with the client.

Characteristics of a MAS engagement

• Service is for Management

• Scope is broad
• Future orientation
• Non-recurring
• Highly qualified staff
• Diversity

MAS Engagement Process

1. Engagement negotiation

2. Engagement planning

3. Engagement execution

5 Reference: Franklin Agamata (2019). Management Services 6 Reference: Franklin Agamata (2019). Management Services

MODULE IN MAC 302 - MANAGEMENT REPORTING MODULE IN MAC 302 - MANAGEMENT REPORTING
MODULE 2: UNDERSTANDING EXPENSES i. immediate recognition, such advertising, salaries and research

Learning Objectives: ii. Associating cost and effect such as cost of sales

1. Differentiate expenditures, cost and expenses iii. Rational and systematic allocation, such as depreciation
2. Understand the importance of controlling expenses
Cost v. Expenses v. Losses
3. Discuss the classification of expenditures according to accountant perspectives, managers
perspectives and economists’ perspectives Cost are traditionally classified in relation to the functional activities of the business, that is according to
4. Explain the relationship of economic costs to the level of production and sales the place and purpose of their use.

CONTROLLING EXPENSES Costs of goods manufactured are those incurred in producing goods and services. Examples are direct
materials, direct labor and factory overhead. Cost of goods sold are production cost relating to the units
Management accounting is about profit management that include expenses as its vital component. are that already sold.
Expenses affect operating results, hence should be understood and intelligently managed. The accounting
for the accumulation preparation, and presentation of expenses to serve as basis for management Expenses are those incurred in distributing goods and managing a business. Marketing promotions and
decisions is the pioneering area of management accounting. shipping expenditures are distribution expenses. Those relating to systems and control, government
compliance, and other corporate costs incurred to manage the business are referred to as administration
The end-point of operating performance is to generate maximum profit out of the resources used. expenses.
Traditional management accounting provides intelligent information to managers in order to reduce
expenses and increase profit. Reducing expenses requires for its thorough understanding in line with the Both cost and expenses give benefits to the business.
planning and controlling functions of the management. This drives the development of standard costing
Losses are reduction in the value of assets without benefit to the business leading to the impairment of
system leading the brilliant formulation of principles, techniques and processes, governing the cost-
equity. Examples of losses are loss on sales of equipment, loss on inventory obsolescence, loss on
volume-profit analysis and profit planning, responsibility accounting, operational budgeting, segment
shortages, spoilage and loss on uncollectibles.
reporting and variance analysis.
Product Cost vs. Period Cost
Costs Concepts
Product cost are those incurred in the process of producing the product. They are inventoriable and are
The use of the term “costs” here includes cost and expenses.
deferred as assets while the units are unsold. Once sold, the cost of inventory is transferred from the asset
Managing costs means knowing their nature, behavior and other characteristics. Costs may mean classification to cover cost of goods sold classification as expense. Direct materials, direct labor and
differently to different people. We will deal here with costs in the perspective of accountants, managers, factory overhead are product costs. Direct materials and direct labor are called prime costs. Direct labor
and economist. and factory overhead are called conversion costs. Direct materials, direct labor and variable factory
overhead are called variable production costs.
Accountant’s Perspectives
Period costs are those incurred outside of the production activities. They are incurred to administer a
Capital Expenditures v. Operating Expenditures business, sell or distribute a product, conduct researches, or attend to customer’s needs which are not
directly related to the production activities. They are instantly expensed once incurred.
Capital expenditures are investing outlays normally requiring large amount of money and resources
having a long-term investment impact to business profitability. These expenditures would create probable Direct Product Cost v. Indirect Product Cost
future economic value and benefit and are capitalized as assets. These costs are converted to expense once
their related income has been generated. Examples of capital expenditures are those used in long-term Cost are further classified as to their degree of relation to the product.
projects and classified as long-term assets and become an expense once consumed in the production or
Direct product costs are those that are directly identified with the finished goods or services or those that
sale of a product.
are directly attributable in the process of making them (i.e., converting materials into finished goods).
Operating expenditures are outlays or consumption used to directly support the normal operating Direct materials and direct labor are direct products costs, Factory overhead is an indirect product costs.
activities of the business. They are expensed in the period the statement of profit or loss is presented
because of the following reasons:

7 Reference: Franklin Agamata (2019). Management Services 8 Reference: Franklin Agamata (2019). Management Services
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Manager’s Perspective Unavoidable costs remain to be incurred regardless of option a manager chooses. They remain constant,
they do not change, and are irrelevant in short-term decisions. Common examples of unavoidable costs
Relevant cost v. Irrelevant cost are rent, depreciation, interest property taxes and all other committed fixed costs.
Cost may be classified according to their use in the decision-making process.

Cost that are useful in making decisions are relevant costs, otherwise they are irrelevant. Relevant cost Controllable Cost v. Uncontrollable Cost
have two characteristics, differential and future. Differential costs vary from one alternative to another
while future costs relate to the estimated quantification of the amount of a prospective expenditure. Cost may be classified in relation to the authority of the manager.

Managers have at least two alternatives in making a decision, otherwise there is no decision to be hardly Another way of classifying costs relates to the degree of authority given to a manager. Controllable costs
made at all. When a cost differs from one alternative to another, that cost is a differential cost. When a are those which incurrence or non-incurrence can be decided or influenced upon by a manager. The
cost remains the same regardless of a choice to be made, that cost is irrelevant. influence or decision-making power of a manager depends on the scope, nature and extent of authority
granted to him by the organization. The concept of controllability is related to the organizational structure
Relevant costs are not only differential costs, they should be future costs as well. Those costs that are not of an organization. The organizational structure reflects the manner on how the business, strategy is to be
to be incurred in the future are irrelevant. Past cost, sunk cost, historical costs are irrelevant cost in undertaken. Structures varies from one organization to another. Noncontrollable costs are those outside of
making decisions because they can no longer be changed. Management deals about the future and not on the decision power or influence of a given manager in a specific situation.
the past. The future could be influence or directed while the past cannot.
Planned cost v. Actual cost
Direct Segment or Indirect Segment
Cost may be classified in relation to its incurrence in a future undertaking.
Cost may be classified as to their relation to the business segment or unit.
Planned cost relate to future occurrences and are referred to a multifarious names such as projected costs,
Direct departmental cost are cost that are directly identified with the department, process, segment, or estimated costs budgeted cost, applied costs and standard costs.
activity. They may be variable or fixed costs.
Projected costs are future values derived from using forecasting models such as profitability, regression
Indirect departmental cost are those that are not directly identified with a department or a business unit. and causal models. Estimated costs are those future values derived out of normal observations without the
They are sometimes referred to as “allocated costs”, “common costs”, or plainly “unavoidable costs”. aid of standards or any reliable bases. Applied costs are estimated values derived using the normal costing
Direct department cost are avoided upon cessation of business unit operations while indirect department system. Standard costs are reliable values accepted by men in the organizations derived from empirical,
costs continuously persist despite thereof. scientific, and controlled studies.

Examples of direct department cost are salaries of a department manager, salaries of a personnel assigned Actual costs are expenditures already incurred and recorded in the accounting books. The difference
between the planned costs and actual cost is called planning gap or planning variance.
to the department, supplies purchased and used, rental of equipment directly used in the departmental
activities, utilities (electricity and water) which are directly identified with a department, Budgeted cost v. Standard cost
telecommunications, indirect materials, indirect labor and depreciation of equipment used in the
department. Examples of indirect departmental costs (or allocated cost) are salaries of executives in the Cost may be classified in relation to the level of activity being considered for estimation.
central office, other central administrative costs such as advertising, system review and development,
interest expenses, training, research and development, real estate property taxes, and allocated Budgeted costs are those expected to be incurred at the level of activity used in preparing the master
depreciation of noncurrent assets. budget. Standard costs are those expected to be incurred at any level of activity aside from that being used
in the master budget. The level of activity used in computing the standard cost may be actual or estimated.
Avoidable Cost v, Unavoidable Cost
Budgeted cost and standard costs use the same predetermined standard rates. The difference between the
Cost may be classified in relation to the occurrence of an activity. budgeted cost and standard costs is called a capacity variance. Budgeted costs refer to the master budget
while standard cost is called flexible budgets.
Avoidable costs are those not incurred once an activity is not performed. They normally become savings
on the part of the business. These savings are considered an inflow in the economic sense and referred to Out-of-pocket cost v. Non-cash cost
as imputed costs.
Cost may be classified in relation to cash.

9 Reference: Franklin Agamata (2019). Management Services 10 Reference: Franklin Agamata (2019). Management Services

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Out-of-pocket costs are those that are incurred and are paid in cash. OPCs require cash payments. Those Variable cost v. Fixed cost
that are not paid in cash are non-cash costs.
Cost may be classified in relation to quantity or level of activity. In the following discussions, we assume
Sunk cost v. Future cost the level of production and sales to be equal.

Cost may be classified according to their period of incurrence. Costs are classified as fixed or variable with regard to their behavior in relation to and the changes in the
activity level or production sales.
Sunk costs are those that have been incurred in the past and can no longer be changed. They represents
commitments made by the business in its previous decisions and cannot be avoided in the future. They are Fixed costs are those that remain constant regardless of the change in the level of production and sales,
constant and not differential. They are historical and irrelevant in short-term decisions. but inversely changes from unit basis Fixed costs could be either committed or discretionary. Committed
fixed costs are those which incurrence have been committed by the business in the past by reason of
Future costs are to be incurred in the upcoming periods. They are relevant and are of value in making contract, acquisition or agreement. Examples are rental expenses, interest expense, insurance expense,
decisions. They affect the upcoming activities where the manager should plan, organize, direct, and executive salaries, depreciation expense, patent amortization, real estate, property taxes, and salaries of
control. They are sometimes called planned costs, budgeted costs or estimated costs. production executives.
Economist’s perspective Discretionary fixed costs are costs which incurrence is assured but the amount may change depending on
Explicit cost v. implicit cost the discretion of value judgment of the manager. Examples are advertising expense, research and
development costs, executive training costs, salaries of security guard and janitors, and repairs and
Cost may be classified according to the manner on how they are stipulated. maintenance of buildings and grounds. For academic purposes, all fixed costs, whether committed or
discretionary should be treated as constant in total.
Explicit costs are those already incurred or intended to be incurred. They are already recorded or to be
recorded in the accounting books. Implicit costs are theoretical costs. They are assumed and are not Variable costs vary directly in proportion to the change in the level of production and sales. Hence, total
recognized in the accounting books. Two good examples of implicit costs are opportunity costs and variable costs change. That is, if sales increase by 10% total variables costs also change by 10%. If sales
imputed costs. decreased by 12%, total variable costs also decreased by 12%. Notice that there is a direct or complete
proportion in the change of variable costs and sales. Variable costs change in total direct proportion to
Opportunity cost v. Imputed cost changes in the level of production and sales but constant per unit basis. Examples of variable costs are
direct materials, direct direct labor, variable overhead, and variable expenses. Examples of variable
Costs may be classified in relation to the theoretical condition upon which they are created. Opportunity
overhead are factory supplies, indirect materials, indirect labor and repairs. Example of variable expenses
costs are benefits given up in favor of another choice. In each decision, there is always a beneficial
are delivery expenses, salesmen’s commission, packaging costs and supplies.
alternative (or choice) not followed but could had been followed.
EXERCISES:
Imputed costs are those not incurred but are implied in a given decision. Say, a business uses its own cash
in buying an equipment. If the borrows from a bank to buy the equipment, it should pay an interest rate of Directions: Answer the following questions comprehensively.
15% per annum. The imputed rate of using its own money instead of borrowing is, clearly, equivalent to
the amount of the 15% interest rate that should have been paid had the money been borrowed. 1. What are controlling expenses?

Opportunity costs and imputed costs are not recorded in the financial accounting system because they are 2. Differentiate product cost from period cost.
not actually incurred, they are only theoretical. But they are relevant in making decision.
3. Differentiate explicit cost from implicit cost.
Incremental cost v. Marginal cost
4. Differentiate variable cost and fixed cost.
Cost may be classified in relation to particular product or activity.
5. Define costs from manager’s perspective, accountant’s perspective and economist’s perspective.
Incremental costs represent a total increase in costs. Marginal cost is an increase in cost per unit.
Decremental costs are decreases in costs.

11 Reference: Franklin Agamata (2019). Management Services 12 Reference: Franklin Agamata (2019). Management Services
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MODULE 3: VARIABLE COSTING & ABSORPTION COSTING The Variable Costing Profit or Loss Statement – Expanded Form
Learning Objectives: Variable cost may be segregated into variable cost of goods sold and variable selling and
1. Prepare the profit or loss statement under the variable costing and absorption costing method administration expenses. Fixed costs may be segregated into direct and indirect fixed costs and
2. Explain the nature and characteristics of product costs and period costs expenses. And direct fixed costs and expenses may be controllable or non-controllable .
3. Account the difference in profit under the absorption costing and variable costing method
4. Explain the importance of normal capacities to profit
5. Compute the volume variance and understand its connection to normal capacity.
Variable Costing
There are two profit determination models that are popularly used – the variable costing and the Pro-Forma Statement of Profit or Loss
absorption costing. For a Given Period

The Variable Costing Sales Px

Variable Costing is premised on the philosophy that costs are either fixed or variable. Variable costs Less: Variable Cost of Goods Sold x
relates to units sold. The difference between sales and variable cost is called the contribution margin. It is Manufacturing Margin x
used to absorb fixed costs and generate profit. Less: Variable Selling and Administrative expenses x
Contribution Margin x
A condensed variable costing statement of profit or loss is shown below:
Less: Controllable direct fixed cost and expenses x
Pro-forma Condensed Statement of Profit or Loss – Variable Costing Controllable margin x
Less: Non-controllable direct fixed costs and expenses x
Variable Costing Segment(direct) margin x
Pro-Forma Statement of Profit or Loss Less: Indirect Fixed cost and Expenses x
For a Given Period Profit Px

The margins are sorted to serve the specific needs in management activities.
Sales Px
The Absorption Costing
Less: Variable Cost and Expenses x
Contribution Margin x Absorption costing operates within the framework of the International Financial Reporting
Less: Fixed Cost and Expenses x Standards. It is also known as “ full costing” or “traditional costing”. It classifies costs and
Profit Px expenses according to the functional nature of business operations such as cost of goods sold,
marketing, selling, and administrative expenses. The pro-forma absorption costing is shown
below:

The variable costing (also called marginal costing or direct costing) income statement is not in
accordance with the established financial reporting standards. Rather, it follows the economic
model of determining profit and gives business managers much more accurate perspective on
how profit and operating wealth are accumulated and controlled.

Variable costing follows the economic model in determining profit.

13 Reference: Franklin Agamata (2019). Management Services 14 Reference: Franklin Agamata (2019). Management Services

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Under the absorption costing method, the fixed overhead is a product cost and therefore is
deducted from sales based on the number of units sold (i.e. units sold x standard unit fixed
Absorption Costing overhead). In variable costing, the fixed overhead is a period cost and therefore, treats the entire
Pro-Forma Condensed Statement of Profit or Loss budgeted fixed overhead as expense during the period.
For a Given Period
Sample Problem: Product Cost vs. Period Cost
Sales Px
EFEM Corporation gives you the following production data with respect to its March, 2020
Less: Cost of Goods Sold x
operations:
Gross Profit x
Less: Marketing, Selling and Administrative Expense x Production costs P4,000,000 (standard)
Earnings before interest and tax x Production costs P4,200,000 (actual)
Less: Interest Expense x Production units 10,000
Profit before Tax x Sales units 8,000
Less: Provision for Income Tax x
Profit Px Determine the cost of goods sold and the value of the ending inventory assuming all the
production costs are considered as:

1. Product costs
The Difference between Absorption and Variable Costing Methods
2. Period costs
The difference between absorption and variable costing methods lies on how the fixed overhead
is treated. Under the absorption costing, fixed overhead is treated as a product cost while under Solutions/Discussions
the variable costing, fixed overhead is treated as period cost. The matrix below shows how costs
• Management costing uses the standard costing system. Hence, the computation of the unit
and expenses are classified under absorption and variable costing systems.
costs is based on the standard costs
Cost and Expenses Absorption Costing Variable Costing • The unit product cost is P400 (P4,000,000/10, 000 units)
Direct Materials Product Cost Product Cost • The cost distribution shall be as follows:
Direct Labor Product Cost Product Cost
Variable Overhead Product Cost Product Cost
Fixed overhead considered as
FIXED OVERHEAD PRODUCT COST PERIOD COST Product Cost Period Cost
Variable Expenses Period Cost Period Cost Cost of Goods Sold (8,000 x P400) ₱ 3,200,000 ₱ -
Fixed Expenses Period Cost Period Cost Endimg Inventory (2,000 x P400 800,000
Operating Expenses (10,000 x P400) - 4,000,000
Product costs, also called inventoriable costs or deferrable costs, are those that are associated Total Costs as accounted ₱ 4,000,000 ₱ 4,000,000
with units produced. These costs follow the flow of the units produced. They are deferred to
inventory if the units are still unsold and are charged to expense (e.g. cost of goods sold) once Under variable costing system, the entire P4,000,000 is deducted outright as an operating
sold. expense and no amount is deferred to inventory.
Period costs are charged outright as expenses are incurred in the period. They are not affected
on whether the units are already sold or not. They do no relate to the flow of units but, rather in
the period of incurrence.

15 Reference: Franklin Agamata (2019). Management Services 16 Reference: Franklin Agamata (2019). Management Services
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Understanding the Profit Behavior under the Absorption and Variable Costing Systems 2. The Case Environment

The difference in the accounting for fixed overhead and the reconciliation of profit between the
absorption costing and the variable costing are amplified by considering the following Notice that the cases have the same level of production at 20,000 units which is equal to the
illustration. normal capacity. Normal capacity is the expected capacity over the long-term. This is an
important observation. It means we do not have volume variance in this sample problem.
Sample Problem: Profit(Loss) Calculation, Assuming Normal Capacity Equals Actual
Production Next, in case “A” sales are greater than production, in case B, sales are less than production, and
in case C, sales is equal to production.
Mela Corporation has the following standard costs and production data in 2020:
3. Profit (loss) determination
Unit sales price P200
Unit variable cost of production 120 Now, let us compute the profit and loss by getting the differences in sales, costs, and expenses
Unit fixed over overhead 20 under each costing systems. Costs and expenses include all of the available cost of goods sold,
Unit variable expenses 10 fixed overhead, variable expenses, and fixed expenses. The profit under each method is
Unit fixed expenses 5
computed as follows:
Beginning inventory 4,000 units
Normal Capacity 20,000 units Computation Absorption Variable
Quantity sold x unit
The company fixed its expenses based on normal capacity. Sales sales price 22,000 x P200 ₱ 4,400,000 ₱ 4,400,000
Required: Determine the operating profit or loss using the absorption costing and variable
Quantity sold x unit
costing system in each of the following cases:
variable cost of
Variable Cost of Goods Sold production 22,000 x P120 (2,640,000) (2,640,000)
Case Production Sales
Quantity sold x unit
A 20,000 22,000
B 20,000 19,000 Fixed Overhead fixed overhead 22,000 x P20 (440,000)
C 20,000 20,000 Normal capacity x
fixed overhead rate 20,000 x P20 (400,000)
Discussions: Case A – Sales (22, 000 units) > Production (20,000 units) Quantity unit sold x
unit variable
1. Formulas Variable Expenses expense 22,000 x P10 (220,000) (220,000)
Normal capacity x
Fixed Expenses unit fixed expenses 20,000 x P5 (100,000) (100,000)
Sales = Quantity Sold x Unit Sales Price Profit (Loss) ₱ 1,000,000 ₱ 1,040,000
Variable Cost of Good Sold = Quantity Sold x Unit Variable Production Cost
The fixed overhead under the absorption costing method is based on the number of units sold
Variable Cost of Goods Quantity Produced x Unit Variable Production
= (i.e. 22,000 units) because it is a product cost and therefore is expensed based on the number of
Manufactured Cost
Variable expenses = Quantity Sold x Unit variable Expenses unit sold.
Standard Fixed Overhead Rate = Budgeted Fixed Cost/ Normal Capacity The fixed overhead under variable costing method is a period cost. As such all the budgeted
Standard Fixed Expenses Rate = Budgeted Fixed Expenses/ Normal Capacity fixed overhead is deducted from sales without regard to the number of units sold. The budgeted
fixed overhead and budgeted fixed expenses are computed as follows:

Budgeted fixed overhead = Normal Capacity x Standard Fixed Overhead Rate

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variable costing methods. The difference in the fixed overhead amount explains the difference in
= 20,000 units x P20 profit between the two profit modeling systems.

Method 2. Beginning and Inventory units Perspective. Another way to get the change in
= P400,000
inventory is by getting the difference in the beginning and ending inventory unit.
Budgeted fixed expenses = Normal Capacity x Standard Fixed Expenses Rate
Beginning Inventory 4,000 units
Less: Ending Inventory (2,000 units)
= 20,000 units x P5 Change in Inventory 2,000 units
x Standard fixed overhead rate P 20
= P100,000 Change in Profit P 40,000

To emphasize, budgeted fixed overhead and fixed expenses are based on normal capacity. In Ending Inventory = Beginning Inventory + Production – Sales
case actual fixed overhead is given, the same shall be included in the variable costing income
statement, instead that of the budgeted fixed overhead. However, under the absorption costing = 4,000 units +20,000units -22,000units
system, the fixed overhead based on standard cost and the difference between the actual and = 2,000 units
standard fixed overhead is reported as fixed overhead variance to be reflected in the profit or loss
statement. Method 3. Beginning and Inventory amounts Perspective. Get the changes in the values of
beginning and ending inventories under each of the methods.
The fixed expenses is allocated over normal capacity for more strategic reason is used purposely
for this particular type of problem. For short-term analysis, the standard fixed expense rate us
related to units sold.
Absorption Variable Change
3. The difference in profit Beginning Inventory
(4,000 units x P140) ₱ 560,000
In Case A, the difference in profit is P40,000 (i.e.P1,040,000 – P1,000,000). The difference in (4,000 units x P120) ₱ 480,000 ₱ 80,000
profit between absorption and variable costing methods may be accounted for using four (4) Less: Ending Inventory
methods, as follows: (2,000 units x P140) 280,000
(2,000 units x P120) 240,000 (40,000)
Method 1. Direct Reconciliation. Get the difference in the amount of fixed overhead charged Change in Profit ₱ 40,000
under the two methods, as shown below:

Absorption Variable Change

Sales ₱ 4,400,000 ₱ 4,400,000 - 5. The Unit Product Cost
Variable Cost of Goods Sold (2,640,000) (2,640,000) -
The unit product costs (or unit inventoriable costs) for the two profit modeling systems are
Fixed Overhead (440,000) (400,000) 40,000
determined below:
Variable Expenses (220,000) (220,000) -
Fixed Expenses (100,000) (100,000) - Absorption Variable
Profit (Loss) ₱ 1,000,000 ₱ 1,040,000 ₱ 40,000 Unit Variable Cost P120 P120
Unit Fixed Overhead 20 n.a.
Note that sales, variable cost of goods sold, variable expenses and fixed expenses are the same Unit Product Costs 140 P120
under each method. Only the fixed overhead differs in amount between the absorption and

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Unit variable costs include the costs of direct materials, direct labor, and variable overhead. The Case C- Sales (20,000 units) = Production (P20,000 units)
fixed overhead is a period cost, and not a product cost, under the variable costing method.
The profit is computed as follows:
6. The Cost of Goods Sold
Absorption Variable
Cost of goods sold is units sold times the unit product cost. It could also be determined using the Sales (20,000 x P200) ₱ 4,000,000 ₱ 4,000,000
financial accounting as follows: Variable cost of goods sold (20,000 x P120) (2,400,000) (2,400,000)
Fixed overhead (20,000 x P20) (400,000) (400,000)
Absorption Variable
Variable expenses (20,000 x P10) (200,000) (200,000)
Beginning Inventory 560,000 480,000
Fixed expenses (20,000 x 5) (100,000) (100,000)
Add: Cost of Goods Manufactured
20,000 x P140 2,800,000 Profit (Loss) ₱ 900,000 ₱ 900,000
20,000 x P120 2,400,000
Total Goods Available for Sale 3,360,000 2,880,000
Less: Ending Inventory 280,000 240,000 There is no difference in profit or loss because there is no change in inventory. This means
Cost of Goods Sold 3,080,000 2,640,000 production equals sales, and cost of goods manufactured equals cost of goods sold.

Case A Case B Case C

Case B – Sales (19,000 units) < Production units (20,000 units) Sales (units) 22,000 19,000 20,000
Production (units) 20,000 20,000 20,000
The profit is computed as follows: Absorption costing, profit ₱ 1,000,000 ₱ 850,000 ₱ 900,000
Variable costing, profit ₱ 1,040,000 ₱ 830,000 ₱ 900,000

Absorption Variable From this, we can learn the following learning points:
Sales (19,000 x P200) ₱ 3,800,000 ₱ 3,800,000
Variable cost of goods sold (19,000 x P120) (2,280,000) (2,280,000) CASE Where Profit (Loss)
Fixed overhead (19,000 x P20)-budgeted amount (380,000) A Sales > Production Variable Profit > Absorption Profit
Fixed overhead (20,000 x P20) -budgeted amount (400,000) B Sales < Production Variable Profit < Absorption Profit
Variable expenses (P19,000 x P10) (190,000) (190,000) C Sales = Production Variable Profit = Absorption Profit
Fixed expenses (P20,000 x 5) -unchanged (100,000) (100,000)
Profit (Loss) ₱ 850,000 ₱ 830,000
Variable costing profit follows the trend in sales. When sales are greater than production,
variable costing profit is greater than absorption costing profit; and when sales are lower than
The difference in profit (loss) of P20,000 is accounted for as follows: production, variable costing profit is less than absorption costing profit. When sales equal
production, the profit (loss) between variable costing and absorption costing is equal.
Production 20,000 units
Less: Sales 19,000 units When sales exceed production, the cost of fixed overhead recorded in the absorption costing is
Change 1,000 unit greater than that of variable costing. This is because the amount of fixed overhead charged
x Standard Fixed Overhead against income is determined based on the number of actual units sold. Therefore, in as much as
Rate P20
sales in units are greater than production, the fixed overhead is recorded under absorption costing
Change in Profit P20,000
is also greater, resulting to higher cost of goods sold and lower profit than that of the variable
costing system.

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When sales are lower than production, the fixed overhead charged in the absorption costing is x Standard Fixed Overhead Rate P20
lower and its profit is higher than variable costing. The fixed overhead charged in the variable Volume Variance in Pesos ₱ 20,000 Favorable
costing is constant regardless of the level of sales while the fixed overhead charged in the
absorption costing changes in relation to its units sold. Volume variance represents the ability of the business to meet the normal capacity. Volume
variance is related to fixed overhead, it is constant per total amount but changes per unit. In
In variable costing, as sales increase, profit also increases, as sales decline, profit also declines. short, fixed overhead is not controlled on its total amount but is controlled in relation to volume
This observation follows a manager’s normal train of thought with regard to the relationship of (production). Over the years, a business would have already developed it average capacity (i.e.
shares and profit. This differs from the reports using absorption costing where there are instances normal capacity) that settles at the middle of the ups and downs of its production levels. If
that sales are increasing but profit is declining and vice-versa. normal capacity is greater than the actual capacity, there is a under-absorbed capacity and it is an
unfavorable variance. If normal capacity is less than the actual capacity, there is an over-
If variable costing follows sales, then absorption costing follows production. If production is absorbed capacity, a favorable variance.
greater than sales, absorption costing income is greater than that of variable costing. If
2. A cost variance is the difference between the actual costs and standard costs. If actual costs are
production is less than sales, absorption costing profit is less than that of variable costing.
greater than standard costs, the cost variance is unfavorable. If actual costs are less than standard
Sample Problem: Profit (Loss) Calculation, Normal Capacity Differs from the Actual costs, the cost variance is favorable.
Production
Under the standard costing system, the costs are recorded at standard. Financial reports,
Hunter X Hunter Corporation has the following standard costs and production data in 2020: however, are prepared at actual data. As such, unfavorable variances are added to standard cost
of goods sold, while favorable variance are deducted from standard cost of goods sold to get the
Unit sales price P200 actual cost of goods sold. That is why unfavorable cost variance is also called debit variance,
Unit variable cost of production 120 why favorable cost variance is called credit variance.
Unit fixed overhead 20
Unit variable expenses 10 Volume variance is included only in the absorption costing income statement. Since volume
Unit fixed expenses 5 variance relates to fixed overhead which is a product cost under the absorption method, hence the
Beginning inventory 4,000 units volume variance is considered. Under the variable costing, however, the fixed overhead is a
Normal capacity 20,000 units period cost, an expense and is not subject to cost variable analysis.

The fixed expenses are also based on normal capacity. The computation of profit (loss), with volume variance, is shown below:
Absorption Variable
Required: Determine the operating income under absorption costing and variable costing under Sales (22,000 x P200) ₱ 4,400,000 ₱ 4,400,000
each of the following independent cases: Variable cost of goods sold (22,000 x P120) (2,640,000) (2,640,000)
Fixed overhead (22,000 x P20) (440,000)
CASE Production Sales Fixed overhead (20,000 x P20) (400,000)
A 21,000 22,000 Volume variance - favorable 20,000
B 18,000 15,000 Variable expenses (22,000 x P10) (220,000) (220,000)
Fixed expenses (20,000 x P5) (100,000) (100,000)
Solutions: Profit ₱ 1,020,000 ₱ 1,040,000
Case A – Sales (22,000 units) > Production (21,000 units), with Volume Variance
The favorable volume variance is added because the profit is computed directly. The normal
1. First, compute the volume the volume variance because the actual production is not equal to treatment, though, for a favorable cost variance is to deduct it from the standard cost of goods
the normal capacity. sold. Note that the volume variance is treated only under the absorption costing method.

Normal Capacity in units 20,000 The difference of profit of P20,000 is accounted as follows:
Less: Actual Capacity in units 21,000
Volume variance in units (1,000) Production 21,000 units

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Less: Sales (22,000) units Change in Profit ₱ 60,000
Change in Inventory (1,000 units)
x Standard Fixed Overhead Rate P20
Change in Profit ₱ 20,000 EXERCISES:

Problem
Cost B – Sales (15,000 units) < Production (18,000 units), with capacity variance
Lighthouse Corporation has the following standard costs and production data in 2021:
1. Compute the capacity variance because the actual production is not equal to the normal
capacity. Unit sales price P150
Unit variable cost of production 100
Normal Capacity in units 20,000 Unit fixed overhead 25
Less: Actual Capacity in units 18,000 Unit variable expense 15
Unit fixed expenses 10
Volume variance in units 2,000 Beginning Inventory 5,000 units
x Standard Fixed Overhead Rate P20 Normal capacity 25,000 units
Volume Variance in Pesos ₱ 40,000 Unfavorable
In profit or loss calculation, it is assumed that normal capacity equals actual production.

CASE A: Production (25,000 units); Sales(30,000 units)

1.a Compute the profit or loss using absorption costing and variable costing
1.b Compute the difference in profit using the beginning and inventory units perspective
1.c Compute the difference in profit using the beginning and inventory amounts perspective
2. The profit (loss) is computed as follows:
CASE B. Production (25,000 units); Sales (23,000 units)
2.a Compute the profit or loss using absorption costing and variable costing.
Absorption Variable 2.b Compute the change in profit using the production and sales perspective.
Sales (15,000 x P200) ₱ 3,000,000 ₱ 3,000,000
Variable cost of goods sold (15,000 x P120) (1,800,000) (1,800,000) CASE C: Production (25,000 units) ; Sales (25,000 units)
Fixed overhead (15,000 x P20) (300,000) 3.a Compute the profit or loss using absorption costing and variable costing
Fixed overhead (20,000 x P20)-budgeted (400,000)
Volume variance-unfavorable (40,000) -
Variable expenses (15,000 x P10) (150,000) (150,000)
Fixed expenses -unchanged (100,000) (100,000)
Profit (loss) ₱ 610,000 ₱ 550,000

The unfavorable volume variance is deducted from profit. The normal treatment of an
unfavorable variance is as addition to the standard cost of goods sold. Using a direct method of
computing profit, an increase in cost of goods sold is a deduction from profit.

The difference in operating profit of P60,000 is accounted for as follows:

Production 18,000 units

Less: Sales (15,000) units
Change in Inventory 3,000 units
x Standard Fixed Overhead Rate P20

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Less: Variable marketing and

MODULE 4: PROFIT PLANNING & COST-VOLUME PROFIT ANALYSIS
Less: Fixed costs and expenses x administrative expense x
Learning Objectives: Profit Px Contribution Margin x
1. Enumerate the underlying assumptions of cost-volume profit analysis Less: Fixed costs and Expenses x
2. Discuss the basic cost-volume-profit analysis
3. Discuss the importance of contribution margin Profit Px
4. Calculate the margin of safety and explain its relation to profit

Profit Planning For the purpose of profit analysis and control, managers give emphasis to the contribution
margin. To avoid operating loss, contribution margin should be at least equal to fixed costs. Any
Profit planning is the process of anticipating profit under varying conditions and analyzing the amount of contribution margin in excess of fixed costs is profit. A peso increase in contribution
effects of variables affecting it. It directly relates to the normal operating activities and is short- margin is a peso increase in operating profit.
term in nature.
Assumptions in Profit Planning and CVP Analysis
Variable Costing and Profit Planning
Management has to control costs. The process of understanding the relationships of costs; sales
The Variable Costing system is preferred as a managerial tool in profit planning. Variable price and sales volume as they impact profit is known as Cost-Volume Profit analysis, e.g. CVP
costing is straight forward, stresses the importance of quantity and price to sales and profit and analysis. The process of understanding and controlling the impact of changes in costs, sales
follows the foundation of economic principles. In this model, costs are classified as fixed or price, volume and sales mix to profit in order to identify the level of optimal operating
variable. Total fixed costs are related to normal capacity and are independent from the changes in performance in achieving the overall goal of an enterprise is profit planning.
the level of sales volume. Variable costs change directly in relation to the change in volume of
sales. Variable costing system (also known as marginal costing system or contribution margin The variables of profit are the unit sales price, unit variable costs, total fixed costs, sales volume
approach) determines profit as follows: (or volume) and the sales mix. Sales mix is happens when a business sells two or more products.
The assumptions to these variables as they relate to units sold, are as follows:
Quantity Price Amount
Sales 10,000 ₱ 200 ₱ 2,000,000 Profit Planning Assumptions
Less:Variable Cost 10,000 ₱ 120 (1,200,000)
Basic Assumptions Sensitivity Assumptions
Less: Fixed Cost (500,000)
Sales Volume Changes Changes
Profit ₱ 300,000
Unit Sales Price Constant Changes
Unit Variable Cost Constant Changes
Contribution Margin Total Fixed Cost Constant Changes
Sales Mix Constant Changes
Sales and variable costs directly relate with sales volume. The difference in sales and variable
costs is originally called profit/volume, but is now popularly referred to as contribution margin.
This amount is used to absorb fixed costs. The difference between contribution margin and fixed Basic Assumptions
costs is profit. The format to determine profit using the variable costing system is as follows:
The sales price is considered constant for planning purposes. It is influenced by competition
variability in supply and demand, laws, technology, distribution, channels, emerging practices,
Condensed Format Expanded Format
production input prices, taxes, subsidies, seasonality, and other determinants. However, once set
Sales Px Sales Px
by the marketing and planning department, the sales price is considered constant hence,
Less: Variable costs and expenses x Less: Variable costs of goods sold x considered outside the controllable domain of the expense management. The most the
Contribution Margin x Manufacturing margin x management accountant can do is to influence the setting of the sales price.

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The variable cost rate is considered constant for planning purposes. It is affected by a change in The Basic CVP analysis
the prices of suppliers, labor, rentals, telecommunications, fuel, warehousing, distribution, taxes
and licenses, agency costs, and such other determinants. The total fixed costs and expenses are The Basic CVP analysis covers the study on contribution margin, break-even point, margin of
also considered constant for planning purposes. safety, profit setting, sales mix analysis and degree of operating analysis.

The Basic CVP Analysis is based on following assumptions: The contribution margin is the heart of variable costing analysis (i.e., marginal analysis,
profitability analysis, differential costing analysis). Its relevance is based on the premise that “an
Areas Basic Assumptions increase in contribution margin means an increase in profit”.
Costs classification Segregated as to fixed and variable costs. Sample Problem – The Contribution Margin, Break-even Point, and Margin of Safety

Pilot Company establishes the following information for its profit-planning activities:
The behavior of sales and costs is linear within the relevant
range. Total fixed costs remain constant, but unit fixed cost Unit sales price P200
inversely changes in relation to volume (i.e.. Unit fixed costs Unit variable costs 120
Total fixed costs 400,000
decreases as production increases.) Units sold 8,000 units
Total variable costs change but unit variable cost os constant.
Linearity and behavior Unit sales price is constant. Determine the following for Pilot Company’s profit planning analysis:
1. Unit contribution margin, contribution margin rate and variable cost rate.
There is only one product or, in case of multi-product 2. Break-even point in units and in pesos.
Product operations, the sales mix is constant. 3. Margin of safety in units and in pesos, and the margin of safety rate.
Work-in-process inventory There is no work in process inventory.
Solutions/Discussions:
There is no change in the finished goods inventory, that 1. Unit contribution margin (UCM), contribution margin rate(CMR), and variable cost
Production equals sales means production equals sales. rate (UVC)

Cost-volume profit analysis also assumes that labor productivity, production technology, and If: Contribution Margin = Sales – Variable costs
market conditions will not change. Or if they change, their impact shall be covered in the And: Unit Contribution Margin = Unit Selling Price – Unit Variable Cost
sensitivity analysis. Also, it is assumed that there is no inflation, or if it can be forecasted, it is Then: The unit contribution margin is P80, i.e. P200-P120
The contribution margin rate is 40% i.e., P80/P200
already included in the CVP analysis data.
The variable cost rate is 60% i.e., P120/P200
CVP sensitivity assumptions
The basic interrelationships.
The assumption that sales price, unit variable costs, and total fixed costs are constant are used to Units Unit Prices Amount Percentage
establish the “standard costs”. These costs serve as the “ballpark figures” or initial points of Sales 8,000 ₱ 200 ₱ 1,600,000 100 Sales rate
understanding the results of business operations. Less: Variable costs 8,000 120 960,000 60 VC rate
Contribution Margin 8,000 ₱ 80 ₱ 640,000 40 CM rate
The assumptions used in the basic CVP analysis are stiff, unreal, and are not reflective of
practical business conditions. In the real world, changes abound and their impacts are sometimes Less: Total Fixed Costs 400,000
profound. Sales price change. Unit variable costs and total fixed costs also change. Sales mix Profit ₱ 240,000
changes as well. The process of considering the impact and the results of the profit of the
changes in its variables is called CVP sensitivity analysis. Note that net sales is based, i.e. total sales is 100%., unit sales price is also 100%.

• Now, focus in the power of contribution margin. In as much as the total fixed costs is
constant, then as increase in the contribution margin is automatically an increase in profit.

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5. Margin of Safety in units and in pesos, and the margin of safety rate.
Contribution Margin may be computed in at least (4) important ways, as follows:
1. CM = Sales – Variable Costs • Margin of Safety is the difference between budgeted sales and break-even sales. It is the
2. CM = Fixed costs + Profit maximum amount of reduction in sales before loss happens.
3. CM = Unit sold x Unit contribution margin • The margin of safety in units is 3,000, the margin in safety pesos is P600,000 and the
4. CM = Sales x Contribution margin rate margin of safety rate is 37.50%.
• The margin of safety expressions and computations are tabulated below:
2. Break-even point in units and in pesos Units Amount Rate
Budgeted sales (8,000 units x P200) 8,000 ₱ 1,600,000 100%
• Break-even point (BEP) is where total sales equal total costs. At this point of sales level,
Less:Break-even sales 5,000 ₱ 1,000,000 62.5%
there is no profit or loss. Also, at breakeven point, contribution margin equals total fixed
costs. Margin of Safety 3,000 ₱ 600,000 37.5%
• The break-even point in units is P5,000.
• The break-even point in pesos is P1,000,000
Margin of Safety Ratio (MSR) is margin of safety over budgeted sales. The MSR may be
The break-even point formulas are as follows: determined based in units or in pesos.

Break-even point units = Total Fixed Cost/Unit Contribution Margin • The presence of a margin of safety indicates profit. Since margin of safety is the amount
Fixed Cost = Break-even point in Units x Unit Contribution Margin of sales in excess of break-even point, it means that in every peso of margin of safety,
Unit Contribution Margin = Fixed Cost/Break-even Point in units there is a profit. And profit is the incremental contribution margin after the break-even
Break-even points in pesos = Fixed Cost/Contribution Margin Rate point because all fixed costs have already been covered by the contribution margin by
then. Managing the margin of safety is the second approach in controlling the economic
To derive break-even point formula, we have: profit.
Total sales = Total costs
Total sales = Fixed Costs + Variable Cost From this understanding:
Applying it, we have :
Applying the formulas in our illustrative problem, we have: Profit = P600,000 x 40%
BEP (units) = P400,000/P80 = 5,000 units Profit = P240,000
BEP (pesos) = P400,000/40% = P1,000,000

To prove: EXERCISES:
Sales (5,000 units x P200) ₱ 1,000,000
Less: Variable costs (5,000 x P120) 600,000 Direction: Solve the given problems.
Contribution Margin 400,000 Dianne Company makes a product that sells P240 per unit. Variable costs are P144 per unit and fixed
costs total P3,840,000. The company sold 68,000 units during the current year.
Less: Fixed Costs 400,000
Required:
Profit (loss) ₱ - 1. Unit contribution margin, contribution margin rate and variable cost rate.
2. Breakeven point in units and in pesos.
And also: 3. Margin safety in units and in pesos.
Contribution Margin (5,000 x P80) ₱ 400,000 4. Margin of safety ratio.
Less: Fixed Costs 400,000
Profit (loss) ₱ - Highlands Inc., produces and sells camping equipment. One of the company’s products, a camp lantern,
sells for P150 per unit. Variable expenses are P120 per lantern, and fixed expenses associated with the
lantern total P450,000 per month.
At Break-even point, total contribution margin equals total fixed costs. Required:
1. Determine the breakeven point in units and in pesos

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2. At present, the company is selling 15,000 lanterns a month. The sales manager is convinced that a 10% Standards that are set too low would attract mediocre performance and would fail to maximize the
reduction in the selling price would result in a 25% increase in the number of lanterns sold each. How potentials of employees.
much is the change in net income if the sales manager’s expectations are correct.
Standard Levels
MODULE 5: STANDARD COSTING AND VARIANCE ANALYSIS
Standard levels may be theoretical, practical or tax.
Learning Objectives
Theoretical standards (or ideal, maximum efficiency, or perfection standards) are set at the highest
1. Discuss the concepts of standards and standards-setting possible capacity where there are no allowances for waste, spoilage, inefficiencies, machine breakdowns
2. Determine and analyze the cost variances of direct materials, direct labor, and factory and other downtimes, and other interruptions in the production line. Standards bring the organization at
overhead the level of business operations where machines, systems, and personnel are working in the best possible
3. Analyze cost variances in one-way and two-way analyses situation without allowances for normal operating interruptions. It is based on the work of most skilled
workers, most efficient machines, and best production design and processes. These standards may bring
STANDARDS in positive attitude and behavior if employees are motivated to strive for quality and excellence. If the
standards are perceived to be too high to attain, employees react negatively – this defeats the motivational
Standards are expected levels of performance. purpose of standards. Theoretical standards are adopted by companies which employ total quality
management principles. Theoretical standards are normally replaced by practical standards in financial
Standards are established to institute order, discipline, expectations, and normalcy. Standards are
planning and controlling to make estimated financial data more reliable.
expressed and used in many forms. Societal standards are reflective of ethics, values, culture, traditions,
beliefs, laws and decrees. Organizational standards are expressed in policies, procedures, rules, Practical standards attain the most reasonable production level, with allowances for machine breakdowns,
regulations, manuals and systems. Standards could be financial or non-financial, quantitative or non- downtimes, inefficiencies, waste and spoilage, and other normal production disturbances. Practical
quantitative. In the field of financial accounting, for example, the standards used are the International standards still require utmost efficiency and optimum use of resources under normal circumstances.
Financial Reporting Standards, while tax laws and regulations are the standards on taxation services. Practical standards are reasonable and attainable.
Standards are oftentimes quantitative for objectivity in measurement. There are standards established and Lax standards (or slack standards) provide the maximum allowances for inefficiencies and ineffectiveness
followed in accounting, treasury, engineering, design, legal, administration, marketing, human resources, and are not geared towards producing less than the reasonable output from the process. It is a sure
distribution, customer relations, information technology and other areas of responsibility centers. formula to slowdown activities and make the business much less competitive and self-sustaining.
Standards are used in almost all facets of management – planning, organizing, directing, and controlling. Budget, Standards, and Normal Volume
In planning, standards serve as basis for forecasting. In organizing and directing, standards are used as
indicators to monitor production yield rate, conformity or nonconformity with administrative policies, and Budget, standards and normal volume levels differ in terms of usage (or quantity) but not in their rate per
personnel efficiencies. In controlling, standards are used in costs variances analyses for on-line unit.
monitoring and adjustments and for – end-of-the-line evaluation and remedial actions.
Budgeted (or expected actual capacity is the estimated level of performance that the company plans to
Standards Setting achieve in the next 12 months. Budgeted quantity is based on budgeted level of production. It equals the
budgeted unit of production multiplied by the standard quantity (eg, pounds or hours) per unit of product.
Standards-setting is strategic in nature. Standards could be set by top management, outsourced from an
independent entity, developed by the industrial engineering department, or established with the Standard capacity is the estimated capacity that should have been used in actual capacity. It is determined
participation and involvement of lower level managers and personnel. The process of developing by multiplying the actual production in units by the standard quantity rate per unit produced.
standards is a matter of managerial prerogative.
Normal capacity (or normal volume) may be set based on the average sales demand of the product,
When standards are developed with the participation of operating personnel and officers, there appears no engineering or estimates and technical specifications, legal variables, cultural orientations, or other
reasons for not meeting them. Besides, standards set by hands-on personnel are more reflective on the factors.
realities in the production line and other facets of business operations.
Normal capacity is the average production level of the business over the period covered by the budget. It
Standards set in organizations could either motivate or de-motivate employees, give relevance or is the middle point of variations in the budgeted production levels serving as the basis in budgetary
insignificance in the meaning of their work, or produce excellent or mediocre performance. If the planning where the concept of stability is of prime importance. Normal capacity is also the basis in
standards set are too high and improbable to achieve, it will create dysfunctional employee behavior. determining the fixed overhead rate, where:
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Standard fixed overhead rate = Budgeted fixed overhead/Normal capacity Mela Company Date established 11.20.2019
Cutting Department Product Tungki
Sample Problem – Capacity Levels
Standard Costs Sheet
Melanie Corporation acquired a machine with a 200,000 units level of capacity five years ago. Using this
machine, the standard labor time is 2 hours per unit. Engineering estimates based on attainable
performance is 170,000 units. Management has planned to produce only 160,000 units in the coming year Qty. Price Unit cost
using the same machine. Total production in the last 5 years is 828,000 with annual production recorded Direct Materials
as follows:
A4 - 44 3 Ibs. ₱ 2.00 ₱ 6.00
First year, 180,000 units BB - 77 6 pcs. ₱ 6.20 ₱ 37.20
Second year, 140,000 units CC -12 4 units ₱ 3.40 ₱ 13.60 ₱ 56.80
Third year, 170,000 units Direct Labor 4 hrs. ₱ 7.00 ₱ 28.00
Fourth year, 182,000 units
Variable overhead 4 hrs. ₱ 3.00 ₱ 12.00
Fifth year. 156,000 units
Fixed overhead 4 hrs. ₱ 5.00 ₱ 20.00
The capacity levels are as follows: Total Standard Unit Cost ₱ 116.80

Units Hours (units x 2 hours)

Maximum capacity 200,000 400,000 The standard materials per unit (3 Ibs,, 6 pcs., 4 units) may be initially determined by the production
Practical capacity 170,000 340,000 manager and the standard number of hours to make a unit of output may be based on the study of the
Budgeted capacity 160,000 320,000 industrial engineering department. The unit materials costs shall be primarily determined by the
purchasing manager. The quality and specifications of the materials shall however be that of the
Normal capacity (828,000 production manager. The standard labor rate may be estimated on the advise of the human resource
units/5 years) 165,600 331,200 manager, legal officer, and the production manager.
Standard capacity first year 180,000 360,000
The standard variable overhead rate is determined based on past experiences with adjustments on current
*The standard hours is based on the actual capacity, and in this case is 180,000 units. and anticipated developments that impact variable overhead. The fixed overhead rate is based on normal
capacity. Standard rate or price should be based on a net basis. Standard hours are quantity should be set
Standard Costs at gross basis after including allowances for spoilage, breakdowns, and similar events.

Standard costs (standard quantity times standard price) are used to motivate optimal productivity and The standard quantities and prices shall be consensusly developed and recommended for approval by the
efficiency. These are monetary measures with which actual costs are compared to. Standard costs may be standard setting committee.
based on engineering, accounting, and statistical quality control studies. Standard costs are used in all
phases of managerial functions. It is also applied in all types of industries where performance levels could Sample Problem: Setting Standard Materials Costs
be established based on historical performance, time and motion study, and other means of establishing
standards. Southern Corporation produces product Durito after 45 minutes of direct labor time. The company pays
its production personnel for eight (8) hours a day and gives a 30-minute daily paid breaktime. It normally
The standard quantities and prices are to be established by the standard-setting fee created for such starts its process with 5,000 units and completes at 4,500 good units. It pays its personnel at an hourly rate
purpose. This sub-committee, under the supervision of the Budget Committee, is composed of the chosen of P70 plus social welfare benefits of approximately 10% on the basic rate. What is the standard direct
operating managers from various functional line of operations such as production, purchasing, human labor hours, rate and cost per unit?
resources, payroll, legal, industrial engineering, accounting among others.
Solutions/Discussions:
Budgeting would be a disaster if estimates are not based on a well-established standard cost systems.
Standard cost are bases of intelligent forecasting and projections. The determination of standard unit costs The productivity rate is 90% , (4,500/5,000). Since it is not mentioned on when does the loss occur, it is
ordinarily needs the participation of middle and lower level managers. assumed to have happened at the start of the process. The standards are determined as follows:

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Standard direct labor hours = Standard output time/ (100-loss rate) 1. Profit planning and cost-volume-profit analysis.
= 45 minutes/90%/(7.5/8)
= 53.3333 minutes or 0.888889 hours Standard costs are used in predicting scenarios under varying conditions of volume, prices, and cost
leading to the basic analysis and sensitivity analysis of contribution margin, margin of safety and
*53.3333/60 = 0.888889 operating leverage.

Standard direct labor rate per hour: 2. Responsibility accounting

Standard direct labor rate per hour: Standard costs are used to make the assignment of controllable and non-controllable costs more
Basic wage rate per hour: ₱ 70.00 meaningful and acceptable to managers of various responsibility centers.
Fringe benefits (10%) ₱ 7.00
3. Budgeting
Standard rate per hour ₱ 77.00
Standard costs are used as reliable bases in anticipating budgeted costs and expenses.
Standard direct labor costs = Standard direct labor time x Standard labor rate
= 0.88889 x P77.00 = P 68.44 4. Performance evaluation

Each department should have its own standard costs sheet. The plant operations should also have its Standard costs are used as meaningful benchmarks in evaluating actual performances of center managers,
plant’s standard cost sheet which is a summary of all departmental standard costs sheets. An example of a otherwise known as “cost variances analysis”.
plant standard cost sheet is shown below:
5. Pricing
Mela Company Date established: 11.12.2019
Laguna Plant Product: Tungki Standard costs are used in setting regular as well as incremental sales prices used in determining the right
Standard Cost Sheet and winning amount of bid prices most especially in a stiff competitive bidding.
Cutting Assembly Packaging Total 6. Interim reporting
Direct Materials
AA - 44 3 Ibs. ₱ 2.00 ₱ 6.00
Standard costs are very useful in interim reporting where to compare with actual costs in evaluating
BB-77 6 pcs. ₱ 6.00 ₱ 37.20
situations and alternatives and in making managerial decisions.
CC -12 4 units ₱ 3.00 ₱ 13.60 ₱ 13.60
DD-55 6 units ₱ 2.00 ₱ 12.00 ₱ 82.40
Bases of Cost Variances
Direct Labor
Costs variance analysis may be based on master budget or flexible budget,
Activity/Operation
A-12 4 hrs. ₱ 7.00 ₱ 28.00
The broadest type of variance is the static (or master) budget variance. It is the difference between the
B-23 3 hrs. ₱ 4.00 ₱ 12.00
actual amount and the budgeted amount. It is composed of the flexible budget variance and the sales
C-44 2 hrs. ₱ 6.00 ₱ 12.00 ₱ 12.00
volume variance.
D-55 3 hrs. ₱ 6.00 ₱ 18.00 ₱ 82.00
Variable Overhead
Standard Flexible budget variance is the difference between actual costs and standard costs in a given actual level
Activity / Operation Rate of activity. It is analyzed in relation to sales prices, costs, and input quantities.
Allocation Basis Basis
A -12 Set-up time ₱ 1.25 ₱ 12.00 ₱ 15.00
B- 23 Machine hours ₱ 2.00 ₱ 8.00 ₱ 16.00 Sales volume (or sales activity) variance is the difference between flexible budget and static budget
C- 44 DL hours ₱ 0.75 ₱ 10.00 ₱ 7.50 amounts, assuming sales prices and costs are constant. Its components are the sales mix and the sales
D -55 DL hours ₱ 1.75 ₱ 10.00 ₱ 17.50 ₱ 56.00 quantity variances.
Total Standard Unit Costs ₱ 96.20 ₱ 51.10 ₱ 73.10 ₱ 220.40
FLEXIBLE COSTS VARIANCES
Standard cost shall regularly be evaluated to maintain relevance, validity and reliability.
The difference between actual and standard costs is called a “variance”. It is sometimes called as
Uses of standards costs “planning gap”. A variance should be investigated, analyzed, studied and the same should be avoided in
the future. A variance may be unfavorable or favorable. If actual cost is more than the standard costs, the
Some of the most regular uses of standard costs are as follows: variance is unfavorable. Otherwise, it is favorable.

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standard in terms of price and quantity. As such, material variances are classified as price variance and
quantity variance, as shown below:
Case 1 Case 2
Actual Costs ₱ 650,000 ₱ 790,000 Direct Materials Costs
Standard costs -₱ 600,000 -₱ 800,000 Quantity Unit Price Amount
Actual 525,000 Ibs. P 3.90 P 2,047,500
Variances - UF (F) P 50,000 UF (P 10,000) F
Standard (130,000 units x 4 Ibs.) 520,000 4.00 2,080,000
Variances -UF (F) 5,000 UF P (0.10) F P (32,500) F
In case 1, the cost variance is unfavorable (e.g., positive) because there is an excess cost of P50,000. The
business is supposed to spend only P600,000 but spent P650,000 instead, so there is an increase in costs,
an overspending and an unfavorable variance. Standard quantity is estimated quantity based on actual production. The phrase “actual quantity used” also
refers to equivalent production, if the business is using process costing in accumulating production costs.
In case 2, the costs variance is favorable (e.g., negative) because there is a saving. The business is allowed The standard materials per unit and the standard price remain constant. The total peso value of these
to spend P800,000 but spent only P790,000, so there is a reduction in costs. materials variances are computed as follows:

Unfavorable cost variance is called debit variance because it is added (i.e., debited) to cost of good sold at Direct Materials Costs Variances
standard to get the actual cost of goods sold. Favorable cost variance is called credit variance because it is 2-way analysis
deducted (i.e., credited) from cost of goods sold at standard to get the actual cost of goods sold. Materials Price Variance = (Actual Price – Standard Price) x Actual Quantity = P x AQ
Materials Quantity Variance = (Actual Quantity – Standard Quantity) x Standard Rate = Q x SP
Production Costs Variance
MVP = (AP-SP) x AQ = (P3.90- P4.00) x 525,000 Ibs. = (P(0.10)F x 525,000 Ibs. = P(52,500) F
Production costs are composed of direct materials, direct labor and factory overhead. Each of these MQV = (AQ-SQ) x SP = (525,000 -520,000) x P4.00 = 5,000 UF x P4.00 = 20,000 UF
elements of costs have their respective variances. Direct materials have price and quantity variances. Net Direct Materials Costs Variance P(32,500) F
Direct labor has rate and efficiency variances. Factory overhead has controllable and volume variances.
Variances whether favorable and unfavorable need to be studied, analyzed and given solutions to avoid
Sample Problem – Direct Materials and Direct Labor Costs Variances repeating the same in the next production cycle.

The standard unit cost of Melanie Company is given below: Determining price and quantity (or usage) variances allows management to evaluate the efficiency of the
Direct Materials 4 lbs @ P4.00 ₱ 16 purchasing department and the production departments. Material price variance is primarily the
Direct Labor 3 hrs. @ P8.00 24 responsibility and accountability of the purchasing department. A favorable materials price variance
Variable overhead 3 hrs. @ P2.00 6 indicates savings generated from lower cost of materials purchased. A favorable variance contributes to
the increase in the overall estimated profit of the business.
Fixed overhead 3 hrs. @ P2.00 9
Total Standard unit cost ₱ 55 Some reasons for a favorable materials price variance are: unforeseen reduction in prices of materials
ordered due to market forces, unnecessary compromises in the quality of materials ordered, or perhaps,
The company has a normal capacity of 135,000 units and a budgeted capacity of 132,000 units. Actual standards set for materials price per unit is impartially overstated.
data taken from the production records in the month of September 2020 are as follows:
An unfavorable materials quantity (or efficiency) variance indicates overspending in terms of units used.
Actual production 130,000 units This variance is primarily the responsibility and accountability of the production manager . Possible
explanations on this variance include frequent machine and production downtimes, personnel
Materials purchases (580,000 lbs. @ P3.90) ₱ 2,262,000
inefficiencies, weak production scheduling, or understatement in the standard quantity of materials per
Materials used 525,000 lbs. unit. Remedial actions should be immediately taken to rectify variances in accordance with plans.
Payroll incurred (380,000 Ibs. @ P8.15) ₱ 3,097,000
Factory overhead: Variable ₱ 800,000 Direct Materials Costs Variances, 3 –way Analysis
Fixed ₱ 1,250,000
Materials Price Variance = (Actual Price – Standard Price x Actual Quantity ) = P x SQ
Solutions/Discussions:
Materials Quantity Variance = (Actual Quantity – Standard Quantity ) x Standard Price = Q x SR
1. Direct Materials Costs Variances Analyses
Joint Materials Variance = (Actual Price – Standard Price) x (Actual Quantity –Standard Quantity) =
Direct materials cost is basically affected by two factors: quantity and price. The difference between
Px Q
actual materials and standard materials is materials variance. There is a difference between actual and

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Total standard hours equals actual production multiplied by standards hours per unit (i.e., 390,000 hours
MPV = (AP-SP) x AQ = P(0.10) F X 525,000 lbs. = P(52,000) = 130,000 units x 3hrs.)
MQV = (AQ –SQ) x SP = 5,000 UF x P4.00 = 20,000 UF
JMV = (AP-SP) x (AQ – SQ) = P(0.10) F x 5,000 UF = (500) UF Direct Labor Cost Variances, 2 –way Analyses
Net Direct Materials Costs Variance = P(32,500)F
Labor Rate Variance = (Actual Rate – Standard Rate) x Actual Hours = R x AH
The 3-way variance analysis determines the materials price variance on standard quantity. This differs Labor Efficiency Variance = (Actual Hours – Standard Hours ) x Standard Rate = H x SR
from the 2-way variance analysis which determines price variance based on actual quantity. The materials
quantity variance is the same as that of the 2-way analysis. The third variance is “joint materials variance” LRV = (AR – SR) x AH = (P8.15 – P8.00) x 380,000 lbs. = P0.15UF x 380,000 lbs. = P57,000 UF
which is the product of the difference in price and the difference in quantity. LEV = (AH-SH) x SR = (380,000 -390,000) x P8.00 = (10,000)UF x P8.00 = (80,000) F
Net Direct Labor Costs Variance = P (23,000) F
Direct Labor Costs Variance Analyses
The unfavorable labor rate variance is the responsibility and accountability of the human resource
Except for terminologies, the manner in which the direct labor cost variances are analyzed is similar to manager and perhaps, the production supervisor. In a labor-intensive production environment where
that of the direct materials. direct labor costs immensely consist of the total manufacturing costs, labor rate variance analysis is of
great importance. A reduction in wage rate will have reverberating effects on the cost competitiveness of
Direct labor is also basically affected by two factors – hours and rate per hour. In variance analysis, we an enterprise. Sometimes, an unfavorable labor rate variance is a result of a negotiated labor contract. In
consider the labor cost as variable, the labor hour (s) per unit as constant, and the labor rate per hour as this case, the variance is no longer within the control of supervisors and middle operating managers.
constant. There are differences in actual and standards in terms of hours, rate per hour and the total costs,
The difference in rate per hour is the labor rate variance. The difference in hours is the labor efficiency The standard labor rate should be consequently adjusted. An unfavorable labor rate variance may also
variance (i.e. efficiency is measured in terms of hours spent in an activity. indicate assigning a multi-skilled, highly paid worker in a job that could be performed by a lowly paid
worker. The supervisor should always examine unfavorable labor rate variance to be certain that workers
The standard unit cost of Melanie Company is given below: are allocated most efficiently.
Direct Materials 4 lbs @ P4.00 ₱ 16
Direct Labor 3 hrs. @ P8.00 24 The favorable labor efficiency variance is the accountability of the production manager. An increase in
Variable overhead 3 hrs. @ P2.00 6 efficiency means increase in productivity that brings savings in the financial reports of the business.
Efficiency may indicate more units , less idle tie, and highly motivated work force which may be
Fixed overhead 3 hrs. @ P2.00 9
converted into higher return of investment and operating competitiveness.
Total Standard unit cost ₱ 55
Favorable and unfavorable labor variances must be investigated, analyzed, and given remedy to minimize
The company has a normal capacity of 135,000 units and a budgeted capacity of 132,000 units. Actual the recurrence of the same variance, if not to abruptly and completely eliminate the variance.
data taken from the production records in the month of September 2020 are as follows:
Direct Labor Variances, 3 –way Analysis
Actual production 130,000 units
3-way analysis
Materials purchases (580,000 lbs. @ P3.90) ₱ 2,262,000
Labor Rate Variance = (Actual Rate – Standard Rate) x Actual Hours = R x AH
Materials used 525,000 lbs. Labor Efficiency Variance = (Actual Hours – Standard Hours) x Standard Rate = H x SR
Payroll incurred (380,000 Ibs. @ P8.15) ₱ 3,097,000 Joint Labor Variance = (Actual Rate – Standard Rate ) x Actual Hours – Standard Hours) = Rx H
Factory overhead: Variable ₱ 800,000
LRV = (AR-SR) x AH = (P0.15)UF x 390,000lbs. = P (58,500) F
Fixed ₱ 1,250,000
LEV = (AH-SH) x SP = 10,000UF x P8.00 = (20,000) F
JLV = (AR-SR) x (AH-SH) = P(0.15) F x (10,000) F = (1,500) F
Using the data above, the direct labor costs variances are presented below:
Net Direct Labor Cost Variance P(23,000) F
Direct Labor Costs
Quantity Rate/Hr. Amount The differences between the 2-way and the 3-way direct labor variance analyses are found in the
Actual 380,000 Ibs. P 8.15 P 3,097,000 computation of labor rate variance and the accounting for the joint labor variance. The labor rate variance
Standard (130,000 units x 3 Ibs.) 390,000 8.00 3,120,000 in the 3-way analysis is computed based on standard hours in contrast to the 2-way analysis which is
based on actual hours worked. The joint labor variance represents the mix variance of the rate and
Variances -UF (F) (10,000) F P 0.15 UF P (23,000) F
efficiency variances.

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Factory Overhead Variance Analysis 2. Fixed overhead costs variances
Sample Problem
The two (2) fixed overhead cost variances are as follows:
The following relevant data are taken from the records of Melanie Corporation: 1. Spending variance
2. Production volume variance
Normal capacity 135,000 units or 405,000 units (i.e. 135,000 x 3 units)
Standard hours 390,000 hours The computation for the fixed overhead variances are shown below:
Actual hours 380,000 hours
Fixed Overhead Spending Variance = Actual Fixed Overhead – Budgeted Fixed Overhead
Standard overhead rates: = P1,250,000 – P1,215,000
Fixed overhead rate P3.00 per hour = P35,000 UF
Variable overhead rate 2.00 per hour
Total overhead rate P5.00 per hour *Budgeted fixed overhead = (405,000 x 3) = P1,215,000

Actual overhead costs Fixed Overhead Volume Variance = Budgeted Fixed overhead – Standard Fixed Overhead
Variable, P798,000, and Fixed, P1,250,000 = P 1,215,000 – P1,170,000
= P45,000 UF
Required:
1. Variable overhead costs variances. *Standard Fixed Overhead = (390,000 x 3) = P1,170,000
2. Fixed overhead costs variances.
Total Fixed overhead variance = FO Spending variance + FO Volume Variance
Solutions/Discussions: = P35,000 + P45,000
1. Variable overhead costs variances = P80,000 UF

The analysis for the variable overhead variance follows that of the direct materials and labor costs EXERCISES:
variances. This is true because variable overhead, like direct materials and direct labor, is also a variable Test I. Direction: Compute the direct materials cost variance using the 1-way and 2-way
cost.
Problem: Good Shepherd Corporation has the following information given below:
The two (2) variable overhead costs variances, efficiency and spending variances are computed as
follows: Direct materials : 5 lbs @ P5.00
Direct labor : 4 hrs @ P9.00
Variable Overhead Costs Variable overhead : 4 hrs. @ P3.00
Fixed overhead: 4 hrs. @ P4.00
Hours Rate/Hr. Amount
Actual 380,000 P2.10 P798,000 The company has a normal capacity of 150,000 units and a budgeted capacity of 140,000 units. Actual
Standard (130,000 units x 3 hrs.) 390,000 2.00 780,000 data taken from the production records in the month of November, 2020 are as follows:
Variances in units (10,000)F P0.10 UF P18,000 UF
x Base P2.00 380,000 Actual production 135,000 units
Variance in amount P(20,000) F P38,000 UF Materials purchases (600,000 x P4.15) P2,490,000
Variance description Efficiency Spending Materials used 550,000 lbs.
Payroll incurred (400,000 x P9.00) 3,600,000
Equationally, the variable overhead variances are determined as follows: Factory overhead: Fixed P1,500,000
Variable P900,000
VOH Efficiency Variance = (Actual Hours – Standard Hours) x Standard VOH rate
= (AH-SH) x SVOR Test II. Direction. Answer the following questions comprehensively.
= (380,000 – 390,000) x P2 = P (20,000) F 1. Define standards.
2. What are the ways to set a sound and effective standards?
VOH Spending Variance = (Actual VOH rate – Standard VOH rate) x Actual hours 3. Differentiate standard levels.
= (AR – SR) X AH 4. What is standard costing?
= (P2.10 – P2.00) x 380,000 = P38,000 UF 5. What are variances? Differentiate favorable and unfavorable variance.

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MODULE 6: TRANSFER PRICING Consumer Products Company. The Packaging Company (selling division) sells packaging materials to
Consumer Products Company (buying division). The central issue is: What transfer price is to be used in
Learning Objectives: the interdivisional transaction?

1. Explain the importance of transfer pricing to segment reporting Goal Congruence and Suboptimization
2. Identify the various transfer prices, the proper applications
Another issue on transfer pricing arises when the entity goal of the transacting division center runs in
3. Explain the importance of transfer pricing to segment evaluations and differentiate selling
conflict with the overall goal of the organization. When the overall goal of the organization prevails over
division, buying division and parent company
that of the divisional goals, it is called goal congruence. When the entity goal of the division prevails
Related Parties over the overall organization goals, it is called suboptimization. Managerial effort is the extent to which
a manager attempts to accomplish a goal. Goal congruence and managerial effort are managerial
Transfer Pricing happens when two or more legally independent but related companies transact with each motivation. Motivation is the desire to attain a specific goal (goal congruence) and the commitment to
other. accomplish the goal (managerial effort).

The related companies may be a wholly-owned company, subsidiary, affiliate, special purpose entity, or a Transfer Prices
business enterprise however created having a legal existence to conduct commercial and other activities.
Transfer price is an artificial price used to record interdivisional transactions or goods or services and
The Related Parties correspondingly evaluate divisional performance in the with the overall objective of the enterprise.
Transfer pricing may be a market-based pricing, cost-based pricing, negotiated pricing, arbitrary pricing,
Parent Company or dual pricing. The best transfer price is market price. Because individual business units or segments
have to compete with the rest of the world, they have to beat or conform with the prevailing market price
to stay competitive. They have to follow the market rules in the capitalistic model of a free enterprise
A Company B Company system.
(affiliate) (subsidiary)
A cost-based transfer price equals cost plus a lump-sum or a mark-up percentage. Cost may be either
standard or actual cost. Standard cost has the advantage of isolating variances. Actual costs give the
C Company D Company E Company F Company selling division a little incentive to control costs. Actual cost-based transfer pricing does not promote
(subsidiary) (subsidiary) (affiliate) (wholly-owned long-term manufacturing efficiencies. Also, the cost-based transfer pricing does not give motivation on
entity) the part of the buying division since the costs incurred by the selling division may not reflect the best
possible performance in the market which is adversely transferred to the buying division.

Any transaction entered into by the parent company with any of its related entities or entered into by any Negotiated transfer price may occur when segments are free to determine the prices at price which they
two or more of its elated parties is defined as related-party transactions. buy and sell internally. It is especially appropriate when market prices are subject to rapid fluctuations. It
reflects the best bargain price acceptable to the selling and buying divisions without adversely sacrificing
The issue of transfer pricing occurs when an independent unit sells to or buys from another independent their respective interests.
unit within the same business conglomerate. This is an issue of interdependence. Since independent
business unit managers have authority to decide on how they run their business operations, they deal with Arbitrary transfer pricing is set by the management in the corporate headquarters. Its strength is
external suppliers and customers and also with affiliated divisions (e.g. internally independent units) as anchored on the premise that the entire corporate organization has to promote its overall goals
well. (optimization) over and above that of the division’s goals (suboptimization). On the contrary, it does not
jibe well with the very principle of decentralization where authority is given to division managers to make
Selling division, buying division and parent company decisions with regard to their operations.
Whenever there is an interdivisional transaction, there are at least three (3) independent but related parties Dual pricing is used when the selling and buying divisions, use two (2) different prices in recording their
affected thereto, the selling division, the buying division and the parent company. inter-company transfers. For example, the selling division records the transfer at market prices as if the
sale is made to outside customers, while the buying division records the purchases at variable cost of
Say, Asian Holdings Corporation (parent company) has several related companies operating
production. Each division’s performance would improve using the dual pricing scheme. In a sense, the
independently from each other. Two of its related companies are the Packaging Company and the
variable costs would be the relevant price for decision-making purposes but the segment’s performance is
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evaluated based on market prices. In this pricing model, the sum of the profits of the individual divisions
would be greater than the overall profit of the organization. This model reduces managerial efforts to Great Flowers
Asian Enterprise Malayan Corporation
control costs. The seller is assured of a high price, and the buyer is assured of an artificially low price. Holdings, Inc. (Parent
(Seller) (Buyer)
This model is rarely used in practice because division managers are assured of a good segment Company)
performance and may not exert much effort to report higher segment margin.

Sample Problem – Basic Transfer Prices

3. Transfer price is negotiated price of P73.
Great Flower Holdings Inc., has two independent divisions, Asian Enterprises and Malayan Corporation, ₱ ₱ ₱
that conduct business in the same country. Asian Enterprises produces product “Cute” of which Malayan Transfer price 73 Market price 80 Market price 80
Corporation buys from an external supplier at P80 per piece. The relevant production data of Asian Less: Variable Less: Variable
Enterprises is as follows: production cost 66 Less: Transfer Price 73 production cost 66
₱ ₱ ₱
Variable production costs P66
Allocated factory overhead P15
Profit 7 7 Profit 14

Required: Determine the profit for Asian Enterprises, Malayan Corporation, and Great Flowers Inc., if a
interdivisional transfer of goods occurred under each of the following transfer prices:
1. Market price of P80. Asian Enterprise Malayan Corporation Great Flowers Holdings,
2. Variable production costs of P66. (Seller) (Buyer) Inc. (Parent Company)
3. Negotiated price of P73. 3 Transfer price is dual
4. Dual pricing. price.
₱
Solutions/Discussions: Transfer price ₱80 Market price 80 Market price ₱80
• The profit of the concerned companies is computed as follows:
Less: Variable Less: Variable
Asian Enterprise Malayan Corporation Great Flowers Holdings, production cost 66 Less: Transfer Price 66 production cost 66
(Seller) (Buyer) Inc. (Parent Company) ₱
1. Transfer Price is at market price at P80. Profit ₱14 14 Profit ₱14

Transfer price ₱80 Market price ₱ 80 Market price ₱80

Less: Variable Less: Variable production • If the transfer price is based on the market price, the selling division reports all the profit of P14
production cost 66 Less: Transfer Price 80 cost 66 and thereupon reports higher return on investment, or residual income, or economic value-added.
₱ The selling division manager has a higher chance of getting more rewards such as job bonuses
Profit ₱14 Profit - Profit ₱14 and other perks and privileges assuming all things are the same in all divisions.
• If the transfer price is based on costs, the buying division registers all the profit of P14, reports
higher return on investment, or residual income, or economic value-added, and the buying
Malayan Corporation Great Flowers Holdings, division manager would have a higher chance of getting more rewards and recognition, assuming
(Buyer) Inc. (Parent Company) all things are the same on all divisions.
2. Transfer Price is variable production costs of P66. • If the transfer price is based on negotiated pricing, both the selling and the buying divisions have
share on the transaction profit, report higher return on investment, or residual income or
Transfer price ₱66 Market price ₱ 80 Market price ₱80 economic value added, and have equal chance of being considered in the next round of
Less: Variable Less: Variable production promotions or giving of rewards, assuming all things are the same among divisions.
production cost 66 Less: Transfer Price 66 cost 66 • If the transfer price is based on dual pricing, both the selling and the buying divisions record
₱ profit at P14, report much higher return on investment, or residual income or economic value
Profit - ₱ 14 Profit ₱14 added tax, and have an equal chance of being considered in the next round or promotions or
giving of rewards, assuming all things are the same among the divisions.

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• The allocated factory overhead is not considered in the computation of divisional profit for MODULE 7: PRODUCT PRICING AND PROFIT ANALYSIS
performance purposes because it is not reflective of the controllable performance and it does not
change regardless of the option to buy the product from an outside supplier or from a relative Learning Objectives
division.
1. Understand the importance of pricing as a business strategy
• It should had been immediately noticed the transfer price is not relevant in the perspective of the
company. First, because the divisions are in the same country and therefore is covered by the
2. Illustrate different models of product pricing, use the different cost-based pricing
same taxation laws and regulations. Second, the transfer price is an input cost and a revenue techniques and compute the mark-up rate
involving the same amount, therefore is only a transfer payment, and has no impact on the overall 3. Identify cost-based from non-cost-based costs and expenses
performance of the parent company. If in case, the transacting divisions are covered by different 4. Relate product to profitability, calculate the sales price variance, sales quantity variance,
set of tax rules and regulations, although located in the same country however have varying tax cost price variance, cost quantity variance, sales mix variance, and final sales volume
impacts, the change in the tax effects should be considered in the analysis in the parent company. variance
• Overall, the profit of Great Flowers Holdings, Inc., remains the same at P14, despite the 5. Explain the general causes of sales and cost variances affecting profit.
differences in the transfer price used by transacting divisions. Following the doctrine of goal
congruence, a holding company should continue advising its holding division to buy the goods
from its selling division as long as the incremental cost of producing the goods is lower than the Product Pricing
cost of buying the same from an outside supplier. This decision would produce overall savings,
regardless of the transfer price used in recording the interdivisional transaction, and would be • The operating profit or loss is not only affected by cost and expenses, but also by sales.
beneficial for the overall operations of the holdings company.
• Sales are affected b volume and unit sales price.

• The number of units sold is something not directly controlled y manager but is influenced
EXERCISES: by various market factors such as general financial and economic conditions,
technological developments, changes in customer’s needs and wants, competition and
Problem 1
other forces in the market place.
X Company, the parent company has two independent divisions, Y Company which is the seller • If your product is priced too exorbitantly, the market would repudiate it.
and Z Company which is the buyer. The market price of the goods is P125, the variable
production costs is P100 while the negotiated price is P115. If the transfer price is variable • If the product the product is priced too low, it may stir strong reactions from competitors
production costs, how much is the profit of the seller? that may lead to strenuous and unfavorable operational circumstances.

• If the product is priced too low, customers may consider the product cheap and not worth
Problem 2 their utility and possession.
Company A, the parent company has two independent divisions, Company B which is the seller
and Company C which is the buyer. The market price of the goods is P300, the variable Traditional Pricing Model
production costs is P250 while the negotiated price is P275. If the transfer price is market price
how much is the profit of the parent company? • It follows the basic methods of determining a unit sales price.

• The Economist’s Model – this is based on the principle of scarcity of resources and
rationality of men. It anchors on the law of supply and demand which state that as the
demand for a product increase, the price correspondingly increases and vice versa.

• If the supply for a product increase or exceeds the market needs, the price corresponding
decreases and vice versa.

• The pricing in this model is fundamentally based on the reaction of the market.

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• The change in price in relation to the change in the level of demand and supply could • Once the cost is determined, processes, activities, systems are established accordingly to
either be elastic or inelastic. produce a product not in excess of the determined cost, otherwise the profit will suffer.

• There is demand elasticity if a minimal change in price greatly affects the demand of a Life Cycle-based pricing
product. And there is demand inelasticity if a minimal change in price significantly
changes the demand of a product. o Here, a price is established that would be applicable over the life-span of a product.

Demand Elasticity • The price is determined by dividing the total costs (i.e., locked-in costs and operational
costs) over the total estimated units to be produced and sold.
• If the elasticity of demand is equal to 1, it is called unitary.
• The life cycle stages of a product are normally divided into four: infancy (start-up) stage,
• If the elasticity of demand is greater than 1, it is called elastic. growth stage, expansion stage, and maturity decline stage.

• If the elasticity of demand is less than 1, it is inelastic. Life Cycle-based pricing

• In life cycle based pricing, another stage is included which is the pre-infancy (or
conception) stage. This stage precedes the infancy stage.

• During this pre-infancy stage, strategic decisions are made and costs are locked-in.
Premium Pricing (or perception-based pricing)
• Locked-in costs (or designed-in costs) are not yet incurred but are expected to be incurred
• This pricing model resides on the psychology of the market participants. in the future, as caused by decisions made during the infancy stage.

• If a product offers good utility and value, buyers are willing to pay for more. There • To effectively reduce costs, locked-in costs should be minimized.
satisfaction is heightened.
Penetration-based pricing
• If a product offers inferior value and use, the market would absorb the product if the price
• This pricing model is applied when a company wants to enter a market where entry is
is lowered.
relatively easy due to minimal amount of investment needed, absence of high-level
• If the price of the product is high, the value and utility of the product is also high. technological requirements, and a market not controlled by one or few players.

Controlled market-based pricing • To penetrate a market, pricing is set at a lower level to gain widespread market
acceptance.
• The product pricing model based its prices on government regulations or implied
agreements among key players in the market. • Penetration pricing is most applicable in a buyer’s market where the behavior of the
market is significantly influenced by buyers than by sellers.
• Gas and oil companies, mining companies, and utility companies use this model.
Skimming pricing

• This pricing model is applicable in a sellers’ market. This market is difficult to enter due
STRATEGIC PRICING MODEL to some entry barriers such as great amount of investment requirement, need for a high-
level of technological applications, and presence of only a few sellers in the market.
o Target Pricing – In this model, the company looks at the market, determines the
prevailing market price, establishes its desires profit, then computes the amount of cost to • At this instance, the seller influences the level of pricing and normally sets the price at a
be incurred in producing and selling a product. higher level.

• This pricing model gives more protection to sellers than that of the penetration pricing.
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Predatory (or anti-competition) pricing • It also has an advantage of creating savings in product handling, packaging and invoicing
costs.
• In this model, a company sets a very low price purposely to gain greater share of and
ultimately control the market. • Bundling is successful when used to matured products and customer loyalty is already
high.
• The price set is so low that ordinary producers and sellers would not dare follow to avoid
incurrence and recurrence of operational loss. • However, issues are to be handled on the reaction of competitors on the bundling policy
and the customers reactions when products are unbundled later.
• This pricing model drives away operationally inefficient and financially insufficient
players who do not have the critical financial string to absorb operational losses and Tactical pricing
maintain their market presence.
• Time pricing – This pricing model considers time as the basis in settling a price. This
• This technique is considered not conducive to a healthy trade and development business applies to professionals (such as lawyers, accountants, doctors, consultants) and non-
environment. professionals (such as repairmen and technicians) alike.

Loss leader pricing Materials-based pricing

• Loss leader pricing applies when there is a main product with subsequent sales of parts • In this model, price is based on the expected amount of materials to be used. For
and services. example, construction companies estimate contract prices substantially based on
materials to be used in a given construction project.
• The main product is priced at a very low price that sometimes is lower than the cost of
producing it but company would recover later by selling unique parts, consumables, Distress (or incremental) pricing
rendering highly technical services that are priced at a much higher amount.
• This pricing technique is used when there is an idle capacity, competition is very stiff,
• Ex: low-priced computer printer with high-priced cartridges, low-priced gadget with and businesses have to sell hard their products to at least break-even.
high-priced supplies
• In this case, sales price is based not on the regular production costs but on relevant (i.e.
Pricing with additional features incremental) costs to produce and sell a product.

• Main products are sometimes sold with additional features or “extras”. • Here, profitability is subordinated to recoverability of cost and sustainability of
operations.
• With the “extras” on the product, the price of the product would logically change.
Transfer pricing
• At what price level depends on the acceptability of the additional features to the
customers, whether the “extras” add value to their use of the product or not. • This pricing model applies when there is an inter-company oriented-divisional transfer of
products between affiliated companies and company or divisional managers are evaluated
Pricing bundling based on their operating performances.
• Product bundling is packaging the interrelated products together to make a complete set • Transfer prices may be based on market, cost, negotiated prices, arbitrary or dual prices.
and offered to customers at a temptingly low price.
Cost-based pricing
• This technically sets the average price and margin for all the products included in the
bundle. • This pricing model rationalizes that price equals cost plus mark-up.

• It has the advantage of selling slow moving products and still maintain the desired overall • This is a traditional and simple technique of setting a sales price.
financial performance of an enterprise.

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• The cost of producing a product and the operating a business will be determined then add • Sales is a factor of number of units sold and sales price.
the desired profit.
• A change in sales, which causes a change in gross profit, is affected by a change in units
sold and unit sales price.

Gross Profit Variation Analysis

• Cost of goods sold is a factor of units sold and unit cost.

• Cost has different meanings. A cost may pertain to materials costs, prime costs,
conversion costs, total production costs, variable production costs, variable costs and • A change in cost which also causes a change in gross profit, is affected by a change in
expenses, total costs and expenses or any other definition of cost. Sales price is restated units sold and unit cost price.
as:
• Sales – Cost of Goods Sold = Gross Profit

Gross Profit Variance

• Gross Profit Variance is a difference between the actual gross profit and a base gross
profit. The base gross profit is the gross profit in the last year. The base in computing
the gross profit variance may also be the budgeted data, industry averages, or a chief
• Cost-based is anchored on the definition of cost. If the sales price is based on absorption competitor’s data.
cost, then the cost based-pricing includes the cost of materials, labor, variable overhead
and fixed overhead. If the cost is defined as prime cost, then the cost-based is the sum of This Year Last Year Net Variance
direct materials and direct labor. Sales Px Px Px
Less: Cost of Goods Sold x x x
• Non-cost based refers to all other cost and expenses not included in the cost-based. Gross Profit Px Px Px
• If the cost-based is prime cost, the non-cost based includes variable overhead, fixed Data treated as Actual Standard
overhead, variable expenses and fixed expenses. The Sales Variance
Gross Profit Variation Analysis • The sales variance is composed of the sales price variance and sales quantity variance.
• Profitability is determined not only to measure a department’s performance but that of a
manager as well.

• It serves as a feedback information on the what and why of operating performance,

productivity and profitability wise.

• It gives a glimpse of what happened on the business operations.

• SPV = Sales price variance
• It is also an indicator in identifying excellent managerial techniques to sustain
organizational effectiveness and in determining causes of operational failures. • USPTY = Unit sales price this year

Gross Profit Variation Analysis • USPLY = Unit sales price last year

• Gross Profit is the difference of sales and cost of goods sold. Ergo, a change in gross • QSTY = Quantity sold this year
profit is caused by a change in sales and cost of goods sold.
• QSLY = Quantity sold last year
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The Cost of Sales Variance The Gross Profit Variance

• Actual unit price = unit sales price this year

• Standard unit price = unit sales price last year

• Actual quantity = Quantity sold this year

• Standard quantity = Quantity sold last year

• CPV = Cost price variance Sample Problem
• CQV = Cost quantity variance • The management of Triple Star Corporation is analyzing the factors that cause a decrease
• UCPTY = Unit cost price this year in its gross profit in 2020.

• QSTY = Quantity sold this year Increase

2019 2020
(Decrease)
• QSLY = Quantity sold last year Sales ₱ 2,640,000 ₱ 2,750,000 ₱ 110,000
Less: Cost of Goods Sold ₱ 1,760,000 ₱ 2,125,000 ₱ 365,000
The Gross Profit Variance
Gross Profit ₱ 880,000 ₱ 625,000 -₱ 255,000
• The gross profit variance is normally accounted for following the sources and operational Units sold 22,000 25,000 3,000
classification of variances as follows: Unit sales price ₱ 120.00 ₱ 110.00 -₱ 10.00
Unit cost price ₱ 80.00 ₱ 85.00 ₱ 5.00

Sales variances:
Sales price variance Px
Sales quantity variance x Px 2-way variance analysis
Cost of goods sold variances:
Price variances:
Cost price variance Px Sales price variance (-P10 U x 25,000 units) P (250,000)U
Cost quantity variance x Px Less: Cost price variance (P5 U x 25,000 units) 125,000 U
Gross Profit Variance Px Net Price Variance P(375,000) U
Quantity variances:
Sales quantity variance (3,000F units x P120) 360,000 F
• The gross profit variance may also be classified as price factor and quantity factor. Less: Cost quantity variance (3,000 U units x P80) 240,000 U
Net Quantity Variance 120,000 F
Gross Profit Variance -255,000 U
Price factor:
Sales price variance Px 3-way variance analysis
Cost price variance x
Net Price Variance Px
Quantity factor:
Sales quantity variance Px
Cost quantity variance x
Net QuantityVariance Px
Gross Profit Variance Px

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Price variances:
Sales price variance (-P10 U x 22,000 units) P (220,000)U Variance Rates
Less: Cost price variance (P5 U x 22,000 units) 110,000 U P(330,000) U
Quantity variances: • Sales quantity variance rate = Sales quantity variance/sales last year
Sales quantity variance (3,000F units x P120) 360,000 F
Less: Cost quantity variance (3,000 U units x P80) 240,000 U 120,000 F • Cost quantity variance rate = Cost quantity variance/Cost last year
Joint variances:
Joint sales-price-quantity variance (-P10 x 3,000 units ) (30,000) U • Cost price variance rate = Cost price variance/CTY@UCPLY
Joint cost-price-quantity variance (P5 x 3,000 units) 15,000 U -45,000U
Gross Profit Variance -255,000 U • Sales price variance rate = Sales price variance/STY@USPLY

Gross Profit Variance analysis with only a variance ratio given

MODULE 8: FINANCIAL STATEMENT ANALYSIS
• Arabian Corporation decreased its sales price by 10% in 2020 as compared with 2019. Its
gross profit data are provided below. Learning Objectives:

1. Understand and appreciate information conveyed by the accounts and amount reported on
the financial statements.
2019 2020 Change + (-)
2. Explain the operating cycle of the business as presented on the statement of profit or loss.
Sales ₱ 2,000,000 ₱ 2,340,000 ₱ 340,000
3. Analyze financial statements through vertical analysis and horizontal analysis.
Less: Cost of Goods Sold ₱ 1,400,000 ₱ 1,911,000 ₱ 511,000 4. Compute liquidity ratios, solvency ratios and profitability ratios.
Gross Profit ₱ 600,000 ₱ 429,000 -₱ 171,000 5. Discuss the limitations of financial statement analysis.

BASICS OF FINANCIAL STATEMENT ANALYSIS

Gross Profit Variances
Analyzing financial statements involves evaluating three characteristics of an entity: its liquidity,
Sales Price variance profitability and solvency. For example, a short-term creditor such as a bank is primarily interested in the
Sales This Year ₱ 2,340,000 ability of the borrower to pay obligations when they come due. The liquidity of the borrower in such a
Sales This Year at unit sales price last year ₱ 2,600,000 -₱ 260,000 U case is extremely important in evaluating the safety of the loan. A long-term creditor, such as a
(P2,340,000/90%) bondholder, however looks to indicator such as profitability and solvency that indicate the firm’s ability
to survive over a long period. Long-term creditors consider such measures as the amount of debt in the
Sales Quantity Variance entity’s capital structure and the ability to meet interest payments. Similarly, shareholders are interested in
Sales This Year at unit sales price last year ₱ 2,600,000
the profitability and solvency of the enterprise when they assess the likelihood of dividends and the
Sales Last Year ₱ 2,000,000 ₱ 600,000 F
growth potential of the share.
Cost price Variance TOOLS OF FINANCIAL STATEMENT ANALYSIS
Cost this year ₱ 1,911,000
Cost This Year at unit cost price last year ₱ 1,820,000 ₱ 91,000 U 1. Horizontal analysis is a technique for evaluating a series of financial statement data over a period of
(P1,400,000 x 130%) time.

Cost quantity Variance 2. Vertical analysis is a technique for evaluating financial statements data that expresses each item in a
Cost This Year at unit cost price last year ₱ 1,820,000 financial statement in terms of a percent of a base amount.
Cost Last Year ₱ 1,400,000 ₱ 420,000 U
3. Ratio analysis expresses the relationship among selected items of a financial statement data.
Gross Profit Variance -₱ 171,000 U
HORIZONTAL ANALYSIS

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Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement
data over a period of time. Its purpose is to determine the increase or decrease that has taken place, Vertical analysis is use to compare trends in the relative performance of any financial statement line items
expressed as either an amount or a percentage. over time. For example, from the statement of comprehensive income, cost of goods sold and a profit as a
percentage of sales can be tracked. These two indicators reflect whether year to year costs are becoming
You can use this method to compare trends over time of any financial statement line items. For example unreasonable and whether profit trends are as desired. By tracking ratios over time, positive and negative
managers often want to track changes on the statement of comprehensive income in net sales and profit trends can be observed and corrective actions can be done. Vertical analysis can also be used to compare
entity’s performance relative to the performance of other entities operating in similar industries.
over time. If in a particular reporting period, net sales increased by 8% and profit rose by 12% over the
prior year, you can learn information from this. First, compare the performance of the line items with Statement of Financial Position
forecasts to determine the level of entity performance. Some entities would consider an 8% increase in net The following illustration is the comparative statement of financial position of L. Victorino Corporation
sales a dramatic failure while others would consider it a tremendous success; the relationship of for 2019 and 2018, analyzed vertically. The base, for the asset items is total assets, and the base for the
performance to forecast is the key. In this example, it is likely a positive indication that profit rose at a liability and equity items is total liabilities and equity.
much higher rate (12%) than did net sales (8%).

For example, the recent net sales figures of L. Victorino Corporation are as follows: L. Victorino Corporation
Condensed Statement of Financial Position
L. Victorino Corporation December 31
(Net Sales stated in millions)
2019 2018
2019 2018 2017 2016 2015
P 6,562.80 P 6,295.40 P 6,190.60 P 5,786.60 P 5,181.40 Assets Amount Percent Amount Percent
Current Assets ₱ 1,020,000 55.60% ₱ 945,000 59.20%
Assume that 2015 is the base year, percentage increases or decreases from the base period amount is Property and Equipment, Net 800,000 43.60% 632,500 39.70%
computed as follows: Intangible Assets 15,000 .8% 17,500 1.10%
Current year amount – Base year amount Total Assets ₱ 1,835,000 100.00% ₱ 1,595,000 100.00%
Base year amount

For example, net sales for L. Victorino Corporation increased approximately 11.70% [(P5,786.60- Liabilities
P5,181.40) / P5,181.40] from 2015 to 2016. Similarly, net sales increased over 26.70% [(P6,562.80 – Current Liabilities ₱ 344,500 18.80% ₱ 303,000 19%
P5,181.40)/ P 5,181.40) from 2015 to 2019. The percentage of the base period for each of the 5 years, Long-term Liabilities 487,500 26.50% 497,000 31.20%
assuming 2015 as the base period, is shown in the following illustration. Total Liabilities ₱ 832,000 45.30% ₱ 800,000 50.20%

L. Victorino Corporation Equity

(Net Sales stated in Millions)
Ordinary share, P1 par value ₱ 275,400 15.00% ₱ 270,000 16.90%
Base Period 2015
Retained Earnings 727,600 39.70% 525,000 32.90%
2019 2018 2017 2016 2015 Total Equity ₱ 1,003,000 54.70% ₱ 795,000 49.80%
P 6,562.80 P 6,295.40 P 6,190.60 P 5,786.60 P 5,181.40 Total Liabilities and Equity ₱ 1,835,000 100.00% ₱ 1,595,000 100.00%
127% 121% 119% 112% 100%

VERTICAL ANALYSIS
In addition to showing the relative size of each category on the statement of financial position, vertical
analysis may show percentage change in the individual asset, liability and equity items. In this case, even
Vertical analysis is a method of analyzing financial statements in which you can compare individual line
though current assets increased by P75,000 from 2018 to 2019, they decreased from 59.20% to 55.60% of
items to a baseline item such as net sales from the statement of comprehensive income, total assets from
total assets. Property and equipment-net have increased from 39.70% to 43.60% of total assets, and
the asset section of the statement of financial position, and total liabilities and owner’s equity section of
retained earnings have increased from 32.90% to 39.70% of liabilities and equity. These results may
the statement of financial position. The word vertical is used to describe this analysis method because the
signify that L. Victorino Corporation is choosing to finance its growth through retention of earnings
method generates a vertical column of ratios next to the individual items on the financial statements.
rather than through the incurrence of additional debt.
For example, on a statement of financial position, current assets are 22% of total assets with total assets
Statement of Comprehensive Income
(the 100%) as the base amount. In the case of the statement of comprehensive income, distribution costs
or selling expenses are 16% of net sales with net sales (the 100%) being the base amount.
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Vertical analysis of the comparative statement of comprehensive incomes of L. Victorino Corporation
revealed that cost of goods sold as a percentage of net sales declined by 1% (62.1% vs. 61.1%) and total Managers and investors can use ratio analysis to understand the health of an entity. Ratios lend insight
operating expenses declined by 0.40% (17.40% vs. 17.0%). Consequently, profit as a percent of net sales into many critical aspects such as present and future profit potential, expense control, and solvency. For
increased from 12.30% to 13.40%. example, the ratio of profit to net sales give substantially different information than examining profit and
net sales. Assume Corporation A has a profit of P2,000,000 with net sales of P25,000,000, and
Corporation B has a profit of P1,800,000 on net sales of P9,000,000. Corporation A and Corporation B
have profit to net sales ratios of 8% and 20% respectively. This indicates that Corporation B generated
L. Victorino Corporation less profit than Corporation A, it operates with much higher profit margins. If Corporation B operates in
Condensed Statement of Comprehensive Income the same industry as Corporation A, Corporation B is probably better managed.
For the Years Ended December 31 For example, in 2018 G. Cadelina Corporation has current assets of P41,338,000 and current liabilities of
P29,226,000. In terms of percentage, current assets are 141% of current liabilities.
2019 2018
Amount Percent Amount Percent LIQUIDITY RATIOS
Measuring the Ability to Pay Current Liabilities
Sales ₱ 2,195,000 104.70% ₱ 1,960,000 106.70%
Sales Returns and Allowances 98,000 4.70% 123,000 6.70% Creditors and potential creditors are interested in continuously monitoring an entity’s ability to pay
Net Sales 2,097,000 100.00% 1,837,000 100.00% interest as it comes due and to repay the principal of the debt at maturity. An analysis of a firm’s liquid
Cost of Goods Sold 1,281,000 61.10% 1,140,000 62.10% position provides indicators of its short-term debt-paying ability. Measures of liquid position are also used
to evaluate management’s current operating efficiency; thus, both investors and creditors are interested in
Gross Profit 816,000 38.90% 697,000 37.90%
this statistics.
Distribution costs 253,000 12.00% 211,500 11.50%
Administrative expense 104,000 5.00% 108,500 5.90% Working Capital
Total Operating expense 357,000 17.00% 320,000 17.40%
This equation describes the amount of capital used to run day-to-day business operations. Working capital
Profit from Operations 459,000 21.90% 377,000 20.50% is necessary to finance an entity’s cash conversion cycle. It is a measure of liquidity. The cash conversion
Investment Revenues 9,000 0.40% 11,000 0.60% cycle describes the process by which an entity converts cash into products and then back into cash again.
Finance costs 36,000 1.70% 40,500 2.20% Working capital is current assets minus current liabilities; it is a measure of the liquid resources that
Profit before Income taxes 432,000 20.60% 347,500 18.90% management will control in the short term.
Income Tax Expense 151,200 7.20% 121,625 6.60% Low amounts of working capital can indicate the business is insufficiently liquid and could have
Profit ₱ 280,800 13.40% ₱ 225,875 12.30% problems meeting current debt obligation. Very high working capital accounts could indicate ineffective
management since current assets seldom yield returns as great as long-term assets.
Common- Size Statements
A strong working capital positions can be an advantage to an entity attempting to obtain short-term credit
The percentages in the statement of financial position and statement of comprehensive income of L. at favorable interest rates. Investors and long-term creditors view a strong working capital position as an
Victorino Corporation can be presented as a separate statement that reports only percentages. Such a indication that a firm will be able to make its expected dividend and interest payments in a timely manner.
statement is called a common-size statement.
Firms should seek to maintain working capital levels that provide sufficient current assets to meet short-
On a common-size statement of comprehensive income, each item is expressed as a percentage of the net term debt requirements but in which current asset accounts are not so excessive that overall entity profit
sales amount. Net sales is the “common size” to which we relate the statement’s other amount. In the margins suffer. When working capital is too low, increasing current assets and/or reducing current
statement of financial position, the “common size” is the total on each side of the accounting equation – liabilities can increase working capital. When working capital is trending too high, investing excess
total assets or the sum of the total liabilities and equity. Common- size statements can be used to compare current assets in longer term assets, which yield higher rates of return at acceptable risk levels, can
entities of different sizes. decrease working capital levels. W. Blanche Corp.’s working capital for 2018 follows:

RATIO ANALYSIS

Ratio analysis compares one indicator to another. Ratios can give you a significant insight into the
performance and relative importance of two indicators. A ratio, which may either, be a percentage, a rate,
or simple proportion, expresses the mathematical relationship between one quantity and another.

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Current Assets: This means that for every peso of current liabilities, W. Blanche Corp. has 2.80 of current assets. The
Cash ₱ 5,368,000 acceptable current ratio depends on the nature of the industry. Higher ratios indicate an increased ability
to pay short-term debt obligations such as accounts payable and interest payments on debt. Lower ratios
Trading Investments 3,090,000 can indicate an inability to meet short-term debt obligations, which could lead to insolvency and
Accounts Receivable 35,382,000 bankruptcy. Healthy current ratios equal or exceed the value of 2.0. However, very high current ratios
Merchandise Inventory 62,582,000 much in excess of 2.0, can indicate an entity is not using its assets in an ideal manner. This is because
Prepaid Expenses 2,870,000 current assets seldom yield returns as large as long-term assets such as investments in equipment and
subsidiaries.
Total Current Assets ₱ 109,292,000
Less: Current Liabilities Too much reliance on the current ratio may not be advisable, as the following illustration demonstrates.
Accounts Payable ₱ 24,235,000 The current ratios for Corporation A and Corporation B are as follows:
Accrued Payables 9,758,000
Income Tax Payable 2,040,000 Corporation A Corporation B
Current Assets:
Current Portion of Long-term debt 3,000,000
Cash ₱ 40,000 ₱ 175,000
Total Current Liabilities 39,033,000
Accounts Receivable 60,000 125,000
Working Capital ₱ 70,259,000
Merchandise Inventory 180,000 95,000
Prepaid Expenses 20,000 5,000
The formula and the calculation of W. Blanche Corp.’s working capital for 2018 follows: Total Current Assets ₱ 300,000 ₱ 400,000
=3:1 =2:1
Working Capital = Current Assets – Current Liabilities Current Liabilities ₱ 100,000 ₱ 200,000
Working Capital = P109,292,000 – P 39,033,000
= P 70,259,000 Corporation A’s current ratio of 3:1 is much better than Corporation B’s 2:1. Upon inspection of the
composition of the current assets, however, A’s cash and accounts receivable are only one-third of total
Working capital for 2017 was P 53,189,000 ( current assets of P94,104,000 minus current liabilities of current assets, while three-fourths of B’s current assets are composed of these two particular liquid
P40,915,000) . During 2018, working capital increased by P17,070,000 (P70,259,000 – P53,189,000). resources. So, in reality, B may be in a better position to meet its current obligation than A is. Corporation
The increase indicates that more liquid resources were created than were used during the year. A decrease A can further improve its current ratio by paying off P400,000 of current liabilities with the P40,000 cash
in working capital would have indicated that the entity was using more liquid resources than it was on hand. If this is done, the new current ratio would be:
creating. The current ratio and the acid test ratio are decision-making tools based on working capital.
P300,000 - P40,000 P260,000
Current Ratio Corporation A Current Ratio (revised) = = = 4.33:1
P100,000 - P40,000 P60,000
The current ratio describes the ability of an entity to meet current debt obligations with assets that are
readily available. The current ratio is used to evaluate an entity’s liquidity and short-term debt paying Such manipulation of current assets near the end of an accounting period can produce a ratio that may
capacity. The ratio is obtained by dividing current assets by current liabilities. This statistics is often satisfy creditors while actually weakening the immediate liquid position of the entity. Accountants
assigned great importance by lenders in making credit granting decisions since current assets and current sometimes call this practice window dressing. It demonstrate that limiting an analysis to too few statistics,
liabilities represent the core of the entity’s daily operations. The formula and the 2018 current ratio for W. relying on arbitrary rules of thumb, and not understanding the limitations behind the calculation of a ratio
Blanche Corp. follow: are pitfalls that should be carefully avoided.

Quick Ratio
Current Assets
Current ratio =
Current Liabilities Quick ratio or acid test ratio tells whether the entity could pay all its liabilities even if none of the
inventory is sold. Quick assets are those that may be converted directly into cash within a short period of
₱ 109,292,000 time. These include cash, trading investments and receivables. Merchandise inventory is omitted because
Current ratio = merchandise is normally sold on credit and then the receivables must be collected before cash is realized.
₱ 39,033,000
Thus, merchandise inventory is two steps away from cash. Prepaid expenses are also omitted because
they are usually relatively small in amount and because they are used up in operations rather than
converted into cash. W. Blanche Corp.’s quick ratio on December 31, 2018 calculated as follows:
Current ratio = 2.80 or 2.8:1

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Quick Assets P 862,915,000

Quick Ratio = Accounts Receivable Turnover =
Current Liabilities (P32,936,0000 + P 35,382,000)/2

Cash ₱ 5,368,000 P 862,915,000

=
Trading Investments 3,090,000 P 34,159,000
Accounts Receivable (Net) 35,382,000
Total Quick Assets ₱ 43,840,000 = 25.3 times

₱ 43,840,000 You can increase accounts receivable turnover by tightening credit policies and by more proactively
2018 Quick Ratio = = 1.12 or 1.12:1 speaking payment of outstanding accounts. Note that tighter credit policies may have the undesirable
₱ 39,033,000 effect of reducing sales since some customers are likely to seek other suppliers with more liberal credit.

Average Age of Receivables

Creditors generally use the rule of thumb that a quick ratio of at least 1:1 is satisfactory. W. Blanche
Corporation’s quick ratio appears to be acceptable. Average age of receivables provides a rough approximation of the average time that it takes to collect
receivables. Average age of receivables is determined as follows:
The quick ratio, when considered with the current ratio, gives an idea of the influence of merchandise
inventory and prepaid expenses. Looking at the Corporation A and Corporation B illustration, by using
365 days
quick ratios, it is shown that Corporation A’s current ratio may be misleading. Current ratio should not be Average Age of Receivables =
used as the sole indicator of short-term liquidity. Accounts Receivable Turnover

Corporation A Corporation B 365 days

=
Quick Assets: 25.3 times
Cash ₱ 40,000 ₱ 175,000
Accounts Receivable 60,000 125,000 = 14.4 days
= 1:1 = 1.5:1
Total Quick Assets ₱ 100,000 ₱ 300,000
W. Blanche Corporation takes an average of 14 days to collect its receivables. If W. Blanche’s credit
Corporation B has the stronger quick ratio though with a weaker ratio, indicating that merchandise terms are net 10 days. Its collection efforts should be improved. If the credit terms are 15 or 30 days, W.
inventory and prepaid expenses play a less important role in its current position than these assets do in Blanche collection efforts appear to be excellent. The general rule is that the collection period should not
Corporation A’s. materially exceed the credit period.

Measuring the Ability to Sell Inventory and Collect Receivables Inventory Turnover

Accounts Receivable Turnover Inventory turnover is a measure of the number of times an entity sold its average level of inventory during
the period. A high rate of turnover indicates relative ease in selling inventory. However, a high value can
Accounts Receivable turnover measures the entity’s ability to collect from credit customers. It indicates mean that the business is not keeping enough inventories on hand, and thus, may result to lost sales.
the number of times that the average balance of accounts receivable is collected during the period. The Inventory turnover is calculated by dividing cost of goods sold by average merchandise inventory. Cost of
ratio is calculated as follows: goods sold is used instead of net sales because both cost of goods sold and merchandise inventory are
stated at cost. The formula and the 2018 W. Blanche’s inventory turnover are as follows:
Net Credit Sales
Accounts Receivable Turnover =
Average Net Accounts Receivable

In general, the higher the ratio, the more successfully the business collects cash. However, a turnover that Inventory Cost of Goods Sold
=
is too high may indicate that credit is too tight, causing the loss of sales to good customers. Assuming that Turnover Average Merchandise Inventory
substantially all of W. Blanche’s sales are on credit, the 2018 receivables turnover is as follows:

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P 564,346,000 W. Blanche Corporation’s return on total assets for 2018 is calculated as follows:
=
(P50,434,000 + P62,582,000)/2
Profit + Interest expense
Return on Total Assets =
P 564,346,000 Average Total Assets
=
(P56,508,000)
Profit + Interest expense
Return on Total Assets =
(Total Assets, Beg. Of the Year + Total Assets, End of the Year)/2
= 9.99 times
P17,575,000 +P3,120,000
=
Since W. Blanches’ Inventory turned over about 10 times this period, the ending inventory should be (P156,625,000 + P172,583,000)/2
about 10% of cost of goods sold. W. Blanche’s ending inventory of P62.582,000 is a little above this
amount (10% x P564,346,000 = P56,434,000). This excess is probably in anticipation of increasing sales P20,695,000
volume. =
P164,604,000
Higher inventory turnover ratios generally increase entity profitability since an entity can use the cash
normally tied up in inventory for higher return investments. Higher inventory turnover is easier to
= 1.257 or 12.57%
accommodate by improving a number of factors. These include production planning, scheduling, capacity
planning, product quality, equipment quality, relations with raw materials suppliers, and inventory W. Blanche’s management earned an average of 12.57% on every peso asset invested .
planning. Simply increasing inventory turnover without improvement in these critical areas can lead to
disastrous results. Return on Ordinary Equity

Average Age of Inventory Return on ordinary equity shows the relationship between profit and ordinary shareholders’ investment in
the entity. This rate may be higher or lower than the return on total assets, depending on how judiciously
Average age of inventory provides a rough measure of the length of time it takes to acquire, sell and management has combined debt and preference share with ordinary share in financing the entity’s
replace inventory. Average age of inventory is determined as follows: resources. The formula for computing this ratio is:

365 days Profit-Preference Shares

Average Age of Inventory = Return on Ordinary Equity =
Inventory Turnover Average Ordinary Equity

Operating Cycle The numerator yields the profit available to the ordinary shareholders and is the net amount earned on the
equity of the ordinary shareholders. Average ordinary entity is an approximation of the amount invested
This measures the average time period between buying the inventory and receiving cash proceeds from its by this group of owners throughout the year.
sales. It is determined by adding the average age of inventory and the average age of receivables.
Preference Dividends:
PROFITABILITY RATIOS

Return on Total Assets Par Value of Preference Share (at

the time dividends are declared) P 500,000
Return on total assets is a measure of management’s efficiency in using its assets to earn profits. Creditors Dividend Rate Paid 5%
have loaned money to the entity and interest is their return. Shareholders have invested in the entity and Amount of Preference Dividends P25,000
profit is their source of return. The sum of interest expense and profit is the returns to the two groups who
have financed the entity’s operations. The formula for computing the ratio follows:

Profit + Interest expense

Return on Total Assets =
Average Total Assets

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Average Ordinary Equity: Corporation can also improve their earnings per share figures by repurchasing outstanding shares. This
will decrease the amount of shares outstanding and, for a fixed amount of earnings, inflate earnings on a
per-share basis. If an entity sells additional shares, dilution occurs and the opposite effect results earnings
Total Equity Preference Equity Ordinary Equity
per share decline.
Jan. 1, 2018 P 87,710,000 - P 500,000 = P 87,210,000
Dec. 31, 2018 P103,550,000 - P 500,000 = P103,050,000 Price-Earnings Ratio
Total P 190,260,000/2 The price earnings (P/E) ratio indicates the degree to which investors value an entity. When investors pay
Average Ordinary a high price for a given amount of corporate earnings, they increase the entities P/E ratio. The price-
earnings ratio of the market price per ordinary share to the basic earnings per share. This ratio reflects
Equity for 2018 P 95,130,000
investors assessment of the entity’s future earnings. The formula for calculating the price-earnings ratio
is:
The return on W. Blanche Corporation’s ordinary equity for 2018 is:
P 17,575,000 - P 25,000
Return on Ordinary Equity = Market Price per Ordinary Share
P 95,130,000 Price Earnings Ratio =
Basic Earnings per Ordinary Share

= .1845 or 18.45% The higher the entity’s P/E ratio, the more potential investors typically see in the particular entity.
Generally, corporations with higher P/E ratios tend to have higher growth rates and deliver products or
services that will probably be in demand for a significant time into the future. Because of such positive
Since the 18.45% return on ordinary equity exceeded the 12.57% return on total assets, management has projections, investors are willing to pay a higher share price in the hope that sales and earnings growth
made effective use of leverage or trading on the equity. This difference resulted from borrowing at a will fuel further increases in share price.
lower rate and investing the funds to earn a higher rate of return on ordinary equity. This practice is
directly related to the debt ratio; the higher the debt ratio, the higher the leverage. Trading on equity does Assuming a current market price of P27 for W. Blanche Corporation’s ordinary share, the price-earnings
not always guarantee improved profitability; it is because when revenues drop and operations resulted to ratio for 2018 would be calculated as follows:
losses, interest on debts must still be paid.
P 27
Basic Earnings Per Ordinary Share Price Earnings Ratio =
P 1.80
Basic earnings per ordinary share is a measure of the profit earned on each ordinary share. The formula
for a simple capital structure and the calculation of 2018 earnings per share for W. Blanche Corporation = 15 or 15:1
follows:
W. Blanche’s share is currently selling at 15 times earnings. Investors are generally willing to buy a share
Profit-Preference Dividends for as many as 15 to 20 times the current per-share earnings because they feel that the future profit growth
BEPS = of the firm will be sufficient to provide an adequate return on this investment. This return is normally
Average No. of Ordinary Shares Outstanding
received through a combination of dividends and an increased market value of the share. Many investors
interpret a sharp increase in a share’s price-earnings ratio as a signal to sell a share.
P 17,575,000 - P 25,000
=
(9,500,000 shs. + 10,000,000 shs. )/2 Price earnings ratio can be increased by increasing net sales and profit growth rates. Increasing larger
profits margins also tend to increase P/E ratios. Profit margins can be increased by controlling costs and
P 17,550,000 by maintaining optimum pricing by offering competitive, highly desirable products and services.
=
P 9,750,000 shs. Dividend Yield

Dividend yield is the ratio of dividends per share to the share’s market price. This ratio measures the
= P 1.80
percentage of a share’s market value that is returned annually as dividends. This indication of the cash
payout rate on an investment allows shareholders and potential shareholders to compare interest rates on
Increasing profit can directly increase earnings per share. It is achieved by providing highly demanding certificates of deposit, corporate bonds, and other securities with this measure of return on ordinary share.
products or services in a cost-effective manner. Highly demanded products or services can increase net
sales by causing sales of larger volumes of products or services at premium prices. By producing the The formula for calculating 2018 dividend yield for W. Blanche Corporation assuming that P8,000,000
product or service in a cost – effective manner, you can increase profit margins to strengthen earnings. cash dividends were paid to ordinary shareholders follows:

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Cash Dividend per Ordinary Share Thus, W. Blanche Corporation’s profit available to meet its interest responsibilities was way over 9 times
Dividend Yield = the amount of its interest expense. Usually, if interest is covered several times, long-term creditors
Market Price per Ordinary Share
consider this an acceptable margin of safety.
P8,000,000 / P10,000,000 shs. Higher ratios indicate healthy entities that generate high income streams from operations and/or entities
=
P27 that employ little or no debt. As the times interest earned ratios increase, there is typically less risk to
creditors that debt payment schedules will not be met.
P80
= Lower ratios indicate highly leverage firms with significant interest expense and/or those firms that
P27 generate small income streams from operations. While creditor risk increases as times interest earned
ratios decrease, there is the potential that the leverage gained with the financed debt may allow enhanced
future returns. Less mature entities especially start-ups, will tend to exhibit lower ratios. This is because
= .0296 or 2.96%
these entities typically require larger amounts of debt because profit generation has not yet reached
optimum levels and because growth generally requires cash investments for assets such as inventories and
This relatively low dividend yield rate of about 3% on W.Blanche Corp. ordinary share would not attract accounts receivable. Higher ratios can be achieved through paying off debt and reducing interest expense
investors who count on cash flow from dividends to pay their living expenses. A potential W. Blanche and/or increasing operations profitability.
Corp. shareholder would probably be more interested in speculating on the growth in the market value of
the share. This type of investor would rely more heavily on growth in earnings per share and recent trends Debt to Total Assets Ratio
in the market price of the share than on the dividend yield.
Debt to total asset ratio or debt ratio shows the percentage of the entity’s assets financed by debt. Higher
SOLVENCY RATIOS ratios indicate that an entity has financed a large portion of assets with debt. As debt-to-asset ratios climb,
creditor risk increases because there is less margin available if the entity must liquidate assets. Creditors
Solvency ratios measure the ability of the entity to survive over a long period of time. Long-term creditors may require higher interest rates or refuse to issue additional debt under these circumstances. However, a
and shareholders are interested in the long-run solvency, particularly its ability to pay interest as it comes certain degree of debt is generally quite acceptable; especially in the view of investors because the
due and to repay the principal of the debt at maturity. leverage gained with debt financing may yield higher returns on equity investments.

Times Interest Earned Ratio An acceptable level of debt can be determined by examining the ratio of interest payments to operating
profit. In the case of start-ups or entities experiencing special situations, compare all sources of income
Times interest earned is a measure of how readily an entity can meet interest payments with profit earned including additional debt financing with interest payments to ascertain the acceptability of current debt
from operations. The times interest earned ratio indicates the margin of safety provided by current levels. The higher this percentage is, the greater the risk that the entity will be unable to meet its
earnings in meeting the entity’s interest responsibilities. obligations when due. Thus, if the debt ratio is 100%, then debt has been used to finance all the assets.
The debt ratio for W. Blanche Corporation follows:
Profit Before Interest Expense and Income Taxes
Times Interest Earned = Total Liabilities
Annual Interest Expense Debt To Total Assets Ratio =
Total Assets
The ratio uses profit before interest expense and income taxes because this amount represents the amount
available to cover interest. Times interest earned for W. Blanche Corp. in 2018 is: P 69,033,000
=
P 172,583,000
P 17,575,000 + P 3,120,000 + P 9,463,462
Times Interest Earned =
P 3,120,000
= 0.399 or .40 or 40%
P 30,158,462
= Thus, 40% of W. Blanche Corp.’s total assets were financed by debt.
P 3,120,000
Equity to Total Assets Ratio
= 9.7 times Equity to total assets ratio or equity ratio, shows the percentage of the firm’s assets financed by
shareholders. The higher this ratio is, the smaller the risk that the entity will be unable to meet its
obligations when due. Observe that debt ratio and equity ratio are complementary; that is the two
percentages should always add up to 100%. This is true because all assets are financed by either debt or

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equity funds. The equity to total assets ratio may be found by subtracting the debt to total assets ratio
from 100%.

Equity Ratio = 100% - Debt Ratio Problem 2 Make a vertical analysis in given statement of comprehensive income
Equity Ratio = 100% - 40% = 60%
Magnificat Corporation
This ratio may also be calculated by the following formula:
Condensed Statement of Comprehensive Income
For the Years Ended December 31
Total Equity
Equity Ratio =
Total Assets
2020 2019
Amount Percent Amount Percent
P 103,550,000
= Sales ₱ 3,000,000 ₱ 2,750,000
P 172,583,000
Sales Returns and Allowances 50,000 80,000
Net Sales 2,950,000 2,670,000
= 0.60 or 60% Cost of Goods Sold 1,500,000 1,600,000
Gross Profit 1,450,000 1,070,000
Thus, 60% of W. Blanche Corp.’s assets came from the shareholders and 40% from creditors. This ratio Distribution costs 170,000 190,000
should be satisfactory to long-term creditors. Administrative expense 90,000 70,000
Total Operating expense 260,000 260,000
EXERCISES: Profit from Operations 1,190,000 810,000
Problem 1 Make a vertical analysis in given statement of financial position
Investment Revenues 15,000 30,000
Magnificat Corporation Finance costs 50,000 80,000
Condensed Statement of Financial Position Profit before Income taxes 1,155,000 760,000
December 31 Income Tax Expense 85,000 90,000
Profit ₱ 1,070,000 ₱ 670,000
2020 2019
Assets Amount Percent Amount Percent
Current Assets ₱ 1,500,000 ₱ 1,800,000
Property and Equipment, Net 900,000 1,000,000
Intangible Assets 100,000 85,000
Total Assets ₱ 2,500,000 ₱ 2,885,000

Liabilities
Current Liabilities ₱ 500,000 ₱ 400,000
Long-term Liabilities 175,000 500,000
Total Liabilities ₱ 675,000 ₱ 900,000

Equity
Ordinary share, P1 par value ₱ 700,000 ₱ 900,000
Retained Earnings 1,125,000 1,085,000
Total Equity ₱ 1,825,000 ₱ 1,985,000
Total Liabilities and Equity ₱ 2,500,000 ₱ 2,885,000

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MODULE 9: CAPITAL BUDGETING carrying value of P300,000 and will be sold for P180,000. If the new equipment is not
purchased, the old equipment must be overhauled at a cost of P90,000. This cost is deductible for
Learning Objectives: tax purposes in the year incurred. Tax rate is 35%.
1. Explain the nature and concept of strategic planning Sample Problem - Net Cost of Investment
2. Identify several areas in applying capital budgeting
3. Identify the variables included in the determination of net cost of investment Lighthouse Company is planning to purchase a new machinery costing P1,000,000. Freight and
4. Differentiate and interrelate profit from net cash inflows installation cost are P50,000. If the new machine is acquired, the company’s working capital
5. Explain and compute the marginal cost of capital and the weighted cost of capital requirement will be reduced by P80,000. The new machinery will be purchased to replace an old
unit that was acquired 3 years ago at a cost of P300,000, for which an annual depreciation
What is Capital Budgeting? expense of P30,000 will be recorded. This old unit will be sold for P200,000. If the new
• Capital budgeting refers to the decision-making process that companies follow with equipment is not purchased, extensive repairs on the old machine will have to be made at an
regard to which capital-intensive projects they should pursue. estimated cost of P60,000. This repairs expense can be avoided by purchasing the machinery.
The company’s income tax rate is 30%.
• It deals with analyzing the profitability and liquidity of a given project proposal over its
economic life. Sample Problem - Net Cost of Investment

• Projects include capital budgeting analyses as to replacement and expansion, Bluewave Company is planning to purchase a new production equipment costing P2,000,000.
improvement or retention, research and development. Freight and installation cost are P100,000. If the production equipment is acquired, the
company’s working capital requirement will be reduced by P120,000. The production equipment
Main Issues in Capital Budgeting will be purchased to replace an old unit that was acquired 5 years ago at a cost of P500,000, for
which an annual depreciation expense of P50,000 will be recorded. This old unit will be sold for
❑ Net Cost of Investment
P220,000. If the new production equipment is not purchased, extensive repairs on the old
❑ Recovery equipment will have to be made at an estimated cost of P90,000. This repairs expense can be
avoided by purchasing the production equipment. The company’s income tax rate is 30%.
❑ Project Evaluation Techniques
Investment Recovery
❑ Cost of Capital
▪ The recovery of investment could either be viewed as annual cash inflows or accounting
Net Cost of Investment profit.
▪ It refers to the net cash outflows, after tax considerations, that are normally paid by ▪ Investors have two preference:
investors in relation to the investing transaction.
❖ Yield - preference theory
▪ It includes opportunity costs such as possible savings and tax effects on possible gain,
loss or savings on related transactions. ❖ Liquidity –preference theory

Sample Problem - Net Cost of Investment Sample Problem – Investment Recovery

The World Trade Center Co. plans to acquire a new equipment costing P1,200,000 to replace the ▪ The Paragon Company is planning to add a new product line to its present business. The
equipment that is now being used. The terms of the acquisition are 3/30, n/90. Freight charges new product will require a new equipment costing P2,400,000, with a five-year life, no
are estimated at P23,000 and it will cost P14,000 to install. Special attachment to be used with residual value.
this unit will be needed and will cost P36,000. If the new equipment is acquired, operations will
be expanded and this will additional working capital of P250,000. The old equipment has a

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▪ Annual Sales, P12M; Selling and administrative expense, P2.1M; Materials, P4.4M; Accounting Rate of Return
Labor, P2.2M; Factory overhead (excluding depreciation on new equipment), P1.3M;
Income tax rate 40%. ▪ It measures the annual profitability of a proposed project.

Sample Problem – Investment Recovery ▪ It measures the attractiveness of a proposed investment.

▪ Cedar falls Company is planning to introduce a new product to the current business. The ▪ The Tarlac Company is considering the production of a new product line which will
new product will require a new machinery costing P3,000,000, with a five-year life, no require an investment of P3,000,000, with P200,000 residual value.
residual value. ▪ The investment will have a useful life of 10 years during which annual cash inflows
▪ Annual Sales, P15M; Selling and administrative expense, P3M; Materials, P5M; Labor, before income taxes of P1,400,000 are expected. The income tax is 40%.
P4M; Factory overhead (excluding depreciation on new machinery), P1.5M; Income tax Sample Problem
rate 30%.
Montfort Co. is considering the purchase of new data transmission equipment. Estimated
Project Evaluation Techniques annual cash revenues for the new equipment are P1M, and operating costs (including
▪ Project investments are evaluated on their liquidity or profitability. Annual cash inflow is depreciation of P400,000) are P825,000. The equipment costs P2M, it has a 5-year life
used to measure liquidity while profit is used to measure profitability. and it will have no residual value at the end of 5 years. The income tax is 30%.

▪ The higher the profitability, the better the investment is. Cost of Capital

Payback period ▪ It refers to the cost of using long-term money or funds from investors.

▪ It refers to the length of time before an investment is recovered. It is the time period ▪ The funds coming from investors is called financing money.
where the cumulative cash inflows is equal to the cost of investment. ▪ Investors expect returns on their investment.
▪ It is otherwise known as the breakeven time Weighted Average Cost of Capital
Sample Problem – Payback period • WACC formula can be used in determining the minimum required return.
▪ A project requires an investment of P600,000, with 5 years use life, no residual value, • It can be used to determine the appropriate cost of capital by weighing the portion of the
and uses straight line method of depreciation. Other data are given below: asset funded through equity and debt.
Expected sales revenue P2,000,000

Out-of-pocket costs 1,600,000

Tax rate 40%

Additional working capital P500,000

Sample Problem

Thomas & Therese Company is deciding to acquire a new machinery. Estimated annual cash
revenues for the new machinery are P1.5M, and operating costs (including depreciation of
P300,000) are P700,000. The equipment costs P3M. The income tax is 30%.

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Capital Asset Pricing Model Problem:

The business has risk-free rate is 5%, market return of 12% and the beta is 1.3.

Compute for the cost of equity.

Cost of Debt

Illustration:

The risk-free rate is 5% while the market return is roving around at 11.91%, the beta is
1.5.
Illustration:
The cost of equity is 15.365% [5% +1.5 (11.91% - 5%)].
The risk-free rate is 5% and in order to borrow in the industry, a debt premium is
considered to be about 6%.

The cost of debt is 11% [5% + 6%].

Problem:

The business has risk-free rate is 4%, market return of 8% and the beta is 1.5.
Illustration:
Compute for the cost of equity.
The risk-free rate is 7% and the debt margin is 5%
Sample Problem-Capital Asset Pricing Model
Compute for the cost of debt

Weighted Average Cost of Capital

To continue the illustration, assuming that the share of financing is 30% equity and 70%
debt, and the tax rate is 30%.

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MODULE 10: RECEIVABLES MANAGEMENT

Learning Objectives:

1. Expound the relationship of credit sales and trade receivables.

2. Explain the credit and collection cycle.
3. Identify the variables of setting credit and collection policies.
4. Compute the effective discount rate.
5. Interrelate the relationships of receivable turnover, collection period and receivable
Sample Problem- Weighted Average Cost of Capital balance.

Assuming that the share of financing is 40% equity and 60% debt, and the tax rate is
30%. The cost of equity is 15% while the cost of debt is 10%. Compute for the WACC. The Concept of Trade Receivables

• Trade receivables spring out of the need to sell merchandise. An excellent business
proposition is to generate sales without offering a credit facility to customers.

• Once credit sales are made, inventory is already withdrawn from the warehouse and no
cash is received yet.

• The business helps its customers by entrusting their merchandise and money to them.

• The collectability of accounts receivable depends to a large extent on the quality of

customers.

• The quality of customers depends on the standards of credit policies set up and used by
an organization.

• Credit policies is an integral part of the entire credit cycle which includes credit
standards, credit evaluation, credit approval and credit system assessment.

The Credit Cycle

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The Collection Cycle Credit Management

Credit Management Receivable Receivable Collection

Credit Policy Collection
Variables balance turnover period
Discount rate high faster decrease increase shorter
Discount rate low slower increase decrease longer
Discount time short (strict) faster decrease increase shorter
Discount time long (lax) slower increase decrease longer
Credit period short (strict) faster decrease increase shorter
Credit period long (lax) slower increase decrease longer
Credit cap high (strict) faster decrease increase shorter
Credit cap low (lax) slower increase decrease longer
Credit class low risk (strict) faster decrease increase shorter
Credit class high risk (lax) slower increase decrease longer

❑ Accounts Receivable Turnover = Net Credit Sales/Average Accounts Receivable balance

❑ Collection Period = 365 days/Accounts Receivable Turnover

Effective discount rate

❖ Trade discounts or credit discounts are given to encourage credit customers to pay their
Credit Management accounts earlier.
▪ It strategically defines the quality of accounts receivable collections. ❖ The bait is, the higher the discount rate, the more attractive it is for the buyer to pay at an
▪ Credit and collection have a direct relationship. If credit standards are high, the rate of earlier date.
collection is expected to e high, and vice versa.
Discount Rate Days in a year
Effective Discount Rate = x
▪ Credit processes precede collection activities. 100% - Discount Rate Remaining credit time

▪ 5C’s of credit: Character, Capacity, Capital, Collateral and Conditions ❖ Effective Discount Rate = Periodic discount rate x no. of non-free discount time periods

▪ Stiff credit criteria – implemented to have a high collection rate ▪ The periodic discount rate is net financing costs divided by net proceeds. Discount rate
relates to the financing cost and 100%-discount rate refers to the net proceeds.
▪ Lax credit criteria – implementation which result to high amount of bad debts,
collection, costs and receivables ▪ The remaining credit time is the non-free discount time which is the number of days from
the date the discount period ends up to the end of the entire credit period.
▪ Variables of Credit Management Discount rate
▪ Credit period refers to the entire credit days granted to customers. A long credit period
▪ Discount time slows down collection while a short credit period quickens the receipts of money from
customers.
▪ Credit period
▪ The number of non-free discount time periods or discount time turnover represents the
▪ Credit cap
number of times in a year where the seller could use the money that he received at an
▪ Credit class earlier date.

▪ Credit assessment ▪ Assume a credit term of 2/10, n/30.

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Discount Rate Days in a year ❖ New deliveries will be made once an account has been paid or becomes current.
Effective Discount Rate = x
100% - Discount Rate Remaining credit time
Credit Class
2% 365 days
EDR = x ❖ It pertains to the group of customers to whom merchandise shall be delivered.
100% -2% 20 days

❖ Customers may be classified according to income level, place of residence, gender, age,
EDR = 36.73% geographical location, civil status, and other matters of social demographics.

❖ Credit limits and other credit terms are determined for each credit class.

❖ Sometimes a product is not given to a credit class because of very high credit risk.
Party IF the THEN
Seller EDR < ROI of money collected offer the trade discount Sample Problem- Change in Credit Policy
Seller EDR > ROI of money collected do not offer the trade discount
Robert Company is considering to change its credit policy from 2/10, n/30 to 2/15, n/45.
Buyer EDR > cost of money avail of the trade discount
This change would push the 2021 sales to reach 48M, or an increase of 20% from last
Buyer EDR < cost of money ignore the trade discount
year’s. 90% of total sales would be on credit. 80% of credit customers are expected to
Buyer EDR < ROI if money is used avail of the trade discount avail of the discount. Account receivable at the end of year is estimated at 15% of sales.
Buyer EDR > ROI if money is used ignore the trade discount Variable costs ratio shall be maintained at 75%.
The discount time offered by the business is affected by the practice in the ❖ In relation to changing the credit terms, collection costs would increase by 10% of the
industry, competition, quality of customers, operating cycle, financial capability of the incremental sales. Doubtful accounts are expected to increase from 1% to 2.75% of credit
seller, and long-term objectives of the organization. sales. The effective rate of return on a given investment is determined at 12%.
❖ Discount time is also set in relation with the discount rate. If the discount time is short, ❖ Question: Should Robert Company change its credit policy in 2021?
the discount rate goes higher; and if the discount time is long, the discount is lowered.
Before After Inc. (Decrease)
❖ If the discount time is short, collection is accelerated, receivable balance is reduced, Sales (P48M/120%) ₱ 40,000,000 ₱ 48,000,000 ₱ 8,000,000
receivable turnover is higher and the collection period is shortened. Credit sales (90% of sales) ₱ 36,000,000 ₱ 43,200,000 ₱ 7,200,000
Variable costs (75% of sales) ₱ 30,000,000 ₱ 36,000,000 ₱ 6,000,000
❖ If the discount time is long, collection is delayed, receivable balance tends to balloon, Contribution margin (Sales -
receivable turnover gets lower, and the collection period is lengthened. Variable costs) ₱ 10,000,000 ₱ 12,000,000 ₱ 2,000,000
Accounts receivable-end
❖ A change in discount time also changes the effective discount rate.
(15% of sales) ₱ 6,000,000 ₱ 7,200,000 ₱ 1,200,000
Credit Cap and Credit block Doubtful accounts expense
(1% x P36M) ; (1.75% x
❖ Credit cap (or credit limit) refers to the limitation of credit line in terms of amount (or P43.2M) ₱ 360,000 ₱ 756,000 ₱ 396,000
even merchandise items) set or imposed by the seller to a given customer depending on
the capability to meet trade payments. Increase in Collection costs
(10% x P8M) ₱ 800,000
❖ The higher the credit risk of a customer, the lower the credit cap is. Sales discount (Credit sales
x 80% x 2%) ₱ 576,000 ₱ 691,200 ₱ 115,200
❖ Credit block is the policy of non-delivery of merchandise to customers once their
accounts become past due.

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Incremental contribution margin Before After Change +(-)
Increase in gross sales ₱ 8,000,000 Collection period 45 days 30 days 15 days
Increase in sales discount -₱ 115,200 Receivable turnover (360 days/Collection
period) 8 times 12 times 4 times
Increase in net sales ₱ 7,884,800
Net Sales ₱ 70,000,000 ₱ 70,000,000 none
x CM ratio 25% ₱ 1,971,200 Accounts receivable balance
Less: Incremental costs (Net Sales/Receivable turnover)
Collection costs ₱ 800,000 (P70M/8 days) ₱ 8,750,000
Doubtful accounts 396,000 (P70M/12 days) ₱ 2,500,000 -₱ 6,250,000
Opportunity costs on the increased balance of accounts Increase in collection costs (1% x P70M) ₱ 700,000
receivable (P1,200,000 x 12% x 75%) 108,000 1,304,000
Income from the released balance of
Incremental profit from the change in credit policy 667,200
accounts receivable
(P6,250,000 x 12%) ₱ 750,000 (Benefit)
❖ Collection management starts from the date the merchandise is sold to credit customers. Less: Increase in collection costs ₱ 700,000 (Cost)
Complete and reliable records and corroborating documents should be maintained to Net advantage of new collection policy ₱ 50,000 (Net benefit)
ensure an efficient basis of collection.
Formulas:
❖ Billing and collection policies are interrelated processes to complete a collection cycle.
❑ Collection period = 365 days/Receivable Turnover
How to maintain an Efficient Billing System
❑ Receivable turnover = 365 days/Collection period
❖ Bill completeness
❑ Receivable turnover = Net Credit Sales/Average Accounts Receivables
❖ Error-free statement of bills
❑ Accounts receivable balance = Net Credit Sales/Receivable Turnover
❖ Send bills on time
Receivable Portfolio Analysis
❖ Frequency of collection follow-up
❑ Receivable portfolio - it refers to the strategy of spreading investments in receivables
❖ Visibility of collection personnel over a defined customer base.

❖ Electronic fund transfer and concentration banking ❑ It gives an impression of whether the management is strict or lax in imposing it
receivable policies and whether the management is conservative or aggressive in its
Sample Problem- Change in Collection Policy receivable investments.
▪ Golden Corporation is studying a proposed collection system that will decrease collection ❑ Receivable should be tracked down – per customer, customer group, customer receivable
period from 45 days to 30 days. To do this, administrative costs in relation to collection age, and customer balances. This is done in relation with the goal of spending up the
activities are expected to increase by 1% of net sales, which is projected to remain at collection of receivables.
P70M. The effective rate of return prevailing in the market with the same type of
investment risk is 12%. ❑ Customers are analyzed based on their historical attitude of meeting trade obligations,

▪ Question: Should Golden Corporation change the collection system? ❑ Customers are also classified per group for customer-relations efficacy and
standardization of approaches and techniques.

❑ Accounts receivable are to be aged in relation with the credit period.

❑ An account which is not yet due for collection is classified as “current account”.

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❑ An account that is still outstanding even after the credit period is called as “past due Aging of Accounts Receivable
account”.
❑ It classifies the accounts receivable according to the number of days outstanding. It has
Past due classifications the following advantages:
1-30 days ▪ It tracks down receivable balances
31-60 days
▪ It serves as an analysis sheet to study receivable balances according to their “age” as
61-90 days either current account or past due account.
91-120 days
▪ It gives an idea of which accounts are “moving” or “not moving” by doing a
121-180 days
supplemental analysis of the long past due accounts.
181-360 days
more than 360 days ▪ It is a reasonable technique of estimated doubtful accounts expense.

Illustration: Effects of Receivable Portfolio-Two companies with credit terms, 2/10, Internal Control for Receivables – The Revenue-Receipt Cycle
n/30 have receivable spread on Dec. 31, 2021. To protect the amount of investment in receivables, a firm should provide an
Company A Company B
accurate and reliable accounting report on receivables, promote operational efficiencies
Account group Amount Spread Amount Spread on credit and collection systems, and encourage adherence to prescribed managerial
Current account ₱ 6,000,000 75.00% ₱ 2,000,000 25.00% policies, there are receivables internal control principles to be observed.
Past due account
1-30 days ₱ 1,000,000 12.50% ₱ 3,500,000 43.75%
31-60 days ₱ 500,000 6.25% ₱ 1,000,000 12.50%
61-90 days ₱ 300,000 3.75% ₱ 500,000 6.25%
91-120 days ₱ 100,000 1.25% ₱ 400,000 5.00%
121-180 days ₱ 50,000 0.63% ₱ 300,000 3.75%
181-360 days ₱ 30,000 0.38% ₱ 200,000 2.50%
more than 360 days ₱ 20,000 0.25% ₱ 100,000 1.25%
Total Accounts Receivable ₱ 8,000,000 100.00% ₱ 8,000,000 100.00%

Collection costs include the amount spend on man hours lost, machine hours used,
telecommunications, gas and oil, supplies, opportunity lost on the hours used, and the
opportunity costs of the money tied up in the receivables which could have been used to
generate earnings in other activities.

❑ Receivable portfolio analysis can also be used in evaluating the credit and collection
Functional responsibilities must be segregated where top management authorizes
policies of an organization.
the sale of a product or product line, the sales department makes the sales, the accounting
❑ If the policies and implementation thereof are strict, collection would be faster and more department does the recording, the cash department receives collection and the auditing
assured, and the receivable balance would tend to be smaller. department checks the transactions

❑ Conversely, if the policies and implementation are lax, collection would be slower, and ✓ Sales order slip, delivery receipts, official receipts, and billing statements should be pre-
the receivable balance would tend to increase. numbered and multi-copied.

✓ Deliveries of merchandise to customers should be supported by a written authority to ship

the goods (sales delivery slip).

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✓ Proper documentation of merchandise shipment should be ensured to assure accuracy and
accountability.

✓ Merchandise should be insured, especially when in transit

✓ Delivery receipts should be signed by customers.

✓ Efficient and effective billing system must be in place.

✓ Sales reports should be prepared regularly.

✓ Daily cash reports should always be made.

✓ Accounts receivable subsidiary ledgers should be periodically reviewed and totaled.

✓ Receivable confirmation letter should be regularly sent to customer.

✓ Account receivable should be regularly aged and analyzed.

✓ Accounts should be written-off after exhausting all possible collection efforts and
possibilities.

✓ Accounts receivable ledgers should always be updated.

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