Course Title: Cost &

Management Acct.II
 Course Contents
1. Cost Behavior (CB) and Cost Volume Profit
(CVP) Analysis
2. The Master Budget
3. Flexible Budget and Standards
4. Measuring Mix and Yield Variances
5. Decision Making and Relevant Information
6. Price Decision and Cost Management
 Chapter-One
Cost Behavior (CB) and Cost Volume Profit (CVP)
Analysis
 1.1. Cost Behavior
• Cost behavior is the way costs respond to changes in
volume or activity
• It is a factor in almost every decision managers make.
1.1.2. Classifications of Cost Behaviors
 Some costs vary with volume or operating activity
(variable costs).
 Others remain fixed as volume changes (fixed costs).
 Between those two extremes are costs that exhibit
characteristics of each type (mixed costs).
 A) Variable cost:
• Changes in total in proportion to changes in the related
level of activity or volume.
• Variable costs remain constant on a per unit basis.
• Variable cost rises when the volume of activity increases
and it drops when the volume of activity goes down
• The variable cost formula for variable cost behavior is that
of a straight line: Y = a(X)
where
 Y =is total variable cost,
 a = is the variable rate per unit, and
 X =is the units produced.

• Direct material is a good example of a variable cost.

 B) Fixed Costs:
• Fixed costs are total costs that remain constant
within a relevant range of volume or activity.
• Relevant range is the span of activity in which a
company expects to operate.
• Fixed costs are costs that do not vary in response
to a volume of activity over some range of
production.
• Total fixed costs do not vary with volume of
activity
• The fixed cost per unit does change as activity
changes.
 Cont..
• Fixed cost behavior expressed mathematically in the
fixed cost formula is a horizontal line in the relevant
range:
Y=b
• where
 Y is total fixed cost and
 b is the fixed cost in the relevant range.
• Rent is a good example of fixed cost.
 C) Mixed/Semi Variable Costs:
• A mixed cost is one that contains both variable
and fixed cost elements together.
• Mixed cost is also known as semi variable cost.
• Examples of mixed costs include:
 electricity,
water and
telephone bills.
 The rent paid for the line or counter is a fixed cost, the
kilowatt hour or number of calls payment is a variable
cost as payment varies with usage.
 1.2. Cost-Volume-Profit (C-V-P) Analysis
• Cost-volume-profit (C-V-P) analysis is an examination of the
cost behavior patterns that underlie the relationships among
cost, volume of output, and profit.
• C-V-P analysis usually applies to a single product, product
line, or division of a company.
• For that reason, profit, which is only part of an entire
company’s operating income, is the term used in the C-V-P
equation.
• The equation is expressed as

Profit = Sales Revenue - Variable Costs - Fixed Costs

P = S - VC - FC
 Cont…
• C-V-P analysis is a tool for both planning and control.
• Managers use C-V-P analysis to measure the effects of
alternative courses of action, such as
changing variable or fixed costs,
expanding or contracting sales volume, and
increasing or decreasing selling prices.
• C-V-P analysis is useful in making decisions about
product pricing, product mix (when an organization
makes more than one product or offers more than one
service), adding or dropping a product line, and
accepting special orders.
 Cont…
• C-V-P analysis is used extensively in budgeting as well,
and is also a way of measuring how well an
organization’s departments are performing.
• In cost-volume-profit analysis, volume refers to some measure
of profit-generating activity.
• Volume can be measured by:
Sales in units,
Sales in Birr,
Production in units,
Hours worked by employees, or
Any other activity that might be important.
 Cont…
• C-V-P analysis has many applications, all of which
managers use to plan and control operations
effectively.
• However, it is useful only under certain conditions
and only when certain assumptions hold true.
• Those conditions and assumptions are as follows:
 Selling price is constant:- The price of a product or service
will not change as volume changes.
 Costs are linear and can be accurately divided into
variable and fixed elements.
o The variable element is constant per unit, and the fixed
element is constant in total over the relevant range.
 Cont…

 In multi-product companies, the sales mix is constant.

 In manufacturing companies, inventories do not change.
o The number of units produced equals the number
of units sold
 Profit Equation and Contribution Margin
• CVP analysis begins with the basic profit equation.
Profit = Total revenue -Total costs
• Separating costs into variable and fixed categories, we
express profit as:
Profit =Total revenue - Total variable costs -Total fixed
costs
• Contribution margin indicates why operating income
changes as the number of units sold changes.
• The contribution margin is total revenue minus total
variable costs.
• Similarly, the contribution margin per unit is the
selling price per unit minus the variable cost per unit.
 Cont…
• Both contribution margin and contribution margin
per unit are valuable tools when considering the
effects of volume on profit.
• Contribution margin per unit tells us how much
revenue from each unit sold can be applied towards
fixed costs.
• Once enough units are sold to cover all fixed costs,
then the contribution margin per unit from all
remaining sales becomes profit.
 Contribution Margin Income statements
 A contribution margin income statement is formatted
to emphasize cost behavior rather than organizational
functions.
 All variable costs related to production, selling, and
administrations are subtracted from sales to determine
the total contribution margin (CM) (i.e., the amount
that remains after all variable costs are subtracted
from sales).
 All fixed costs related to production, selling, and
administration are subtracted from the total
contribution margin to determine operating income.
 Cont…
• Contribution margin is the difference between selling
price and variable cost/The difference between total
sales and total variable costs.
• In some cases, expressing contribution margins as
percentage is useful and convenient.
• The contribution margin percentage is contribution
margin per unit divided by selling price per unit, or
total contribution margin divided by total sales Birr.
(Both calculations give the same result.) The
percentage of variable costs to selling price is called
the variable cost percentage.
 Cont…
Contribution Margin percentage = contribution margin per unit
Selling price per unit
Or
= Total contribution margin
Total sales Birr
• The percentage of variable costs to selling price is called
variable cost percentage.
Variable costs percentage = total variable costs
Total sales
• The income statement is prepared based on the following
data for ABC Company for the month ended December
31’2013.
• Total units sold during the period 5,000 units
• Selling price per unit Br10.00
• Variable costs per unit 6.00
• Fixed costs in total 20,000.00
 Contribution margin form of income statement
ABC Company
Income Statement
For the month ended Dec 31, 2013
Units produced and sold 5,000 units
Sales [Birr 10.00 X 5,000 units] Br.50,000
Variable costs [Birr 6 X 5,000 units] 30,000
Contribution margin [Birr 4 X 5,000 units] 20,000
Fixed costs 20,000
Operating Income [Loss] -0-
 1.3. Breakeven Point
• Breakeven analysis uses the basic elements of cost-
volume-profit relationships.
• The breakeven point is the point at which total
revenues equal total costs. It is thus the point at
which an organization can begin to earn a profit.
• Break even analysis depends on the following
variables:
1. The fixed production costs for a product.
2. The variable production costs for a product.
3. The product's unit price.
4. The products expected unit sales [sometimes called
projected sales.]
 Cont…
• Breakeven point can be determined by using:
1. the equation method,
2. the contribution margin method and
3. the graph method.
• The equation method and the contribution margin method
are most useful when managers want to determine
operating income at few specific levels of sales.
• The graph method helps managers visualize the
relationship between units sold and operating income
over a wide range of quantities of units sold.
• However, different methods are useful for different
decisions.
 Cont…
• The following abbreviations are useful in subsequent
analysis.
 USP = Unit selling price
 S = Sales
 UVC = Unit variable costs
 UCM = Unit contribution margin (USP-UVC)
 CM % = Contribution margin percentage (UCM/USP)
 FC = Fixed costs
 Q = Quantity of outputs units sold (and manufactured)
 OI = Operating income
 TOI = Target operating income
 TNI = Target net income
 P = Profit
 Cont…
• The general equation for finding the breakeven point is as
follows:
S - UVC - FC = Br0
or
USP(X) - VR(X) - FC = Br0
• Suppose, for example, that one of the services My Media
Place sells is website setups. Variable costs are Br50 per
unit, and fixed costs average Br20,000 per year.
• A unit is a basic website setup which sells for Br90.
 Cont…
• Breakeven in sales units: Given this information, we can
compute the breakeven point for website setup services in
sales units (X equals sales units):
S – UVC – FC = Br0
Br.90X - Br50X - Br20,000 = Br0
Br40X -Br20,000
X = 500 Units
• Breakeven in sales dollars: We can also compute
breakeven in sales dollars since sales price multiplied by
breakeven in sales units equals breakeven in sales dollars:
Br90 X 500 Units = Br. 45,000
 1.3.1.Methods of Breakeven Computation
• The breakeven point can be computed in three different
ways.
1) Equation method
2) Contribution margin method and
3) Graphic method.
Each method is discussed by using the following example:
• Assume that a company manufactures and sells a single
product line with the following summarized data.
o Selling price per unit (USP) ............................. Br30/unit
o Variable cost per unit (UVC) ............................ 20/unit
o Fixed costs (total) (FC) ..................................... 100,000.
 a) Equation method
• The equation method is derived from the relationship that
exists among income statement items: revenues, and costs.
• The operating income is determined by deducting costs from
revenue as stated below:
Operating Income =Revenues - Variable costs - Fixed costs
• The break-even point is the point where the total cost equals
the total revenue. Which means the operating income (z) is
zero.
• The break-even point for the company in our example is;
therefore, computed using the formula:

P= SP/unit * x – VC/unit * x - FC, Where the value of P is

zero
0 = (Birr 30 x X) - (Birr 20 x X) - Birr 100,000
0 = Birr 30X - Birr 20X - Birr 100,000
10X = Birr 100,000
X = 10,000 units
 Cont…
• If the company produces and sells 10,000 units, it will break-even.
The operating income at this level of sales volume is zero. The total
revenue is generated to cover only the total costs incurred. This can
be proved as follows:

P = SP/unit * units - VC/unit * units - FC

= (Birr 30 x 10,000 units) - (Birr 20 x 10,000 units) - Birr 100,000
= Birr 300,000 - Birr 200,000 - Birr 100,000
= Birr 0

• Breakeven in sales dollars: The breakeven point in total sales dollars

may be determined by multiplying the breakeven point in units by
the selling price
(SP) per unit:
BE in Birr = selling price per unit x BE Units
= Birr 30 x 10,000 units
=Br.300,000
 b) Contribution margin Method:
• Contribution margin is the difference between total
revenue and total variable costs. The formula to determine
contribution margin is derived from the formula used to
determine the operating income.
Operating income = Revenue – Total costs
P = SP. Q – VC. Q – FC………………Equation (1)
SP .Q – VC .Q = P+FC………………………… (2)
(SP-VC)Q = P+FC……………………………. (3)
(SP-VC) Q = O+FC ▬ (SP-VC) Q = FC………..…. (4)
• Used to determine the value of quantity (breakeven point
in units) (5) to compute the break even points in units.
Q= FC
SP- VC
 Cont…
Using contribution margin approach , the break even points in
units in the above example is completed as :
Q = FC/SP – VC
= Br 100,000/Br 30-Br 20
= Br 100,000/10 Br = 10,000 units
Contribution margin pre unit = Br30 – Br 20 = Br. 10
Contribution margin percentage = Contribution margin per unit
Selling price
= Br 10 /Br30 = 33. 3%
Compute the breakeven point in total sales in Birr.
Sales in Birr = total fixed costs / Contribution margin ratio
= Br 100,000/33% (rounded)
= Br. 300,000
 c) Graphic Method
• Graphic method is helpful in assessing the probable
effects of changes in the price cost structure.
• Breakeven point is determined by the intersection of total
revenue line and total cost line
Steps:
1) Draw X axis of the graph
2) Draw fixed cost line
3) Compute total cost at any convenient volume
4) Draw variable cost line
5) Compute total sales revenue at any convenient volume
6) Draw total revenue line
7) Label the graph
Cont…
 Cont.
• Choose any convenient volume. For example select a volume of
6,000 units
TVC = Br.10 unit x 6,000 units
= Br 60,000
TC = TVC + FC
= Br60, 000 + Br48, 000
= Br 108,000
• Total revenue = Br 16/unit x 6000 unit
= Br 96,000
 1.4. Breakeven Points for Multiple Products
• To satisfy the needs of different customers, most companies sell
a variety of products or services that often have different
variable and fixed costs and different selling prices.
• To calculate the breakeven point for each product, its unit
contribution margin must be weighted by the sales mix.
• The sales mix is the proportion of each product’s unit sales
relative to the company’s total unit sales.
• The breakeven point for multiple products can be computed in
three steps:
1) Compute the weighted-average contribution margin
2) Calculate the weighted-average breakeven point
3) Calculate the breakeven point for each product
 Example
• To illustrate, My Media produces two products with sales mix
of 60 percent standard websites to 40 percent express websites
and total fixed costs of Br32,000; the selling price, variable cost,
and contribution margin per unit for each product line are
shown in Step 1 below.
Cont…
 Cont…
• To verify, determine the contribution margin of each
product and subtract the total fixed costs:
• Contribution Margin
Standard 600 x Br40 = Br24,000
Express 400 x Br20 = 8,000
Total contribution margin Br 32,000
Less fixed costs (32,000)
Profit Br 0
1.5. Cost-Volume-Profit Analysis and Profit Planning
• Management can use cost-volume-profit analysis to
plan in advance.
• CVP analysis can be used to solve for variables other
than profit.
• Target Profits (Planned profit): The primary goal of a
business venture is not to breakeven; it is to generate
profits.
• C-V-P analysis adjusted for targeted profit can be
used to estimate the profitability of a venture.
• Target profit is total profit that the company planned
to get during the plan period.
Cont...
 1.6. Cost Change and CVP Analysis
• Cost-volume-profit analysis is a helpful tool in cost
planning.
• Consider the following data to show the effects of changes
in variable costs, fixed costs, sales price, and sales volume
on the company’s profitability in a variety of situations.
Per Unit Percent of Sales
• Selling price.................................... Br 250 100%
• Variable expenses.......................... 150 60%
• Contribution margin.................... Br 100 40%
• Fixed expenses are……………… Br 35,000 per month.
 1.6.1. Change in Fixed Cost and Sales Volume
• Assume that the company is currently selling 400 units per
month at Br250 per unit for total monthly sales of
Br100,000.
• The sales manager feels that a Br 10,000 increase in the
monthly advertising budget would increase monthly sales
by Br 30,000 to a total of 520 units.
• Should the advertising budget be increased?
Cont...
 Cont…
• There are two shorter ways to arrive at this solution. The
first alternative solution follows:
Alternative Solution 1
• Expected total contribution margin:
Br 130,000*40% CM ratio..................... Br 52,000
• Present total contribution margin:
Br 100,000*40% CM ratio ........................... (40,000)
Incremental contribution margin .............. 12,000
• Change in fixed expenses:
Less incremental advertising expense .......... (10,000)
Increased net operating income...................... Br 2,000
• Because in this case only the fixed costs and the sales
volume change, the solution can be presented in an even
shorter format, as follows:
 Cont…
Alternative Solution 2
• Incremental contribution margin:
Br 30,000*40% CM ratio............................ Br 12,000
Less incremental advertising expense........ (10,000)
Increased net operating income................. Br 2,000
 1.6.2. Change in Variable Costs and Sales Volume
• Assume that the Company is currently selling 400 units
per month.
• The company is considering the use of higher-quality
components, which would increase variable costs (and
thereby reduce the contribution margin) by Br 10 per unit.
• However, the sales manager predicts that using higher-
quality components would increase sales to 480 units per
month.
• Should the higher-quality components be used? The Br 10
increase in variable costs would decrease the unit
contribution margin by Br 10 - from Br 100 down to Br 90
 Cont…
Solution
• Expected total contribution margin with higher-quality
components:
480 units *Br90 per unit................................. Br 43,200
• Present total contribution margin:
400 units* Br 100 per unit ................................ 40,000
Increase in total contribution margin ..............Br 3,200
• According to this analysis, the higher-quality components
should be used. Because fixed costs would not change, the
Br 3,200 increase in contribution margin shown above
should result in a Br 3,200 increase in net operating
income.
1.6.3. Change in Fixed Cost, Sales Price, and Sales Volume
• Assuming the data given above, the company is currently
selling 400 units per month.
• To increase sales, the sales manager would like to cut the
selling price by Br 20 per unit and increase the advertising
budget by Br 15,000 per month.
• The sales manager believes that if these two steps are
taken, unit sales will increase by 50% to 600 units per
month. Should the changes be made?
• A decrease in the selling price of Br 20 per unit would
decrease the unit contribution margin by Br 20 down to Br
80.
 Cont…
Solution
Expected total contribution margin with lower selling price:
• 600 units*Br 80 per unit .........................................Br48,000
Present total contribution margin:
• 400 units*Br 100 per unit ......................................... 40,000
• Incremental contribution margin.............................. 8,000
Change in fixed expenses:
• Less incremental advertising expense................... 15,000
• Reduction in net operating income....................... Br(7,000)
According to this analysis, the changes should not be made.
The Br 7,000 reduction in net operating income that is shown
above can be verified by preparing comparative income
statements as follows:
Cont...
 1.6.4. Change in Variable Cost, Fixed Cost, and Sales Volume
• Assume the company is currently selling 400 per month.
• The sales manager would like to pay salespersons a sales
commission of Br15 unit sold, rather than the flat salaries
that now total Br 6,000 per month. The sales manager is
confident that the change would increase monthly sales by
15% to 460 units per month. Should the change be made?
Solution
• Changing the sales staff’s compensation from salaries to
commissions would affect both fixed and variable
expenses. Fixed expenses would decrease by Br 6,000,
from Br 35,000 to Br 29,000. Variable expenses per unit
would increase by Br 15, from Br 150 to Br 165, and the
unit contribution margin would decrease from Br 100 to Br
85.
 Cont…
Expected total contribution margin with sales staff on
commissions:
• 460 units*Br 85 per unit ......................Br39,100
Present total contribution margin:
• 400 units*Br 100 per unit …........................... 40,000
• Decrease in total contribution margin............(900)
Change in fixed expenses:
• Add salaries avoided if a commission is paid ... 6,000
• Increase in net operating income ................... Br 5,100
 1.6.5. Change in Selling Price
• Assume that the company is currently selling 400 units per
month. The company has an opportunity to make a bulk sale
of 150 units to a wholesaler if an acceptable price can be
negotiated. This sale would not disturb the company’s regular
sales and would not affect the company’s total fixed expenses.
What price per unit should be quoted to the wholesaler if the
company wants to increase its total monthly profits by Br 3,000?
Solution
Variable cost per units ............................................Br 150
Add Desired profit per units: Br 3,000/150 units ….. 20
Quoted price per unit……………….………..…….. Br 170
 1.7. Effect of Income tax
Net Income = Operating income - income taxes
Revenue – Total cost = Operating income
Net income = Operating income – (Operating income x
income tax rate)
OR = Operating income (1- Income tax rate)
Example: Operating income =Br 100
Tax = 20%
Net income = Operating income (1- income tax rate)
= Br 100 (1-20%)
= Br 100 (1 - 0.2)
= Br 100 x 0.8
= Br 80
 Cont…
• Example: Assume that for Wisdom Company the unit
selling price and unit variable cost for its product are Br50
and Br. 30 respectively. Fixed costs are Br 90,000 and if the
income tax rate is 40%:
Required
• Compute operating income (income before tax)
• How many units are required to earn a net income of
Br120, 000?
Cont…
Cont…
 1.8. Margin of safety (MOS):
o Margin of safety (MOS): is the excess of budgeted or
actual sales over the break even volume of sales. Or
margin of safety is the excess of budgeted sales revenue
over sales at breakeven point.
• Formula of Margin of Safety:
o The formula or equation for the calculation of margin of
safety is as follows:
[Margin of Safety = Total budgeted or actual sales −
Break even sales]
Cont...
 Cont…
Example 1: Freedom manufacturing Company produces product
‘X’ that is a sale for Br.120. Monthly fixed costs are Br, 75,000 and
variable costs are Br.90 per unit. Sales for the past few months
have averaged Br. 350,000.
Required: Compute:
A. Sales value at breakeven (use CM approach
B. Margin of safety in sales value
C. Margin of safety ratio.
a) Sales value at Breakeven = FC + Operating income
Contribution margin ratio
= Br.75,000 + 0
25%
= Br.350,000
 Cont...
Contribution margin ratio = Unit selling price – unit variable cost
Unit selling price
= Br.120/unit – Br.90/unit x 100%
Br.120/unit
= 25%
b) Margin of safety = Current sales – Breakeven point sales
= Br.350, 000 – Br.300, 000
= Br.50, 000
c) Margin of safety ratio = Margin of safety
Current sales
= Br.50,000 X 100%
Br.350, 000
= 14.3%
LO
3-1

CVP Summary: Break-Even

Break-even volume Fixed costs

(units) = Unit contribution margin

Break-even volume Fixed costs

=
(sales dollars) Contribution margin ratio
LO
3-1

CVP Summary: Target Volume

Target volume Fixed costs + Target profit

(units) =
Unit contribution margin

Target volume Fixed costs + Target profit

=
(sales dollars) Contribution margin ratio
 Contents
• The overall Plan and it Characteristics
• Definition of Budget
• Advantages of Budgeting
• Types of Budgets
• Developing the Master Budget
Meaning of Planning
It is the most Fundamental Function of Management
Is a Process of setting future objectives and deciding on the
ways and means of achieving them.
Planning bridges the gap from where we are and where we want to
go.
It is a process of thinking before doing & about the past
Planning involves:-
– Determination of organizational objectives,
– Establishing an overall strategy,
– Formation of programs and courses of action
– Development of schedules and timings of action and
assignment of responsibilities for their implementation.
Planning is a continuous process, required to ensure effective
utilization of human and non-human resources to accomplish the
desired goals.

It is Concerned with ends (What is to be done) and with

means(how it is to be done)

Planning typically starts with a vision and mission.

Planning is a mental predisposition to do things in orderly way, to

think before acting and to act in the light of facts rather than guess

Planning is deciding the best alternative among others to perform

different managerial operations in order to achieve the
predetermined goal
 Planning is deciding in advance what is to be done. It involves the selection
of objectives, policies, procedures and programs from among alternatives
– What is to be done?- The goal
– Who is to do it?- Which specific people to perform
– How is to be done? – Methods for reaching the goal, steps
– When is to be done? – Timing to do it.
– Where is to be done? – The Place of implementation
– Why is to be done? – The reason for implementation
In planning process, mangers:
Establish goals
Anticipate future developments
Identify course of actions required to attain the goals,
Determine the time frame
 Nature And Importance Of Planning
Nature of Planning
Planning has the following characteristics
– Planning is a Continuous Process

– Planning concerns all Managers

– Plans are arranged in a Hierarchy

– Planning is Antithesis of Status Quo

– Planning Commits an Organization into the Future

– It is goal-oriented
 Importance of Planning
– Planning establishes coordinated effort.
– Planning anticipates problems and uncertainties

– Planning helps to determine where it wants to go.

– Helps in determining the most effective way

– Helps to reduces risk and uncertainty

– To increase organizational effectiveness and efficiency

– Planning improves time management

– Planning is necessary to facilitate control

– Planning helps in the process of decision making
– Leads to success….
7
 Meaning of Budgeting
• A budget is the quantitative expression of a proposed
plan of action by management for a future time period and
is an aid to the coordination and implementation of the
plan.
• A budget is a plan usually monetary terms, covering a
specific period of time, usually a year.
• A budget is a systematic plan for the utilization of
manpower and natural resources.
• In a business budget represents an estimate of future costs
and revenues.
• A budget prepared for the organization as a whole is
called master budget.
 Characteristics of a Budget
• A good budget is characterized by the following:
Participation: involve as many people as possible in
drawing up a budget.
Comprehensiveness: embrace the whole organization.
Standards: base it on established standards of
performance.
Flexibility: allow for changing circumstances.
Feedback: constantly monitor performance.
Analysis of costs and revenues:
 Advantages of Budgeting
Budgeting is advantageous for organizations, because:
1. Budgets foster organizational communication.
2. Budgets ensure a focus both on future events and on
resolving day-to-day issues.
3. Budgets assign resources and the responsibility to use
them wisely
4. Budgets can identify potential constraints before they
become problems.
5. Budgets define organizational goals and objectives
numerically.
 Types of Budgets
A. Based on Capacity
• Fixed Budgets:- unchanged irrespective of the level of
activity
• prepared for fixed expenses and their aim is to control
cost
• Flexible Budgets:- change with the fluctuations in
output, turnover and other factors, which are variable
B. Based on Time
• Long-range
• Short range
• Rolling
 Cont…
C. Based on the Coverage
Functional Budgets: relate to the various functions of the
business
• Physical Budget: provide information about the physical
units like sales, production etc
• Profit Budgets: Like Sales budget, Profit and Loss Budget
• Cost Budgets: manufacturing costs, selling costs
• Financial Budgets: cash budget, Capital expenditure Budget
Reflection 1
•What is the similarity and d/ce
b/n Plan and Budget ?
 Master Budget
• What is a Master Budget?
The master budget is the aggregation of all lower-level
budgets produced by a company's various functional areas,
and also includes budgeted financial statements, a cash
forecast, and a financing plan.
The master budget is typically presented in either a monthly
or quarterly format, and usually covers a company's entire
fiscal year.
 The Purposes of the Master Budget
1. Periodic Planning (Formalization of Planning)
2. Integrates and Coordinates
3. Communicates and Motivates
4. Promotes Continuous Improvement
5. Guides Performance
6. Facilitates Evaluation and Control
7. Cost Awareness
 Cont…
• Master budget is a consolidated summary of the various
operational and financial budgets
• Operating decision centers on the acquisition and use of
scarce resources whereas
• financial decisions centers on how to get the funds to
acquire resources
• Comprehensive, organization-wide set of budgets
 Components of Master Budgets
• Operating Budget: building blocks leading to the
creation of the Budgeted Income Statement
• Financial Budget: building blocks based on the
Operating Budget that lead to the creation of the Budgeted
Balance Sheet and the Budgeted Statement of Cash Flows
 The Operating Budget
• As the term implies, operating budgets are plans used in daily
operations.
• Components (Steps) of Operating Budget includes:
a. Sales Budget
b. Production Budget
c. Direct Materials Purchase Budget
d. Direct Labor Budget
e. Overhead Budget
f. Ending Inventories Budget
g. Cost of Goods Sold Budget
h. Selling & Administrative Budget
i. Operating Expense (Period Cost) Budget
j. Budgeted Income Statement
 Financial Budget
• Financial budgets include a budgeted income statement, a
capital expenditures budget, a cash budget, and a budgeted
balance sheet.
• Components (Steps) of Financial budgets:
a. Cash Budget
b. Budget Ending Inventory
c. Budget Income Statement
d. Budget Balance Sheet
 1. Sales Budget
 A sales budget is a detailed plan, expressed in both units and
dollars, which identify the sales expected during an accounting
period.
 The sales budget is the Key to the entire budgeting process
because all other schedules derived from it.
 Therefore, a mistake here makes the entire budget less effective.
 Where would you go to get accurate sales forecasting
information?
 Forecasting includes the following sources: Past History,
Backlog of Unfulfilled Orders, Marketing Plans, Competition,
New Products, Availability of Resources, Economic
Conditions, Customer, Sales Force, Industry Trends
 Cont…
 The following equation is used to determine the total budgeted
sales:

Example: one
• Royal Company is manufacturing business which produces and
sold product X to its existing and new customers.
• The company is preparing budgets for the quarter ending June
30, 2017.
 Cont…
• Budgeted sales for the next five months will be:
April--------------- 20,000 units
May--------------- 50,000 units
June--------------- 30,000 units
July--------------- 25,000 units
August----------- 15,000 units.
• The selling price is $10 per unit.
• So based on the given information prepare the sales (revenue)
budget for the quarter end June 30,2017.
 Solution
 The Sales Budget is
 Cont…
 Solution: The Sales Budget of the company

April May June Quarter

Budgeted 20,000 50,000 30,000 100,000
sales (units) X X X X
Selling $10 $10 $10 $10
price/unit = = = =
Total sales $200,000 $500,000 $300,000 $1,000,000

 All sales are on account. Royal’s collection pattern is:

– 70% collected in the month of sale, 25% collected in the
month following sale, 5% is uncollectible.
– The March 31 accounts receivable balance of $30,000 will
be collected in full.
 Cont…
 Expected Cash Collections
April May June Quarter
A/R March 31/17 $30,000 $30,000
April Sales: 140,000 140,000
70% x $200,000
25% x $200,000 $50,000 50,000
May Sales: 350,000 350,000
70% x $500,000
25% x $500,000 125,000 125,000
June Sales: 210,000 210,000
70% x $300,000
Total sales $170,000 $400,000 $335,000 $905,000
 Note: The 25% of June sales ($75,000) to be collected in July becomes the
Accounts Receivable balance at the end of June.
 2. Production Budget
 A production budget is a detailed plan showing the number of
units that a company must produce to meet budgeted sales
and inventory needs.
 To prepare a production budget, managers must know the
budgeted number of unit sales (which is specified in the sales
budget) and the desired level of ending finished goods
inventory for each period in the budget year.
 Cont…
 The Production Budget information:- from the Above Example
– Production must be adequate to meet budgeted sales and
provide for sufficient ending inventory.
– The management at Royal Company wants ending
inventory to be equal to 20% of the following month’s
budgeted sales in units. This is how much inventory that is
required to meet production needs in the next period.
– On March 31, 4,000 units were on hand.
 Cont…
 Solution: The Production Budget of the company

April May June Quarter

Budgeted Sales 20,000 50,000 30,000 100,000
(units)
Add: Desired Ending 10,000 $6,000 $5,000 $5,000
Inventory
Total Needed 30,000 56,000 35,000 105,000
Less: Beg. Inventory (4,000) (10,000) (6,000) (4,000)
Required Production 26,000 46,000 29,000 101,000

 Ending inventory based on 20% of July sales(25,000)

 3. Direct Material Purchases Budget
 A direct materials purchases budget is a detailed plan that
identifies the quantity of purchases required to meet
budgeted production and inventory needs and the costs
associated with those purchases.
 Cont…
 The Direct Materials Budget information:- from the Above Example
– At Royal Company, five pounds of material are required per
unit of product.
– Management wants materials on hand at the end of each
month equal to 10% of the following month’s production.
– On March 31, 13,000 pounds of material are on hand.
Material cost is $0.40 per pound.
 Cont…
 Solution: The Direct Materials Budget of the company
April May June Quarter
Production 26,000 46,000 29,000 101,000

Materials per Unit 5 5 5 5

Production needs 130,000 230,000 145,000 505,000
Add: Desired End. Inventory 23,000 14,500 11,500 11,500

Total needed 153,000 244,500 156,500 516,500

Less: Beg. Inventory 13,000 23,000 14,500 13,000
Materials to be pur.sed 140,000 221,500 142,000 503,000
Material Cost per unit $0.4 $0.4 $0.4 $0.4
Materials Cost $56,000 $88,600 $56,800 $201,400
 Ending inventory will be 10% of July production needs
 Cont…
Expected Cash Disbursement for Materials
– Royal pays $0.40 per pound for its materials.
– One-half of a month’s purchases are paid for in the month of
purchase; the other half is paid in the following month.
– The March 31 accounts payable balance is $12,000.
 Cont…
 Solution: Expected Cash Disbursement for Materials of the
company
April May June Quarter
Account pay March 31/2017 $12,000 12,000

April Purchases: 28,000 28,000

50% X $56,000
50% X $56,000 28,000 28,000
May Purchases: 44,300 44,300
50% X $88,600
50% X $88,600 44,300 44,300
June Purchase: 28,400 28,400
50% X $56,800
Total cash Disbursements 40,000 72,300 72,700 185,000

 The 50% of June purchases payable in July ($28,400) is the

Accounts Payable balance at the end of June.
 4. Direct Labour Budget
A direct labour budget is a detailed plan that estimates
the direct labour hours needed during an accounting
period and the associated costs.
The following formulas are used to prepare a direct
labour budget:
 Cont…
 The Direct Labour Budget information:- from the Above
Example
– At Royal, each unit of product requires 0.05 hours of direct
labour.
– The Company has a “no layoff” policy so all employees will
be paid for 40 hours of work each week.
– In exchange for the “no layoff” policy, workers agreed to a
wage rate of $10 per hour regardless of the hours worked
(No overtime pay).
– For the next three months, the direct labour workforce will be
paid for a minimum of 1,500 hours per month.
 Cont…
 Solution: The Direct Labour Budget of the company
April May June Quarter
Production 26,000 46,000 29,000 101,000

Labour per Unit 0.05 0.05 0.05 0.05

Labour hours required 1,300 2,300 1,450 5,050
Guaranteed labour hours 1,500 1,500 1,500
Labour hours Paid 1,500 2,300 1,500 5,300
Wage rate 10 10 10 10
Total Direct labour cost 15,000 23,000 15,000 53,000

 Cash disbursement equals total direct labour cost since it is

paid in period earned
 5. The Overhead Budget
An overhead budget is a detailed plan of anticipated
manufacturing costs, other than direct materials and
direct labour costs, which must be incurred to meet
budgeted production needs.
It has two purposes:
1. to integrate the overhead cost budgets developed by the
managers of production and production-related
departments and
2. to group information for the calculation of overhead rates
for the next accounting period.
 Cont…
 The Manufacturing Overhead Budget information:- from the
Above Example
– Royal Company uses a variable manufacturing overhead
rate of $1 per unit produced.
– Fixed manufacturing overhead is $50,000 per month and
includes $20,000 of noncash costs (primarily depreciation of
plant assets).
 Cont…
 Solution: The Manufacturing Overhead Budget of the
company
April May June Quarter
Production in Unit 26,000 46,000 29,000 101,000

Variable MOH Rate $1 $1 $1 $1

Variable MOH Rate Costs 26,000 46,000 29,000 101,000
Fixed MOH Costs 50,000 50,000 50,000 150,000
Total MOH Costs 76,000 96,000 79,000 251,000
Less: Non-cash costs (20,000) (20,000) (20,000) (60,000)
Cash disbursement for MOH 56,000 76,000 59,000 191,000

 Depreciation is non-cash expense

 6. Ending Inventories Budget
• Now, Royal can complete the ending finished goods inventory budget.
• At Royal, manufacturing overhead is applied to units of product on
the basis of direct labour hours
Ending Finished Goods Inventory Budget
Production in costs per Unit Quantity Cost Total
Direct Materials 5.00 $0.40 $2.00
Direct Labour 0.05hrs $10.00 0.50
MOH 0.05hrs $49.70 2.49
Total $4.99
Budgeted FG Inventory
Ending inventory in units
Units product cost $4.99
Ending finished goods inventory
?
 Cont…

• MOH Costs
 Cont…
 Solution: The Ending Finished Goods Inventory Budget of
the company

Production in Costs per Unit Quantity Cost Total

Direct Materials 5.00/unit $0.40 $2.00
Direct Labour 0.05hrs $10.00 0.50
MOH 0.05hrs $49.70 2.49
Total $4.99
Budgeted FG Inventory
Ending inventory in units 5,000
Units product cost $4.99
Ending finished goods inventory $24,950
 7. Selling and Administrative Expense Budget
• A selling and administrative expense budget is a
detailed plan of operating expenses, other than those
related to production, that are needed to support sales
and overall operations during an accounting period.
The selling and administrative expense budget information:-
from the Above Example
– At Royal, variable selling and administrative expenses are $0.50
per unit sold.
– Fixed selling and administrative expenses are $70,000 per month.
– The fixed selling and administrative expenses include $10,000 in
costs – primarily depreciation – that are not cash outflows of the
current month.
 Cont…
 Solution: The Selling and Administrative Expense Budget of
the company
April May June Quarter
Budgeted Sales 20,000 50,000 30,000 100,000

Variable Selling & admin. rate $0.50 $0.50 $0.50 $0.50

Variable expense 10,000 25,000 15,000 50,000
Fixed Selling & admin. expense 70,000 70,000 70,000 210,000
Total expense 80,000 95,000 85,000 260,000
Less: Non-cash expense (10,000) (10,000) (10,000) (30,000)
Cash disbursement for Selling & 70,000 85,000 75,000 230,000
admin.
 Financial Budget
• Financial budgets include a budgeted income statement, a capital
expenditures budget, a cash budget, and a budgeted balance
sheet.
• Components (Steps) of Financial budgets:
a. Cash Budget
b. Budget Ending Inventory
c. Budget Income Statement
d. Budget Balance Sheet
 a) Cash Budget
• A cash budget is a projection of the cash that an organization
will receive and the cash that it will pay out during an
accounting period.
• It summarizes the cash flow prospects of all transactions
considered in the master budget.
• The following formula is useful in preparing a cash budget:
 Cont…
 The Cash Budget information:- from the Above Example
– Royal:
• Maintains a 16% open line of credit for $75,000.
• Maintains a minimum cash balance of $30,000.
• Borrows on the first day of the month and repays loans on
the last day of the month.
• Pays a cash dividend of $49,000 in April.
• Purchases $143,700 of equipment in May and $48,300 in
June paid in cash.
• Has an April 1 cash balance of $40,000.
 Cont…
 Solution: The Cash Budget of the company
April May June Quarter
Beg. Cash Balance 40,000 30,000 30,000 40,000

Add: Cash Collection 170,000 400,000 335,000 905,000

Total Cash Available 210,000 430,000 365,000 945,000
Less: Disbursements
Direct Materials 40,000 72,300 72,700 185,000
Direct Labour 15,000 23,000 15,000 53,000
MOH 56,000 76,000 59,000 191,000
Selling & Admin. 70,000 85,000 75,000 230,000
Equipment Purchase - 143,700 48,300 192,000
Dividends 49,000 - - 49,000
Total Disbursements (230,000) (400,000) (270,000) (900,000)
Excess(Deficiency) of cash
available over Disbursement (20,000) 30,000 95,000 45,000
 Cont…
 Financing and Repayment of the company
April May June Quarter
Excess(Deficiency) of cash
available over Disbursement (20,000) 30,000 95,000 45,000
Financing:
Borrowing 50,000 - - 50,000
Repayment - - (50,000) (50,000)
Interest - - (2,000) (2,000)
Total Financing 50,000 - (52,000) (2,000)
Ending Cash Balance 30,000 30,000 43,000 43,000

 Note: - $50,000 × 16% × 3/12 = $2,000 Borrowings on April

1 and repayment of June 30.
 b) Budget Ending Inventory
• The ending finished goods inventory budget calculates the cost
of the finished goods inventory at the end of each budget
period.
• It also includes the unit quantity of finished goods at the end of
each budget period, but the real source of that information is
the production budget
 c) Budget Income Statement
• A budgeted income statement projects an organization’s net
income for an accounting period based on the revenues and
expenses estimated for that period.
• After we complete the cash budget, we can prepare the budgeted
income statement for Royal based on the information available
from the above budgets.
 Cont…
 Solution: The Budget Income Statement of the company

Royal Company
Budgeted Income Statement
For the Three Months Ended June 30
Sales (100,000 units @ $10) $ 1,000,000

Less: Cost of goods sold (100,000 @ $4.99) (499,000)

Gross margin 501,000
Less: Selling and administrative expenses 260,000
Interest expense 2,000 (262,000)
Net income $ 239,000
 d) Budget Balance Sheet
• A budgeted balance sheet projects an organization’s financial
position at the end of an accounting period.
• It uses all estimated data compiled in the course of preparing a
master budget and is the final step in that process.
• Royal reported the following account balances prior to preparing
its budgeted financial statements:
– Land - $50,000
– Common stock - $200,000
– Retained earnings - $146,150
– Equipment - $175,000
– Add 143,700 in May and 48,300 in June for ending balance
of $367,000
Solution: The Budget Balance Sheet of the company
 Royal Company
Cont…
Budgeted Balance Sheet June 30
Current assets:- Cash
Accounts Receivable
Raw Materials Inventory
Finished Goods Inventory
Total Current Assets
Property & Equipment:- Land
Building
Equipment
Total Property & Equipment
Total Assets
Account Payable
Common Stock
Retained Earnings
Total Liabilities & Equities
 Example: Two
• Preparing the Master Budget (Manufacturing Company):-
1. Great Company manufactures and sells a product whose peak
sales occur in the third quarter. Management is now preparing
detailed budgets for 20x4- the coming year and has assembled
the following information to assist in the budget preparation:
• The company’s product selling price is Br. 20 per unit. The
marketing department has estimated sales in units as follows for
the next six quarters.
 Cont…
20x4 Quarters 20x5 Quarters
Quarter 1 10,000 15,000
Quarter 2 30,000 15,000
Quarter 3 40,000
Quarter 4 20,000
 Cont…
• Sales are collected in the following pattern: 70% of sales are
collected in the quarter in which the sales are made and the
remaining 30% are collected in the following quarter. On January1,
20x4, the company’s balance sheet showed Br.90,000 in account
receivable, all of which will be collected in the first quarter of the
year. Bad debts are negligible and can be ignored.
• The company maintains an ending inventory of finished units equal
to 20% of the next quarter’s sales. The requirement was met on
December 31, 20x3, in that the company had 2,000 units on hand
to start the new year.
 Cont…
• Fifteen pounds of raw materials are needed to complete one unit
of product. The company requires an ending inventory of raw
materials on hand at the end of each quarter equal to 10% of the
following quarter’s production needs of raw materials. This
requirement was met on December 31, 20x3 in that the company
had 21,000 pounds of raw materials to start the New Year.
• The raw material costs Br.0.20 per pound. Raw material
purchases are paid for in the following pattern: 50% paid in the
quarter the purchases are made, and the remainder is paid in the
following quarter. On January 1,20x4, the company’s balance
sheet showed Br.25,800 in accounts payable for raw material
purchases, all of which be paid for in the first quarter of the year.
 Cont…
• Each unit of Great’s product requires 0.8 hour of labor time.
Estimated direct labor cost per hour is Br.7.50.
• Variable overhead is allocated to production using labor hours as
the allocation base as follows:
• Indirect materials Br.0.40
• Indirect labor 0.75
• Fringe benefits 0.25
• Payroll taxes 0.10
• Utilities 0.15
• Maintenance 0.35
 Cont…
• Fixed overhead for each quarter was budgeted at Br. 60,600. Of
the fixed overhead amount, Br. 15,000 each quarter is
depreciation. Overhead expenses are paid as incurred.
• The company’s quarterly budgeted fixed selling and
administrative expenses are as follows:
20X4 Quarters
1 2 3 4
Advertising Br.20, 000 Br.20, 000 Br.20, 000 Br.20, 000
Executive salaries 55, 000 55, 000 55, 000 55, 000
Insurance - 1, 900 37,750 -
Property taxes - - - 18, 150
Depreciation 10, 000 10, 000 10, 000 10, 000
 Cont…
• The only variable selling and administrative expense, sales
commission, is budgeted at Br.1.80 per unit of the budgeted sales.
All selling and administrative expenses are paid during the
quarter, in cash, with exception of depreciation. New equipment
purchases will be made during each quarter of the budget year
for Br. 50, 000, Br. 40, 000, & Br.20, 000 each for the last two
quarter in cash, respectively. The company declares and pays
dividends of Br.8,000 cash each quarter.
 Cont…
• The company’s balance sheet at December 31, 20x3 is presented
below:
ASSETS
Current assets:
Cash Br. 42, 500
Accounts Receivable 90, 000
Raw Materials Inventory (21, 000 pounds) 4, 200
Finished Goods Inventory (2, 000 units) 26, 000
Total current assets Br.162, 700
Plant and Equipment:
Land Br.80, 000
Building and Equipment 700, 000
Accumulated Depreciation (292, 000)
Plant and Equipment, net 488, 000
Total assets Br.650, 700
 Cont…
LIABILTIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable (raw materials) Br.25, 800
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 449, 900
Total stockholders’ equity 624, 900
Total liabilities and stockholders’ equity Br.650, 700
 Cont…
• The company can borrow money from its bank at 10%
annual interest. All borrowing must be done at the
beginning of a quarter, and repayments must be made at
the end of a quarter. All borrowings and all repayments
are in multiples of Br. 1,000.
• The company requires a minimum cash balance of Br.40,
000 at the end of each quarter. Interest is computed and
paid on the principal being repaid only at the time of
repayment of principal. The company whishes to use any
excess cash to pay loans off as rapidly as possible.
Instructions: Prepare a master budget for the four-quarter
period ending December 31. Include the following detailed budget
and schedules:
1. a) A sales budget, by quarter and in total
b) A schedule of budgeted cash collections, by quarter and in
total
c) A production budget
d) A direct materials purchase budget
e) A schedule of budgeted cash payments for purchases by
quarter and in total
 f) A direct labor budget
g) A manufacturing overhead budget
h) Ending finished goods inventory budget
i) A selling and administrative budget
2. A cash budget, by quarter and in total
3. A budgeted income statement for the four- quarter ending
December 31, 20x4
4. A budgeted balance sheet as of December 31, 20x4.
 Contents
• Static Vs Flexible Budget
• Standards for Material and Labour
• Controllability and Variance Analysis
• Direct Material
• Direct Labour
• Overheads
 3.1. Static Vs Flexible Budget
• A fixed/static budget is a budget which is designed to remain
unchanged irrespective of the level of activity actually
attained.
• Thus, a budget prepared based on a standard or fixed level of
activity is known as a fixed budget.
• The static budget, or master budget, is based on the level of
output planned at the start of the budget period.
• The master budget is called a static budget because the budget
for the period is developed around a single (static) planned
output level.
• Flexible Budgets are budgets that “flex” or change with
varying levels of activity.
• Most of the time flexible budgets correspond to actual levels of
output.
 Static Budgets and Variances
• A variance is the difference between actual results and
expected performance.
• The expected performance is also called budgeted performance,
which is a point of reference for making comparisons.
• Variance has various uses for managers in their daily activities
and their long run strategy.
• Variance highlights the areas that have deviated most from
expectations; variances enable managers to focus their efforts on
the most critical areas.
• Variances are also used in performance evaluation and to
motivate managers.
Static Budget Variance = Actual Result - Static Budget Amount
 Cont…
• Variance we compute at last may be Favourable or
Unfavourable variance.
a) Favourable Variance (denoted by F):- has the effect of
increasing operating income relative to the budgeted amount.
– For revenue items, Favourable means actual revenues exceed
budgeted revenues the reverse is true for unfavourable variance.
– For cost items, Favourable means Actual Cost less than
budgeted costs.
b) An unfavourable variances (denoted by u):- has the effect of
decreasing operating income relative to the budgeted amount.
– Unfavourable variances are also called adverse variances in some
countries, such as the United Kingdom.
 Example 1
• ABC Company manufactures and sells jackets. The jackets
require tailoring and many hand operations. The company
incurred only manufacturing costs. ABC Company has three
variable cost categories. The budgeted variable cost per jacket
for each category is:-
Cost Category Variable Cost per Jacket
Direct material costs $ 60
Direct manufactory labour costs $16
Variable manufacturing overhead costs 12
Total variable costs $88
• The number of units manufactured is the cost driver for direct
materials, direct manufacturing labour, and variable manufacturing
overhead. The relevant range for the cost driver is from 0 to 12,000
jackets.
 Cont…
• Budgeted and Actual data for April 2008 follow:-
• Budgeted fixed cost under the relevant range……….. $276,000
• Budgeted selling price ……………………………….. $120 per jackets
• Budgeted production and sales ……………………….. 12,000 jackets
• Actual fixed cost under the relevant rage…………...…. $285,000
• Actual selling price ………………………………..….. $125 per jackets
• Actual production and sales ………………...………….. 10,000 jackets

Cost Category Variable Cost per Jacket

Direct material costs $62.16
Direct manufactory labour costs $19.8
Variable manufacturing overhead costs 13.05
Total variable costs $95.01
 Cont…
 Required: Compute Actual operating income, static budget
operating income and static budget variance for operating income.
 Solution
(1) (2)=(1)-(3) (3)
Level 1 analysis Actual Result Static Budget Variances Static Budget
Unit sold 10,000 2000U 12,000
Revenues $1,250,000 $190,000U $1,440,00
Variable Costs:
Direct material 621,600 98,000F 720,000
Direct Manuf. Labour 198,000 6,000U 192,000
Variable MOH 130,500 13,500F 144,000
Total Variable Costs 950,100 105,900F 1,056,000
Contribution margin 299,900 84,100U 384,000
Fixed costs 285,000 9,000U 276,000
Operating income $14,900 $93,100U $108,000
 Cont…

Variance for Operating Income = actual result – static budget

= $14,900 - $ 108,000 = $93,100 U

• Remember, ABC produced and sold only 10,000 jackets,

although managers anticipated an output of 12,000 jackets in the
static budget.
• Managers want to know how much of the static budget variance
is because of inaccurate forecasting of output units sold and how
much is due to ABC’s performance in manufacturing and selling
10,000 jackets.
• Managers, therefore, create a flexible budget, which enables a
more in-depth understanding of deviations from the static
budget.
 Flexible Budget
• A flexible budget calculates budgeted revenues and budgeted
costs based on the actual output in the budget period.
• The flexible budget is prepared at the end of the period, after the
actual output of 10,000 jackets is known.
• The flexible budget is the hypothetical budget that ABC would
have prepared at the start of the budget period if it had correctly
forecast the actual output of 10,000 jackets.
• Steps in developing a flexible budget
• The three steps of developing Flexible budget
• Using example1 develop flexible budget
 Cont…
• Solution:
• Step1 Identify the actual quantity of output
• In April 2003 ABC produced and sold 10,000 jackets
• Step2 Flexible budget for revenues
• Flexible budget revenue = budgeted selling price x actual quantity
of output
= $120 per jacket x 10,000 jackets
= $1,200,000
• Step 3 flexible budgets for cost
Flexible budget variable costs
• Direct materials, $60 per jacket x 10,000 jackets ………. $600,000
• Direct manufacturing labour, $16 per jacket x10, 000 jackets…... 160,000
 Cont…
• Variable MOH, $12 per jacket x10, 000 Jackets…........ 120,000
• Total flexible-budget variable costs…………………. 880,000
• Flexible budget fixed costs………………………………. 276,000
• Flexible budget total costs ………………………………. $1,156,000
Flexible Budget Variances
• Once the flexible budget is prepared, the manager is ready to compare
actual results for a period against the comparable budgeted level
anywhere within the relevant range.
• The difference between an actual result and the corresponding flexible
budget amount based on the actual output level in the budget period is
called flexible budget variance.
Flexible Budget Variance =Actual Result - Flexible Budget
Amount
 Cont…
• Using data presented in example 1 compute flexible budget variances.
1 2=1-3 3 4=3-5 5
Level 1 analysis Actual Result Flexible Budget Flexible Sales Static
Variances Budget Volume
Variances Budget

Unit sold 10,000 0 10,000 2,000U 12,000

Revenues $1,250,000 $50,000F 1,200,000 240,000U $1,440,00
Variable Costs:
Direct material Vari. 621,600 21,600U 600,000 120,000F 720,000
Direct Manuf.g Labour 198,000 38,000U 160,000 32,000F 192,000
Variable MOH 130,500 10,500U 120,000 24,000F 144,000
Total Variable Costs 950,100 70,100U 880,000 176,000U 1,056,000
Contribution margin 299,900 20,100U 320,000 64,000U 384,000
Fixed costs 285,000 9,000U 276,000 0 276,000
Operating income $14,900 $29,100U 44,000 64,000U $108,000
 Cont…
• The flexible budget variance for revenues is called the selling
price variance because it arises solely from the difference
between the actual selling price and the budgeted selling price:
Selling price Variance = (Actual selling price – Budgeted selling
price) x Actual units sold
= ($125 per jacket – 120 per jacket) x 10,000 jackets
= $50,000F
 Standards For Materials And Labour
• Direct Material Variances
• It includes both the direct material price Variance and the
standard direct material quantity Variance
• Direct Material Price Variance is the difference between the
actual cost of direct material and the standard cost of quantity
purchased or consumed.
• Direct Material Price Variance:
= Actual Quantity x Actual Price - Actual Quantity x
Standard Price
= Actual Cost - Standard Cost of Actual Quantity
 Cont…
• Example 2: Cement PLC manufactured 10,000 bags of cement
during the month of January. Following raw materials were
purchased and consumed by Cement PLC during the period:
Material Actual Quantity Actual Price Standard Price
Limestone 100 tons $ 75/ton $70/ton
Clay 150 tons $20/ton $24/ton
Sand 250 tons $10/ton $12/ton

• Material price variance will be calculated as follows:

 Step 1: Calculate Actual Cost
• Actual cost = Actual Quantity x Actual Price
Limestone: 100tons x 75 = 7,500
Clay: 150 tons x 20 = 3,000
Sand: 250 tons x 10 = 2,500
 Cont…
 Step 2: Find the Standard Cost of Actual Quantity
• Standard Cost = Actual Quantity x Standard Price
Limestone: 100tons x 70 = 7,000
Clay: 150 tons x 24 = 3,600
Sand: 250 tons x 12 = 3,000
Step 3: Calculate the Variance
• Material Price Variance = Actual Cost(step1) – Standard
Cost(step2)
Limestone: 7,500 – 7,000 = 500U
Clay: 3,000 – 3,600 = (600)F
Sand: 2,500 – 3,000 = (500)F
Total Price Variance (600)F
 Cont…
• Direct Material Usage Variances
• Direct material usage Variance is the measure of difference b/n
the actual quantity of materials utilized during a period and the
standard consumption of material for the level of output
achieved.
• Direct Material Usage Variances:
= Actual quantity x Standard Price – Standard Quantity X Standard Price
= Standard Cost of Actual Quantity - Standard Cost of Standard Quantity
= (Actual Quantity – Standard Quantity) x Standard Price

• Example: Cement PLC manufactured 10,000 bags of cement

during the month of January. Consumption of raw materials
during the period was as follows:
 Cont…

Material Actual Quantity Standard Actual Price Standard Price

Usage per Bag
Limestone 100 tons 11KG $ 75/ton $70/ton
Clay 150 tons 14 KG $21/ton $20/ton
Sand 250 tons 26KG $11/ton $10/ton

• Material Usage Variance will be calculated as follows:

Calculate Standard Quantity
Limestone: 10,000 units x 11/1000 = 110tons
Clay: 10,000 units x 14/1000 = 140tons
Sand: 10,000 units x 26/1000 = 260tons
 Cont…
 Example: DM is a denim brand specializing in the manufacture and
sale of hand – stitched jeans trousers. DM manufactured and sold
10,000 pairs of jeans during a period.
 Information relating to the direct labour cost and production time per
unit is as follows:
Actual Hours Standard Hours Actual Rate Standard Rate
per Unit per Unit per Hours per Hours
Direct Labour 0.50 0.60 $ 12 $10
• Labour rate variance shall be calculated as follows:
• Step 1: Calculate Actual Hours
Actual Cost = 10,000units X Actual hours per unit = 5,000 hours
• Step 2: Calculate Actual Cost
Actual Cost = Actual Hours X Actual Rate per hours
= 5,000 hours X 12
= 60,000
 Cont…
• Step 3: Calculate the Standard cost of Actual number Hours
Standard Cost of actual hour = Actual Hours X Standard Rate
5,000 Hours X $10 per Hour = $50,000
• Step 4: Calculate the Variance
Labour Rate Variance = Actual cost – Standard cost of the Actual Hours
= $60,000 – $50,000
= $10,000 Unfavourable
• B. Direct Labour Efficiency Variance: is the measure of
difference b/n the standard cost of actual number of direct labour
hours utilized during a period and the standard hours of direct
labour for the level of output achieved.
• Direct Labour Efficiency Variance:
= Actual Hours X Standard Rate – Standard Hours X Standard Rate
= Standard Cost of Actual Hours – Standard Cost
 Cont…
From the above Example: the Labour rate variance shall be
calculated as follows:
• Step 1: Calculate Actual Hours
Actual Hours = 10,000units X (0.50)Actual hours per unit = 5,000
hours
• Step 2: Calculate the standard cost of Actual number of
hours
Standard cost of Actual Hours = Actual Hours X Standard Rate
= 5,000 hours X 10
= 50,000
• Step 3: Calculate the Standard Hours
Standard hours = 10,000units X Standard hours per unit
= 10,000units X 0.6 per Hour = $6,000
 Cont…
• Step 4: Calculate the Standard Cost
Standard Cost = Standard Hours X Standard Rate
= 6,000 Hours X $10 per Hour = $60,000
• Step 5: Calculate the Variance
Labour Efficiency Variance = Standard Cost of the Actual Hours - Standard Cost
= $50,000 – $60,000
= $10,000 Favourable
 Contents
• Sales Variances
• Sales Volume Variance
• Sales Mix Variance
• Market – size and Market Share Variance
• Input Variances
• Direct Materials Mix and Yield Variances
• Direct Materials Mix and Yield Variances
• Productivity Measurement
 Mix Variances
• A mix variance occurs when the materials are not mixed or
blended in standard proportions and it is a measure of whether
the actual mix is cheaper or more expensive than the standard
mix. Or
• A mix variance is created whenever the actual mix of inputs
differs from the standard mix.
• A yield variance arises because there is a difference between
what the input should have been for the output achieved and the
actual input. Or
• A yield variance occurs whenever the actual yield (output)
differs from the standard yield.
 Sales Volume Variances
• is the difference between a flexible-budget amount and the
corresponding static-budget amount.
• the sales-volume variance shows the effect on budgeted
contribution margin of the difference between actual quantity of
units sold and budgeted quantity of units sold.
• Sales Volume Variance (where standard costing is used):
= (Actual Unit Sold - Budgeted Unit Sales) x Standard price Per
Unit
• Sales Volume Variance (where marginal costing is used):
= (Actual Unit Sold - Budgeted Unit Sales) x Standard
Contribution per Unit
• Sales volume variance (where absorption costing is used)
=(actual unit sold – budgeted unit sales ) x standard profit per unit
 cont…
• For example, the material usage variance needs to take into
account only the difference between the actual consumption of
material and the standard consumption of material for the
actual number of units sold since the sales volume
variance already takes into account the variation in material cost
caused by the difference between budgeted and actual sales
volume.
• Example: Samson Plc is a manufacturer of jeans trousers and
jackets.
• Information relating to Samson Plc's sales during the last period
is as follows:
 cont…
Trousers Units Jackets Units
Budgeted 12,000 5,000
Actual 10,000 8,000
• Standard costs and revenues per unit of trouser and jacket are
as follows:
Trousers $ Jackets$
Revenue 20 50
Direct labor 5 10
Direct Material 6 15
Variable Overheads 4 10
Fixed Overheads 2 5
 cont…
• Solution:- Samson Plc uses marginal costing to prepare its
operating statement.
• Sales Volume Variance shall be calculated as follows:
• Step 1: Calculate the standard contribution per unit
• As Samson Plc uses marginal costing system, we need to
calculate the standard contribution per unit. Allocation of the
fixed overheads may therefore be ignored.
Trousers $ Jackets $
Revenue 20 50
Direct labor (5) (10)
Direct Material (6) (15)
Variable Overheads (4) (10)
Standard contribution per unit 5 15
 cont…
• Step 2: Calculate the difference between actual units sold
and budgeted sales
Trousers Units Jackets Units
Actual 10,000 8,000
Budgeted (12,000) (5,000)
Difference (2,000) 3,000

• Step 3: Calculate the variance for each product

Trousers Jackets
Standard contribution per unit (Step 1) $5 $15
Actual Units Sold - Budgeted Sales (Step 2) x(2000 units) x3000 units
Variance $10,000 $45,000
Adverse Favorable
 cont…
• Step 4: Add the individual variances
• Sales Volume Variance ($10,000 - $45,000) =$35,000
Favorable
• Analysis
• Favorable sales volume variance suggests a higher actual
profit or contribution than the budgeted profit or contribution.
• Reasons for favorable sales volume variance include:
• Favorable sales quantity variance (i.e. higher total number of units
sold than budgeted)
• Favorable sales mix variance> (i.e. higher proportion of the more
profitable products sold than planned in the budget)
 cont…
• Adverse sales volume variance indicated a lower actual profit
or contribution than the budgeted profit or contribution.
• Causes for an adverse sales volume variance include:
• Adverse sales quantity variance (i.e. lower total number of units
sold than budgeted)
• Adverse sales mix variance (i.e. higher proportion of the less
profitable products sold than anticipated in the budget)
• Sales volume variance: has two parts these are;
1. Sale –Mix variance
2. The sales-quantity variance
 1. Sales Mix Variances
• The sales-mix variance is the difference between (1) budgeted
contribution margin for the actual sales mix and (2) budgeted
contribution margin for the budgeted sales mix.
• The formula and computations
• SMV = actual unit of All product Sold x (actual sales mix
percentage - budgeted sales mix percentage) budgeted
contribution margin per /unit
• Sales mix variance quantifies the effect of the variation in the
proportion of different products sold during a period from
the standard mix determined in the budget-setting process.
 cont…
• Analysis- Sales mix variance is only a relative measure of the
variation in performance of an organization and should be
interpreted with care.
• For instance, an adverse sales mix variance may be perfectly
fine where a company is able to earn extra revenue through sale
of lower margin products if such sales are in addition to high
sales of the products with higher margins.
• Favorable sales mix variance suggests that a higher proportion
of more profitable products were sold during the period than
was anticipated in the budget.
 cont…
Reasons for favorable sales mix variance may include:
• Concentration of sales and marketing efforts towards selling the
more profitable products
• Increase in the demand for the higher margin products (where
demand is a limiting factor)
• Increase in the supply of the more profitable products due to for
example addition to the production capacity (where supply is a
limiting factor)
• Decrease in the demand or supply of the less profitable products
 cont…
Reasons for unfavorable sales mix variance may include:
• Demand for the more profitable products being lower than
anticipated
• Decrease in the production of the high margin products due to
supply side limiting factors (e.g. shortage of raw materials or
labor)
• Sales team not focusing on selling products with higher margins
due to for example lack of awareness or misaligned
performance incentives (e.g. uniform sales commission on the
entire product range may not motivate sales staff to compete for
high margin sales)
• Increase in demand or supply of the less profitable products
 2. The sales-quantity variance
• is the difference between (1) budgeted contribution margin based
on actual units sold of all products at the budgeted mix and (2)
contribution margin in the static budget (which is based on
budgeted units of all products to be sold at budgeted mix).
• SQV = actual unit of all product sold -
budgeted unit of all product sold  x budgeted
sales mix percentage x budgeted contribution
margin per unit
 Market-Share and Market-Size Variances
• Market share is the company’s percentage of sales in a
particular industry.
• Market size is number of buyer and seller of a product and
service in a particular product.
• Market-Share Variance
• The market-share variance is the difference in budgeted
contribution margin for actual market size in units caused
solely by actual market share being different from budgeted
market share.
 cont…
• The formula for computing the market share variance is as
follows:
• Market-share Variance = actual market size in unit
x (actual market share - budgeted market share) x
budgeted contribution margin per unit
• Market-Size Variance
• The market-size variance is the difference in budgeted
contribution margin at budgeted market share caused solely by
actual market size in units being different from budgeted
market size in units.
 cont…
• The formula for computing the market size variance is as
follows:
• Market-size Variance = (actual market size -
budgeted market size) x budgeted market share x
budgeted contribution margin per unit
In the above example, Samson Plc had actual sales of 10,000
units and 12,000 budgeted units, at a budgeted contribution
margin of $32 per jacket.
Assume that Samson Plc derived its total unit sales budget for
April 2011 from a management estimate of a 20% market share
 cont…
• and a budgeted industry market size of 60,000 units (0.20 x
60,000 units = 12,000 units). For April 2011, actual market size
was 62,500 units and actual market share was 16% (10,000
units/ 62,500 units = 0.16 or 16%).
• So, calculate Market share variance?
Market share variance = 62,500 units * (0.16 - 0.20) * $32 per unit
= $80,000 U
• Samson Plc lost 4.0 market-share percentage points from the
20% budgeted share to the actual share of 16%.
• The $80,000U market-share variance is the decline in
contribution margin as a result of those lost sales.
 cont…
• Some companies place more emphasis on the market-share
variance than the market-size variance when evaluating their
managers.
• That’s because they believe the market-size variance is
influenced by economy-wide factors and shifts in consumer
preferences that are outside the managers’ control, whereas the
market-share variance measures how well managers
performed relative to their peers.
Market size variance = (62,500 units - 60,000 units) * 0.20 *
$32 per unit
= $16,000F
 cont…
• The market-size variance is favorable because actual market
size increased 4.17% [(62,500 – 60,000) ÷ 60,000 = 0.417, or
4.17%] compared to budgeted market size.
 In Summary
• Sales-Volume Variance = (Actual Quantity - Budgeted Quantity) x Budgeted CMu
• Sales-Quantity Variance = [Actual Quantity (all) - Budgeted Quantity (all)] x Budgeted
Sales Mix% x Budgeted CMu
• Sales-Mix Variance = (Actual Sales Mix % - Budgeted Sales Mix %) x Actual Quantity
(all) x Budgeted CMu
• Market-Size Variance = (Actual Market Size - Budgeted Market Size) x Budgeted Market
Share x BCMu
• Market-Share Variance = (Actual Market Share - Budgeted Market Share) x Actual
Market Size x BCMu
 Input Variances
• Direct Materials Mix and Yield Variances
A. Direct Material Mix Variance
• The total direct materials mix variance is the difference
between (1) budgeted cost for actual mix of actual total quantity
of direct materials used and (2) budgeted cost of budgeted mix
of actual total quantity of direct materials used(arises from a
change in the relative proportion of inputs (a materials or labor
mix variance).
• Direct material mix variance = actual total quantity of All direct material
input used x [ actual direct material input mix % - budgeted direct
material input mix %] budgeted price of direct material inputs
 Cont…
• Explanation
• Material Mix Variance quantifies the effect of a variation in the
proportion of raw materials used in a production process over
a period.
• Material mix variance is only suitable for performance
measurement and control where the proportion of inputs to the
production process can be altered without reducing the
effectiveness of the final product.
 Cont…
• It may not therefore be used in industries that require a high degree
of precision in the input variables such as in the pharmaceuticals
sector.
• Analysis
• A favorable material mix variance suggests the use of a cheaper
mix of raw materials than the standard.
• Conversely, an adverse material mix variance suggests that a more
costly combination of materials have been used than the standard
mix.
• A change in the material mix must also be analyzed in the context of
other organization wide implications that may follow.
 Cont…
Some of the effects a change in direct material mix include:
– Change in the quality, performance and durability of the final
product
– Price offered by customers may vary as a result of a change in
perceived quality of the product
– Change in material mix may affect the workability of materials which
may in turn affect labor efficiency
 Cont…
B. Direct Materials Yield Variances
• is a measure of cost differential between output that should
have been produced for the given level of input and the level of
output actually achieved during a period
• Or measures the difference between expected output from a
given level of inputs and the actual output obtained from those
inputs.
 Cont…
Direct materials yield variance is the difference between (1)
budgeted cost of direct materials based on actual total quantity
of direct materials used and (2) flexible-budget cost of direct
materials based on budgeted total quantity of direct materials
allowed for actual output produced.
• Direct material Yield variance = [actual total quantity of all
direct material Input used - budgeted total quantity of all
direct material inputs allowed being used] x budgeted direct
material input mix % x budgeted price of direct material inputs
 Cont…
• Example:
• To produce ketchup of a specified consistency, color, and taste,
Delpino mixes three types of tomatoes grown in different
regions: Latin American tomatoes (L), California tomatoes (C),
and Florida tomatoes (F). Delpino’s production standards
require 1.60 tons of tomatoes to produce 1 ton of ketchup; 50%
of the tomatoes are budgeted to be L, 30% C, and 20% F. The
direct material inputs budgeted to produce 1 ton of ketchup are
as follows
0.80 (50% of 1.6) ton of L at $70 per ton $ 56.00
0.48 (30% of 1.6) ton of C at $80 per ton 38.40
0.32 (20% of 1.6) ton of F at $90 per ton 28.80
Total budgeted cost of 1.6 tons of tomatoes $123.20
 Cont…
• Budgeted average cost per ton of tomatoes is $123.20 ÷ 1.60 tons = $77
per ton. Because Delpino uses fresh tomatoes to make ketchup, no
inventories of tomatoes are kept. Purchases are made as needed, so all
price variances relate to tomatoes purchased and used. Actual results for
June 2012 show that a total of 6,500 tons of tomatoes were used to
produce 4,000 tons of ketchup:
3,250 tons of L at actual cost of $70 per ton $227,500
2,275 tons of C at actual cost of $82 per ton 186,550
975 tons of F at actual cost of $96 per ton 93,600
6,500 tons of tomatoes 507,650
Budgeted cost of 4,000 tons of ketchup at $123.20 per ton 492,800
Flexible-budget variance for direct materials $14,850 U
 Cont…
• Given the standard ratio of 1.60 tons of tomatoes to 1 ton of
ketchup, 6,400 tons of tomatoes should be used to produce
4,000 tons of ketchup.
• At standard mix, quantities of each type of tomato required are
as follows:
L: 0.50 * 6,400 = 3,200 tons
C: 0.30 * 6,400 = 1,920 tons
F: 0.20 * 6,400 = 1,280 tons
Calculate direct material mix variance and direct material yield
variance
 Cont…
• Solution
• The direct materials mix variances are as follows:
= actual total quantity of All direct material input used x [ actual direct
material input mix % - budgeted direct material input mix %] budgeted price
of direct material inputs
L: 6,500 tons * (0.50 – 0.50) * $70 per ton = 6,500 * 0.00 * $70 = $ 0
C: 6,500 tons * (0.35 – 0.30) * $80 per ton = 6,500 * 0.05 * $80 = 26,000 U
F: 6,500 tons * (0.15 – 0.20) * $90 per ton = 6,500 * –0.05 * $90 = 29,250 F
Total direct materials mix variance $3,250 F
• The total direct materials mix variance is favorable because relative to the
budgeted mix, Delpino substitutes 5% of the cheaper C for 5% of the more-
expensive F.
 Cont…
• The direct materials yield variances are as follows:
= [actual total quantity of all direct material Input used - budgeted total quantity of all
direct material inputs allowed being used] x budgeted direct material input mix % x
budgeted price of direct material inputs

L: (6,500 – 6,400) tons * 0.50 * $70 per ton = 100 * 0.50 * $70 = $3,500 U
C: (6,500 – 6,400) tons * 0.30 * $80 per ton = 100 * 0.30 * $80 = 2,400 U
F: (6,500 – 6,400) tons * 0.20 * $90 per ton = 100 * 0.20 * $90 = 1,800 U
Total direct materials yield variance $7,700 U
 Cont…
• The total direct materials yield variance is unfavorable because
Delpino used 6,500 tons of tomatoes rather than the 6,400 tons
that it should have used to produce 4,000 tons of ketchup.
Analysis
• A favorable material yield variance indicates better productivity
than the standard yield resulting in lower material cost.
• Conversely, an adverse material yield variance suggests lower
production achieved during a period for the given level of input
resulting in higher material cost.
 Direct Labor Mix and Yield Variances
• A labor mix variance (or team composition variance) can be
calculated when more than one type or grade of labor is involved
in marking a product.
• It is a measure of whether the actual mix of labor grades is
cheaper or more expensive than the standard mix.
• A labor yield variance (or labor output variances or team
productivity variance) can be calculated to see how productively
people are working.
• The calculations are the same as those required for materials
mix & yield variances.
 Productivity Measurement
Productivity is commonly defined as a ratio between the output
volume and the volume of inputs.
In other words, it measures how efficiently production inputs, such
as labour and capital, are being used in an economy to produce a
given level of output.
Productivity is considered a key source of economic growth and
competitiveness and, as such, is basic statistical information for
many international comparisons and country performance
assessments.
 Cont…
For example, productivity data are used to investigate the impact of
product and labour market regulations on economic performance.
The ultimate goal of productivity measurement is, indeed,
productivity improvement, which involves a combination of
increased effectiveness and a better use of available resources.
Productivity growth constitutes an important element for modeling
the productive capacity of economies.
 Cont…
It also allows analysts to determine capacity utilization, which
in turn allows one to gauge the position of economies in the
business cycle and to forecast economic growth.
In addition, production capacity is used to assess demand and
inflationary pressures.
There are different measures of productivity and the choice
between them depends either on the purpose of the productivity
measurement and/or data availability.
 Cont…
 One of the most widely used measures of productivity is Gross
Domestic Product (GDP) per hour worked.
This measure captures the use of labor inputs better than just
output per employee.
 Contents
• The Role of Accounting in Special Decisions
• The Meaning of Relevance
• Special Decision Areas
• Make or Buy Decision
• Special order decision
• Add or Drop decision
• Scarce Resource Decision
 The Role of Accounting in Special Decisions
• The information which regards to the financial position of the business,
such as; profit and loss, cost and earnings, liabilities and assets, etc is
provided by Accounting to the management.
• This is why the importance of accounting in business cannot be
overemphasized.
• Management depends on statistical data and information that
accounting provides in order to make the right decision.
• The main motive of Accounting is to systematically record financial
transactions in the books of accounts and to ascertain the profit-loss
and financial position of a business.
 Cont…
• The functions of accounting include:
– ascertainment of profit and loss and financial position,
– interpretation and analysis of accounts and statements,
– development of accounting system,
– collection of statistical and economic data,
– formulation of financial principles and
– financial planning and controlling results as per plan, etc.
• Accounting in modem age is directly related to financial management.
• As a result of expansion in scopes of business, management now depends
on various accounting data and information in taking decisions.
 The Meaning of Relevance
• Relevance means that management accounting information produced
for each manager must relate to the decisions which he/she will have
to make.
• Relevant information includes the predicted future costs and revenues
that differ among the alternatives.
• Any cost or benefit that does not differ between alternatives is
irrelevant and can be ignored in a decision.
• All future revenues and/or costs that do not differ between the
alternatives are irrelevant.
• In brief, there are two criteria that qualify information to be
relevant for decision making.
 Cont…
1. Bearing on the Future:
• To be relevant to a decision, cost or benefit information must involve a
future event.
• Relevant information is a prediction of the future, not a summary of the
past. Historical (past) data have no bearing on a decision.
• Such data can have an indirect bearing on a decision because they may
help in predicting the future.
• But past figures, in themselves, are irrelevant to the decision itself.
Why? Because decision-making affect future, but not past. Nothing can
alter what has already happened.
 Cont…
2. Different under Competing Alternatives:
• Relevant information must involve future costs or benefits that differ
among the alternatives.
• These are called differential revenues and costs. In cost and
management accounting, the term differential cost is synonymous with
avoidable cost and relevant cost.
• Costs or benefits that are the same across all the available
alternatives have no bearing on the decision.
• For example:- if management is evaluating the purchase of either a
manual or an automated drill press, both of which require skilled labor
costing Br. 10 per hour, the labor rate is not relevant because it is the
same for both alternatives.
 Model for Decision Making
• Decisions have to be made by all individuals every day.
• Decision making arises because of the need to choose between
alternatives.
• Careful consideration must be given to all information available at the
time because of the long-term consequences a decision made now will
have.
• There are six main steps in the decision-making process:
1. Define the problem.
2. Identify alternatives as possible solutions to the problem; eliminate
alternatives that are not feasible.
3. Identify the relevant costs and benefits associated with each feasible
alternative; eliminate irrelevant costs and benefits from consideration.
 Cont…
4. Total the relevant costs and benefits for each alternative.
5. Assess qualitative factors.
6. Select the alternative with the greatest overall benefit (make the
decision)
1. Define the problem: is to recognize and define a specific problem.
• This is the most important stage because all other activities in the process
depend on it.
• If one does not have a clear understanding of the specific problem, he/she
may spend valuable time and energy in identify alternatives and gathering
probably irrelevant data.
 Cont…
2. Identify the Alternatives. Decision- making is selecting between two or more
alternatives. This step is concerned with listing and considering of possible
solutions
3. Identify relevant information Here, the costs and benefits associated with
each feasible alternative are identified. At this step, clearly irrelevant costs can
be eliminated from the consideration. The management accountant is responsible
for gathering necessary data.
4. Total relevant costs and benefits: This step involves determining the
relevant costs and benefits of the possible alternatives.
5. Assess qualitative factors. Decision making is based on an evaluation of
quantitative and qualitative factors.
 Cont…
– Typically, the quantitative factors are those for which
measurement is easy and precise.
– In addition to this financial criterion, there are other factors that
bear upon the decision and that are usually referred to as
qualitative.
– Qualitative factors are simply those factors that are hard to put a
number on.
– Put differently, qualitative aspects are those for which
measurement in birrs and cents is difficult and imprecise
– Qualitative factors can significantly affect the manager’s decision.
 Cont…
For example in make-or –buy decision, the quality of the product
purchased externally, the reliability of supply sources, the expected
stability of price over the next years, labor relations, community
image and so on. Therefore, qualitative factors must be taken into
consideration in the final step of the decision making model.
6. Make the decision:- Once all relevant costs and benefits for each
alternative have been assessed, the qualitative factors weighed, a
decision can be made.
 Special Decision Areas
1. Make or Buy Decision
• The make-or-buy decision is the act of making a choice between
producing an item internally (in-house) or buying it externally
(from an outside supplier).
• The buy side of the decision also is referred to as outsourcing.
• Make-or-buy decisions usually arise when a firm that has developed a
product or part-or significantly modified a product or part-is
having trouble with current suppliers, or has diminishing capacity or
changing demand.
• In make or buy decisions, the appropriate means of analysis is to
compare the relevant cost of buying the part with the relevant cots
of making the part.
 Cont…
• Here relevant cost of buying the component is typically the amount
paid to supplier.
• It may also include transportation costs incurred to get the
component to the company’s plant and costs incurred to process the
part upon receipt.
• The alternative chosen make or buy, is typically the one with the
lowest cost.
• Factors that may influence firms to make a part in-house include:
– Cost considerations (less expensive to make the part)
– Desire to integrate plant operations
– Productive use of excess plant capacity to help absorb fixed
overhead (using existing idle capacity)
 Cont…
– Need to exert direct control over production and/or quality
– Better quality control
– Design secrecy is required to protect proprietary technology
– Unreliable suppliers
– No competent suppliers
– Desire to maintain a stable workforce (in periods of declining sales)
– Quantity too small to interest a supplier
– Control of lead time, transportation, and warehousing costs
– Greater assurance of continual supply
– Provision of a second source
– Political, social or environmental reasons (union pressure)
– Emotion (e.g., pride)
 Cont…
• Factors that may influence firms to buy a part externally include:
– Lack of expertise
– Suppliers' research and specialized know-how exceeds that of the buyer
– cost considerations (less expensive to buy the item)
– Small-volume requirements
– Limited production facilities or insufficient capacity
– Desire to maintain a multiple-source policy
– Indirect managerial control considerations
– Procurement and inventory considerations
– Brand preference
– Item not essential to the firm's strategy
 Cont…
• Elements of the "make" analysis include:
– Incremental inventory-carrying costs
– Direct labor costs
– Incremental factory overhead costs
– Delivered purchased material costs
– Incremental managerial costs
– Any follow-on costs stemming from quality and related problems
– Incremental purchasing costs
– Incremental capital costs
 Cont…
• Cost considerations for the "buy" analysis include:
– Purchase price of the part
– Transportation costs
– Receiving and inspection costs
– Incremental purchasing costs
– Any follow-on costs related to quality or service
• Example:- Assume that a division of Dream Company makes an
electric component for its speakers. The management is trying to
decide whether the division of the company should manufacture this
component part or purchase it from another manufacturer.
 Cont…
• The following are production costs for 100,000 units of the component
for the forth-coming year.
•
Direct material Br.500, 000
Direct labor 200,000
Factory overhead
Indirect labor Br. 32,000
Supplies 90,000
Allocated occupancy costs 50,000 172,000
Total cost Br.872, 000
 Cont…
• A small local company has offered to supply the components at a price
of Br.8.20 each. If the division discontinued the production of its
components it would save two thirds of the supplies cost and Br.22,
000 of indirect labor cost. All other overhead costs would continue
regardless of the decision made.
• Instruction:
1. Should the parts be made or bought? Assume that the capacity now
used to make the parts will become idle if they are purchased from
outside.
2. Suppose Ethio may decide to rent the facility it devotes to making the
part to a nearby manufacturer for Br. 45,000 annually, could this
change your answer to part (a)? Why?
 Cont…
• Solution:
1. In this case Br.10, 000 of indirect labor cost and the Br.50, 000 allocated
occupancy costs are unavoidable costs. That is, a total of Br. 60,000 fixed
overhead costs cannot be eliminated irrespective of the decision made.
Therefore, these costs are irrelevant for the decision making at hand. The
relevant costs can be computed as follows.
Cost to Make Cost to Buy
Unit Total Unit Total
Direct material Br. 5.00 Br. 500,000 100,000
Direct labor 2.00 200,000
Factory overhead
Indirect labor 0.22 22,000
Supplies 0.60 60,000
Occupancy costs - - _______
_____
Total cost Br. 7.82 Br.782, 000 Br. Br.820, 000
 Cont…
• Dream Company should make the component internally because the
firm saves Br. 38,000 by purchasing the component.
Net relevant cost to buy Br. 820,000

Net relevant cost to make 782,000

Advantage in favor of make Br. 38,000

• If the space now being used to produce the part would otherwise be
idle, then Dream Company should continue to produce its own
component part and the supplier’s offer should be rejected, as stated
above. Idle space that has no alternative use has an opportunity cost of
zero.
 Cont…
• A small local company has offered to supply the components at a price
of Br.8.20 each.
• If the division discontinued the production of its components it would
save two thirds of the supplies cost and Br.22, 000 of indirect labor
cost.
• All other overhead costs would continue regardless of the decision
made.
 Cont…
2. Special Order Decision
• A special order is a one-time order that is not considered part of the
company’s normal on going business.
• For example, a discount department store chain planning a big sale
offers to make a large one-time purchase of a firm’s product but wants
a reduced price.
• In general, a special order is profitable as long as the incremental
revenue from the special order exceeds the incremental costs of
the order.
• The incremental revenue in this decision will be the price per unit
offered by the potential customer times the number of units to be
purchased.
 Cont…
• The incremental costs will be the amount of the expected cost
increase if the offer is accepted.
• Management must also be assured that it has sufficient capacity to
produce the special order without affecting normal sales.
• When there is no excess capacity, the opportunity cost of using the
firm’s facilities for the special order are also relevant to the decision.
 Cont…
3. Add or Drop decision
• Often a manager needs to determine whether or not a segment or other
segments of a company should be kept or dropped.
• Segment report prepared on a variable-costing basis provides valuable
information for these keep-or-drop decisions.
• However, while segmented reports provide useful information for such
decisions, relevant costing describes how the information should be used.
• In keep-or-drop decisions, many factors must be considered that
are both qualitative and quantitative in nature.
 Cont…
• Ultimately, however, any final decision to drop an old segment or to add a
new one is going to hinge primarily on the impact the decision will have on
net operating income.
• To assess this impact, it is necessary to make a careful analysis of the costs
involved.
• To this end, let us try to distinguish the difference between avoidable and
unavoidable fixed expenses.
• Fixed costs are divided into two categories, avoidable and unavoidable.
• Avoidable costs are costs that will not continue if an ongoing operation is
changed, deleted or eliminated.
• These costs are relevant costs in decision-making.
• Examples of avoidable costs include departmental salaries and other costs
that could be avoided by not operating the specific department.
 Cont…
• Unavoidable costs are costs that continue even if a subunit or an activity
is eliminated and are not relevant for decision.
• The reason for this is that such costs are not affected by a decision to
delete a particular activity.
• Unavoidable costs include many common costs, which are defined as those
costs of facilities and services that are shared by users.
• Examples are store depreciation, heating, air conditioning, and general
management expenses.
 Cont…
• Addis Supermarket has two departments; namely, D 01 and D 02.
• Management is concerned about the continued losses shown by D 01 and
wants a recommendation as to whether or not this department should be
discontinued.
• The predicted income statement for Addis Supermarket is given below:
D 01 D 02 Total
Sales Br.100, 000 Br.60, 000 Br.160, 000
Variable expenses 80, 000 24, 000 104, 000
Contribution Margin 20, 000 36, 000 56, 000
Fixed Expenses 32, 000 12, 000 44, 000
Income (Loss) Br. (12, 000) Br. 24, 000 Br. 12, 000
 Cont…
• A study indicates that Br.15, 000 of the fixed expenses for D 01 will be
avoided if the department is dropped.
• Furthermore, the manger will use the vacated space for expansion of D 02 if
the other department is discontinued.
• The expansion of D 02 would result in a 25% increase in the sales of the
department with 60% contribution margin.
• In addition the expansion requires additional avoidable fixed costs of
Br.3000.
Instruction: Would you recommend that D 01 be
dropped? Why or why not?
 Cont…
• Solution
• Of course, a company considering dropping a segment often has other
alternatives. If Addis Supermarket drops D 01, the company probably could
use the freed-up space in some other way, such as to expand the other
department, add another one, or even to rent the idle facility to another
company.
• Addis Supermarket is considering finding the best way to use existing
resources. These two alternatives under consideration are to keep D 01 or
discontinue D01 and expand D 02. Dropping department D 01 would reduce
profits by Br.5, 000 and the expansion of D 02 would boost income by Br.6,
000. Therefore, dropping D01 and expanding D 02 increases the overall
profit of the company by Br.1, 000.
 Cont…
A B C (A-B)+C
Total before Effect of Effect of Total after
Change dropping expanding Change
D 01 D 02
Sales Br.160, 000 Br.100, 000 Br.15, 000 Br.75, 000
Variable expenses 104, 000 80, 000 6, 000 30, 000
Contribution Margin 56, 000 20, 000 9, 000 45, 000
Fixed Expenses 44, 000 15, 000 3, 000 32, 000
Income (Loss) Br. 12, 000 Br.5,000 Br.6,000 Br.13,000
 Cont…
4. Scarce Resource Decision
• Managers are routinely faced with the problem of deciding how scarce
resources are going to be utilized.
• A scarce resource or a limiting factor refers to any factor that restrict or
constraint the production or sale of a product or service.
• It include the following, among others, labor hours, machine hours,
square feet of floor space, cubic meters of display space.
• A department store, for example, has a limited amount of floor space and
therefore cannot stock every product that may be available.
• A manufacturing firm has a limited number of machine- hours and a limited
number of direct labor-hours at its disposal.
 Cont…
• When capacity becomes pressed because of scarce resource, the firm is
said to have a constraint.
• When a plant that makes more than one product is operating at capacity,
managers often must decide which orders to accept.
• The contribution margin technique also applies here, because the product to
be emphasized or the order to be accepted is the one that makes the
biggest total profit contribution per unit of the limiting factor.
• Fixed cost are usually unaffected by such choices.
• In such kind of decision, the contribution margin technique must be used
wisely.
• Managers sometimes mistakenly favor those products with the biggest
contribution margin or gross margin per sales birr, without regard to
scarce resources.
 Cont…
• Example: Temaru Company has two products: a plain cellular
phone and a fancier cellular phone with many special features. Unit
data follow:
Plain Phone Fancy Phone
Selling price Br.80 Br.120
Variable costs 64 84
Contribution margin Br.16 Br.36
Contribution margin ratio 20% 30%
• Instructions:
a. Which product is more profitable? On which should the firm
spend its resources? Assume that sales are restricted by
demand for only a limited number of phones.
 Cont…
• b. Now suppose that annual demand for phones of both types is
more than the company can produce in the next year and the
major constraint is the availability of time on a processing
machine. Plain Phone requires one hour of processing on the
machine, Fancy Phone requires three hours of processing. Which
product is more profitable? Assume that only 10, 000 machine
hours of capacity are available.
 Cont…
• Solution:
a) Under this circumstance, the limiting factor is units of sale. Thus, the more
profitable product is the one with the higher contribution margin per unit.
The fancier cellular phone appears to be more profitable than the plain
phone. It has Br.36 per unit contribution margin as compared to Br.16 per
unit for the plain model, and it has a 30% CM ratio as compared to 20%
for the plain model.
• To maximize total contribution margin, a firm should not necessarily
promote those products that have the highest contribution margins. Rather,
total contribution margin will be maximized by promoting those products or
accepting those that provide the highest unit contribution margin in relation
to scarce resources of the firm.
 Cont…
b. Here, the productive capacity is the limiting factor because only 10,000
hours of capacity is available. To answer this question, the manager should
look at the contribution per unit of the scarce resource. This figure is
computed by dividing the contribution margin for a unit of product by the
amount of the scarce resource it requires. These calculations are carried
out below for the plain and fancy phones.
Model
Plain Phone Fancy Phone
Contribution margin (CM) per unit (a) Br.16 Br.36
Machine hours required per unit (b) 1 hour 3 hours
CM per limiting factor (a÷b) Br.16per MHR* Br. 12 per MHR
 Cont…
• With this data in hand, it is easy to decide which product is less profitable
and should be de-emphasized.
• Each hours of processing time on the machine that is devoted to the plain
phone results in an increase of Br.16 in contribution margin and profits.
• The comparable figure for the fancier phone is only Br.12 per hour.
Therefore, the plain model should be emphasized in this situation.
• Even though the fancier model has the larger per unit contribution margin
and the larger CM ratio, the plain model provides the larger contribution
margin in relation to scarce resource.