DEPARTMENT OF ACCOUNTING AND FINANCE

Distance Education

Cost & Management Accounting- II

(AcFn 2092)

Prepared by:
Demilie Eshetu (M.Sc.)
Yalemselam Worku (M.Sc.)

Editor:
Amogne Mamaw (M.Sc.)
January, 2017
Debre Berhan, Ethiopia
DEPARTMENT OF ACCOUNTING AND FINANCE

Distance Education

Cost & Management Accounting- II

(AcFn 2092)

Prepared by:
Demilie Eshetu (M.Sc.)
Yalemselam Worku (M.Sc.)

Editor:
Amogne Mamaw (M.Sc.)
January, 2017
Debre Berhan, Ethiopia
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Description of Symbols
Dear Learner, there are a number of symbols in the module to guide you as you study, please
understand those symbols as per the following description.

Symbols Descriptions

This tells you there is an introduction to the unit and what you will learn.

This tells you to note and remember an important point.

This tells you that there are answers in the topic for the activities and self-test questions.

This tells you there is a question about a particular topic.

 This tells you there is an activity for you to do.

This tells you there is a summary to the unit and what you learnt.

 This tells you there is a self test question for you to do.

This tells you there is a reference to a module.

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 TABLE OF CONTENT Page.

UNIT ONE: COST VOLUME PROFIT (CVP) ANALYSIS (1-25)

1.1. Introduction…………………………………………………………………………... 2
1.2. The Assumptions Underlying the CVP Analysis……………………………………. 2
1.3. The Basics of CVP Analysis………………………………………………………… 3
1.4. Break-Even Analysis………………………………………………………………… 6
1.5. Applying CVP Analysis……………………………………………………………... 13
1.5.1. Sensitivity “What if” Analysis……………………………………………. 13
1.5.2. Target Net Profit Analysis………………………………………………... 16
1.5.3. The Margin of Safety……………………………………………………... 19
1.6. Impact of Income Taxes on CVP Analysis…………………………………………... 22
1.7. Limitations of Cost-Volume Profit Analysis………………………………………… 23

UNIT TWO: MASTER BUDGET AND RESPONSIBILITY ACCOUNTING (26-52)

2.1. Introduction…………………………………………………………………………... 27
2.2. The Basics of Budgeting……………………………………………………………... 27
2.3. Advantages of Budgeting……………………………………………………………. 29
2.4. Budgeting and Human Behavior…………………………………………………….. 32
2.5. The Master Budget-An Overall Plan………………………………………………… 34
2.5.1. Components of Master Budget…………………………………………….. 34
2.5.2. Preparing the Master Budget………………………………………………. 41
2.6. Responsibility Accounting…………………………………………………………… 49

UNIT THREE: FLEXIBLE BUDGET AND VARIANCE ANALYSIS (53-87)

3.1. Introduction…………………………………………………………………………... 55
3.2. Static (fixed) budget…………………………………………………………………. 55
3.3. Flexible Budget………………………………………………………………………. 56
3.4. Difference between Fixed Budget and Flexible Budget……………………………... 58
3.5. Choice between Fixed and Flexible Budgets………………………………………… 59
3.6. Static budget variance………………………………………………………………... 60
3.7. Standards for material and labor……………………………………………………... 64

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 3.7.1. Setting Standards……………………………………………………………... 64
3.7.2. Setting of Standard Costs……………………………………………………... 64
3.7.2.1. Direct Material Cost Standard…………………………………………… 64
3.7.2.2. Direct Labor Cost Standard……………………………………………… 66
3.7.2.3. Factory Overhead Standards…………………………………………….. 67
3.8.Variance Analysis…………………………………………………………………….. 67
3.8.1. Possible Causes of Variances………………………………………………… 68
3.8.2. The Pyramid of Variances……………………………………………………. 69
3.8.3. Computation of Variances……………………………………………………. 69
3.8.3.1. Material Cost Variance………………………………………………….. 69
3.8.3.2. Labor Cost Variance……………………………………………………. 72
3.8.3.3. Overhead Variances……………………………………………………... 75
3.9. Measuring Mix and Yield Variances………………………………………………. 79
3.9.1. Components of Sales activity Variance………………………………………. 79
3.9.2. Components of sales Quantity Variance……………………………………… 80
3.9.3. Components of Direct Material Usage Variance……………………………... 82

UNIT FOUR: DECISION MAKING AND RELEVANT INFORMATION (88-108)

4.1. Introduction…………………………………………………………………………... 89
4.2. The Accountant’s Role in Decision Making………………………………………… 89
4.3. The Meaning of Relevance………………………………………………………… 90
4.4. Special Decision Areas………………………………………………………………. 93
4.4.1. Make or Buy Decision……………………………………………………. 93
4.4.2. Special Order Decisions………………………………………………….. 98
4.4.3. Add or Drop Decisions…………………………………………………… 102
4.4.4. Optimal Use of Limited Resources……………………………………….. 105

UNIT FIVE: DECENTRALIZATION AND TRANSFER PRICING (109-123)

5.1. Introduction…………………………………………………………………………... 110
5.2. Comparison of Centralization and Decentralization…………………………………. 110
5.3. Benefits and drawbacks of decentralization………………………………………… 111
5.4. Organizational Structure and Decentralization……………………………………… 111

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5.5.Responsibility Center…………………………………………………………………. 115
5.6. Transfer Pricing……………………………………………………………………… 116
5.6.1. Purposes of Transfer Pricing………………………………………………… 117
5.6.2. Accounting for Transfer Pricing…………………………………………….. 117
5.6.3. Alternative Methods of Transfer Pricing……………………………………. 117

References......................................................................................................................... 124
Appendices........................................................................................................................ (125-138)

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 UNIT ONE

COST VOLUME PROFIT (CVP) ANALYSIS

CONTENTS OF THE UNIT

1.1. Introduction.
1.2. The Assumptions Underlying the CVP Analysis.
1.3. The Basics of CVP Analysis.
1.4. Break-Even Analysis.
1.5. Applying CVP Analysis.
1.5.1. Sensitivity “What if” Analysis.
1.5.2. Target Net Profit Analysis.
1.5.3. The Margin of Safety
1.6. Impact of Income Taxes on CVP Analysis.
1.7. Limitations of CVP Analysis.

Objectives of the Unit

Dear Learner, after studying this unit, you will be able to:
 Define CVP Analysis.
 List and discuss the key assumption of CVP analysis.
 Distinguish between contribution margin and gross margin.
 Prepare and interpret a contribution income statement.
 Compute a breakeven point in total birrs and total units using the contribution margin
approach and the equation approach.
 Prepare a CVP graph, and explain how it is used.
 Applying CVP analysis to determine the effect on profit of changes in fixed expenses,
variable expenses, sales prices, and sales volume.
 Describe the limitations of Cost-Volume Profit Analysis

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1.1. Introduction.

Dear Learner, Cost-Volume-Profit (CVP) Analysis is one of the most powerful tool
that help managers as they make decisions by facilitating quick estimation of net income at
different levels of activity. In other words, it helps them to understand the interrelationship
between cost, volume, and profit in an organization by focusing on interactions between the
following five elements: prices of products, volume or level of activity, per unit variable costs,
total fixed costs, and mix of products sold.

Because CVP analysis helps managers understand the interrelationship between cost, volume,
and profit, it is a vital tool in many business decisions. These decisions include, for example,
 What products to manufacture or sell?
 What pricing policy to follow?
 What marketing strategy to employ? and
 What type of productive facilities to acquire?
1.2. The Assumptions Underlying the CVP Analysis.

 The major assumptions of CVP analysis are the following:

1) Changes in the level of revenues and costs arise only because of changes in the number of
product (or service) units sold.
2) Total costs can be separated into a fixed component that does not vary with the units sold and
a component that is variable with respect to the units sold.
3) When represented graphically, the behavior of total revenues and total costs are linear
(represented as a straight line) in relation to units sold within a relevant range and time
period.
4) The selling price, variable cost per unit, and fixed costs are known and constant.
5) The analysis either covers a single product or assumes that the sales mix when multiple
products are sold will remain constant as the level of total units sold changes.
6) All revenues and costs are added and compared without taking into account the time value of
money.

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 What is the concept of CVP Analysis?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
List and explain the major simplifying assumption that underlies CVP analysis.
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________

1.3. The Basics of CVP Analysis.

Contribution Margin Vs Gross Margin

The form of income statement used in CVP analysis is shown in Illustration 1.1, i.e., the
projected income statement of ABC Company (Merchandising) for the month ended January 31,
20x6. This income statement is called contribution approach to income statement. The
contribution income statement emphasizes the behavior of the costs and therefore is extremely
helpful to manager in judging the impact on profits of changes in selling price, cost, or volume.

ABC Company
Projected Income Statement
For the Month Ended January 31,20x6
Total Unit
Sales (10,000 units) Br. 150,000 Br.15.00
Variable Expenses 120,000 12.00
Contribution Margin Br. 30,000 Br.3.00
Fixed Expenses 24,000
Net Income Br. 6,000

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In the income statement here above, sales, variable expenses, and contribution margin are
expressed on a per unit basis as well as in total. This is commonly done on income statements
prepared for management’s own use since it facilitates profitability analysis.

The contribution margin represents the amount remaining from sales revenue after variable
expenses have been deducted. Thus, it is the amount available to cover fixed expenses and then
to provide profit for the period. Notice the sequence here- contribution margin is used first to
cover the fixed expenses, and then whatever remains goes toward profit. In the ABC Company
income statement shown above, the company has a contribution margin of Br. 30,000. In this
case, the first Br.24, 000 covers fixed expenses; the remaining Br. 6,000 represents profit.

The per unit contribution margin indicates by how much birrs the contribution margin is
increased for each unit sold. ABC Company’s contribution margin of Br.3.00 per unit indicates
that each unit sold contributes Br.3.00 to covering fixed expenses and providing for a profit. If
the firm had sold 5,000 units, this would cover only Br.15, 000 of their fixed expenses (5,000
units x Br.3.00 per unit). Therefore, the firm would have a net loss of Br. 9,000.

Contribution margin Br. 15,000

Fixed expenses 24,000
Net loss Br. (9,000)

If enough units can be sold to generate Br. 24,000 in contribution margin, then all of the fixed
costs will be covered and the company will have managed to show neither profit nor loss but just
cover all of its cost. To reach this point (called breakeven point), the company will have to sell
8,000 units in a month, since each unit sold yield Br. 3.00 in contribution margin.

Total Per Unit

Sales (8,000 units) Br. 120,000 Br. 15.00
Variable expenses 96,000 12.00
Contribution margin Br. 24,000 Br.3.00
Fixed expenses 24,000
Net Income Br. 0

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Computations of the break-even point are discussed in detail later in this unit. For the moment,
note that the breakeven point can be defined as the point where total sales revenue equals total
expenses (variable plus fixed) or as the point where total contribution equals total fixed
expenses.

 Too often people confuse the terms contribution margin and gross margin. Gross margin
(which is also called gross profit) is the excess of sales over the cost of goods sold (that is, the
cost of the merchandise that is acquired or manufactured and then sold). It is a widely used
concept, particularly in the retailing industry.

Distinguish between contribution margin and gross margin.

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________

Contribution Margin Ratio

In addition to being expressed on a per unit basis, revenue, variable expenses, and contribution
margin for ABC Company can also be expressed on a percentage basis:
Total Per Unit Percentage
Sales (8,000 units) Br. 150,000 Br. 15.00 100%
Variable expenses 120,000 12.00 80%
Contribution margin Br. 30,000 Br. 3.00 20%
Fixed expenses 24,000
Net income Br. 6,000

The percentage of the contribution margin to total sales is referred to as the contribution
margin ratio (CM-ratio). This ratio is computed as follows:
CM-ratio= Contribution Margin
Sales
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Contribution margin ratio = 1 – Variable Cost ratio. The Variable-Cost ratio or Variable-Cost
percentage is defined as all variable costs divided by sales. Thus, a contribution margin of 20%
means that the variable-cost ratio is 80%.

In the example here below, the contribution margin percent or contribution margin ratio, also
called Profit/Volume ratio (P/V ratio) is 20%. This means that for each birr increase in sales,
total contribution margin will increase by 20 cents (Br.1 sales x CM ratio of 20%). Net income
will also increase by 20 cents, assuming that there are no changes in fixed costs.

At this illustration suggests, the impact on net income of any given birr change in total sales can
be computed in seconds by simply applying the contribution margin ratio to birr change.

Once the break-even point has been reached, net income will increase by the unit contribution
margin for each additional unit sales. If 8001 units are sold in a month, for example, then we can
expect that the ABC Company’s net income for the month will be Br. 3, since the company will
have sold 1 unit more than the number needed to break even:

Total Per Unit

Sales (8,001 units) Br. 120,015 Br. 15.00
Variable expenses 96, 012 12.00
Contribution margin Br. 24,003 Br. 3.00
Fixed expenses 24,000
Net Income Br. 3

If 8002 units are sold (2 units above the breakeven point), then we can expect that the net income
for the month will be Br.6, and so forth.

1.4. Break-Even Analysis.

 The study of cost-volume-profit analysis is usually referred as break-even analysis. This

term is misleading, because finding break-even point is often just the first step in planning
decision. CVP analysis can be used to examine how various alternatives that a decision maker is
considering affect operating income. The break-even point is frequently one point of interest in
this analysis.

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Break-even point can be defined as the point where total sales revenue equals total expenses, i.e.,
total variable cost plus total fixed costs. It is a point where total contribution margin equals total
fixed expenses. Stated differently, it is a point where the operating income is zero. There are
three alternative approaches to determine break-even point.
1) Equation Method,
2) Contribution Margin Method, and
3) Graphical Method.
1) Equation Method.

 It is the most general form of break-even analysis that may be adapted to any conceivable
cost-volume-profit situation. This approach is based on the profit equation. Income (or profit) is
equal to sales revenue minus expenses. If expenses are separated into variable and fixed
expenses, the essence of the income statement is captured by the following equation.

Profit = Sales Revenue -Variable Expenses -Fixed Expenses

Profit (net income) is the operating income plus non-operating revenues (such as interest
revenue) minus non-operating costs (such as interest cost) minus income taxes. For simplicity,
throughout this unit non-operating revenues and non-operating cost are assumed to be zero.
Thus, the above formula can be restated as follows:

(P XQ) - (V x Q) – F = Profit (Net income)

Where P = Sales Price
Q= Break-Even Unit Sales
V= Variable Expenses per Unit
F= Fixed Expenses per Period
NI= Net Income

At break-even point, Net Income = 0 because total revenue equal total expenses.
That is, NI= PQ-VQ-F
0= PQ-VQ-F……………………………………Equation (1)

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2) Contribution-Margin Method.

 The contribution margin method is merely a short version of the equation method. The
approach centers on the idea that each unit sold provides a certain amount of fixed costs. When
enough units have been sold to generate a total contribution margin equal to the total fixed
expenses, break-even point (BEP) will be reached. Thus, one must divide the total fixed costs by
the contribution margin being generated by each unit sold to find units sold to break-even.

BEP = Fixed expenses

Unit contribution margin

Given the equation for net income, you can arrive at the above short cut formula for computing
break-even sales in units as follows:
NI=PQ-VQ-F
0= Q (P-V)-F because at BEP net income equals zero.
Q (P-V) =F…divide both sides by (P-V)

Q= F ………………….…. Equation (2)

P-V
There is a variation of this method that uses the CM ratio of the unit contribution margin. The
result is the break-even point in total sales birrs rather than in total units sold.

BEP (in sales birrs) = Fixed expenses = F

CM ratio P-V
P

This approach to break-even analysis is particularly useful in those situations where a company
has multiple product lines and wishes to compute a single break-even point for the company as a
whole.

The contribution- margin and equation approaches are two equivalent techniques for finding the
break-even point. Both methods reach the same conclusion, and so personal preference dictates
which approach should be used.

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3) Graphical Method:

 In the graphical method we plot the total costs and revenue lines to obtain their point of
intersection, which is the breakeven point.

Total costs line: This line is the sum of the fixed costs and the variable costs. To plot fixed costs,
draw a line parallel to the volume axis. To plot the total cost line, choose some volume of sale
and plot the point representing total expenses (fixed and variable) at the activity level you have
selected. After the point has been plotted, draw a line through it back to the point where the fixed
expense line intersects the birrs axis (the vertical axis).

Total Revenue Line: Again choose some volume of sales to construct the revenue line and plot
the point representing total sales birrs at the activity you have selected. Then draw a line through
this point back to the origin.

The break-even point is where the total revenues line and the total costs line intersect. This is
where total revenues just equal total costs.

Graphical Method: Sample illustration (all numbers in dollar and unit are imaginary)

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Example 1: XYZ Company manufactures and sells a telephone answering machine. The
company’s income statement for the most recent year is given below:
Total Per Unit Percent
Sales (20,000 units) Br. 1,200,000 Br. 60 100
Variable expenses 900,000 45 ?
Contribution Margin Br. 300,000 Br. 15 ?
Fixed Expenses 240,000
Net Income 60,000

Based on the above data, answer the following questions.

Required:
a) Compute the company’s CM ratio and variable expense ratio.
b) Compute the company’s break-even point in both units and sales birrs. Use the above
three approaches to compute the break-even.
c) Assume that sales increase by Br. 400,000 next year. If cost behavior patterns remain

Solution:
a. CM – ratio = 60-45 = 0.25 (25%)
60
Variable expense ratio = 1 – CM-ratio = P-V= 1-0.25 = 60 – 15 = 0.75 (75%)
P 60
b. Method 1: Equation Method
i) Net Income (NI) = PQ – VQ – FC
0 = Q (60-45) – 240,000
15Q = 240,000
Q = 240,000 = 16,000 units, at Br. 60 per unit, Br. 960,000
15
ii) Let “X” be sales volume in birrs to breakeven
CM- ratio = 0.25
Variable expense ratio = 0.75
Net Income = Total revenue – Total variable expense – Total fixed cost
0 = X – 0.75X-240, 000

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 0.25X = 240,000
X = 240,000
0.25 X = Br. 960,000

b. Method 2. Contribution Margin Method

i) BEP (in units) = Fixed expenses
CM per unit
= Br. 240,000 = 16,000 units
Br. 60 – Br. 45
ii) BEP (in birrs) = Fixed expenses = Br. 240,000 = Br. 960,000
CM – ratio 0.25
b. Method 3. Graphical Method: To plot fixed costs, measure Br. 240,000 on the vertical axis
and extend a line horizontally. Select a point (say, 20,000 units) and determine the total costs
(the total of fixed and variable) at the selected activity level. The total costs at this output level
are Br. 1,140,000= Br. 240,000 + (20,000 X Br. 45). Then, starting from the selected point draw
a line back to the origin where the fixed cost line touches the vertical axis. The break-even point
(BEP) is where the total revenues line and the total costs line intersect. At this point, total
revenues equal total costs. Refer figure 3.1.

Figure 3.1: Cost-Volume-Profit Chart.

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c)
Increase in sales Br. 400,000
Multiply by the CM ratio X 25%

Expected increase in contribution margin Br. 100.000

Since the fixed expenses are not expected to change, net income will increase by the entire Br.
100,000 increase in contribution margin.

Unit 1 Activity 1
1) What are the three approaches to break-even analysis?
________________________________________________________________________
________________________________________________________________________
2) Contribution margin is the excess of sales over fixed costs.” Do you agree? Explain.
________________________________________________________________________
________________________________________________________________________
3) What is meant by a product’s CM-ratio?
________________________________________________________________________
________________________________________________________________________
4) Habesha sales company is the exclusive distributor for a new product. The product sells
for Birr 60 per unit and has a CM ratio of 40%. The company’s fixed expenses are Br.
360,000 per year.
Required:
a) What are the variable expenses per unit?
b) Using the equation method:
i. What is the break-even point in units and sales birrs?
ii. What sales level in units and in sales birrs is required to earn an annual profit of
Br. 90,000?
iii. Assume that through negotiation with the manufacturer the Habesha Sales
Company is able to reduce its variable expenses by Br. 6 per unit. What is the
company’s new break-even point in units and in sales birrs?
c) Repeat (b) above using the contribution margin method.

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1.5. Applying CVP Analysis.
1.5.1. Sensitivity “What If” Analysis

 Dear Learner, Sensitivity analysis is a “what if” technique that examine how a result will
change if the original predicted data are not achieved or if an underlying assumption changes. In
the context of CVP, sensitivity analysis answers such questions as, what will operating income
be if the output level decreases by a given percentage from the original reduction? And what will
be operating income if variable costs per unit increase? The sensitivity analysis to various
possible outcomes broadens managers’ perspectives as to what might actually occur despite their
well-laid plans.

Example: Zena Concepts, Inc., was founded by Zemenu Adugna, a graduate student in
engineering, to market a radical new speaker he had designed for automobiles sound system. The
company’s income statement for the most recent month is given below:

Total Per Unit

Sales (400 speakers) Br. 100,000 Br.250
Variable expenses 60,000 150
Contribution margin 40,000 Br.100
Fixed expenses 35,000
Net income Br. 5,000

Yohannes Tilahun, the senior accountant at Zena Concepts, wants to demonstrate the company’s
president how the concepts developed on the preceding paragraph can be used in planning and
decision-making. To this end, Yohannes will use the above data to show the effects of changes in
variable costs, fixed costs, sales, and sales volume on the company’s profitability.

Changes in Fixed Costs and Sales Volume: Zena Concepts is currently selling 400 speakers per
month (monthly sales of Br.100, 000). The sales manager feels that a Br. 10,000 increase in the
monthly advertising budget would increase monthly sales by Br.30, 000. Should the advertising
budget be increased?

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 Expected contribution margin (Br.130, 000 x 40% CM ratio)………..… Br. 52,000
Present contribution margin (Br.100, 000 x 40% CM ratio)………….… 40,000
Incremental contribution margin………………………………………… 12,000
Change in fixed costs (incremental advertising expense)………………… 10,000
Increased net income…………………………………………………….. Br. 2,000

Yes, based on the information above and assuming that other factors in the company don’t
change, the advertising budget should be increased.

Changes in Variable Costs and Sales Volume: Refer to the original data. Management is
contemplating the use of high- quality components, which would increase variable costs by
Br.10 per speaker. However, the sales manager predicts that the higher overall quality would
increase sales to 480 speakers per month. Should the higher quality component be used?

The Br. 10 increase in variable costs will cause the unit contribution margin to decrease from
Br.100 to Br. 90.
Expected total contribution margin (480 speakers xBr.90)…………… Br. 43,200
Present total contribution margin (400 speakers xBr.100)……………. 40,000
Increase in total contribution margin………………………………… Br. 3,200

Yes, based on the information above, the high-quality component should be used. Since the fixed
will not change, net income will increase by the Br3, 200 increase in contribution margin shown
above.

Change in Fixed Cost, Sales Price, and Sales Volume. Refer to the original data and recall that
the company is currently selling 400 speakers per month. To increase sales, the sales manager
would like to cut selling price by Br 20 per speaker and increase the advertising budget by Br 15,
000 per month. The sales manager argues that if these two steps are taken, unit sales will
increase by 50%. Should the change be made?

A decrease of Br 20 per speaker in the selling price will cause the unit contribution margin to
decrease from Br100 to Br 80.

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Expected total contribution margin: (400-speakersx150%xBr80)…………………..Br. 48,000
Present total contribution margin (400 speakers x Br 100)…………………………….. 40,000
Incremental contribution margin………………………………………………………… 8,000
Change in fixed costs:
Incremental advertising expenses……………………………………………… 15,000
Reduction in net income………………………………………………………….. Br. (7,000)

No, based on the information above, the changes should not be made.

Changes in Variable Cost, Fixed Cost, and Sales Volume: Refer to the original data. The sales
manager would like to replace the sales staff on a commission basis of Br 15 per speaker sold,
rather than on flat salaries that now total Br 6, 000 per month. The sales manager is confident
that the change will increase monthly sales by 15%. Should the change be made? Changing the
sales staff from a salaried basis to a commission basis will affect both fixed and variable costs.
Fixed costs will decrease by Br 6, 00, from Br 35, 000 to Br 29, 000. Variable costs will increase
by Br 15, from Br 150 to Br 165, and the unit contribution margin will decrease from Br 100 to
Br 80.

Expected total contribution margin (400speakers x 115% x Br85)………………. Br. 39,100

Present total contribution margin (400 speakers x Br. 100)……………………… 40,000
Decrease in total contribution margin…………………………………………….. (900)

Change in fixed costs:

Salaries avoided if a commission is paid [to be added on Br. (900)]……………… 6,000
Increase in net income…………………………………………………………….Br. 5,100

Yes based on the information above, the changes should be made. Again, the same answer can
be obtained by preparing comparative income statements:

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 Present 400 Expected 460*
Speakers per month Speakers per month
Total Per unit Total Per unit
Sales ……………………. Br. 100,000 Br.250 Br. 115,000 Br 250
Variable costs…………… 60,000 150 75,900 165
Contribution margin 40,000 Br.100 39,100 Br 85
Fixed expenses 35,000 29,000
Net income Br. 5,000 Br. 10,100

*400 speakers x 115%= 460 speakers

Changes in Regular Sales Price: Refer the original data. The company has an opportunity to
make a bulk sale of 150 speakers to wholesalers if an acceptable price can be worked out. This
sale would not disturb the company’s regular sales. What price per speaker should be quoted to
the wholesaler if Zena Concepts wants to increase its monthly profits by Br 3, 000?
Variable cost per speaker…………………………………. Br 150
Desired profit per speaker (Br3, 000÷150 speakers)……… 20
Quoted price per speaker………………………………..… Br 170

Notice that no element of fixed cost is included in the computation. This is because fixed costs
are not affected by the bulk sale, so all of the additional revenue that is in excess of variable costs
goes to increasing the profits of the company.

1.5.2. Target Net Profit Analysis

Managers can also use CVP analysis to determine the total sales in units and birrs needed to
reach a target profit.

The method used for computing desired or targeted sales volume in units to meet the desired or
targeted net income is the same as was used in our earlier breakeven computation.

Example: ABC Company manufactures and sales a single product. During the year just ended
the company produced and sold 60,000 units at an average price of Br. 20 per unit. Variable
manufacturing costs were Br 8 per unit, and variable marketing costs were Br 4 per unit sold.

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Fixed costs amounted to Br. 180,000 for manufacturing and Br.72, 000 for marketing. There was
no year-end work-in-progress inventory. Ignore income taxes.

Required:
a) Compute ABC’s breakeven point (BEP) in sales birrs for the year.
b) Compute the number of sales units required to earn a net income of Br 180,000 during the
year.
c) ABC’s variable manufacturing costs are expected to increase 10 % in the coming year.
Compute the firm’s breakeven point in sales birrs for the coming year.
d) If ABC’s variable manufacturing costs do increase 10 %, compute the selling price that
would yield the same CM-ratio in the coming year.

Solution:
i- The BEP using contribution margin technique can be calculated as:
BEP (in birrs) = Fixed Expenses
Cost –ratio
BEP (in birrs) = Br. 180,000 + 72,000 = Br. 252,000
20-(8+4) 0.4
20
= Br. 630,000
ii- Target – net profit analysis can be approached using either of these two methods
a) Equation method
b) Contribution margin method

Equation Method: Managers use a targeted income as the starting point in decision which
marketing and pricing strategies to use. The formula to determine a specific targeted income is
an extension of the break-even formula. Here, instead of solving sales volume where profits are
zero, you instead solve sales where profit equals some targeted amount. The equation for target
income is:
TI = Total sales – Variable expenses – Fixed expenses
TI = PQ – VQ – FC
Where P= sales price
Q= sales unit to achieve the targeted income

~ 17 ~
 V= unit variable costs
FC = fixed costs

For ABC Company, the targeted sales volume in units would be determined as given below
TI = PQ – VQ – FC
180,000 = 20Q – 12Q – 252, 000
8Q= 180, 000 + 252, 000

Thus, Q= Br.432, 000 = 54, 000 units

8
Target sales (in birrs) = Br.20 x 54,000=Br. 1,080, 000

Alternatively computed,
Target income = PQ –VQ – FC
= Total CM* - FC
= CM-RATIO X S – FC
Where S= Birr sales to achieve the target income
Target income = 0.4S – Br.252, 000
Br. 180, 000 = 0.4S- Br.252, 000
0.4S= Br.432, 000
S = Br. 432, 000 = Br.1,080, 000
0.4
Contribution Margin Approach: A second approach would be expanding the contribution
margin formula to include the target income requirements. Thus, we can modify the formula
given earlier for BEP computations as follows:

Target sales (in units) = Fixed expenses + Target Profit

Unit CM

This approach is simpler and more direct than using the CVP equation. In addition, it shows
clearly that once the fixed costs are covered, the unit contribution is fully available for meeting
profit requirements.

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Target sales in units (for ABC Co.) = Fixed expenses + Target Profit
Unit CM
= Br.252, 000+180, 000
Br. 8
= 54,000 units
Target sales in birrs (for ABC) = Br.20 x 54,000 = Br.1, 080, 000

The total birr sales required to earn a target net profit is found by:

Target sales (in birrs) = Fixed expenses + Target Profit

CM-ratio

Target sales in birrs (for ABC) = Br.252, 000 + Br. 180, 000
0.4
= Br. 1,080, 000

1.5.3. The Margin of Safety

The margin of safety is the excess of budgeted (or actual) sales over the breakeven volume of
sales. It states the amount by which sales can drop before losses begin to be incurred. In other
words, it is the amount of sales revenue that could be lost before the company’s profit would be
reduced to zero. The formula for its calculations follows:

Total Sales - Breakeven Sales = Margin of safety

The margin of safety can also be expressed in percentage form. This percentage is obtained by
dividing the margin of safety in birr terms by total sales:

Margin of Safety in birrs = Margin of Safety

Total Sales

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Example: Consider the cost structure for ABC Company and XYZ in illustration 1-2

ABC Co. and XYZ Co.

Comparative Cost Structures
ABC Co. XYZ Co.
Amount Percent Amount Percent
Sales Br. 500,000 100 Br. 500,000 100
Variable costs 100,000 20 300,000 60
Contribution Margin 400,000 80 200,000 40
Fixed costs 300,000 100,000
Net income Br. 100,000 Br. 100,000

The break even sales for each company may be computed as follows:

BEP (in birrs) = Fixed Costs

CM ratio

BEP (ABC Co.) = Br. 300,000 = Br.375, 000

0.8

BEP (XYZ Co.) = Br. 100,000 = Br.250, 000

0.4
The margin of safety for each company may be computed as:

Total sales - Break even Sales = Margin of safety

ABC Co.’s: Br.500, 000 - Br.375, 000 = Br.125, 000

XYZ Co.’s: Br.500, 000 - 250,000 = Br. 250,000

Note that the companies’ sales revenues are the same (Br. 500,000) and their net incomes are the
same (Br. 100,000) their individual margins of safety are different. This is because they have
different cost structures, and consequently different breakeven. A higher breakeven sales amount
for ABC Co. produces a lower margin of safety. For ABC Co., the Br.125, 000 margin of safety
means that sales would have to diminish by more than this amount before the company suffers a

~ 20 ~
loss. In effect the margin of safety is a buffer before losses are incurred. The same analysis
applies to XYZ Co., except its buffer is Br. 250,000. At this point, neither company is
experiencing losses; thus it is difficult to say which company is better off. Because they are in
different businesses the amounts computed as buffers may mean the companies’ operating results
are fine. A comparison within each company on a year-by-year basis may shed light on the
possibility of impending difficulties.

The margin of safety may also be expressed as a percentage. The calculation is done by dividing
the margin of safety (in birrs) by the total sales (in birrs). This, the calculation of the margins of
safety percentage is:

Margin of safety percentage = Margin of Safety in birrs

Total Sales in birrs

ABC Co.’s: Br. 125,000 = 25 %

Br.500, 000

XYZ Co.’s: Br. 250,000 = 50 %

Br. 500,000

Suppose Moha Soft Drink Factory plans to sale 5000 bottles of soft drink at the
estimated selling price of Br 8 per bottle during the budget period of 2009. The estimated
variable cost of producing and selling each bottle and fixed cost for the budget year is
planned to be Br. 6 and Br. 120,000 respectively. Required:
a) Compute the safety margin of the factory
b) Compute the safety margin ratio of the factory
c) How many units of the planned sales unit would generate positive profit?
___________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

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1.6. Impact of Income Taxes on CVP Analysis.

 So far we have ignored income taxes. However, profit-seeking enterprises must pay
income taxes on their profits. A firm’s net income after tax, the amount of income remaining
after subtracting the firm’s income- tax expense, is less than its before- tax income. This fact is
expressed in the following formula:

NIAT = NIBT (1 – tax rate)

Where NIAT = Net Income after Taxes
NIBT= Net Income before Taxes

The requirement that companies pay income taxes affects their CVP relationships. To earn a
particular after-tax net income will require greater before-tax income than if there were no tax.

Example: Hydro System Engineering Associates, Inc. provides consulting services to city water
authorities. The consulting firm’s contribution margin ratio is 20%, and its annual fixed expenses
are Br. 120, 000. The firm’s income-tax rate is 40%.

Required:
a) Calculate the firm’s break-even volume of service revenue.
b) How much before-tax income must the firm earn to make an after-tax net income of Br.
48, 000?
c) What level of revenue for consulting services must the firm generate to earn an after-tax
income of Br.48, 000?
d) Suppose the firm’s income-tax rate rises to 45 percent. What will happen to break-even
level of consulting service revenue?

Solutions:
a) Break-even sales = Fixed expenses
CM-ratio
= Br. 120,000
0.2
= Br. 600,000

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b) NIBT = NIAT = Br. 80,000
1- tax rate

c) Target sales (in birrs) = FC + NIBT = Br. 120,000 + Br. 80,000

CM-ratio 0.2
= Br. 1,000,000

Note: In the formula that we have seen previously for target sales volume computations, the
target profit refers to the before-tax income.

d) BEP (in units) = Fixed expenses = FC

Unit CM P–V

BEP (in birrs) = Fixed expenses = FC

CM-ratio P-V
P

Thus, the change in income-tax rate has no effect on break-even sales.

1.7. Limitations of CVP Analysis

 Dear Learner, the CVP analysis is generally made under certain limitations and with
certain assumed conditions, some of which may not occur in practice. Following are the main
limitations and assumptions in the cost-volume-profit analysis:

1) It is assumed that the production facilities anticipated for the purpose of cost-volume-profit
analysis do not undergo any change. Such analysis gives misleading results if expansion or
reduction of capacity takes place.
2) In case where a variety of products with varying margins of profit are manufactured, it is
difficult to forecast with reasonable accuracy the volume of sales mix which would optimize
the profit.
3) The analysis will be correct only if input price and selling price remain fairly constant which
in reality is difficult to find. Thus, if a cost reduction program is undertaken or selling price is
changed, the relationship between cost and profit will not be accurately depicted.

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4) In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely
variable at all levels of activity and fixed cost remains constant throughout the range of
volume being considered. However, such situations may not arise in practical situations.
5) It is assumed that the changes in opening and closing inventories are not significant, though
sometimes they may be significant.
6) Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore,
closing stock carried over to the next financial year does not contain any component of fixed
cost. Inventory should be valued at full cost in reality.

Summary

An understanding of CVP relationships is necessary for successful

management of any enterprise. CVP analysis provides a sweeping overview of the effects
on profit of all kinds of changes in sales volume, expenses, product mix, and sales prices.
Calculation of sales volume required to break-even or earns a target net profit provides an
organization’s management with valuable information for planning and decision-making.

Cost-volume-profit relationships are important enough to operating managers that some

firms prepare a contribution income statement. This income statement format separates
fixed and variable expenses, and helps managers discern the effects on profit from changes
in volume. The contribution income statement also discloses an organization’s cost
structure, which is relatively proportion of its fixed and variable costs.

Sensitivity analysis, a “what-if” technique, examines how an outcome will change if the
original predicted data are not achieved or if an underlying assumption changes. When
making decisions, managers use CVP analysis to compare contribution margins and fixed
costs under different assumptions. Managers also calculate the margin of safety equal to
budgeted revenues minus breakeven revenues.

The breakeven point is unaffected by income taxes because no income taxes are paid when
operating income equals zero.

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Unit 1: Self-Test Questions
Part One: True or False
1) The amount by which budgeted (or actual) revenues exceed breakeven revenues is called the
margin of safety.
2) An increase in the income tax rate increases the breakeven point.
3) Contribution margin is the excess of sales revenue over total costs.
4) Generally, the breakeven point in revenues can be easily determined by simply summing all
costs in the company’s contribution income statement.
5) At the breakeven point, total fixed costs always equals contribution margin.

Part Two: Workout Problems.

1) Assume that the Socks Shop can purchase Socks for Br. 32 from a local factory; other
variable costs amount to Br. 10 per unit. The local factory allows the Socks Shop to return all
unsold Socks and receive a full Br. 32 refund per pair of socks within one year. The average
selling price per pair of Socks is Br. 70 and total fixed costs amount to Br. 84,000.

Required: Compute breakeven point in units and sales birrs using;

a) Equation Method,
b) Contribution Margin Method and
c) Graphic Method.
2) Suppose that SMART Bicycles wants to produce a new mountain bike called Magic bike III
and has forecasted the following information.
Price per bike-------------------------------------------------------------------Br 800
Variable cost per bike -------------------------------------------------------- Br 300
Fixed costs related to bike production ----------------------------------Br 50,000
Required:
a) Compute the amount of revenue if the company sold 200 units of bike?
b) Compute the amount of total cost that would be incurred if the company sold 200
units of bike?
c) Compute the amount of operating income if the company sold 200 units of bike? How
many units must be sold in order to be breakeven?
d) How many units must be sold in order to be breakeven?

~ 25 ~
 UNIT TWO

MASTER BUDGET AND RESPONSIBILITY ACCOUNTING

CONTENTS OF THE UNIT

2.1. Introduction.
2.2. The Basics of Budgeting.
2.3. Advantages of Budgeting.
2.4. Budgeting and Human Behavior.
2.5. The Master Budget-An Overall Plan.
2.5.1. Components of Master Budget.
2.5.2. Preparing the Master Budget.
2.6. Responsibility Accounting.

Objectives of the Unit

Dear Learner, after studying this unit, you will be able to:
 Explain the fundamental elements of budget.
 Enumerate the principal advantages of budgeting.
 Understand the difficulty of sales forecasting.
 Diagram and explain the master budget interrelationships.
 Follow the principal steps in preparing a maser budget.
 Prepare the operating budget and the supporting schedules.
 Prepare the financial budget.
 Anticipate possible human relations problem caused by budgets.
 Describe responsibility centers and responsibility accounting.
 Explain how controllability relates to responsibility accounting.

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2.1. Introduction.

Dear Learner, like many accounting terms, budgeting is used commonly in our
everyday language. The news media discuss budgets of federal and state governments, and many
people describe a variety of resource allocation decisions, ranging from vacation planning to the
purchase of food and clothing, as budgeting. The purpose of this chapter is to introduce the
framework for the budgeting process, define budgeting terms, enumerate the principal
advantages of budgeting, explain the concepts of responsibility accounting and participatory
budgeting and provide a clear understanding of the concepts of budgeting. Although the primary
emphasis in this chapter is on business budgeting, most of the concepts are also applicable to
non-business activities.

2.2. The Basics of Budgeting.

 A budget is a comprehensive formal management plans expressed in quantitative terms,

describing the expected operations of an organization over some future time period. A budget
deals with a specific entity, covers a specific future time period and is expressed in quantitative
terms.

Budget entity .The entity concept, so important in financial accounting, is essential to budgeting
also. A specific budget must apply to a clearly defined accounting entity. For budgeting purpose
the entity may consist of a small part of a business, a single activity, or a specific project. The
concept of a budget entity applies to individuals as well. For example, a student interested in
budgeting the cost of a first year’s college education should not include in the budget the cost of
three weeks’ vacation or the purchase of a Br. 5800 guitar. Although these two expenditures may
be cost of the period, they are not college education expenses.

A budget entity can be as a specific as a single project such as Addisalem’s Langano trip or it
can be a broad activity, such as the budget for an entire manufacturing firm, or for the Ethiopian
government.

Future time period: Many financial figures are meaningless unless they are couched in some
time references. For example, income statements are annual, quarterly, or monthly. A job offer

~ 27 ~
of Br. 40,000 is of little value without knowing if the figure represents pay for a month, a year, a
lifetime, or some other time period. We might assume the Br. 40,000 is annual salary. In
accounting, however, time reference should be clearly stated.

Budgets should express the expected financial consequences of programs and activities planned
for a specific period of time. Annual budget are widespread. In addition to annual budgets,
budgets for many other time periods are prepared. The planning horizon for budgeting may vary
from one day to many years. For example, master budget usually cover 1 month to 1year where
as long-range plan are prepared for 2 to 10 years.

In planning for profits, managers must consider two time horizons: the short term and the long
term.

Short-term planning is the process of deciding what objectives to pursue during a short, near-
future period, usually one year, and what to do to achieve those objectives. The typical short-
term budget covers one year and is broken down into monthly or quarterly units. Another method
frequently used to prepare a short-term budget is the continuous budget. This kind of budget
starts with an annual budget broken down into 12 monthly units. As each month arrives, it is
dropped from the plan and replaced by a new month so that at any given time, the next 12
months are always shown. Thus, in a budgetary period covering January through December
20x4, when January 20x4 arrives, it would be dropped from the plan and replaced by January
20x5, thus creating a new budgetary period covering February 20x4 through January 20x5.
Using this technique, a firm always has guidance for the full following year. When a continuous
budget is not used, a firm will have guidance for only a month or two as it approaches the end of
its budgetary period.

Long-term planning, also known as strategic planning, is the process of setting long-term goals
and determining the means to attain them. Short-term planning is concerned with operating
details for the next accounting period, but long-term planning addresses broad issues, such as
new product development, plant and equipment replacement, and other matters that require years
of advance planning. For example, short-term planning in the automotive industry would be
concerned with which and how many of the current year’s models to manufacture, while long-
range planning would focus on new model development and major changes, as well as

~ 28 ~
equipment replacements and modifications. The time frame for long-range planning may extend
as far as 20 years in the future, but its usual range is from 2 to 10 years. An important part of
long-term planning is the preparation of the capital budget, which details plans for the
acquisition and replacement of major portions of property, plant, and equipment.

Quantitative plan: Often budgets contain materials describing the various programs and
activities planned by the company. This chapter focuses primarily in the way that cost and
revenue estimates of the activities are expressed by the budget. All planned projects or activities
for the organization are reduced to the common denominator of money and other quantitative
measures, such as units of input or output.

2.3. Advantages of Budgeting.

 As noted earlier, a budget is a detailed plan expressed in quantitative terms that specifies
how resources will be acquired and used during a specific period of time. The act of preparing a
budget is known as budgeting. The use of budgets to control a firm’s activities is called
budgetary control.

Companies realize many benefits from a budgeting program. Among these benefits are the
following:
 Requires periodic planning.
 Fosters coordination, cooperation, and communication.
 Provides a framework for performance evaluation.
 Means of allocating resources.
 Satisfies legal and contractual requirements.
 Created an awareness of business costs.

Periodic Planning (Formalization of Planning): The most obvious purpose of a budget is to

quantify a plan of action. The development of a quarterly budget for a Sheraton Hotel, for
example, forces the hotel manager, the reservation manager, and the food and beverage manager
to plan for the staffing and supplies needed to meet anticipated demand for the hotel’s services.

To sum up, budgets forces managers to think a head to anticipate and prepare for the changing
conditions. The budgeting process makes planning an explicit management responsibility.

~ 29 ~
Coordination, Cooperation and Communication: Planning by individual managers does not
ensure an optimum plan for the entire organization. Therefore, any organization to be effective,
each manager throughout the organization must be aware of the plans made by other managers.
In order to plan reservations and ticket sales effectively, the reservation manager for Ethiopian
Air Lines must know the flight schedules developed by the airline’s route manager. The budget
process pulls together the plans of each manager in an organization.

In a nutshell, a good budget process communicates both from the top down and from the bottom
up. Top management makes clear the goals and objectives of the organization in its budgetary
directives to middle and lower level managers, and also to all employees. Employees and lower
level managers inform top-level managers how they can plan to achieve the objectives.

Performance Evaluation or Framework for Judging Performance: Budgets are estimates of

future events, and as such they serve as estimates of acceptable performance. Comparing actual
result against budgeted results helps managers to evaluate the performance of individuals,
departments, or entire companies.

Budgets are generally a better basis for judging actual results than is past performance. The
major drawback of using historical results for judging current performance is that inefficiencies
may be concealed in the past performance.

Means of Allocating Resources: Because we live in a world of limited resources, virtually all
individuals and organizations must ration their resources. The rationing process is easier for
some than for other. Each person and each organization must compare the costs and benefits of
each potential project or activity and choose those that result in the most appropriate resource
allocation decision.

Generally, organizations resources are limited, and budgets provide one means of allocating
resources among competing uses. The city of Addis Ababa, for example, must allocate its
revenue among basic life services (such as police and fire protection), maintenance of property
and equipment (such as city streets, parks and vehicles) and other community services (such as
programs to prevent alcohol and drug abuse).

~ 30 ~
Legal and Contractual Requirements: Some organizations are required to budget because of
legal requirements. Others commit themselves to budgeting requirement when signing loan
agreements or other operating agreements. For example, a bank may require a firm to submit an
annual operating budget and monthly cash budget throughout the life of a bank loan. Local
police department, for example, would be out of funds if the department decided not to submit a
budget this year.

Cost Awareness. Accountants and financial managers are concerned daily about the cost
implications of decisions and activities, but many other managers are not. Production managers
focus on input, marketing manager’s focuses on sales, and so forth. It is easy for people to
overlook costs and cost-benefit relationships. At budgeting time, however, all managers with
budget responsibility must convert their plans for projects and activities to costs and benefits.
This cost awareness provides a common ground for communication among the various
functional areas of the organization.

Define terms budget, budgeting and budgetary control.

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
List and briefly explain the principal advantages of budgeting.
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________

~ 31 ~
2.4. Budgeting and Human Behavior.

 If budgets are to benefit an organization, they need the support all the firm’s employees.
Lower –level workers and managers’ attitudes toward budgets will be heavily influenced by the
attitude of top management. Even with the support of top management, however, budgets –and
the managers who implements them –can run into opposition.

Budgeting necessarily entails behavioral problems. These problems include the following:
conflicting views, imposed budgets, budgets as checkup devices, and unwise adherence to
budgets.

Conflicts: The problem of conflicts in budgeting can be illustrated by considering a matter of

importance to almost any firm-inventory policy. The sales manager of a retail firm wants
inventory to be as high as possible because it is easier to make sales if the goods are available to
the customer immediately. For the same reason, the sales manager in a manufacturing firm also
wants inventory immediately ready for delivery. A financial manager wants low inventories
because of the costs associated with having inventory (storage, insurance, taxes, interest, and so
on). In a manufacturing firm, the production manager is not interested in inventory per se, but in
steady production, no interruptions for rush orders, no unplanned overtime, and other conditions
that minimize production costs. Thus, three managers have different view on the desirable level
of inventory. They will be evaluated by reference to how well they do their job, so each has an
interest in the firm’s inventory policy. In a conventional manufacturing environment, the conflict
is resolved with great difficulty, if at all and the managerial accountant might be called in to help
determine the best inventory level for the firm.

Imposed Budgets: Significant problems can result from the imposition of unachievable budgets.
Managers can become discouraged and feel no commitment to meeting budgeted goals. Or
perhaps they will take actions that seem to help achieve goals (such as scrimping on preventive
maintenance to achieve lower costs in the short run) but are really harmful in the long run (when
machinery breaks down and production must be halted altogether).

Budgets as “Checkup” Devices: Behavioral problems do not arise solely because of the
procedure followed for developing budget allowances. Comparisons of budgeted and actual

~ 32 ~
result and subsequent evaluation of performance also introduce difficulties. In ideal
circumstances managers use actual results to evaluate their own performance, to evaluate the
performance of other, and to correct elements of operations that seem to be out of control. The
budget serves as a feedback device; it lets managers know the result of their actions. Having seen
that something is wrong, they can take steps to correct it.

Unfortunately, budgets are often used more for checking up on manager; that is, the feedback
function is ignored. Where this is the case, managers are constantly looking over their shoulders
and trying to think of ways to explain unfavorable results. The time spent on thinking of ways to
defend the results could be more profitably used to plan and control operations. Some evaluation
of performance is necessary, but the budget ought not to be perceived as a club to be held over
the heads of managers.

Unwise Adherence to Budgets: As noted earlier, the budgets set limits on cost incurrence,
allowances beyond which managers are not expected to go. However, if managers’ view
budgeted amounts as strict limits on spending, they may spend either too little or too much. For
example, there are times when exceeding the budget benefits the firm. Suppose a sales manager
believes that a visit to several important customers or potential customers will result in greatly
increased sales. The sales manager will be reluctant to authorize the visit if it will result in
exceeding the travel budget.

At the other extreme, a manager who has kept costs well under budget might be tempted to spend
frivolously so that expenditures will reach the budgeted level. The manager may fear that the
budget for the following year will be cut because of the lower costs for the current year, the
manager might take an undesirable action-authorize an unnecessary trip-in order to protect
personal interests.

~ 33 ~
2.5. The Master Budget-An Overall Plan.
2.5.1. Components of Master Budget

 Dear Learner, the master budget is the total budget package for an organization; it is the
end product that consists of all the individual budgets for each part of the organization
aggregated into one overall budget for the entire organization.

The two major components of master budget are the operating budget and the financial budget.

Operating budget: It focuses on income statement and its supporting schedules. It is also called
profit plan. However, such budget may show a budgeted loss, or can be used to budget expenses
in an organization or agency with no sales revenues.

Financial budget: It focuses on the effects that the operating budget and other plans will have on
cash.

The usual master budget for a non-manufacturing company has the following components.

1. Operating budget includes: 2. Financial budget include:

a. Sales budget a. Capital budget
b. Purchases budget b. Cash budget
c. Cost of goods sold budget c. Budgeted balance sheets
d. Operating expense budget d. Budgeted statement of cash flows

In addition to the master budget there are countless forms of special budgets and related reports.
For example, a report might detail goals and objectives for improvements in quality or customer
satisfaction during the budget period.

~ 34 ~
Figure 2-1: Preparation of Master Budget (Non Manufacturing Company)

Figure 2-1: above show graphically the follow of process in development of the master budget
for a non-manufacturing firm. The master budget example that follows should clarify the steps
required to prepare the budget package. After studying the entire example, return to Figure 2-1
and follow the example through the flow diagram.
~ 35 ~
OPERATING BUDGET

 The operating budget is composed of the income statement elements. A manufacturing

business budgets both manufacturing and non-manufacturing activities. Below the various
elements of the operating budget of a manufacturing firm have been discussed.

Sales Budget: The sales budget is the first budget to be prepared. It is usually the most important
budget because so many other budgets are directly related to sales and are therefore largely
derived from the sales budget. Inventory budgets, purchases budgets, personnel budgets,
marketing budgets, administrative budgets, and other budget areas are all affected significantly
by the amount of revenue that is expected from sales.

Sales budgets are influenced by a wide variety of factors, including general economic conditions,
pricing decisions, competitor actions, industry conditions, and marketing programs. In an effort
to develop an accurate sales budget, firms employ many experts to assist in sales forecasting.

The sales budget is usually based on a sales forecast. A sales forecast is a prediction of sales
under a given conditions. The objective in forecasting sales is to estimate the volume of sales for
the period based on all the factors, both internal and external to the business that could
potentially affect the level of sales. The projected level of sales is then combined with estimated
of selling prices to form the sales budget.

 Sales forecasts are usually prepared under the direction of the top sales executive.
Important factors considered by sales forecasters include:
a) Past patterns of sales: Past experience combined with detailed past sales by product line,
geographical region, and type of customer can help predict future sales.
b) Estimates made by the sales force: A company’s sales force is often the best source of
information about the desires and plans of customers.
c) General economic conditions: Predictions for many economic indicators, such as gross
domestic product and industrial production indexes (local and foreign), are published regularly.
Knowledge of how sales relate to these indicators can aid sales forecasting.

~ 36 ~
d) Competitive actions: Sales depend on the strength and actions of competitors. To forecast
sales, a company should consider the likely strategies and reactions of competitors, such as
changes in their prices, products, or services.
e) Changes in the firm’s prices: Sales can be increased by decreasing prices and vice versa.
Planned changes in prices should consider effects on customer demand.
f) Changes in product mix: Changing the mix of products often can affect not only sales levels
but also overall contribution margin. Identifying the most profitable products and devising
methods to increases sales is a key part of successful management.
g) Market research studies: Some companies hire market experts to gather information about
market conditions and customer preferences. Such information is useful to managers making
sales forecasts and product mix decisions.
h) Advertising and sales promotion plans: Advertising and other promotional costs affect sales
levels. A sales forecast should be based on anticipated effects of promotional activities.

Purchases Budget: After sales are budgeted, prepare the purchases budget. The total
merchandise needed will be the sum of the desired ending inventory plus the amount needed to
fulfill budgeted sales demand. The total need will be partially met by the beginning inventory;
the remainder must come from planned purchases.

These purchases are computed as follows:

Budgeted Desired Cost of Beginning

Purchases = Ending inventory + Goods Sold - Inventory

Budgeted cost of goods sold: For a manufacturing firm cost of goods sold is the production cost
of products that are sold. Consequently, the cost of goods sold budget follows directly from the
production budget. However, a merchandising firm has no production budget. The cost of goods
sold budget comes directly from merchandise inventory and the merchandise purchases budget.

Operating Expense Budget: The budgeting of operating expenses depends on various factors.
Month-to-month fluctuation in sales volume and other cost-drivers activities directly influence
many operating expenses. Examples of expenses driven by sales volume include sales
commissions and many delivery expenses. Other expenses are not influenced by sales or other

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cost-driver activity (such as rent, insurance, depreciation, and salaries) within appropriate
relevant ranges and are regarded as fixed.

Budgeted Income Statement: The budgeted income statement is the combination of all of the
preceding budgets. This budget shows the expected revenues and expenses from operations
during the budget period.

A firm may have budgeted non-operating items such as interest on investments or gain or loss
on the sale of fixed assets. Usually they are relatively small, although in large firms the birr
amounts can be sizable. If non-operating items are expected, they should be included in the
firm’s budgeted income statement. Income taxes are levied on actual, not budgeted, net income,
but the budget plan should include expected taxes; therefore, the last figure in the budgeted
income statement is budgeted after tax net income.

What is sales forecasting?

__________________________________________________________________
__________________________________________________________________

What factors influence the sales forecast?

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
Why is the sales budget the starting point for master budget?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________

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FINANCIAL BUDGET

 The second major part of the master budget is the financial budget, which consists of the
capital budget, cash budget, ending balance sheet and the statement of changes in financial
position. Although there are some differences in operating budgets of manufacturing,
merchandising and service firms, very little difference exists among financial budgets of these
entities.

Capital expenditure budget: Capital budgeting is the planning of investments in major resources
like plant and equipment, and other types of long-term projects, such as employee education
programs. The capital expenditure budget or capital budget describes the capital investment
plans for an organization for the budget period. It contains some of the most critical budgeting
decisions of the organizations.

Cash budget: The cash budget is a statement of planned cash receipts and disbursements. The
cash budget is composed of four major sections:
i. The receipts section: It consists of a listing of all of the cash inflows, except for
financing, expected during the budget period. Generally the major source of
receipts will be from sales.
ii. The disbursement section: It consist of all cash payments that are planned for the
budget period. These payments will include inventory purchases, wages and salary
payments and so on. In addition, other cash disbursements such as equipment
purchases, dividends, and other cash withdrawals by owners are listed.
iii. The cash excess or deficiency section: The cash excess or deficiency section is
computed as follows:
Cash balance, beginning xxx
Add: receipts xxx
Total cash available before financing xxx
Less: disbursements xxx
Excess (deficiency) of cash available over disbursements xxx

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If there is a cash deficiency during any budget period, the company will need to borrow funds. If
there is cash excess during any budget period, funds borrowed in previous periods can be repaid
or the idle funds can be placed in short-term or other investments.
iv. The financing section: This section provides a detail account of the borrowing and
repayments projected to take place during the budget period. It also includes a
detail of interest payments that will be due on money borrowed.

Budgeted Balance Sheet: The budgeted balance sheet, sometimes called the budgeted statement
of financial position, is derived from the budgeted balance sheet at the beginning of the budget
period and the expected changes in the account balance reflected in the operating budget, capital
budget, and cash budget.

Budgeted Statement of Changes in Financial Position: The final element of the master budget
package is the statement of changes in financial position. It has emerged as a useful tool for
managers in the financial planning process. This statement is usually prepared from data in the
budgeted income statement and changes between the estimated balance sheet at the beginning of
the budget period and the budgeted balance sheet at the end of the budget period.

Unit 2 Activity 1
1) What is a master budget?
________________________________________________________________________
________________________________________________________________________
2) What are the subunits of a master budget?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
3) Which is a better basis for judging actual results, budgeted performance of past
performance? Why?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

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2.5.2. Preparing the Master Budget

 Dear Lerner, the master budget is a network consisting of many separate but
interdependent budgets. This network is illustrated in figure 2-1. The master budget can be a
large document even for a small organization. The simple example that follows on the next
paragraph for Blue Sky Company’s gives some indication of the potential size and complexity of
the master budget of a business. The example illustrates a fixed or static budget prepared for a
single expected level of activity. Flexible budgeting that involves various activity levels will be
discussed later in the next unit.

Example: Blue Sky Company’s newly hired accountant has persuaded management to prepare a
master budget to aid financial and operating decisions. The planning horizon is only three
months, January to March. Sales in December (20x3) were Br. 40,000. Monthly sales for the first
four months of the next year (20x4) are forecasted as follows:

January Br. 50,000

February 80,000
March 60,000
April 50,000

Normally 60% of sales are on cash and the remainders are credit sales. All credit sales are
collected in the month following the sales. Uncollectible accounts are negligible and are to be
ignored.

Because deliveries from suppliers and customer demand are uncertain, at the end of any month
Blue Sky wants to have a basic inventory of Br. 20, 000 plus 80% of the expected cost of goods
to be sold in the following month. The cost of merchandise sold averages 70%of sales. The
purchase terms available to the company are net 30 days. Each month’s purchase are paid as
follows:
50% during the month of purchase and,
50% during the month following the purchases.

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Monthly expenses are:
Wages and commissions…………………Br. 2,500 + 15% of sales, paid as incurred.
Rent expense………………………………………..Br. 2,000 paid as incurred.
Insurance expense…………………………………..Br. 200 expiration per month.
Depreciation including truck……………………….Br. 500 per month
Miscellaneous expense…………………………….5% of sales, paid as incurred.

In January, a used truck will be purchased for Br. 3,000 cash. The company wants a minimum
cash balance of Br. 10,000 at the end of each month. Blue Sky can borrow cash or repay loans in
multiples of Br. 1,000. Management plans to borrow cash more than necessary and to repay as
promptly as possible. Assume that the borrowing takes place at the beginning, and repayment at
the end of the months in question. Interest is paid when the related loan is repaid. The interest
rate is 18% per annum. The closing balance sheet for the fiscal year just ended at December 31,
20x3, is:
Blue Sky Company
Balance Sheet
December 31, 20x3

ASSETS
Current assets:
Cash Br. 10,000
Account receivable 16,000
Merchandise inventory 48,000
Unexpired insurance 1,800 Br. 75,800
Plant assets:
Equipment, fixture and other Br.37, 000
Accumulated depreciation 12, 800 24,200

Total assets Br. 100,000

LIABILITIES AND OWNERS’ EQUITY

Liabilities:
Accounts payable Br. 16,800
Accrued wages and commissions payable 4,250 Br. 21,050
Capital:
Owners’ equity 78, 950
Total liabilities and owners’ equity Br.100,000

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Required:
1) Using the data given above, prepare the following detailed schedules for the first quarter of
the year:
a) Sales budget.
b) Cash collection budget.
c) Purchase budget.
d) Disbursement for purchases.
e) Operating expenses budget.
f) Disbursement for operating expenses
2) Using the budget data given above and the schedules you have prepared, construct the
following pro forma financial statements.
a) Income statement for the first quarter of the year.
b) Cash budget including receipts, payments, and effect of financing.
c) Balance sheet at March 31, 20x3.

Solutions:
1. a) Sales budget
December* January February March Jan.-Mar.
Total
Cash sales (40%) Br.24,000 Br.30,000 Br.48,000 Br.36,000 Br.114,000
Credit sales (60%) 16,000 20,000 32,000 24,000 76,000
Totals Br.40,000 Br.50,000 Br.80,000 Br.60,000 Br.190,000

*December sales are included in the schedule (a) because they affect cash collected in January.

b) Cash collection budget

January February March
Cash sales of the month Br.30,000 Br.48,000 Br.36,000
Credit sales of last month 16,000 20,000 32,000
Total cash collected Br.46,000 Br.68,000 Br.68,000

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c) Purchase budget
January February March Jan.-Mar
Required ending inventory Br.64,800 Br.53,600 Br.48,000
Cost of gods sold 35,000 56,000 42,000 Br.133,000
Total needed Br.99,800 Br.109,600 Br.90,000
Beginning inventory 48,000 64,800 53,600
Purchases budget Br.51,800 Br.44,800 Br.36,400

d) Disbursement for purchases

January February March
50% of last month’s purchase Br.16,800 Br.25,900 Br.22,400
50% of current month’s purchase 25,900 22,400 18,200
Total disbursement for purchase Br.42,700 Br.48,300 Br.40,600

e) Operating expense budget

January February March Jan.-Mar.
Wages and commissions Br.10,000 Br.14,500 Br.11,500 Br.36,000
Rent expense 2,000 2,000 2, 000 6,000
Insurance expense 200 200 200 600
Depreciation expense 500 500 500 1,500
Miscellaneous expense 2,500 4,000 3,000 9,500
Total Br.15,200 Br.21, 200 Br.17,200 Br.53,600

f) Disbursement for operating expenses budget

January February March
Wages and commissions Br.14,250 Br.14,500 Br.11,500
Rent expense 2,000 2,000 2,000
Miscellaneous expense 2,500 4,000 3,000
Total Br.18,750 Br.20,500 Br.16,500

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2. a) Budget income statement

Blue Sky Company

Budget Income Statement
For the Quarter Ended, March 31, 20x3

Sales (Schedule 1(a)) Br.190,000

Cost of goods sold (Schedule 1(c)) (133,000)
Gross Profit 57,000
Operating Expenses
Wages and commissions Br.36,000
Rent expense 6,000
Insurance expense 1,500
Depreciation expense 600
Miscellaneous expense 9,500 (53,600)
Operating income 3,400
Interest expense* (885)
Net Income Br. 2,515

*Interest expense computation

Paid interest = 11, 0003/12= 495
Accrued amount:
On the first batch borrowing:
8, 0000.183/12= 360
On the second batch borrowing:
1, 0000.182/12= 30
Total interest expense incurred Br. 885

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b) Cash budget including receipts, payments and effects of financing

January February March

Beginning balance Br.10,000 Br.10,550 Br.10,750
Collections (Schedule1 (b)) 46,000 68,000 68,000
Cash available for the use (X) Br.56,000 Br.78,550 Br.78,750
Cash disbursements for:
Purchases (Schedule 1(d)) 42,700 48,300 40,600
Operating expenses (Schedule1 (f)) 18,750 20,500 16,500
Truck purchases 3,000 - -
Total disbursement (Y) Br.64,450 Br.68,800 Br.57,100
Minimum cash balance required 10,000 10,000 10, 000
Total cash needed Br.74,450 Br.78,800 Br.67,100
Cash excess (deficiency) Br.(18,450) Br.(250) Br.11,650
Effects of financing
Borrowing 19,000 1,000 -
Payment of the principal - - (11,000)
Payment of interest - - (495)
Net effect of financing (Z) Br.19,000 Br.1,000 Br.(11,495)
End cash balance (X+Z-Y) Br.10,550 Br.10,750 Br.10,155

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c) Budgeted balance sheet
Blue Sky Company
Budgeted Balance Sheet
March 31, 20x3

ASSETS
Current assets
Cash Br. 10,155
Accounts receivable 24,000
Merchandise inventory 48,000
Unexpired insurance 1,200 Br. 83,355
Plant assets
Equipment, Fixture and others 40,000
Accumulated depreciation 14,300 25,700
Total assets Br. 109,055

LIABILITIES AND OWNER’S EQUITY

Liabilities
Accounts payable Br. 18,200
Loan payable 9,000
Interest payable 390
Total liabilities Br. 27,590
Capital
Beginning owners’ equity Br. 78,950
Net income 2,515
Ending capital balance 81,465
Total equities Br. 109,055

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Unit 2 Activity 2
Hollywood Company, an office supplies specialty store, prepares its master budget on a
quarterly basis. The following data have been assembled to assist in the preparation of the master
budget for the first quarter of a current year.

a. As of December 31 (end of the prior quarter), the company’s general ledger showed the
following account balances:
Debit Credit
Cash Br. 48,000
Accounts Receivable 224,000
Inventory* 60,000
Buildings and Equipment (net) 370,000
Accounts Payable 93,000
Capital Stock 500,000
Retained Earnings 109,000
Totals Br. 702,000 Br. 702,000

* Inventories are 10,000 units at a unit cost of Br. 6.00 each.

b. Actual sales for December and budgeted sales for the next four months are as follows:
December 28,000 Units
January 40,000 Units
February 60,000 Units
March 30,000 Units
April 20,000 Units
c. Sales are 20% for cash and 80% on credit. All payments on credit sales are collected in the
month following sale. The accounts receivable at December 31 are a result of December
credit sales. Unit selling price is to be Br. 10.00 per unit.
d. Monthly expenses are budgeted as follows: salaries and wages, Br. 27,000 per month;
advertising, Br. 70,000 per month; shipping, 5% of sales; depreciation, Br. 14,000 per
month; other expenses, 3% of sales.

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e. At the end of each month, inventory is to be on hand equal to 25% of the following month’s
sales needs, stated at cost.
f. One-half of a month’s inventory purchases are paid for in the month of purchase; the other
half is paid for in the following month.
g. During February, the company will purchase a new copy machine for Br. 1,700 cash. During
March, other Equipment will be purchased for cash at a cost of Br. 84,500.
h. During January, the company will declare and pay Br. 45,000 in cash dividends.
i. The company must maintain a minimum cash balance of Br. 30,000. An open line of credit is
available at a local bank for any borrowing that may be needed during the quarter. All
borrowing is done at the beginning of a month, and all repayments are made at the end of a
month. Borrowings and repayments of a principal must be in multiples of Br. 1,000. Interest
is paid only at the time of payment of principal. The annual interest rate is 12%.

Required:
Prepare a master budget for the quarter comprising:
1. Sales budget (Supplement your sales budget with a schedule of expected cash
collections)
2. Inventory purchases budget (along with schedule of cash payments for inventories)
3. Operating Expenses budget (along with a schedule of cash payments for operating
expenses)
4. Cash Budget
5. Budgeted Income Statement for the quarter
6. Budgeted Balance Sheet

2.6. Responsibility Accounting

 Responsibility Accounting is a fundamental concept of accounting performance

measurement systems. The basic idea is that large and diversified organizations are difficult, to
manage as a single segment, thus they must be decentralized or separated into manageable parts.
These parts or segments are referred to as responsibility centers which include:
1. Revenue centers,
2. Cost centers,

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 3. Profit centers and
4. Investment centers.

Advantages
Responsibility accounting has been an accepted part of traditional accounting control systems for
many years because it provides an organization with a number of advantages. Perhaps the most
compelling argument for the responsibility accounting approach is that
 It provides a way to manage an organization that would otherwise be unmanageable.
 Assigning responsibility to lower level managers allows higher level managers to pursue
other activities such as long term planning and policy making.
 It also provides a way to motivate lower level managers and workers.
 Managers and workers in an individualistic system tend to be motivated by measurements
that emphasize their individual performances.

Disadvantages
 It ignores the interdependencies within the organization. Segment managers and
individual workers within segments tend to compete to optimize their own performance
measurements rather than working together to optimize the performance of the system.

Summary

The budget is a key tool for planning, control, and decision making in virtually
every organization. Budgeting systems are used to forcing planning, to facilitate
communication and coordination, to allocate resources, to control profit and operations, to
evaluate performance and provide incentives. Various types of budgets are used to
accomplish these objectives.

The comprehensive set of budgets that covers all phases of an organization’s operation s is
called a master budget. The first step in preparing a master budget is to forecast sales of the
organization’s services or goods. Based on the sales forecast, operational budgets are
prepared to plan production of services or goods and to outline the acquisition and use of
material, labor, and other resources. Finally, a set of budgeted financial statements is

~ 50 ~
prepared to show what the organization’s overall financial condition will be if planned
operations are carried out.

Since budgets affect almost everyone in the organization, they can have significant behavioral
implications and can raise difficult ethical issues. One common problem in budgeting is the
tendency of people to pad budgets. The resulting budgetary slack makes the budget less useful
because the padded budget does not represent an accurate picture of expected revenue and
expenses.

Participative budgeting is the process of allowing employees throughout the organization to have
a significant role in developing the budget. Participative budgeting can result in greater
commitment to meet the budget by those who participated in the process.

Unit 2: Self-Test Questions

Part One: True or False
1) Sales budget is the base for the preparation of other master budget schedules.
2) Cash collection budget is prepared based on sales budget and collection pattern of the credit
sales.
3) Budgets summarize the historical financial performance of a particular company.
4) Budgeting includes only the financial aspects of the plan and not any nonfinancial aspects
such as the number of physical units manufactured.
5) Budgets can play both planning and control roles for management.
6) Long-run planning and short-run planning are best performed independently of each other.
7) A four-quarter rolling budget encourages management to think about the next 12 months.
8) The sales forecast should primarily be based on statistical analysis with secondary input from
sales managers and sales representative.

Part Two. Choose the best answer among the given alternatives.
1) Which one of the following is/are the purpose of budgeting?
A. It provides a criterion for performance evaluation.
B. It compels planning.
C. It promotes communication and coordination.
D. All of the above.

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2) Which of the following is not a component of operating budget?
A. Sales budget. D. Purchase budget.
B. Cash budget. E. None of the above.
C. Budgeted income statement.

USE THE FOLLOWING INFORMATION TO ANSWER QUESTIONS NUMBER 3

THROUGH 7.

Tara Company, a Manufacturer of Bottles for different soft drink companies, has sold 120,000
bottles at selling price of Br 2 per bottle in November 2014 and is planning to increase the
number of sales by 10% by decreasing price to Br1.5 for December 2014. The manager expects
the same percentage increase for the coming three months. Collection policy of the company
dictates that 80% of sales of the month are collected in the same month and the other 20% in
the month following sales. Tara Company has policy of maintaining 50% of the next month’s
sales as ending inventory.
3) Compute total revenue budget of Tara for December 2014?
A. Br 264,000 C. Br132, 000
B. Br 198,000 D. None
4) Balance of Account receivable at December 1, 2014:
A. Br 48,000 C. Br 39,600
B. Br 29.000 D. None
5) Total cash collection in the month of December 2014
A. Br 194,400 C. Br 231,600
B. Br 141,600 D. None
6) How much would the production budget of Tara for December be?
A. Br 132,000 C. Br 121,200
B. Br 133,200 D. None
7) If cost of beginning finished goods per unit and production cost of a bottle in December
given as Br 1.2. How much would cost of goods sold of be?
A. Br 158,400 C. Br 145,200
B. Br 134,640 D. None

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 UNIT THREE

FLEXIBLE BUDGET AND VARIANCE ANALYSIS

CONTENTS OF THE UNIT

3.1. Introduction.
3.2. Static (fixed) budget.
3.3. Flexible Budget.
3.4. Difference between Fixed Budget and Flexible Budget.
3.5. Choice between Fixed and Flexible Budgets,
3.6. Static budget variance.
3.7. Standards for material and labor.
3.7.1. Setting Standards.
3.7.2. Setting of Standard Costs.
3.7.2.1. Direct Material Cost Standard.
3.7.2.2. Direct Labor Cost Standard.
3.7.2.3. Factory Overhead Standards.
3.8.Variance Analysis.
3.8.1. Possible Causes of Variances.
3.8.2. The Pyramid of Variances.
3.8.3. Computation of Variances.
3.8.3.1.Material Cost Variance.
3.8.3.2. Labor Cost Variance.
3.8.3.3. Overhead Variances.
3.9. Measuring Mix and Yield Variances.
3.9.1. Components of Sales activity Variance.
3.9.2. Components of sales Quantity Variance.
3.9.3. Components of Direct Material Usage Variance.

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Objectives of the Unit
Dear Learner, after studying this unit, you will be able to:
 Dist inguish between flexible budgets and master (static) budget
 Understand the performance evaluat ion relat ionship between master (static) budgets and
flexible budgets
 Compute flexible-budget variance and sales act ivit y variance.

 Explain how direct materials standards and direct labor standards are set.
 Compute the direct materials price and quantit y variances and explain their significance.
 Compute the direct labor rate and efficiency variances and explain their significance.
 Compute the manufacturing overhead variances.
 Compute Mix and Yield Variances

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 3.1. INTRODUCTION

Formal budget ing procedures result in co mprehensive operational and financial

plans for future periods. These budgets guide managers and emplo yees as they make their daily
decisio ns and as they try to anticipate future problems and opportunit ies.
One of the decis io ns that a budget manager has to make is whether to allow budgets to change
over the course of a reporting period. A budget that never changes is called static, while a budget
that changes based on actual act ivit y is called flexible. Both approaches o ffer advantages and
disadvantages for the new business owner.

3.2. Static (fixed) budget:

 Static (fixed) budget is defined by The Institute of Cost and Management

Accountants [U.K.] as ‘the budget which is designed to remain unchanged irrespective of the
level of activity actually attained. It is based on a single level of activity.’ For preparation of this
budget, sales forecast will have to be prepared along with the cost estimates.
Cost estimates can be prepared by segregating the costs according to their behavior i.e. fixed and
variable. Cost predictions should be made element wise and the projected profit or loss can be
worked out by deducting the costs from the sales revenue. Actually in practice, fixed budgets are
prepared very rarely. The main reason is that the actual output differs from the budgeted output
significantly. Thus if the budget is prepared on the assumption of producing 50, 000 units and
actually the number of units produced are 40, 000, the comparison of actual results with the
budgeted ones will be unfair and misleading. The budget may reveal the difference between the
budgeted costs and actual costs but the reasons for the deviations may not be pointed out. A fixed
budget may be prepared when the budgeted output and actual output are quite close and not
much deviation exists between the two. In such cases, maximum control can be exercised
between the budgeted performance and actual performance.
Because static budget is fixed, it is usually used by stable companies. Also, this type of budget
can be used by departments with operations independent from capacity levels. For example,
operations of administrative and general marketing departments usually does not depend on the

~ 55 ~
level of production and sales and is rather determined by the department’s management; as the
result, static budget can be used by such departments.

A fixed budget is designed to remain unchanged irrespective of the level of activity. This budget
is prepared on the basis of a standard or fixed level of activity. Since the budget does not change
with the change of level of activity, it becomes an unrealistic yardstick in case the level of
activity (volume of production or sales) actually attained does not conform to the one assumed
for budgeting purposes. The management will not be in a position to assess the performance of
different heads on the basis of budgets prepared by them, because they can serve as yardsticks
only when the actual level of activity corresponds to the budgeted level of activity. On account
of the limitations of fixed budgeting and its inability to provide for automatic adjustments when
the volume changes. Firms whose sales and production, cannot be accurately estimated have
given up the practice of fixed budgeting.

3.3. Flexible Budget:

 Flexible (expense) budget is the budget at the actual capacity level. Because flexible
budget is dynamic, it is commonly used by companies. Flexible budget is adjusted to the actual
activity of the company.

Another way of thinking of a flexible budget is a number of static budgets. For example, a
restaurant may serve 100, 150, or 300 customers an evening. If a budget is prepared assuming
100 customers will be served, how will the managers be evaluated if 300 customers are served?
Similar scenarios exist with merchandising and manufacturing companies. To effectively
evaluate the restaurant's performance in controlling costs, management must use a budget
prepared for the actual level of activity. This does not mean management ignores differences in
sales level, or customers eating in a restaurant, because those differences and the management
actions that caused them need to be evaluated, too.

The basic principle of flexible budget is that if a budget is prepared for showing the results at
say, 15, 000 units and the actual production is only 12, 000 units, the comparison between the
expenditures, budgeted and actual will not be fair as the budget was prepared for 15, 000 units.
Therefore a flexible budget is developed for a relevant range of production from 12, 000 units to

~ 56 ~
15,000 units. Thus even if the actual production is 12, 000 units, the results will be comparable
with the budgeted performance of 12, 000 units. Even if the production slips to 8, 000 units, the
manager has a tool that can be used to determine budgeted cost at 9, 000 units of output. The
flexible budget thus, provides a reliable basis for comparisons because it is automatically geared
to changes in production activity. Thus a flexible budget covers a range of activity, it is flexible
i.e. easy to change with variation in production levels and it facilitates performance measurement
and evaluation.
While preparing flexible budget, it is necessary to study the behavior of costs and divide them in
fixed, variable and semi variable. After doing this, the costs can be estimated for a given level of
activity.

The Flexible Budget is designed to change in accordance with the level of activity attained.
Thus, when a budget is prepared in such a manner that the budgeted cost for any level of activity
is available, it is termed as flexible budget. Such a budget is prepared after considering the fixed
and variable elements of cost and the changes that may be expected for each item at various
levels of operations. Flexible budgeting is desirable in the following cases:

 Where, because of the nature of business, sales are unpredictable, e.g. in luxury or semi-
luxury trades.
 Where the venture is new and, therefore, it is difficult to foresee the demand e.g.,
novelties and fashion products.
 Where business is subject to the vagaries of nature, such as soft drinks.
 Where progress depends on adequate supply of labour and the business is in an area,
which is suffering from shortage of labour.

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 3.4.Difference between fixed budget and flexible budget

In general the difference between fixed budget and flexible budget can be
summarized in the following table.

Particulars Fixed budget flexible budget

It is a Budget designed to remain It is a Budget, which by recognizing the
a. Definition unchanged irrespective of the level of difference between fixed, semi variable
activity actually attained and variable costs is designed to Change
in relation to level of activity attained
It does not change with actual volume It can be recasted on the basis of activity
b. Rigidity of activity achieved. Thus it is known level to be achieved. Thus it is not rigid.
as a Rigid or Inflexible budget.
It operates on one level of activity and It consists of various budgets for
c. Level of under one set of conditions. It assumes different levels of activity
Activity that there will be no change in the
prevailing conditions, which is
unrealistic.
Variance Analysis does not give useful Variance Analysis provides
d. Effect of information as all Costs (fixed, variable useful information as each cost
variance and semi variable) are related to only is analyzed according to its behavior
analysis one level of activity.
If the budgeted and actual activity If facilitates the ascertainment of
e. Use for levels differ significantly, then aspects cost, fixation of selling price and
Decision like cost ascertainment and price submission of quotations
making fixation do not give a correct picture.
Comparison of actual performance with It provides a meaningful basis of
f. Performance budgeted targets will be meaningless, comparison of the actual
Evaluation especially when there is a difference Performance with the budgeted targets.
between two activity levels

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 3.5. Choice between Fixed and Flexible Budgets

A budget may be fixed or flexible. A fixed budget is based on a fixed

volume of activity. It may lose its effectiveness in planning and controlling if the
actual capacity utilization is different from what was planned for any particular
unit or time e.g. a month or a quarter, The flexible budget is more useful for
changing levels of activity as it considers fixed and variable costs separately.
Fixed costs, as you are aware, remain unchanged over a certain range of output.
Such costs change when there is a change in capacity level. The variable costs
change in direct pro-portion to output. If flexible budgeting approach is adopted,
the budget controller can analyze the variance between actual costs and budgeted
costs depending upon the actual level of activity attained during a period of time.

What is the concept of flexible budget?

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Differentiate between fixed budget and flexible budget.

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 3.6. Static budget variance

Variance is the difference between the actual and budgeted amounts.


The static budget variance is the difference between the actual result and the corresponding
budgeted amount in the static budget.
A variance may be favorable or unfavorable. On an income statement budget report, think of
how the variance affects operating income and you will know if it is a favorable or unfavorable
variance.
A favorable variance (F)-has the effect of increasing the operating income relative to the
budgeted amount. For revenue items, F means actual revenues exceed budgeted revenues. For
cost items, F means actual costs are less than budgeted costs.
An unfavorable variance (U)-has the effect of decreasing operating income relative t o the
budgeted amount. Unfavorable variances are also called adverse variances.

Example: assume Webb Company manufactures and sells jackets. For simplicity, we assume that
Webb’s only costs are manufacturing costs; it incurs no costs in other value chain functions, such
as marketing and distribution. We also assume that all units manufactured in May 2011 are sold
in May 2011. Therefore all direct materials are purchased and used in the same budget period,
and there is no direct materials inventory at either the beginning or at the end of the period.
There are also no work-in-process or finished goods inventories at either the beginning or the
end of the period.
The number of units manufactured is the cost driver. The relevant range for the cost driver is
from 0 to 25,000 jackets.

Given the following information related to Webb’s company.

Actual amounts budgeted amounts
Selling price per jacket Br.38 Br.40
Units of jackets produced and sold 23,000 20,000
Variable cost per jacket Br.27.40 Br.25
Fixed costs Br.195,000 Br.200,000
Variance Analysis of Webb Company for May

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Level 0 Analysis
Actual operating income (see calculations below) ------------- Br. 49,000
Budgeted operating income (see calculations below) --------- 100,000
Static-budget variance of operating income ---------------------- Br. 51,000 U
Level 1 Analysis
Actual Static Budget Static Budget
Results Variances
(1) (2)=(1)-(3) (3)

Units sold 23,000 3,000 F 20,000

Revenues Br.874,000 Br.74,000 F
Br.800,000
Variable costs 630,000 130,000 U 500,000
Contribution margin 244,000 56,000 U 300,000
Fixed costs 195,000 5,000 F 200,000
Operating income Br.49,000 Br.51,000 U Br.100,000
Br.51,000U
Exhibit 2-1 Total Static Budget Variance
The unfavorable variance of Br.51,000 in exhibit 2-1 for level 0 is simply calculated by
subtracting static budget operating income of Br.100,000 from actual operating income of
Br.49,000.
Level-1 analysis provides managers with more detailed information on the static budget variance
for operating income of Br.51,000U. the level one analysis indicates how the line items that
make up operating income- revenues, individual variable costs and fixed costs-add up to the
static budget variance of Br.51,000.
Remember, Webb produced and sold 23,000 Jackets, although managers anticipated an output of
20,000 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 because of
Webb’s performance in manufacturing and selling 20,000 jackets. Managers, therefore, create a
flexible budget, which makes it possible for them to gain a more in-depth understanding of
deviations from the static budget.

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  A flexible budget calculates budget revenues and budgeted costs based on the actual
output in the budget period. The flexible budget is prepared at the end of the period (May
2011), after the actual output of 23,000 jackets is known.

The flexible budget is a budget that Webb would have prepared at the start of the budget period
if it had correctly forecast the actual output of 23,000 Jackets.
In preparing the flexible budget:
 The budgeted selling price is the same Br.40 per jacket used in preparing the static
budget.
 The budgeted variable costs are the same Br.25 used in the static budget.
 The budgeted fixed costs are the same static budget amount of Br.195,000 because the
23,000 jackets produced falls within the relevant range of 0 to 25,000 jackets for which
fixed costs are Br.200,000.

The only difference between the static budget and the flexible budget is that the static budget is
prepared for the planed output 0f 20,000 jackets, whereas the flexible budget is based on the
actual output of 23,000 jackets. The static budget is being ‘’flexed’’ or adjusted from 20,000
jackets to 23,000 jackets.
Webb develops its flexible budget in three steps.
Step- 1 Identify the actual quantity of output. In May 2011, Webb produced and sold
23,000 jackets.
Step- 2 Calculate the flexible budget for revenues based on budgeted selling price and
actual quantity of output.
Flexible budget revenues=Br.40 x 23,000 jackets.
=Br.920,000
Step- 3 Calculate the flexible budget for costs based on budgeted variable cost per out
put unit, actual quantity of output and budgeted fixed costs.
Flexible budget variable costs Br.25x 23,000 jackets -----------Br.575,000
Flexible budget fixed costs-------------------------------------------200,000
Flexible budget total costs--------------------------------------------Br.775,000
These three steps enable Webb to prepare a flexible budget.

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Webb uses the flexible budget to move to a level 2 variance analysis that further subdivides the
Br.51,000 unfavorable static budget variance for operating income.
Level 2 analysis
Actual Flexible budget Flexible Sales-volume Static
Results Variances Budget Variances Budget
(1) (2) = (1)-(3) (3) (4) = (3)-(5) (5)
Units sold 23,000 0 23,000 3,000 F 20,000
Revenue Br.874,000 Br.46,000 U Br.920,000 Br.120,000 FBr.800,000
Variable costs 630,000 55,000 U 575,000 75,000 U 500,000
Contribution margin 244,000 101,000 U 345,000 45,000 F 300,000
Fixed costs 195,000 5,000 F 200,000 0 200,000
Operating income Br.49,000 Br.96,000 U Br.145,000 Br.45,000 F
Br.100,000
Br.96,000 U Br.45,000 F
Total flexible-budget Total sales- volume
Variance Variance
Br.51,000 U
Exhibit 2-2
 Flexible budget variance for revenues is Br.46,000 U.
Cause: The actual selling price per unit is Br.38 (Br.874,000 ÷ 23,000) compared to a budgeted
Br.40 per unit. This reduction in selling price may explain the 15% increase in unit sales (23,000
versus the budgeted 20,000).

 Flexible budget variance for variable costs is Br.55,000 U.

Reason: Variable costs may have exceeded the budget for many reasons, including individual
price increases in materials and supplies and possible inefficiencies because of the 15% spurt in
production.
 Flexible budget variance for fixed costs is Br.5,000 F.
Reason: Fixed cost could be less than the budget because of delays in planned salary increases,
adjustments in insurance coverage, or other reasons.

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 State how Static budget variance and flexible budget variance are computed.
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__________________________________________________________________
__________________________________________________________________
_________________________________________________________

3.7. Standards for material and labor

3.7.1. Setting Standards

 When setting standard the management should be done extremely carefully to ensure
that the standards are realistic and neither too high nor too low. If very high standards are set, it
will be impossible to attain the same and there will be always an adverse variance. This will
result in lowering the morale of the employees. On the other hand, if standards are set too low,
they will be attained very easily and the favorable variances will create complacency amongst
the employees. In view of this, the standards should be set very carefully.
3.7.2. Setting of Standard Costs
3.7.2.1.Direct Material Cost Standard:

 The standard direct material cost indicates as to how much the material cost should
have been. The establishment of standard cost for direct materials involves the determination of,
a] standard quantity of standard raw materials and b] standard price of raw material consumed.
The standard quantity of materials is determined with the help of production department and
while fixing the same; normal or inevitable losses are taken into consideration. The cost
accounting department in co-operation with the purchase department determines standard price
of material consumed. Recent prices, past prices and the likely trend of prices in the future are
taken into consideration while fixing the standard prices. Similarly stock on hand, purchase
orders already placed and likely fluctuations in the price should also be taken into consideration
while fixing the material price standards.

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Example:
Calculation of standard price per unit of direct materials or raw materials:
Purchase price, top-grade material ………………………………………… xxx
Freight, by truck, from suppliers’ warehouse …………………………………. xxx
Receiving and handling ……………………………………………………… xxx
less: purchase discount ………………………………………………….………… xxx
Standard price per pound ……………………………………………………..…… xxx

Calculation of standard quantity per unit of direct materials or raw materials:

Materials requirement (in pounds) per unit as specified in the bill of materials*……… xxx
Allowance for wastage and spoilage ……………………………………………..………. xxx
Allowance for rejects ……………………………………………………………………..…... xxx

Standard of materials requirements (in pounds) ……………………………………………… xxx

*A bill of materials is a list that shows the quantity of each type of material in a unit of finished
product. It is a handy source of determining the basic material input per unit, but it should be
adjusted for waste and other factors as shown above, when determining the standard quantity per
unit of product. "Waste and spoilage" in the table above refers to materials that are wasted as a
normal part of the production process or that spoil before they are used. "Rejects" refers to the
direct material contained in units that are defective and must be scrapped.
Once the direct materials price and quantity standards have been set, the standard cost of a
material per unit of finished product can be computed as follows.

Material per unit × Br. amount per unit

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 3.7.2.2. Direct Labor

 Labor is also an important element of cost and the standard labor cost indicates
the labor cost that should be incurred. Two factors need to be taken into consideration while
fixing the standard labor cost. The first one is the standard time and the second one is the
standard rate. For setting the standard time, it is necessary to conduct time and motion study
with the help of Work Study Engineer. Firstly motion study is conducted to identify
unnecessary motions and then to eliminate them. After elimination of unnecessary motions,
standard time is allotted to the motions that are required to be performed for producing the
product. While determining the standard time, allowance is made for normal idle time to
cover mental and physical fatigue. The standard wage rate is fixed after considering the level
of rates in the market, the degree of skill required for performing the job, the availability of
manpower and the wage structure in the concerned industry. Concept of ‘Standard Hour’ is
extremely important in setting the standards for labor. It is a hypothetical hour, which
represents the amount of work, which should be performed in one hour under standard
conditions.

Example of Standard rate per direct labor hour:

Basic wages rate per hour ……………………………………………………… xxx
Employment taxes at 10% of the basic rate ………………………………. xxx
Fringe benefits at 30% of the basic rate……………………………………………… xxx
Standard rate per direct labor hour ………………………………………………….. xxx

Example of standard labor hours per unit:

Basic labor time per unit, in hours ……………………………………………. xxx
Allowance for breaks and personal need …………………………………… xxx
allowance for cleanup and machine downtime …………………………….. xxx
Allowance for rejection ………………………………………………………..……… xxx
Standard labor hours per unit of product ………………………………………….…. xxx

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 3.7.2.3.Factory Overhead Standards:

 To set overhead cost standard, first it need to determine, a] standard capacity and
b] standard overhead cost for that capacity. The standard overhead cost can be computed
using normal capacity. Normal capacity is not the total installed capacity but it is the
practical capacity, which is based on the resources available and efficient utilization of the
same. After this the standard overheads are fixed. In case of variable overheads, since they
remain constant per unit of the production, it is necessary to calculate only standard variable
overhead rate per unit or per hour. In case of fixed overheads, budgeted fixed overheads and
budgeted production are to be taken into consideration. A standard rate of fixed overhead per
unit is then computed by dividing the budgeted fixed overheads by the budgeted production.

 Unit 3 Activity 1
Assume a coffee table manufacturer uses lumber. Lumber is purchased in large volume and cut
in to pieces as needed and assembled to manufacture the Coffee table. A given sized coffee table
will require a specified meter of lumber. 4 meters of lumber is needed per Coffee table. The cost
per meter of lumber is Br 6. A certain production order of 500 coffee tables will be
manufactured.
Required:
a. What is the standard quantity of material per coffee table?
b. What is the standard price per meter of lumber?
c. Determine the direct material budget for the order?
d. Determine the standard cost for material per coffee table?

3.8. Variance Analysis

 Variance is the difference between the standard cost and the actual cost. In other
words it is the difference between what the cost should have been and what the actual cost is,
while Variance Analysis is the analysis of variances in a standard costing system into their

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constituent parts. It is the analysis and comparison of the factors which have caused the
difference between pre-determined standards and actual results with a view to eliminating
inefficiencies.

3.8.1. Possible Causes of Variances

The following are the more common factors attributed to variances in manufacturing concerns.
a. Material Price - Buying materials at a price different from the specified buying price.
i. Inefficiency of the purchasing department in seeking the most advantageous
sources of supply.
ii. Changes in market condition causing general price increase.
iii. Purchase of inferior (or superior) quality materials.
b. Material Usage - Using more or less quantities of material than those specified to achieve
the actual production
i. Careless handling of materials by the production workers.
ii. Purchase of inferior quality materials.
iii. Changes in method of production.
c. Labor Rate- Paying labor at a rate different from the agreed/standard rate
i. Assignment of work to higher grade labor.
ii. Increase in wage rates not reflected in the standard wage rate.
d. Labor Efficiency - The work force spending more or less time than allowed for the actual
production
i. Waste of time due to use of inferior quality materials.
ii. Use of different grade of labor from that specified.
iii. Waste of time due to failure to maintain machines in proper conditions.
e. Overhead - Since the Recovery Rates are always based on budgeted figures, any deviation
from budget will give rise to a variance. Therefore, overhead variance will be caused by the
following factors:
i. Actual expenditure being different from the budgeted expenditure.
ii. Actual production being different from the budgeted production.

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 3.8.2. The Pyramid of Variances
The following diagram can be used to depict the various major factors causing variances:
Total cost Variance

Material cost Labor cost variance Factory overhead variance

Variance

Price Usage Rate variance Efficiency VOH Cost FOH Cost

Material mix Material yield Spending Efficiency

Expenditure /budget Volume variance

3.8.3. Computation of Variances

 After setting the standards and standard costs for various elements of cost, the next
important step is to compute variances for each element of cost. Element wise computation of
variances is given in the following paragraphs.

3.8.3.1.Material Cost Variance

This variance shows the difference between the standard cost of material consumed for actual
production and the actual cost. The following formula is used for computation of this variance.
Material Cost Variance:

Standard Cost of Material Consumed for Actual Production – Actual Cost.

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It is also given by the formula [(AP*AQ) - (SP*SQ)]. If the actual cost of material consumed is
less than the standard cost of material consumed, the variance is ‘favorable’ (F), otherwise it is
‘adverse’ (A) /or ‘unfavorable’ (U). This can be analyzed into material price and material usage
variances.
Material cost variance

Price variance Usage variance

 Material Price Variance: One of the reasons for difference between the standard
material cost and actual material cost is the difference between the standard price and
actual price. Material Price Variance measures the difference between the standard price
and actual price with reference to the actual quantity consumed. The computation is as
shown below:

Material Price Variance: Actual Quantity [Standard Price – Actual Price]

AQ [SP - AP]

 Material Usage Variance: This is that part of material cost variance arising from the use
of more or less quantity of raw materials to achieve the actual production. It is given by
the formula Material Usage Variance = (Standard Qty - Actual Qty) Standard Price.

*The total of Price Variance and Quantity Variance is equal to Cost Variance
Material Cost Variance = Material Price Variance + Material Quantity Variance

Example
Standard quantity of materials for producing 1 unit of finished product ‘P’ is 5 kg. The standard
price is Br.6 per kg. During a particular period, 500 units of ‘P’ were produced.
Actual material consumed was 2700 kg at a cost of Br.16, 200.

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Solution:
I. Material Cost Variance = Standard Cost of Materials – Actual Cost
500 units ×5 kg × Br.6 =Br.15, 000
Br.15, 000 – Br.16, 200 = Br.1, 200 [A]
II. Material Price Variance = Actual Quantity [Standard Price – Actual Price]
2, 700 [Rs.6 – Rs.6] = Nil
III. Material Quantity Variance = Standard Price [Std. Qty – Actual Qty]
Br.6 [2500 – 2700] = Br.1, 200 [A]
One can also computed the material cost variance as such:
IV. Material Cost Variance = Material Price Variance + Material Quantity Variance.
Br.1200 [A] = Br. Nil + Br.1, 200 [A]

 Unit 3 Activity 2
3F Furniture factory has planned to use 4 meters of lumber for a coffee table as a standard. A
meter of lumber is expected to be purchased on average at Br 8. During the manufacturing
period, the factory produced 200 units of coffee table 600 meters of lumber have been used.
Actually direct materials have been purchased at Br 7per meter. The total meters of lumber
purchased were 15,000 meters.
Required : Compute
a. material price variance
b. Material Usage Variance
c. Flexible budget Variance for direct material

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 3.8.3.2. Labor Cost Variance

 This is the difference between the actual labor cost for the actual production in
a given period and what labor should have cost if labor worked at normal efficiency and
was paid at the standard wage rate.
Formula:

Labor Cost Variance = Standard Labor Cost for Actual Production –

Actual Labor Cost

This variance is usually analyzed into Labor Rate Variance and Labor Efficiency
Variance. Thus:
Labor Cost Variance

Labor rate variance Labor efficiency variance

 Labor Rate Variance

This is the variance due to paying labor for hours worked at a rate different from the
agreed/standard rate, that is,

Labor Rate Variance: Actual Hours [Standard Rate – Actual Rate]

(SR-AR) AH.

This variance will be favorable if the actual rate paid is less than the standard rate. The labor rate
variance is that portion of direct labor cost variance, which is due to the difference between the
labor rates.
 Labor Efficiency Variance:
It measures the productivity of labor time. For doing this, the actual time taken by the
workers should be compared with the standard time allowed for the job. The standard

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 time allowed for a particular job is decided with the help of time and motion study. The
efficiency variance is computed with the help of the following formula.

Labor Efficiency Variance = Standard Rate [Standard Hours– Actual Hours

worked]

This variance will be favorable is the actual time taken is less than the standard time.

Example
Standard hour for manufacturing two products, M and N are 15 hours per unit and 20 hours per
unit respectively. Both products require identical kind of labor and the standard wage rate per
hour is Br.5. In a particular year, 10,000 units of M and 15, 000 units of N were produced. The
total labor hours worked were 450, 000 and the actual wage bill came to Br.2,297,500. This
includes 12, 000 hours paid @ Br.7 per hour and 9,400 hours paid @ Br.7.50 per hour, the
balance having been paid at Br.5 per hour. You are required to calculate labor variances.
Solution:
I. Labor Cost Variance: Standard Labor Cost for Actual Production – Actual Labor Cost
Br.2,250, 000 – Br.2,297,500 = Br.47,500 [A]
Note: Standard Labor Cost for Actual Production is computed as under,
Product M: 10, 000 units X 15 hrs per unit X Br.5 per hour = Br.750, 000
Product N: 15, 000 units X 20 hrs per unit X Br.5 per hour = Br.1,500, 000
Total standard labor cost for actual production = Br.2,250, 000

II. Labor Rate Variance: Actual Hours [Standard Rate – Actual Rate]
12, 000 [Br.5 – Br.7] = Br.24, 000 [A]
9, 400 [Br.5 – Br.7.50] = Br.23, 500 [A]
428, 600 [Br.5 – Br.5] = Nil
Total Labor Rate Variance = Br.47, 500 [A]
III. Labor Efficiency Variance = Standard Rate [Standard Time – Actual Time]
Br.5 [450, 000 – 450, 000] = Nil

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 IV. Labor Cost Variance = Labor Rate Variance + Labor Efficiency Variance
Br.47, 500 [A] = Br.47, 500 [A] + Nil
Or
Labor cost variance = actual labor cost – standard labor cost allowed for
actual output (AQ XAP) – (AQ X SH) SR
[ [(12,000 X7) + (9,400 X 7.5) + (428,600 X5)] - [(10,000 units X 15hrs
XBr.5) + (15,000 units X 20hrs X Br.5)] ]
Br.47,500 unfavorable =Br.2,297,500 – Br.2,250,000

 Unit 3 Activity 3
Consider the following information for Abyssinia spring water for June, when 3000 bottles of

water were manufactured. The standard labor time allowed is 2.5 hours per unit at wage rate of

Br 5 per hour. During the month, 5000 hours of labor were actually used at a total cost of Br

30,000

Required:-Compute

a. Labor Rate Variance

b. Labor Efficiency Variance

c. Flexible Budget Variance

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 3.8.3.3. Overhead Variances:

 In case of overheads variance, it is necessary to divide them into fixed and variable for
computation of variances. We will take up the fixed overhead variances first and then the
variable overhead variances. The fixed overhead variances are discussed in the following
paragraphs.
 Fixed Overhead Cost Variance: This variance indicates the difference between the
standard fixed overheads for actual production and the actual fixed overheads incurred.
Actually this variance indicates the under/over absorbed fixed overheads. If the actual
overheads incurred are less than the standard fixed overheads, it indicates the under
absorption of fixed overheads and the variance is favorable. On the other hand, if the
actual overheads incurred are more than the standard fixed overheads, it indicates the
over absorption of fixed overheads and the variance is adverse. The following formula is
used for computation of this variance.

Fixed Overhead Cost Variance: Standard Fixed Overheads for Actual

Production – Actual Fixed Overheads.

Fixed overhead cost variance

Spending/expenditure/budget variance FOH volume variance

 Fixed Overhead Expenditure/Budget Variance: This variance indicates the difference

between the budgeted fixed overheads and the actual fixed overhead expenses. If the
actual fixed overheads are more than the budgeted fixed overheads, it is an adverse
variance as it means overspending as compared to the budgeted amount. On the other
hand, if the actual fixed overheads are less than the budgeted fixed overheads, it is a
favorable variance. This variance is computed with the help of the following formula.

Fixed Overhead Expenditure Variance:

Budgeted Fixed Overheads – Actual Fixed OH
Overheads

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  Fixed Overheads Volume Variance: This variance indicates the under/over absorption of
fixed overheads due to the difference in the budgeted quantity of production and actual
quantity of production. If the actual quantity produced is more than the budgeted one, this
variance will be favorable but it will indicate over absorption of fixed overheads. On the
other hand, if the actual quantity produced is less than the budgeted one, it indicates
adverse variance and there will be under absorption of overheads. The formula for
computation of this variance is as shown below:

Fixed Overhead Volume Variance:

Standard Rate [Budgeted Quantity – Actual Quantity]

Fixed Overhead Cost Variance = Expenditure Variance + Volume Variance

 Variable Overhead Cost Variance: This variance indicates the difference between the
standard variable overheads for actual output and the actual overheads. The difference
between the two arises due to the variation between the budgeted and actual quantity. The
formula for the computation of this variance is as follows:

Variable Overhead Cost Variance = Standard Variable Overheads for Actual

Production – Actual Variable Overheads.

Variable overhead cost variance

Spending/expenditure VOH Efficiency variance

 Variable Overheads Expenditure Variance: This variance indicates the difference

between the standard variable overheads to be charged to the standard production and the
actual variable overheads. If the actual overheads are less than the standard variable
overheads, the variance is favorable, otherwise it is adverse. The formula for the
computation is as follows:

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 Variable Overhead Expenditure Variance = Standard Variable Overheads for
Actual Production – Actual Variable Overheads.

 Variable Overheads Efficiency Variance: It indicates the efficiency by comparing

between the outputs actually achieved and the output that should have been achieved in
the actual hours worked. [Standard Production] This variance will be favorable if the
actual output achieved is more than the standard output. The formula for computation is
given below:

Variable Overheads Efficiency Variance: Standard Rate [Standard Quantity – Actual

Quantity]

Illustration
From the following information extracted from the books of a manufacturing company, calculate
Fixed and Variable Overhead Variances.

Particulars Budgeted Actual

Production in Units 22, 000 24, 000

Fixed Overheads Br.44, 000 Br.49, 000

Variable Overheads Br.33, 000 Br.39, 000
Number of hours 25, 000 27, 000

Solution:
A. Fixed Overhead Variances:
i. Fixed Overhead Cost Variance: Standard Fixed Overheads allowed for Actual Production

- Actual Fixed Overheads = Br.48, 000 – Br.49, 000 = Br.1, 000 [A]

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Note: Standard fixed overheads for actual production = Actual Production 24, 000 X standard
rate Br.2 [Br.44, 000 budgeted fixed overheads / 22, 000 budgeted production = Br.2]
ii. Fixed Overhead Expenditure Variance: Budgeted Fixed Overheads – Actual Fixed
Overheads = Br.44, 000 – Br.49, 000 = Br.5, 000 [A]
iii. Fixed Overhead Volume Variance: Standard Rate [Budgeted Quantity – Actual
Quantity] = Br.2 [22, 000 – 24, 000] = Br.4, 000 [F]
The variance is favorable as the actual quantity produced is more than the budgeted quantity.
iv. FOH Cost Variance = Expenditure Variance + Volume Variance
Br.1, 000 [A] = Br.5, 000 [A] + Br.4, 000 [F]
B. Variable Overheads Variance:
I. VOH Cost Variance: Standard Variable Overheads for Standard Production – Actual
Variable Overheads:
Br.33, 000 – Br.39, 000 = Br.6, 000 [A]
Note: Standard Variable Overheads for Actual Production = Standard Rate per Unit X Actual
Production in Units = Rs.1.5 [Budgeted variable overheads Rs.33, 000 /Budgeted production in
units 22, 000 =
Br.1.5] X 24, 000 units = Br.36, 000
II. Expenditure Variance: Standard Variable Overheads for Actual Production – Actual
Variable Overheads:
Br.39, 000– Br.35,640 (Br.1.32 X 27,000) = Br.3,360 [A]
III. Efficiency Variance: Standard Rate [Standard Quantity – Actual Quantity] Br.1.32
[25,000 – 27, 000] = Br.2,640[A]

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 3.9. Measuring Mix and Yield Variances
3.9.1. Components of Sales activity Variance

 It is the difference between the amount of contribution margin in the budget based on
the actual sales volume and the amount in the static budget. In calculating the sales activity
variance, fixed costs are the same in the same flexible budget and master budget. It has two
components
A. Sales Quantity Variance
B. Sales mix Variance

3.9.1.1. Sales Quantity Variance

It is computed by multiplying the difference between the actual units sold and maser budget units
by the weighted average budgeted average contribution margin per unit
 OR, alternatively, sales quantity variance

SQV= (Actual sales units of all products sold–budgeted units of products to be sold)
Budgeted CM/unit
Where:
Weighted Average CM/unit = Total budgeted CM/Total budgeted units
 If actual units of all products sold> budgeted units of all products sold, there is
favorable variance.
 If actual units of all products sold< budgeted units of all products sold, there is
unfavorable variance.

3.9.1.2. Sales Mix Variance

 Sales mix variance- is the difference between the budgeted amount for actual sales
mix & the budgeted amount for the budgeted sales mix.
It is the difference between the budgeted contribution margin for a constant sales mix and the
budgeted contribution margin for a budgeted sales mix.
SMV= Actual units of all products (Actual sales mix%-Budgeted sales mix) Budgeted CM/unit.
 If actual sales mix> budgeted sales mix….Favorable variance

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  If actual sales mix< budgeted sales mix….Unfavorable variance

3.9.2. Components of sales Quantity Variance

3.9.2.1. Market Share Variance

Market Share Variance = Actual market size units (Actual market share- Budgeted market
share) XBCM per composite unit for budgeted mix
3.9.2.2. Market size Variance

 Market Size Variance = (Actual Market size -Budgeted Market size) Budgeted
market share X Budgeted CM per composite unit for budgeted mix
Purple manufactures two types of products of Viny flooring. Budgeted and actual data for 2003
are;
Static Budget Actual results
Com. Resid. Com. Resid.
Units sales 20,000 60,000 25,200 58,800
Total Cont. Margin 10 mill 24 mill 11.97 mill 24.496 mill
In the late 2005, a marketing research firm estimated the industry volume for commercial and
Residential Flooring in 2015 at 800,000 units. Actual industry volume for 2014 was 700,000
units.

Required: Compute
a. Sales mix variance c. Market share variance
b. Sales quantity variance d. Market size variance

Solution
A. Sales Mix variance

= actual units of all products (Actual sales mix %- Budgeted sales mix %) BCM per unit
Actual Sales mix Percentage Budgeted sales mix percentage
Comm. 25,200/84,000= 30% Comm. 20000/80,000= 25%
Resid. 58,800/84,000= 70% Resid. 60,000/80,000= 75%

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Budgeted CM per unit
Comm. 10 mill/20,000= 500 per unit
Resid. 24 mill/60,000= 400 per unit
Sales mix Variance= Actual units of All products (Actual sales mix%- Budgeted sales mix
%) BCM /unit
Sales mix variance for Commercial= 84,000 (0.3-0.25) x Br500= 2,100,000 F
Sales mix variance Residential = 84,000 (0.7-0.75) x Br400= 1,680,000U
Total Sales mix Variance 420,000 F
B. Sales Quantity variance
= (actual sales units of all products- Budgeted sales units of all products) Budgeted sales mix
%X budgeted
CM
Sales quantity variance for Comm.= (84,000- 80,000) .25x Br 500= Br500,000 F
Sales quantity variance for Resid.= (84,000- 80,000) .75x Br 400=Br1,200,000F
Total Sales quantity Variance Br 1,700,000 F
C. Market Share variance

Actual market share= 84,000/700,000= 12%

Budgeted market share= 80,000/800,000= 10%
Budgeted Cm Per composite unit of budgeted mix
= Br34 mill/ 80,000= Br 425/unit
Market share variance
=Actual market size in units (Actual market share- Budgeted market share) x BCM per
composite unit of budgeted mix
= 700,000(0.12- 0.10) x Br 425
= 5,950,000 F
D. Market size variance
= (Actual market Size variance- Budgeted Market size in units) Budgeted market share X BCM
per composite unit for budgeted mix
= (Actual market size in units- Budgeted market size in units) X Budgeted market share X BCM
per composite unit for budgeted mix
= (700,000- 800,000) x .1x Br 425 per unit = 4,250,000
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 3.9.3. Components of Direct Material Usage Variance
3.9.3.1. Material Yield Variance

= Actual total quantity of all DM input used (Actual DMs input mix %- Budgeted DMs input
mix %) X Budgeted price of DM input
3.9.3.2. Material Mix Variance

= (Actual quantity of all direct inputs used- budgeted quantity of all direct inputs) X Budgeted
Direct materials input mix % X Budgeted price of direct materials inputs.

State the concepts of Mix and Yield Variances.

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________

Define the following properly.

a. Sales mix variance

b. Sales quantity variance
c. Market share variance
d. Market size variance

Example
EAT FRUIT produces tomatoes ketch up from different species of tomatoes; Latomtoes,
caltomes and Flotoms.
To produce a kg of keichup 1.6 tons of tomatoe is required. Out of which 50% are Latomes, 30%
Caltomes and 20% Flotoms.
Direct material inputs budget is as follows
 0.8(50% of 1.6) ton of Latomes at Br 70/ton..Br56

 0.48(30% of 1.6) ton of Caltoms at Br80ton. 38.4

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 0.32(20% of 1.6) ton of Latoms at Br 90/ton..Br28.8

Budgeted average cost per ton of tomatoes is Br123.2 /1.6 tones= Br 77per tone
Actual results for June 2003 shows that a total of
6,500 tons of tomatoes were used to produce 4,000 kgs of Kitchup.
3250 tons of Latoms at actual cost of Br 70 per ton………………….Br227, 500
2275 tons of Caltoms at actual cost of Br 82 per ton………………….Br186, 550
975 tons of Flotomes at actual cost of Br 96 per ton…………………..Br93, 600
6500 tons of tomatoes…………………….Br507, 650
Budgeted cost of 4000 tons of kitchup at Br123.2 per ton…………….Br 492,800
FBV for direct material …………………………………………………Br 14,850
At the standard mix, the quantities of each type of tomatoes required are
Latomes 0.5 x 6,400 tons= 3,200 tons
Cal tomes 0.3 x 6,400 tons = 1,920 tons
Flotoms 0.2 x 6,400 tons = 1,280 tons
i.e 4000 x 1.6 tones= 6400 tones
Actual results FB MB
Latomes 3250x Br 70 3250xBr 70 3200xBr70
Cal tomes 2275x Br 82 2275xBr 80 1920xBr80
Flotoms 975x Br 96 975xBr 90 1280xBr90
Br 570,650 Br497, 250 Br492, 800
PV= Br10, 400 U EV= Br 4,450 U
FBV = Br 14,850 U
Direct Material Mix Variance
= Actual total quantity of all DM input used (Actual DMs input mix %- Budgeted DMs
input mix %) X Budgeted price of DM input
Latomes = 6500 tons (0.5- 0.5) Br 70/ton = Br 0
Cal tomes = 6500 tons (0.35- 0.3) Br 80/ton=Br26, 000 U
Flotoms = 6500 tons (0.15- 0.2) Br 90/ton = 29,250 F
Total DM mix Variance …………………………..Br 3,250 F
Direct Materials Yield Variance for each input

~ 83 ~
 = (Actual quantity of all direct inputs used- budgeted quantity of all direct inputs) X
Budgeted Direct materials input mix % X Budgeted price of direct materials inputs
Latomes = (6500 -6400) tons0.5 x Br 70/ton = Br 3500 U
Cal tomes = (6500 -6400) tons0.3 x Br 80/ton = Br 2400 U
Flotoms = (6500 -6400) tons0.2 x Br 90/ton = Br 1800 U
Direct material yield variance……………….Br 7,700 U
Actual results FB MB
Latomes 6500x0.5x Br70 6500x0.5x Br70 6400x0.5x Br 70
Caltomes 6500x0.35x Br80 6500x0.30x Br80 6400x0.3x Br 80
Flotoms 6500x0.15x Br90 6500x0.20x Br90 6400x0.2x Br 90
Br 497,250 Br 500,500 Br 492,800
Mix Variance = Br 3250 F Yield variance = Br 7,700 U
Efficiency variance = Br 4,450 U
3.10. Summary

Master budget (static budget) assume the planned/fixed/ level of activity. All
master budget schedules are prepared based a fixed level of sales, which cannot be adjusted to
the actual operation of the company. To evaluate performance using master budgets creates the
problem of using a budget for one level of activity. Therefore there is a need for a budget that
can be modified to the changing levels of activity. This budget is termed as flexible budget.
Unlike master budget, flexible budget is prepared at the end of the period when the actual
activity is known. Flexible budget gives insight in to why the actual results differ from the
planned performance.
The master budget variance is the deviation of the actual results from the master budget. This
master budget variance has two components such as activity level variance and flexible budget
variance. Activity level variance is the difference between the master budget and the flexible
budget. Flexible budget variance is the difference between actual results and the flexible budget
amounts prepared for actual level of activity. The flexible budget variance may be caused by the
change in selling price& Variable cost per unit or/and fixed cost per period. This flexible budget
is further categorized in to price and efficiency variance for direct and indirect cost inputs

~ 84 ~
  Unit 3: Self-Test Questions
Part I. True /false items
1. A static budget is a series of static budgets at different levels of activities.
2. Flexible budgets are widely used in production and service departments.
3. A static budget is an effective means to evaluate a manager's ability to control costs,
regardless of the actual activity level.
4. A flexible budget is a budget that is designed to cover a range of activity.
5. Flexible budget is prepared at the end of the period.
6. A flexible budget performance report compares actual costs to what the costs should have
been, given the planned level of activity for the period.
7. Flexible budget is used for control purposes.

Part II. Multiple Choice Questions

1. A static budget
A. Should not be prepared in a company.
B. Is useful in evaluating a manager's performance by comparing actual variable costs and
planned variable costs.
C. Shows planned results at the original budgeted activity level.
D. Is changed only if the actual level of activity is different than originally budgeted.
2. What is the primary difference between a static budget and a flexible budget?
A. The static budget contains only fixed costs, while the flexible budget contains only
variable costs.
B. The static budget is adjusted for different activity levels, while a flexible budget is
prepared for a single level of activity.
C. The static budget is prepared for a single level of activity, while a flexible budget is
adjusted for different activity levels.
D. The static budget is prepared for a single level of activity, while a flexible budget is
adjusted for different activity levels.
3. The master budget of Company a shows that the planned activity level for next year is
expected to be 50,000 machine hours. At this level of activity, the following manufacturing
overhead costs are expected:
Indirect labor ------------------------------------birr 300,000
Machine supplies ---------------------------------80,000
Indirect materials-------------------------------- 70,000
Depreciation on factory building--------------- 50,000
Total manufacturing overhead----------------- Br. 500,000

~ 85 ~
A flexible budget for a level of activity of 60,000 machine hours would show total
manufacturing overhead costs of
A. Br.420,000 C. Br.540,000
B. Br.504,000 D. Br.600,000
4. Rickets Ltd. prepared a 2010 budget for 90,000 units of product. Actual production in 2010
was 100,000 units. The actual production in 2009 was 97,000 units. To be most useful, what
amounts should a performance report for this company compare?
A. The actual results for 100,000 units with the original budget for 90,000 units
B. The actual results for 100,000 units with a new budget for 90,000 units.
C. The actual results for 100,000 units with last year's actual results for 97,000 units
D. It doesn't matter. All of these choices are equally useful.
5. Star Lite Manufacturing Company prepared a static budget of 50,000 direct labor hours, with
estimated overhead costs of Br.250,000 for variable overhead and Br.60,000 for fixed
overhead. Trepid then prepared a flexible budget at 38,000 labor hours. How much is total
overhead costs at this level of activity?
A. Br.190,000 C. Br.250,000
B. Br.247,000 D. Br.260,000
6. Universal Industries’ budgeted manufacturing costs for 25,000 units are:
Fixed manufacturing costs---------------- Br.25, 000 per month
Variable manufacturing costs------------- Br.300, 000
The company produced 21,000 units during March. How much is the flexible budget for total
manufacturing costs for March?
A. Br.260,000 C. Br.277,000
B. Br.252,000 D. Br.325,000
7. True Masons budgeted costs for 30,000 linear feet of block are:
Fixed manufacturing costs----------------------------- Br.12, 000 per month
Variable manufacturing costs-------------------------- Br.16.00 per linear
True Masons installed 25,000 linear feet of block during March. What are the budgeted total
manufacturing costs in March?
A. Br.320,000 C. Br.400,000
B. Br.360,000 D. Br.412,000

~ 86 ~
8. Wayman Company uses flexible budgets. At normal capacity of 10,000 units, budgeted
manufacturing overhead is: Br.50,000 variable and Br.135,000 fixed. If Wayman had actual
overhead costs of Br.187,500 for 11,000 units produced, what is the difference between
actual and budgeted costs?
A. Br.2,500 unfavorable C. Br.4,500 unfavorable
B. Br.2,500 favorable D. Br.6,000 favorable
9. A company’s static budget estimate of total overhead costs was Br.100,000 based on the
assumption that 10,000 units would be produced and sold. The company estimates that 30%
of its overhead is variable and the remainder is fixed. What would be the total overhead costs
according to the flexible budget if 12,000 units were produced and sold?
A. Br.96,000 C. Br.106,000
B. Br.100,000 D. Br.116,000
10. A flexible budget
A. Is prepared when management cannot agree on objectives for the company.
B. Projects budget data for various levels of activity.
C. Is only useful in controlling fixed costs.
D. Cannot be used for evaluation purposes because budgeted data are adjusted to reflect
actual results.
11. What budgeted amounts appear on the flexible budget?
A. Original budgeted amounts at the static budget activity level
B. Actual costs for the budgeted activity level
C. Budgeted amounts for the actual activity level achieved
D. Actual costs for the estimated activity level
12. In the Glexo Company, indirect labor is budgeted for Br.36, 000 and factory supervision is
budgeted for Br.12, 000 at normal capacity of 80,000 direct labor hours. If 90,000 direct
labor hours are worked, flexible budget total for these costs is
A. Br.48,000 C. Br.52,500
B. Br.54,000 D. Br.49,500

~ 87 ~
 UNIT FOUR

DECISION MAKING AND RELEVANT INFORMATION

CONTENTS OF THE UNIT

4.1. Introduction.
4.2. The Accountant’s Role in Decision Making.
4.3. The Meaning of Relevance.
4.4. Special Decision Areas.
4.4.1. Make or Buy Decision.
4.4.2. Special Order Decisions.
4.4.3. Add or Drop Decisions.
4.4.4. Optimal Use of Limited Resources.

Objectives of the Unit

Dear Learner, after studying this unit, you will be able to:
 Describe the management accountant’s role in the decision process.
 Explain the relation between quantitative and qualitative analyses in decision making.
 Discriminate between relevant ad irrelevant information for making decisions.
 Identify relevant costs and benefits, giving proper treatment to sunk costs, opportunity
costs and unit costs.
 Identify qualitative and quantitative factors to be considered in a make or buy decision.
 Prepare an analysis to support a decision to make or buy certain parts or products.
 Analyze data by the contribution approach to support a decision for accepting or
rejecting special sales order.
 Analyze data by the relevant-information approach to support a decision for adding or
deleting a product line.
 Compute a measure of product profitability when production is constrained by a scare
resource.

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4.1. Introduction.

Dear Learner, decision-making is a fundamental part of management. Managers are

constantly faced with problems of deciding what product to sell, what production method to use,
whether to make or buy component parts, what prices to charge, what channels of distribution to
use, whether to accept special orders at special prices, and so forth. This unit covers the role of
management accounting information in a variety of marketing and product decisions.

4.2. The Accountant’s Role in Decision Making.

 The management accountant’s role in the decision-making process is to provide relevant

information to the managers who make the decisions. Production managers typically make the
decisions about alternative production processes and schedules, marketing managers make
pricing decisions, and specialists in finance usually are involved in decisions about major
acquisitions of equipment. All of these managers require information pertinent to their decisions.
The management accountant’s role is to provide information relevant to the decisions faced by
managers throughout the organization. Thus, the management accountant needs a good
understanding of the decisions faced by those managers.

~ 89 ~
4.3. The Meaning of Relevance.

 Accountants have an important role in the decision-making process, not as a decision

maker but as collectors and reporters of relevant information. What makes information relevant
to a decision problem? Relevant information is the predicted future costs and revenues that will
differ among the alternatives. These two criteria are discussed here under:

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.

Different under Competing Alternatives: Relevant information must involve future costs or
benefits that differ among the alternatives. 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.

Example: XYZ Company, a manufacturer of a line of ashtrays, is thinking of using aluminum

instead of copper in the manufacture of its product. Historical direct material costs were Br. 0.30
per unit. The company expected future costs for aluminum is Br 0.20 and it is unchanged for
copper. Direct labor costs were Br. 0.70 per unit and will not be affected by the switch in
materials. The analysis in a nutshell is as follows.

Copper Aluminum Difference

Direct material Br. 0.30 Br. 0.20 Br. 0.10
Direct labor 0.70 0.70 -

Required: Given the above-summarized data identify the relevant data for the decision on hand.

~ 90 ~
Solution:
The cost of copper and direct labor costs used for this comparison probably came from historical
cost records on the amount paid most recently for copper and direct laborers, respectively. Past
or historical costs are relevant to the decision only if they are expected to continue in the future,
or are used as the basis for predicting the future costs.

In the foregoing analysis, the material cost (the expected future cost of copper compared with the
expected future cost of aluminum) is the only relevant cost. The material cost met both criteria
for relevant information.

That is, bearing on the future and an element of difference between the alternatives. However,
the direct – labor cost will continue to be Br. 0.70 per unit regardless of the material used. It is
irrelevant because the second criterion – an element of difference between the alternatives – is
not met.

Therefore we can safely exclude direct labor. There is no harm in including irrelevant items in a
formal analysis, provided that they are included properly. However, confining the reports to the
relevant items provides greater clarity and time savings for busy managers.

Accuracy and Relevance

Information used for decision-making would be both relevant and accurate. However, the cost of
such information exceeds its benefits. As a result, accountants often trade off relevance versus
accuracy.

Relevant information must be reasonably accurate but not precisely so. Precise but irrelevant is
worthless for decision – making. On the other hand, imprecise but relevant information can be
useful.

The degree to which information is relevant or precise often depends on the degree to which it is
qualitative or quantitative. Qualitative aspects are those for which measurement in birrs and cents
is difficult and imprecise. Quantitative aspects, on the other hand, are those for which
measurement is easy and precise. To summarize, relevance is more crucial than precision in
decision – making. Thus, a qualitative aspect may easily carry more weight than a measurable
(quantitative) aspect.

~ 91 ~
Why Isolate Relevant Information?

 Why is it important for the management accountant to isolate the relevant costs and
benefits in a decision analysis? The reasons are twofold.

First, generating information is a costly process. The management accountant can simplify and
shorten the data gathering process by focusing on only relevant information.

Second, people can effectively use only a limited amount of information. If a manager is
provided with irrelevant revenues and costs, these figures can cause information overload, and
decision-making effectiveness of the manager declines.

What are relevant costs in the decision making process?

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
“All future costs are relevant in decision making.” Do you agree? Why?
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
Distinguish b/n quantitative & qualitative factors in decision-making. Give examples.
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________

~ 92 ~
4.4. Special Decision Areas.

 Many of the decisions described in this unit are frequently referred to as alternative
choice decision. Alternative choice decisions are situations with two or more courses of action
from which the decision maker must select the best alternative.

The variety of alternative choice decisions is limitless. Some business example follows:
 Should we make or buy a component part?
 Should we accept a special order for a product below our normal selling price?
 Should we raise the price of a product or maintain the current price?
 Should we sell a joint product at the split off point or process it further?
 Should we keep our copying machine or acquire a faster one?

The analyses of these and other types of alternative choice decisions are aided by relevant cost
and benefit data. The discussions that follow illustrate a variety of to each decision. The first
special decision area a for which we examine relevant information is the make or buy decisions.

4.4.1. Make or Buy Decisions

 Managers in manufacturing companies are often faced with the problem whether to
manufacture a component used in manufacturing a product or to purchase from the outside.
Production of such basic materials as screws, nails, washers, sheet metal and so on is not usually
economical owing to specialization and returns to scale. These materials can almost always be
acquired more cheaply from outside suppliers. But for many materials, such as subassemblies
and special parts, it is not always clear which is least costly means of acquisition. The cost and
management accounting system assist managers in arriving at a correct decision by presenting
suitable analysis of the cost of production and comparing it with the purchase price of the
product.

In make or buy decisions, the appropriate means of analysis is to compare the relevant cost of
buying the part with the relevant cost of making the part. 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.

~ 93 ~
The relevant cost of making the component is often the variable costs incurred to produce the
component. In some cases, however, the company will need to acquire special equipment to
produce the product or will hire additional supervisory personnel to assist with making the
product. These incremental fixed costs will be part of the relevant cost of making the part. The
alternative chosen-make or buy is typically the one with the lowest cost.

In the final decision regarding make or buy qualitative factors, besides the quantitative data,
should be considered as part of the decision.

In make or buy decision, the following qualitative factors, besides the quantitative considerations
may favor the decision to “buy”:
 Advantage of long-term relationship with suppliers.
 Possibility of shortage of material or labor for making the component.
 Uninterrupted supply of requisite quality from reliable suppliers.
 The internal demand for the product under consideration is small and, as such, it is no use
to set up manufacturing facilities for it and so forth.

On the contrary, the following qualitative factors may favor the decision “to make”:
 The quality of the product is decided to be controlled.
 If the purchase price is likely to rise due to increased demand in the market, it becomes
uneconomical to buy.
 Where the technical know-how is to be kept secret and not to be passed on to the
suppliers and so on.

Example: Great Company manufactures 60,000 units of part XL-40 each year for use on its
production line. The following are the costs of making part XL-40:

Total Costs Cost per

60,000 units unit
Direct material Br. 480,000 Br. 8
Direct labor 360,000 6
Variable factory overhead (FOH) 180,000 3
Fixed FOH 360,000 6
Total manufacturing costs Br. 1,380,000 Br. 23

~ 94 ~
Another manufacturer has offered to sell the same part to Great for Br. 21 each. The fixed
overhead consists of depreciation, property taxes, insurance, and supervisory salaries. The entire
fixed overhead would continue if the Great Company bought the component except that the cost
of Br. 120,000 pertaining to some supervisory and custodial personnel could be avoided.

Required:
a) Should the parts be made or bought? Assume that the capacity now used to make parts
internally will become idle if the pats are purchased?
b) Assume that the capacity now used to make parts will be either (i) be rented to nearby
manufacturer for Br. 60,000 for the year or (ii) be used to make another product that will
yield a profit contribution of Br. 250,000 per year. Should the company purchase them
from the outside supplier?

Solutions:
a) To approach the decision from a financial point of view, the manager must focus on the
relevant or differential costs. The differential cost can be obtained by eliminating from the
cost data those costs that are not avoidable –that is, by eliminating the sunk costs and the
future costs that will continue regardless of whether the parts XL-40 are produced internally
or purchased from outside.

Thus, the relevant cost computation follows:

COST TO MAKE COST TO BUY
Per Unit Total Per Unit Total
Direct materials Br. 8.00 Br. 480,000
Direct labor 6.00 360,000
Variable FOH 3.00 180,000
Fixed FOH, avoidable 2.00 120,000
Total cost Br. 19.00 Br. 1,140,000 Br. 21.00 Br. 1,260,000

Here above, the analysis shows that the variable costs of producing the part XL-40 (materials,
labor, and variable overhead) are differential costs. All these variable costs, therefore, can be
avoided or eliminated by buying the part from the outside supplier.

~ 95 ~
Again, are only the variable costs relevant? No. Perhaps Br. 120,000 of the total fixed factory
overhead cost is avoidable by purchasing the component part from outside, then it too will be a
differential cost and relevant to the decision. Therefore, the decision should be made by
comparing the total of all variable costs and the avoidable fixed factory overhead against the
total purchase price- that is, cost to buy.

Recommendation: Great Company should reject the outside supplier’s offer because it costs Br.
2 less per unit to continue to make the part XL-40. This is a total of Br. 120,000 net advantages.
Relevant Costs Per Unit
Cost to buy Br. 21.00
Cost to make 19.00
Advantage of making the part internally Br. 2.00

Total advantage = Br. 2.00 x 60, 000 units = Br. 120, 000
b) If the space now is used to produce the part would otherwise be idle, then Great should
continue to produce its own XL-40 and the supplier’s offer should be rejected, as stated
above. Idle space that has no alternative use has an opportunity cost of zero.

But what if the space now being used to produce the part would not sit idle rather could be used
for some other purpose? In that case, the space would have an opportunity cost that would have
to be considered in assessing the desirability of the supplier’s offer. What would this opportunity
cost be? It would be the segment margin that could be derived from the best alternative use of the
space. Therefore, the use of the idle facilities may change our previous decision in requirement
(a) above.
Assuming the space now being used to produce part XL-40 would be:
I. Rented to a nearby manufacture for Br. 60,000 per annum or
II. Used to produce other product that contributes a profit of Br. 250,000 per year, the
relevant cost computation follows:
Make Buy and Leave Buy and Rent Buy and Produce
Facility Idle out Other Product
Cost to obtain parts Br. 1,140,000 Br. 1,260,000 Br. 1,260,000 Br. 1,260,000
Contribution from other - - (250,000)
products
Rent revenue - - (60,000) -
Net relevant costs Br. 1,140,000 Br. 1,260,000 Br. 1,200,000 Br. 1,010,000

~ 96 ~
Great company would be better off through accepting the supplier’s offer and using the available
facility to produce the new product line. This move has the least net relevant cost of Br.
1,010,000.

Unit 4 Activity 1
Assume that a division of Yemi 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.

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
A small local company has offered to supply the components at a price of Br. 7.80 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.

Required: 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.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

~ 97 ~
4.4.2. Special Order Decisions

 Potential customers seeking a special deal will frequently approach firms directly with
their proposal. For example, a discount department store chain planning a big spring sale offers
to make a large one-time purchase of a firm’s product but wants a reduced price. Or a foreign
buyer is interested in a firm’s product and also requests a reduced selling price. In each case
management must decide whether to accept or reject the special sales order at a reduced selling
price. In brief, a special order is a one-time order that is not considered part of the company’s
normal ongoing business.

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. The
incremental costs will be the amount of the expected cost increase if the offer is accepted. The
incremental cost usually includes variable manufacturing costs of producing the units. Since the
units being sold in the special order are not being sold through the firm normal distribution
channel, the firm may or may not incur variable selling and administrative expenses in
conjunction with the special order.

The incremental costs usually do not include fixed manufacturing costs. Although the fixed
costs must be incurred to permit production, the amount of fixed costs incurred by the firm
usually will not increase if the special order offer is accepted. For the same reason, other fixed
expenses, such as fixed selling and administrative expenses, are usually not relevant in the
special order price.

However, 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. The opportunity
cost would be the contribution margin forgone on regular sales that have to be reduced to
accommodate the special order. The relevant costs to accept the special order, therefore, would
include a forgone contribution margin on regular sales that could not be made in addition to the
incremental costs associated with the special order that have already been discussed.

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Example: Consider the following details of the income statement of Alex Company for the year
ended December 31, 20x3.
Sales (1,000,000 units) Br. 20,000,000
Cost of Goods Sold 15,000,000
Gross Margin Br. 5,000,000
Selling and Administrative Expenses 4,000,000
Operating Income Br. 1,000,000

Alex’s fixed manufacturing costs were Br. 3 million and its fixed selling and administrative costs
were Br. 2.9 million.

Near the end of the year, Ethio Company offered Alex Br. 13 per unit for 100,000 unit special
order. The special order would not affect Alex’s regular business in any way. Furthermore, the
special sales order would not affect total fixed costs and would not require any additional
variable selling and administrative expenses.

Required: Should Alex accept or reject the special order? By what percentage the operating
income decreases or increases if the order had been accepted? Assume that the company would
utilize its idle manufacturing capacity to accept the special order.

Solution:
There are two approaches to costs on income statement.
1. Absorption/financial approach
2. Contribution approach

An absorption approach is a costing technique that considers all factory overheads (both variable
and fixed) to be product costs that become an expense in the form of manufacturing cost of
goods sold as sales occur.

A contribution approach is a method of internal reporting (management accounting) that

emphasizes the distinction between variable and fixed costs for the purpose of better decision.

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Financial Approach Contribution Approach
Sales xxx Sales xxx
Cost of goods sold xxx Variable costs xxx
Gross profit xxx Contribution margin xxx
Selling and Administrative expenses xxx Fixed costs xxx
Operating income xxx Operating income xxx
Figure 4-2: Approaches to costs on income statement.

The correct analysis to the above problem employs the contribution approach to income
statement, not the financial approach. The fallacy in the case of the later approach is that it treats
a fixed cost, i.e., fixed manufacturing cost as if it were variable.

Figure 4-3: The Correct Analysis.

Without special Effect of With special
order special order order
1,000,000 units 100,000 units 1,100,000 units
Sales Br. 20,000,000 Br. 1,300,000 Br. 21,300,000
Variable expenses
Manufacturing Br. 12,000,000 Br. 1,200,000 Br. 13,200,000
Selling and Administrative 1,100,000 - 1,100,000
Total variable expenses Br. 13,100,000 Br. 1,200,000 Br. 14,300,000
Contribution Margin Br. 6,900,000 Br. 100,000 Br. 7,000,000
Fixed expenses
Manufacturing Br. 3,000,000 - Br. 3,000,000
Selling and administrative 2,900,000 - 2,900,000
Total fixed expenses Br. 5,900,000 - Br. 5,900,000
Operating income Br. 1,000,000 Br. 100,000 Br. 1,100,000

The accountant’s role in decision making is primarily that of a technical expert on cost analysis,
i.e., collecting and reporting relevant information. However, many managers want the accountant
to recommend the proper decision; the final choice always rests with the operating executives.

Recommendation: Based on the relevant data, Alex Company should accept the special order
because it brings an additional income of Br. 100,000 for company and as a result the operating
income increase by 10% if the order had been accepted.
Income with special order Br. 1,100,000
Income without special order 1,000,000
Additional income if the order had been accepted Br. 100,000

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%  NI = NI
NIo
Where %  NI = Percentage change in income.
 NI = Change in income.
NIo = Income if the special order had not been accepted.

%NI = NI = Br. 100,000 = 0.1 or 10%

NIo Br. 1,000,000

Figure 4-4: The Incorrect Analysis.

Without Special Incorrect effect With special
order of special order order
1,000,000 units 100,000 units 1,100,000 units
Sales Br. 20,000,000 Br. 1,300,000 Br. 21,300,000
Manufacturing COGs* 15,000,000 1,500,000 16,500,000
Gross margin Br. 5,000,000 Br. (200,000) Br. 4,800,000
Selling & administrative 4,000,000 - 4,000,000
expenses
Operating income Br. 1,000,000 Br. (200,000) Br. 800,000

*CoGS denote Cost of Goods Sold.

Here above, the analysis treats the fixed manufacturing CoGS as if it were variable. Refer the
effect of the special order on manufacturing CoGS; it amounted to Br. 1,500,000 that include Br.
300,000 fixed cost. However, the special sales order would not affect the total fixed costs.

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Unit 4 Activity 2
1) What is the advantage of the contribution approach as compared with the absorption
approach?
2) ABC Company produces a single product. The cost of producing and selling a single unit of
this product at the company’s normal activity level of 8,000 units per month is as follows:
Direct materials……………………………… Br. 2.50
Direct labor……………………………………… 3.00
Variable manufacturing overhead………………. 0.50
Fixed manufacturing overhead………………….. 4.25
Variable selling and administrative expenses…… 1.50
Fixed selling and administrative expenses……… 2.00

The normal selling price is Br.15 per unit. The company’s capacity is 10,000 units per month. An
order has been received for 2,000 units at a price of Br. 12 per unit. This order would not disturb
regular sales. If the order is accepted, by how much will the monthly profits be increased or
decreased? The order would not change the company’s fixed cost and would not require any
additional variable selling and administrative expenses.

4.4.3. Add or Drop Decisions

Decisions relating to whether old product lines or other segments of a company should be
dropped and new ones added are among the most difficult that a manager has to make. In such
decisions, many factors must be considered that are both qualitative and quantitative in nature.
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. Unavoidable costs are

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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.

Example: Eyoha Department Store has three major departments: groceries, general merchandise,
and drugs. Management is considering dropping groceries, which have consistently shown a net
loss. The following table reports the present annual net income (in thousands).

DEPARTMENTS
General
Groceries Merchandise Drugs Total
Sales Br. 1,000 Br. 800 Br. 100 1,900
Variable CoGS & Expenses 800 560 60 1,420
Contribution margin Br. 200 Br. 240 Br. 40 Br. 480
Fixed expenses
Avoidable Br. 150 Br. 100 Br. 15 Br. 265
Unavoidable 60 100 20 180
Trial fixed expenses Br. 210 Br. 200 Br. 35 Br. 445
Operating income (loss) Br. (10) Br. 40 Br. 5 Br. 35

Required:
a) Which alternative would you recommend if the only alternatives to be considered are
dropping or continuing the grocery department? Assume that the total assets would be
unaffected by the decision and the space made available by dropping groceries would remain
idle.
b) Refer the income statement presented above. However, assume that the space made available
by dropping groceries could be used to expand the general merchandise department. The
space would be occupied by merchandise that would increase sales by Br. 500,000, generate
a 30% contribution margin percentage and have additional avoidable fixed costs of Br.
70,000. Should Eyoha discontinue grocery and expand merchandise department?

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 Solutions
a)
A B A–B
Total before change Effect of dropping Total after change
grocery
Sales Br. 1,900 Br. 1,000 Br. 900
Variable COGS and 1,420 800 620
Expenses
Contribution margin Br. 480 Br. 200 Br. 280
Fixed expenses
 Avoidable Br. 265 Br. 150 Br. 115
 Unavoidable 180 - 180
Total fixed expenses Br. 445 Br. 150 Br. 295
Operating income (loss) Br. 35 Br. 50 Br. (15)

Income with grocery department = Br. 35,000

Loss assuming grocery is eliminated = (15,000)
Disadvantage of discontinuing grocery = Br. (50,000)
Notice that all of the grocery’s variable expenses are avoidable. If the grocery department is
discontinued, the Br. 60,000 of the fixed expenses will continue. Eyoha Department Store will
incur these expenses regardless of its decision about that particular department.

Recommendation: Dropping grocery and leaving the vacated facilities idle would be worse.
Groceries bring in contribution margin of Br. 200,000, which is Br. 50,000 more than the Br.
150,000 fixed expenses that would be saved by closing the grocery department.
b)

A B C (A – B) + C
Total Effect of Effect of Total
before Dropping Expanding after
change Groceries General Change
Merchandise
Sales Br. 1,900 Br. 1000 Br. 500 Br. 1,400
Variable COGS and Expense 1,420 800 350 970
Contribution margin Br. 480 Br. 200 Br. 150 Br. 430
Fixed expenses
o Avoidable Br. 265 Br. 150 Br. 70 Br. 185
o Unavoidable 180 - 180
-
Total fixed expenses Br. 445 Br. 150 Br. 70 Br. 365
Operating income (loss) Br. 35 Br. 50 Br. 80 Br. 65

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Effect of expanding general merchandise:
Incremental revenue = Br. 500,000
Incremental cost
Variable cost = (1-0.30) x 500,000 = (350,000)
Fixed cost = (70,000)
Incremental income Br. 80,000

Note: All birrs in the exhibit above are in thousands.

Recommendation: The conclusion in (a) will be correct if and only if the space made available
by dropping grocery would be idle. As the above analysis shows, dropping grocery and using
the vacated space to expand general merchandise is recommendable. The Br. 80,000 increase in
operating income of general merchandise more than offset the Br. 50,000 decline from
eliminating groceries, providing an overall increase in operating income of Br. 30,000, i.e., Br.
65,000 less Br. 35,000.

4.4.4. Optimal Use of Limited Resources.

 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. 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.

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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.

Example: Wedajo 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%

Required:
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.
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.

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.
b) 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.

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In requirement (b) above, for instance, the productive capacity is the limiting factor because only
10, 000hours 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 unit of the scarce resource (a÷b) Br.16 per machine hour Br. 12 per machine hour

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.

Summary

The accountant is responsible for seeing that relevant, timely data are available
to guide management in all of its decisions, including those that relate to special, non-
routine situations. Reliance by management on irrelevant data can lead to incorrect
decisions, reduced profitability, and inability to meet stated objectives. All future costs that
make difference between the alternatives under consideration are relevant.

The concept of cost relevance has wide application. In this unit, we have observed its use
in make or buy decisions, in special order decisions, in discontinuance of product-line
decisions, and in decision relating to the effective use of economic resources. This list does
not include all of the possible applications of the relevant cost concept. Indeed, any
decision involving costs hinges on the proper identification and use of those costs that are
relevant, if the decision is to be made properly.

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Unit 4: Self-Test Questions
Part One: True or False
1) The book value of old equipment is not a relevant cost in a decision.
2) All future costs are relevant in decision making.
3) A cost that will be incurred regardless of which course of action a manager takes is relevant
to the manager’s decision.
4) Opportunity costs are recorded in the accounts of an organization.
5) Only the variable costs identified with a product are relevant in a decision concerning
whether to eliminate the product.

Part Two. Workout problem.

A company is producing, on average, 10,000 units of product A per month despite having 30%
more capacity. Costs per unit of product A are as follows:
Direct Material Br. 8.00
Direct Labor 5.00
Variable Factory Overhead 2.00
Variable Selling Expense 0.50
Fixed Factory Overhead 3.00
Fixed Office Expense 2.00
Br. 20.50

The company received a special order of 2,000 units of product A at Br. 17.00 per unit from a
new customer. Should the company accept the special order, provided that the customer has
agreed to pay the variable selling expenses in addition to the price of the product?

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 UNIT FIVE

DECENTRALIZATION AND TRANSFER PRICING

CONTENTS OF THE UNIT

5.1. Introduction.
5.2. Comparison of Centralization and Decentralization
5.3. Benefits and drawbacks of decentralization
5.4. Organizational Structure and Decentralization
5.5. Responsibility Center
5.6. Transfer pricing
5.6.1. Purposes of Transfer Pricing
5.6.2. Accounting for Transfer Pricing
5.6.3. Alternative Methods of Transfer Pricing

Objectives of the unit

Dear Learner, after studying this unit, you will be able to:
 Distinguish between centralization and decentralization
 Define decentralization and identify its expected benefits and costs
 Distinguish between profit centers and decentralization
 Define the concept of decentralization and its purpose
 Define the concept of Responsibility Center
 Identify the bases to determine transfer prices

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 5.1. Introduction

Management’s ability to react to change is determined by the timing and nature

of available information, the continuous nature of change; its limited familiarity with the
operations of other units and the difficulty of predicting their ripple effects of decisions and
actions.
This chapter deals with the role of management control system in decentralized organizations. It
also addresses the advantages and disadvantages associated with centralized and decentralized
forms of administration.
5.2. Comparison of Centralization and Decentralization

 Some organizations are very centralized, decisions are handled down from the top
and subordinates carry them out. At the extreme there are highly decentralized organizations in
which decisions are made at divisional and departmental levels. Most organizations
administration falls between the two extremes. In many organizations operating units are
decentralized and supporting departments like research and development and finance are
centralized.
Centralized organizations are those organizations in which decisions are made by a relatively
few personnel in the top level of management of the organizations while in decentralized
organization decisions are devolved to middle and lower level managerial positions.
As organizations grow in size and capacity they will undertake more diverse and complex
activities, their geographical market and diversity of their product tend to expand. When this
happens, the expertise and time required to manage the organization would increase. The
organization responds to these increasing needs by adding different levels of managemet such as
middle and lower level of management hierarchy because central control of these widely
different business operations becomes inefficient. Thus, organizations elect to delegate decision
making authority to managers throughout the organization. This delegation of freedom to make
decisions is said to be decentralization. It is a management philosophy that attempts to make
each division of the organization as autonomous to pass different decisions. The necessary
authority and responsibility to administer departmental operations are delegated to department
management. Central management provides only general operating guidelines and goals for each

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divisions. Decentralized management in an organization leads to the need for measuring and
evaluating divisional operating performance. In decentralized organization structure managers
have a great freedom to make decisions. The greater freedom, the greater autonomy. Total
decentralization means minimum constraints and maximum freedom for managers at the lowest
levels of the organization to make decisions. However, the organizations’ structure fall
somewhere between pure centralization and pure decentralization.
5.3. Organizational Structure and Decentralization

 Management control system must be fit to the organization’s structure. An

organization whose organizational structure is decentralized has additional issues to consider for
its management control system to be effective.
All organizations exist on a continuum between fully centralized, where all decisions that affect
day-to-day operations are made by top management, to fully decentralized, where managers at
lower levels make day-to-day and sometimes strategic decisions without senior management
approval. Arguments can be made for and against decentralization because the success of any
management structure often depends on the corporate culture and overall structure of the
organization.
5.4. Benefits and drawbacks of decentralization

 Advocates of decentralization consider that managers at lower levels can have a better
understanding of the local conditions and concerns than senior managers, and that lower level
managers are therefore in a better position to make certain types of decisions.
In this view, decentralization can
a. segregate duties
b. create greater responsiveness to local needs
Sound decisions cannot be made without good decisions. Relatively lower level managers are
better informed about their customers, competitors, suppliers and employees as well as local
factors such as the way to decrease costs and improve the competitive advantage of the
organization in which they are working. Therefore, decentralization improves the organization’s
knowledge of market place and improves service to customers.
c. Lead to quicker decision-making:-
Decisions are better and more timely because of the manager’s proximity to local conditions.

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Decentralization facilitates decision making process, creating competitive advantage over
centralized organizations. Centralization slows decision making as responsibility for decisions
creeps upward through layer after layer of management. Lower level managers can react a
changing environment more quickly than top managements can. In decentralized management
delays occur while information is transmitted to decision makers, and further delay exists while
information are communicated to lower managers.
d. increase motivation: managers’ motivation increases because they have more control
over results
Lower level managers are more motivated when they have a freedom to make decisions. It gives
local managers decision making ability and other managerial skills that help them in moving
upward in the organization, ensuring continuity of leadership.
e. Aid management development and learning, and sharpen the focus of managers
Increased decision making provides better training for managers for higher level positions in the
future. Decentralization allows managers to receive on job training in decision making. It gives
lower level managers more responsibility helps to develop an experienced pool of management
talent and skill to fill higher level management positions. Top management can observe the
outcomes of local managers decisions and evaluate their potential for promotion.
f. Top managers are not distracted by routine, local decision problems.
Arguments against decentralization suggest that some decisions are too important to leave to
lower-level managers. Depending on how they are compensated, managers at this level are
sometimes encouraged to make decisions counterproductive to the goals and strategies of the
organization as a whole, and may also be tempted to make decisions in their own best interests
rather than the company’s.

g. Sharpens focus of departmental managers

In decentralization organization structure, managers of subunits has a concentrated focus in the
operation of their department. A division is more flexible than a large subunit to adapt quickly to
changing market opportunities.
h. Efficient use of management time and devolving of problems to a manageable size
By decentralizing decision making top management would be relieved of the burden of day to
day operating decisions, and can speed more time and effort on strategic planning for the entire

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organization. Therefore local managers may be able to make better operating decisions in a very
short time because of their technical expertise and knowledge about the local conditions. In short
decentralization reduces complexity of time and increase the efficiency of managers in making
sound decisions.
In this view, decentralization has the following costs
a. Lead to sub-optimal decision making (goal incongruence)
Goal incongruent arises when decision’s benefit to one sub unit is more than the costs/ losses/ of
benefit to the organization as a whole. This cost arises because top management has given up
control over decision making. It exists when either/both/ of the of the following conditions occur
 There is absence of harmony/ congruence/ among the overall goals of the organization,
subunits and individual goals of decision makers
 Lack of guidance to subunit managers concerning the effects on their decisions on other
parts of the organization. Sub optimal decision making is most likely to occur when the
subunits in the organization are more likely to occur when the subunits in the
organization are highly independent.
b. Result in duplication of duties
Several subunits of the organization may undertake the same activity separately. For instance,
there may be a duplication of supporting department in each division such as accounting, human
resource, legal, transport service if an organization is extremely decentralized. Centralizing these
functions helps to consolidate their service and at the same time reduces resources of these
services.
c. Decrease loyalty toward the organization as a whole
d. Increase costs of gathering and processing information.
Decentralization increases the cost of accumulating and processing information in making
decisions by each sub unit. Top managers may spend too much time in obtaining information
about each subunit of the organization and process to coordinate their actions. This is time
consuming and a cost consuming in evaluating the performance of decentralized units and their
managers.
e. Increases time to negotiate for goods and services
Managers in decentralized units may waste time negotiating with other units about goods and
services one unit provides to others.

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 f. Focuses the manager’s attention on the subunits rather than the organization as a
whole
Individual sub unit managers may consider the sub unit that they administer as a competing unit
with the operation of other sub units in the same organization. Eventually, managers may be
unwilling to share information or to assist other sub units when they face problems.

Degrees of Decentralization


Managers decide on the degree of decentralization to set up for different purposes.
For example, top management might consider that centralization of international transfer pricing
decisions would allow the company to lower overall taxes with a centrally coordinated strategy
while leaving other areas, such as budget preparation, decentralized. Such a structure would
allow managers to have more say in the budgeting process and could therefore increase buy-in
on company goals and objectives.

Compare Centralization and Decentralization.

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
State some of the Benefits and drawbacks of decentralization.
__________________________________________________________________
______________________________________________________________

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 Unit 5 Activity 1
1. What is decentralization organization? -------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------
2. What are the pros and cons of decentralization? --------------------------------------------------------
-------------------------------------------------------------------------------------------------------------------
3. How do you characterize the nature of administration existed in the organization that you are
currently working? ---------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------

5 . 5. Responsibility Center

 A responsibilit y center is defined as a set of activit ies assigned to a manager, a group

of managers, or other emplo yees.
For example, a set of machines and machining tasks are a responsibilit y center for a production
supervisor; the full production depart ment may be a responsibilit y center for department head ;
and the ent ire organization may be a responsibilit y center for the president.
An effect ive management control system gives each lower-level manager responsibilit y for a

group of activit ies and object ives and then reports on:

 The results of the activit ies.

 the managers influence on those results and
 Effects of uncontrollable events.

System designers apply responsibilit y account ing to identify what parts of the organizat ion have
primary responsibilit y for each objective, develo p measures of achievement of object ives, and
create reports of these measures by organizat ion subunits, or responsibilit y center.
Responsibilit y centers usually have mult iple object ives (e.g. cost and qualit y) that the

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management control system mo nitors. Responsibilit y centers usually are clarified according to
their financial responsibilit y, as cost centers, profit centers, or investment centers.
A cost center: Is a responsibilit y center for which costs are accumulated. Its financial
responsibilit ies are to control and report costs only. An ent ire department may be considered a
single cost center, or a department may contain several cost centers. For example, although one
manager may supervise an assembly department, it may contain several assembly lines and
regard each assembly line as a separate cost center. The determinat ion o f the number of cost
centers depends on cost-benefit considerat ions.
Profit Center: Is a responsibilit y center for controlling revenue as well as costs (or expenses)
that is, profitabilit y. Despite the name, a profit center can exist in nonpro fit organizat ions
(though it might not be referred to as such) when a responsibilit y center receives revenues for its
services. All profit center managers are responsible for both revenues and costs, but they ma y
not be expected to maximize profits.
An investment center: Is a responsibilit y center whose success is measured not only by it s
inco me, but also by relat ing that inco me to its invested capital, as in a ratio of inco me to the
value of the capital emplo yed.
5.6. Transfer pricing

 A centralized department can be a profit center. Centralization relates to the degree of

autonomy that a department has for decision making. This concept is independent of the type of
responsibility center used to evaluate performance. (For example, the Glass Department could be
a profit center if upper management chooses a transfer price for the glass transferred from the
Glass to the Wood and Metal Departments.) A department may be organized as a profit center
but it will be centralized if it has little freedom in making decisions.
In many organizations, intermediate products or services are transferred from one subunit to
another within the organization. The price at which the product or service is transferred
determines the profitability of the particular subunit. This in turn can affect management
compensation, and may be used for performance measurement evaluations through the
company’s management control system.
The management accounting theme of cost behavior (variable and fixed) is particularly important
in this topic because transfer pricing is based on a straightforward distinction between variable

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and fixed costs. Cost definitions are also important because variable costs are taken as proxy for
marginal product costs, and opportunity costs are considered in setting transfer prices.
Transfer pricing helps manage the flow of goods and services in companies that are divided into
responsibility centers. Although transfer prices are usually set between profit and investment
centers, in practice transfer pricing can take the form of transferring costs from cost centers to
other divisions. There is no single pricing policy to cover all transfer situations.
5.6.1. Purposes of Transfer Pricing

There are two main reasons for instituting a transfer pricing scheme:
• Generate separate profit figures for each division and thereby evaluate the performance of each
division separately.
• Help coordinate production, sales and pricing decisions of the different divisions (via an
appropriate choice of transfer prices). Transfer prices make managers aware of the value that
goods and services have for other segments of the firm.
• Transfer pricing allows the company to generate profit (or cost) figures for each division
separately.
• The transfer price will affect not only the reported profit of each center, but will also affect the
allocation of an organization’s resources.
5.6.2. Accounting for Transfer Pricing

If intra-company transactions are accounted for at prices in excess of cost, appropriate

elimination entries should be made for external reporting purposes. Examples of items to be
eliminated for consolidated financial statements include:
• Intra company receivables and payables.
• Intra company sales and costs of goods sold.
• Intra company profits in inventories
5.6.3. Alternative Methods of Transfer Pricing

 A transfer pricing policy defines rules for calculating the transfer price. In addition, a
transfer price policy has to specify sourcing rules (i.e., either mandate internal transactions or
allow divisions discretion in choosing whether to buy/sell externally). The most common transfer
pricing methods are described below.

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 I. Market-based Transfer Pricing

 It is available in the general market to third-party outside buyers and sellers. Market-
based transfer prices are used to determine internal transfer prices.
Using market-based transfer prices generally leads to the most optimal pricing decision for a
company. Under conditions of perfectly competitive markets — when there are homogeneous
products and neither buyer nor seller can influence the pricing structure of the market —
interdependence between subunits is minimal and using market prices offers no additional costs
or benefits. The objectives of goal congruence, evaluation of management effort, optimal subunit
performance, and subunit autonomy can be achieved using market-based transfer prices.
If management wanted to ensure internal transfers to maintain quality, a transfer price of less
than the market price would motivate divisional managers to purchase internally. If both units
had autonomy to do so, the giving division would be motivated to sell externally to another
company. Setting the price at the market price ensures both divisions act in the best interests of
the company as a whole.
When market prices fluctuate greatly, companies may opt to use long-run average prices, rather
than market-based prices.
When the outside market for the good is well-defined, competitive, and stable, firms often use
the market price as an upper bound for the transfer price.
Concerns with market-based Transfer Pricing
When the outside market is neither competitive nor stable, internal decision making may be
distorted by reliance on market-based transfer prices if competitors are selling at distress prices
or are engaged in any of a variety of “special” pricing strategies (e.g., price discrimination,
product tie-ins, or entry deterrence). Also, reliance on market prices makes it difficult to protect
“Infant” segments.
II. Negotiated Transfer Pricing

 Managers are allowed to negotiate their own transfer prices and are given the
autonomy to buy from, or sell to, a subunit. Some managers feel this is a good training ground in
negotiation.
Transfer prices should lead to goal congruence with the overall strategy of the organization, and
help to sustain high performance levels by management.

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Negotiated transfer prices are used as a training ground for managers. In addition to the relative
bargaining strengths of the buying and selling division, the ability of each manager to negotiate
is used to determine a transfer price between the minimum variable cost for the selling division
and the market price for the buying division.
Negotiating transfer prices can sometimes lead to conflicts between managers, especially when
management compensation is based on profitability of the divisions. In such cases, the senior
management can either step in or have an arbitration hearing to hear both sides.
Here, the firm does not specify rules for the determination of transfer prices. Divisional
managers are encouraged to negotiate a mutually agreeable transfer price. Negotiated transfer
pricing is typically combined with free sourcing. In some companies, though, headquarters
reserves the right to mediate the negotiation process and impose an “arbitrated” solution.
III. Cost-based Transfer Pricing

 Cost-based transfer pricing is based on the cost (either budget or actual) of producing
the specific product. Cost can be defined as either straight variable cost, manufacturing
(absorption) cost, or full cost (production plus other costs such as distribution and marketing).
When market-based prices are not readily available, such as with specialty or unique products,
internal cost-based transfer prices may be an alternative. Companies can choose a variety of cost-
based transfer prices including variable cost, absorption cost (also called full absorption cost), or
cost-plus pricing (with a mark-up over either variable or full-absorption costing). A company can
also opt for a dual-pricing transfer cost strategy.
Full-costing may lead to sub-optimal decisions for the company. To achieve goal congruence,
the minimum transfer price that should be accepted by the service giving division is the variable
cost of production. Below this price, they would lose money. The maximum amount the service
using division is willing to pay is the market price that they can purchase from the outside. Some
companies may wish to prorate the difference between the minimum and maximum amounts to
determine a transfer price. One such method is to prorate the percentage of variable cost of
production of the supplying division over the difference in costs.
Dual pricing is also an alternative. In this case, the selling division would use a cost-based
pricing strategy to determine its own profitability, while the buying division would use market
prices in determining its profitability. The difference in profits is recorded in a separate corporate
account. Dual pricing is not widely used in practice.

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In the absence of an established market price many companies base the transfer price on the
production cost of the supplying division. The most common methods are:
 Full Cost  Variable Cost plus Opportunity cost
 Cost-plus  Dual Transfer Prices
 Variable Cost plus Lump Sum charge
Each of these methods is outlined below
A. Full Cost
A popular transfer price because of its clarity and convenience and it is often viewed as a
satisfactory approximation of outside market prices.
(i) Full actual costs can include inefficiencies; thus its usage for transfer pricing often fails to
provide an incentive to control such inefficiencies.
(ii) Use of full standard costs may minimize the inefficiencies mentioned above.
B. Cost-plus
When transfers are made at full cost, the buying division takes all the gains from trade while the
supplying division receives none. To overcome this problem the supplying division is frequently
allowed to add a mark-up in order to make a “reasonable” profit. The transfer price may then be
viewed as an approximate market price.
C. Variable Cost plus a Lump Sum Charge
In order to motivate the buying division to make appropriate purchasing decisions, the transfer
price could be set equal to (standard) variable cost plus a lump-sum periodical charge covering
the supplying division’s related fixed costs.
D. Variable Cost plus Opportunity Cost
Also known as the Minimum Transfer Price: Minimum Transfer Price = Incremental Cost +
Opportunity Cost. For internal decision making purposes, a transfer price should be at least as
large as the sum of:
 cash outflows that are directly associated with the production of the transferred goods; and,
 The contribution margin foregone by the firm as a whole if the goods are transferred
internally.

Sub-optimal decisions can result from the natural inclination of the manager of an autonomous
buying division to view a mix of variable and fixed costs of a selling division plus, possibly, a

~ 120 ~
mark-up as variable costs of his buying division. Dual transfer pricing can address this problem,
although it introduces the complexity of using different prices for different managers.
E. Dual Transfer Prices
To avoid some of the problems associated with the above schemes, some companies adopt a dual
transfer pricing system. For example:
• Charge the buyer for the variable cost. The objective is to motivate the manager of the buying
division to make optimal (short-term) decisions.
• Credit the seller at a price that allows for a normal profit margin. This facilitates a “fair”
evaluation of the selling division’s performance.

 Unit 5 Activity 2
1. What is transfer price? --------------------------------------------------------------------------------------
---------------------------------------------------------------------------------
2. What are the alternative methods of setting transfer pricing? -----------------------------------------
---------------------------------------------------------------------------------------------------------------
3. What are the purposes of transfer price? -----------------------------------------------------------------
------------------------------------------------------------------------------------------------------

5.7. Summary

Organizations management style falls between the two extremes of

administration. i.e. centralization and decentralization. As organizations grow, the ability of
managers to effectively plan and control becomes more and more difficult because top officials
are away from the day to day operations. One approach to effectively handle this difficulty is to
decentralize the decision making. This means that top managers give the middle and lower level
managers the freedom to make decisions that impact the sub unit’s performance. This would
result in segregation of duties among different line of management, create greater responsiveness
to local needs, Lead to quicker decision-making, increase motivation among managers, aid
management development and learning, sharpens the focus of managers, top managers would not

~ 121 ~
distracted by routine activities, efficient use of management time and devolving of problems to a
manageable size.

In large organizations with many departments, each department often provides products/services
to another department within the organization. Deciding on the amount of price to be charged for
these transfers is difficult. Organizations use various types of transfer pricing such as cost based,
market based or/and negotiated transfer pricing technique. The overall purpose of transfer price
is to motivate managers as well as employees of the segment to act in the best interest of the
organization, not just the segment.

Unit 5: Self-Test Questions

Part One: True or False
1. Decentralization decision making leads to gains from quick decision making.
2. Transfer price is useful to assess the performance of departments in an organization.
3. Decentralization creates responsibility to meet local needs of customers, employees and other
stakeholders of the company.
4. Centralized management style facilitates management learning and development
5. If the type of service provided by a particular department to other departments is not
available in the external market, transfer price would be determined using either negation
base or cost based.

Part Two: Multiple Choices

1. A price charged by a department when it provides goods/services/ to other departments
within the organization is referred to as;
A. Common price
B. Transfer price
C. Market price
D. All

2. Which type(s) of transfer pricing is appropriate when a perfectly competitive market exists;
A. Negotiated transfer pricing
B. Cost based transfer pricing

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 C. Market based transfer pricing
D. None
3. One of the following is not the benefit of decentralization?
A. it creates responsiveness to the needs stakeholders.
B. It results in slow decision making process.
C. It enhances motivation of lower managers.
D. It frees of top management from day to day activities.

4. Which of the following factors that executives consider important in transfer pricing
decisions?
A. Performance evaluation
B. Management motivation
C. Pricing and product emphasis
D. External market recognition

5. Which of the following the basic feature of decentralized way of management?

A. Top managers would focus on strategic issues only
B. It enhances effectiveness of decision making
C. It facilitates decision making
D. It meets the local needs of customers, suppliers and operating employees
E. All
III. Short Answer
1. What is the rationale of transfer pricing?
2. Why transfer pricing is administered centrally?

~ 123 ~
 References
1) Atikinsun Antony A., et.al. Management Accounting. 2nded. Prentice Hall. New Jersey. 1997.
2) Charles, T. Horngren, Datar & Rajan. Cost Accounting: A Managerial Emphasis, 14th Ed.
2012.
3) Charles, T. Horngren. Introduction to Management Accounting. 12 th ed. Prentice-Hall, Inc.
New Jersey, 2002
4) Dominiak and Louderback. Managerial Accounting.7th ed South-western New York
5) Engler, Calvin. Managerial Accounting. 2nd ed. Richard D. Irwin, Inc. Boston, 1990.
6) Garison. Noreen and Brewer, Managerial Accounting, 13th Ed. 2010
7) Heitger, Lester E. and Serge Matulich. Managerial Accounting; 2 nd ed. McGraw-Hill, Inc.
New York, 1987.
8) Hilton, Ronald W. Managerial Accounting. 4th ed. Irwin McGraw Hill. New York. 1997.
9) Lere, John C. Managerial Accounting: A Planning -Operating –Control Framework Wiley &
Sons, Inc. New York. 1991
10) More & Jaedicke. Managerial Accounting. 4 th ed. South-Western. New York. 1976.
11) Moriarity, Shane and Carl P. Allen. Cost Accounting. 3 rded. John Wiley & Sons, Inc. New
York.1991

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Appendices

 Unit 1 Activity 1 Solutions

1) There are three approaches to break-even analysis
a) Equation approach.
b) Contribution approach.
c) Graphic approach.
2) No, contribution margin is the excess of sales over total variable costs.
3) CM-ratio refers to the percentage of contribution margin in total sales.
4) a) CM – ratio = P-V
P
40% = 60 – V
60
24 = 60 – V
V = Br. 36

b) i) NI = PQ – VQ – FC
0 = Q (60 – 36) – 360,000
Q = 360,000
24
Q = 15,000 units or at Br. 60 per unit, Br.900, 000

Let “X” be break-even sales in birr

Net income = Sales – Variable expenses – fixed expenses
0 = X – 0.6X – 360,000
0.4X = 360,000
X = Br. 900,000
CM-ratio = 40%  Variable cost ratio = 1-0.4 = 0.6

ii) NI = PQ – VQ – FC
90,000 = Q (60 – 36) – 360,000
24Q = 450,000

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 Q = 18,750 units or at Br. 60 per unit, Br. 1,125,000.

Let “X” be sales volume to achieve a target profit of Br. 90,000

NI = Sales – Variable expenses – Fixed expenses
90,000 = X – 0.6X – 360,000
0.4X = 450,000
X = Br. 1,125,000
iii) Breakeven point (in units) will be computed as follows
0 = Q (60-30) – 360,000
30Q = 360,000
Q = 12,000 units (or Br. 720,000)

c) i. BEP (in units) = 360,000 = 15,000 units

60 – 36
BEP (in birrs) = 360,000 = Br. 900, 000
0.4
ii. Target sales (in units) = 360,000 + 90,000 = 18,750 units
60 – 36
Target sales (in birrs) = 360,000 + 90,000 = Br. 1,125,000
0.4
iii. BEP (in units) = 360,000 = 12,000 units
60 – 30
BEP (in birrs) = 360,000 = Br. 720,000
60 – 30
60

Unit 1: Self-Test Questions

Part One: True or False
1) True 4) False
2) False 5) True
3) False

~ 126 ~
Part Two: Workout Problems.

1)
a) Under equation approach, breakeven point in units and sales birrs is computed a follows
At breakeven point;

TR=TC
Q*Sp/unit= TVC + TFC
Br70Q= VC/unit*Q + Br 84,000
Br 70 Q= (Br 32+Br 10) Q+ Br 84,000
(Br70- Br 42)Q= Br 84, 000
Q=Br 84,000
28
= 3000 pairs of socks

Break even Revenue = Break even units X Selling price

= 3000 pairs of socks X Br 70
= Br 210,000

b) Under this approach, breakeven point in units and sales revenue is computed as follows
Break even units = Fixed cost
Contribution margin per unit
= Br 84,000
SP/unit- VC/unit
= Br 84,000
Br 70 - Br 42
= 3000 pairs of socks

Breakeven Revenue = Fixed cost

Contribution margin%
= Br 84,000
40%
= Br 210,000

~ 127 ~
Contribution margin% = Contribution Margin = Br 42/70 = 40%
Selling price
c) Under this approach, breakeven point in units and sales revenue is computed as follows

378
Graphic Method
336
294
$(000) 252 Breakeven
210
168
126
84 Fixed costs
42
0
0 1000 2000 3000 4000 5000
Units
,

2)
a) Total revenue of 200 units of bike= Price per bike X Units of bike to be sold
= Br 800 X 200 bikes
= Br 160, 000
b) Total cost of producing and selling 200 units of bike= Variable cost + Fixed cost
Variable cost = Units of bike to be sold X Variable per unit
= 200 bikes X Br 300
= Br 60,000
Fixed Cost = Br 50,000
= Br 60,000 + Br 50,000
= Br 110,000

~ 128 ~
c) Operating Income/loss= TR- TC
= Br 160,000- Br 110,000
= Br 50,000
d) Break even units= Fixed Cost
Contribution margin per unit

= Br 50,000
Br 500
= 100 bikes

We determine the quantity of bikes needed for the target profit as follows:
Quantity= (Br 5,500,000 – Br 200,000) / (Br 800 – Br 300)
= 11,400 bikes

 Unit 2 Activity 1 Solutions

1) Master budget is a company’s overall financial plan for the coming year or other planning
period, which usually includes an operating budget, a cash budget, and projected financial
statements.
2) The subunits (components) of the master budget may be classified as operating and financial
budget.
 The operating budget
a. Sales budget
b. Purchase budget
c. Operating expense budget
i. Marketing expense budget
ii. Administrative expense budget
d. Budgeted income statement
 The financial budget
a) Capital budget
b) Cash budget
c) Budgeted balance sheet
d) Budgeted statement of cash flow

~ 129 ~
3) Budgeted goals and performance are generally a better basis for judging actual results than is
past performance. The major drawback of using historical results for judging current
performance is that inefficiencies may be concealed in the past performance. Changes in
economic conditions, technology, personnel, competition, and so forth also limit the
usefulness of comparisons with the past.

 Unit 2 Activity 2 Solutions

Schedule A: Sales Budget
Hollywood Company
Sales Budget
For the First Quarter Ended March 31, 2005
January February March Quarter Total
Sales (Units) 40,000 60,000 30,000 130,000
Unit Selling Price (Birr) 10 10 10 10
Sales (Birr) 400,000 600,000 300,000 1,300,000
OR
Cash Sales 80,000 120,000 60,000 260,000
Credit Sales 320,000 480,000 240,000 1,040,000
Total (Birr) 400,000 600,000 300,000 1,300,000

Schedule B: Schedule of Cash Collections

Hollywood Company
Schedule of Cash Collections (Birr)
For the First Quarter Ended March 31, 2005
January February March Quarter
December Credit Sales 224,000 224,000
January Sales 80,000 320,000 400,000
February Sales 120,000 480,000 600,000
March Sales 60,000 60,000
Total 304,000 440,000 540,000 1,284,000

Schedule C: Inventory Purchases Budget

Hollywood Company
Inventory Purchases Budget
For the First Quarter Ended March 31, 2005
January February March Quarter
Physical Units
Budgeted Sales 40,000 60,000 30,000 130,000
Add: Desired Ending Inventory 15,000 7,500 5,000 5,000
Total Requirements 55,000 67,500 35,000 135,000
Less: Beginning Inventory 10,000 15,000 7,500 10,000
Purchases (Units) 45,000 52,500 27,500 125,000
Purchases (Birr 6.00 each) 270,000 315,000 165,000 750000

~ 130 ~
Schedule D: Schedule of Disbursement for Purchases
Hollywood Company
Schedule of Disbursement for Purchases (Birr)
For the First Quarter Ended March 31, 2005
January February March Quarter
December Purchase 93,000 93,000
January purchases 135,000 135,000 270,000
February Purchase 157,500 157,500 315,000
March Purchases 82,500 82,500
Total 228,000 292,500 240,000 760,500

Schedule E: Operating Expenses Budget

Hollywood Company
Operating Expenses Budget (Birr)
For the First Quarter Ended March 31, 2005
January February March Quarter
Salaries and Wages 27,000 27,000 27,000 81,000
Advertising 70,000 70,000 70,000 210,000
Shipping 20,000 30,000 15,000 65,000
Depreciation 14,000 14,000 14,000 42,000
Others 12,000 18,000 9,000 39,000
Total 143,000 159,000 135,000 437,000

Schedule F: Schedule of Disbursements for Operating Expenses

Hollywood Company
Schedule of Disbursements for Operating Expenses (Birr)
For the First Quarter Ended March 31, 2005
January February March Quarter
Salaries and Wages 27,000 27,000 27,000 81,000
Advertising 70,000 70,000 70,000 210,000
Shipping 20000 30000 15000 65,000
Others 12000 18000 9000 39,000
Total 129,000 145,000 121,000 395,000

~ 131 ~
Schedule G: Cash Budget
Hollywood Company
Cash Budget (Birr)
For the First Quarter Ended March 31, 2005
January February March
Cash Balance, Beginning 48,000 30,000 30,800
Add: Cash Collections (Sch. B) 304,000 440,000 540,000
Total Cash Available 352,000 470,000 570,800
Less: Disbursements
Purchase of Inventory (Sch. D) 228,000 292,500 240,000
Operating Expenses (Sch. F) 129,000 145,000 121,000
Purchase of Equipment 1,700 84,500
Cash Dividends 45,000 ________ ________
Total Disbursements 402,000 439,200 445,500
a-b
Excess (Deficiency) of Cash (50,000) 30,800 125,300
Financing:
Borrowing (Beginning) 80,000
Repayments (Ending) (80,000)
Interest Payment (12%) ______ (2,400)
Net Financing 80,000 (82,400)
a-b-c
Cash Balance, Ending 30,000 30,800 42,900

Schedule H: Budgeted Income Statement

Hollywood Company
Budgeted Income Statement (Birr)
For the First Quarter Ended March 31, 2005
Sales (Sch. A) 1,300,000
Less: Cost of Goods Sold (Sch. B) 780,000
Gross Margin 520,000
Less: Operating Expenses (Sch. E) 437,000
Net Operating Income 83,000
Less: Interest Expense (Sch. G) 2,400
Net Income 80,600

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Schedule I: Budgeted Balance Sheet
Hollywood Company
Budgeted Balance Sheet
March 31, 2005
Assets
Cash (Sch. G) 42,900
Accounts Receivable Sch. B) 24,0000
Inventory (Sch. C) 30,000
Buildings and Equipment (Net)* 414,200
Total Assets 727,100

Liabilities and Owners' Equity

Accounts Payable (Sch. D) 82,500
Capital Stock 500,000
Retained Earnings* 144,600
Total Liabilities and Owners' Equity 727,100

* Buildings and Equipment Ending (net) = Beginning Buildings and Equipment + Additional
Acquisitions – Depreciation for the period.
= 370,000 + 1,700 + 84,500 – 42,000
= Birr 414,200
** Retained Earning ending = Beg. Retained Earnings + Net Income – Dividends Declared.
= 109,000 + 80,600 – 45,000
= Birr 144,600

Unit 2: Self-Test Questions

Part One: True or False
1) True 4) False 7) True
2) True 5) False 8) True
3) False 6) False

Part Two. Choose the best answer among the given alternatives.
1. D 5. C
2. B 6. A
3. B 7. A
4. C

~ 133 ~
 Unit 3 Activity 1 Solutions
a. the standard quantity of material/lumber is 6 meters of lumber
b. the standard price is Br 4 per meters of wood
c. Direct material budget= std quantity X Std price X total number of coffee tables
= 6/liters X Br 4 X 500 = Br 12,000
d. Standard cost = std quantity X std price
= 6 X Br 4 = Br 24
Or = standard cost of materials for ordered goods
Number of coffee tables ordered
= Br 12000/500 units of coffee table = Br 24/unit

 Unit 3 Activity 2 Solutions

a. MPV = (AP-SP) AQ
= (Br 7 - Br 8) 600 meters = Br 600 F
b. ME (U) V= (AQ - SQ) SP
= (600 meters- 800 meters) Br 8 =Br 1600 F
c. FBV for direct materials = MPV + MEV
= Br 600 F + Br 1600 F
= Br 2, 200 F

 Unit 3 Activity 3 Solutions

a. LRV= (AR - SR) AH
= (Br 6 –Br 5) 5000 hours = Br 5000 U
b. LEV= (AH - SH) SR
= (5000 hours- 7500 hours) Br 5 =12,500 F
c. FBV for direct labor= LRV + LEV
= Br 5000 U + Br 12,500 F = 7500 F

 Unit 3: Self-Test Questions

Part One: True or False
1. False 3. False 5. True 7. True
2. True 4. True 6. False

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Part Two. Multiple Choices
1. C 4. B 7. D 10. B
2. D 5. C 8. B 11. C
3. C 6. C 9. C 12. C

 Unit 4 Activity 1 Solutions

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
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.7.80 Br. 780,000

Yemi should purchase the component from the supplier because the form saves Br. 2,000 by
purchasing the component.

Net relevant cost to make Br. 782,000

Net relevant cost to buy 780,000
Advantage of purchasing the part from outside Br. 2,000

~ 135 ~
 Unit 4 Activity 2 Solutions
1) The contribution format focuses on cost behavior (fixed and variable), whereas the
absorption format reports costs by business functions. The contribution approach makes it
easier for managers to evaluate the effects of changes in demand on income and thus it is
better for decision-making.
2) Effect of the special order:
Incremental revenue (2000 x Br.12)……………………………..Br. 24,000
Incremental costs
Direct materials (2000 x Br.2.50)………Br. 5,000
Direct Labor (2, 000 x Br.3.00)………… 6,000
Variable overhead (2, 000 x Br.0.50)…… 1,000 12,000
Incremental income……………………………………………. Br. 12,000

Recommendation: It is better for ABC Company to accept the special order because it increases
net income of the company by Br. 12,000.

Unit 4: Self-Test Questions

Part One: True or False
1. True 4. False
2. False 5. False
3. False

Part Two. Workout Problem

The increment cost per unit for the special order is calculated as:
Direct Material $8.00
Direct Labor 5.00
Variable Factory Overhead 2.00
$15.00
Since the incremental cost per unit is less that the price offered in the special order, the company
should accept it. Accepting special order will generate additional contribution of $2.00 unit and
$4,000 in total.

~ 136 ~
 Unit 5 Activity 1 Solutions
1. As organizations grow in size and capacity they will undertake more diverse and complex
activities, their geographical market and diversity of their product tend to expand. When
this happens, the expertise and time required to manage the organization would increase.
Thus, organizations elect to delegate decision making authority to managers throughout
the organization. This delegation of freedom to make decisions is said to be
decentralization.
2. I. Benefits of decentralization
a. create greater responsiveness to local needs
b. segregate duties
c. Lead to quicker decision-making
d. increase motivation: managers’ motivation increases because they have more control
over results
e. Aid management development and learning, and sharpen the focus of managers
f. Top managers are not distracted by routine, local decision problems.
g. Sharpens focus of departmental managers
h. Efficient use of management time and devolving of problems to a manageable size
II. Drawbacks of decentralization
a. Lead to sub-optimal decision making (goal incongruence)
b. Result in duplication of duties
c. Decrease loyalty toward the organization as a whole
d. Increase costs of gathering and processing information.
e. Increases time to negotiate for goods and services
f. Focuses the manager’s attention on the subunits rather than the organization as a whole

Unit 5 Activity 2 Solutions

1. A transfer price is the price at which divisions of a company transact with each other, such as
the trade of supplies or labor between departments. Transfer prices are used when individual
entities of a larger multi-entity firm are treated and measured as separately run entities. A
transfer price can also be known as a transfer cost.

~ 137 ~
2. -Market-based Transfer Pricing
-Negotiated Transfer Pricing
-Cost-based Transfer Pricing
3 i. Generate separate profit figures for each division and thereby evaluate the performance of
each division separately.
ii Help coordinate production, sales and pricing decisions of the different divisions (via an
appropriate choice of transfer prices). Transfer prices make managers aware of the value that
goods and services have for other segments of the firm.

Unit 5: Self-Test Questions

Part One: True or False

1. True 2. True 3. True 4. True 5. True

Part II. Multiple Choice

1. B 2. C 3. B 4. A 5. E

Part III. Short Answer

1. Transfer prices exist in centralized organizations to record the transfer of goods and services
from one unit to another for the same reasons such organizations allocate costs (e.g.,
inventory valuation, cross-department monitoring).

2. The advantages of a centrally administered transfer price are that it promotes short-run
profits by ensuring proper action by divisional managers and allows division managers to
maintain their autonomy. The disadvantages of such a transfer price are that top
management will become too involved in pricing disputes, and that division managers will
lose flexibility in their decision making. The company also loses the other advantages of
decentralization.

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 DEPARTMENT OF ACCOUNTING AND FINANCE
Distance Education
Cost & Management Accounting II (AcFn 2092)

Assignment I out of 15%

Name: __________________________ I.D_____________ Center____________

Dear learner, this assignment is intended to evaluate you, so you are expected to rely on yourself
to do the included questions. You are strongly advised not to attempt the questions until you
have completely covered every part of the topic and the respective activities and chapter end
exercises in the module.

Submission Date: June 10 - 11/2009

~1~
Part One: Say “True” if the statement is correct and “False” if not. (0.5 pt. each)
1) Variable costs are always relevant costs.
2) If the selling price per unit is $50 and the contribution margin percentage is 40%, then the
variable cost per unit must be $20.
3) A budget is the quantitative expression of a proposed plan of action by management for a
specified period.
4) In a decision to drop a segment, the opportunity cost of the space occupied by the segment
would be the profit that could be derived from the best alternative use of the space.
5) Contribution margin and gross margin are terms that can be used interchangeably.
6) The cash budget and the budgeted income statement are necessary to prepare the budgeted
balance sheet and budgeted statement of cash flows.
7) Breakeven point is that quantity of output where total revenues equal total costs.
8) Managers should pay little attention to bottleneck operations because they have limited
capacity for producing output.
9) The financial budget is that part of the master budget that includes the capital expenditures
budget, cash budget, budgeted balance sheet, and the budgeted statement of cash flows.
10) The selling price per unit is $25, variable cost per unit $15, and fixed cost per unit is $4.
When this company operates above the breakeven point, the sale of one more unit will
increase net income by $6.

Part Two: Choose the Best Answer from the Given Alternatives (1pt each)
1) The margin of safety is the difference between:
A. Budgeted expenses and breakeven expenses.
B. Budgeted revenues and breakeven revenues.
C. Actual operating income and budgeted operating income.
D. Actual contribution margin and budgeted contribution margin.
2) Financial budgets include the all of the following EXCEPT:
A. Capital expenditures budget.
B. Budgeted income statement.
C. Budgeted balance sheet.
D. Budgeted statement of cash flows.
E. None of the above.
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3) A primary consideration in assigning a cost to a responsibility center is:
A. Whether the cost is fixed or variable.
B. Whether the cost is direct or indirect.
C. Who can best control the change in that cost.
D. where in the organizational structure the cost was incurred
4) In which order are the following developed? First to last:
A = Production budget
B = Direct materials costs budget
C = Budgeted income statement
D = Sales budget
A. ABDC D. CABD
B. DABC E. None.
C. DCAB

USE THE FOLLOWING INFORMATION FOR QUESTIONS 5 THROUGH 8.

Beat, Inc., expects to sell 60,000 athletic uniforms for $80 each in 2012. Direct materials costs
are $20, direct manufacturing labor is $8, and manufacturing overhead is $6 for each uniform.
The following inventory levels apply to 2011:
Beginning inventory Ending inventory
Direct materials 24,000 units 18,000 units
Work-in-process inventory 0 units 0 units
Finished goods inventory 12,000 units 10,000 units
5) How many uniforms need to be produced in 2012?
A. 52,000 uniforms. D. 58,000 uniforms.
B. 68,000 uniforms. E. None.
C. 60,000 uniforms
6) What is the amount budgeted for direct material purchases in 2012?
A. $1,040,000 D. $1,520,000
B. $1,200,000 E. None.
C. $1,160,000

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7) What is the amount budgeted for cost of goods manufactured in 2012?
A. $2,040,000 D. $2,380,000
B. $1,972,000 E. None.
C. $2,312,000
8) What is the amount budgeted for cost of goods sold in 2012?
A. $2,312,000 D. $4,800,000
B. $1,972,000 E. None.
C. $2,040,000

Part Three: Workout Problem (2 Points)

The estimated costs of producing 6,000 units of a component are:

Per Unit Total
Direct Material Br. 10 Br. 60,000
Direct Labor 8 48,000
Applied Variable Factory Overhead 9 54,000
Applied Fixed Factory Overhead 12 72,000
(Br. 1.5 per direct labor)
$39 $234,000

The same component can be purchased from market at a price of Br. 29 per unit. If the
component is purchased from market, 25% of the fixed factory overhead will be saved. Should
the component be purchased from the market? Why? (2 Points)

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 DEPARTMENT OF ACCOUNTING AND FINANCE
Distance Education
Cost & Management Accounting II (AcFn 2092)

Assignment II out of 15%

Name: __________________________ I.D_____________ Center____________

Dear learner, this assignment is intended to evaluate you, so you are expected to rely on yourself
to do the included questions. You are strongly advised not to attempt the questions until you
have completely covered every part of the topic and the respective activities and chapter end
exercises in the module.

Submission Date: June 10 - 11/2009

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Part One: Say “True” if the statement is correct and “False” if not. (0.5 pt. each)
1. A flexible budget report will show both actual and budget cost based on the budgeted activity
level achieved.
2. If transfer prices are to be based on cost, then the costs should be actual costs rather than
standard costs.
3. Responsibility accounting functions most effectively in decentralized organizations.
4. In a strongly centralized organization there is a large amount of freedom to make decisions
at all levels of management.
5. All profit centers are responsibility centers, but not all responsibility centers are profit
centers.
6. Static budget is prepared at the end of the period.
7. If actual costs are less than standard costs, the variance is favorable.
8. A materials quantity variance is calculated as the difference between the standard direct
materials price and the actual direct materials price multiplied by the actual quantity of direct
materials used.
Part Two: Choose the Best Answer from the Given Alternatives (1pt each)
1. Flexible budget and static budget are similar in that:
A. Both consider planned unit price and unit variable cost.
B. Both consider budgeted fixed cost and unit price.
C. Both consider planned unit price, unit variable cost and fixed cost.
D. All.
E. None
2. When using a flexible budget, a decrease in activity within the relevant range:
A. Decreases unit variable cost. D. Increases variable cost per unit
B. Decreases total costs. E. None
C. Increases total fixed costs.
3. An example of favorable variance is:
A. Actual Revenues are less than expected.
B. Actual Expenses are less than expected.
C. Material prices are greater than expected
D. A and C E. None.

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4. If the flexible budget variance Br 7,000 favorable and the sales activity variance was Br
1,000 favorable, the total master budget variance was:
A. Br 6,000 U B. Br 6,000 F C. Br 8,000 U D. Br 8,000 F
5. Sales volume variance is the difference between:
A. A revenue or cost item in the static planning budget and the same item in the flexible
budget.
B. How much the revenue should have been, given the actual level of activity, and the
actual revenue for the period
C. How much a cost should have been, given the actual level of activity, and the actual
amount of the cost?
D. None
6. Which of the following is the extension of materials usage variance?
A. materials yield variance D. overhead variance
B. materials cost variance E. None
C. labor usage variance
7. Which of the following statements is false?
A. A flexible budget is used for control purpose and a static budget is used for planning
purposes.
B. A flexible budget is prepared at the end of the period and a static budget is prepared at the
beginning of the period.
C. A flexible budget is not useful for controlling variable costs.
D. A static budget provides budgeted estimates for one level of activity.
E. None
8. If actual direct material costs are greater than standard direct materials costs, it means that
A. Actual costs were calculated incorrectly.
B. The actual unit price of direct materials was greater than the standard unit price of direct
materials.
C. The actual unit price of raw materials or the actual quantities of raw materials used was
greater than the standard unit price or standard quantities of raw materials expected.
D. The purchasing agent or the production foreman is inefficient.
E. None

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9. The direct materials quantity standard would not be expressed in
A. Pounds. D. Board feet.
B. Barrels. E. None
C. Dollars.
10. A total materials cost variance is analyzed in terms of
A. Price and quantity variances. D. Tight and loose variances.
B. Buy and sell variances. E. None
C. Quantity and quality variances.
11. The standard rate of pay is Br.10 per direct labor hour. If the actual direct labor payroll was Br.
39,200 for 4,000 direct labor hours worked, the direct labor price (rate) variance is
A. Br. 800 unfavorable. D. Br. 1,000 favorable.
B. Br. 800 favorable. E. None
C. Br. 1,000 unfavorable.

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