1. Welcome Back
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2. Welcome Back
Time for Any Question
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3. Variable Costing and Analysis
Chapter 06
Variable Costing and Analysis
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4. Distinguishing between Absorption Costing and Variable Costing: Absorption Costing
Direct Materials
Direct Labor
Variable Overhead
Fixed
Overhead
Product costs generally consists of direct materials, direct labor, and overhead. Costs of both direct materials and direct labor usually are easily traced to specific products. Overhead costs, however, must be allocated to products because they cannot be traced to product units. Under absorption costing, all overhead costs, both fixed and variable, are allocated to products as the diagram on this slide shows.
Product Cost
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5. Distinguishing between Absorption Costing and Variable Costing: Variable Costing
Direct Materials
Direct Labor
Variable Overhead
Fixed Overhead
Under variable costing, the costs of direct materials and direct labor are also traced to products, but only variable overhead costs (not fixed overhead) are allocated to products. Fixed overhead costs are treated as period costs and are reported as an expense immediately in the period in which they are incurred.
Product Cost
Period Cost
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6. NEED-TO-KNOW
Zbest Manufacturing reports the following costing data for the current year. 20,000 units were produced, and 14,000 units were sold.
Direct materials per unit $6
per unit
Direct labor per unit
$11
per unit
Variable overhead per unit $3
per unit
Fixed overhead for the year
$680,000
per year
Sales price
$80
per unit
Variable selling and administrative cost per unit $2
per unit
Fixed selling and administrative cost per year
$112,000
per year
1. Prepare an income statement for the year using absorption costing.
Product cost per unit using Absorption Costing:
Direct materials per unit
$6.00
Direct labor per unit
11.00
Variable overhead per unit
3.00
Fixed overhead per unit ($680,000 / 20,000 units produced)
34.00
Cost per unit
$54.00
Need-to-Know 6.2
Zbest Manufacturing reports the following costing data for the current year.
20,000 units were produced, and 14,000 units were sold.
Prepare an income statement for the year using absorption costing.
The product cost per unit under absorption costing includes all manufacturing costs:
Direct materials per unit, $6.00; Direct labor, $11.00; Variable overhead, $3.00; and Fixed overhead, $680,000 divided by 20,000 units produced, $34.00 per unit.
The total cost per unit under absorption costingis $54.00.
The income statement report sales, 14,000 units $80.00 per unit, $1,120,000.
Less cost of goods sold: 14,000 $54 per unit, $756,000. Sales minus cost of goods sold
equals gross margin, $364,000.
From gross margin, we subtract the Selling, general and administrative expenses.
Variable selling and administrative expenses, 14,000 units sold multiplied by $2.00 per unit, $28,000;
and Fixed selling and administrative costs, $112,000.
Total Selling, general and administrative expenses are $140,000.
Net income under absorption costing is $224,000.
Zbest Manufacturing
Absorption Costing Income Statement
Sales (14,000 $80 per unit)
$1,120,000
Cost of goods sold (14,000 $54 per unit)
756,000
Gross margin
364,000
Selling, general and administrative expenses:
Variable selling and administrative expenses (14,000 x $2)
$28,000
Fixed selling and administrative expenses
112,000
Total selling, general and administrative expenses
140,000
Net income (loss)
$224,000
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7. NEED-TO-KNOW
Zbest Manufacturing reports the following costing data for the current year. 20,000 units were produced, and 14,000 units were sold.
Direct materials per unit $6
per unit
Direct labor per unit
$11
Variable overhead per unit $3
Fixed overhead for the year
$680,000
per year
Sales price
$80
Variable selling and administrative cost per unit $2
Fixed selling and administrative cost per year
$112,000
2. Prepare an income statement for the year using variable costing.
Product cost using Variable Costing:
Direct materials per unit
$6.00
Direct labor per unit
11.00
Variable overhead per unit
3.00
Cost per unit
$20.00
Zbest Manufacturing
Variable Costing Income Statement
Sales (14,000 $80 per unit)
$1,120,000
Need-to-Know 6.2
Prepare an income statement for the year using variable costing.
The product cost per unit under variable costing includes only the variable manufacturing costs:
Direct materials, $6.00 per unit; Direct labor, $11.00 per unit; and Variable overhead, $3.00 per unit;
total cost per unit under variable costing is $20.00.
The income statement begins with Sales, 14,000 $80.00 per unit, $1,120,000.
We subtract all of the variable costs: Variable production costs, 14,000 units multiplied
by $20.00 per unit, $280,000; Variable selling and administrative expenses, 14,000 units multiplied by $2.00 per unit, $28,000; total variable costs, $308,000.
Sales minus total variable costs equals contribution margin, $812,000.
From contribution margin, we subtract all of the fixed expenses:
Fixed overhead costs, $680,000; and fixed selling and administrative expenses, $112,000.
Total fixed expenses are $792,000.
Net income under variable costing is only $20,000.
Less: Variable costs
Variable production costs (14,000 x $20 per unit)
$280,000
Variable selling and administrative expenses (14,000 x $2)
28,000
Total variable costs
308,000
Contribution margin
812,000
Less: Fixed expenses
Fixed overhead costs
680,000
Fixed selling and administrative expenses
112,000
Total fixed expenses
792,000
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Net income (loss)
$20,000
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8. NEED-TO-KNOW P 2 Zbest Manufacturing
Absorption Costing Income Statement
Sales (14,000 $80 per unit)
$1,120,000
Cost of goods sold (14,000 $54 per unit)
756,000
Gross margin
364,000
Selling, general and administrative expenses:
Variable selling and administrative expenses (14,000 x $2)
28,000
Fixed selling and administrative expenses
112,000
Total selling, general and administrative expenses
140,000
Net income (loss)
$224,000
Zbest Manufacturing
Variable Costing Income Statement
Sales (14,000 $80 per unit)
$1,120,000
Less: Variable costs
Variable production costs (14,000 x $20 per unit)
$280,000
Variable selling and administrative expenses (14,000 x $2)
28,000
Need-to-Know 6.2
Net income under variable costing is $204,000 less.
6,000 units were added to inventory (20,000 units produced minus 14,000 units sold)
We multiply by the fixed overhead cost per unit $680,000 divided by 20,000 units, $34.00 per unit, to explain the total change in income, $204,000.
Total variable costs
308,000
Contribution margin
812,000
Less: Fixed expenses
Fixed overhead costs
680,000
Fixed selling and administrative expenses
112,000
Total fixed expenses
792,000
Net income (loss)
$20,000
Number of units added to inventory
6,000
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Fixed overhead per unit ($680,000 / 20,000 units)
$34.00
Change in income (Absorption vs. Variable)
$204,000
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9. Master Budgets and Performance Planning
Chapter 07
Master Budgets and Performance Planning
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10. Master Budget Process for a Manufacturer
This slide summarizes the master budgeting process for a company that manufacturers a product. The master budgeting process typically begins with the sales budget and ends with a cash budget and budgeted financial statements. The master budget includes individual budgets for sales, production (or purchases), various expenses, capital expenditures, and cash.
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11. I - Operating Budgets
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12. II - CAPITAL EXPENDITURES Budgets
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13. III - Cash Budget
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14. Preparing the Cash Budget
Beginning Cash Balance
Budgeted Cash Receipts
Budgeted Cash Disbursements
Preliminary Cash Balance + – =
If adequate, repay loans or buy securities.
If inadequate, increase short-term loans.
Now that we have completed the following budgets: cash receipts from sales budget, cash payments for direct materials, cash payments for direct labor, cash payments for variable overhead, cash payments for selling expenses and cash payments for general and administrative expenses, we are ready to complete the cash budget. When preparing a cash budget, we add expected cash receipts to the beginning cash balance and deduct expected cash disbursements. If the expected ending cash balance is inadequate, additional cash requirements appear in the budget as planned increases from short-term loans. If the expected ending cash balance exceeds the desired balance, the excess is used to repay loans or to acquire short-term investments.
Some additional events affecting TSC’s cash are displayed on your screen. You may need to make a few notes from this information to keep from referring back to this screen as we use this information. We will continue with the additional information on the next slide.
Additional information for TSC’s cash budget:
Has a September 30 cash balance of $20,000.
Will pay a cash dividend of $3,000 in November.
Continue
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15. Flexible budgets & standard costs
Chapter 08
Flexible budgets & standard costs
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16. Fixed Budget Performance Report
A fixed budget, also called a static budget, is based on a single
predicted amount of sales or other activity measure.
If unit sales are higher, should we expect costs to be higher?
How much of the higher costs are because of higher unit sales?
U = Unfavorable variance Actual cost is greater than budgeted cost.
Optel’s fixed budget was prepared for January at an expected sales level of 10,000 units. However, Optel actually sold 12,000 units during the month. All of the expense variances are unfavorable because actual expenses are greater than budgeted expenses.
As a result of the increase in sales from 10,000 units to 12,000 units, variances for sales and income are favorable.
Since the cost variances are unfavorable, has Optel done a poor job controlling costs? But wait, if sales volume is greater than expected, shouldn’t we expect Optel’s costs to be higher? If so, what portion of the higher costs is due to activity and what portion is due to poor cost control?
The question is really difficult to answer using a fixed budget. The sales level was higher than the budgeted level, so it follows that variable expenses should be higher to support the higher level of sales. We actually don’t have a grip on cost control. One of the ways we can answer the question about the effectiveness of cost control is to use flexible budgeting. We will prepare a budget at the actual level of activity. In other words, we will flex Optel’s fixed budget up to the actual level of sales.
F = Favorable variance Actual revenue and income are greater than budgeted revenue and income.
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17. Preparation of Flexible Budgets
Variable costs are a constant amount per unit.
Total variable cost = $4.80 per unit × budget level in units
Let’s see how flexible budgeting works by preparing flexible budgets for 10,000 units, 12,000 units, and 14,000 units for Optel. Notice that Optel’s costs have been classified by behavior, either variable or fixed, in the flexible budget. The first thing we do is express the variable costs in per unit amounts. For example, we divide the $57,600 variable cost by 12,000 units to obtain a unit variable cost of $ Next we multiply the $4.80 unit variable cost times each of the budgeted levels of activity to get the total variable costs at each activity level. For example, at 14,000 units of activity, the budgeted variable cost of $67,200 is computed by multiplying $4.80 per unit times 14,000 units.
Total fixed costs remain unchanged in the budgeting process as long as we operate within the relevant range of activity.
Next, after we examine these flexible budgets for Optel for a few minutes, we will compare the flexible budget for 12,000 units with the actual costs at 12,000 units.
Total Fixed costs do not change within the relevant range.
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18. Flexible Budget Performance Report
A flexible budget performance report compares actual performance and budgeted performance based on actual sales. In Optel’s case, January’s sales are 12,000 units.
Favorable sales variance indicates that the average selling price was greater than $10.00 per unit.
A flexible budget performance report compares actual performance and budgeted performance based on actual sales volume (or other activity level). In Optel’s case, we prepare this report after January’s sales volume is known to be 12,000 units.
Part I
At 12,000 units, we would expect sales revenue to be $120,000. Since the actual sales revenue was $125,000, we conclude that Optel’s average selling price was greater than $10 per unit. Now we can begin to analyze cost control.
Part II
Comparing actual costs at 12,000 units with a flexible budget prepared at 12,000 units reveals that Optel has unfavorable cost variances. These variances are due to cost control issues because we have removed the activity differences by flexing the fixed budget from 10,000 units up to the actual activity of 12,000 units.
Part III
The favorable variances for contribution margin and income indicate that the favorable sales variance is larger than the unfavorable cost variances.
Unfavorable cost variances indicate costs are greater than expected for 12,000 units.
Favorable variance because favorable sales variance is greater than unfavorable cost variances.
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19. NEED-TO-KNOW 8.1
A manufacturing company reports the fixed budget and actual results for the year as shown below. The
company’s fixed budget assumes a selling price of $40 per unit. The fixed budget is based on 20,000 units
of sales, and the actual results are based on 24,000 units of sales. Prepare a flexible budget performance
report for the year.
Fixed Budget
Actual Results
(20,000 units)
(24,000 units)
Sales
$800,000
$972,000
Variable costs
160,000
240,000
Fixed costs
500,000
490,000
Budget assumptions:
Selling price per unit
$40.00
($800,000 divided by 20,000 units)
Variable cost per unit
$8.00
($160,000 divided by 20,000 units)
Budget Assumptions
Flexible Budget
(24,000 units)
A manufacturing company reports the fixed budget and actual results for the year as shown below.
The company’s fixed budget assumes a selling price of $40 per unit.
The fixed budget is based on 20,000 units of sales, and the actual results are based on 24,000 units of sales.
Prepare a flexible budget performance report for the year.
First, let’s look at the assumptions that were used to create the fixed budget (20,000 units).
The selling price per unit is $40 per unit ($800,000 divided by 20,000 units).
The variable cost per unit is $8 per unit ($160,000 in variable costs divided by 20,000 units).
We use these budget assumptions to create the flexible budget for the actual number of units sold, 24,000 units.
Had the company known they were going to sell 24,000 units, total sales would have been budgeted at $960,000 ($40.00 per unit multiplied by 24,000 units).
Variable costs would have been budgeted at $192,000 ($8.00 per unit multiplied by 24,000 units).
Fixed costs remain constant, regardless of the production volume, $500,000.
Sales
$40.00 x 24,000 units =
$960,000
Variable costs
$8.00 x 24,000 units =
192,000
Fixed costs
500,000
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20. NEED-TO-KNOW 8.1
A manufacturing company reports the fixed budget and actual results for the year as shown below. The
company’s fixed budget assumes a selling price of $40 per unit. The fixed budget is based on 20,000 units
of sales, and the actual results are based on 24,000 units of sales. Prepare a flexible budget performance
report for the year.
Fixed Budget
Actual Results
(20,000 units)
(24,000 units)
Sales
$800,000
$972,000
Variable costs
160,000
240,000
Fixed costs
500,000
490,000
Budget Assumptions
Flexible Budget
(24,000 units)
Sales
$40.00 x 24,000 units =
$960,000
Variable costs
$8.00 x 24,000 units =
192,000
Fixed costs
500,000
FLEXIBLE BUDGET PERFORMANCE REPORT
The flexible budget performance report compares the company's actual results with the predicted results from the flexible budget.
$960,000 of sales in the flexible budget vs. $972,000 in actual sales is a $12,000 favorable variance, as additional sales increase net income.
$192,000 of variable costs in the flexible budget vs. $240,000 in actual variable costs is a $48,000 unfavorable variance, as additional costs decrease net income.
Contribution margin, Sales minus Variable Costs, $768,000 per the flexible budget vs. $732,000 actual is a $36,000 unfavorable variance.
$490,000 in actual fixed costs vs. budget fixed costs of $500,000 is a $10,000 favorable variance.
Net income $242,000 actual vs. $268,000 in the flexible budget is an overall unfavorable variance of $26,000.
Flexible Budget
Actual Results
(24,000 units)
(24,000 units)
Variances
Sales
$960,000
$972,000
$12,000
Favorable (F)
Variable costs
192,000
240,000
48,000
Unfavorable (U)
Contribution margin
768,000
732,000
36,000
Unfavorable (U)
Fixed costs
500,000
490,000
10,000
Favorable (F)
Net income
268,000
242,000
26,000
Unfavorable (U)
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21. Manufacturing Overhead
Cost Variances
This variance is unfavorable (U) because the actual cost exceeds the standard cost.
A standard cost variance is the amount by which an actual cost differs from the standard cost.
This variance is favorable (F) because the actual cost is less than the standard cost.
Direct Materials
Standard cost
Direct Labor
$ Amount
Part I
You can see from this diagram that direct labor cost is equal to the standard cost for labor, while direct materials cost is above standard and manufacturing overhead cost is below standard. The difference between actual cost and standard cost is called a standard cost variance.
Part II
In the example shown, the material variance is unfavorable because the actual cost exceeds the standard cost. The manufacturing overhead cost is favorable because the actual cost is less than standard cost.
Manufacturing Overhead
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Type of Product Cost
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22. Cost Variance Computation
Management needs information about the factors causing a cost variance, but first it must properly compute the variance. In its most simple form, a cost variance (CV) is computed as:
Cost Variance (CV) = Actual Cost (AC) - Standard Cost (SC)
where:
Actual Cost (AC) = Actual Quantity (AQ) x Actual Price (AP)
Standard Cost (SC) = Standard Quantity (SQ) x Standard Price (SP)
Actual quantity (AQ) is the input (material or labor) used to manufacture the quantity of output.
Standard quantity (SQ) is the standard input for the quantity of output.
Actual price (AP) is the actual amount paid to acquire the input (material or labor).
Standard price (SP) is the standard price.
Management needs information about the factors causing a cost variance, but first it must properly compute the variance. In its most simple form, a cost variance (CV) is computed as: Actual Cost (AC) minus Standard Cost (SC). We can break the formula down even further by defining how to calculate Actual Cost and how to calculate Standard Cost. The formulas for both are listed on this screen.
A cost variance is further defined by its components. Actual quantity (AQ) is the input (material or labor) used to manufacture the quantity of output. Standard quantity (SQ) is the standard input for the quantity of output. Actual price (AP) is the actual amount paid to acquire the input (material or labor), and standard price (SP) is the standard price.
Price variances result when we pay an actual price for a resource that differs from the standard price that should have been paid. Quantity variances are caused by using an actual amount of a resource that differs from the standard amount that should have been used.
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23. Cost Variance Computation
Two main factors cause a cost variance:
Cost Variance
Quantity Variance
Price Variance
The difference between the actual price and the standard price.
The difference between the actual quantity and the standard quantity.
Two main factors cause a cost variance:
1. The difference between actual price per unit of input and standard price per unit of input results in a price (or rate) variance.
2. The difference between actual quantity of input used and standard quantity of input used results in a quantity (or usage or efficiency) variance.
To assess the impacts of these two factors in a cost variance, let’s look at the model on the next slide.
To assess the impacts of these two factors in a cost variance, let’s look at the model on the next slide.
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24. Cost Variance Computation
Standard quantity is the quantity that should have been used for the actual good output.
Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price
Price Variance
Quantity Variance
Standard price is the amount that should have been paid for the resources acquired.
Here’s a general model for computing standard cost variances. We multiply the actual quantity times the actual price and compare that to the actual quantity times the standard price. The difference is the price variance. Then we compare the actual quantity times the standard price to the standard quantity at the standard price. The difference is the quantity variance.
The standard quantity is the standard quantity for one unit multiplied times the number of good units produced. It is the amount of a resource that should have been used given the actual good output achieved.
The standard price is the amount we should pay for the resource acquired.
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25. Cost Variance Computation
Actual Cost
Standard Cost
Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price
Price Variance
Quantity Variance
We can reduce these relationships to mathematical equations. For example, we can determine the material price variance by multiplying the actual quantity times the difference between the actual price and the standard price, and we can determine the material quantity variance by multiplying the standard price times the difference between the actual quantity and the standard quantity.
(AP - SP) x AQ (AQ - SQ) x SP
AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity
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26. NEED-TO-KNOW 8.2
A manufacturing company reports the following for one of its products. Compute the direct materials
(a) price variance and (b) quantity variance and indicate whether they are favorable or unfavorable.
Direct materials standard
8 $6.00 per pound
Actual direct materials used
83,000 $5.80 per pound
Actual finished units produced
10,000 AQ
83,000
lbs. AP
$5.80
per lb. SQ
80,000
lbs.
(10,000 units x 8 lbs. per unit) SP
$6.00
per lb.
Actual Cost
Standard Cost
AQ X AP
AQ x SP
SQ x SP
83,000 x $5.80
83,000 x $6.00
[10,000 x 8] x $6.00
$481,400
$498,000
$480,000
$16,600 Favorable
$18,000 Unfavorable
A manufacturing company reports the following for one of its products. Compute the direct materials price variance and quantity variance, and indicate whether they are favorable or unfavorable.
Variance analysis compares the total actual cost of inputs with the total standard cost.
The actual cost is equal to the actual quantity purchased multiplied by the actual price per pound.
The total standard cost is the standard quantity of materials multiplied by the standard price per pound.
In between these two values, we'll standardize the pricing first:
Actual quantity multiplied by the standard price. The actual quantity of materials is 83,000 pounds. The actual price is $5.80 per pound.
The standard quantity is 80,000 pounds, because each of the 10,000 units produced should have used exactly 8 pounds of materials. The standard price is $6.00 per pound.
83,000 pounds of materials purchased, at an actual rate of $5.80 per pound, is a total actual cost of $481,400.
The actual quantity, 83,000, multiplied by $6.00 per pound is $498,000. The difference between the actual quantity at the actual price and the actual quantity at the standard price is the materials price variance, $16,600.
This variance is favorable, as the company paid $0.20 less per pound for each of the 83,000 pounds purchased.
The standard quantity, 80,000 pounds, (10,000 units multiplied by 8 pounds per unit) multiplied by the standard price of $6.00 per pound, is a total standard cost of $480,000.
The difference between the actual quantity at the standard price and the standard quantity at the standard price is the materials quantity variance.
The difference is $18,000, and this variance is unfavorable, as the actual quantity used, 83,000 pounds, exceeded the standard quantity of 80,000 pounds.
3,000 additional pounds at $6.00 per pound is an $18,000 unfavorable materials quantity variance.
The total materials variance, the difference between the actual cost, $481,400, and the total standard cost, $480,000, is a $1,400 unfavorable total direct materials variance.
Notice that when we combine the $16,600 favorable materials price variance with the $18,000 unfavorable materials quantity variance, the total variance is $1,400 unfavorable.
Materials Price Variance
Materials Quantity Variance
$1,400 Unfavorable
Total Direct Materials Variance
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27. NEED-TO-KNOW 8.3
The following information is available for York Company.
Actual direct labor cost (6,250 per hour)
$81,875
Standard direct labor hours per unit
2.0 hours
Standard rate per hour
$13.00
Actual production (units)
2,500
Budgeted production (units)
3,000
Compute the direct labor rate and efficiency variances. SQ
(2,500 units x 2 hrs. per unit = 5,000 standard hrs. )
Actual Cost
Standard Cost
AQ X AR
AQ x SR
SQ x SR
6,250 x $13.10
6,250 x $13.00
(2,500 x 2) x $13.00
$81,875
$81,250
$65,000
$625 Unfavorable
$16,250 Unfavorable
Labor Rate Variance
Labor Efficiency Variance
The following information is available for York Company.
Compute the direct labor rate and efficiency variances. Variance analysis identifies the reasons for the differences between total actual cost and total standard cost.
The actual cost is calculated by multiplying the actual number of direct labor hours by the actual rate. The standard cost is equal to the standard number of direct labor hours multiplied by the standard rate.
And, in between these two values, we standardize the rate first.
The actual number of direct labor hours is 6,250 hours. The actual rate is $13.10 per hour.
The total actual cost of direct labor is the $81,875.
If we multiply the actual number of hours, 6,250, by the standard rate of $13.00 per hour the total is $81,250.
The difference between these two values is the direct labor rate variance, a $625 unfavorable variance, as the company paid $0.10 per hour more for each of the 6,250 direct labor hours.
The standard number of direct labor hours is calculated based on the number of units produced.
Each of the 2,500 units produced should have required exactly 2 hours of direct labor, a total of 5,000 standard direct labor hours.
When we multiply the standard hours, 5,000, by the standard rate, $13.00 per hour, the total standard cost of direct labor is $65,000.
The difference between the actual quantity at the standard rate and the standard quantity at the standard rate is the labor efficiency variance. In this case, it's a $16,250 unfavorable variance, as the company used 1,250 more direct labor hours than was budgeted.
1,250 additional hours at $13.00 per hour explains the $16,250 unfavorable efficiency variance.
The total direct labor variance is $16,875 unfavorable; the $81,875 actual cost minus the $65,000 standard cost.
Notice that when we combine the $625 unfavorable labor rate variance with the $16,250 unfavorable labor efficiency variance, it explains the $16,875 unfavorable total direct labor variance.
$16,875 Unfavorable
Total Direct Labor Variance
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28. Computing Overhead Cost Variances
When standard costs are used, a company applies overhead to the units produced using the predetermined standard overhead rate.
The difference between the total overhead cost applied to products and the total overhead cost actually incurred is called an overhead cost variance. It’s defined as:
Overhead Cost
Variance
(OCV)
Actual Overhead
Incurred
(AOI)
Standard Overhead
Applied
(SOA) = –
When standard costs are used, the cost accounting system applies overhead to the good units produced using the predetermined standard overhead rate. At period-end, the difference between the total overhead cost applied to products and the total overhead cost actually incurred is called an overhead cost variance (total overhead variance).
During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000.
Ex: During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000.
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29. Total Overhead Cost Variance
Ex: During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000.
Overhead cost
variance
(OCV)
Actual overhead
incurred
(AOI)
Standard overhead
applied
(SOA) = –
$3,650 + $4,000
3,500 DLH × $2.00 per DLH = –
(OCV)
When standard costs are used, the cost accounting system applies overhead to the good units produced using the predetermined standard overhead rate. At period-end, the difference between the total overhead cost applied to products and the total overhead cost actually incurred is called an overhead cost variance (total overhead variance).
The standard overhead applied is based on the standard number of hours that should have been used, based on the actual production, and the predetermined overhead rate. To illustrate, G-Max produced 3,500 units during the month, which should have used 3,500 direct labor hours. G-Max’s predetermined overhead rate at the predicted capacity level of 4,000 units was $2.00 per direct labor hour, so the standard overhead applied is $7,000 (computed as 3,500 x $2.00). Additional data from cost reports show that the actual overhead cost incurred in the month is $7,650; thus, G-Max’s total overhead variance is $650, computed as $7,650 less $7,000. This variance is unfavorable, as G-Max’s actual overhead was higher than it should have been based on budgeted amounts.
To help identify factors causing the overhead cost variance, managers analyze this variance separately for controllable and volume variances. The results provide information useful for taking strategic actions to improve company performance.
$7,650
$7,000 = –
(OCV) =
(unfavorable ) $650
(OCV)
To help identify factors causing the overhead cost variance, let’s analyze this variance separately for controllable and volume variances.
P 3
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30. NEED-TO-KNOW 8.4
A manufacturing company uses standard costs and reports the information below for January. The company
uses machine hours to allocate overhead, and the standard is two machine hours per finished unit.
Predicted activity level
1,500 units
Variable overhead rate
$2.50 per machine hour
Fixed overhead budgeted
$6,000 per month ($2.00 per machine hour at predicted activity level)
Actual activity level
1,800 units
Actual overhead costs
$15,800
Compute the total overhead cost variance, overhead controllable variance, and overhead volume variance
for January. Indicate whether each variance is favorable or unfavorable.
Actual Overhead
Flexible Budget
1,800 units
Standard Cost
SQ x SR
VOH [(1,800 x 2) x $2.50] + FOH $6,000
(1,800 x 2) x $4.50
$15,800
$15,000
$16,200
$800 Unfavorable
$1,200 Favorable
Controllable Variance
Overhead Volume Variance
A manufacturing company uses standard costs and reports the information below for January.
The company uses machine hours to allocate overhead, and the standard is two machine hours per finished unit.
Compute the total overhead cost variance, overhead controllable variance, and overhead volume variance for January. Indicate whether each variance is favorable or unfavorable.
The difference between total actual overhead and the amount of overhead in the flexible budget is the controllable variance.
The difference between the flexible budget and the total amount of overhead applied is the overhead volume variance.
The actual overhead incurred is $15,800. The flexible budget is the amount that would have been budgeted had they known that they were going to produce 1,800 units rather than the 1,500 units predicted.
The flexible budget includes both variable and fixed overhead.
Variable overhead is equal to 3,600 standard machine hours (2 machine hours per unit for each of the 1,800 units produced) multiplied by the variable overhead rate of $2.50 per machine hour; a total of $9,000 of variable overhead.
Fixed overhead is constant, regardless of the amount of production. Fixed overhead in the flexible budget is $6,000. The total flexible budget for 1,800 units is $15,000.
The difference between the flexible budget, $15,000, and the actual costs, $15,800, is an $800 unfavorable controllable variance.
Overhead is applied based on the 3,600 machine hours at the total overhead rate of $4.50 per machine hour (the fixed overhead rate of $2.00 per hour plus the variable rate of $2.50 per hour) Work in process is charged for the total standard cost: 3,600 machine hours multiplied by $4.50 per machine hour, $16,200.
The difference between the flexible budget, $15,000, and the standard cost, $16,200, is a $1,200 favorable overhead volume variance.
Whenever the actual activity level exceeds the predicted activity level, the volume variance is favorable.
The total overhead variance is a $400 favorable variance, as total actual costs are $400 less than the total standard cost.
$400 Favorable
Total Overhead Variance SQ
3,600
MHs
(1,800 units x 2 MHs per unit = 3,600 standard hrs. ) SR
$4.50
per MH
(FOH $ VOH $2.50 = $4.50 per MH)
P 3
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31. Performance Measurement and Responsibility Accounting
Chapter 09
Performance Measurement and Responsibility Accounting
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32. Performance Evaluation
The accounting system provides information about resources used and outputs achieved. Managers use this information to control operations, appraise performance, allocate resources, and plan strategy. The type of accounting information provided depends on whether the department is a . . .
Evaluated on ability to control costs.
Cost center
Evaluated on ability to generate revenues in excess of expenses.
Profit center
Evaluated on ability to generate return on investment in assets.
Investment center
All departments, whether production, sales, or service, use resources to achieve a desired output. If our decentralized accounting system is properly designed and implemented, we can control operations, appraise performance, allocate resources, and plan strategy. One of top management’s objectives for this type of system is to be able to allocate more resources to those departments who are performing at the highest level.
Financial information used to evaluate a department depends on whether it is evaluated as a cost center, profit center, or investment center. Cost centers incur costs without directly generating revenues. Cost centers are evaluated on their ability to control costs. Profit center managers are judged on their ability to generate revenues in excess of the profit center’s costs. In addition to generating revenues and controlling costs, investment center managers make asset investment decisions and are evaluated based on the investment return on those investments.
A responsibility accounting system can be set up to control costs and evaluate managers’ performance by assigning costs to the managers responsible for controlling them. We will look at responsibility accounting and cost control in the next section of this presentation.
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33. Responsibility Accounting Performance Reports
Amount of detail varies according to the level in the organization.
The amount of detail in performance reports varies according to the level in the organization. The number of controllable costs reported varies across management levels. At lower levels, managers have limited responsibility and thus few controllable costs. Responsibility and control broaden for higher-level managers; therefore, their reports span a wider range of costs. In general, lower-level managers receive detailed reports, but the level of detail decreases at higher levels. Top management receives reports that are highly summarized. If a problem arises, top management can request greater detail to look into the problem.
A store manager receives summarized information from each department.
A department manager receives detailed reports.
P 1
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34. Departmental Income Statements
Let’s prepare departmental income statements using the following steps:
Accumulating revenues and direct expenses by department.
Allocating indirect expenses across departments.
Allocating service department expenses to operating departments.
Preparing departmental income statements.
Now that we have discussed direct expenses and the allocation of indirect expenses, we are ready to put our knowledge to work by preparing departmental income statements. These statements are the primary tool for evaluating departmental performance. Before we prepare the departmental income statements, we must determine the expenses for each department using the first three steps of the four-step process that you see on your screen.
Step 1: Accumulating revenues and direct expenses by department.
Step 2: Allocating indirect expenses across departments.
Step 3: Allocating service department expenses to operating departments.
Step 4: Preparing departmental income statements.
P 3
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35. Departmental Income Statements Step 1: Accumulating revenues and direct expenses by department
Revenues and/or Direct expenses are traced to each department without allocation.
Revenues and Direct Expenses
Revenues and Direct Expenses
Direct Expenses
Direct Expenses
Service Dept. (Cost Center) General Office
Service Dept. (Cost Center) Purchasing
Step One is to accumulate revenues and direct expenses by department. Recall that direct expenses are incurred for the sole benefit of one department. Note that two of the departments on your screen, the Hardware department and the Housewares department, are both operating departments, and two, the General Office and the Purchasing departments, are service departments. Service departments may have direct expenses, but no revenue. After we have accumulated all of the expenses in the service departments, we will allocate the total from each service department to the operating departments.
Operating Dept. (Profit Center) Hardware
Operating Dept. (Profit Center) Housewares
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36. Departmental Income Statements Step 2: Allocating indirect expense across departments
Indirect expenses are allocated to all departments using appropriate allocation bases.
Allocation
Allocation
Allocation
Allocation
Service Dept. (Cost Center) General Office
Service Dept. (Cost Center) Purchasing
Step Two is the allocation of indirect expenses across departments. Indirect expenses can included items such as depreciation, rent, advertising, and any other expenses that cannot be directly assigned to a department. Indirect expenses are first recorded in company accounts. Then, an allocation base is identified for each expense, and costs are allocated using a departmental expense allocation spreadsheet. Now each department has a combination of direct expenses and allocated expenses.
Operating Dept. (Profit Center) Hardware
Operating Dept. (Profit Center) Housewares
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37. Departmental Income Statements Step 3: Allocating service department expenses to operating departments
Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to operating departments.
Service Dept. (Cost Center) General Office
Service Dept. (Cost Center) Purchasing
Step Three is the allocation of service department expenses to operating departments. The total expense to be allocated from each service department is made up of the service department’s direct expenses from step one and the allocated expenses from step two.
We will illustrate this three-step process using the Ames Hardware Company.
Allocation
Allocation
Operating Dept. (Profit Center) Hardware
Operating Dept. (Profit Center) Housewares
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38. Balanced Scorecard Collects information on several key performance indicators within each of the four perspectives.
Customer Perspective
How do our customers see us?
Performance Indicators
Innovation/Learning How can we continually improve and create value?
Internal Processes
In which activities must we excel?
A balanced scorecard consists of an integrated set of performance measures that are derived from and support a company’s vision and strategy. The balanced scorecard is used to assess company and division manager performance. The balanced scorecard requires managers to think of their company from four perspectives:
1. customer perspective: What do customers think of us?
2. internal processes: Which of our operations are critical to meeting customer needs?
3. innovation and learning: How can we improve?
4. financial: What do our owners think of us?
In the balanced scorecard approach, we continually develop indicators that help us analyze or answer questions such as: how do we appear to our owners; how do we appear to our customers; what kind of continual innovation and learning is taking place; and which processes within the organization are excellent and which need improvement?
The key sequence of events in the balanced scorecard approach is that learning improves business processes. Improved business processes translate to improved customer satisfaction. When we have a high degree of customer satisfaction, we have improved financial results.
Financial Perspective
How do we look to the firm’s owners?
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39. Cycle Time and Cycle Efficiency
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40. Process Time + Inspection Time + Move Time + Wait Time
Cycle Time and Cycle Efficiency A metric that measures the time involved in manufacturing a product.
Order Received
Production Started
Goods Shipped
Process Time + Inspection Time + Move Time + Wait Time
Manufacturing Cycle Time
Total time is the elapsed time from when a customer order is received to when the completed order is shipped. The manufacturing cycle time is the amount of time required to turn raw materials into completed products. This includes process time, inspection time, move time, and wait time. Process time is the time spent producing the product and it is the only value-added activity of the four components of cycle time because it is the only activity in cycle time that adds value to the product form the customer’s perspective.
Total Time
Process time is the time spent producing the product and it is the only value-added time!
A 4
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41. Cycle Time and Cycle Efficiency
Order Received
Production Started
Goods Shipped
Process Time + Inspection Time + Move Time + Wait Time
Manufacturing Cycle Time
Companies strive to reduce non-value-added time to improve cycle efficiency (CE), which is a measure of production efficiency. Cycle efficiency (CE) is computed by dividing value-added time by cycle (throughput) time. A CE less than one indicates that non-value-added time is present in the production process and they need to evaluate it to identify ways to reduce non-value-added activities.
Total Time
Cycle
Efficiency
Value-added time Manuf. Cycle time =
A 4
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42. Break for Minutes

43. Relevant Costing for Managerial Decisions
Chapter 10
Relevant Costing for Managerial Decisions
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44. Describe the importance of relevant costs for short-term decisions.
10-C1: Describe the importance of relevant costs for short-term decisions.
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45. C 1
Relevant Costs
Sunk costs are the result of past decisions and cannot be changed by any current or future decisions. Sunk costs are irrelevant to current or future decisions.
Out-of-pocket costs are future outlays of cash associated with a particular decision. Out-of-pocket costs are relevant to decisions.
Sunk costs cannot be changed by any decision we make as they have been incurred in the past and cannot possibly differ between any alternative that we might currently choose. Sunk costs should not be considered in the decision process. For example, if you bought an automobile two years ago for $15,000, that amount is a sunk cost. Whether you drive the car, park it, trade it, or sell it, the $15,000 cost will not change.
An out-of-pocket cost is a future outlay of cash associated with a particular decision alternative. Out-of-pocket costs are relevant costs as they are future costs that differ between alternatives. For example, in considering the decision to take a vacation or stay at home, you will have travel costs (out-of-pocket costs) only if you choose a vacation.
Opportunity costs are the potential benefits that are given up when one alternative is selected over another. Opportunity costs are not actual dollar outlays; however, they may impact our decisions. For example, the opportunity cost of attending college is the lost salary that you could have earned by working.
Besides relevant costs, management must also consider the relevant benefits associated with a decision. Relevant benefits refer to the additional or incremental revenue generated by selecting a particular course of action over another.
Opportunity costs are the potential benefits given up when one alternative is selected over another. Opportunity costs are relevant to decisions.
Management must also consider relevant benefits.
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46. Need to Know 10.1
P 1
A company receives a special order for 200 units that requires stamping the buyer’s name on
each unit, yielding an additional fixed cost of $400 to its normal costs. Without the order, the
company is operating at 75% of capacity and produces 7,500 units of product at the
costs below. The company's normal selling price is $22 per unit. The sales price for the
special order is $18 per unit.
Costs
Variable
Fixed costs
(7,500
costs per
units)
unit
Direct materials
$37,500
$5.00
Direct labor
60,000
$8.00
Overhead (30% variable)
20,000
$0.80
$14,000
Selling expenses (60% variable)
25,000
$2.00
$10,000
The special order will not affect normal unit sales and will not increase fixed overhead and
selling expenses. Variable selling expenses on the special order are reduced to one-half
the normal amount. Should the company accept the special order?
In order for the special order to be accepted, it must 1) increase net income; the incremental
revenue must exceed the incremental expense, and 2) not adversely impact normal sales.
Need-to-Know 10.1
A company receives a special order for 200 units that requires stamping the buyer’s name on each unit,
yielding an additional fixed cost of $400 to its normal costs.
Without the order, the company is operating at 75% of capacity and produces 7,500 units of product at the costs below.
The company's normal selling price is $22 per unit. The sales price for the special order is $18 per unit. The special order will not affect normal unit sales and will not increase fixed overhead and selling expenses. Variable selling expenses on the special order are reduced to one-half the normal amount. Should the company accept the special order?
First we need to determine which costs are variable, costs that will increase on a per unit basis, and which costs are fixed.
Direct materials are variable costs. $37,500 divided by 7,500 units is a variable cost per unit of $5.
Direct labor is also a variable cost. $60,000 divided by 7,500 units is a variable cost per unit of $8.
30% of the overhead is variable. 30% of $20,000 is $6,000. $6,000 divided by 7,500 units is a variable cost per unit of $0.80.
The remaining 70%, $14,000, is a fixed cost.
Selling expenses: 60% are variable. 60% of $25,000 is $15,000.
$15,000 divided by 7,500 units is a variable cost per unit of $2.
The remaining 40%, $10,000, is a fixed cost.
So, now, we can look at the profitability of the additional 200 units. In order for the special order to be accepted, it
must increase net income; the incremental revenue must exceed the incremental expense, and the special order must not adversely impact normal sales.
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47. Yes, the company should accept the special order.
Need to Know 10.1
P 1
A company receives a special order for 200 units that requires stamping the buyer’s name on
each unit, yielding an additional fixed cost of $400 to its normal costs. Without the order, the
company is operating at 75% of capacity and produces 7,500 units of product at the
costs below. The company's normal selling price is $22 per unit. The sales price for the
special order is $18 per unit.
Costs
Variable
Fixed costs
(7,500
costs per
units)
unit
Direct materials
$37,500
$5.00
Direct labor
60,000
$8.00
Overhead (30% variable)
20,000
$0.80
$14,000
Selling expenses (60% variable)
25,000
$2.00
$10,000
The special order will not affect normal unit sales and will not increase fixed overhead and
selling expenses. Variable selling expenses on the special order are reduced to one-half
the normal amount. Should the company accept the special order?
Incremental revenues
(200 units x $18.00)
$3,600
Direct materials
(200 units x $5.00)
$1,000
Need-to-Know 10.1
The incremental revenue for this order, 200 units at $18 per unit, $3,600.
The incremental costs will include direct materials: 200 units at $5 per unit, $1,000; Direct labor, 200 units at $8 per unit, $1,600; the variable portion of the overhead, 200 units at
$0.80 per unit, $160; variable selling expenses, 200 units multiplied by the $2 per unit multiplied by 50%, as the as the variable selling expenses are reduced to one-half the normal amount, $200.
The special order will also have additional fixed cost for the stamping of $400.
Total incremental expenses are $3,360.
Net income will increase by $240.
So yes, the company should accept the special order.
Direct labor
(200 units x $8.00)
1,600
Overhead (30% variable)
(200 units x $0.80)
160
Selling expenses (60% variable)
(200 units x $2.00 x 50%)
200
Additional fixed costs
(Stamping costs)
400
Total incremental expenses
3,360
Net income increases by:
$240
Yes, the company should accept the special order.
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48. Need to Know 10.2
P 1
A company currently buys a key part for a product it manufactures. The company buys the part for $5 per
unit and believes it can make the part for $1.50 per unit for direct materials and $2.50 per unit for direct
labor. The company allocates overhead costs at the rate of 50% of direct labor. Incremental overhead costs
to make this part are $0.75 per unit. Should the company make or buy the part?
(per unit)
Make
Buy
Direct materials
$1.50
Direct labor
2.50
Overhead
0.75
Cost to buy the part
$5.00
Total
$4.75
$5.00
The company should make the part, because the $4.75 cost to make is less than the $5.00 cost to buy.
Need-to-Know 10.2
A company currently buys a key part for a product it manufactures. The company buys the part for $5 per unit and believes it can make the part for $1.50 per unit for direct materials and $2.50 per unit for direct labor.
The company allocates overhead costs at the rate of 50% of direct labor.
Incremental overhead costs to make this part are $0.75 per unit.
Should the company make or buy the part?
The costs to make the part include: Direct materials, $1.50 per unit; Direct labor, $2.50 per unit, and variable
overhead, $0.75 per unit.
The cost to buy the part is $5.00 per unit.
The total cost to make each unit is $4.75, which is $0.25 less per unit than the cost to buy the units.
The company should make the part.
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49. Need-to-Know 10.3
P 1
For each of the two independent scenarios below, determine whether the company should sell the partially
completed product as is or process it further into other saleable products.
1. $10,000 of manufacturing costs have been incurred to produce Product Alpha. Alpha can be sold as is
for $30,000 or processed further into two separate products, BB and CC. The further processing will
cost $15,000, and products BB and CC can be sold for total revenues of $60,000.
2. $5,000 of manufacturing costs have been incurred to produce Product Delta. Delta can be sold as is for
$150,000 or processed further into two separate products, YY and ZZ. The further processing will cost
$75,000, and Products YY and ZZ can be sold for total revenues of $200,000.
Need-to-Know 10.3
For each of the two independent scenarios below, determine whether the company should sell the partially completed product as is or process it further into other saleable products.
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50. Need-to-Know 10.3
P 1
1. $10,000 of manufacturing costs have been incurred to produce Product Alpha. Alpha can be sold as is
for $30,000 or processed further into two separate products, BB and CC. The further processing will
cost $15,000, and products BB and CC can be sold for total revenues of $60,000.
Alpha
Sell as is
Process Further
Incremental revenue
$30,000
$60,000
Incremental cost
(15,000)
Incremental income
$30,000
$45,000
Alpha should be processed further; doing so will yield an extra $15,000 ($45,000 - $30,000) of income.
2. $5,000 of manufacturing costs have been incurred to produce Product Delta. Delta can be sold as is for
$150,000 or processed further into two separate products, YY and ZZ. The further processing will cost
$75,000, and Products YY and ZZ can be sold for total revenues of $200,000.
Delta
Sell as is
Process Further
Incremental revenue
$150,000
$200,000
Incremental cost
(75,000)
Need-to-Know 10.3
1. $10,000 of manufacturing costs have been incurred to produce Product Alpha. Alpha can be sold as is for $30,000 or processed further into two separate products, BB and CC. The further processing will cost $15,000, and products BB and CC can be sold for total revenues of $60,000. The incremental revenue is $30,000 if we sell the products as is.
If the units are processed further, they can be sold for $60,000. There is no incremental cost if we sell the products
as is.
If we process the units further, the additional cost will be $15,000.
The incremental income if we sell the units as is, $30,000, vs. $45,000 if the units are processed further.
Alpha should be processed further; doing so will yield an extra $15,000 ($45,000 - $30,000) of income.
2. $5,000 of manufacturing costs have been incurred to produce Product Delta. Delta can be sold as is for $150,000 or processed further into two separate products, YY and ZZ.
The further processing will cost $75,000, and Products YY and ZZ can be sold for total revenues of $200,000.
If we sell the units as is, incremental revenue is $150,000. If they're processed further, incremental revenue is
$200,000.
There is no additional cost if we sell the units as is.
The incremental cost if the units are processed further is $75,000.
Incremental income if we sell the units as is, $150,000, vs. incremental income if the units are processed further, $125,000.
Delta should be sold as is; doing so will yield an extra $25,000 ($150,000 - $125,000) of income.
Incremental income
$150,000
$125,000
Delta should be sold as is; doing so will yield an extra $25,000 ($150,000 - $125,000) of income.
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51. Need-to-Know 10.4
P 1
A company produces two products, Gamma and Omega. Gamma sells for $10 per unit and Omega sells
for $12.50 per unit. Variable costs are $7 per unit of Gamma and $8 per unit of Omega. The company has
a capacity of 5,000 machine hours per month. Gamma uses 1 machine hour per unit, and Omega uses 3
machine hours per unit.
1. Compute the contribution margin per machine hour for each product.
2. Assume demand for Gamma is limited to 3,800 units per month, and demand for Omega is
limited to 1,000 units per month. How many units of Gamma and Omega should the company
produce, and what will be the total contribution margin from this sales mix?
(per unit)
Gamma
Omega
Sales
$10.00
$12.50
Variable costs
(7.00)
(8.00)
Contribution margin per unit
$3.00
$4.50
Machine hours per unit 1 3
Contribution margin per machine hour
$3.00
$1.50
Total machine hours available
5,000
Need-to-Know 10.4
A company produces two products, Gamma and Omega. Gamma sells for $10 per unit and Omega sells for $12.50 per unit.
Variable costs are $7 per unit of Gamma and $8 per unit of Omega.
The company has a capacity of 5,000 machine hours per month. Gamma uses 1 machine hour per unit, and Omega
uses 3 machine hours per unit.
1. Compute the contribution margin per machine hour for each product.
Contribution margin per unit is equal to sales:
$10.00 per unit for Gamma, and $12.50 per unit for Omega; minus variable costs; $7.00 per unit for Gamma and $8.00 per unit for Omega.
Contribution margin is $3.00 per unit for Gamma and $4.50 per unit for Omega.
At first glance, it may look like the production of Omega is more profitable, but we need to consider the limiting resources, in this case machine hours. It only takes one machine hour to produce 1 unit of Gamma, generating $3.00 in contribution margin per machine hour. It takes 3 machine hours to produce each unit of Omega; the contribution margin per machine hour is only $1.50.
2. Assume demand for Gamma is limited to 3,800 units per month, and demand for Omega is limited to 1,000 units per month.
How many units of Gamma and Omega should the company produce, and what will be the total contribution margin from this sales mix?
With the 5,000 available machine hours, the company should choose to produce the units with the highest contribution margin per machine hour, Gamma, producing as many units as the market demands.
The market demand for Gamma is 3,800 units per month, which will require 3,800 machine hours (1 hour per unit).
With the remaining 1,200 machine hours, the company should produce the less profitable units, Omega.
1,200 machine hours divided by 3 MHs per unit will allow the production of 400 units of Omega.
Machine hours used for production of Gamma
(3,800 units x 1 MH per unit)
3,800
Machine hours available for production of Omega
1,200
Machine hours used for production of Omega
(1,200 MHs / 3 MH per unit = 400 units)
1,200
Remaining machine hours
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52. Need-to-Know 10.4
P 1
A company produces two products, Gamma and Omega. Gamma sells for $10 per unit and Omega sells
for $12.50 per unit. Variable costs are $7 per unit of Gamma and $8 per unit of Omega. The company has
a capacity of 5,000 machine hours per month. Gamma uses 1 machine hour per unit, and Omega uses 3
machine hours per unit.
1. Compute the contribution margin per machine hour for each product.
2. Assume demand for Gamma is limited to 3,800 units per month, and demand for Omega is
limited to 1,000 units per month. How many units of Gamma and Omega should the company
produce, and what will be the total contribution margin from this sales mix?
(per unit)
Gamma
Omega
Sales
$10.00
$12.50
Variable costs
(7.00)
(8.00)
Contribution margin per unit
$3.00
$4.50
Machine hours per unit 1 3
Contribution margin per machine hour
$3.00
$1.50
Contribution margin (calculated on a per unit basis)
Gamma
3,800 units x $3.00 contribution margin per unit
$11,400
Need-to-Know 10.4
At this sales mix, 3,800 units of Gamma, each contributing $3.00 per unit is a total contribution margin of $11,400 for Gamma,
and 400 units of Omega, each contributing $4.50 per unit is a total contribution margin of $1,800 for Omega.
Total contribution margin is $13,200.
We can prove this answer by calculating the contribution margin per machine hour.
While producing Gamma, the machines run for 3,800 hours generating a contribution margin of $3.00 per machine hour, $11,400.
While producing Omega, the machines run 1,200 hours generating a contribution margin of $1.50 per machine hour, $1,800.
Total contribution margin, $13,200.
Omega
400 units x $4.50 contribution margin per unit
1,800
Total contribution margin
$13,200
Contribution margin (calculated on a per machine hour basis)
Gamma
3,800 machine hours x $3.00 contribution margin per machine hour
$11,400
Omega
1,200 machine hours x $1.50 contribution margin per machine hour
1,800
Total contribution margin
$13,200
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53. Need-to-Know 10.5
P 1
A bike maker is considering eliminating its tandem bike division because it operates at a loss of $6,000
per year. Sales for the year total $40,000, and the company reports the costs for this division as shown
below. Should the tandem bike division be eliminated?
Avoidable Expenses
Unavoidable Expenses
Cost of goods sold
$30,000
Direct expenses
8,000
Indirect expenses
2,500
$3,000
Service department costs
250
2,250
Total
$40,750
$5,250
Keep Tandem Division
Eliminate Tandem Division
Sales
$40,000 $0
Total costs and expenses
46,000
5,250
Net income (loss)
($6,000)
($5,250)
Quantitative Analysis: Total avoidable costs of $40,750 are greater than the division’s sales of $40,000, suggesting the division should be eliminated.
Need-to-Know 10.5
A bike maker is considering eliminating its tandem bike division because it operates at a loss of $6,000 per year.
Sales for the year total $40,000, and the company reports the costs for this division as shown below.
Should the tandem bike division be eliminated?
If the tandem division is kept, sales of $40,000 minus total costs and expenses, both the avoidable and unavoidable expenses of $46,000 is an operating loss of $6,000.
If the division is eliminated, sales will be $0, but the unavoidable expenses of $5,250 will remain.
The operating loss is $5,250.
Based on this information alone, the tandem division should be eliminated.
It makes sense to give up $40,000 in revenues if, in doing so, you can avoid $40,750 in expenses. You are $750 better off.
Of course, other factors might be relevant. For example, are sales expected to increase in the future? Does the sale of tandem bikes help sales of other types of products?
Other factors might be relevant, since the shortfall in sales ($750) is low. For example,
are sales expected to increase in the future? Does the sale of tandem bikes help sales of other types
of products?
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54. Capital Budgeting and Investment Analysis
Chapter 11
Capital Budgeting and Investment Analysis
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55. 1) Compute payback period and describe its use.
11-P1: Compute payback period and describe its use.
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56. Need to Know 11.1
P 1
A company is considering purchasing equipment costing $75,000. Future annual net cash
flows from this equipment are $30,000, $25,000, $15,000, $10,000, and $5,000. Cash
flows occur uniformly during the year. What is this investment's payback period?
Period Expected Net Cash Flows Cumulative Net Cash Flows
Year 0
($75,000)
($75,000)
Year 1
30,000
(45,000)
Year 2
25,000
(20,000)
Year 3
15,000
(5,000)
Year 4
10,000
5,000
Year 5
5,000
10,000
Payback between the end of Year 3 and the end of Year 4
Fraction of Year:
Absolute Value Cumulative Cash Flows Beginning of Year
$5,000
0.5
Expected Net Cash Flows During Year
$10,000
Payback = 3.5 years
Need-to-Know 11.1
A company is considering purchasing equipment costing $75,000.
Future annual net cash flows from this equipment are $30,000, $25,000, $15,000, $10,000, and $5,000.
Cash flows occur uniformly during the year. What is this investment's payback period?
The payback period is the point in time where cumulative cash inflows, ignoring the time value of money, are exactly equal
to the cost of the investment.
We start out with an immediate cash payment of $75,000 to acquire the equipment.
In the first year, net cash flow is $30,000. $30,000 of the machine’s cost has been “paid back”, with a remaining $45,000 to go.
In year 2, net cash flow is $25,000, bringing the cumulative net cash flow to a negative $20,000.
In year 3, net cash flow is $15,000,$5,000 of the machine’s cost is still unpaid.
In year 4, net cash flow is $10,000, bringing the cumulative net cash flow to a positive $5,000.
Since the investment has gone from a net cash outflow of $5,000 to a net cash inflow of $5,000, the investment is
repaid between years 3 and 4.
The payback period is greater than 3 years, but less than 4 years.
To calculate the fraction of the year, the numerator is equal to the net cash outflow at
the end of year 3, still $5,000 of the investment is unpaid, and the denominator is the amount of the net cash inflow
during year 4, $10,000. The fraction of the year is .5.
The payback period = 3.5 years.
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57. 2) Compute accounting rate of return and explain its use.
11-P2: Compute accounting rate of return and explain its use.
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58. Need to Know 11.2
P 2
The following data relate to a company’s decision on whether to purchase a machine:
Cost
$180,000
Salvage value
15,000
Annual after-tax net income
40,000
Assume net cash flows occur uniformly over each year and the company uses straight-line
depreciation. What is the machine's accounting rate of return?
The Accounting Rate of Return (ARR) measures the amount of net income generated from a capital investment.
Accounting Rate of Return = Annual After-Tax Net Income
Annual Average Investment
Annual After-Tax Net Income
(Cost + Salvage) / 2
$40,000
($180,000 + $15,000) / 2
$97,500
41%
Need-to-Know 11.2
The following data relate to a company’s decision on whether to purchase a machine:
Assume net cash flows occur uniformly over each year and the company uses straight-line depreciation.
What is the machine's accounting rate of return?
The Accounting Rate of Return (ARR) measures the amount of net income generated from a capital investment.
It's calculated by taking the annual after-tax net income and dividing by the annual average investment.
The annual average investment is calculated by taking cost plus salvage and dividing by two.
$40,000 of annual after-tax net income divided by the asset's cost, $180,000, plus the salvage value, $15,000, $195,000, divided by two.
$40,000 divided by $97,500 is an accounting rate of return of 41%.
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59. 3) Compute net present value and describe its use.
11-P3: Compute net present value and describe its use..
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60. Need to Know 11.3
P 3
A company can invest in only one of two projects, A or B. Each project requires a $20,000
investment and is expected to generate end-of-period, annual cash flows as follows:
Net Cash Inflows
Year 1
Year 2
Year 3
Total
Project A
$12,000
$8,500
$4,000
$24,500
Project B
4,500
8,500
13,000
26,000
Assuming a discount rate of 10%, which project has the higher net present value?
Project A
Net Cash
PV of $1 at
PV of Net
Inflows
10%
Cash
Inflows
Year 1
$12,000
0.9091
$10,909
Year 2
8,500
0.8264
7,024
Year 3
4,000
0.7513
3,005
$24,500
$20,939
Need-to-Know 11.3
A company can invest in only one of two projects, A or B.
Each project requires a $20,000 investment and is expected to generate end-of-period, annual cash flows as follows:
Assuming a discount rate of 10%, which project has the higher net present value?
Net present value is calculated by subtracting the present value of the cash outflows from the present value of the cash inflows.
If the investment’s net present value is positive, it's an acceptable investment.
Project A has three annual cash flows of different amounts.
To convert these future values to their present value, we multiply by the factor found in the Present
Value of 1 chart, Table B.1.
At a required return of 10%, the one payment of $12,000 received one year from now is the equivalent of payments of $12,000 today, $10,909.
One payment of $8,500 received two years from now is the equivalent of payments of $8,500
today, $7,024.
The final payment of $4,000 received three years from now is the equivalent of payments of $4,000 today, $3,005.
The present value of the cash inflows, $20,939, less the present value of the cash outflow, the immediate payment of $20,000 today is a net present value of $939.
Since the net present value is positive, the investment return is greater than 10%.
PV of Net Cash Inflows
$20,939
Amount invested
(20,000)
Net Present Value – Project A
$939
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61. Need to Know 11.3
P 3
A company can invest in only one of two projects, A or B. Each project requires a $20,000
investment and is expected to generate end-of-period, annual cash flows as follows:
Net Cash Inflows
Year 1
Year 2
Year 3
Total
Project A
$12,000
$8,500
$4,000
$24,500
Project B
4,500
8,500
13,000
26,000
Project B
Net Cash
PV of $1 at
PV of Net
Inflows
10%
Cash
Inflows
Year 1
$4,500
0.9091
$4,091
Year 2
8,500
0.8264
7,024
Year 3
13,000
0.7513
9,767
$26,000
$20,882
PV of Net Cash Inflows
$20,882
PV of Net Cash Inflows
$20,939
Need-to-Know 11.3
Since Project B is also a 3-year investment with a required return of 10%, the factors remain the same.
We multiply each of the annual cash flows by the present value factor to calculate the present value of the cash inflows, $20,882.
We subtract the present value of the cash outflow, the immediate payment of $20,000, to calculate the net present value of $882. Since the net present value is positive, the investment return is also greater than 10%.
So both projects are acceptable, with returns of greater than 10%, but Project A has a slightly better net present
value.
It has a higher rate of return, and should be chosen over Project B.
Amount invested
(20,000)
Amount invested
(20,000)
Net Present Value – Project B
$882
Net Present Value – Project A
$939
Project A has the higher net present value.
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62. 4) Compute internal rate of return and explain its use.
11-P4: Compute internal rate of return and explain its use.
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63. Need to Know 11.4
P 4
A machine costing $58,880 is expected to generate net cash flows of $8,000 per year for each of the next 10 years.
1. Compute the machine’s internal rate of return (IRR).
2. If a company’s hurdle rate is 6.5%, use IRR to determine whether the company should purchase this machine.
Internal rate of return (IRR) is the interest rate at which the net present value cash flows from a project or
investment equal zero.
PV of Net Cash Inflows
$58,880
Amount invested
(58,880)
Net Present Value $0
PV of Net Cash Inflows = Annual Amount x PV Annuity of $1 factor
$58,880 =
$8,000 x
PV of Annuity of $1 factor
$58,880 =
PV of Annuity of $1 factor
$8,000
7.3600 =
PV of Annuity of $1 factor
Need-to-Know 11.4
A machine costing $58,880 is expected to generate net cash flows of $8,000 per year for each of the next 10 years.
1. Compute the machine’s internal rate of return (IRR).
2. If a company’s hurdle rate is 6.5%, use IRR to determine whether the company should purchase this machine.
Internal rate of return (IRR) is the interest rate at which the net present value of the cash flows from a project or investment equals zero.
Net present value equals the present value of the cash inflows minus the amount of the investment.
We know the investment is $58,880. So we need to determine the interest rate where the present value of the net cash inflows is equal to $58,880.
The present value of the net cash inflows is calculated by taking the annual dollar amount and multiplying by the present value of an annuity of one factor.
$58,880 equals $8,000 multiplied by the present value of an annuity factor.
To solve for the factor, we divide $58,880 by $8,000.
The present value of an annuity factor is 7.36
Now we go to the present value of an ordinary annuity table, for n equals 10, and we look for the factor of 7.36, and we see the factor of at the intersection of n equals 10 and an interest rate of 6%.
So, at the intersection of n equals 10 and an interest rate of 6%. The internal rate of return is approximately 6%.
Since this rate is lower than the 6.5% hurdle rate, the machine should not be purchased.
IRR is approximately 6%.
Since this rate is lower than the 6.5% hurdle rate, the machine should not be purchased.
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64. Comparing Capital Budgeting Methods
On this screen, we see a summary comparing the strengths and limitations of each of the four capital budgeting methods that we have studied. Recall that the major limitation of the payback method and the accounting rate of return method is that they neglect the time value of money. This limitation is overcome by using either the net present value or internal rate of return methods.
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65. 5) Analyze a capital investment project using break- even time.
11-A1: Analyze a capital investment project using break-even time.
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66. Break even time for this investment is between 5 and 6 years.
Break-even time incorporates time value of money into the payback period method of evaluating capital investments. It tells us the number of years an investment requires for its net present value to equal its initial cost.
Break even time for this investment is between 5 and 6 years.
Cash
Flows
The payback example that we saw earlier in the chapter neglected the time value of money. Break-even time is a variation of the payback method that incorporates the time value of money by telling us the number of years an investment requires for its net present value to equal its initial cost.
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67. I) Liquidity and efficiency
Ratio Analysis
I) Liquidity and efficiency
II) Solvency
III) Profitability
Ratios are among the more widely used tools of financial analysis because they provide clues to and symptoms of underlying conditions. A ratio can help us uncover conditions and trends difficult to detect by inspecting individual components making up the ratio. Ratios, like other analysis tools, are usually future oriented; that is, they are often adjusted for their probable future trend and magnitude, and their usefulness depends on skillful interpretation.
A ratio expresses a mathematical relation between two quantities. It can be expressed as a percent, rate, or proportion. For instance, a change in an account balance from $100 to $250 can be expressed as (1) 150% increase, (2) 2.5 times, or (3) 2.5 to 1 (or 2.5:1). Computation of a ratio is a simple arithmetic operation, but its interpretation is not. To be meaningful, a ratio must refer to an economically important relation.
This section describes an important set of financial ratios and their application. The selected ratios are organized into the four building blocks of financial statement analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects. All of these ratios were explained at relevant points in prior chapters. The purpose here is to organize and apply them under a summary framework. We use four common standards, in varying degrees, for comparisons: intracompany, competitor, industry, and guidelines.
IV) Market prospects
P 3
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68. I) Liquidity and Efficiency
1) Current
Ratio
4) Inventory Turnover
2) Acid-test
Ratio
5) Days’ Sales Uncollected
3) Accounts Receivable Turnover
Liquidity refers to the availability of resources to meet short-term cash requirements. It is affected by the timing of cash inflows and outflows along with prospects for future performance. Analysis of liquidity is aimed at a company’s funding requirements. Efficiency refers to how productive a company is in using its assets. Efficiency is usually measured relative to how much revenue is generated from a certain level of assets.
6) Days’ Sales in Inventory
7) Total Asset Turnover
P 3
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69. 3) Pledged Assets to Secured Liabilities 4) Times Interest Earned
II) Solvency
1) Debt
Ratio
2) Equity
Ratio
3) Pledged Assets to Secured Liabilities
Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations. All of a company’s business activities—financing, investing, and operating—affect its solvency. Analysis of solvency is long term and uses less precise but more encompassing measures than liquidity. One of the most important components of solvency analysis is the composition of a company’s capital structure. Capital structure refers to a company’s financing sources. It ranges from relatively permanent equity financing to riskier or more temporary short-term financing. Assets represent security for financiers, ranging from loans secured by specific assets to the assets available as general security to unsecured creditors.
4) Times Interest Earned
P 3
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70. 2) Return on Total Assets 3) Return on Common Stockholders’ Equity
III) Profitability
1) Profit
Margin
2) Return on Total Assets
3) Return on Common Stockholders’ Equity
We are especially interested in a company’s ability to use its assets efficiently to produce profits (and positive cash flows). Profitability refers to a company’s ability to generate an adequate return on invested capital. Return is judged by assessing earnings relative to the level and sources of financing. Profitability is also relevant to solvency.
P 3
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71. 1) Price-Earnings Ratio
IV) Market Prospects
1) Price-Earnings Ratio
2) Dividend Yield
Market measures are useful for analyzing corporations with publicly traded stock. These market measures use stock price, which reflects the market’s (public’s) expectations for the company. This includes expectations of both company return and risk—as the market perceives it.
Key measures of market prospects include the price-earnings ratio and dividend yield.
P 3
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72. Summary of Ratios
This slide summarizes the major financial statement analysis ratios illustrated in this chapter and throughout the book. This summary includes each ratio’s title, its formula, and the purpose for which it is commonly used.
Review what you have learned in the following NEED-TO-KNOW Slide.
P 3
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73. Happiness is having all homework Done before due date
Homework assignment
EXAM # 3 is open 8/7 till 8/8 at 8 PM for 60 Points.
Last day of the Homework for Chapters 6, 7, 8, 9, 10, and 11 is 08/08 at 11:59 PM.
COURSE FINAL EXAM ON 8/9 AT 6 PM IN CLASS; GOOD LUCK.
Happiness is having all homework Done before due date
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74. END OF THE COURSE THANK YOU
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