intermediate management accounting primer

Intermediate Management Accounting Primer

Chartered Professional Accountants of Canada, CPA Canada, CPA are trademarks and/or certification marks of the Chartered Professional Accountants of Canada.

© 2020, Chartered Professional Accountants of Canada. All Rights Reserved. 2020-10-29

Table of Contents

INTRODUCTION............................................................................................................. 1PART 1: ROLE OF THE MANAGEMENT ACCOUNTANT AND QUALITY INFORMATION ............................................................................................................... 1

Cost classifications ..................................................................................................... 1Cost flows used in manufacturing systems and the schedule of cost of goods

manufactured........................................................................................................ 2Cost estimation ........................................................................................................... 3Cost-volume-profit analysis......................................................................................... 4Using data to build business models........................................................................... 7Practice questions....................................................................................................... 8

PART 2: CAPACITY ...................................................................................................... 13Support department cost allocation........................................................................... 13Job order costing ...................................................................................................... 14Joint and byproduct costing ...................................................................................... 17Practice questions..................................................................................................... 18

PART 3: PROCESS COSTING ..................................................................................... 24Illustration of a typical process costing system at a soft drink manufacturing plant... 24Spoilage.................................................................................................................... 28Transferred-in costs .................................................................................................. 28Indirect cost allocation systems ................................................................................ 28ABC systems ............................................................................................................ 29Supply chains and the strategic use of costing systems ........................................... 31Practice questions..................................................................................................... 31

PART 4: VARIOUS COSTING METHODS AND BUDGETING ..................................... 37Variable (direct), absorption (full), and throughput costing........................................ 37Budgeting.................................................................................................................. 41Pricing....................................................................................................................... 43Practice questions..................................................................................................... 45

PART 5: STANDARDS AND VARIANCES..................................................................... 53Standards for cost and usage of materials, labour, and overhead ............................ 53

Static budget versus flexible budget ......................................................................... 54Flexible budget versus actual results ........................................................................ 56Investigating variances ............................................................................................. 59Recording and presentation of variances.................................................................. 59Practice questions..................................................................................................... 60

PART 6: RELEVANT COSTS ........................................................................................ 64Make-or-buy decision................................................................................................ 64Add-or-drop decision................................................................................................. 65Special order decision............................................................................................... 66Scarce resource allocation decisions........................................................................ 67Data and professional skepticism ............................................................................. 68Transfer pricing ......................................................................................................... 68Practice questions..................................................................................................... 70


INTERMEDIATE MANAGEMENT ACCOUNTING PRIMER

INTRODUCTION Intermediate Management Accounting expands on the introductory course with an emphasis on costs for management decision-making. This will include exploring cost-volume-profit analysis, job costing, process costing, and activity-based costing. In addition, Intermediate Management Accounting will touch on variable versus absorption costing, budgeting, and pricing. It also looks in detail at variance analysis and then touches on transfer pricing. Additionally, this module highlights some of the ways in which information systems affect management decision-making.

PART 1: ROLE OF THE MANAGEMENT ACCOUNTANT AND QUALITY INFORMATION

One of the key roles of the management accountant is to support the decision-making process of the organization. This includes the following tasks:

• recording and evaluating costs

• developing information to support planning and control

• developing, implementing, and operating performance measurement systems Effective decision-making requires the availability of relevant, timely, and accurate information that is in a format that addresses the types of decisions made at each level of management. Management accountants are responsible for ensuring the data used for decision-making is a faithful representation of the details contained in the data set.

Cost classifications Management accounting has its own terminology that is used for more effective and concise communication. Knowledge of these terms is also essential in this course, as they are used throughout.

• Cost terms used in costing system design o Product (or inventoriable) and period costs: A distinction is made between a

cost incurred to produce a product (product cost) and all other operating costs (period costs).

o Cost object: A cost object is anything to which a cost can be traced, such as a product, a part of the organization (division or department), a project, a client, an event, or even the entire organization.

o Direct and indirect costs: A direct cost is any cost that can be uniquely and unambiguously traced to a cost object in an economic and convenient way. All other costs are indirect.

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• Cost terms used to describe and predict cost behaviour o Fixed cost: A cost that does not change in total over the relevant range of

activity. o Variable cost: A cost that increases in constant proportion with changes in

activity level while the cost per unit stays the same within the relevant range of activity.

o Relevant range: The normal range of activity in which a company expects to operate. Management accounting decisions are made based on the cost behaviour within this range of activity.

• Cost terms used in manufacturing costing systems o Prime and conversion costs: Prime costs generally consist of direct material

and direct labour. Conversion costs generally consist of direct labour and manufacturing overhead.

• Cost terms used in planning and control o Controllable versus non-controllable costs: The idea of controllable and

uncontrollable costs relates to responsibility accounting where managers are responsible only for those costs they can control.

o Discretionary versus engineered costs: Engineered costs, such as materials, labour and equipment costs are driven by a cause-and-effect relationship (materials are driven by production, selling costs are driven by sales). Discretionary costs such as advertising and research and development are, instead, subject to periodic budget allocations.

• Cost terms used in decision-making o Opportunity cost: The benefit forgone when a resource is used for one purpose

instead of another or one course of action is taken over another. o Sunk cost: A cost that has already been incurred and cannot be changed by any

decision made now or in the future. o Relevant cost: A relevant cost (or revenue) is a cost (or revenue) that differs

among the alternatives being considered and that will be incurred in the future.

Cost flows used in manufacturing systems and the schedule of cost of goodsmanufactured The following diagram illustrates the flows of costs through the various accounts used in a manufacturing system. Note the key accounts used to record these costs and the financial statements on which each account appears. As the diagram shows, costs flow from raw materials inventory to work-in-progress inventory (which includes direct labour, variable overhead, and plant overhead) to finished goods inventory. These are shown as assets on the balance sheet. At the point of sale, costs flow to the costs of goods sold account, which is shown as an expense on the income statement.

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A summary of the activity in the work-in-process (WIP) account is called the schedule of cost of goods manufactured. The following is a simple version of this schedule:

Cost estimation As discussed above, management accounting consists of using historical costing data to make predictions about the future. The first step is to estimate the cost. This is the basic cost function:

Y = a + bX

Where: Y = cost to be estimated a = vertical intercept or fixed cost b = slope or variable cost X = level of activity (for example, number of units produced)

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There are a number of cost estimation methods including judgment and data approaches. Judgment approaches include engineering estimates, account analysis, and the conference method, while data approaches include the high-low method, visual fit, and statistical regression analysis. You may have covered many of these in your introductory course, so this primer will only touch on the statistical regression approach.

Statistical regression approach The statistical regression approach fits an equation to the observed data using the criterion of minimizing the sum of the squared differences between the values predicted by the regression equation and the original data.

The data is entered into a software package such as Microsoft Excel. The software then analyzes the data by applying regression analysis.

The summary output provided by this tool consists of the following key regression statistics:

• the adjusted R-square (R2), which is a “best-fit” criterion also known as a goodness-of-fit measure (called the coefficient of determination). This measures the amount of variability in the dependent variable (Y) that is explained by changes in the independent variable (X).

• the estimated coefficients consisting of the intercept or fixed cost and the X variable or variable cost.

• The t-statistic, which is a formal statistical test of the hypothesis. For this course it can be assumed that, if the absolute value of the t-statistic is 2.00 or greater, a statistically significant relationship exists between the independent variable and the dependent variable.

There are several limitations of using historical costing data when making cost estimates. These limitations will be covered in the course.

Cost-volume-profit analysis Managers use cost-volume-profit (CVP) analysis to assist in making decisions based on the relationship between costs and revenues and how changes in either affect the bottom line.

The CVP model The basic CVP model is: (Px) – (Vx) – F = OI

Where: P = selling price per unit V = variable cost per unit F = total fixed cost

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x = number of units produced and sold OI = operating income

This equation allows the decision maker to answer a number of questions relating to profitability. One of these is the ability to identify the number of units (x) that must be made and sold to cover fixed costs (break-even point) and/or provide a target operating income.

Contribution margin (CM) is the term used to identify how much revenue remains after deducting all variable costs. It is calculated as follows:

• CM per unit = P – V

• CM ratio = CM/P

Example

Selling price: $4 per unit Variable costs: $2.50 per unit

Fixed costs: $150,000

1. How many units must be sold to break even? Using the CVP formula note that at break-even net income is $0.($4x) – ($2.5x) – $150,000 = 0 Solve for x: $1.5x – $150,000 = 0 $1.5x = $150,000 x = $150,000 / $1.5 x = 100,000 units must be sold to break even.

Break-even can also be calculated as follows: Break-even in units = F/CM = $150,000 / $1.5 = 100,000 units

2. How many units must be sold to earn a pre-tax operating income of $100,000? ($4x) – ($2.5x) – $150,000 = $100,000 Solve for x: $1.5x – $150,000 = $100,000 $1.5x = $250,000 x = $250,000 / $1.5x x = 166,667 units must be sold to earn a pre-tax operating income of $100,000.

Achieving a target pre-tax operating income can also be calculated as follows: Units for target OI = (F + OI)/CM = ($150,000 + $100,000)/$1.5 = 166,667

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Additionally, the br eak-even point or point to achieve desired income can be solved in dollars. Besides simply multiplying the break-even units by the selling price per unit, the CVP formula can be rewritten as follows: Revenues to break even = F/CM ratio For this example, CM ratio = 1.5/4 = 37.5% $150,000 / 37.5% = $400,000 sales revenue is required to break even.

Revenues to achieved desired operating income = (F + OI)/CM ratio For this example, ($150,000 +$100,000)/37.5% = $666,667 sales revenue is required to achieve the target operating income. Note that this is an estimate. If 166,667 units are required, then in dollars this would be 166,667 × $4 = $666,668. Also, note that you can’t sell part units so the number of units to break even must always be rounded up to the nearest whole number.

Taxes and the CVP equation If taxes are to be considered, the CVP equation is expressed as follows:

Units for target NI = {F + [NI / (1 – tax rate)]} / CM Operating income = NI / (1 – tax rate) Where after-tax net income = [(Px – Vx) – F] × (1 – tax rate)

Example

Selling price: $4 per unit Variable costs: $2.50 per unit Fixed costs: $150,000 Tax rate: 30%

How many units must be sold to earn an after-tax net income of $100,000?

{F + [NI / (1 – tax rate)]} / CM {$150,000 + [$100,000 / (1 – 0.3)]} / $1.50 ($150,000 + $142,857.16)/$1.50 = 195,239 units (rounded up)

Multi-product CVP analysis CVP analysis can be used where a company produces and sells more than one product. In those situations, the units are combined in a bundle based on the projected sales mix. The CM of the bundle is the denominator of the break-even equation while the numerator is the total fixed costs. As with calculating unit break-even point, bundle break-even is always rounded up to the nearest complete bundle. Once the break-even in sales mix bundles has been determined, the bundles are broken apart and each product in the mix is multiplied by the number of bundles.

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Example

Account Product A Per unit

Total (200units)

Product B Per unit

Total (100 units)

Firm total

Revenue $100 $20,000 $ 250 $ 25,000 $ 45,000 Variable cost 40 8,000 100 10,000 18,000CM $ 60 $12,000 $ 150 $ 15,000 $ 27,000

— — — — Firm total CM $27,000 Fixed costs (21,600) — — — — Operating income $5,400 — — — —

The sales mix based on the sales volume is: two units of Product A are sold for every unit of Product B. 200:100 = 2:1

The CM using the sales mix is: (2 × $60) + (1 × $150) = $270 per bundle of product

Then use the F/CM equation to arrive at the break-even bundles: $21,600 / $270 = 80 bundles.

Each bundle consists of two units of Product A and one unit of Product B. (2 × 80) = 160 units of Product A (1 × 80) = 80 units of Product B

Using data to build business models Models such as CVP and scenario planning are useful in decision-making. When making decisions, managers rely on sources of sufficient, quality data to reduce the risk of decision error. Big data is an ever-growing source of this information. It is the accumulation of current and historical data from both internal and external sources. By effectivity exploring (mining) this data using tools such as Excel and PowerBI, organizations can prepare business scenarios that help simulate the future and reduce these risks. The process of analyzing this data is called data analytics, and it can be broken down into the following three types:

• descriptive analytics: finding trends in historical data

• predictive analytics: using data to make predictions

• prescriptive analytics: prescribing the best possible solution

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Practice questions 1. Multiple-choice questions:

i. The following selected data from April were taken from Elfin Inc.’s financial statements:

Account Amount Cost of goods available for sale $ 79,000 Manufacturing overhead 20,000 Cost of goods manufactured 69,000 Finished goods inventory — beginning 10,000 Direct materials used 16,000 Sales 130,000 Direct labour 23,000 WIP inventory — beginning 15,000 Cost of goods sold 71,000

What was the WIP inventory at the end of April?

a) $5,000 b) $10,000 c) $15,000 d) $44,000

Solution

Option a) is correct. Cost of goods manufactured is calculated as follows:

Account Amount Direct materials used $16,000

Direct labour 23,000 Manufacturing overhead 20,000

Total manufacturing costs $59,600 Plus: Beginning WIP inventory 15,000

Less: ending WIP inventory 5,000 Cost of goods manufactured $69,000

*59,000 + 15,000 – 69,000 = 5,000

Option b) is incorrect. This is the difference between cost of goods manufactured and the sum of direct material used, direct labour, and manufacturing overhead costs. Opening WIP inventory was not taken into account.

Option c) is incorrect. This is beginning WIP.

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Option d) is incorrect. This is the sum of direct materials used, direct labour, and manufacturing overhead less the beginning WIP inventory. Cost of goods manufactured was not taken into account.

ii. In which of the following lists of costs would all costs be classified as direct costs when manufacturing ice cream? a) Supplies to clean the mixing tanks, wages of shift supervisor, cream b) Chocolate flavouring, plant utilities costs, powdered milk c) Plastic pails for the finished product, wages of the worker who runs the

assembly line, vanilla flavouring d) Equipment maintenance costs, janitorial costs, marshmallow sauce

Solution

Option c) is correct. Plastic pails and vanilla flavouring are direct ingredients and the wages of the worker who runs the assembly line is direct labour.

Option a) is incorrect. Both the supplies to clean the mixing tanks and the wages of the shift supervisor are manufacturing overhead costs.

Option b) is incorrect. The plant utilities costs are a manufacturing overhead cost.

Option d) is incorrect. Both equipment maintenance and janitorial costs are manufacturing overhead costs.

2. ALF Inc. is starting to manufacture metal desks. It has been determined that the market demand can be 7,000, 8,000 or 9,000 units. To start up, ALF obtained a $3 million term loan at 6%. Other information is as follows:

Selling price per desk $200 Variable cost per desk $50 Total fixed costs $1,000,000 (includes interest on the term loan)

Required:

a) What is ALF’s break-even point in units and in dollars? b) There is a risk that ALF may have to take out an additional loan for $1,500,000 at

the same rate as its current loan. If so, what is the minimum level of demand (7,000, 8,000 or 9,000 units) at which ALF must operate?

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Solution

a) CPA Way step: Assess the Situation Break-even in units = $1,000,000 ÷ ($200 – $50) = 6,667 units

Break-even in sales dollars = $1,000,000 ÷ [($200 – $50) ÷ $200] = $1,333,333 Or 6,667 units × $200 = $1,333,400

b) CPA Way steps: Analyze Major Issue(s) and Conclude and Advise An additional loan of $1,500,000 at 6% annual interest will require $1,500,000 × 0.06 = $90,000 in additional profits to pay the interest.

($1,000,000 + $90,000) / ($200 – $50) = 7,267 units

Thus, ALF must operate at a minimum level of 8,000 units to pay the loan interest.

3. Shirley owns a small factory that manufactures hot tubs. Shirley sells two distinctive hot tubs: the Great Little Spa and the Majestic. She sells most of her products to one discount retailer and ships the products by truck to the stores. She is planning for the coming quarter and has the following data on revenues and costs per product:

To make more accurate predictions of profits, Shirley needs to focus on shipping costs, which vary by month. She knows that the cost is mixed, and she would like to be able to determine the fixed and variable portions, which she believes vary by shipping weight.

She gathers the information and prepares a regression analysis which generates an Adjusted R2 of 0.989865 and a cost function of 0.976x + $9,466 where x is the shipping weight.

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Required:

a) What would be the estimated cost if the expected shipping weight was 5,100 kg? b) Does the Adjusted R2 indicate a good fit? Explain why or why not. c) Calculate the break-even point in units for the two hot tubs for the coming quarter

assuming no change in the sales mix.

Solution

a) CPA Way step: Assess the Situation Cost estimate: $9,466 + 5,100 × 0.976 = $14,443.60 which would be rounded to $14,444

b) An Adjusted R2 value of 0.989865 means that 99% of the variability in the dependent variable is explained by changes in the independent variable. This is considered to be a good representation of the explanation of change in cost.

c) CPA Way steps: Analyze Major Issue(s) and Conclude and Advise CM calculation:

Break-even analysis:CM per bundle:

(3 × $607.40) + (1 × $984.60) = $2,806.80

Then to calculate the numbers of bundles to break even: Fixed costs of $69,456 is divided by the CM per bundle of $2,806.80 to get 23 bundles. Note always round the number of bundles up to the next whole number.

Then calculate the number of units of each type of spa:

The Great Little Spa : 23 bundles × 3 per bundle = 69 units × 3 months = 207 units for the quarter.

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The Majestic: 23 bundles × 1 per bundle = 23 units × 3 months = 69 units for the quarter.

To break even for the quarter, 207 Great Little Spa and 69 Majestic hot tubs must be sold.

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PART 2: CAPACITY

Manufacturing capacity is the constraint on the amount of resources that are available to manufacture a product or provide a service. Actual, normal, theoretical, and practical capacity are some of the ways of valuing capacity. Typically, the greater the capacity, the greater the related fixed costs. Managing the use of capacity, therefore, allows companies to manage related fixed costs.

Support department cost allocation Support (or service) departments assist production departments by providing resources that the production departments need to complete their work. The main reason that the costs of these departments are allocated to the production departments is to help organizations have a better understanding of the costs of all resources needed to produce a good (product or service). Common examples of support departments include accounting, legal, administrative, and human resources.

Three different methods can be used to allocate support department costs to production departments.

Allocation methods The simplest of the three, the direct method, writes off the support departments’ costs directly to each of the production departments.

Example The Janitorial and Human Resources departments provide a service to the Machining and Assembly departments. Janitorial costs are allocated based on the square metres of each of the production departments, and Human Resources costs are allocated based on the number of employees working in each of the production departments.

Costs incurred by department to allocate are Janitorial $250,000 and Human Resources $750,000. Costs are allocated based on the following:

Item Janitorial Human

Resources Machining Assembly Total Service units provided from

Janitorial (square metres) 160 190 900 1,500 2,750

Service units provided from Human Resources (employees)

4 8 10 20 42

Under the direct method, costs are allocated to each of the production departments directly without taking into consideration service that these support departments also give to other support departments.

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The other two methods are the step method and the reciprocal method. They will be covered in detail in the Intermediate Management Accounting course.

Job order costing Management accountants use job order costing to accumulate costs associated with a unique cost object. Examples of organizations that would use a job order costing system are dental practices, automobile repair shops, and print shops.

Components and steps of a job order costing system A typical job order costing system would have a job cost sheet for each job in production. That job cost sheet records the direct materials, direct labour and manufacturing overhead incurred (applied) for the job.

The steps in a job order costing system are as follows:

• Identify the cost object or job (a unique order or service).

• Assign direct materials and direct labour costs to the cost object.

• Allocate manufacturing or service-related overhead to the cost object.

Normal overhead rates and denominator activity Because manufacturing overhead is not directly assignable to a job, a manufacturing overhead application rate is calculated usually based on beginning-of-year estimates. This rate is applied to each job based on an activity driver. Common activity drivers used in a manufacturing business are direct labour hours, direct labour costs, or machine hours. A costing system that uses an estimated rate to apply overhead is called a normal costing system. The formula for determining the predetermined overhead rate is as follows:

Manufacturing overhead rate = Budgeted manufacturing overhead costs / Budgeted denominator activity

The denominator activity chosen is one that attempts to reflect the underlying cost behaviour of manufacturing overhead cost. In a labour-intensive company, the direct labour hours are often chosen as the denominator-level activity, whereas in an

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automated company, machine hours are usually chosen. Common choices for activity level are historic actual, estimated, average, and practical capacity of the cost driver.

The amount of manufacturing overhead applied to a job will equal the manufacturing overhead rate multiplied by the actual denominator activity specific to the job.

Single plant-wide versus multiple overhead cost pools Management accountants must make decisions as to what drives the cost of manufacturing overhead. In some situations, where there is little variability in the cost driver between processes or departments, a single plant-wide rate may be used to allocate manufacturing overhead. In other cases, especially where one department’s costs are primarily driven by manual labour and another department’s costs by machine operations, it makes more sense to set different cost drivers for each department.

Example Consider the following job that records the costs for manufacturing a chair:

JOB: 2945: Chair

Item Cutting

department Assembly

department Finishing

department Materials costs $95.00 $3.00 $6.00 Labour hourly rate $18.00 $12.00 $15.00 Labour hours 3 5 0.5 Machine hours 4 1 1

Using a plant-wide rate of $39.22 per direct labour hour results in the following costs:

Job 2945: Chair

Item Cuttingdept.

Assembly dept.

Finishing dept. Total

Materials costs $ 95.00 $ 3.00 $ 6.00 $104.00 Direct labour costs 54.001 60.002 7.503 121.50 Manufacturing overhead

allocation 117.664 196.104 19.614 333.37

Total manufacturing costs 266.66 259.10 33.11 558.87 1 $18.00 per hour × 3 hours = $54.00 2 $12.00 per hour × 5 hours = $60.00 3 $15.00 per hour × 0.5 hours = $7.50 4 $39.22 per direct labour hour × 3 hours = $117.66; $39.22 × 5 = 196,20 and $39.22 × 0.5 = $19.61

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Alternatively, if the overhead costs in each of the departments had different cost drivers, the overhead costs could be applied as follows:

Department Cost driver

Cost driver average activity

level

Estimated manufacturing

overhead Manufacturingoverhead rate

Cutting Machine hours 5,000 $400,000 $80.00/MH Assembly Direct labour hours 12,000 $250,000 $20.83/DLH Finishing Number of chairs 7,000 $150,000 $21.43/unit

Total estimated manufacturing overhead is $800,000.

The application of overhead costs above would have the following effect on costs:

Job 2945: Chair

Item Cutting

department Assembly

department Finishing department Total

Materials costs $ 95.00 $ 3.00 $ 6.00 $104.00 Direct labour costs $ 54.00 $ 60.00 $ 7.50 $121.50

Manufacturing overhead allocation

$320.001 $104.152 21.433 $445.58

Total manufacturing costs $469.00 $167.15 $34.93 $671.08

1 $80.00 per machine hour × 4 machine hours = $320.00

2 $20.83 per direct labour hour × 5 direct labour hours = $104.15

3 $21.43 per unit × 1 unit = $21.43.

Recording manufacturing overhead and writing off year-end residual

The manufacturing overhead account is a clearing account. Under normal costing, actual manufacturing costs are accumulated in the clearing account and then applied to jobs in WIP using a predetermined overhead allocation rate multiplied by the actual denominator activity.

As the rate is usually based on estimates, a residual balance is common at year end. A debit balance means insufficient overhead was applied during the year, while a credit

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balance means too much overhead was applied to the jobs. Two methods used to write off this amount are the direct charge to cost of goods sold method and the prorating based on ending balances method.

Accounting entries underlying job order costing The following diagram illustrates the flow of costs through a typical manufacturing job order costing system:

Joint and byproduct costing In some production environments such as forestry, a single raw material produces multiple products. For example, a single log can produce a variety of products, such as two-by-fours or two-by-sixes, or it can be processed further into plywood or flooring. These products are called joint products. Additional products of lesser value, such as sawdust or bark mulch, are classified as byproducts. The split-off point is where the joint and byproducts become separately identifiable, and the cost incurred up to the split-off point is called the joint cost.

Some of the practical reasons to allocate joint costs include external reporting, transfer pricing, and costing the product for insurance-related purposes.

Joint cost allocation methods Four basic methods are used to allocate joint costs to joint products: physical output, sales value at split-off, net realizable value, and constant gross margin percentage. These methods will be covered in the Intermediate Management Accounting course in detail.

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i. When are departmental overhead rates generally preferred to plant-wide overhead rates?

a) When activities of each of the various departments in the plant are not homogenous

b) When all products passing through various departments require the same manufacturing effort in each department

c) When most of the overhead costs are fixed d) When all products passing through the various departments require a

different amount of direct materials in each department

Solution

Option a) is correct. A unique rate should be established for each department to better reflect the level of activity and consumption when activities across departments are different.

Option b) is incorrect. If the same effort is required throughout, then a plant-wide rate would be preferred.

Option c) is incorrect. If the overhead costs are fixed, they will not vary based on the different drivers used by departmental overhead rates.

Option d) is incorrect. The amount of direct materials is unlikely to be a driver of the overhead cost allocation, so it is irrelevant in deciding between departmental and plant-wide rates.

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ii. The following is an excerpt from DellCo’s accounting information system: Account Amount

Indirect factory materials $ 48,000Direct manufacturing materials 114,000Indirect office wages 14,000Manufacturing overhead applied 182,000Factory depreciation 86,000Office depreciation 14,000Direct office wages 32,000Factory supervisors’ salaries 36,000Factory supplies 7,000

Based on the information above, what value will be debited to the WIP account regarding manufacturing overhead?

a) $177,000 b) $182,000 c) $191,000 d) $205,000

Solution

Option b) is correct. Manufacturing overhead is applied to WIP by crediting the manufacturing overhead account and debiting WIP.

Option a) is incorrect. This is the total of indirect factory materials, factory depreciation, factory supervisors’ salaries, and factory supplies costs, not the amount applied. The manufacturing overhead is applied using a predetermined rate.

Option c) is incorrect. This is the total of indirect factory materials, indirect office wages, factory depreciation, factory supervisors’ salaries, and factory supplies costs, not the amount applied. In addition, indirect office wages would not be part of the manufacturing overhead.

Option d) is incorrect. This is the total of indirect factory materials, indirect office wages, factory depreciation, office depreciation, factory supervisors’ salaries, and factory supplies costs, not the amount applied. In addition, indirect office wages and office depreciation would not be part of the manufacturing overhead.

2. Renaissance Wood Products Ltd. manufactures wooden knife blocks. The marketing manager wants to set the selling price of these blocks.

There are two distinct designs. The simpler design is the curve block, which holds four knives. The more complicated design is the square block, which holds eight

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knives. The production manager has just completed a production run of 350 of the curve blocks. The following data pertain to this run of curve blocks:

Item Amount Opening inventory, direct materials $500 Purchases of direct materials $1,000 Ending inventory, direct materials $625

Direct labour to make the blocks was 52.50 hours at $25/hour.

Budgeted indirect costs for the year (for all jobs):

Item Amount Supplies such as glue and stain $ 840 Hydro 1,230 Machine maintenance 1,250 Machine depreciation 3,000 Indirect labour 16,630 Total budgeted indirect costs $22,950

Machine hours is the cost driver for the indirect costs. The budgeted machine hours for the year are based on the production of 4,200 curve blocks at 0.30 hours each and 3,600 square blocks at 0.50 hours each. The machine hours used to produce the 350 curve blocks are the same as the budgeted level.

Renaissance’s pricing policy is to mark up its products by 50% of product cost.

Required:

a) CPA Way step: Assess the Situation

i. Calculate the total cost for 350 curve blocks. ii. Calculate a unit cost per block.

b) CPA Way steps: Analyze Major Issue(s) and Conclude and AdviseAdvise management on the appropriate selling price for the curve block product.

Solution

a) i. Direct materials $ 875.00 ($500.00 + $1,000.00 – $625.00)

(52.50 × $25.00) Direct labour 1,312.50 Manufacturing overhead 787.501 Total cost $2,975.00

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1 To calculate the manufacturing overhead, the first step is to determine the predetermined rate by dividing the total budgeted indirect costs by the total machine hours for the year.

Total machine hours = 4,200 × 0.30 = 1,260 hours = 3,600 × 0.50 = 1,800 hours Total 3,060 hours $22,950 ÷ 3,060 = $7.50 per hour

Next, determine how many machine hours were used to manufacture the 350 curve blocks: 350 × 0.30 = 105 hours

The overhead applied to the production of curve blocks was 105 hours × $7.50/hour = $787.50.

ii. Unit cost for each curve block = $2,975/350 = $8.50

b) Based on Renaissance’s pricing policy, the selling price of each curve block should be $8.50 × 1.5 = $12.75.

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1. Steppe Co. has two production departments: Stamping and Painting. There are three support departments: Administration, Maintenance, and Cafeteria. The Administration costs are allocated based on direct labour hours. The Maintenance costs are allocated based on square metres. The Cafeteria costs are allocated based on number of employees. The following data describe the costs incurred in each department and the cost driver consumption:

Costs Production — Stamping

Production — Painting

Support — Admin.

Support — Maintenance

Support — Cafeteria

Direct labour costs (in ’000s)

$1,950 $2,050 $90 $80 $87

Direct materials costs (in ’000s)

$3,130 $950 $0 $65 $91

Overhead costs (in ’000s)

$1,650 $1,850 $70 $55 $62

Total (in ’000s)

$6,730 $4,850 $160 $200 $240

Allocation based

Production – Stamping

Production – Painting

Support – Admin

Support – Maintenance

Support Cafeteria

Direct labour hours (in ’000s)

562.5 437.5 31 27 42

Number of employees

280 200 12 8 20

Square metres (in ’000s)

88 72 1.75 2 4.8

Cost driver n/a n/a Direct labour hours

Square metres

Number of employees

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Required:

Applying the direct method, allocate the support department costs to the production departments.

Solution

CPA Way step: Assess the Situation

Allocated costs Allocated costs Department Costs Driver — Stamping — Painting Total

Administration $160 Direct labour hours

562.5/1,000 × $160 = $90

437.5/1,000 × $160 = $70

$160

Maintenance $200 Square metres 88/160 × $200 = $110

72/160 × $200 = $90

$200

Cafeteria $240 Number of employees

280/480 × $240 200/480 × $240 = $100 = $140

$240

Total allocation received

n/a n/a $340 $260 $600

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PART 3: PROCESS COSTING

Process costing is a costing system suitable for costing the mass production of identical products (for example, packaging soft drinks and manufacturing plastic bottles). Instead of costing individual units or jobs as is done in job costing, total costs are simply divided by the number of units produced to compute the cost per unit. The purpose of job and process costing is to cost products and services. However, some of the differences are as follows:

Item Job order costing Process costing Products Each product is unique. Each product is the same as all

others. Cost

accumulation Costs are collected andrecorded for each job.

Costs are collected and recorded by department/process.

Reporting of costs

Costs are accumulated and reported on the job cost sheet.

Costs are reported on the department production report.

Unit costs Unit costs are calculated for each job.

Unit costs are calculated for each department.

Illustration of a typical process costing system at a soft drink manufacturing plant It would not be practical to cost each can of soft drink individually, and it is not necessary because each can should contain the same ingredients as all the other cans. However, it is still necessary to know the cost of producing the soft drink.

The following highlights three basic processing steps taken to produce soft drinks:

Each step takes place in a separate division or department. Because each can of soft drink is homogeneous, costs are assigned by department instead of job. As the diagram below illustrates, each department has its own WIP account to accumulate the product cost. When the product is complete in one department, the costs are transferred to the next department, where more direct materials and conversion costs are added as required.

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The two most widely used process costing approaches in Canada are the weighted average method and the first in, first out (FIFO) method. The main difference between the two is that the weighted average method does not separate the cost of the work done in the previous period from the work done in the current period, whereas FIFO separates the costs and units of each period.

Using the soft drink example and focusing on the Syrup Production department, four steps are required to determine how the following costs in that department are assigned. This illustration uses the weighted average method of allocating costs. The second method, called first in, first out (FIFO), will be discussed in the Intermediate Management Accounting course.

First, note that in this example there are two cost pools: one is the direct materials (direct ingredients) costs; the second is the conversion costs pool comprising all direct labour and manufacturing overhead costs.

Item Units Percentage complete

Cans in beginning inventory 1,000 80% Cans of soft drink started during the month 50,000 n/a Cans of soft drink completed in the month 49,500 n/a Cans in ending inventory 1,500 40%

Item Costs Cost of ingredients in beginning inventory $1,500 Conversion costs in beginning inventory $200 Cost of ingredients added this month $6,150 Conversion costs added this month $12,325

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Step 1: Determine physical flow of goods Goods in beginning WIP plus all units started during the period end up in one of three places: units completed and transferred to the next department, units in ending inventory, or spoiled units.1

Syrup Production department Physical flow Physical units

Opening WIP

1,000 Started this period 50,000 Units to account for 51,000

Units completed and transferred out 49,500 Units in ending WIP 1,500 Units accounted for 51,000

It is also important to understand the flow of costs in each department (that is, when the costs are incurred in the process). For example, in the Syrup Production department, direct materials are added at the beginning of the production process, and conversion costs are added evenly throughout. Understanding when costs are added in the process will be vital in calculating the equivalent units in Step 2.

Step 2: Calculate the equivalent units of production for the period The second step in process costing is to identify the equivalent units of production for materials and conversion costs. The equivalent unit concept is used when there is partially completed WIP at the end of an accounting period. The equivalent unit is used to quantify the amount of work that has been done on the unit. Equivalent units for ingredients are 1,500 because all ingredients (direct materials) are added at the beginning of the process; therefore, the amount of work completed is 100% of the ingredients for both units completed and units in the ending WIP. In contrast, the amount of conversion effort is added evenly throughout the production process; therefore, the conversion costs put into the ending inventory would be equivalent to the effort expended to complete, that is, 40% × 1,500 = 600 units.

1 Note that where inspection takes place, units that do not pass inspection are classified as spoiled units and are also considered in this step. This will be covered in detail in the Intermediate Management Accounting course.

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Item Physical units

Equivalent units — direct

materials

Equivalent units —

conversion costs

Units transferred out 49,500 49,500 49,500 Ending inventory 1,500 1,500 600 Total 51,000 51,000 50,100

Step 3: Calculate the cost per equivalent unit for each cost category The equivalent units calculated in Step 2 are then used to calculate the cost per equivalent unit. Under the weighted average method, costs incurred from the previous period, which accumulated in the beginning WIP, are not separated from the costs incurred in the current period. The total costs incurred to date would be assigned to the units based on the work completed to date — that is, the equivalent units.

Item Direct

materials Conversion

costs Total costs

Costs in beginning inventory $ 1,500 $ 200 $ 1,700 Costs incurred this period 6,150 12,325 18,475

Total costs to date $ 7,650 $12,525 $20,175 Divide by equivalent units 51,000 50,100 n/a

Cost per equivalent unit $ 0.15 $ 0.25 n/a

Step 4: Assign costs to appropriate accounts The cost per equivalent unit is then used to assign costs to those units transferred to the next department and those left in the Syrup Production department.

Item

Costs assigned — direct materials

Costs assigned — conversion

costs

Costs assigned — total costs Notes

Units transferred out: 49,500 × $0.15; 49,500 × $0.25 $7,425 $12,375 $19,800

DR WIP of Bottling/Canning dept. CR WIP of Syrup Production dept.

Units in ending inventory: 1,500 × $0.15; 600 × $0.25 225 150 375 Amount left in WIP

Total $7,650 $12,525 $20,175 n/a

The journal entry to record this would be a debit to the WIP account of the next department (Bottling/Canning) and a credit to the WIP account of the Syrup Production department.

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Spoilage Spoilage is identified at a point of inspection and can be classified as either abnormal or normal. Abnormal spoilage is spoiled units above the number that is expected or normal for the process. Normal spoilage contributes to the cost of the good units produced, whereas abnormal spoilage is reported as a period cost in the period incurred. The cost of spoiled units is based on the percentage of completion at the point where the units were inspected.

Transferred-in costs When production is complete in one department, the direct materials and conversion costs incurred in that department are transferred with the units to the next department. Thus, in subsequent departments, costs will consist of the costs accumulated in all previous departments and the addition of conversion and direct materials costs in the current department.

Indirect cost allocation systems A major focus of management accounting is how to allocate indirect costs effectively. Various factors, including inaccurate pricing, may indicate that a cost allocation system is producing inaccurate information. This may result in inappropriate decision-making or even loss of competitive advantage.

For example, if the costs of indirect resources are grouped together into a single indirect cost pool and allocated in proportion to one single quantity measure (such as units produced, machine hours or labour hours), the high-volume products tend to pick up more than their fair share of costs if resources used are not proportional to the single volume measure. It would lead to product cost cross-subsidization: one product is under-costed and the other over-costed.

To improve the accuracy of assigning indirect costs, a cost allocation system for indirect costs can be designed by identifying activities as the fundamental cost objects. Under this approach, the indirect cost pool is expanded into groups of activities each carrying the same cost driver. The cost drivers are selected based on a causal relationship with the costs in the cost pool. Each cost pool will then have an individual cost driver rate to apply the costs to the products.

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This approach to cost allocation recognizes that it is the activities the organization undertakes to produce goods and services that create costs. This focus on using activities as the cost driver for indirect costs is called activity-based costing (ABC). Under a carefully constructed ABC system, the actual use of the resources will be reflected, thus improving the accuracy of cost allocation.

ABC systems In ABC, an activity is any event that causes overhead costs to be incurred. The costs of performing these activities are accumulated in an activity cost pool. There must be a cause-and-effect relationship between the activity measures and the costs of the activities. Any of the cost estimation methods discussed in Part 1 can be used to establish and measure the relationship between the costs of an activity and the activity measure.

The ABC cost hierarchy Activity-based costs can be classified into one of the following ABC cost hierarchy elements:

• Unit-level costs vary directly with the level of production. They are often called variable costs.

• Batch-level costs are incurred whenever a batch or group of units is processed, regardless of the number of units. An example is setting up machines for a production run.

• Product-sustaining costs are incurred without regard to the number of batches or units produced. Examples include costs of developing and advertising a product line.

• Customer-sustaining costs are incurred to provide a service to specific customers. Examples include the cost of sales representative visits to a customer or of sending out catalogues.

• Facility-sustaining costs benefit all business functions. They are incurred to enable an organization to continue, regardless of customers, products, batches, or units. An example is head office administrative costs. These costs are not usually allocated, because there is no apparent cause-and-effect relationship with activity levels.

Consider an example of an organization that produces Product 1 and Product 2. A total of $140,000 of indirect costs must be allocated to these two products. Using a single rate based on direct labour hours ($1.60/DLH), the costs are allocated as follows:

Product Units Direct labour

hours Cost

allocated Cost

per unit Product 1 (0.50 DLH/unit) 100,000 50,000 $ 80,000 $0.80 Product 2 (0.50 DLH/unit) 75,000 37,500 60,000 $0.80 Total 175,000 87,500 $140,000 n/a

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In this case, indirect costs per unit are the same for Product 1 and Product 2.

Now consider that indirect costs consist of costs for setting up machines and for materials handling. Cost pools are set up for both activities with the following costs, cost drivers and usage of cost driver for each product:

Activity Cost

driver Product 1

usage Product 2

usage

Total activity driver Total cost

Cost per unit of activity

driver Machine setups Setup 100 200 300 $120,000 $400.00

Materials handling Kilogram 50,000 50,000 100,000 20,000 $0.20 Total — — — — $140,000 —

Note the differences in activity for both products. Product 1’s batch size is 1,000 units (100,000 units / 100 batches), while Product 2’s batch size is only 375 units (75,000 units / 200 batches). Setup costs are not dependent on batch size. The smaller the batch size, the higher the number of batches for setup to produce the same number of units. Therefore, higher setup costs are absorbed by Product 2. Then consider materials handling costs. Each unit of Product 1 requires the handling of 0.5 kilograms of materials (50,000 kilograms of materials / 100,000 units), whereas each unit of Product 2 requires the handling of 0.667 kilograms of materials (50,000 kilograms of materials / 75,000 units). As a result, Product 2 will absorb more materials handling resources and costs.

These differences in indirect cost consumption result in the following unit product costs:

Apply costs to products Product 1 Product 2

Machine setups 100 × $400 = $ 40,000 200 × $400 = $80,000 Materials handling 50,000 × 0.2 = 10,000 50,000 × 0.2 = 10,000 Total cost $ 50,000 $90,000 Units produced 100,000 75,000 Cost per unit $ 0.50 $ 1.20

The following is a comparison of the differences in unit cost using a single allocation rate and using ABC:

Difference in unit cost:

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Comparison Cost using single

rate Cost using ABC Difference Product 1 $0.80 $0.50 $0.30 Product 2 $0.80 $1.20 ($0.40)


Using a single rate method would result in over-costing Product 1 and under-costing Product 2. Companies setting selling price based on a markup of cost would have overpriced Product 1 and could have potentially sold Product 2 at a loss.

Supply chains and the strategic use of costing systems The supply chain is a process that connects departments in the organization. It starts with the customer order and then continues by purchasing raw materials to fulfil the order, manufacturing the product, and delivering the final product or providing the service to the customer. Using a sophisticated network of communications allows the organization to partner with its suppliers and customers to efficiently and effectively deliver quality products and services. Management accounting tools such as ABC and open-book accounting remove the information barrier and allow supply-chain partners to freely share relevant information.


i. Which of the following best describes the calculation of equivalent units for a period?

a) The number of units actually finished for the period b) The number of units that the direct materials and/or conversion expended

would have completed to 100% c) The number of units actually finished plus the unfinished units in WIP at the

end of the period d) The number of units started in the period less the unfinished units in WIP at

the end of the per iod

Solution

Option b) is correct. Equivalent units represent the efforts and resources to start and complete a unit. Thus, the time and resources put into two units that are 50% complete represent the time and resources to start and complete one unit (2 × 50% = 100%).

Option a) is incorrect. This only covers the units of the finished products. Partially completed units should be converted into equivalent units based on the amount of work that has been done.

Option c) is incorrect. This describes the physical units of the finished units and the units in WIP. Partially completed units should be converted into equivalent units based on the amount of work that has been done.

Option d) is incorrect. This calculates the physical units started and finished.

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ii. Using ABC, how would the costs of inspecting the quality of the product be accounted for?

a) As an organization-sustaining activity b) As a product-level activity c) As a batch-level activity d) As a unit-level activity

Solution

Option c) is correct. A batch-level cost is incurred whenever a batch or group of units is processed. The cost of inspecting is a cost incurred whenever a batch of units is processed as a batch of product is inspected before being moved forward to the next step in the process.

Option a) is incorrect. An organization-sustaining activity, such as general administration costs, supports the entire organization. Inspection of product quality supports activities at a lower level.

Option b) is incorrect. A product-level activity, such as design, supports individual products or services regardless of the number of units or batches produced. Therefore, it is not limited to one batch, whereas inspecting a batch of products for quality would be.

Option d) is incorrect. Inspection is done on a number of units, but the cost is not driven by the unit. The cost is driven by the number of batches, not by the number of units in the batch.

2. Clyde’s Cleaning Supplies makes a liquid industrial cleaner for the shipbuilding industry. The ingredients for the liquid cleaner pass through the Mixing department and the Finishing department, where the cleaner is put into containers. The information for the Mixing department for March is as follows: Item Amount Beginning WIP 4,000 litres Units started 18,000 litres Units completed 19,000 litres

Beginning WIP direct ingredients $7,400 Beginning WIP conversion $1,200 Direct ingredients added during the month $33,300 Conversion costs added during the month $30,832

The company uses the weighted average method of process costing. Beginning WIP was 20% complete as to conversion. Direct ingredients are added at the beginning of the process. All conversion costs are incurred evenly throughout the process. Ending WIP was 60% complete.

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Before the cost accountant had a chance to prepare the production report, the company president added up all of the costs for the month and divided by the units transferred. This resulted in a unit cost of $3.828 for the month. The president is concerned about rising costs because the original budget for the month was a unit cost of $3.40.

Required:

a) What was the total cost of one unit of production for March?

b) What was the total cost of goods transferred to the Finishing department during the month of March?

c) Provide a brief response to the president explaining the difference between the actual unit cost and the unit cost that the president calculated.

Solution


Units to be accounted for: Physical

units

Equivalentunits — material

Equivalentunits —

conversion Units transferred out 19,000 19,000 19,000 Ending inventory

(3,000 × 100%; 3,000 × 60%) 3,000* 3,000 1,800 Total units 22,000 22,000 20,800

*Note: the ending inventory of physical units is calculated as 4,000 + 18,000 – 19,000 = 3,000

Cost to be accounted for: Physical

units

Equivalent units — material

Equivalent units —

conversion Beginning inventory $ 8,600 $ 7,400 $ 1,200 Added in current period 64,132 33,300 30,832

Total cost to be accounted for $72,732 $40,700 $32,032 Equivalent units of production — 22,000 20,800 Cost per equivalent unit — $ 1.85 $ 1.54

Total cost per equivalent unit is $3.39 (1.85 + 1.54).

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b) CPA Way step: Assess the Situation Cost reconciliation Cost of goods transferred $64,4101 $35,150 $29,260

Ending WIP inventory $ 8,3222 $5,550 $2,772 Total cost reconciled $72,732 $64,410 + $8,322


1 19,000 units × $1.85 = $35,150; 19,000 units × $1.54 = $29,260; $35,150 + $29,260 = $64,410 or 19,000 unit × ($1.85 + $1.54) = $64,410

2 3,000 units × $1.85 = $5,550; 1,800 units × $1.54 = $2,722; $5,550 + $2,722 = $8,322. Total cost transferred to the Finishing department is $64,410.

c) CPA Way steps: Analyze Major Issue(s) and Conclude and Advise The president’s calculation of unit cost did not take into consideration the 3,000 units in ending inventory. The ending inventory consists of 3,000 additional equivalent units for direct materials and 1,800 (3,000 × 60%) additional equivalent units for conversion costs. When this is taken into consideration, the equivalent unit cost is $3.39, which is closer to the budgeted cost of $3.40.

3. A furniture manufacturer makes two different tables: a dining table and a coffee table. Data related to the two products are as follows:

ItemDining table

Coffee table

Annual production in units 5,000 10,000 Direct materials costs $75,000 $60,000 Direct manufacturing labour costs $25,000 $20,000 Direct manufacturing labour hours 1,000 500Machine hours 11,000 13,000 Number of production runs 20 5Inspection hours 190 30 Machine setups per run 4 1 Number of purchase orders per run 100 20

Budgeted indirect costs for the year are as follows: Item Amount

Machining $ 60,240 Setup 19,975Inspection 25,520 Purchasing 18,900 Total $124,635

Originally, the company assigned these costs to products using a company-wide overhead rate based on total machine hours. Selling prices were set using a cost

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plus system, which applied a set markup based on total cost. However, to be competitive, the selling price on the coffee table was subsequently dropped, and the company was losing CM. The president felt there was an error in the data. She had read about ABC and thought that using it might uncover the problem. An initial assessment identified the following activities and associated cost drivers:

• machining — machine hours

• setup — number of machine setups

• inspection costs — inspection hours

• purchasing — number of purchase orders

Required:

a) Calculate the unit cost for dining tables and coffee tables using a single overhead allocation rate based on machine hours.

b) Calculate the unit cost for dining tables and coffee tables using ABC.

c) Explain which method the manufacturer should use and why.

Solution

a) CPA Way step: Assess the Situation Using a single overhead allocation rate based on machine hours

Overhead allocation rate: Amount Total manufacturing overhead $124,635

Total machine hours (11,000 + 13,000) = 24,000 Allocation rate per machine hour $ 5.1931

Item Dining table Coffee table Direct materials $ 75,000 $ 60,000

Direct labour 25,000 20,000 Indirect costs $5.1931 × 11,000 = 57,124 $5.1931 × 13,000 = 67,511

Total costs 157,124 147,511 Units produced 5,000 10,000

Unit cost $ 31.42 $ 14.75

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b) CPA Way step: Assess the Situation Using ABC Calculate cost per activity driver unit:

Activity driver Dining

table Coffee

table Total

activity Total

cost

Cost per activity

driver unit Machining

(machine hours) 11,000 13,000 24,000 $60,240 $2.51 Setup (no. of setups)

(20 × 4) | (5 × 1) 80 5 85 19,975 $235.00 Inspection

(inspection hours) 190 30 220 25,520 $116.00 Purchasing (no. of POs)

(20 × 100) | (5 × 20) 2,000 100 2,100 18,900 $9.00 Total n/a n/a n/a $124,635 n/a

Allocate to products: Account Dining table Coffee table

Direct materials $ 75,000 $ 60,000 Direct labour 25,000 20,000 Indirect costs: — —

Machining (11,000 × $2.51) 27,610 (13,000 × $2.51) 32,630 Setups (80 × $235.00) 18,800 (5 × $235.00) 1,175

Inspection (190 × $116.00) 22,040 (30 × $116.00) 3,480 Purchasing (2,000 × $9.00) 18,000 (100 × $9.00) 900

Total costs 186,450 118,185 Units 5,000 10,000 $/unit $ 37.29 $ 11.82

c) CPA Way steps: Analyze Major Issue(s) and Conclude and Advise The manufacturer should consider using ABC as its costing method. Its current costing system is not providing the correct information to price its coffee tables competitively. Consequently, it appears that a required reduction in selling price is reporting a loss of CM. However, this is incorrect because the CM does not accurately reflect the consumption of manufacturing costs.

When a single overhead application rate of machine hours is used, more overhead is allocated, proportionately to coffee tables. However, when ABC is used, even though twice as many coffee tables as dining tables are produced, all activities consumed by coffee tables are significantly less than those consumed by dining tables. The result is a lower cost per coffee table, which justifies a lower and more competitive selling price.

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PART 4: VARIOUS COSTING METHODS AND BUDGETING

Variable (direct), absorption (full), and throughput costing Three different costing methods can be used to record costs for financial statements: variable, absorption, and throughput. Absorption costing is required by both accounting standards for private enterprises (ASPE) and International Financial Reporting Standards (IFRS); however, a significant number of organizations use a form of variable or throughput costing for internal decision-making.

The following is a summary of the treatment of various costs under all three costing methods:

Cost item Absorption

costing Variable costing

Throughputcosting

Direct materials Product cost Product cost Product cost Direct labour Product cost Product cost Period cost Variable manufacturing overhead Product cost Product cost Period cost Fixed manufacturing overhead Product cost Period cost Period cost Variable non-manufacturing overhead Period cost Period cost Period cost Fixed non-manufacturing overhead Period cost Period cost Period cost

The following example highlights the differences between operating income using absorption and variable costing.

Carlysle Inc. produces a single product. Assuming a relevant range of 400,000 to 600,000 units and current production of 500,000 units, its price and variable and fixed costs are as follows:

The unit product costs under variable and absorption costing are as follows:

Variable costing Item Amount

Direct materials $3.75 Direct labour 4.50

Variable overhead 1.47 Total $9.72

Absorption costing Item Amount

Direct materials $3.75 Direct labour 4.50

Variable overhead 1.47 Fixed manufacturing overhead

($1,000,000/500,000 units) 2.00 Total $11.72


Consider the operating income under the following scenarios.

Production is the same as sales In this example, Carlysle produces 500,000 units and sells all 500,000 units. Assume there is no beginning inventory.

Carlysle Inc.Variable costing income statement

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Carlysle Inc.Absorption costing income statement

Note that the variable costing income statement only considers variable manufacturing costs as product costs. Fixed manufacturing overhead is expensed in the period incurred, making it a period cost. In contrast, absorption costing considers all manufacturing costs to be product costs. As such, fixed manufacturing costs of unsold inventory are carried as an asset in the inventory account until the product is sold. In this example, because all inventory produced is sold, there is no difference in operating income between both options.

Production is greater than sales Now consider the effect on operating income of variable and absorption costing when production is greater than sales. If a company produces more than it sells, ending inventory will be recorded as a current asset on the balance sheet. Using variable costing, this ending inventory will be the cost of direct materials, direct labour, and variable overhead. In comparison, absorption costing will also include fixed manufacturing cost per unit in addition to these variable costs. Using absorption costing, the additional production will spread the fixed costs over all units produced, including those that are not sold. This reduces the unit cost and increases operating income and the amount of costs transferred to the statement of financial position.

In this example, Carlysle produces 500,000 units and sells only 475,000 units. Assume that there is no beginning inventory.

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Carlysle Inc.Variable costing income statement

Carlysle Inc.Absorption costing income statement

The income reported under absorption costing is $50,000 higher ($107,000 – $57,000) than the income reported under variable costing. The variable costing approach expenses all fixed manufacturing costs in the period incurred ($1,000,000), and the absorption costing approach only expenses the amount of fixed manufacturing overhead related to the goods that were sold [($1,000,000/500,000 units × 475,000 units sold) = $950,000]. The difference between these two numbers ($1,000,000 – $950,000) represents the amount of fixed costs recorded in the ending inventory account. The difference in ending inventory will flow to opening inventory in the following period.

The following method can be used to reconcile the difference between both methods:

Income under absorption costing $ 107,000 + Fixed costs in opening inventory 0 – Fixed costs in ending inventory (25,000 × $2/unit) (50,000) Income under variable costing

$ 57,000

Performance evaluation Absorption costing can lead managers to increase operating income in the short run by increasing the production volume regardless of demand, which is undesirable for the

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long-run interests of the company. To monitor this situation, the company can choose to use variable costing for internal performance evaluation.

Budgeting A budget is the quantitative expression of an organization’s plans for a set future period of time. Budgets are used to help control an organization’s use of resources. The planning role of the manager involves setting objectives and preparing budgets that will achieve those objectives. The control role involves regularly comparing the budget to actual results achieved and taking actions to address any significant differences.

• The budget is usually prepared by a budget committee consisting of managers who control the costs and revenues of the organization. An operating budget is prepared for the company’s fiscal year, and a capital budget can span several years.

• The figures for a budget must come from reliable, objective sources and align with the organization’s goals and objectives. The budget committee should be held accountable for data provided and the monitoring and reporting of variances.

The master budget The master budget is the overall budget plan. It begins with the organization’s business strategies and sales forecasts. The organization’s objectives result in a formal sales budget that identifies the planned level of sales for the organization’s products. The sales budget, combined with the organization’s inventory policy, results in the production plan for a manufacturing company and a purchase plan for a merchandising company.

For manufacturing companies, details of the production plan trigger the activities needed to support production. These activity triggers may include the need to acquire additional machinery or to hire or lay off employees and the amount and timing of raw materials for production.

The sales budget can also be used to estimate selling and administration expenses to complete the budgeted income statement. Cash collections estimated based on the sales budget, together with cash disbursements, will be used to develop the cash budget and the balance in accounts receivable/payable for the statement of financial position.

Budgeting should also take into account the costs of developing and operating information systems. Developing or upgrading information systems requires a type of capital expenditures budget that takes into account all costs of purchasing hardware and software along with labour costs for such activities as project management, software development, and training.

Data analytics tools, such as Power BI, can be used to summarize budget and actual data from both internal and external sources. Descriptive analytics, such as analyzing historical variances between budget and actual, help identify trends. Predictive

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analytics, where historical trends are combined with industry forecasts, help in forecasting. This allows companies to strategically control costs and profits.

The following diagram summarizes the components and interrelationships of the master budget components for a manufacturing company.

The following example illustrates how to develop a production plan from a sales budget.

GardenPlus manufactures lawn mowers. The company has estimated sales for March, April, May, June and July as follows:

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Month Number of units March 12,000 units

April 20,000 units May 50,000 units June 30,000 units

July 25,000 units

At the end of each month, the company wants to have 20% of the next month’s budgeted sales in inventory. Therefore, the following is the production budget for GardenPlus:

Item March April May June Budgeted sales units 12,000 20,000 50,000 30,000

Add: desired ending inventory 4,000 10,000 6,000 5,000 Total needs 16,000 30,000 56,000 35,000

Less: beginning inventory 2,400 4,000 10,000 6,000 Production requirement 13,600 26,000 46,000 29,000


All remaining budgets then flow from the production budget. The remaining budgets, along with the cash budget and pro-forma financial statements, are covered in the course.

Pricing The three main considerations in pricing decisions are customers, competition, and costs. Customers have a range of prices they will be willing to pay, up to a maximum price. Competition affects price, as companies compete to substitute or replace each other’s products. The costs the company incurs in operating and in producing its products need to be considered to ensure the company obtains a high enough return to remain in business.

Cost information and short- and long-term pricing

Short-term pricing One of the approaches to short-term pricing is to set a price that at least meets the variable cost plus any opportunity cost of supplying the product or service. Because the price does not consider fixed costs, this type of pricing is sustainable only for the short term.

Long-term pricing The three main choices for long-term pricing are market pricing, cost-based pricing, and cost-plus pricing. Market pricing is used in a competitive environment; a business examines the market and its customers to determine what the market will pay for its product. In cost-based pricing, a business factors in fixed costs as well as variable costs when setting a long-term price for a product. The most widely used approach is cost

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plus pricing, whereby a markup is added to the cost base. This approach reflects a stable, long-term equilibrium price that supports both demand and supply.

The following example illustrates how a selling price is set using the estimated costs of a product over its lifetime.

TubZone is developing a new solar-powered hot tub called the SolarSpa. The company predicts that customers will be willing to pay a higher price for this product because the solar cells used to heat the tub will produce constant, even heat in areas that receive little direct sunlight. Marketing expects to sell an average of 2,500 SolarSpa tubs per year and expects demand to last for eight years.

To appropriately price this product, the cost accountant worked with the development team to arrive at the following prospective costs. TubZone marks up its products by 30% of the lifetime costs to provide a satisfactory return on investment.

Other factors should be considered when using cost-based prices. Prices are subject to factors such as fluctuating demand and competition. Some companies, such as airlines, practice price discrimination because they know that certain customers are willing to pay higher prices than others. Additionally, peak-load pricing is used in the hotel industry — higher prices are charged during months when tourism is high.

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i. Doug’s Holistic Dog Treats manufactures healthy dog biscuits in 500-gram packages. The company sells the treats in cartons of 10 packages for $45. Last year, the company produced 100,000 cartons and sold 80,000. This was the company’s first year of business. Costs are as follows:

Per carton Direct materials $10

Direct labour 15 Variable manufacturing overhead 2 Fixed manufacturing overhead $300,000 Variable selling 1.45 Fixed selling

60,000

What is the difference between absorption costing operating income and variable costing operating income?

a) Variable operating income is $56,000 more than absorption operating income.

b) Absorption operating income is $60,000 more than variable operating income.

c) Variable operating income is $124,000 more than absorption operating income.

d) Absorption operating income is $300,000 more than variable operating income.

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Solution

Option b) is correct.

Account Absorption cost Variable cost Sales (80,000 × $45)

$ 3,600,000 $ 3,600,000 Cost of goods sold calculation starts with

opening inventory 0 0

Cost of goods manufactured: ($10 + $15 + $2 + $300,000/100,000)

× 100,000 units | ($10 + $15 + $2) × 100,000

3,000,000

2,700,000

Cost of goods available for sale 3,000,000 2,700,000 Less: ending inventory ($30 × 20,000) |

($27 × 20,000) 600,000 540,000

Cost of goods sold 2,400,000 2,160,000 Variable selling costs ($1.45 × 80,000) n/a 116,000

Total variable costs n/a 2,276,000 Gross margin | CM 1,200,000 1,324,000

Variable selling 116,000 n/a Fixed selling 60,000 60,000

Fixed manufacturing n/a 300,000 Total costs 176,000 360,000

Net operating income $ 1,024,000 $ 964,000


Operating income under absorption costing is $1,024,000 – $964,000 = $60,000 more than under variable costing.

Option a) is incorrect. You did not include the variable selling costs in total variable costs when calculating the net operating income using variable costing.

Option c) is incorrect. This is a comparison of the gross margin and the CM, not of the net operating incomes.

Option d) is incorrect. This amount is the difference between the cost of goods manufactured under each method.

ii. Which of the following budgets is the first to be prepared when developing the master budget?

a) Production budget b) Cash budget c) Direct materials budget d) Sales budget

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Solution

Option d) is correct. The master budget begins with the organization’s business strategies and sales forecasts. Thus, the sales budget drives the production, direct materials, and cash budgets.

Option a), b) and c) is incorrect. All other budgets flow from the sales budget, which determines the levels of production.

iii. Pan Co. purchases and resells water bottles at a price of $8/bottle with a gross margin of 40%. During the month of April, Pan plans to sell 5,000 water bottles. In May, it plans to sell 6,000 and in June, 5,500. If the company plans to have inventory on hand at the end of each month at 10% of the following month’s sale, what would be the planned purchases in units for April?

a) 5,100 b) 5,600 c) 5,950 d) 6,550

Solution

Option a) is correct. The purchase of the water bottles should meet the sales target and be adjusted for the inventory level.

To fill sales in April 5,000 units For ending inventory 600 units Required 5,600 units Beginning inventory 500 units (5,000 × 0.10) Purchases for April 5,100 units

Option b) is incorrect. This is the number of units required for sales plus ending inventory. You did not adjust for the beginning inventory.

Option c) is incorrect. This is the amount of purchases required for May.

Option d) is incorrect. This is the number of sales units plus the ending inventory units for May.

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2. Alarums Ltd. produces Wi-Fi home security alarms. The company had the following results for January 20X1:.

Units: January Beginning inventory 0 Production

1,000

Sales 900 Ending inventory 100

Costs: Variable manufacturing costs per unit:

Direct materials $ 10

Direct labour 5 Variable manufacturing overhead 3 Variable marketing costs per unit 2 Fixed manufacturing overhead 8,000 Fixed marketing and administrative costs 12,000 Sales price per unit $ 45


The president has heard that there are alternatives to the inventory costing and wonders if management control might be better using an alternative.

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Required:

Analyze and recommend to management which method of costing (absorption or variable) to use for management control purposes.

Solution


Alarums Ltd. Variable costing income statement

For the month ended January 31, 20X1

Alarums Ltd. Absorption costing income statement For the month ended January 31, 20X1


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Reconcile the difference:

CPA Way steps: Analyze Major Issue(s) and Conclude and Advise Alarums’ management should use the variable costing method to reduce the potential overproduction of inventory. Because the absorption costing method holds back fixed costs of unsold units in inventory, operating income is increased even though sales have not increased. A production manager whose bonus is based on operating income may be tempted to increase production to increase the bottom line. The variable costing method expenses all fixed costs in the period incurred.


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3. .Gosch Ltd. manufactures high-end appliances. It is currently developing a unique voice-activated cooktop called Audiocuisine. Based on the technology of the cooktop, Gosch expects the life cycle of the Audiocuisine to be five years with average demand of 2,000 cooktops per year. Because Gosch produces high-end, unique appliances, the company is able to set a selling price at a 50% markup on the lifetime cost.

The financial manager on the development team has budgeted the following costs:

Unit costs Amount Direct materials cost $2,100 Direct labour cost 650 Variable manufacturing overhead cost 860 Variable selling, general, and administrative costs 450

Annual costs Amount

Fixed manufacturing 2,500,000 Fixed selling, general, and administrative 450,000 Marketing and distribution 540,000 Cost of quality (including warranty costs) 360,000 After-sales service 420,000

One-time costs Amount

Research and development 13,000,000 Production line setup 5,000,000

Required:

Using the CPA Way, calculate the selling price using the cost-plus method and advise management on whether the selling price should be set using market pricing or cost-plus pricing.


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Solution


Total lifetime unit sales

CPA Way steps: Analyze Major Issue(s) and Conclude and Advise The Audiocuisine is a unique product with little competition in the market. As such, customers would be willing to pay a higher price for the product, and there is less concern over costs. Market-based pricing is used in a competitive environment where sales are based on a price that is better than the competition. In this situation, management should set the price using cost-plus pricing.


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PART 5: STANDARDS AND VARIANCES

Standards provide management accountants with a set of expectations for manufacturing and production. Standards for cost indicate the specific amounts that should be paid for each unit of input. Standards for quantity indicate specifically how much of an input (good or service) should be used for each unit produced. Standards are based on historical information as well as consultation with production and purchasing managers and other managers or employees involved with the manufacturing or production process.

Standards for cost and usage of materials, labour, and overhead Standards are usually set on a per-unit basis and often focus on the standard costs and quantities of resources required to produce one unit of finished product. Standard costs for materials are usually based on the final cost of goods received. Standard quantities are based on the amount of materials needed to produce one unit of finished product.

One of the main benefits of standard costing is that it allows management accountants to focus on any deviations from the standards, called variances. Looking at a summary of the variances in cost and usage for a period helps direct the management accountant’s attention to areas that may require investigation. In addition, standards provide employees with benchmarks for individual performance.

Illustration of standard costing Parker Co. produces furniture that it sells on the wholesale market. The following is a standard cost card for sofas. It shows the planned cost and use of materials, labour and variable overhead for Parker’s line of sofas:

Standard cost card — one sofa

Account Quantity (physical units)

Unit measure

Cost per unit Total

Direct materials 10.0 kilograms $12.60 $126 Direct labour 5.0 hours $20.00 100 Variable overhead* 5.0 hours $ 8.80 44 Fixed overhead* 5.0 hours $ 7.00 35 Total cost — — — $305

*Variable overhead and fixed overhead are applied based on direct labour hours

Parker applies overhead based on direct labour hours. Estimates at the beginning of the year were for production and sales of 1,500 sofas and fixed overhead costs of $52,500. Thus, the fixed overhead application rate was set at $52,500 / (1,500 sofas × 5 direct labour hours) = $7 per direct labour hour.


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Static budget versus flexible budget Because the master budget is based on sales estimated at the beginning of the period, it is considered static. Any changes in sales activity from the budget will not be reflected in the static budget.

Using the Parker example, the static budget would be as follows:

Account

Per unit (from standard

cost card) Static budget Planned production (sofas) — 1,500 Revenue $450 $675,000 Variable costs: — —

Direct materials 126 189,000 Direct labour 100 150,000 Variable overhead 44 66,000

Total variable costs 270 405,000 CM 180 270,000 Fixed manufacturing costs 35 52,500 Gross margin $145 $217,500

The following are Parker’s actual results for the year:

Account Actual Volume (sofas) 1,300 Revenue ($475 per sofa) $617,500 Variable costs: —

Direct materials (14,400 kg at $12.50) 180,000 Direct labour (6,500 hours at $21.50) 139,750 Variable overhead (6,500 hours at $9.50) 61,750

Total variable costs 381,500 CM 236,000 Fixed manufacturing costs 61,500 Gross margin $174,500


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Now consider the following, which compares the actual results with the static budget results:

Account Actual Variance U/F Static budget Volume (sofas) 1,300 200 U 1,500 Revenue $617,500 $57,500 U $675,000 Variable costs: — — — —

Direct materials 180,000 9,000 F 189,000 Direct labour 139,750 10,250 F 150,000 Variable overhead 61,750 4,250 F 66,000

Total variable costs 381,500 23,500 F 405,000 CM 236,000 34,000 U 270,000 Fixed manufacturing costs 61,500 9,000 U 52,500 Gross margin $174,500 $43,000 U $217,500

This basic static budget variance analysis compares actual results with the static budget. By convention, management accountants compute variances by subtracting the budget amount from the actual amount. Variances that have a favourable impact on income are labelled F, whereas variances that have an unfavourable impact on income are labelled U.

The problem with this analysis is that it provides few insights into how well costs were controlled, because the budgeted and actual costs reflect different activity levels. For example, Parker’s direct materials variance is $9,000 favourable, meaning that it spent less on direct materials than budgeted. A misinformed manager might be led to believe that the variance was due to efficient production or the use of lower-cost direct materials. Instead, the fact that 200 fewer sofas were produced and sold than planned should also be taken into consideration.

To resolve this issue, Parker could develop a flexible budget to show expected revenues and costs at the actual level of activity. The flexible budget is calculated using the per-unit costs and quantities from the standard cost card at the actual level of activity. Parker’s standard cost card indicates that each sofa should have $126 of direct materials. Whereas the static budget multiplies $126 by 1,500 sofas to get $189,000, the flexible budget multiplies $126 by 1,300, the actual number of sofas produced, to arrive at $163,800. It is also important to note that fixed costs do not change in a flexible budget because they are not affected by units produced and sold.


Account Actual

Flexible budget

variance U/F Flexible budget

Sales volume variance U/F

Static budget

Volume (sofas) 1,300 — 1,300 200 U 1,500 Revenue $617,500 $32,500 F $585,000 $90,000 U $675,000 Variable costs: — — — — — — —

Direct materials 180,000 16,200 U 163,800 25,200 F 189,000 Direct labour 139,750 9,750 U 130,000 20,000 F 150,000 Variable overhead 61,750 4,550 U 57,200 8,800 F 66,000

Total variable costs 381,500 30,500 U 351,000 54,000 F 405,000 CM 236,000 2,000 F 234,000 36,000 U 270,000 Fixed manufacturing costs 61,500 9,000 U 52,500 — 52,500 Gross margin $174,500 $ 7,000 U $181,500 $36,000 U $217,500

$ 43,000 U Static budget variance

Flexible budget versus actual results The flexible budget now splits the $43,000 unfavourable static budget gross margin variance into two components: an unfavourable variance of $36,000, called a sales volume variance, and an unfavourable variance of $7,000, called a flexible budget variance.

The sales volume variance, which compares the difference between the flexible budget and the static budget, is simply the change in profit that results from a change in volume when all the per-unit standard prices and the standard usage of direct materials, direct labour, and variable overhead are held constant. On the other hand, the flexible budget variance, which compares the difference between the actual budget and the flexible budget, is derived from changes in unit price, unit variable costs, and fixed costs when the sales units are held constant at actual.

The following is an overview of some of the flexible budget variances using the Parker example:

Sales price variances The sales price variance compares the actual and flexible budget sales revenue as follows: (Actual price – Budgeted/standard price) × Actual sales volume = Sales price variance ($475 – $450) × 1,300 = $32,500 F

Direct materials variances The direct materials variance is broken down into two parts: quantity variance and price variance. The quantity variance informs us whether more (U) or less (F) direct materials

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were used in the production of the units as compared to the standard quantity allowed. The price variance informs us whether the company paid a higher (U) or lower (F) price for the direct materials purchased during the period.

Using Parker’s standard cost card, 10 kg of materials at a cost of $12.60 per kg should have been used per sofa.

Therefore, the flexible budget allowance for direct materials will be 13,000 kg (1,300 sofas × 10 kg) at total cost of $163,800 (1,300 sofas × 10 kg × $12.60). The actual amount of materials purchased and used was 14,400 kg. The actual price paid per kg was $12.50. The following calculations explain the $16,200 unfavourable flexible budget variance:

Direct materials

Actual quantity of inputs × Actual

price Actual quantity of inputs

× Standard price

Standard quantity allowed for actual output × Standard

price Calculation 14,400 × $12.50=

$180,000 14,400 × $12.60=

$181,400 13,000 × $12.60 =

$163,800


Note that the direct material quantity variance should be determined for the amount of materials purchased instead of the amount used. In this example, the amount of materials purchased is the same as the amount used.

Direct labour variances The direct labour variance has two components: efficiency variance and rate variance. In an identical manner as the direct materials variances, the efficiency variance informs management on the hours used in production, whereby more than budgeted is unfavourable and less than budgeted is favourable. Furthermore, the rate variance informs the management accountant or manager on whether the average rate paid for labour was higher (U) or lower (F) than budgeted.

Parker’s standard direct labour use is five hours per sofa. Therefore, the flexible budget allowance for direct labour will be 6,500 hours (1,300 sofas × 5 hours per sofa) at a total cost of $130,000 (1,300 sofas × 5 hours × $20/hour). While the standard rate for direct labour is $20 per hour, the actual rate paid for direct labour was $21.50 per hour. The actual direct labour hours were 6,500. Note that because actual hours (6,500) and standard hours allowed for 1,300 sofas are the same (1,300 sofas × 5 hours = 6,500), there is no direct labour efficiency variance. The following calculations explain the unfavourable flexible budget variance of $9,750:

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Direct labour Actual quantity of

inputs × Actual price Actual quantity of

inputs × Standard price

Standard quantity allowed for actual

output × Standard price Calculation 6,500 × $21.50

=$139,750 6,500 × $20.00 =

$130,000 6,500 × $20.00 =

$130,000


Variable manufacturing overhead variance is treated much like the other variable cost variances and will be covered in detail in the course.

Fixed manufacturing overhead variances Fixed manufacturing overhead is analyzed to determine the budget and volume variances. The budget variance simply identifies the difference between the budgeted fixed overhead and the actual fixed overhead incurred for the period. The volume variance identifies the difference in the amount of fixed overhead applied due to producing more or less units than planned.

In the case of Parker, fixed manufacturing overhead is applied to production using direct labour hours. Parker’s standard direct labour hour use is five hours per sofa. The fixed overhead allocation rate is budgeted at $7 per hour. Therefore, the fixed overhead applied for the 1,300 sofas would be $45,500 (1,300 sofas × 5 hours × $7/hour). The fixed overhead budget cost is $52,500. The fixed overhead actual cost is $61,500.

Fixed overhead Actual

fixed overhead Budgeted

fixed overhead

Standard hours allowed for actual output ×

Standard rate

Amount $61,500 $52,500 5 × 1,300 × $7 $45,500

Note that the model used here is different from the model used to calculate variable cost variances. This model provides evidence of the reason for underapplied or overapplied overhead in the manufacturing overhead account.

In this example, the analysis explains the reason for the $16,000 of underapplied overhead illustrated in the following T-account. $9,000 of the underapplied overhead

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was due to spending more than planned and $7,000 was due to producing 200 fewer sofas than planned (200 × $7 × 5 hours).

Additional variances that will be covered in the course are the mix and yield variances and the revenue variances consisting of sales mix, sales quantity, market share, and market size variances.

Investigating variances Part of the management control process is to monitor variances from budget. Breaking down static budget figures into flexible budget variances assists in determining who is responsible for controlling the variance. Managers often use decision models to determine which of these variances should be investigated further.

Information technology tools can be useful in illustrating key data items that help in this process. These tools sift through the myriads of data available and highlight important areas of focus through illustrations. For example, the market costs of key manufacturing ingredients could be monitored and compared to internal data. Management could then be alerted when the variances between the latest purchase costs and external market prices do not align. These alerts can be presented in graphical format using a dashboard.

Recording and presentation of variances Some managers will formally record and report variances on the income statement. In such situations, variances from standard would be considered a period cost. As such, they would be listed in the cost of goods sold section of the income statement and would either reduce (if favourable) or increase (if unfavourable) cost of goods sold.

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i. Balto Co. budgeted for production and sales of 63,000 units of Xeron in June, but produced and sold only 60,000 units. Actual direct labour costs of $125,000 were incurred during this period. Direct labour cost was budgeted at $2.25 per unit. What is the flexible budget variance for the direct labour cost?

a) $10,000 F b) $10,000 U c) $16,750 F d) $16,750 U

Solution

Option a) is correct. At actual production, Balto planned to spend $135,000 (60,000 × $2.25). Balto actually spent $125,000. Therefore, there is a $10,000 F variance ($125,000 – $135,000).

Option b) is incorrect. Balto’s actual direct labour costs are $10,000 less than the budgeted cost. This is a favourable variance.

Option c) is incorrect. While this is a favourable variance, the actual cost of $125,000 was compared to the static budget cost instead of the flexible budget cost.

Option d) is incorrect. The actual cost of $125,000 was compared to the static budget cost instead of the flexible budget cost. Additionally, the actual cost is less than the budgeted cost. This means that the variance would have been favourable.

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ii. Jasper Co. makes a single product. Its standard costs per unit are as follows:

Direct materials: 2 kg at $4.50/kg $ 9Direct labour: 3 hours at $5/hour 15Overhead: $10 per direct labour hour* 30 Total $54

*Based on normal capacity of 50,000 units. $7 per direct labour hour is variable.

At the beginning of the year, there were no inventories. During the year, the following events occurred:

• Direct labour was $790,750 for 151,000 direct labour hours worked.

• Variable overhead incurred was $1,046,000.

• Fixed overhead was $490,000.

• Jasper produced 48,000 units. There were no unfinished goods or WIP at the end of the year.

What was the fixed manufacturing volume variance for the year?

a) $18,000 U

b) $18,000 F c) $40,000 U d) $58,000 U

Solution

Option a) is correct. Jasper produced 2,000 fewer units (50,000 – 48,000) than planned. The overhead application rate is $3 ($10 – $7) per direct labour hour and the standard hours per unit is three. Thus, the volume variance is 2,000 × 3 hours × $3 = $18,000 unfavourable. Fixed manufacturing overhead

Actual fixed overhead

Budgeted fixed overhead

Standard hours allowed for actual

output × Standard rate

Caculations and amounts $490,000

($10 – $7) × 3 hours × 50,000 units =

$450,000

($10 – $7) × 3 hours × 48,000 units =

$432,000

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Option b) is incorrect. There is indeed an $18,000 variance; however, because Jasper produced less units than planned, it is unfavourable.

Option c) is incorrect. This is the budget variance, not the volume variance.

Option d) is incorrect. This is the total of the budget and volume variances, as well as the amount of underapplied overhead. This amount must be split into the budget variance and the production volume variance.

2. Valley Co. uses a standard cost system to control production costs. The following information is available for the past year:

Account Actual Budget Production 22,000 units 20,000 units

Direct materials: — — Quantity 100,000 kg 5 kg per unit of output

Cost $185,000 $160,000 at $1.60/kg Direct labour: — —

Hours 10,500 hours 1 hour per unit of output Cost $160,000 $240,000 at $12/hour

There were no direct materials beginning and ending inventories for the year.

Required:

a) Calculate the following: i. Direct materials price and quantity variances ii. Direct labour rate and efficiency variances

b) Management is concerned about the direct materials price variance. When asked, the purchasing agent informed management that the production manager wanted to purchase higher-quality, more expensive materials. Explain to management how this increase in the price of direct materials may have affected other variances.

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Solution


i.

Direct materials

Actual quantity of

inputs × Actual price

Actual quantity of inputs× Standard price

Standard quantity allowed for actual output × Standard

price

Calculation $1.85 ×

100,000 = $185,000

$1.60 × 100,000 = $ 160,000

5 kg × 22,000 × $1.60 = $176,000

ii.

Direct labour

Actual quantityof inputs

× Actual price

Actual quantityof inputs

× Standard price

Standard quantityallowed for actual output

× Standard price

Calculation 10,500 × $15.24 = $160,000

10,500 × $12 = $126,000

1 hour × 22,000 × $12 = $264,000

b) CPA Way steps: Analyze Major Issue(s) and Conclude and Advise

When reviewing the variances, it is important to analyze how the circumstances surrounding these variances can be interconnected. As the purchasing agent stated, the purchase of the more expensive direct materials caused a $25,000 unfavourable variance. However, note that both the direct materials and direct labour efficiency variances are favourable. Most notable is the $138,000 favourable direct labour efficiency variance. Perhaps one of the reasons why direct labourers are more efficient is due to the quality of the direct materials. This could also explain the $16,000 favourable direct materials quantity variance — better-quality inputs may have reduced wastage.

While these observations are not conclusive, it does provide management with a starting point to determine whether it was worth the additional direct materials costs. If this is the case, the additional cost of $25,000 is far surpassed by the favourable variance of $154,000 ($16,000 + 138,000).

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PART 6: RELEVANT COSTS

A relevant cost is a cost or revenue that changes as a result of a decision. The idea behind the relevant cost approach is that the decision maker need only, and should only, consider the relevant costs associated with a decision.

The concept of a sunk cost is a key focus in decision-making. Sunk costs (past costs that have been incurred and are irreversible) are not relevant according to the relevant cost approach. Management accountants should ensure that sunk costs do not affect current managerial choices.

When making decisions, managers must consider both quantitative and qualitative factors. Qualitative factors, such as laying off long-time, loyal personnel when eliminating a department, must be considered along with quantitative figures relating to profits and losses.

Four basic relevant costing models are illustrated here; a fifth will be covered in the course.

Make-or-buy decision Businesses often need to decide whether to produce a product (or part of a product needed in production) or purchase it from an external supplier. Relevant costs in this decision often include, but are not limited to, the costs saved from not producing the item internally, revenue that can be earned if the space is used for other purposes, and of course the cost incurred to purchase externally. Below is an example of such a decision.

Calvin’s SUP Ltd. makes 30,000 stand-up paddleboards each y ear. One of the paddleboard components is a fin that aids the stability of the board. Currently, the fins are made by Calvin’s SUP at the following cost:

Account Amount Direct materials (unit) $25.00 Direct labour (unit) $20.00 Variable manufacturing OH (unit) $4.80 Fixed manufacturing costs (total) $950,000

An outside supplier has offered to sell Calvin’s SUP all the fins it requires to manufacture its paddleboards for $58 each. If the company decides to purchase all of its fins from the outside supplier, it would lay off one plant supervisor who currently has an annual salary of $66,000. All other fixed costs relate to plant and equipment shared by all product lines and cannot be avoided.

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The first step is determining which costs are relevant. If the fin manufacturing is outsourced to the supplier, all costs that can be eliminated are relevant to the decision. For Calvin’s SUP, it consists of the following:

Account Amount Direct materials (unit) $25.00 Direct labour (unit) $20.00 Variable manufacturing OH (unit) $4.80

Usually fixed costs are not easily eliminated as they tend to be allocated to divisions and are based on company-wide costs. However, in this situation, the salary of the laid-off supervisor is relevant. The cost of the salary per unit is $2.20 ($66,000 / 30,000).

Calvin’s SUP would be better off by $180,000 ($6 × 30,000) if it continues to manufacture the fins for the paddleboards as opposed to buying them from the outside supplier. The unavoidable common fixed costs are not relevant to the cost comparison as these fixed costs remain the same regardless of whether the company chooses to make the fins or purchase them from the outside supplier.

Qualitative factors that should be considered in these types of decisions include the quality of the supplier’s products and the ability of the supplier to provide timely deliveries.

Add-or-drop decision Organizations are constantly faced with decisions relating to whether to keep or abandon products or divisions whose profitability is declining. These types of decisions involve complex considerations of the interactions among strategic, cost-cutting, and human resource objectives in organizations. Consider the following example of a multi-division business where one division is reporting a loss:

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Account Calgary Edmonton Halifax Total Revenue $310,000 $252,000 $ 56,000 $618,000 Variable costs 110,000 84,000 24,000 218,000 CM $200,000 $168,000 $ 32,000 $400,000 Fixed costs 170,000 98,000 65,000 333,000 Division income $ 30,000 $ 70,000 $(33,000) $ 67,000

Management is considering closing the Halifax Division; however, 60% of the division’s fixed costs are common to all divisions and cannot be saved.

The relevant costs in this decision are those that will be eliminated if the Halifax Division is closed. First, it is important to note that not only will all of the variable costs be avoided, but all of the associated revenue will also be lost. Therefore, the entire CM of the Halifax Division will be eliminated. Furthermore, 40% (100% – 60%) of the fixed costs will be eliminated — that is, 60% of the fixed costs will still be incurred by the company even if the division is eliminated. This results in the following:

Lost CM $(32,000) Fixed costs saved (40% × 65,000) 26,000 Net loss if Halifax Division closed $ (6,000)

In this situation, the decision would be to keep the Halifax Division running. Closing the division would result in a total decrease of $6,000. This is because of the $32,000 the Halifax Division is still providing to cover the $26,000 (40% × 65,000) in fixed costs attributable to the division.

Special order decision The special order problem considers the situation where an organization receives a one-time offer to buy a product (good or service). The assumption is that accepting or rejecting this order will have no future consequences other than the incremental cash flows created by the order. Additionally, the decision to accept the order would depend on the availability of capacity to process the order.

If an organization does not have capacity to meet the special order, then it would have to forfeit sales from its existing customers. This is referred to as the opportunity cost of the special order, and it has both qualitative and quantitative effects on the organization. Finally, fixed costs are usually not considered in the special order, as they are fixed and would be incurred regardless of if the order is taken or not. The only fixed costs relevant to special orders are additional fixed costs caused by the new order.

Consider a company that manufactures water bottles with a total manufacturing cost of $7.50 per bottle, of which $5 is variable. The normal selling price of the water bottle is $15. The company has a capacity of 20,000 water bottles per month and is currently producing 12,000 water bottles per month. A local sports retailer is organizing a bicycle race and would like to purchase 6,000 water bottles for $6 each. The water bottle

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company will be responsible for putting the sports retailer’s logo on the bottle for $0.40 each. Should the water bottle company take the offer?

A key factor for this order is that the company has idle capacity to produce an extra 8,000 (20,000 – 12,000) water bottles. This indicates there would be no opportunity cost to accommodating the 6,000 bottles for the special order. That is, the company will not have to forfeit any of its current sales to meet the requirements of the special order. Furthermore, since the fixed costs are already covered by the sales from existing customers, the only relevant costs for the special order would be the variable costs and the logo printing costs.

The incremental analysis shows the following: Number of units: 6,000

Account Unit Total Revenue $6.00 $36,000 Costs — —

Variable manufacturing cost $5.00 $30,000 Logo cost 0.40 2,400

Total cost $5.40 $32,400 Incremental profit $0.60 $ 3,600

Because this results in an incremental profit of $3,600 (6,000 × $0.60), the water bottle company should take on the special order.

Scarce resource allocation decisions In the business world, there are times when the amount of resources available to organizations are restricted, or “scarce.” The restriction could be the number of machine hours or labour hours available, or direct materials available on the open market — any input that has a finite amount available over a period.

Relevant costing helps in effective resource allocation by focusing on allocating a scarce resource to its different uses, and making the allocation to the product mix that maximizes total CM and operating income. In the product mix decision, the product with the highest CM per unit of constraining resource should be given priority to be produced first. The constraining resource will limit the production.

Consider a company that produces Gidgets and Widgets with the following CMs and production times:

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CM Machine hours Gidgets $20 2 Widgets $24 3

If the company’s machine hours are restricted and there is unlimited demand for both Gidgets and Widgets, which product will allow the company to maximize its CM?

Solving this problem relies on determining the CM each product will produce per machine hour (constrained resource):

CM / Machine hour = CM per MH Gidgets $20 2 $10 Widgets $24 3 $ 8


In this case, the company should focus on producing Gidgets. Even though its CM per unit is less than Widgets, its ability to be completed in two hours allows the company to make $10 per machine hour. On the other hand, the production of one unit of Widgets takes three hours, resulting in an hourly contribution rate of $8 per machine hour. Given the limited amount of machine hours, the more profit generated per hour the better. Thus, producing Gidgets maximizes profit for the company.

Data and professional skepticism The accountant must use a level of professional skepticism when determining which data is relevant and which data is irrelevant. Stakeholders to the decision, for whatever reason, may provide incorrect decision-making data to sway the decision in their favour. For this reason, the accountant must remain free from bias, use data from reliable sources, and be alert to situations where data provided may be misleading.

Transfer pricing The primary role of the profit centre approach is to promote an entrepreneurial spirit in managers who are held accountable for the profit of the unit they manage, thus improving the organization’s overall performance. In other words, a profit centre helps ensure that the goals of the division are congruent with those of the organization. Transfer pricing involves valuing the transfer of a good or service between two responsibility centres.

When setting a transfer price, it is important to be aware of the two perspectives:

• how the transfer price and the resulting profits for the profit centres affect the overall organizational performance

• how the transfer price and the reported profits motivate the managers of the divisions affected by the transfer price

These two perspectives can cause conflict in the organization, especially when a manager of a division behaves in ways that will make their own centre’s profit as large as possible at the risk of the organization’s total profit being reduced.

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Approaches to setting the transfer price Some of the types of transfer pricing are:

• approaches based on market price

• approaches based on cost

• negotiated

These methods will be discussed in the course.

A general transfer pricing model Generally, a transfer should occur between two divisions if it results in incremental income to the company.

The minimum transfer price is the price that would make the selling division as well off as it was before the transfer. It is generally expressed as:

Variable cost + Opportunity cost of lost sales = Minimum transfer price

The maximum transfer price is the price that would make the purchasing division as well off as it was before and is generally equal to the price the purchasing division would pay on the external market.

If the maximum transfer price exceeds the minimum transfer price — that is, the cost to purchase the product from the external market is higher than the cost to make the product internally (in another division) — then making a transfer will benefit the company and the two divisions.

Consider two divisions of a bicycle manufacturing plant: the Seat Division and the Assembly Division. The Seat Division manufactures bicycle seats at a variable cost of $75. It can sell the seats for $125 on the external market. The final assembly of the bicycles takes place in the Assembly Division, where an additional $650 of variable costs are incurred before adding the cost of a seat. The bicycles are then sold for $1,200. The Assembly Division can purchase the seats from the external market for $115. Consider the minimum and maximum transfer prices in the following scenarios:

1. The Seat Division has enough capacity to satisfy the Assembly Division’s need for seats. Using the general pricing model, the following illustrates the calculation of the minimum transfer price, the maximum transfer price, and the resulting profits:

Maximum transfer price = $115 (what the Assembly Division pays the external supplier).

Variable cost + Opportunity cost

of lost sales = Minimum transfer price

$75 + $0 = $75

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The idle capacity in the Seat Division means there is no opportunity costs from lost sales for the external market. Furthermore, no additional or incremental fixed costs will be incurred. Since it costs the corporation less to produce the seats internally than to purchase them externally, the transfer should happen between the divisions. The corporation as a whole will save $40 ($115 – $75) on each of the seats produced and transferred internally.

If the transfer price is set at $110 between the two divisions, the Seat Division will generate an additional $35 ($110 – $75) per unit for each of the seats transferred, and the Assembly Division will save $5 ($115 – $110) per unit for each of the seats purchased internally.

2. Now assume that the Seat Division is operating at capacity and will have to forgo outside sales to satisfy the Assembly Division’s need for seats. As the Seat Division is operating at capacity for the external market, each seat transferred internally will mean one seat sale to external customers is lost. Therefore, the CM lost on the external customers should be included as the opportunity cost. CM = Selling price – Variable costs = $125 – 75 = $50/seat.

Maximum transfer price = $115 (what the Assembly Division pays the external supplier).



$75 + $50 = $125

Note that the minimum transfer price will equal the external selling price that the Seat Division is charging.

Under this scenario, the minimum transfer price exceeds the maximum transfer price, so it is better to purchase externally. The transfer should not happen.


i. Michelangelo Co. makes a single product. Cost information for the product is as follows: Direct materials $12 Direct labour 8 Variable manufacturing overhead 6 Variable selling expenses 5 Fixed manufacturing overhead 1

The fixed overhead cost per unit is based on a normal volume of 20,000 units. Fixed selling and administrative expenses are $40,000 regardless of the number of units produced and sold.

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Michelangelo has an opportunity to buy this product at a cost of $28 per unit. It is expecting to sell 18,000 units in the upcoming year.

Which of the following actions should Michelangelo take?

a) Continue to make the product because buying the product will incur $36,000 of incremental costs.

b) Buy the product because it will save the company $54,000. c) Buy the product because it will save the company $72,000. d) Continue to make the product because buying the product will incur

$144,000 of incremental costs.

Solution

Option a) is correct.

Option b) is incorrect. Variable selling costs are not relevant. The company will continue to incur selling costs whether the product is made or bought.

Option c) is incorrect. You included all product costs and variable selling costs as relevant. Only direct materials, direct labour, and variable manufacturing overhead are relevant in this situation.

Option d) is incorrect. Variable manufacturing overhead is also a relevant cost and should be considered when making this decision.

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ii. Gamma Co. has two divisions: Division A and Division B. Division A’s practical capacity is 750,000 units of component FF2517 per year. Component FF2517 can be sold at a market price of $325. Division B needs 150,000 units of component FF2517 to manufacture its product. Last year, the cost of manufacturing component FF2517 in Division A was:

Cost Per unit Direct material $67 Direct labour $55 Variable manufacturing overhead $21 Fixed manufacturing overhead $102


What is the minimum transfer price that Division A would be willing to accept for the 150,000 units sold to Division B if Division A has enough excess capacity to take on the order? Round to the nearest dollar.

a) $123 b) $143 c) $245 d) $325

Solution

Option b) is correct. Because Division A has sufficient capacity, opportunity cost on lost sales is $0. The relevant variable costs to consider are direct materials $67 + direct labour $55 + variable manufacturing overhead $21 = $14.



$143 + $0 = $143

Option a) is incorrect. This is the variable and fixed manufacturing overhead. Only variable overhead, along with other variable costs, is relevant.

Option c) is incorrect. This is the total of all manufacturing costs. Only the variable manufacturing costs are relevant.

Option d) is incorrect. The selling price would be the minimum transfer price if Division A was operating at capacity.

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2. .Anvil Co. is operating at 80% of its maximum capacity of 50,000 units. The company makes a single product and is selling all of its regular production, and it anticipates a surge in demand in the foreseeable future. The company is considering a proposal to supply 10,000 units to a customer as a special one-time order. The proposed price per unit is $14.50. The regular selling price for this product is $22.50. The per-unit variable costs are as follows: Variable cost Per unit Direct materials $2.50 Direct labour (1/4 hour) $6.00 Variable manufacturing overhead $1.50 Sales commission $0.50

Annual fixed manufacturing cost is $72,000. There will be no sales commission or any other administrative costs associated with the special order.

Required:

a) Should the company take on the proposed special order for 10,000 units at a selling price of $14.50 per unit? Provide calculations.

b) The customer requesting the special order called the next day and asked Anvil to engrave its logo on each unit. This would require an additional 10 minutes of direct labour per unit and the purchase of a special etching tool that would cost $7,500. Anvil would have no use for the tool after the project and it would not have any resale value. What effect would this have on the profitability of the special order?

c) Review the results from parts (a) and (b) and provide a recommendation to management. The answer should discuss the alternatives and provide management with a revised price that takes into consideration the cost of the additional labour and etching tool and allows Anvil the choice to either break even or ensure the same incremental income as the part (a) proposal. Discuss a qualitative concern relevant to the revised proposal.

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Solution


If the company takes on the special order at a selling price of $14.50 per unit, the incremental profit is $45,000. This is calculated as follows:

Account Unit Total Revenue $14.50 $145,000 Costs — — Direct materials $ 2.50 $ 25,000 Direct labour (per 1/4 hour) 6.00 60,000 Variable manufacturing overhead 1.50 15,000 Total cost $10.00 $100,000 Incremental profit $ 4.50 $ 45,000

There is no opportunity cost for the special order as there is idle capacity of 20% × 50,000 = 10,000 units.

b) CPA Way step: Assess the Situation

If Anvil takes on the additional customer requests, its profits will decrease by $2,500.

Account Unit Total Revenue $14.50 $145,000

Costs — — Direct materials $ 2.50 $ 25,000

Direct labour (per 25 minutes) 10.00* 100,000 Variable manufacturing overhead 1.50 15,000

Etching tool 0.75 7,500 Total cost $14.75 $147,500

Incremental loss $ (0.25) $ (2,500) *$6.00/15 × 25 = $10.00

c) CPA Way step: Analyze Major Issue(s) and Conclude and Advise

Taking on the project with the initial parameters in part (a) at $14.50 per unit is a good use of Anvil’s available capacity as it provides the company with an increase in profits of $45,000. Anvil’s management would have to consider if it is willing to take a loss on the project by satisfying the customer’s additional requirements of etching its logo on the product. Alternatively, Anvil could revise its selling price to one that breaks even or one that provides the same incremental profit based on the initial parameters.

If Anvil wants to break even on the project, the new selling price would be $14.75 to cover all the costs.

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If Anvil wants to make a profit equal to the return on the first proposal, the new selling price would be $19.25 ($14.75 + $4.50).

Management would have to take into consideration how motivated it is to make use of its capacity. Because it is expecting a surge in growth, this order might preclude any increase in demand in the immediate future. As such, if management were to accept the order, they would want to ensure that the order provides more than a break-even return.

It should also be noted that by taking on the additional 10,000 units, the plant would be operating at capacity. Management should take into consideration if the additional 10 minutes per unit would even be possible if it measured capacity in direct labour hours.

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intermediate management accounting primer

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