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é 2) ReSA- the Koriew School of Accountancy + Management Services MS-01: COST BEHAVIOR ANALYSIS cost monet ry amount of the resources given up or sacrificed to attain some objective such as goods and services. When notified by a term that defines the purpose, cost. becomes (€.9., acquisition cost; production cost; cost of goods sold) COST BEHAVIOR lation nship between cost and activity - as to how costs react to changes in an activity like production. As production increases, some costs remain the same (j.e., constant or fixed) while if _| ive. inverse relationship) _ Tncreases as production increase | ionship) ae Constant cs [ao wixe ] portionately (vs, total | Decreases less proportionately (vs. unit | (eemi-variable) | variable costs) as production increases | fixed costs) as production increases. | FIXED COST v VARIABLE COST Discretionary Fixed < 4 > True Variable Cinomisetriied Step Variable MIXED ¢ Wea bx ] - the total costs (dependent varial a] - the total fixed costs (y-intercept/vertical axis-intercept) [b] < the variable cost per unit (slope of the line) [X]- the activity or cost driver (independent variable [bx] - the total variable costs ‘COST BEHAVIOR ASSUMPTIONS and LIMITATIONS RELEVANT RANGE Assumption Relevant range refers to the range of activity within which the cost behavior patterns are valid. An level of activity outside this range may show a different cost behavior pattern TIME Assumption The cost behavior patterhs identiied are true only peciied period of inte. Beyond this, the cost may show.a diferent cost behavior pattern LINEARITY Assumption The cost is assumed to manifest a linedr relationship over a relevant range despite its tendency t now otherwise over the long run COST ESTIMATION: SEGREGATING VARIABLE & FIXED COSTS 1), HIGH-LOW POINTS Method The fixed and variable portions of the mixed ampled data points the highest and lowest points ba : Variable cost per unit (b) = change Change x) | SCATTERGRAPH (Scatter Diagram) Me All observed costs at various activity levels are plotted on 2 graph. € nt regression line is then fitted to the plotted points to represent the lie function ) LEAST-SQUARES REGRESSION Method Least-squares method is @ statistical technique that investigates the association between dependent and independent variables. This method determin ne of best ft for a set of observations by nimizing the sum of the squared deviations between cost line and the dats + If there is only one independent variable, the analysis is Known as SIMPLE REGRESSIC + Ifthe analysis involves multiple independent variables, it ls known as MULTIPLE REGRESSION, 4) Other Cost Estimation Methods: A) Industrial Engineering Method - based on the relationship between inputs and outh physical forms; engineering estimates indicate what and how much costs shoul 8) Account Analysis Method each account is classied 3 variab experience and judgment of accounting and other qualified personnel inthe organisation ) Conference Method ~ costs are classified based on opinions from various company det Page 1 of 4 pageReSU - the Rerrew School of Gacourtanrey MS-01 COST BEHAVIOR ANALYSIS CORRELATION ANALYSIS CORRELATION ANALYSIS is used to measure the strength of Jinear relationship variables. es The Correlation between two variables can be seen by drawing a scatter diagram: the points seem to form a straight line, there is a high Correlation. + Ifthe points form a random pattern, there is a low Correlation or no correlation at all ctween two or more COEFFICIENT OF CORRELATION (r) measures the relative strength of linear relationship between t Variables. Its value ranges from ~ 1.0 to + 1.0. * Ifr = 1.0, there is gerfect inverse linear relationship between X and ¥. + If r= 0, no linear relationstip: 2 ifr = +1.0, there is perfect direct relationship between X and ¥. COEFFICIENT OF DETERMINATION (+) is the proportion of the total variation in ¥ that is aceollfited for by the regression equation, regardless of whether the relationship between X and Y is direct or inverse. It is a measure of ‘goodness of fit’ in the regression. ‘The higher the °, the more confidence one can have in the estimated cost formula, EXERCISES: COST BEHAVIOR ANALYSIS Variable Costs vs. Fixed Costs ‘Adriel Company manufactures and sells a single product. A partially completed schedule of the ‘company's total and per unit costs over a relevant range of 60 to 100 units produced each year is given below nits Produced 1) 80 Gil) 100 TOTAL COSTS (A) Variable costs P 120 p72 P (8) Fixed cost: 2 2 500 (C) Total costs P? P 760 P 7 e PER UNIT COSTS. (0) Variable costs P > 2 (©) Fixed costs P 2 REQUIRED. L. Complete the schedule by writing the missing amounts 2. Which two (2) specific costs remain constant over the relevant range? 3. Which two (2) specific costs dre directly related with production? 4. Which specific cost is inversely related with production? 3 6 Express the cost formula based on the line equation form "Y = a + DX. If the company produces 75 units, then how much is the expected total co (Adapted: Managerial Accounting by Garris 2. High-Low Method The controller of SUREDEAD Hospital would like to come up with a cost formula that links emergency department cost to the number of patients admitted during a month. The emergency department's costs and the number of patients admitted during the past nine months follow Month Number of Patients Emergency Department's Cost April P 15,600 ‘A May 2007 june 7 00 duly 4,600 August P 14,306 Septembe 1 P 13,200 October 114 2,800 November N48 P 72,500 December 16 4,000 REQUIRED: Using the high-low methad, determin 1. The variable cost per unit 2. The anqual fixed costs 3. The emergency department's monthly cost 4. The department's estimated cost if 20 patients are expected to be admitted next month. ‘Adapted: Managerial Accounting by Garrison & Ne Page 2 of 4 pagesKe Fd - the Review School of Uecorntaney MS-01 COST BEHAVIOR ANALYSIS 3. Correlation Analysi AY The cagenasof he inearreatonahip between the cost an the acti ithe ¥ correlation Deviation Variation 4. Standard error B) Looking at the following scatter diagrams, we can conclude that . Units ‘Units ‘ Cost A Cost B DN Tag rere Cost A will be easier to predict than cost B. Cost B will be easier to predict than cost A. Cost A is out-of-control. Cost 8 has no variable component. v C)_ Which of these correlation coefficients represents strangest celatianshig between two variables? a. + 0.50 Taner 005 “hots C47 b 2080 a +105 Aeiae Bi = sit Ae item WE Wa! D9Ce a taptecs Manegerial Accounting by Louderback) 4. Least- res Regression Method “Cui. ‘Sy Company's total overhead costs at various levels of activity are presented below: Month Machine Hours Total Overhead Costs 4 March 500 P 970 js dene April 400 hk P85" Yorrible, cork pur seit tune May 600 wp 1,089 1 June 7004 ~ P 1,2087 > ssa Trini monn nates mie yn tios)30 2) 453-241 & 5 a ueenie = . jupplies (Variable) P 260 /400 VK ASS. oosuees Salaries (Fixed) 300 300 eed Utilities (Mixed) 291. say ac ys at bt Total PBs oy 088 8= 3 ecouinen: \ = 29) ~G4(4a}. How much of June's overhead cost of P 1,208 consisted of utilities cost #463, 295 2, Using high-low method, determine the cost fuaction for uti st yn ac + 4K 3. Using high-low method, determine the cost function for fatal overhead cst. y= 34¢ 41 19% <7) 84+ 05 = 119 ast rh JTION GUIDE (requirement 1) per April hrs) June (700 hrs) #)¥ Supplies (Variable) P 260 ASE Salaries (Fixed) 300 a Utilities (Mixed) Total Overhead Costs sc+ de) Month Hours (xX) Total Costs (Y) aay x Mar 500 P970 465/00 250/000 . Apr 400 Past 240,400 (<0, cow May 600 P 1,089 453/40 349/000 Jun 7200 P4208 - TENE LAOS, } SUM 2,960 ane 2934, 100 Ey-na + bex > "age mets ain 24a 49008 €1 19) iint =49 + 2,209) S50 ya qt -2618 Ce eg. 490 = 22000 + 1,240 0006 We 1500 _ 596 2214 Woo = Wes eeReSU - The Review School of lecommtoncy MS-01 COST BEHAVIOR ANALYSIS WRAP-UP EXERCISES (TRUE OR FALSE; MULTIPLE-CHOICE) Unit variable costs are costs that change in direct proportion to changes in the activity level é 4 Tote Varese RAge. Aue UME UE remain Conte e 2. Consider the following graphic representation of certain costs Costs (P) units Which of the following costs are «nost likely represented by the graph?, ‘Total ixed costs and total variable costs b. Total fixed costs and unit variable costs Unit fixed costs and total variable costs pce 4. Unit fixed costs and unit variable costs... jead@ibet slottd C x In cost analysis using the line equation = 4 + b¥-unit variable cost (b) Is regarded as the 7 "2. Dependent variable €. Slope of the line bs Independent variable a. Y-awis intercept D 4 A company has developed a production cost equation for Its lone product: Y = 50 + 5X, where X is based on the number of labor hours. Assuming a relevant-range of 10 to 20 labor hours, what is the estimated production cost at zero (0) labor hour? a PS Felevort vonge b. P50 cP 5S d. An amount that cannot be determined from the given information 21 0nd obwe. 9. If the coefficient of correlation’ (r) between two variables is + 0.95, how might a scatter diagram of re these variables appear? gues ri ‘of. 2. Random points er ge 6 b. Aregression liné that slopes up to the eft } €. _Aregression line that slopes up.to the right ie A repression line that slopes dove tothe right mene. 4 5. Ana Company is interested in the relationship between sales (dependent variable) and occurrence of + fain (independent varisble). ‘Using the proper formula, te coefficient of correlation (r) fs computed as 199. What conclision about the sales and rain occurrence could one make? 7 2, Rnincrease in sales causes an increase in rain occurrence jel Bo Amincrease in sales causes a decrease In rain occurrence x ¢c, An increase in rain occurrence’ causes a decrease in sales. &.Amincrease in rain occurrence causes an increase in sales, A %7) wnat isthe appropriate range forthe coefficient of determination (2 x a. Oto+t Hie ee A ee bo itor 4. Oto infinity a b, 4, 6 9% Which cost segregation technique gives the most mathematically-precis cost estimate? a, Scatter-diagram method. or b. Least-squares method | €. High-low method d, Calendar method TRUE ~ 10. Knowledge on cost behavior is critical to profit planning, particularly In cost-volume-profit analysis. Page 4 of 4 pages GS ©be brie ; : oF ferlit () ReSA- The Review School of Accomrtancy. « Mamogement Services MS-02: COST-VOLUME-PROFIT ANALYSIS = IS useful for profit planning by way of a systematic analysis of the profi’s relationship with various costs and volume of salgs.c= petty \ese\ FACTORS At AFFECTING PROFIT _ Hf there is an increase in... | Then profit fends to. | 1. Selling Price _ “2. Unit Variable Cost ef. 5 - oles a otal Fived CPF ele Cort per Unit moles Mix 3. Fixed Cost E 4. Volume (Unit Sales) Increase 1m mult-product companies, a change in sales mix may also-affect company profit. UNDERLYING CVP ASSUMPTIONS (Limitations) Relevant range, time and linearity assumptions in MS - 01 are also assumed in CVP analysis. ¥ Unless indicated otherwise, unit selling price is constant even if sales volume changes, 7 Inventories do not change significantly from period to period, Perdverian FOUNL * GALES of tn cose raul itcaceesiopay, caer con OT erases BeGaent im mtr Const ree bor product orodyeton Sectaaly TERMS USED IN CVP ANALYSIS Contribution Margin (CM) - is the difference between sales and variable cost. It is otherwise known {8s inarginal income, profit contribution, contribution to fixed cost or incremental contribution. ‘+ CM Ratio = CM + Sales = Unit CM“ Unit Selling Price | CM Ratio = ACM + A Sales NOTE: The sign °A’ is used to mean change or difference. . Break-Even Point’ (BEP) - a level of activity, in units (break-even volume) or in pesos (break-even sales), at which total revenues equal total costs, At the break-even point, there ‘s neither a profit nar a loss. +) BEP units = Fixed Costs ~ CM per unit + BEP peso sales = Fixed Costs + CM Ratio + Unit Sales with Target Profit = (Fixed Costs + Profit) CM per unit Fixed Costs EM Ratio - Return on Sales * Profit must be expressed before tax: Profit after tax + (100% - tax rate) Margin of Safety - the difference between actual sales and break-even sales. It indicates the ‘maximum amount by which sales could decline without incurring,@ loss. + Peso Sales with Target Return on Sales = + Margin of Safety = Sales - Breakeven Sales + | Margin of Safety Ratio = Margin of Safety + Sales Indifference Point ~ the level of volume at which two alternatives being analyzed would yield equal ‘amount of total costs or profits. Alternative A Alternative 8. ? + Unit CM x Q) ~ Fixed Cost (Unit CM x Q) ~ Fixed Cost + Fixed Cost + (Unit VC x Q) Fixed Cost + (Unit VC x Q) NOTE: Q - number of units (indifference point) Sales Mix - the relative combination of quantities of sales of various products that make up ‘the total sales of a company. + Over-all BEP unjes = Fixed Costs + Weighted Average CM per unit ‘+ Qver-ail BEP peso sales = Fixed Costs + Weighted Average CM Ratio Degree of Operating Leverage (DOL) - measures how a percentage change in sales will affect ‘company profits. Tt indicates how sensitive the company is to sales volume increases and decreases. It is also known as operating leverage factor. Of ‘+ DOL = Contribution Margin + Profit before tax + A% sales x DOL = A % profit before tax Page 1 of 3 pagesRSA The Review School of Aecourtance MS-02 COST-VOLUME- PROFIT ANALYSIS. EXERCISES: COST-VOLUME-PRC ‘The company’s sales and expenses for a recent FIT ANALYSIS 4. Popoy Company manufactures and sells a single pr month follows? See ee Sales (1,500 units) P-37,500 /iF96 = 25.) ig Less: Variable Costs ___ 15,000 1£50 = _19 (2) Contribution Margin if econ : ae? 1G cue = c/s REQUIRED: 2a) Fo. oS ; 1. Determine the following: fhe, } ‘A) Unt seling price ee | = B) Unit variable cost UH) 15/009 5 : €} Conthibution margin ratio (CHR) Taste KN vy es | oft pa poses, compute the following: 4c 2 2, For profit planning purposes, compute the followings 4 cee + & Sy Break even palnt inne at 5 B) Break-even peso sales a una ales oe required to e0rnP 9,060 prof forthe month? What besa sales are required to earn an after-tax profit of 7.200 (assuming tax rate 6 2008)? ee Sed eat the company president Assume that Popoy Co; Guventy sverisiig were increased by P6,000. How many unks shou! soles increase to give Popoy Co. the same profit or Joss that it is currently earning? sae ease Oe eb how many unis Bre now beng Sold, You dont nsed ths formation 2 Ohette movant) Se aslo a, ike te robler” os sfery of Clean Co. at ts present sales of 27,500? SRE Ne tee atespcople. a monthly slary-of-P4,000-per_manth without ery Popoy, Co. currently Bays Ie sates considers a pla whereby the salespeople would recelve ¢ i tomy the oper acy would fal to 2,500. What sles level wil the company be indifferent between the two compensation plaris? ‘Assume that Popoy Co. is currently selling 800_units i Leg (Adapted and edited: Managerial Accounting by Louderback) é I~ 4 »} SOLUTION GUIDE 2@ a (2).2,000 units (3) 1,600. units (5) 800 units’ —~ Sales 51260 42; 000 20/0 #500 Less: Variable Costs _19.800_ 1p, 900 s10d0 Contribution Margin 1; 600 24,009 i000. . Less: Fixed Costs tgp 800 15,000 Csi ee z . Profit (Loss) oO” 9,00 7 ots g Requirement Nol?) Aewosvt Golub See ret ay fixed cost will decrease by P 1,500 under the proposal (P 4,000 > P 2,500), eh 7 Unie variable cost increases by P 2.50 (10% of P 25) joas = 2u0e [2X Soe cont em ers ts] CU Costs (old) = Costs (new) 1,500 = 2.5 | 15,000 + 10 x = 13,500 + 12.5 X x = 600 units = 108 [26 ai byortne! (Fea Contribution margin ratio x Margin: of safety ratio = net profit Wek ated main rasa « cbuncn mera+ Sle Margin of safety ratio = Margin of safety + Sales Net profit ratio = Profit + Sales ratio 4. Basha’s break-even sales are P 528,000. The variable cost ratio is 60% while the profit ratio i= 89% REQUIRED: Determine the following: Fixed Costs 2, 208 Sales coe Profit 2.9 Margin of Safety cle ~ Margin of Safety Ratio 32% 2 ve Page 2 of 3 pagesReSO The Rerrew School of Cccowntomeg MS-02 COST-VOLUME-PROFIT ANALYSIS. 4. Mahjong Company produces and sells two products, tables and chairs. Following is next month's income budget : Chairs Tables Total’ 1) 86, TES Unit sales 60u 1Su 75u whee Sales P 1,200.00 P 187.50 P 1,387.50 = HO Variable Costs 1,050.00 __112.50 62.50 ae Contribution Margin P'150.00 P'75.00 P'225.00 sai Fixed Costs. 90.0¢ cae Profit 135,00 REQUIRED: 1. How many units of chairs should be sold next month to break-even? 29 \tt 2) How many-Units of fables should be sold to earn a profit of P1207 uists (Adapted: Managerial Accounting by Garrison, et.al.) TION GUIDE Chairs Tables Contribution Margin (CM) per unit P. 2.50 P 5.00 “Sales Mix (4:1 > 80%:20%) 80% 20% ‘Weighted Average CM per unit: 5. Ms, Rita has recently opened the UBE Fitness Gym being offered exclusively for malnourished individuals The results for the gym’s first year of operations are presented as follows Sales 250,000 Variable Costs (100,000) Contribution Margin P 150,000 Fixed Costs. (120,000) Profit P.30,000 Ms, Rita is unhappy abouit the results of his gym’s first year of operations. She observed that despite the high contribution margin, profit was still low because of the high fixed costs. She concludes that an increase in sales would not yleld a satisfactory increase in profit. ») oe REQUIRED: ‘1, Explain to Ms, Rita that his conclusion is not right by computing the operating leverage factor. 2. If sales increase by 10%, then how many percent would profit increase, ceteris paribus? (NOTE: determine the percentage 6 in profit by using the operating leverage factor.) (Adapted: Managerial Accounting by Garrison, et.al.) WRAP-UP EXERCISES (TRUE OR FALSE: MULTIPLE-CHOICE) = *) 75 a) 2 _A® Bt the break-even point, total contribution margin is zm aiczero €. Equal to total costs BL Equal to total fixed costs d. Equal to total variable costs T ._-Aminerease in contribution margin ratio reduces the break-even point ase © the taxuate jacceases, then the break-even point also increases. WF Amincrease in the income tax rate rept ge aa. Raises the break-even point OT SiS b. Lowers the break-even point to C._ Increases sales required to earn a particular after-tax profit a) 4G. Decreases sales required to earn a particular after-tax profit, SS. An increase in actual sales also increases the margin of safety. ©. A campany that has a negative margin ofsfey necessary operates at alse. + GF Under CvP analysis, which of the following is not assumed to be constant? — 5 ‘a. Unit variable cost c. -Unit selling price D._Unit fixed cost 4, Sales mix DBE A% change In pre-tax profit can be quickly computed by multiplying a % change in peso sales by the 2. Sales mix c. Indifference point b. Margin of safety d. Degree of operating leverage ' D9 The operating leverage factor is equal to 2. Gross margin + profit after tax Contribution margin = profit after tax _ b. Gross margin + profit before tax 4. Contribution margin = profit before tax 130. If inventories are expected to change, the type of costing that provides the best information for breakeven analysis is ‘a. Job-order costing © Joint costing b. Variable costing d. Absorption costing Page 3 of 3 pagesfl SUMMARY ARSURETIOS 1) Sctider ALL Monarch "y Ly Fited Had Ganobie é J eroH ae a “PRORUCT Co BAKa Fu coraNe ©) GSU. The Review Sthoobof Cecometancy, MS-03: ABSORPTION & VARIABLE COSTING ABSORPTION COSTING - is 9 costing method that Jachudes all manufacturing casts - direct" materials, 4 abo janie a rt asi — in the cost of a unit of product: Uk tinats Ged factory Gverhead (FFOH) as a product cast. Absorption osting is alsa kaawe as ful) VARIABLE COSTING- is 2 met cludes ariable manufac tala bias, diect Jahor, and aniable manufac in the cost of a unit of product. Wtkaats EROH as 2 pened cost. Variable costing is alsa called dibert ening: PRODUCT vs. PERIOD COST A product cost (san inventariahle cost that ts 5 unsold units Current income ig reduced only by the amount allocated to the saldualts. Consider the following allocation = —.._--? UNSOLD UNITS + Asset (as Inventory) rooucr cost << ce > SOLD UNITS > Expense (as Cost of Goods Sold) A peclod cost is a cost that is charged as expense against income, i Howilocation is necessary; current income is reduced by the Aulamaunt of the period cost. Ceerion cost >—————> FULLY ExpENSED. in.the period incurred, regardiess of sales i Deen +d scone D cuinest te pleconen 2 10a ABSORPTION vs. VARIABLE COSTING 1) RATIONALE Supporters of variable costing argue that FFOH costs are incurred in order to have the capacity to produce Units. These costs are incurred whether or not production occurs. Thus, FFOH costs, having no future service potential, should be dully-axpansed in the came period incurred. ek i 79 POL. a sched ey tepals MEL pres Supporters of atisctnin costing believe! that all manufacturing costé ~~ varlable and xed’ —ore necessary for production to take place and hence should not he ignored in determining product casts. (IMC 2) INVENTORIES, Since FFOH costs are simply expensed (i.e., period cost) \under the variable costing, the peso ‘amount of inventories under variable costing \s always lower than the peso amount of inventories under ‘absorption costing FNC 1 1PAG 3) ACCEPTABILITY Since treating FFOH as part of inventory cost Is consistent with accounting standards, nly absorption costing is acceptable tor nancial reposting and tax puenases, Variable costing, ‘which \iglates the ‘matching niiaciole,’ is accentable omly for internal use by management NOTE: Matching principle is an accounting principle that calls for the recognition of expense by matching it with the related revenue in the same accounting period. It supports the treatment oF cost of, sales es pane grly hen tose ute ava Seen So Nereaien » Sabale EoMHAsy 2) nereprare ie FMA Dacceproblt eek) 5 4) INCOME staTeMeNT are Naas Deets An income statement prepared Wader absorption costing thet casts, Production costs pertaining to sold uns are fst deducted from sales t¢ ave at gross profit, and then other costs are deducted to obtain net income #) gery Marsieg tomar 2) acre, wei Under watlable costing, the income statement distinguishes between variable and fixed costs. All variable costs are first deduicted from revenue te arrive at the contribution margin, and then fired costs are deducted to obtain profit 5) INCOME COMPUTATION rable casting in wy differ (om sbeocption tacti because of the difference in the amount of FFOH recognized as expense during @ period. This is actually caused by the difference between pcoduction and sales In the fong run, however, horh methods sould yield the same results since sales cannot " a s. (NOTE: the term “income” in many accounting literatures is liberally used to mean. “groht") ypcoeti): core mk nr “9 “Wage 1 of 4 pages x STreting thane ty eg eerie x Fr omnes en) pelircans ee ee aurKeSU - The Review School of Cccoumfancy, MS-03° ABSORPTION & VARIABLE COSTING RECONCILIATION OF INCOME UNDER ABSORPTION COSTING & VARIABLE COSTING Under variable costing, EEQH costs are fully expensed as incurred, while under absorption costing, S&0M Consider the following patterns based on production and sales: + Pattern No. 1: When groduction equals sales, there is oa .change in inventory. EEOH expensed under absorption costing equals FFOH expensed under variable costing. PRODUCTION = SALES => Income (Absorption) = Income (Variable) + Pattern No. 2: When production is greater than sales, there is an increase in inventory. £FOH ‘xpansed under absorption costing ic ess than FFOH expensed under variable costing. ‘Therefore, PRODUCTION > SALES ‘=> Income (Absorption) > Income (Variable) + Pattern No. 3: When productian is less than sales, there is a deccease in inventory. EEQH expensed inder absorption costing is greater than FFOH expensed under variable costing. PRODUCTION < SALES ‘=> Income (Absorption) < Income (Variable) + Basie Formula: ‘A Income = A Inventory x unit FFOH Where: 4 Inventory = Ending Inventory ~ Seginning Inventory {4 Inventory = Units Produced ~ Units Sold + Alternative Formula: Income, Absorption costing Pree Add: FFOH in beginning inventory wx Total Proc. Less: FFOH in ending inventory (2000 Income, Variable costing Pox ADVANTAGES OF USING VARIABLE COSTING e Variable costing reports are simpler and more understandable. ‘ The problems involved in allocating fixed costs are eliminated. i ata needed for break-even and cost-volume-profit analyses are readily available Variable costing is more compatible with the standard cost accounting system. Variable costing reports provide useful information for pricing decisions and other operational problems encountered by management DISADVANTAGES OF USING VARIABLE COSTING 1. Variable costing is not in accordance with GAAP; hence, it is not acceptable for external repo? 2. Segregation of costs into fixed and variable might be difficult. 3. The matching principle is violated by using variable costing, which excludes FFOH from product » costs and charges the same as period costs regardless of production and sales. 4. With variable costing, inventory costs and other related accounts, such as working capital, current ratio, and acid-test ratio are understated because of the exclusion of FFOH in the computation of product cost. EXERCISES: ABSORPTION and VARIABLE COSTING : 1, Adriel Company makes state-of-the-art toy car. Each toy car sells for P 1,000 each, Data for 2016's ‘operations are as follows: Units: Variable Costs. Beginning Inventory 5 Direct Materials 24,000 Production 80 Direct Labor 16,000 Ending Inventory 15 Factory Overhead 8,000- Selling and Administrative 4,000 Fixed Costs: Factory Overhead P 20,000 Selling and Administrative 2,000 REQUIRED: ) ‘ Determine the inventory cost per unit uncer: es 'A) Absorption costing“? = 8) Variable costing > 2. Determine the cost of ending inventory under ‘A) Absorption costing Frat 8) Variable costing 360 Boe =, Page 2 of 4 pagesAC YC, Erdiiig ¢ Bey ReSU - the Review School of Cecomedaney MS-03 ABSORPTION & VARIABLE COSTING 3: Prepare income statements under (A) absorption and (2) variable costing. 4+ How muem i the eltference in income between the costing methods? sec 2099 = 21c00 5. What causes the difference in iname between the costing methods? (Adapted: Managerial Accounting by Garrison) cap SOLUTION GUIDE 6 requir (A.) Absorption Costing (B) Variable Costing Total Per Unit, Per Unit pM 24 000 200 50 DL leout Ba 4 VFOH yon Iso . FFOH 259 ath Total 60D et ig Prodick 2 Lay ge ‘SOLUTION GUIDE to requirement 3 ce ADRIEL COMPANY Income Statement, for the period of 2016 (A) ABSORPTION Costing (B) VARIABLE Costing . Sales P 40;e09 Sales Pa eo =Costofsales <9, 00 =Variable cost Gross profit 191508 Contribution margin > Expenses _ Gs 000 > Fixed cost Net income P 4,530 Profit 2. The following information are taken fram the books of Mylene Company, which assumes first-in, first= ut (FIFO) for inventory cost flow > Inventory (in units) 2015 2016 Beginning inventory None 7 Production 10,000 units 9,000 units : Ending inventory 2,500 units 1,000 units Sales (P 2 per unit) 2» m7 Veriable manufacturing costs (P 0.75 per unit) P 7,500 P6,750 Fixed manufacturing costs P'5)000 5,400 Selling and administrative costs (50% variable) _P 4,500 P 7,500 REQUIRED: 4. Determine 2015 profit under Variable and absorption costing 2. Reconcile the two income figures in NO. 1 3. Determine 2016 profit under variable and absorption costing 4. Reconcile the two Tacome figures in No, 3 : (Adapted: Cost Accounting by Horngren, et.al.) LUTIONS & ANSWERS to iter no. 2 201 — Abs —Wariable —Absorption, Variable — Sales P'13,000 Sales 13,000 Sales 23,000 Sales P 23,000 ccs _ (8,125) ve _.@,425)_ ccs (5,175) ve (12,375 GP 4,875. CM P5875 GP 7,825 CM P 10,625 Expense. _(4,500)_ FC __(7,250)_ Expense 7,500) FC (9,350) Income P3275 Loss (P.1,375) Income P325 Profit. — PiLd7s 2015: CGS = 6,500 x P 1.25 = P 8,125 VC = (6,500 x P 0.75) + (4,500 x 50%) = P 7,125 FC = 5,000 + (4,500 x 50%) = P 7,250 Reconciliation: Iricome = (3,500 - 0) P 0.50 = P 1,250 9 375 - (-1,375) 2016: CGS = (3,500 xP 1.25) + (8,000 x P 1.35) = P 15,175 (using FIFO) (11,500 x P 0.75) + (7,500 x 50%) = P 12,75 FC = 5,400 +, (7,500 x 50%) = P 9,150 Reconciliation: A Income = A Inventory x unit FFOH beginning inventory (2015 layer): 3,500 x P.0.50 = P 1,750 ending inventory (2016 layer): 1,000 x P.0.60 = _(600) P4,150 > 1,475 - 325 Page 3 of 4 pages &ReSO - the Review School of ecourtaney MsS-03 ABSORPTION & VARIABLE COSTING WRAP-UP EXERCISES (TRUE OR FALSE: MULTIPLE-CHOICE) 1. Under absorption costing, fixed manufacturing overhead costs are best described as, a. Direct period costs €. Direct product costs b. Indirect period costs 4. Indirect product costs Under variable costing, fixed manufacturing overhead costs are best described as, a. Direct period costs ©. Direct product costs b. Indirect period costs 4d. Indirect product costs 3. Under variable costing, all product costs are variable. 4. Absorption casting differs from variable costing in that: ‘a. Variable costing treats all variable costs as product costs. b. Variable costing treats selling costs as period costs. Inventory cost is higher under absorption costing, d. Profit is higher under absorption costing, Items 5 to 7 are based on the following information White Company manufactures a single product. Unit variable production costs are P 20 and fixed production costs are P 150,000. White uses a normal activity of 10,000 units. White began the year with no inventory, produced 12,000 units, and sold 7,500 units. 5. What is the unit product cost under variable costing? ‘a, P20.00 c. P35.00 b. P32.50 d. P.40.00 6. What is the unit product cost under absorption costing? a. P 20.00 c P35.00 b. P 32.50 4. P.40.00 What is the volume (capacity) variance under absorption costing? a. P 24,000 unfavorable ©.” P 30,000 unfavorable b. P 24,000 favorable d. P 30,000 favorable NOTE: volume variance = (actual production ~ normal production) x unit FFOH 8. There is no volume or capacity variance under variable costing. 9. If production is higher than sales, then absorption costing income is expected to be ‘a, Lower than variable costing income b. Higher than variable costing income Equal to the variable costing income d, Incomparable with variable costing income 10. Black Company produced 10,000 units and sold 9,000 units, Fixed manufacturing overhead costs. were P 20,000, and variable manufacturing overhead costs were P 3 per unit. Which of the following best describes the net income under the absorption costing method? ’2. P 2,000 more than net income under variable costing method b. P-5,000 more than net income under variable costing method .P 2,000 less than net income under variable costing method ‘ d. P-5,000 less than net income under variable costing method 11, Green Company has operating income of P 50,000 using direct costing for a given period. Beginning and ending inventories for that period were 13,000 units and 18,000 units, respectively. If the fixed factory overhead application’rate is P 2 per unit, then what is the operating income using the absorption costing? ‘a. P 70,000 &P50,000 b. 60,000 d. P 40,000 12. Violet Company had 16,000 units in its beginning inventory. During the year, the company’s variable production costs were P 6 per unit’and its fixed manufacturing overhead costs were P 4 per unit. The Company's net income for the year was P 24,000 lower under absorption costing than it was under variable costing, How many units does the company have in its ending inventory? a. 22,000 units . 6,000 units b. 10,000 units, 4. 4,000 units 13. Pink Co. had a net income of P 85,500 using variable costing and net income of P 90,000 using absorption costing. Total fixed manufacturing overhead cost was P 150,000, and production was 100,000 units. How did the inventory level change during the year? {. 3,000 units increase . 3,000 units decrease b. 4,500 units increase d. 4,500 units decrease 14, Under a just-in-time (JIT) production environment, income under absorption costing tends to be equal with income under variable costing. 15, Variable costing income fluctuates with production and does not react to changes in sales: 16. Variable costing is unacceptable for ‘a. Financial reporting c. Transfer pricing b. Cost-volume-profit analysis Short-term decision making Page 4 of 1 pages5 ito i over] © ReSU- The Review School of GecourTancg, » Momagement Services MS-04: RELEVANT COSTING DECISION MAKING ~ is the process of choosing from at least two alternatives. For business entities infanagenient must choose n fave ofthe option thats most bene to the company ogy we ercvlem Inorer to atte the corporate objective of maximizing prof oe Aseeve on OE ttc ee be re ‘SHORT-TERM DECISION ALTERNATIVES (MASS<) FROGS ONT, ten pis oiee site a Gc oulie Gumie GNvey _Susget icing Sosa 2! Accept or reject a special order : ar \prredetog PU 2 Age ORR REELS, mcrae eet etme wee. Wea. 4. Continue or shutdown a business segment 2) Neck the asics sates i Jvientein a ckovie lononstyp erscen te / od Be a Calg aes ema ne, ean Eades eicks (Ns eee 5. Choosing the best product combination 6. Selecting a change in profit factors compen so Ane Wea Gare | ST oiccdnetny THU) 3 Ponung deunone Rieke autre. cw seal pel orc “TYPICAL DECISION MAKING PROCESS Fader saptienne, poser erly, . (_Demante ning 1. Defining the problem. Nore eae ser tecTe I), M compen Sept 2. Specifying the objective and criteria. DSA devon cong, (RYO. On Ae vay gee 5: Edenifnng the alternative courses of action. scm ege nam COE oan cS 4. Evaluating the possible consequences of the alternatives.) "°F er Aieacey /copouty 5. Collecting the data needed to make decision. Deytenal Fouton ane proach are hd 6. Choosing the best alternative and making the decision.” hcjye op yeaneh hee NETS eet poe 7,_ Evaluating the results of the decision. - Tiere Cae Oe ic sent Sows eo metoonanid MOLE EM NONE Tanigerg et ereen Oe ee beemre nO FACTORS CONSIDERED IN DECISION MAKING Tenarogene ny COME NT ORS Qualitative Factors Factors that cannot be expressed effectively in numerical terms Quantitative Factors Factors that can easily be expressed in terms of money or other numerical units. T) vemond onc fae i APPROACHES IN PROBLEM-SOLVING INVOLVING DECISION MAKING ¢) custornters pereepnen of ome ond Pick Total approach Total revenues and costs are determined for each alternative, and the results a. are compared to serve as a basis for the decision to make. <) Poce Foun sity ; ieebcly eblsadh Gey dtr ences oy cshgna i coes wi yeanues'9ve Se ha ae cE end ane ‘TYPES OF COSTS AND TERMINOLOGIES USED IN SHORT-TERM DECISION MAKING J vcginly Hie are veMnt RELEVANT COSTS Future costs that are expected to be differeht ationg alternatives; it Is“0rdse muse considered as the avoidable costs of a particular decision. Vite or NO eyed” ®& DIFFERENTIAL COSTS Increases (increments) or decreases (decrements) in total costs that result from, : pene vet) (S18 feces eek (© AVOIDABLE COSTS Costs that will be saved or those that will not be incurred if a certain decision is made. [Relevant] : {R OPPORTUNITY COSTS —_Income sacrificed or benefit foregone when a certain alternative is chasen over ‘another alternative. (Relevant) i FR SUNK COSTS, Costs that are incurred already and cannot be avoided. regardless of what WOKS Leet Rage decision is made. [Irrelevant] ur mey wey Sac a wosis For making FREMIETY 1% SHUTDOWN Costs Usual costs that a company will continue even if it decides to discontinue or shutdown the operation of 2 company segment. [Irrelevant] & QUT-of POCKET COSTS Costs that will require expenditure of cash or incurrence of a liability as a consequence of a management decision. (Usually relevant) {@ JOINT costs Costs incurred in simultaneously manufacturing two or more (joint) products. that are difficult to identify individually as separate types of products until the products reach @ certain processing stage known as the split-off point. {trrelevant R FURTHER PROCESSING Costs incurred beyond the split-off point as separated joint products are to be costs processed further [Relevant] | SPLIT OFF POINT ‘The earliest stage in the production where joint products can be recognized as distinct and separate products, BOTTLENECK Any particular resource or operation where the capacity is less than the demahd RESOURCES placed upon it. +! RAGE Bee eeLe ANT oN ey) Page 1 of 5 pages Aes Sao O-gemrrunty RE Fouaner recency CO Org -oF Focker Sout S-aink Cost# Pdidagy Dcwitseona PAuR ~ skeen a tere wen grt etheds Wen oF RELEVANT COSTING ime ar ot Say she ene natu hake Tene 2 cor+ me¥up| © eased on Cietel Gots —__, cso] LV Highest revenues, —— Highest possible profit) Lire sy Lowest costs ef Seay o. rae uN + MU Pes awe + Cw MG?) SHORT-TERM DECISION MAKING GUIDELINES Basic rule: choose the action that will yield the BEST PROFIT POSITION. 2) Moder Based Priktg CBanjer 6 Uy orices based On congth te caer ren om Peon caste Os yea ext BY vols Baainces ey, ape tnrgeh ent SS yon wee we ever + | eceray ac a5 = Ga ened He aan gh ah soe cant bo peel a Fakes. Pichon raption ered ct + Gaed on respon Freahne Mead tee ieee orgek erie ~ expe Prices nee + (APE RNID) sib Rarcigoagar sore [pices Ate + (are regent en pe ™ Wocmpatted restore neers of ved Sd oie mec) ae Se wieghaF Cm ath (mActecs) i a =r ae NATURE OF ] ‘ALTeRNATIves | __DESCRIPTION |___DECISION GUIDELINES oS MAKE or BUY. ‘Should a part or product be | Choose the option that has the lower |~ "rt pasion 8 part/preduct ‘manufactured | (in-sourced) or | cost. In most cases, fixed costs are | oe 9 bought (outsourced) from outside | irrelevant. Consider opportunity | °" reais le a | supplier? costs,.if any. by ws 2. ACCEPT or REIECT —|'Should a special order that | Accept the order when Hie addons 5) conpedtion| special order | requires a price lower than the | revenue from the special order |") | regular seling price be accepted? | exceeds additional cost, provided the a) hes Pred regular market will not be affected, |?" In most cases, fixed costs are | "9 I a : i irrelevant [Price celmelag 3. CONTINUE oF ‘Should a Business segment, which | Continue if avoidable revenue of the | Ls yw iy ost SHUTOOWN I ete of te iner_,2 | Seament involved is greater than is, vox icy ee a business segment | department or a branch, be | avoldable costs; otherwise, consider aa yas continued or discontinued? Shutting ‘down the segment. Since |) Penetott= allocated fixed cost is usually | Lp (me's 1-6 | | unavoidable, it is considered | “2 Levt| 4 ¢ —__| irrelevant g 4. SELL or PROCESS Shoulda product, after | Process further if additional revenue FURTHER a product | undergoing the joint process, be | from processing further is ‘greater | S0ld at the spit-off point or be | than further processing costs. Joint | | processed further? ‘costs, since already incurred prior to the split-off point, are considered f —__| sunk costs and irrelevant. | 5. BEST PRODUCT Which product(s) should be | Identify and measure the constraint COMBINATION | Produced and sold when there is a | on the limited resource(s). Rank the (Optimization of given limited resources. or | product(s) according to the highest Scarce Resources) _| bottleneck operation? contribution margin per unit of 8. &. CHANGE IN PROFIT" |'Should any of thé profit factors | Identity the factor to change and the FACTORS such as selling price, unit sales, | amount of contemplated change. panayacormas” | variable cost, fixed cost and sales | Change the profit factor if it. wil Pe mearae C2) | mie be manipulated to Increase |icause’ an itnprovenerr or nd Ue profit? {company’s over-all profit position. | Autumn Company has a sin Kyoto at P-40 per unit, The com; REQUIRED: EXERCISES: RELEVANT COSTING 1. TOTAL ANALYSIS vs. DIFFERENTIAL ANALYSIS Variable Costs. Direct materials Direct labor Variable Overhead Variable Selling Expense Fixed Costs: Fixed Overhead Fixed Selling Expense 1. What is Autumn Company's present profit? 2. Auturnn Company could increase its sales by 25% Determine the effect on company profit using: A) Total analysis 8) Differential analysis Page 2 of 5 pages P10 8 5 2 P25 P 50,000 30,000 if it spends P 20,000 for advertisements. © wgle product called Kyoto. The company currently sells 8,000 units of pany’s costs at this level of activity are given below:ReSU - The Review School of ecourdaney MS-04 RELEVANT COSTING 2. MAKE OR BUY (OUTSOURCING DECISION) BMW Motors is trying to decide whether it must continue to produce an engine component or buy it from SARAW-Philippines for P 2,500 each. The demand for the coming year Is 20 units. The costs of producing a single unit of the engine component are as follows: Direct materials P 1,200 Direct labor 800 Factory Overhead (80% fixed) 1,000 P.3,000 If BMW buys the components, the facility now used to make the components can be rented out to another firm for P 10,000. REQUIRED: ‘Should BMW make or buy the components? 3. ACCEPT OR REJECT (SPECIAL ORDER DECISION) ‘Antonia Company sells a product for a regular unit price of P 75.00. The cost of producing and ‘selling a unit of this product at the normal activity level of 50,000 units per month is as follows: ‘Manufacturing costs. Direct materials P 32,80 per unit Direct labor 7.20 per unit Variable manufacturing overhead 3.00 per unit Fixed manufacturing overhead P 100,000 per month Selling and administrative costs: : Variable P 2,50 per unit Fixed P 36,000 per month ‘An order has been received from a customer for 5,000 units at a discounted unit price of P 50.00. This order has no effect on normal sales and would not change the total fixed costs. The variable selling and administrative expense would be P 0.50 less per unit on this order than on normal sales. REQUIRED: ‘Should Antonia accept or reject the special arder? 4. SPECIAL ORDER PRICING Conrada Company sells I-Phone 8 at a price of P 28,000 per unit,. The costs per unit are: Direct materials 8,000 Direct labor 6,000 Variable overhead 4,000 Fixed overhead 2,000 TOTAL P 20,000 ‘A special order for 1,000 units was received from Marcia Bona, a well-known cell phone dealer based in Cavite. Additional shipping costs for this sale are P 2,000 per unit. REQUIRED. ‘What is the minimum selling price per unit for the special order if A) Conrada is operating at FULL capacity? 8) Conrada has EXCESS capacity? 5. SHUTTING DOWN OPERATIONS The most recent monthly income statement for Gorgon Stores is given below: China Branch Japan Branch Total sales 1,200,000" P.800,000 2,000,000 Less: Variable expenses (840,000) (360,000) (1,200,000) Contribution margin 360,000 P.446,000 "£00,000 Less: Traceable fixed expenses (210,000) ’ (180,000) (390,000) Segment margin P.150,000 260,000 -—-P.410,000 Less: Common fixed expenses (480,000) (120,000) (300,000) Profit (oss) (P 30,000) -P 140,000 P.130,000 If China Branch were eliminated, then its traceable fixed expenses could be avoided. The total cominon fixed expenses are merely allocated and would be unaffected. |A) What will be the new company profit (loss) if China Branch is eliminated? 2. P 260,000 < (P 40,000) b. P 140,000 4, (P 70,000) B) What will be the decrease in company profit if Gorgon closes its China Branch and 20% of its traceable fixed expense would remain unchanged while Japan sales would decrease by 20%? a. P 352,000 <& P 136,000 b. P 280,000 d, No decrease; profit will increase Page 3 of 5 pageseS. The Review School of lccouedamcy MS-04 RELEVANT COSTING ©. PRODUCT ELIMINATION POINT Chrissy Company expects that sales wall drop below the current level of 5,000 units per month. An income statement prepared for the monthly sales of 5,000 units show the following: Sales (5,000 @ P 3) 15,000. Less: Variable costs (5,000 @P 2) P 10,000 Fixed costs. __5,000__15,000 Profit = Nil - If plant operations are suspended, a shutdown cost (i.e., plant maintenance and taxes) of P 2,000 per month will remain as incurred. Since there is no immediate possibility of profit. under’ present conditions, the problem of the company is just how to minimize the loss, REQUIRED: 1. What is the shutdown point in units? 2. Should the company continue or shut down operations if sales next month are expected to be: A) 4,000 units? 8) 2,000 units? SOLUTION GUIDE oe es pe *)8.000 units | B)2,000 units | 3.000 units | (5,000) 000) | 7. SELL OR PROCESS FURTHER ‘Oval Company produces four praducts for a joint cost of P 10,000. The firm could sell the products at the spit-off point forthe following amounts | 15,000 40,000 | 2,000" o Contribution Margin =Lixed Costs (5,000) Profit (loss) fh At present, the products are processed beyond the split-off point and they are sold as follows: ‘Adgitional Processing Cost_ REQUIRED: 1. Which product(s) should the firm sell at split-off point? 2._ Ifthe company takes the most profitable action, then what will be its profit? 2,25 8. BEST PRODUCT COMBINATION Kapos Co. produces three products: A, B and C. One machine is used to produce the products. ‘The contribution margins, sales demands, and time on the machine (in hours) are as follows: Market Limit Unit Contribution Margin Hours on Machine A 100 units 10 per unit 8B 80units 5 per unit C150 units 40 per unit There are 2,400 hours available on the machine during the week. Total fixed cost is P 5,000, REQUIRED: 1. What is the best product combination that maximizes the weekly contribution? 8, 100 units of Aj 80 units of B; 150 units of C b. 50 units of A; 80 units of B; 150 units of C i es €. 90 units of A; 0 unit of B; 150 units of C 6. 100 units of A; 80 units of B; 100 units of C 2. How much is the profit associated with the best product combination? ‘SOLUTION GUIDE pete iS Product A_| Unite |p 20 Hours per unit | 10 hrs, Page 4 of 5 pagesKeSla - The Review School of Cecourtancy MS-04 RELEVANT COSTING P_EXERCIS TIPLE-CHOICE} 4. Which of the following costs is generally considered irrelevant in decision making process? a. Direct labor b. Direct materials c. Fixed factory overhead d. Variable factory overhead A. The salary you would otherwise earn by working rather than attending the CPA review is @ good example of 2. Asunk cost b. An opportunity cost © An ineremental cost 4d. An out-of-pocket cost XA opportunity cost is usualy 2. Relevant, but is jot part of traditional accounting records. b. Not relevant, but is part of traditional accounting records. ¢. Relevant, and is part of traditional accounting records, d. Not relevant, and is not part of traditional accounting records. : Al Wihat is the opportunity cost of making @ component part in a factory with excess capacity for which there is no alternative use? a. The total manufacturing cost of the component b. The variable cost of the component ©. The fixed cost of the component é. Zero If there is excess.capacity, the minimum acceptable price for a special order must cover a. Usual fixed manufacturing costs b. Variable and usual fixed manufacturing costs ¢. Variable manufacturing costs associated with the specia) order 44. Variable manufacturing costs plus contribution margin foregone on lost regular units, whe oper pop welerng, fe 2 % 6. If the margin that will be lost by dropping a product line is more than the fixed costs that will be “> avoided, then \ ‘a. The product line operates at a loss b. The product line shall be continued The product line shall be shutdown 4d. The product line has no significant impact on company profit f ime 6 2 Ifthere are shutdown costs, a company’s shutdown point is a. Nilor zero poy dlolang eieddiwo cit = te Bo a b. Below its break-even point i Above its break-even point ; 4. Equal to its break-even point ‘ Bs Which is usually considered irrelevant in sell or process further’ decision making? a. Joint costs b. Further processing costs Sales valve at the split-off point d. Sales value after further processing 5 9. A company that has a limited number of machine hours and abundant labor hours should produce first : the product that has the highest roe a. Demand in units Contribution margin per unit © Contribution margin per labor hour 4. Contribution margin per machine hour ® 1. The role of sunk costs in decision making can be summed up in which of the following sayings? ‘a. No pain, no gain b. Bygones are bygones ©. A penny saved is a penny earned d. The love of money is the root of all evil Page 5 of 5 pagesReSlh- The Review School of lcconetancy, « Mamagemert Serrices | MS-05: BUDGETING BUDGET - Is a detailed olan, expiessed in quantitative terme, about business operations for a specific period @ budget is @ useful too! for Glanning and controling company exnenses, cash flows and earings. The term budgeting is used (o denote the process of coming up with budgets. ADVANTAGES & LIMITATIONS OF BUDGETING _Lesstedeatenes ot budgeting F¥ Planning | «© Teforces managers to.plan 1g Goals /a\ecahing Recawees Limtations of Budgeting Considerable Limeand costs are reaulced + Itprovides 2 means of cammanicating Budgets are merely estimates that ceauice management's plans throughout the entity. + | Itdirects the activities toward the ecessare 2 + successful budgetary systern gequires + Teeoordinates the activities of the entire conperation of all members of the ‘entity by integrating plans of various parts. ‘xganization, + Teprovides a means of allocating resources + Budgets sometimes cestuict the Hexibilty of to seqments efficiently and effectively, ‘the decision-making process. + Tt defines goals that serve as benchmarks for «The budget program is merely a quide, aoa evaluating subsequent performance, ‘substitute for good management ability. » pmenaa bowtenccks cod be discwiceed before ‘THE MASTER BUDGET “') °° MASTER BUDGET. is @ comprehensive budoet that consolidates the overall plan of the organization for a + speciied period: The master budget ts mainly composed of: (1) aneratina buuigets and ewes (2) finansial budgets. The master budget, in. some organizations, 1 also referred to as Stns profane bageet, planning budaet, forecast budget, guaster profit plan Foacam\ wade ea eet Planning tucker —f =“ : arora Pion + [master BuoceT |} OPERATING BUDC FINANCIAL BUOGET ‘Sales Duda: Cash budget Production budget Budgeted balance sheet Direct materials budget Sudgeted cash flow statement Direct labor budget Capital expenditure budget Factory overhead budget Working capital budget Budgeted cost of goods sold Budgeted operating expenses Budgeted net income Budgeted income statement BUDGETING-RELATED TERMINOLOGIES. FIXED BUDGET A budget prepared for 2 ane level of activity within a certain period. (other term: static budaet) FLEXIBLE BUDGET A budget prepared for differeor levels of activity within a certain pesind. (other terms: wariable budget, sliding scale budget) CONTINUOUS A 12-month budget thet (lls two oie month os the cument cont is BUDGETCRSHLING > gompleted (other term: perpetual budget) ZERO-BASED A method of tuceting in which managers ore suid ta BUDGETING a ce being proposed for the first ume IMPOSED A process wherein repated by t ent ait BUDGETING fhguts Go patina erst PARTICIPATORY. ‘A process wherein budgets are deyeiones Nhiough Jou deciee i BUDGETING anagement and operating persone! BUDGET COMMITTEE A group of key management person sesponsible for averall policy mattes fee athe budget graces and for contacaling he budnet orenarsnina, BUDGET MANUAL This lescribes how get Is brenared and lcludles a alanning calendas cin atl istribulion instiuetions for all budget schedules D budget Harming coiendar Keizer -. Japanese tenn stad means > ceatnine Sipraviment aty (2) "10it Gales tov 20 Kas or! Beet ReSU ~The Review School of Uecowitoreg LH Tou MS-05 © Gre +10,000- scvet sect - roe BUDGETING = 65-00 EXERCISES: BUDGETING 1. Monkey Company has budgeted sales at P 100,000 and expects a pialit-of 10% of the sales, Expenses are estimated as follows: selling = 10% of sales; administrative = 15% of sales, Labor is expected to be 40% of the, total manufacturing costs. Factory overhead is to be applied at 75% of direct labor costs. Inventories are to be as follows: January 1 December 31." Materials 2,500, P7500 Worksin-process 8,000 3,000 (0) es oe Finished goods 5,000 10,000 C2tom) pe C3809 OH REQUIRED: Determine the follawing Fee 1, Gost of goods sold a5: co 3. Factory overhead '*'900 Moe : 2) Total manufacturing cost “5.020 4. Matertals purchases 24 SCO) Saad: 296097 (Adapted: AICPA) 2. Past collections experienced by Fire, Inc. indicate 60% of the net sales billed in a month are collected during the month of sales, 30% are collected in the following month, and 10% are collected in the second following month. A record of monthly net sales of previous months is as follows: P 450,000 [March TP 500,000, [i 0. m gah: [P460,000] ,,,, |_April_| 550,000 2016 “February |_-420,000 june | P-790,000_ On January 1, 2016, the accounts receivable balance showed P 229,000. REQUIRED: Determine the following ‘+ Cash collections on accounts receivable during: 1. January 2016 “10% 2, March 2016 444 ‘+ Accounts receivable balance at the end of: a0 May 2016 5? 0 4. February 2016 iva S. Apri 2016 22000 6. june 2016.40 0a SOLUTION GUIDE to Item No. 2 _ Schedule of 2016 Monthly Collections | 480, 000 May | P-600,000 (Adapted: AICPA) mber_| P 450,000 | December | P.460,000 || January | _P 480,000 12 [February | 1P420,0 000 | 500,000 _| P 550,000 | 600,000 700,000 | _ [torat cofections hedule of 2016 M Accounts Recelvabl ch [April [May [ine January | Febroary | Marct AR, beginning eam | Myeod | Ace | 247 @O | 200s, | 295 CoN | + Net Sales Bere SU) aee Oc uns cone yeesv0. con sou aaa A 700 000 = Collections (431-200) | ( | {REED FeO te rome. Ceeoe | {gst cm pigece | tad000 [Zar 8b AR, ending 989 Goo [716 Goo 5. The sales manager of Fresh Merchanelising has budgeted the following sales for the 4% quarter of 2018 ‘October ® 123,500 1 November 156,000 / December 208,000 Other budgeted estimates are: + All merchandises are to sel) at its invoice cost plus 30% mark-up. + Beginning inventories of each month are budgeted at 40% of that particular month's projected cost of goods soid. REQUIRED: Determine the following: 1, Projected merchandise purchases for the month of October. 10.5) 000 2. Projected merchandise purchases for the month of November. 34-909 (Adapied: Managerial Accounting by Warren) coae a5 900 Page 2 of 4 pages 5) StS OD) Heemiee cous (oaby g nf gotyi En 4 . quev0® Jogcod re xy (4 Hom? oe, Tete Tee oeOpercins - TS eng ones Paani - Llobity (rae ROSA - the Review School of lccor tomer MS-05 BUDGETING . 4, The following information is taken from. Glory Corporation's accounting records for the year ended December 31, 2015. These data would be used as the basis for the next year’s cash budget © A). Customer sales seceipts for P 870,000 Pa Aye £ B) Purchased mactinery and equipment for P 425,000 cash, <) | Hoc C) Settled income taxes of P 110,000 9 (2s0ce) ED) Sold javestment securities for P 500,000, Peiiatoy ¥ E) Paid dividends of P 600,000. 5 Pct © F). Recelved rentals of P 105,000, nes G), Issued 500 shares of common stock for P 250,000, =) i © HY Paid a sum of P 100,000,due to suppliers and payroll to employees. 4) 105 008 E}F 1) Purchased real estate for P 550,000 cash that was b a) ayo ote ve 3). Paid P 450,000 for treasury shares. Pies) REQUIRED: Determine the following: 5 sfo0w) gsesee 1. Net cash provided by operations. ox aou Tom !=¥= \ oh 2. Nef cash used in investing activities 9 9%) te, D (ascot) 3, Net cash used in financing activities(secoe) ak gions PR ae ee f niccanh meverpe i ceceere eee ee wrens aCe SOS OD (Fic on)" (ESP) (Adapted: AICPA) WRAP-UP EXERCISES (Multiple > AG The master budget usually begins with the a. Production budget b. Operating budget Financial Budget a. Sales budget choice Questions) (All of the following are considered operating budgets, EXCEPT a, Sales budget Sa 4.’ Capital budget ¢. Materials budget d, Production budget 3 3. The production budget process usually begins with the ~ a.” Sales budget b. Direct labor budget c. Direct’materials budget d._ Manufacturing overhead budget 4 2 Which of these budgets is usually, prepared first? 2. Production budget b. Materials purchases budget c. Cash disbursements budget d. Cash budget p _X-5. whieh of the following budgets is pased oo many othe) Direct labor budget b. Overhead budget Sales budget d. Cash budget aster budget components? pics hg ae a tis orl lata tcn dics ch wamai tn. nas poser sales 10 be P 260,000 nung,» 270,00 in ly and P 300/00 i August J Heal 2Ohate Baath ales the mowth of sale Soe nthe moot followin the sale ard ove inte second ont elowng te sle What is the accounts receivable balance on. Se hy gu 90,000 0 Be | ey as 4 6 P210,000 ee Go gd) 20k ©. P 264,000 a Bie Same other nuinber yy 30 50 25 pein 2u Page 3 of 4 pages TAY 290, UX Zod = G4, 070 ti Aig, 30 0D X 302 = 210,000 264 oyNoch Apok Mey Meh 20, dod | S52 not they 1e/0u0 + 3/000 ape 304, 4s sul Noah 000 FAO xss2= 3 46S mor aol A EW Ayal Goo xa e a= 2240 * 7305 KOS - the Review School of Gecountancy MS-05 BUDGETING 8. Arizona Inc. has projected sales: February, P 10,000; March, P 9,000; April, P 8,000; May, P 10,000; and June, P 11,000. Arizona has 30% cash sales and 70% sales on account, Accounts are collected 40% in the month following the Sale and 55% collected the second month, What would be the. total sh ri cay? cae May 19,000 x 307 = * 3.000 & ps.705 lectures en B pasts0 4. Somme otner number 440) Rowe x sol nag} 8 Morn yomereited = 2 3 Yhe Ohio Company haste oewing strc! pattern on is cred sales: a ahs colected inthe month of ae 15% coltected in the first month after sale <7 10% collected in the second month after sale 4% collected in the third month after sale 1% uncollectible ‘The Sale’ on open account have been budgeted for the last she months of 2016 are shown below: daily 60,000 dled Waite ; ‘August 70,000 ak fois m= ad September 80,000 ty Sore ieee ac October 90,000 Novernber 100,000 oe we at December 85,000 e What would be the eninated total cash collections during the Jaurth.calendar quarter from sales made ‘on open account within the fourth calendar quarter? Oddie SOON Ist = gt Tod, a, P172,500 €. P251,400 Nov. |@,OUx ESL © tooD b. P.230,000 4. P 265,400 bee gs ax ye? = £9500. 0. POY 40. Nevada Company manufactures a single product. The company keeps inventory of raw materials at ‘50% of the coming month's budgeted production, Each unit of product requires 3 pounds of materials, ‘The production budget is (in units): May, 1,000; tune, 1,260; July, 1,300; August, 1,600. 2400 Determine the raw materials purchases in uly. Soy = ae ‘ 8, 1,450 pounds o © 3,900 pounds end wots maemncds 240 b. 2,400 pounds 4. Some other number ea gest bey s4oey tan) 42. PhilSdelphia Company has budgeted sales of 24,000 finished units for the forthcoming 6-month period. 425% Tetakes 4b. of direct materials 10 make one fished unt. Given the following: ay oon Finished Units Direct Materials (pounds) ua) Beginning inventory 14,000 44,000 Target ending inventory 12,000 48,000 ge (How? How many pounds of direct natenals should be budgeted for puschase during the 6-month periSa? 1. 92,000 c- 96,000, freed #2.000 4 b. 88,000 d, 100,000 ©. -BkO00 + 4€c00 w M3000 ~ 4400 % 12. Florida Co. has projected sales to be P 60,000 in January, P 75,000 in February, and P 80,000 In March. = <1. Flora wonts eofave 2586 of ree months gales needs on hand at the end oF a month. If Florida has an average gross profit of 40%, what are the February purthases? Sole. Fran xtad = a. P 30,500 ei ©. P46,250 Eod YOu xéal as b. 45,750 d. P 76,250 ey asobux sel ° Py 13. Michigan Merchandising is preparing its cash budget for June 2016 and made the following projections: ">" ) Sales P 1,500,000 Pudbares TES Gross Profit Rate 25% ee Decrease in Inventories 70,000 sale SH sey Decrease in Accounts Payable for Inventories 120,000 ee aos For June 2016, what will be the estimated:cash disbursements for inventories? LE OOS. Datsun ivertog @. P-935,000 .- P 1,055,000 ee bP 1,050,000 d. P 1,175,000 TOPE Tes Peweare in AP n Ty Bs OZ e _J4. Texas Company hes prepared the Hexible budget formula. for production costs: costs 340,000 9x, where Xs the number of unite produced. Texas prodiced 20,000 units ata total cost of 190,000, ‘What is the variance of actual costs from budgeted costs (ie., budget variance)? Actwol 8 a. P-150,000 favorable ©. P-30,000 unfavorable 499,980 Haron + (20.0%) b. P 30,000 favorable — d. P-90,000 unfavorable < 49009) - s70,080 =. 0, cog, Fovoratle A 75. The use of standard costs in the budgeting process signifies that an organization Ras most likely implemented a oa 'a._ Flexible budget . Zero-based budget b.- Capital budget d, Static budget Page 4 of 4 pages eReSth. the Keview School of Gecourtancy « Management Services MS-06: STANDARD COSTING STANDARD — a benchmark set by management’ in aid of performance measurement, in manufacturing companies, standards are classified into two (2) categories: + QUANTITY Standard ~ indicates the quantity, of raw materials oF labor time required to produce a Unit of product. This is normally expressed per unit of output (e.g., 3 pieces per unit) * COST Standard ~ indicates what the cost of the quantity standard should be. This is normally expressed per unit of input (e.9., P 2.00 per piece). STANDARD COSTS ~ systematically pre-determined costs established by management to be used as a basis for comparison with actual cost. BUDGETS vs. STANDARDS: STANDARDS | Pirpose Standards pertain to what costs should be | Pe Topstee ea | given a certain level of performa sini | Einphasis | Budgets emphasize cost levels that | Standards emphasize the levels to which costs | ty | should not be exceed. | should be reduced. i Coverage | Budgets are set for all departments in | Standards are set only for the production or [the frm (e9., sales, administration, | manutactuang division ofthe fn. manufacturing) eta ne i Shes Analysis | When actual. data difer trom the | Wateral amounts of variance are reviewed so | budget, it_may be an indication of | that necessary corrective actions are L either good or | implemented accordingly. vents of expected STANDARD COST VARIANCE ANALYSIS ‘Actual Costs (AC) ~ Standard Costs (SC) VA ‘AC > SC: Unfavorable (debit balance) AC < SC: Favorable (credit balance) MATERIALS Variance Actual Materials Cost ¢ Actual Quantity (AQ) x Actual Price (AP) = Standard Materials Cost © Standard Quantity (SQ) x Standard Price (SP) Materials Cost Variance Analysis: Quantity variance; AQ SP Price variance: AQxaP Difference i quantities x Standard price Actual quantity x Difference in prices LABOR Variance Actual Labor Cost © Actual Hours (Atl) x Actual Rate (AR) =) Standard Labor Cost € Standard Hours (SH) x Standard Rate (SR) Labor Cost Variance Analysis, Efficiency variance: A Hx S Difference in hours x Standard rate Rate variance: AHKAR ‘Actual hour x Difference in rates FACTORY OVERHEAD (FOH) Variance = (Actual FOH cost) ~ (Standard FOH cost) (Refer to page 2 for complitte FOH Variance Analysis) MATERIALS PRICE, MIX and YIELD Variances . Mix and yield variances are normally calculated whenever the production process involves combining several materials to produce a unit of product a Materials variance = Actual Materials Cost - Standard Materials Cost Analysis: Price variance: AQxAP Mix variance: (AQ «5 P) - TAQASP Yield variance TAQASP ~ Standard Cost Legend AQ- Actual quantity AP - Difference in prices S$ P- Standard price TAQASP - Total Actual Quantity at Average Standard Price i NOTE! mix and yield variances may also apply to direct labor Page 1 of 6 pages| ReSU. the Review School of Oecourtomey MS-06 STANDARD COSTING IMPORTANT NOTES: MATERIAL and LABOR VARIANCE ANALYSIS Material PRICE Variance is also known as: Material spending variance, material money variance, material rate variance ‘ Material QUANTITY variarice is also known as: Material usage variance, material efficiency varianct Material usage variance is a quantity variance while material price usage variance is a price variance. Labor RATE variance is also known.as Labor price variance, iabor spending variance, labor money variance 5. Labor EFFICIENCY variance is also known as. Labor hours variance, labor usage variance, labor tine vanance, 6 Labor efficiency variance excludes idje time spent in the production. if any, idle time is separately explained through the Ile Time Variance, whic 's regarded as unfavorable IDLE TIME variance ~ Idle time x Standard Labor Rate FACTORY OVERHEAD (FOH) VARIANCE ANALYSIS One-way variance analysis. nputation Leaend “OH Variance AFOH ~ SFOH AFOH: Actual FOH SFOH: Standard FOH = (SH x SR) Two-way varjance analysis. Controllable variance AFOH ~ BASH BASH: Budget Adjusted for Standard Hours Volume variance BASH ~ SFOH BASH = Budgeted FFOH + (SH x Variable FOH Rate) FFOH: Fixed Factory Overhead Three-way variance anolysis: . Spending variance AFOH — BAAH BAAH: Budget Adjusted for Actual Hours . Efficiency variance BAAH - BASH BAAH = Budgeted FFOH + (AH x Variable FOH Rate) . Volume variance BASH ~ SFOH Four-way variance analysis Variable Spending variance AFH (V) ~ BAAH (v)_AFOH (V): Actual Variable FO Fixed Spending variance AFOH (F) - BAAH (F) AFOH (F): Actual FFOH Enteere varnce ara) AA ash” Ghat) ctu Hou 3 Vari FOH Rae Volume variance (fixed) BASH - SFOH BAAH (F}: Budgeted FFOH } ——_AMpORTANT NOTES: FACTORY OVERHEAD VARIANCE ANALYSIS 1. Standard Factory Overhead (SFOH) = Standard Hours x Standard FOH Rate. Under standard costing . SFOH is likewise referred to as the Applied Factory Overhead. 2. If AFOH is more than SFOH, then factory overhead Is said to be under-appifed; hence, under-application indicates an unfavorable variance, while over-application indicates a favorable variance. 3. The term capacity variance is also used to mean the volume variance. 4. Budget Varlance = Actual Cost ~ Budgeted Cost = Actual FOH ~ Budgeted FOH (BFOH) ‘+ IF BFOH is adjusted based on standard hours (BASH), then budget variance |s controllable variance + IF BFOH is adjusted based on actual hours (BAAN), then budget variance is spending variance 5. Volume Variance is actually the Fixed Volume Variance; there is no such thing as a variable volume or variable capacity variance. 6. Under the 3-way approach, the FOH Efficiency Variance is actually the Variable Efficiency Variance. Other than ‘BAAH ~ BASH,’ variable overhead efficiency variance may also be computed based on Change in hours x varlabje FOH rate = (AH - SH) VR 7. FOH variances may classified inte. + Variable FOH Variances = Variable Spending Variance + Efficiency Variance (variable) + Fixed FOH Variances = Fixed Spending Variance + Volume Variance (fixed) * 8. Alternatively, another FOH variance analysis may include the following variances (NOTE: this version is not included in the board exam syllabus for Management Services) + IDLE Capacity variance: BAAH ~ (AH x SR) + TOTAL Efficiency variance: AH x SR + FIXED Efficiency (Effectiveness) variance: 4 H x FR (where: FR is the Fixed FOH Rate) 9, Manufacturing Efficiency Variance incorporates the effect of both FOH Efficiency Variance and Labor Efficiency Variance. In some cases, the material quantity variance may also be included, 10. DM Variance + DL Variance + FOH Variance = Production or Manufacturing Cost Variance. USES OF STANDARD Costs: STANDARD COSTING PROCEDURES 2. Cost contro} 4, Establishing standards 2. Pricing decisions ‘Measuring actual performance 3. Costing of inventories Comparing actual performance with standards 4. Motivation and performance appraisal” Taking corrective action when needed 5. Cost awareness and cost reduction Revising standards when needed 6 7 8 Preparation of budgets Preparation of cost report Management By exception Page 2 of 6 pagesReSA - The Review School of Cccownctomey * MS-06 STANDARD COSTING EXERCISES: STANDARD COSTING Materials and Labor Variance Analysis selfie Company has established the following standards for a single unit of its main product, The 360 Camera Tripod (Stainless Edition): Inputs Standards Direct matenais 3 metal bars at P 2 per bar Direct labor ‘labor hour at P 10 per hour +t fhe start of the month, the budget includes a planned production of 100 units of tripod based on orma} capacity. : + At the end of the month, actual production was 120 units of triped, which resulted to using 400 bars of metel, purchased at a cost of P 2.10 ver bar. RED 1, Based on the BUDGETED production of 100 units A). How many bars must the company plan to use? (Budgeted quantity) joa 3 = 300 seks! boss ; 8) How much materials cost is included in the budget? (Budgeted cost) aouxz =Ptoy 2. Determine the actual cost of materials used. (Actual cost) 400% 2s @ eo 3. Based on the ACTUAL production of 120 units A) How many bars should have been used? (Standard quantity) 243 = 340 metal bes @). How much materials cost should have been incurred? (Stendard materials cost) 940x z= T7420 ©) How many labor hours should have been spent? (Standard hours) 120% k= co he 1D) How much labor cost should have been incurred? (Standard labor cost) gong « 10 = 6 | 4. Determine he fe letiog Se pear cone ing , A) Matenals budget variance BRO) et PS ee piss 808. (41053 8) Materials standard cost variance gc - 420. = (2OUF our €) Materials quantity and price variance wav = (400- 90) x 2 = 2OUE, a 5; In the following month, Seifie purchased 500 bars at 2 total cost of P 850 while only 400 bars ut of these were used: the standard quantity allowed for tne actual production was 380 bars. Betermine the following A) Total materials variance gar 8) Materials quantity variance 40 Ur C) Materials price usage variance 1207 5), Materials purchase price variance co (\4-2) = ISOF During the month, a total payroll of P SAO vias paid to laborers, working 45 labor hours, to produce the 120 units of Tripod. Determine the following A) Total labor variance cor B) Labor efficiency variance 1S0F ©) Labor rate variance qouF Solution guide to requirement no. 5 ‘STANDARD sQ SP DIRECT MATERIAL Variance’= AC~SC = ‘go 3 f Materials Quantity Variance (MQV) = (AQ ~ SQ) SP. Materials Price tsap> Variance (MPM) = AQ yocs (AP = “AQ x AP: 900. x o * 2 Wor tMemative v= or 7, “i AQx SP: 4 ie ‘OM Var = SOF wma AG x: Seis Beh Solution quide te requirginent no. 6 ACTUAL STANDARD AH = 40 he. SH= GOW (\20%'4) AR =P12_(s40/45) DIRECT LABOR Wanance = AC - SC = 540 Gor Labor Efficiency Variance (LEV) = (AH - SH) SR (4-40) 10. = ISOF Labor Rate Variance (LRV) = AH (AR + SR) = 45 - 40" )= qour AH x AR: 4S x 12 = S40 40 ur. Mfcmie ig. “Re GR AS x AO — ae + bf Solution SHS SRI GOL ae wo Fieve isor J wee Page 3 of 6 pagesReSU - The Review School of Cccourtancy MS-06 STANDARD COSTING 2 ry Overhead Budget Nadat Company shows the following data ré {_Fexible Budget Formul + Mosmal Capacity; 2,500 units °D 6 Standard: 1 unit of product requires 4 labor hours jarding its factory overhead where: X = number of labor hours i o sd Hours: A) 104800 hours g Fixed Overhead (FFOH) | f | 2e12 /iooo $8 ble Gverhead (VFOH) | C) 46,209 | | Variable Overhead Rate (VR) 0,009) 40/000 13 | “Total Budgeted Overhead 5 “a,092 | | “Standard Overhead Rate (SR) oy rag £3 requireo. éZ 1. Compute for the missing amounts. a 2 2. What is the flexible FOH budget based on 7,500 actual hours? FOH = 2° ocu.4 C4500), = g 3 hatle tne Mele FO budget esed on 000 standorahours?raH = Zo.c00 + 1 (RH) = & 2- P3, Factory Overhead Variance Analysis, Two-Variance Method 2 ape ry of Borg Company is 12,000 labor hours per month. At normal capacity, the & standard factory overhead rate Is P 13 per labor hour based on P 96,000 of budgeted fixed cost per " month and a variable cost rate of P 5 per labor hour. During January, the company operated at 12,500 J labor hours, with actual factory overhead cost of P 165,000. The number of standard labor hours. | oo % alowed fring production aiualy attained 511,000, AEM pace es oud. Ue FOO UE Repeat 2 REQUIRED: 1) Overfl FOH Variance 2) FON contesbie variance 3) FOH volume variance, eX W een Ton = BA eaEH = apptied cot ‘4, Factory Ovemead Varlance Analysis (Two; Three, Fout-Way Variance Method) { * Rata Company provides the folowing production dat prow WS, 000 & Standard factory overhead cost per Unit of product: 4 hours at 3.00 per hour Ceoy, ad A) Budgeted fixed factory overhead P 20,000 Cs x se) ee pi a= 8) alormal production 2,500 units, WS $ seo uF C) Actual production 3, ,000 units. ha = B) Actual hours. 7,500 hours GASH. FC ~ a, ce E) Actual factory overhead incurred (75% fixed) 26,000 Ne - 55/000 OUR, Determine the following o 7 peal xo Budgeted factory overhead 6 Wolume variance (= ARO - Bac estat? a 2 seanawa tece'y svernona 7. Spending variance Rar aie 3. Budgeted FOH based on actual hours 8, Efficiency variance Je \eeuur mi 4. Budgeted,FOH based on standard hours 9. Variable spending variance 5. Controllable variance 10. Fixed spending vanance = pacn - Factory Overhead Vari Analysis (Budget, Variable, Fixed Variances) PEAR: * ‘Assume the same data in item number 4: We gomur One-way ‘Two-way Three-way * Four-way =~ AFOH: P.26,000 Cons LSE 5S = NOOR 3 FS (V)= lO SFOH: P24,000 “Vol” = _40m0F “LE oo F US (ry = cto F FOH Var: P 2,000 U P 2,000 U Vol 4 OOU.UF E(v)= Smr P 2,000 U Vol{F) = 4090 UF P 2,000 U ADDITIONAL REQUIREMENTS (continued from item number 4) 11. Budget (flexible) variance (2-wey) 14. Fixed volume variance 4000 UF 12. Budget (flexible) variance (3-way) 15. Variable FOH variance |SOOF {SOF 15. Variable controllable variance 16. Fixed FOH variance 3 509 ue 6. Materials, Labor and Overhead Variances (Compute for the missing amounts) Standard variable costs per unit A) Materials: 4 pounds @ P | tas Pas B) Direct Labor: 0.5 _ hours @ P 12.00 P 6:00 C)_ Variable overhead: P 8 per direct jabor hour pd + Production 8,000 units + Materials purchases, 32,000 pounds ?'62,000 + Materials used at standard prices, 31,200 pounds P Sz c00 © Direct labor (actual) -4 [60 hours P 47,290 + Material purchase price variance 2,000 adverse ‘ + Material use variance P Van ue 2 Direct labor rate variance P 2,000 favorable = * Direct labor efficiency variance P 200 UF + Variable overhead spending variance 1,500 favorable + Variable overhead efficiency variance p oar + Actual vanable overniead cost P 31200. Page 4 of 6 pagesga a £ fe € 4. a P. & Under a standard cost system, the material efficiency variances are the responsibility of a ReSU «the Remit Sotool of Beteetancy ‘MS-06 STANDARD. COSTING Answers totem. + Materials: 4 pounds @ 2.875 22.50 ‘+ Direct Labor: 0.5 hour @ P 12.00 P6.00 +’ Variable overhead: P 8 per direct labor hour 4.00 + Haterials used at standard prices, 31,200 pounds 58,500 + Direct labor (actual) 4,200 hours P 47,200, + Material usage variance P1S00F + Direct jabor efficiency variance 1,200.0 + Variable overhead efficiency variance P00. U + Actual variable overhead cost P31.300 7. Materials Price, Mix and Yield Variances Dayarita Merger produces the popular “Makating” face powder, Dayarita has in its budget the following standards for one kilo of the “Makating” face powder: Ingredients Standard Quantity (Input) (Grams) Standard Unit Cost Standard Cost Paminta (20%) 200 P 3.00 600 Gawgaw (70%) 700 4.00 P 2,800 Atstiete (10%) 100 5:00 P00 TOTAL 1,000 P3900 7ipron F9 Aiesh ‘The company reported the following production and cost data for the 2015 operations! Inggadeate Actual Guomty eee ee (Input) (Grams) Actual Unit Price Actual Total Cost. Paminta 45,000, P 4.00. P 180,000 TAGACPe 200000 3:9 Gawgaw 125,000 P 3.00 ? 375,000 toc Atsuete 30,000 P6.00 P 180,000 Py 0,0 I0°9%3 = 195080 TOTAL 00 P 735,000 & De ber te The company produced 190 kilos of Makating face powder in 2016. A 39 onKS REQUIRED: Oe hap inant 000 RE Fae O00 GO® “1. Total materials cost variance ps om (3-4) = BS oe F (440,000) s0.00F 2. Materials price variance @rs Reine —Fo00 oF Foon 3, Materials mix variance * A aa.cue (4-5) = wee = 2qoc uF 4 Materials yield variance s Bojo08 @ loaioaree ine? 2 OMe TH cS WRAP-UP EXERCISES (TRUE OR FALSE; MuLTipLEcHoIcE) [129 62% = Sao, _}, Standaa costing apes to Beth antacturing and non maruactuna cats. 182 wage” ‘The standlard cost system is terMpatible with job order costing, but-not with process casting. A variance with a debit balance indicates unfavorable performance. See Unfavorable variances shi! be reviewed, but sues favorable vanances need fot be tay Material amount of variances should be closed. fo the 3. Cost of goods sold only b. Cost of goods sold and finishes goods inventory &. Gost of goods sold, finished goods inventory and work In process 4, Cost of goods sold, finished goods inventory, work in process and direct materials Standards can pinpoint responsibility and, if properly used, can help motivate employees. Which department should usually be held responsible for an unfavorable materials price variance? 2. Production © Engineering b. Materials handling ©. Purchasing 4 is, 2. Production and industrial engineering Plirchasing and sales b. Purchasing and industrial engineering 4d, _ Sales and industrial engineering Which set of terms describes the same type of variance? Price variance, rate variance, use variance b. Price variance, rate variance, efficiency variance. Use variance, efficiency variance, quantity variance Se G. Use variance, efficiency vatiance, spending variance, 13*7 10. The standard for each finished unit of product allows for 3 pounds of plastic at P 0.72 per pound. During December, 4,500 pounds of plastic were Sought at ? 0.75 per pound, and used 4,100 pounds in the production of 1,300 finished units of product. A) What is the materials quantity variance for December? (4190 = 3900) x 092 a. P 144 favorable © P432 favorable > M4. 6 P 144 unfavorable o.P-432 unfavorable A). What is the materials price variance for December? 5 ie a. 123 favorable ce © 2.135 favorabl asao. (09s QU? b. P 123 unfavorable 4. P'135 unfavorable igsut Page 5 of 6 pagesSU - The Review School of lccounitancy, MS-06 STANDARD COSTING 4. When performing input-output analysis in standard costing, standard hours allowed is a means of measuring 2. Actual output at actual hours b. Actual output at standard hours Standard output at actual hours Standard output at standard hours 42. A debit balance in the labor efficiency variance indicates that 3 Adtuar hours exceed standara hours 5. Standard hours exceed actual hours ©. Actual hours exceed normal hours 4, Normal hours exceed actual hours : 13: Ifa project required 50 hours to complete at a cost of P 10.00 per hour but should have taken only 45 hours at.a cost of P 12.00 per hour, wtiat is the proper entry to record.the costs? "a. Work-in-Process 540 {Labor Usage Variance 60 ¢ E : ‘Labor Rate Variance 100 2¢ ! Accrued Payroll 500 b. Wages Expetise 440 Labor Usage Variance 60 fe : ‘Accrued Payroll 500 c. Work-In- Process 460 ; Labor Rate Variance 109 HAE Labor Usage Variance 60 Aecrued Payroll 500 4, Worksin Process 500 ‘Accrued Payroll 500 5 34 The direct labor costs for the month of January 2016 were as follows: any CAR SED ‘Actual direct laor hours 20,000 3 ier Standard direct labor hours 21,000 aie Direct labor rate variance, unfavorable —_P 3,000, Total payroll Ail tA What was the direct labor efficiency variance? a, P 6,000 favorable b. 6,150 favorable z c. P.6,150 unfavorable 4, P6,300 unfavorable (C35. Under the two-variance. method for analyzing factory overhead, ‘budget or controllable variance is computed by. subtracting from actual factory overhead costs incurred the a, Budget allowance based on actual hours b. Budget allowance based on normal hours. . ¢c. Budget allowance based on standard hours 4. Budget allowance based on budgeted hours 36. The manufacturing overhead variances were determined as Follows: Variable overhead spending variance P 3,500 F Variable overhead efficiency variance 4,000 U | 4 G00 F Fixed overhead spending variance 5,000 F Fixed overniead volume variance P6500 U What is the overhead controllable variance? a, P500U b. P 1,500 U © P-4,500 F d, P5,500U 17. Assuming the same data in item 16, what is the total overhead variance? 4 2,000 under- applied : b. P2000 over-applied €. P 3,500 under-appiied 4, Cannot be determined from given information 36. Howdo you call the sum of materials variance, labor variance, and overhead variance? a. Mix variance b. Yield variance © Volume variance d. Production cost variance Page 6 of 6 pagesReSt- The Review School of Gacourtoneg + MonagemornA Services MMS-07: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING Seesinhg Irene ata ty nach suet De EGA at ackositing wherein pbdlfmalce, based on costs/revenues, Se rccocaed and cvonusted. by \eede’ @f rexponsiony witnin at organization, Y sowed RESPONSIBILITY ACCOUNT! L Responsibility Accounting | =~ ee ee Pore nora amen Oban eeraG i cost cent REVENUE Center ROFL center INVESTMENT Center ~ Controllable + Controllable [ aralable o-oo Non-controiable| |_ Non-controtlable Nion-controilabie | [_ Non-controliable = ROI ----- > ERFORMANCE x a i REPORT Nature of Expenses /, ——> \ maintenance Expense / <———_ "EVA" \\ Supplies Expense / i Direct Labor “itl ne Residual income"--- STEPS IN IMPLEMENTING RESPONSIBILITY ACCOUNTING 4) Responsibility accounting requires that costs and/or revenues be classified according to responsibility es conters. RESPONSIBILITY CENTER - is. a Segment of an entity engaged in performing a single function or ‘a group of related functions and is usually governed by a manager, who is accountable and responsible for the activities of the segment. Types of Responsibility Centers: woivatione ef PT: "COST center ~ managers are held responsible for the costs incurred by the Segment, Saies Der 2, REVENUE center - managers are held responsible primanly for revenues of the segment Beoweh 3. PROFIT center - managers are held responsible for both revenues and costs of the segment. mre) S\Isctde 1 INVESTMENT center ~ managers are held responsible for revenues, costs and investments, 3 ‘The central performance is measured in terms of the use of the assets as well 35 revenues 5 seniee Cher eared and the costs incurred. The following may -be used as basis of evaluating set ecoigel o a performance of iayestment-centers: i Cort Seema ga '[ Raburn an Investment (Rol) = Operating Tcame + Operating Rawls ] EF oe Alternative formula: ROX = Margin x Turnover : Where! Margin = Operating Income + Sales ¥en je Turnover = Sales = Operating Assets: ON Ler Rol is patterned after the DuPont technique to compute Return on Assets: 7 wher seen Det spemnt wtetiel Return on Assets = Return on Sales x Asset Tumover tort evel doen %, MY Sane Net Income Net Income , Sales ee eked Assets Sales ssets, Cusoney titted esired ee eae fave Residual Income = Operating Income - Required Income] * 2) bod vreet Where: Required Income = Operating Assets x Minimum Rol eS ee sesehy » Sb Lynercd poe @ ciuethy Sta aoa nega A ene ooag ecoue Morus’ economic value added (eva) ord sfc ‘ersion*AF fesiual incom! that | Remnures tie investment centers real economic gains. It uses the wesed-average 4 i s Cost of capital (WACC) to compute the required income. (eat x C1 79) eet EVA = Operating Income after Tax ~ Required Income Where: Required Income = (Latab Assets - Cazsmaat Liabilities) x WACC 4 Eguity SPREAD (ES) soe PRIETO NOT no Ri cael egy woke ce. =e. ates ae ve Beg, Equity CoP4O x (Ook ~ forenieng cont Rage 1 af B pages: (tence dutctordi x MP) eRe) 9 Less! Bauity Suppiied by cH (4) & Total grovehoider Reta (TSE) ee \GD verey Cade (Guromer Ceepeme Fe) erbemes Tun, OT Bete on coe. 4 ipa Feet phat of oe NMETV 7 Sopesonsnt > eae ae” Soy = che or MORE GetUCng Cycle Ak j hes en Sun eat eas Disanc Gowen Orwospet “5 x e THON Tine | MAEM Famer Mowe payee conest QA Ae evese tre y ee ReSl “ho Revie Sthvol of eresintocys Gh reer oe pec OF, RESPONSIBILITY ACCOUNTING & TRANSFER PRICING Yor) se" erccere fiwe' ig Vobe-Added 2) Within each responsiblity center, costs are classified as either controttable or non-controfiabie.“*-* Generally, ali costs are controllable. The key difference lies in the level of management who can control the costs: + CONTROLIABLE COSTS are costs that may be directly’ regulated ot lower levels of management. + TON-CONTROLLABLE COSTS aire costs that cannot be regulated at a particular management Jevel.other than the top level. F Costs may also be classified into DIRECT (attributable to a particular segment) or INDIRECT (common to a number of segments), the latter being subject to arbitrary allocation. 3) Within the controllable classitication, costs are classified according to the fat 4) (A eufarmance separtis furnished by each center and reported to the appropriate level of management, the PERFORMANCE KEPOL js the end product of responsibility accounting process. It-is a report Boch oc compas aun ule wh te aed (ust or eaners)renite Fosponsivilty center, thereby highlighting deviations that need corrective actions The ‘contribution’ format to cofmputing results of operations (Le, profit) is emphasized in esponsibility accounting. This income statement presentation highlights controllability of costs by hehavioral classification. in addition to the usual variable costs and fixed costs, a more detailed classification of costs may be made, Consider the following jilustrative example (all amounts are assumed) sales » 50,000 | Variable manufacturing costs 150,000) Manufacturing contribution margin 350,000 Variable selling and admunistrative costs ‘(ee Maneesto)'50,000) | ognepitt ¢ Perici tats Contribution marair P 300,000 garateR= eeegtel oe wees. + Controllable direct fixea casts, Pane pees See Manufacturing 2 P 100,000 TOUSo eked ; coeerereieine inc uenee 008 1178000). Oe wae. Short-run performance margin 125,000 lecker mst aeveopnet Hon-controilable direct fixed costs: Ecepetenentar engines roe Depreciation 40,000 trier ege soeat Rent and leases, insurance 10,000 __ (50,000). $ Segment margin P75, F eeminaniowAl swacrihllocated-corinion costs (30,000) income 48,000 DCEUTRALIZATION > top wemeyerrert neko 2)DECENTRALIZATION wou deucions * roe ic “EMPLOYEES EMPOWERMENT | DECENTRALIZATION ~ refers to the separation or division of the organization into more manageable units ’ wherein each unit is maneged by.an individual who is given decision authority and Is. Peta acres toggle oath oh Al eae - Serre encree owe whee me ke ems Y DECENTRALIZATION-RELATED CONCEPTS meee GOH COMGRUEAEE Ms foot ents pt fr 9 anon ere en The purpose of a responsibility system is to motivate management Soret ot is Sararet a ean pal oe oi eaie, ne See Ses OEE an ace el « tet WA, ERS SARE aD segment of 8 company takes action that 6 its bet to ipa te re alle Se SUB-OPTIMIZATION ~ NOTE: Aside from its contro: function, responsibility accounting is designed to achieve goal congruence and te discourage sub-optimization within an organization, ‘ ORGANIZATIONAL CHART A chart that shows the responsibilty relationship ambng managers in an S:garization. It sets forth each principal management position and helps define outhonty. fespoqsiilty, and accountability, A well-designed organizational chart helps 1 decentralized organ}zation in carrying out duties in clear “y of respc eee delegated to) each of the segment of an organization. i rece aigeton i Page 2 of 6 pages |RESO . The Rerrew School of Uecomtoncy, MS-07 RESPONSIBILITY ACCOUNTING & TRANSFER PRICING TRANSFER PRICING TRANSFER PRICE - the amount charged by one segment of a firm for products or services that are supplied to another segment of the same firm. It s also known as intersegment price Primary objective To evaluate performance By virtually transfofming cost centers into profit centers so that performance of the manager of mainly cost centers can be measured reliably in terms of both revenues and expenses. Secondary objective "To save of) costs Involved Ih producing or buying @ product by in:sourcing rather than outsourcing, = transter Price > C Cost Center) ey C Cost Center virtually transforms 1 into Basis of Transfer Price (CMAN) + COST-BASED TRANSFER PRICE ¥ Variable cost ¥ Fullcost (Vanable and fixed manufacturing and non-manufacturing costs) ¥ Full absorption cost (Variable and fixed manufacturing costs) ¥ _Cost-plus (Variable costs / Full costs / Full absorption costs plus mark-up) + MARKET-BASED TRANSFER PRICE ¥ Market price (Regular selling price) “Modified market (Selling price adjusted for any allowance for discounts, etc.) ‘+ NEGOTIATED PRICE + ARBITRARY PRICE ‘Maximum vs. minimum transfer prices For transfer pricing not to defeat its purpose, organization normally sets a limitation as to the transfer price being charged by one segment to another segment. To minimize the effect of sub- optimization, a range for transfer price must be set based on the following limits: . > UPPER LIMIT: ~ Purchase Pete Lower Lint Maximum transfer price = Cost of buying from outside suppliers = tu cop ST > LOWER LIMIT: Seping PE ane exci Ky Minima Wanster price = Variable cost par unit > Lost CM per unit on cutSide sales ** Strictly speaking, upper limit shall be the higher amount of aes 11) Cost of buying from outside suppliers, OR Dae oe 2) Selling price to outside customers Fal cogierty When a company segment is operating at full capacity, the lost CM per unit on outside sales is the opportunity cost of transferring products to another company seqment. Dual pricing concept ‘The ‘selling’ center could transfer to another segment at the usual market price that would be paid by an outsider. The ‘buying’ center, however, would record a purchase at the variable cost of production. This practice 's now rarely applied because neither manager from both the buying and selling center must exert much effort to show a profit on a segmental performance reports. Transfer pricing considerations ‘+ Goal congruence factors Will the transfer price promote the goals of company 4s 2 whole? + Segmental performance factors Will the transfer price promote the interest of the segment under the manager's responsibility? + Capacity factors Does the-seller have exc ‘+ Cost structure factors What portions of production costs are variable or fixed, direct or indirect? 5 capacity to accommodate further inter-seginent transfer? fe Hegetiotion a roees Page 3 of 6 pagesReSQ - the Review Fchook of becovetancy MS-07 RESPONSIBILITY ACCOUNTING & TRANSFER PRICING EXERCISES: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING 1, RESPONSIBILITY CENTERS Indicate ow each of the business situations below is most likely to be organized: cost ‘center (CC), revenue center (RC), profit center (PC), of investment center (IC) ge ee we ce re Re ce ee ‘The accounting department of Banco de Orocan Bank The Trinomial Mall car park ticket gutlets. 5 The Magnolia product division of Saf Miguel Corporation. The repairs and maintenance department of Air Asiana. The Recto branch of Starbox Coffee é ‘The AMY College of Accountancy of the University of Santo Tomas. The parts department of Honda Motors Corporation, ‘The convenience store that is owned by a-chain organization; the head office supplies all the goods to be sold and determines the selling prices, ommoos> 2. CONTROLLABLE /NON-CONTROLLABLE COSTS, DIRECT/INDIRECT COSTS The supervisor of the PAINTING DEPARTMENT of Toyota Cars is in-charge of (1) purchasing supplies, (2) ‘Authorizinig repairs, and'(3) hiring labor for the department. Various costs are given: @)__@). G)__ @) Factory insurance | Labor costs, Painting departme! | Salary of factory supervisor A | Sales, salaries and commission eC {| P 18,000 aay A aprr meet cet ss aiehaad ot gent sf eet eisai heen inne eee @ oe ewer onary fortes fF ntreraig Moarisery i eee ea areca palpialeiare. | : H a REQUIRED: Determine the following’ 1. Total costs controfiable by the supervisor of the Painting department. 2, Total casts direct identified with the Painting department 5. Total casts that will have to be allocated to the factory departments 4. Total costs that do not pertain to fectary operations, 3. SEGMENTED INCOME STATEMENT ‘Common fixed expenses The following data pertain to Zest-O Airlines cperations for the year 2016 = 5 _ TOTAL TONG Division _"_YANG Division ‘Amount he Amount Amount sales 1,000,000 (100%) _ (100%), (200%) Less: Variable Expenses Reb eg Ah gop Ca) Contribution margin ae { ) - P360)000 (60%) = Oret Less: Traceable fixed expenses (-).(P 150,000. ( ee Division segment margin ace ey. (30% ) Less: Cy pies Income. REQUIRED: Fill-in the missing data. (Adapted: Managerial Accounting by Garrison & Noreen) 4, RETURN ON INVESTMENT vs. RESIDUAL INCOME é For each of the following independent cases, the miniinum desired Return on Investment (Ral) ts 20%. REQUIRE! Bivision"Z2” Division "25" Division "ZB" Sates P 400,000 (5) 29 P 700,000 Operating Income (1) Cosy (6) 44co P 42,000. Operating Assets (ewem — P:300,000 (9) 100 OO Mnargit 15% 5% (io) 6 Turnover (3) Baws. 3times (11) aes ~ Return on Investments 30% (7 ABL | (12) saad Residual Income (42220 (8) (2, 22,000 Compute for each division's missing items. (Adapted: Managerial Accounting by Louderback) Page 4 of 6 pages AaKeSA - The Review School of Cccourtomey MS-07 RESPONSIBILITY ACCOUNTING & TRANSFER PRICING 5S. SERVICE COST ALLOCATION ‘The Fatness First has two service departments (A and 6) and two producing departments (x and ¥), Setvice Departments Operating Departments A 8 Y x Bicect costs pi50 F300 Services performed by Dept. A 40% 40% 20% Services performed:by Depr-B 20% 70% 10% REQUIRED. Compute allocated cost to departments X and Y using the following method: 1) Direct method 2), Step-down method (cost of department A is allocated first) 3). Step-down method (cost of department B is allocated first) 4). Reciprocal method SOLUTION GUIDE to Item No. 5 FATNESS FIRST Service Cast Allocation __(2) binect meTHOD A 6 Peet (2) STEP DOWN METHOD ~ A B | piso aie cay (Pp 180) haere { | 300. | 70% 7005 (e300) ["ae2s | ss. | Allocated Costs: | 342.5 SAS. Allocated Costs: ___{3) STEP DOWN METHOD ~ 8 (4) RECIPROCAL METHOD 8 B x eben — as (390) [ wo__| P 150 | 20 be LC 210 1 BAK 2, | ( 391.90) [Ayo 140.43 | E Allocated Costs: | Allocated Costs: {252.8 | 1iv.cv | Reciproca/Algebraic/Simultaneous method Equation 1: A= 150+0.2B Equation 2: B = 300 + 0.4 A Substitute Equation 1 to Equation 2: Substitute Value of 8 to Equation 1: B = 300 + 0.4 (150 + 0.2 8) ‘A= 150 + 0.2 (391.30) 8 = 360 + 0.92 A= 228.26 B = 391.30" (rounded) TRANSFER PRICING ‘Tamaneo Company's Division ‘A’ (Aldayag) produces a small too! used by ather companies as a key part in their products, Cost and sales data relating to the small tool are given below: Selling price per unit P5oy Variable costs per unit P3022 ° Fixed costs per unit* PA? * based on Aldayag division's capacity of 40,000 tools per year. ‘The company’s Division 8’ (Bonanta) is introducing a new product that will use the same too) such as the one produced by Division A, An outside supplier has quoted the Division B a price of B 48 per tool. Division 88 would like to purchase the tools trom Division A, if an acceptable transfer price can be worked out REQUIRED: 1. Determine the lower limit of the transfer price assuming thats a ’A). Division Khas ample idle capacity to handle all the Division B's needs 29 YS/*! 8) ‘ivision A ts presently selling ail the tools it can produce to outside customers “o SF ! From the standpoint of the entire company, should the Division B purchase the tools from the sa@iit'48- Givision'a (operating at capacity) oF trom ouside supplier? Why? eeu AA ce cuppll*> Gouinag P24 3. Assume that the Division B requires 10,000 tools per year and the Dwision A is presently selling =~ 36,000.200s per year to outside customers: 'A). Determine the lower imit of the transfer price 8) What would be overall effect on company profits all 10,000 tools were acquired from the Division A rather than from the outside suppliers? a) (Adapted: Managerial Accounting by Garrison & Noreen) fee Fory 36 = lIeoe ey i kite Ge full Cops Goeo x50 = gu Page § of 6 pages COC ae ey 1206 /joou ‘ ost + Paap Gene Seana wnt ee vce GeO, a i od& & ReSU - The Review School of Cecoumorey ‘ MS-07 RESPONSIBILITY ACCOUNTING & TRANSFER PRICING % PRICE-SETTING METHODS The Air Phil Company 1s operating with two, divisions, Division $ is producing a product line that is required as @ component part of the product being manufactured by Division B. For Division S, the costs of producing the component part per unit are: + Direct materials Pic) Direct labor Pe Variable factory overhead P5- Fixed factory overhead P2 The product of Division S is being sold in a highly competitive market for P 30 per u! nit. Division Bis currently buying 80% of the production output of Division S at a negotiated price of P 28 per unit. It expected that 25,000 units of product will be produced by Division S. With emphasis on divisional welfare rather than the company’s welfare, a, new transfer price must be developed.’ Tt is suggested that a 40% mark-up on cost wil) be added when transferring the praduct from Division § to Division B. An Additional proc P.45 per unit REQUIRED: Determine the gross profitpaeunit of the product from Division B under each of the following Independent assumptions, sing cost for Division Bis P 8 per unit. The selling price of the product of Division B is ‘Ay Transfer price ts full-cost based, GP = 45 - (8 + 25) = P12 8) Transfer price is cost-based plus mark-up. GP = 45 ~ [8 + 25(1.4)] =P 2 ), Transfer price is based on @ negotiated price. GP = 45 ~ (8 + 28) =P 9 ) Transfer price is market-based. GP =45 -(8 + 30)=P7 (Adapted: Cost Accounting by Barfield) WRAP-UP_EXERCISES (TRUE OR FAL fez, MULTIPLE-CHOICE) 1, Which sequence reflects increasing level of responsibility? a, Cost center, investment center, profit center 'b. Cost center, profit center, investment center Profit center, cost cartter, investment center 4. Investment center, cost center, profit center 2. In responsibility accounting, what is the MOST RELEVANT classification of costs? ‘a. Fixed and variable b. Discretionary and committed ¢. Controllable and nion-controtlable 4, Incremental and non-incremental 53, Which of the following techniques would be best for evaluating the management performance of a department that is operated as a COST CENTER? 2. Return on investment ratio——— b. Return on assets ratio Payback method 4d. Variance analysis 4. The Segment margin of the Division ABC of XYZ Corporation should NOT include Net sales of ABC D. Fixed selling expenses of ABC ¢. Vanable selling expense of ABC Gd. ABC’s share of XYZ president's salary 5. Which of the following methods of allocating the costs of service departments provides the broadest recognition of departments served? 2, Step-down allocation b, Reciprocal allocation & Arbitrary allocation d._ Direct allocation 6. Which of the following describes the computation of Return on Investment (Rol)? ‘Sales x Investment Turnover , b. Return on Sales x Investment Mae TEX €._Income - (Investment x Minimum Rol) d. Return on Sales x Investment Turntover 7, The cos ice is considered as-the ideal transfer price to use in charging co-segment within a compan 8. When a division is operating 2! of opportunity cost: { L femmes on sales pacity, the transfer price to other divisions should include an element Page 6 of gesResa Yhe Kovvew School of lecoundancy | Mewsagormie? Serica: ie MS-08: ACTIVITY-BASED COSTING & BALANCED SCORECARD * _ ACTIVITY-BASED COSTING (ABC) - is o,systematic costing method that mainly uses ‘activities’ as basis to allocate overhead and indirect costs to products or segments. ABC provides reliable data for product costing by using multiple cost arivers that are more reflective of the actual causes of incurred overhead costs. ‘ABC vs. TRADITIONAL COSTING | Under the traditional costing, overhead costs are allocated to products by using @ single.cost driver (usually fabor hour). This costing ts volume-based and suitable for labor-intensive, low-overhead companies. Traditional costing (a.k.a. peanut-butter costing) is simple and inexpensive to implement. Under ABC, overhead costs are allocated to products using seuarai cost drivers associated with the Identified cost pools. ABC is suitable for capital-intensive, product-diverse and high-overhead companies. ABC often leads to accurate product costing and elimination of non-value-added activities. STEPS IN IMPLEMENTING ACTIVITY-BASED COSTING 1. Identify cost drivers (activities), cost pools and activity centers. + Accost driver is the particular activity that causes the inicurrence of certain costs. + Accost poo! is a group of costs usually associated with a common cost driver. + An activity center is 2 unit of organization that performs a set of tasks. It Is part of the Production process, for whjch management wants a separate reporting of the costs of the tivity Involved. Level of activity centers can be classified into four general categories: Unit-level activities performed each time a unit is produced. Batch-level activities performed each time a batch of goods is handled or processed, © Product-level activities performed to support production (sales) of specific product type. @_Facilty-level activities performed to sustain a facility’s manufacturing process. 2. Calculate predetermined overhead rates for each identified activity. Predetermined overhead rate = estimated overhead Costs + estimated activity level NOTE; Estimated figures are used because actual figures are ndt yet known at the start of the period. 3. Allocate overhead costs to the products on the basis of predetermined overhead rates. In summary, ABC is a ‘two-stage’ allocation process, First, overhead costs are traced to activities; then, overhead costs are allocated to products in proportion to their consumption of the activities, ACTIVITY-BASED MANAGEMENT (ABM) - integrates ABC with other concepts such as Total Quality Management (TQM), process value analysis and target costing to produce a management system that strives for excellence through cost reduction end continuous process improvement. {An important goal of ABM Is to reduce or eliminate non- value-added activities and costs: + VALUE-ADDED activities are necessary activities that incur costs but increase the perceived value of a'particular product to the customer. Example: engineering designs modification, + NON-VALUE-ADDED activities are operations that are elther (1) unnecessary or dispensable, or (2) necessary, but inefficient and improvable. Example: rework of defective units, BALANCED SCORECARD - is an approach to performance measurement thet combines traditional financial teasures with non-financial performance measures. Balanced Scorecard was created by David Novton and Robert Kaplan in response to value-based management, a perfocmance evaluation techrique that is based Solely on traditional financial measures. FOUR PERSPECTIVES OF THE BALANCED SCORECARD Coie! 1) FINANCIAL perspective - measures reflecting financial performance. ly Examples: proft, return on investment (Rol), revenue growth eusrO""2) CUSTOMER perspective - measures having a direct impact on customers. Alon enon ot we Examples: customer satisfaction, customer retention, market share, customer complaints ewe 3) LEARNING 8 GROW perspective - measures describing the company employee's learning curve, Examples: employee satisfaction, employee turnover, training and recreation ‘ JAN FeB ‘MAR APR Queries: 1, Which task is the longest in completion time? 2. All tasks are simultaneously performed in which month? reer PROGRAM EVALUATION AND REVIEW TECHNIQUE (PERT) - CRITICAL PATH METHOD (CPM) PERT is developed to aid managers in controlling large-scale, complex problems. PERT-RELATED TERMINOLOGIES * PERT diagram is a probabilistic diagram of the interrelation aship of a complex series of activities; it {a free-form netwark showing each activity as line between events, + EVENTS - discrete moment in time representing the start or finish of an activity; they consume no > Series ~ an activity that > Parallel ~ an activity that can be pe CPM, like PERT, is a network technique; however, CPM uses deterministic time its advantages include cost estimates plus the concept of crash efforts and casts, Page 1 of 6 pages MS A-PSRReSUh - The Review School of lecowAanrey Ms-09 QUANTITATIVE TECHNIQUES ELATED TERMINOLOGIES + CRITICAL PATH ~ is longest path through the PERT network. + EXPECTED TIME (f,) ~ is the average time an activity would require i times te = (to-+ 4 tm +) +6 . 5 Where: t, - optimistic time; tq ~ most likely time; t, ~ pessimistic time «SLACK TIME ~ the amount of time that can be added to an activity without increasing the total time required on the critical path; the length of time an activity can be delayed without forcing 2 delay for the entire project. = CRASH TIME — the amount of time to complete an activity assuming that, under rush or urgent condition, all available resources were devoted to the task (e.g., overtime, extra labor, etc.); any . crash time spent in an activity normally would incur crash cost. EXERCISES: PER’ 1, Dayagdag Construction Firm, Inc. will soon begin to work on a building for US Tea that was initially started by another firm that has gone out of business, The construction firm’s schedule of activities and related ‘expected completion time for US Tea project are presented in the following time table: sTCPM Activity Code Activity Descriptor Estimated Time (in weeks) A-B Obtain on-site work permits at a B-E —_ Repair damages done by vandals 8 Wigs B-c Inspect construction materials left on site 1 @-8—9—O < C-£ ~ Order and receive construction materials - 7 Vedas CD Apply for waiver to add new materials 3 seo Ye D-E Obtain waiver to add new materials 2 y9 & bia Perform electric’ work 6 F-G Complete interior partitions 4 REQUIRED: sink Foe 1A prepare the PERT netwark for the US Tea project 5) et! 8) Whet is the critical path and its expected time in weeks? ABE FG FAO vcs —C) What is the shortestpath and its slack time in weeks? pq --C CF = js ee 5 hoo -0-9-v FG trucks 2.. Acompany is faced with the following PERT network situation for a certain project (time in days): swat yx @ : Ope Drs S) FINISH #2. 7) 2. —~ Boar 4. 12% O).22 een Lota AE YS Satr = Hons ae ber, Eas, slay = at ye REQUIRED: ; t ast = P40, 0895, sepa ay dye ‘A). Determine the expected time (t,) for each activity. B) Identify the critical path(s). LAST ¢ Loi C) What is the shi to complete the entire project? 2 ¢. =F wees PROBABILITY ANALYSIS PROBABILITY ANALYSIS is important to decision-making because of the unpredictability of future events. Decision-making involves: RISK = this occurs when the probability distribution of the possible future state of nature is known. * UNCERTAINTY - this occurs when the probability distribution of possible future state of nature is not known and must be subjectively determined ‘The probability of an event varies fram 0 to 1 (0% to 100%). 100% or probability of 1.0 means that event is certain to occur while zero probability means the event cannot occur under any circumstances, THE CONCEPT OF EXPECTED VALUE “The expected value of an action is found by multiplying the probability of each outcome by its pay-off and summing up the products. A decision tree diagram is normally devised to show several possible decisions or ‘cts and the possible consequences (outcome or events) of each actLene cu@vE— (eu?) 2 preage O oo O unite ¢ avenge 2 fotol RESO - The Review School of Occourtoneg ett go FOR MS-09 QUANTITATIVE TECHNIQUES Poli Serge 4 aed 2d wanene PROBABILITY RELATED TERMINOLOGIES ‘+ Objective probabilities ~ calculated from either logic or actual experience. ‘Subjective probabilities - estimates, based on judgment, of the likelihood of future events. Two events are said to be mutually exclusive if they cannot occur simultaneously. Two events are said to be independent if occurrence of one has no effect on probability of another. ‘The joint probability of two events is the probability that both will occur. ‘The conditional probability of two events Is the probability that one will occur given that the other has already occurred : EXERCISES: PROBABILITY ANALYSIS 1. Mojito Club sells cold sodas at Far Western University’s home basketball games. In the year 2016, the frequency of distribution of the demand for cups of sodas per day is presented below: ‘Sales Volume Frequency 2,000 cups: a8 days |Z = 90 4/000 cups BO days ge = 10C0 6,000 cups 144 days ge = 2300 8,000 cups 32 days 19 pis 10,000 cups 16 days © £60 320 days, ee REQUIRED: 200 Determine the projected daily demand for sodas in 2017 using A) Deterministic approach (based on most likely event) Gace cape haces oF 8) ‘Expected value approach 5) 2c Cups Leied on veighredt cuerOge 2. Ube-AM Rita-PM Company plans to introduce a new product that needs an initial cash investment of P 440; IF the product becomes successful, the net cash inflow is forecasted at P 800, However, if the product becomes a failure, net cash inflow is estimated at P 200 : a os + cxceeey REQUIRED. . TATE [@ A) Ifthe probability of success 1s 70%, what is the value of dct “to invest?” 8) What probability-percentages should be assigned to the events ‘success’ and “failure’ to make the 8 eee tT company indifferent between the two actions “to invest” and "not to invest?” we v me(xy deo (I-X) = 440 * LEARNING CURVE = Fe + 200—-20N y cok = 2a Ceara LEARNING CURVE describes the efficiencies arsing from experienc®, because with experience come incised producti); Ths productivity Increases wich production size, but ata decreasing rate as dlegrammed belowist Ace) Tape = The time required to perform a given task becomes progressively shorter, but this 1s applicable only to the tory stapes of production Units Nees Produced) The curve is expressed as a percentage of reduced time n per day’ (usually between 60% and 80 %) to complete a task of | each doubling of cumulative production. Hence, the time required is reduced by 20% to 40% each time cumulative production is doubled. Cumulative Production IMPORTANT NOTES IN LEARNING CURVE ANALYS = The cumulative average time per unit is reduced by a certain percentage each time production doubles, ‘+ Incremental unit time (time to produce the,last unit) is reduced when production doubles. EXERCISES: LEARNING CURVE 1. particular manufacturing job Is subject to an estimated 80% experience curve. The first unit required 20 * Jabor_hours to complete. REQUIRED: ‘A) What is the cumulative average time per unit after four units are completed? 12.7 B) What Is the total time in hours required to produce two (2) units? 32 this C) How many hours are required to produce the second unit? (2 ins 2 Which of the following unfavorable variances would be directly affected by the relative position of a production process on the learning curve? 7 ‘a. Material price Labor rate b. Material usage d. Labor efficiency Page 3 of 6 pagesqueen pee i i. magna gags Coos RSA The Pon Shoot of oes) MS-09 QUANTITATIVE TECHNIQUES COTE hay ode INVENTORY MODELS megane with inventory while maintaining INVENTORY MODELS are usually devised to minimize the-costs associate: certain level of inventories needed to sustain smooth operations. COMPONENTS OF INVENTORY COSTS The total inventory costs are comprised of. © CARRYING COSTS: This cost increases with order size or quantity of inventory on hand. Example: Storage costs, insurance on inventory, normal spoilage, record keeping cost ) ORDERING COSTS: This cost decreases with order size or quantity of inventory on hand Example: Delivery costs, administrative costs - inspection, purchasing and receiving, quantity discount lost, handling costs ECONOMIC ORDER QUANTITY (EOQ) E0Q refers to the number of units that should be placed every order to economize on the sum of ordering costs and carrying costs, Where: 0 > Costs of placing one order E0Q = 2 D'0 D> Annual demand in units c is € > Cost of carrying one unit for one year At EOQ, a firm incurs the lowest total inventory costs computed as follows: OQ D Total Costs wy = © + G09 ©) eee en CARRYING ORDERING ‘Costs Costs Average inventory is computed as follows ‘ + No safety stock: E0Q + 2 ‘+ With safety stock: (£0Q =2) + safety stoc + IF EOQiis not available; (Beginning Inventory + Ending Inventory) = 2 ASSUMPTIONS & LIMITATIONS OF EOQ ANALYSIS 1. Annual determinable demand for inventory |s spread evenly throughout the year. 2. Lead time does not vary and each order is delivered in a single delivery. 3. The unit cost of the units ordered is constant; thus, there can be no quantity discounts. ute the Eeonomic Lot Size (ELS) ‘When applied to production operations, the £0Q formula is used to com; Where: © > Set-up cost ELS = 2D0 D > Annual production requirement é ¢ 9 Cost of carrying one unit for one year THE CONCEPT OF REORDER POINT ‘ORDER (Reorder) POINT is the inventory level (in units) that automatically calls for placing a new order When is the perfect time to place an order? “When to reorder” is a stock-out problem; the objective is to order at a point in time so as not to run. ut of stock before receiving the inventory ordered but not so early that an unnecessary quantity of safety stock is maintained. When order point is computed, there may be stock-out situation if: > Demand is greater than expected during the lead time, or > The order time exceeds the anticipated lead time, + LEAD TIME is period from the time an order is placed until such time the order is received. > NORMAL (AVERAGE) LEAD TIME - this refers to the usual delay in the receipt of ordered goods. > MAXIMUM LEAD TIME - this adds to normal lead time a reasonable allowance for further delay. NORMAL LEAD TIME USAGE = normal lead time x average usage SAFETY STOCK = (maximum lead time ~ normal lead time) x average usage RE-ORDER POINT (without safety stock) = Normal lead time usage RE-ORDER POINT (with safety stock) = Normal lead time usage + safety stock = maximum lead time x average usage Page 4 of 6 pages BRSeats: OL (depends of rie, oh © hee) SE TO Mae € 20 vdeq x P20 = 4D ReSO the Review co (deren oe MISO 43 rota! QUANTITATIVE TECHNIQUES Nem home. | uy / aE tT), EXERCISES: INVENTORY MODELS 1., Shirley Company requires 40,000 shells for its signature product, “Pearly Shirl.” The sheits will be used ‘evenly throughout the year. The cost to place one order is P 20 while the cost to carry the shells in inventory for one year is P 0.40. sets ) £08 ~ [romeo Tay ey REQUIRED. 6 Fe A 2208 ‘A) What & the optimal order quantity (E00)? © voc, See 8) How many times should orders be placed during the year? “aus ~ “ESSE ~ ESS @) What is the average inventory in units? ‘ ; © Ae: Soucy FOS/a = 20g = 1900) Based on an F0Q analysis, the optimal order quantity is 3,000 units. Annual inventory carrying costs equal 30% of the average inventory level. The company pays P 5 per unit to buy the product and P 112.50 to jlace an order. The monthly demand for the product is 5,000 units. iia Pe : © REQUIRED: Determine the following @ c= SN (5 yod)'- 220 sau ‘A) Annual inventory carrying costs. a 10 8) ‘anndslinenmry orden cone. ¢)) @) Ct = SemNet 250 | cecetr €} Total inventory costs. re ete com 3. Bonitafe subsidiary purchases 7,500 units of laundry soap per annum. The average purchase lead time is 7 working days, Maximum lead-time is 10 working days. The company works 300 days per year. 00 re REQUIRED. = = 28uldey Clg2adey) 209 60'S A) How many units should Bonitafe maintain as safety (buffer) stock? he Pee is Bonitafe’s reorder r the laundry s¢ feta 20 ute B). What is Bonitafe’s reorder point for the laundry Soaps? (@)ewie!. ode x 2cu> agoy Si Ha> Fe 4, Each stock-out of a product sold by Gorgon Company costs, P 2,000 per occurrence. The carrying cost per Unit of inventory is PS per year and the company orders 1,500 units of product 18 times,a year at a cost of P 200 per order. The probability of a stock-out at various levels of safety stock is: Units of Safety Stock Probability of a Stock-Out 0 50% 200 30% 400 14% 600 5% 800 1% What Is the optimal level of safety stock for the company? ‘a. 200units 600 units b. 400 units dd. 800 units SOLUTION GUIDE: Safety Stock Tota! Costs 0 leo 200 units Ugo 400 units Leese 600 units 800 units Carrying Cost: P 5.00 per unit (given) ‘Maximum Stock-Out Cost: P 2,000 x 18 orders = P 36,000 5, Krish Bookstore publishes a book about accounting. Set-up cost is P10. Krish prints 675 copies of the book evenly throughout the year. The optimal production run (economic lot size) ip 20. atl radeon fo retup cout REQUIRED: How much is the unit carrying cost per year? (OS S— congiig, Coot SOLUTION 30 2500) Page 5 of 6 pages 6% KReSO - The Review School of Qecourtomeg Ms-09 QUANTITATIVE TECHNIQUES LINEAR PROGRAMMING LINEAR PROGRAMMING is a mathematical technique that helps managers to determine the volume of various products to produce when resources are limited or scarce in order to maximize net income. It is a technique used to optimize an objective function (maximize revenue of profit function, or minimize a cost function), subject to constraints (such as scarce resources, minimum/maximum levels of production, performance, etc.) Maximize revenue ossecrive jaximize net Limited resources must be allocated to the company’s most profitable products so that net income is maximized. Linear programming models are extremely helpful in the analysis and solution of resource allocation problems. Simplex method is a much detailed linear programming technique especially useful if there are more than two variables in a linear programming problem. EXERCISES: LINEAR PROGRAMMING Now es = 1. Maxi Company has following available materials X and ¥ to produce the its products A and B: Product A Product B £ Unit Contribution Margin Po pa sya i Required Materials Material x > 2pieces Spieces 120 piecdg) "°°" 44 12 Material Y > 4 meters 2meters 80 meters REQUIRED: Determine the following: 'A). Objective function - involving maximization of the company’s contribution margin 8) Constraint function for Material X tS 1h +5B°= 120 €) Constraint function for Material ¥ eo ©) Optimal product mix jou a” Af 204958 Ar 4 2. Neo Corporation produces a product in 50-gallon batches, The baste ingredients used for material 8 are costing P 20 per gallon and for Material A, costing P 10 per gallon, No more than 1 gallon of A can be used, and at least 15 gallons of 8 must be used met) 44h £29, = 20 ~ n= 22, D=e REQUIRED: ner N ee {ino , $240 How would the objective function (minimization of product cost) be expressed? WRAP-UP EXERCISES (TRUE OR FALSE; MULTIPLE-CHOICE) Bags 1. Quantitative techniques help management in decision-making by way of employing various { aaharaacel spplcabons i setal bucese talons Pe 40 2. The critical path through a network is the path that has the highest slack time. — te 3. Which of the following is heavily weighted in calculating PERT's expected time? A aces ae Bb Moseley time cl © Opumeteune pies Pesan time \ te pacapeks siete earring satis eal and pratt the lesining curve psa Nog 5. An 80% learning curve means that Hie Re oe Sefer atent tine fe ct anice Bye of he trie of unt bare Wie Beer nana clersse tine’ enh of te Gijinive everene tia the prevdus® “= be AS production doubles, the incremental time for a unit 1s 80% of the time at the previous doubling point d. As production doubles, the cumulative average time is 80% of the time at, the previous doubling point 6, The purpose of economic order quantity (FO) is to minimize ‘a. the safety stock b. the Inventory quantities © the sum of the demand costs and the back-log costs d._ the sum of the ordering costs and hoiding (carrying) costs 7. The time a company should place an order is when inventory level has reached zero, 8. The term ‘constraints’ in a linear programming model generally refers to a. Costs ©. Scarce resources b._ Inefficiencies d. Dependent variables Page 6 of 6 pages @ Dra TG RSA. The Rerion School Mecennctaniiy » Pamagemenit Sovrice MS-10: CAPITAL BUDGETING CAPITAL INVESTMENT - involves significant commitment of funds to receive satisfactory return over an extended period of time, Example: purchase of equipment for expansion, replacement of old equipment + CHARACTERISTICS OF CAPITAL INVESTMENTS + As to COST usually entails large amount of resources, relative to business size + As to COMMITMENT usually funds invested are tied up for a long period of time + AStO FLEXIBILITY usually more difficult to reverse than short-term decisions + Asto RISK usually involves so much risks & uncertainties due to operational and economic changes over an extended periad of time CAPITAL BUDGETING 5. the oraceBs by which management ienties, evaluates, and mated decsen on Capitl investment projects ofa organization, k implies capital bodsetins oneon involves the felling sens Step 1: Step 2: Step 3: Herseaton ) "> CF valition > Cees) Replacement (Equipment) Improvement (Products) Capital Investment Decisions [5 Factors oF consioersrion i Expansion (Facilities) Net Jovest ments Net Returns Costs of Capital Addition (Technology) s eee eae Reduction (Costs) Seer ea ely Copital budgeting, after the selection | Non-discounted methods Discounted methods Of the capital investment project, Payback period ‘Net present valve typically extends up to the financing, Bail-out payback Profitability index $ implementation and, monitoring of | Accounting rate of return Internal rate of return ithe project. Payback reciprocal Present value payback sae = a a CAPITAL INVESTMENT FACTORS f 1) NET INVESTMENTS (for decision-makiog purposes) t * Costs less savings incidental to the acquisition of the'capital investment projects * Cash outflows less cash inflows incidental to the acquisition of the capital investment projects Costs or cash outtlows 1. Pusghase price of the asset, pet of related cash discount 2, Incidental project-related expenses such as freight, insurance, handling, installation, test-runs, etc. CONDISER ALSO THE FOLLOWING, if any: + Additional working capital needed to support the operation of the project at the desired level. + Markat value of existing idle assets to be used in the operation of the proposed capital project. +. Training cost, net of related tax , Savings or Cash inflows Proceeds from sale of old asset disposed, net of related tax CONSIDER ALSO THE FOLLOWING, if any: + Trade-in value of old asset + Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax 2) NET RETURNS Ceacy fvemy ME 6) + ACCRUAL basis? Accounting net ingame (after tax) *) CASH basi: Net cash inflows, @_DIRECT method : Net cash inflow: INDIRECT method . Net cash inflows = Net income (after tax) + noncash expenses (e.9,, depreciat Cash inflows ~ Cash outflows expense) Page 1 of 8 pagesReSA - The Review School of CccourToncr MS-10 CAPITAL BUDGETING 3) COSTS of CAPITAL + The ‘costs of capital’ used in capital budgeting is the Weighted Average Costs of Capital (WACC). These are specihc costs of using lana-term funds, obtained from the different sources: borrowed (Gent) and invested (gguitv) capita souRCES | ai: costs Debi ‘Afier-tax interest rate* Preferred Stock (PS)/ Dividend yield** ‘Common Stock (CS)’ Dividend yield** plus growth rate Retained Earnings (RE) Dividend yield** plus growth rate * The after-tax cost of debt is computed based on: interest yield rate (1 ~ tax rate) ** Dividend yield = dividend per share + price per share + Dividend growth rate a lividend per share he oe Be ‘Market price per common share > The dividend growth rate is assumed to be consfant over time. 7 In computing cost of CS.& PS, the mazkélprice should be net of flotation costs (e.9., Underwriting fees). > In computing the cost of RE, flotation cost should be lanarest as RE is not sold or issued, > Alternatively, the cost of equity capital may be computed based on Capital Asset Pricing Model (CAPM), NOTE: refer to page 4 of MSQ - 10 for detailed discussions on CAPM and the Dividend Growth Model. + Other terms used to denote the weighted average cost of capital (WACC): Minimum required rate of return * Minimum acceptable rate of return Cut-off rate Target rate Desired rate of return Standard rate Hurdle rate CAPITAL BUDGETING TECHNIQUES SS nemslscutted methata 2 hot consider the be vake of money 4 it paybock period method + =F Babu povteck metod : 3, Accounting rate of return method 4. Payback reciprocal method = Discounted methods - consider the time value of money 1. Net present valule method: 2. Profitability index method 3. Internal rate of return method 4, Present value payback method NON-DISCOUNTED TECHNIQUES | payback Period Leone eee nual net after-tax cash inflows ‘Advantages: 1. Payback is simple to compute and easy to understand, 2. Payback gives information about the liquidity of the project. 3. Its a good surrogate for risk. A quick or short payback period indicates a less risky project, Disadvantages: 1. Payback does not consider the time value of money. All cash received during the payback period is assumed to be of equal value of in analyzing the project. 2. Ih gives more emphasis on liquidity rather than on profitability of the project. tn ather wards, more emphasis is given on return of investment rather than the return om investment: 3. Itdoes not consider the salvage value of the project 4. It ignores cash flows that may occur after the payback period Bail-out Payback Period a modified payback period method wherein cash recoveries include not only the net cash inflows from operations but also the estimated salvage value realizable at the end of each year of the project life. Page 2 of 8 pages a) SeeReSO the Review School of Cccountomeg Ms-10 CAPITAL, BUDGETING ~ Average ai nua income + A€counting Rate of Réturn A 1g Rate of Réturn (ARR aoe * may he based on original or average investment, Advantages: ‘ 1 The ARR closely parallels accounting concepts of income measurement and investment return. 2. It facilitates re-evaluation of projects due to ready availability of data from the accounting This method considers income over, the entire life of the project. It indicates and emphasizes the project's profitatility. s Disadvantages Like traditional payback inethods, the ARR misthod dees not consider the time value of money. 2, Wit the computation of income and book value based on the historical cost accounting data, the effect of inflation is ignore. Other terms used to denote the ARR: > Book rate of return > Approximate rate of return method > Unadjusted rate of return > Financial statement rate of return method > Simple rate of return | Payback Reciprocal = i Payback reciprocal is # reasonable estimate of the discounted cash flow rate of return (a.k.a, IRR) provided that the following conditions ire met: 1, the payback period is at’ nost half of the economic life of the project. 2. The net cash inflows are: uniform throughout the life of the project. DISCOUNTED TECHNIQUES the time vaive of money \s an opportunity cost concept. & peso on hand today Is worth more. than a beso to be received tontorrow . “A peso could eatn interests by putting it in a savings account or placing it Jo a profitable investment. The time value of money is usually measured by using a discount rate that is implied to be the interes'c foregone by receiving funds at a later time. Mee sash Inflows - Present vaive of cash Outflows | (CNet Present Value (NPV) = Present value. » Cash infloves include cash infused by the capital investment project on a regular basis (e'9., annual cxsh inflow) and cash realizable at the end of the capital investment project. (€.9., salvage value, return of working capital requirements) > The net investment cost required at the inception of the project usually represents the present value of the cash outflows. Advantages: 1. Emrunasizes cash flows 2. Re,cognizes the time value of money 3. /ssumes discount rate as reinvestment rate Disad'vantages: It requires determination of the costs of capital or the discount rate to be used. 2. ‘The net present values of different competing projects may not be comparable because of differences in magnitudes or sizes of the projects. Profitability Index = sant value Of cash i ent value of cash outflows. |) NPV Index = SRT investient The prétitabilty index method \6 designed to provide a common basis of ranking alternatives that require different amounts of investment NOTE: Profitability index method is also known as desirability Index, present value index and benefit: ost vatio, . Page aot 8 pages &RES the Review School of Accountancy MS-10 CAPITAL BUDGETING Internal Rate of Return (FRR) - is the rate of return that equates the present value of cash inflows to present value of cash outflows. It is also known as discounted cash flow, rate of return, time-adjusted cate of return or Sophisticated cate of, rom Guidelines in determining IRR 1. Determine the present value factor (PVF) forthe internal rate of return (IRR) with the use of the following formula “Net investment cost PYF for IRR = "Net cash inflows 2. Using the present value annuity table, find on line *n' (economic life) the PVF obtained in No. 1 The corresponding rate ts the IRR. If the exact rate is not found on the PVF table, ‘interpolation’ process may be necessary. Advantages: 1, Emphasizes cash flows 2. Recognizes the time value of money 3. Computes true return of project Disadvantages: 1. Assumes that IRR is the re-investment rate. 2. When project includes negative earnings during its life, different rates of return may result. _ EXERCISES; CAPITAL BUDGETING 1. NET INVESTMENTS FOR DECISION-MAKING ‘8aq-You Company plans to replace a unit of equipment with a new one: feat + The old unit was acquired three years ago; the old unit’s carrying value ts now at P 65,000 while it can be sold for P,75,000. Tax rate is 25%. + The new unit can be acquired at a list price of P 200,000. A 2% cash discount is available if the equipment is paid for within 30 days from acquisition date. Shipping, instalation and testing - charges to be paid are estimated at P 14,000. + Other assets with a book value of P 12,000 that ace to be retired as a result of the acquisition of the new machine can be salvaged and sold for P £0,000. ‘+ Additional working capital of P 23,000 will be needed to support operations planned with the new equipment, + The anow {rom the operation of the new equipment has been estimated at P 50,000, Thenew equipment has a useful life of 5 years with a salvage value of P 4,000 at the end of S— Tee ih eee REQUIRED: . What is the initial cost of net investments for decision-making purposes? 150,060 at is the initial cost of net 0 2. WEIGHTED AVERAGE COST OF CAPITAL (WACC) Bee-Cool Company wants to determine the weighted average cost of capital that it can use to evaluate capital investment proposals. The company’s capital structure with corresponding market values follows: 8% Term Bonds P.600,000 367 ‘5% Preferred stack (P 100 par) 200,000 192 Common stock (no par, 10,000 shares outstanding) 400,000. 222 Retained earnings 800,000 402 TOTAL 2,000,900 ‘Additional data: 1) Current market price per share > Preferred stock: P50 > Common stock: P 40 2) Expected common dividend: P 2 per share 3) Dividend growth rate: 4% 4) Conporate tax rate: 30% REQUIRED: z ‘A) Given an operating income 6t P 500,000, how much is the earnings per share (EPS)? 8) Determine the weighted average cost of capitalReSU The Review School of Gecorrtenen MS-10 CAPITAL BUDGETING SOLUTION GUIDE to Item 2 i 500,000) Operating income ~ interests (8%) (48,000) pq __Income available to common shares Income before tax 452,000 ‘Number of outstanding shares tax (30%) (135,600) Income after tax P 316,400 = —P.306,400° ~ preferred dividends (5%) __(10,000)~ £P5= 40,000 shares ee Income available to common shares P306,400* L200, co5 4 £2 Tc Hise pias dtr (2 44074 42 e Wee ii >.) eat eerear easiest aie 3. NET RETURNS (INCREASE IN REVENUES) Star-Luck Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee are estimated to be 10,000 cups to be sold for P 15 per cup. Variable costs are estimated at P 6 per cup, while incremental fixed cash costs, excluding depreciation, at P 20,000 per year. The machines are expected to have a service tife of 5 years with no salvage value. Depreciation will be computed on a straight-line basis. The company’s income tax rate is 30%. 8) Sales ow x IF 2 1.000 REQUIRED: Determine the following: Gab fir Caco) ve ‘A) The increase in annual-net.incame. 2), 060 cm ae B) The annual cash inflows that will be generated by the project. Teron) calc 8600) // —— 1000 FC (Dipny, Se a 4. NET RETURNS (COST SAVINGS) 5 Totes rh Een Moon-Use Corporation is planning to buy a high-tech machine that can reduce cash expenses by an Ca average of P 70,000 per year. The new machine will cost P 100,000 and will be depreciated for 5 years on ” 2 straight-line basis. "No salvage value Is expected at the end of the machine's life, Income tax rate Is 20% 30 of income rl) =e REQUIRED: (asia Biss (9:60) Saeed Determine the net cash inflows that will be generated by the project, O06 c eset Cath TH 5. PAYBACK PERIOD & ARR (WITH EVEN CASH FLOWS) Gs Green-Niche Company considers the replacement of some old equipment. The coiEOf the new equipment |s P 90,000, with a useful Mf estimate of 8 years and a salvage vetue’of P'10,000. ‘The snneel Dre-tax cash savings from the Use ofthe new equipment is P 40,000. The old equipment has zero maviet value and is fully depreciated. The company uses a cost of capital of 25%. were KOO frat) SAYNIQS 30006 (Camm) REQUIRED: Assuming that the income tax rate is 40%, compute: Aen: 1 Sa@ meee Gye ‘A) Payback period 2-21 -fes r ORK 8) Accounting rate of return on arigical investment 20% 2 Pole-tand Company hase nt opportunity. costing. P_20,000 that, is expected to Yield the next fivg years: (33 REQUIRED: ‘A). Payback period in months go ws Mercashin 8) Book rate of return go aa guoe— (treo /t1s following cash flows over tt 5: (assume a hurdle rate of 30%) r iy hla Year Amount es QA Braye Ob 1 P40,000 sae She Seri se 281 2" 38%000 Ripn duev 20% gio natn @ 3 30,000 Gon —= t 1 4 20,000 rs sania zy TE acd | can? he 5 . 40,000 ,. pore) Or aed Pi3s.000 Orerae BERLE 2/5 2149) ler cau To oefwetye A Nae Nees Massy Gyem) ° 7. ALL-OUT PAYBACK PERIOD ; eer Com), ‘project costing P 160,000 wil produce the folowing annual cash flows and Salvage Valieisouyqg\ re See) Year Cash flows Salvage value Trew T5000. 60,000 Dep | sume 2 P80/000 55,000 . = 3 40,000 50,000 eee) ta 2: 4 paojo00 ~—Bas"000 e pat REQUIRED: Ha 160 4 Ball-out payback perio. ED some and od ; ath ee ed te 5) epee 8 of pape Lh ©) agi csaile ares Er it ae loc ee) 22 ~(E awe / Gh fanned Het Srcome qos Cy cate ey TGQ) yd ; ya0e < qacto/rya Le Caste + SY M57 + geenReSO . The Review School of decowrtoney MS-10 CAPITAL BUDGETING 8. NET PRESENT VALUE (WITH UNIFORM CASH FLOWS) Bull-Can Company plans to buy a new machine costing P 28,000. The new machine is expected to have a salvage value of P 4,000 at the end of its economic life of 4 years. The annual cash inflows before income tax from this machine are estimated at P 11,000. The tax rate is 20%. The company desires a minimum return of 25% on invested capital. SOLUTION GUIDE totem 8 uraschor Cash inflows before tax 1,000 Deprecation 200 Earnings before tax 5, 08. = Tax (20%) _¢1090) Earnings after tax 1/°0° + Depreciation 01000 Cash inflows after tax 0 Yr. Yr Yr. Yr, Yr m Yr, “1440S nev = (440) aauneo NPV, PROFITABILITY INDEX & IRR (EVEN vs. UNEVEN CASH FLOWS) Can-Yeah Corporation gathered the following data on two capital investment opportunities: aa Project 1 Project2 MEN Proje A BU Cool Ort Cost of investment —P 195,200 P- 150,000, ox 2484 = taste Cost of capital 108 1h Pen f Expected useful life 3 years years f ase RSF Net cash inflows, P 100,000 P.100,000%%% 400,001 ume: E). Internal rate of return: 28.65% (approximation through tria/ and error or interpolation)von). Pogds. GIRS : a ers tt : % cpsital Yo=aly @FR RS The Review School of lcomunteoy creer S “eax MS-10 CAPITAL BUDGETING €2.werCaih in -uniponin 11, PAYBACK RECIPROCAL Live-Biz Company is planning to buy an equipment costing P 640,000 with an estimated life of 30 years ‘and is expected to produce after-tax net cash Inflows of P 128,000 per year. oven = ACO REQUIRED: 02 2K ow CE) = GAOMMY Without using present value factors, what is the best estimate of the iRR? 2° 12. RELATIONSHIPS - DISCOUNTED TECHNIQUES Fill in the blanks for each of the following independent cases. In all cases, the investment has a useful life of ten (10) years and no salvage value. Round off factors to three decimal places. Project Annual Cash Flow Investment Cost of Capital IRR apy a P 45,000 oa 188,640 14% I _g0%. Coke a 75,000 Fp 80. 12% 18% A) 26208 3. 8) Ws 300,000 (6Y i 16%, P 81,440 4 BD [eh ove P 450,000 12% (sy_L97 P 115,000 13. CAPITAL RATIONING - RANKING PROJECTS * Case-Zone Corporation is considering five different investment opportunities, The company’s cost of capital is 12%. Protect Investment PV-Cash Flow NPV IRR(%) P,_Index 1 35,000 P39,325°. P4325 16 112 2 20,000, 22,930 2,930 15, 145 3 25,000 27,453 2,543 14 1.10 4 10,000 10/854 854 38 1.09 5 9,000 8,749 (251) 11, 0.97 REQUIRED. : A) Rank the projects in descending order of preference according to NPV, IRR and profitability index. 8) IFonly a budget of P 55,000 is available, which projects,should be chosen? Geo SOLUTION GUID! ; wen G) Umikd Budgd Rrow Project NPY IRR P Index ayers 2b 4 1 ile o 2 Be sed ake. (tastd wf ) 3 ae al 4 am Ast sh. woe a5 sth eth wap WRAP-UP EXERCISES (TRUE or FALSE; MULTIPLE-CHOICE) a bits ul toate tes es wa Tce ude ceca hh rsslce e655) the project's net investments for decision-making purposes. \QS"" 2. The payback period emphasizes the profitability of a capital-project while the accounting rate of return, ‘on the other hand, emphasizes the project's liquidity. € c 3. , Annual cash inflows from the capital projects are measured in terms of a. Income after depreciation and taxes b. Income before depreciation and taxes . Income before depreciation but after taxes, 4. . Income after depreciation but before taxes h © 4, vnen computing for the accounting rate of return (ARR), which ofthe following is used? a, Income after depreciation and taxes b. Income before depreciation and taxes €. Income before depreciation’ but after taxes 4. Income after depreciation but before taxes C5, What technique does not use cash flow for capital investment decisions? a. Payback ARR b. NPV @ IRR D 6, Which of the following groups of capital budgeting techniques uses the time value of money? 8. Book rate of return, payback and profitability index b. IRR, payback and NPV c. IRR, ARR and profitability index d. IRR, NPV and profitability index Page 7 of 8 pagesRS. the Review School of beconectaney MS-10 CAPITAL BUDGETING B 7. Cost of capital js 3%; economic life in years = 4 years; what is the simple PV factor for year 4? a. 0.915 0.455 Sarat b. 0.888 d. 0,350 ~ 8, Discount rate is 11%; economic life in years = 3 years; what is the PV annuity factor for 3 years? a. 0.731 c. 2aag oa bo 1713 d. 3.102 9. As the discount rate increases, v a. Present value factors increase b. Present value factors decrease . Present value factors remain constant 4d, It is impossible to tell what happens to the factors. & 10. What is the PV factor of any amount at year zero or zero percent? a, Zero b. 0.50 c 1.00 d. An amount that cannot be determined without more information 12. The present value of P 50,000 due in five years would be highest if discounted at a rate of a. 0% b. 10% c. 15%. d, 20% 12. A capital project with a positive NPV also has ‘a. A profitability index of one b. A positive profitability index ¢. A profitability index less than one de A profitability index greater than one 13: A capital project that has a positive NPV based on a discount rate of 12% also has an IRR of a. zero b. 12%. ©. Less than 12% d. Greater than 12% 14, Which of the following. combinations js-possioie? Di goe Profitability Index NPV IR a ee a: Greater than 1 . Positive Equals cost of capital 4 b. Greater than 1 Negative Less than cost of capita! yen" Ge “Lessthan Negative _ Less than cost of capital eo 4. Lessthan f Positive __Less than cost of capital Fs ¢, 35: The net present value method assumes that the project's cash flows are reinvested at the ‘a. Internal rate of return b. Simple rate of return © Cost of capital a. Payback period % 16. The dnternal rate of return method assumes that the project’s cash flows are reinvested at the a. Required rate of return b. Internal rate of return Simple rate of return d. Payback period 17. Which one of these methods is a project ranking method rather than a project screening method? a. Net present value We b. Profitability index ¢. Simple‘rate of return d. Sophisticated rate of return ‘Q 18, If the IRR on an investment is zero, = 4 v a MteNeWispositve | b. Its generally a wise investment Its cash flows decrease over its life d. Its annual cash flows equal its required investment Page 8 of 8 pages cA +G2) RSU- the Review School of Wccorwtance » Mamagemnert Services MS-10: CAPITAL BUDGETING CAPITAL INVESTMENT - involves significant commitment of funds to receive 3 satisfactory return over an extended period of time. Example: purchase of juipment for expansion, replacement of old equipment CHARACTERISTICS OF CAPITAL INVESTMENTS + Asto COST usvally entails large amount of resources, relative to business size + As to COMMITMENT usually funds invested are tied up for a long period of time + ASto FLEXIBILITY usually more difficult to reverse than short-term decisions + Asto RISK Usually involves so much risks & uncertainties due to operational and economic changes over an extended period of time CAPITAL BUDGETING ~ is the process by which management identifies, evaluates, and makes decision on capital investment projects of an organization. A’simplified capital budgeting process Involves the following steps: Step 1 Step 2 Step 3: ee < Identification >) ————> (_Fvaluation Jere Decision) Capital Investment Decisions \> FACTORS OF CONSIDERATION }-> Replacement (Equipment) ¥ | improvement (Products) |S expansion (Facilities) Net Investments Net Returns Costs of Capital [> Addition (Technology) ee — TS Reduction (Costs) 3 Pa Seat — > Capital budgeting, after the selection | Non-discountea methods Discounted methods of the capital investment project, Payback period ‘Net present value typically extends up to the financing, Bail-out payback Profitability index implementation and monitoring ot | Accounting rate of return Internal rate of return the project. Payback reciprocal Present value payback CAPITAL INVESTMENT FACTORS 1) NET INVESTMENTS (for decision-making purposes) + Costs less savings incidental to the acquisition of the capital investment projects + Cash outflows less cash inflows incidental to the- acquisition of the capital investment projects Costs of cash outflows 1. Purchase price of the asset, net of related cash discount 2, Incidental project-related expenses such as freight, insurance, handling, installation, test-runs, ete, CONDISER ALSO THE FOLLOWING, if any: ‘+ Additional working capital needed to support the operation of the project at the desired level. + Market value of existing idle assets to be used in the operation of the proposed capital project. + Training cost, net of related tax Savings or Cash inflows Proceeds from sale of old asset disposed, net of related tax CONSIDER ALSO THE FOLLOWING, if any + Trade-in value of old asset ‘ + Ayoidable cost of immediate repairs on the Old asset to be replaced, net of related tax 2) NET RETURNS + ACCRUAL basis: Accounting net income (after tax) + CASH basis: Net cash inflows eth Net cash inflows @_INDIRECT method Net cash inflows = Net income (aiter tax) + noncash expenses (e.9., depreciation expense) Cash outflows Cash inflows Page 1 of 8 pagesReSU - The Review School of Aecourstancy MS-10 CAPITAL BUDGETING 3) COSTS of CAPITAL +The ‘costs of capital’ used in capital budgeting is the Weighted Average Costs of Capital (WACC). These are specific costs of using long-term funds, obtained from the different: sources: borrowed (debt) and invested (equity) capital SOURCES Eicosts 23 Debt ‘After-tax interest rate*™ Preferred Stock (PS) Dividend yield** Common Stock (CS) Dividend yield** plus growth rate Retained Earnings (RE) Dividend yield** plus growth rate * The after-tax cost of debt is computed based on: interest yield rate (1 - tax rate) ** Dividend yield = dividend per share = price per share Expected cash dividend per share Dividend growth rate | Cost of CS and RE = —~"Market price per common share > The dividend growth rate is assumed to be constant over time. > In computing cost of CS & PS, the market price should be net of flotation costs (e.9., underwriting fees). In computing the cost of RE, flotation cost should be ignored as RE is not sold or issuad. > Alternatively, the cost of equity capital may be computed based on Capital Asset Pricing Model (CAPM). NOTE: refer to page 4 of MSQ - 10 for detailed discussions an CAPM and the Dividend Growth Model : + Other terms used to denote the weighted average cost of capital (WAC) » Minimum required rate of return Minimum acceptable rate of return Cut-off rate Target rate Desired rate of return Standard rate Hurdle rate CAPITAL BUDGETING TECHNIQUES + Non-discounted methods - do not consider the time value of 1. Payback period method 2. Bail-out payback method 3. Accounting rate of return method 4. Payback reciprocal method oney + Discounted methods - consider the time value of money 1, Net present value method 2. Profitability index method 3. Internal rate of return method 4. Present value payback method NON-DISCOUNTED TECHNIQUES: Fi pavosck Paves a Net initial cost of lavestment Annual net after-tax cash inflows Advantages: 1. Payback is simple to compute and easy to understand, 2. Payback gives information about the /iquidity of the project. 3. It is a good surrogate for risk. A quick or short payback period indicates a less risky project Disadvantages: 1, Payback does not consider the time value of money. All cash received during the payback period is assumed to be of equal value of in analyzing the project. 2. It gives more emphasis on liquidity rather than on profitability of the project: In other words, more emphasis is given on return of investment rather than the return on investment. 3. It does not consider the salvage value of the project 4. It ignores cash flows that may occur after the payback period. Bail-out Payback Period 3 modified payback period method wherein cash recoveries include not only the net cash inflows from operations but also the estimated salvage value realizable at the end of each year of the project life Page 2 of 8 pages EyROS - the Review School of lccowectamen MS-10 CAPITAL BUDGETING ‘Average anual iet income] Accounting Rate of Return (ARR) Tavesione= * may be based on original oF average investment, Auvantages: The ARR closely parallels accounting concepts of income measurement and investment return. It facilitates re-evaluation of projects due to ready: availability ‘of data from the accounting records 3. “This method considers income over the entire life of the project. 4. Tt indicates anid emphasizes the project's profitability. Disadvantages 1. Like traditional payback methods, the ARR method does not consider the time value of money 2. With the computation of income’ and book value based on the historical cost accounting data, the effect of inflation is ignored: Other terms used to denote the ARR >. Book rate of return > Approximate rate of return method > Unadjusted rate of return > Financial statement rate of return method > Simple rate of return aN, cash inflows aaa Payback reciprocal is a reasonable estimate of the discounted cash flow rate of return (a.k.a. IRR) provided that the following conditions “are met 1. ihe payback period Is at ‘ nost haif of the economic'life of the project. 2. The net cash inflows are uniform throughout the life of the project. DISCOUNTED TECHNIQUES the time value of money is an opportunity cost concept. A peso on hand today is worth more than a eso to be received tomorrow. A peso could earn interests by putting it in a savings account or placing Itin a profitable investment The time value of money is usually measured by using a discount rate that is implied to be the interes'c foregone by receiving funds at a later time. __|_Net Present Value (NPI = Present value of cash Inflows — } > Cash inflaves include cash infused by the capital investment project on a regular basis (e.9., annual cigh inflow) and cash realizable at the end of the capital investment project, (€.9, salvage value, return of working capital requirements) > The nex investment cost required at the inception of the project usually represents the present value of the cash outfows: ‘Advantages 1. Emesnasizes cash flows 2. Re.cognizes the time value of money 3. fsssumes discount rate as reinvestment rate Disadvantages: It requires determination of the costs of capital or the discount rate to be used 5. The net present values of different competing projects may not be comparable because of iferences in magnitudes or sizes ofthe projects. Profitability Index = Pi Preset NPV Index = _ Investment The profitability index method is designed to provide a common basis of ranking alternatives that require different amounts of investment. profitability index method Is also known as desirability index, present value index and benefit- ‘cost ratio Page 3 of 8 pagesReSQ the Review School of Ueconrtancey MS-10 CAPITAL BUDGETING Internal Rate of Return (IRR) - is the rate of return that equates the present value of cash inflows to present value of cash outflows. It js also known as discounted cash flow : rate of return, time-adjusted rate of return or sophisticated vate of return Guidelines in determining IRR 1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the following formula: ~ Net investment cost jet'cash inflows | 2. Using the present value annuity table, find on linie n’ (economic life) the PVF obtained in No. 4 The corresponding rate is the IRR. If the exact rate 1s not found on the PVF table, ‘interpolation’ process may be necessary. Advantages. 1. Emphasizes cash flows 2. Recognizes the ume value of money 3. Computes true return of project Disadvantages. 1. Assumes that IRR is the re-investment rate 2. When project includes negative earmngs during its life, different rates of return may result. EXERCISES. CAPITAL BUDGETING NET INVESTMENTS FOR DECISION-MAKING Bag-You Company plans to replace a unit of equipment with a new one: + The old unit was acquired three years ago; the old unit’s carrying value is now at P 65,000 while it can be sold for P 75,000. Tax rate is 25%. ‘+The new unit can be acquired at a list price of P 200,000. A 2% cash discouint is available if the equipment is paid for within 30 days from acquisition date. Shipping, installation and testing charges to be paid are estimated at P 14,000 * Other assets with a book value of P 12,000 that are to be retired as a result of the acquisition of the new machine can be salvaged and sold for P 10,000 * Additional working capital of P 23,000 will be needed to support operations planned with the new equipment + The annual cash flow from the operation of thie new equipment has been estimated at P 50,000. The new equipment has a useful life of 5 years with a salvage value of P 4,000 at the end of 5 years. REQUIRED: . What is the initial cost of net investments for decision-making purposes? 2. WEIGHTED AVERAGE COST OF CAPITAL (WACC) Bee-Cool Company wants to determine the weighted average cost of capital that it can use to evaivate capital investment proposals. The company’s capital structure with corresponding market values follows: 8% Term Bonds 600,000 '5% Preferred stock (P 100 par) 200,000, Common stock (no par, 10,000 shares outstanding) 400,000 Retained earnings 800,000 TOTAL 2,000,000" Additional data: 4) Current market price per share » Preferred stock: P50 > Common stock: P40 2) Expected common dividend: P 2 per share 3) Dividend growth rate: 4% 4) Corporate tax rate: 30% REQUIRED: . ‘A). Given an operating income of P $00,000, how much is the earnings per share (EPS)? | B) Determine the weighted average cost of capital Page’ SSReSU - The Review School of Gccounitoneg. MS-10 CAPITAL BUDGETING SOLUTION GUIDE to Item 2 © Operating income P 500,000 ~ interests (8%) (48,000) p< _ _Income available to common shares Income before tax — P 452,000 Number of outstanding shares ~ tax (30%) __(135,600) Income! after tax P 316,400 py, __P-306,400* Penek - preferred dividends (5%) __ (10,000) Income available to commen shares P 306,400" [sources 7 weieerc36)_T 10,000 shares Bonds_ Preferred stock 2 ‘Common stock & Retained Earnings 3. NET RETURNS (INCREASE IN REVENUES) ‘Star-Luck Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee are estimated to be 10,000 cups to be sold for P15 per cup. Variable costs are estimated at P 6 per cup, while incremental fixed cash costs, excluding depreciation, at P 20,000 per year. The machines are expected to have @ service life of 5 years, with no salvage value, Depreciation will be computed on 3 straight-line basis. The company’s income tax rate is 30%. REQUIRED: Determine the following: 'A). The increase in annual net income. B) The annual cash inflows that will be generated by the project. 4, NET RETURNS (COST SAVINGS) Moon-Use Corporation is planning to buy a high-tech machine that can reduce cash ‘expenses by an average of P 70,000 per year. The new machine will cost P 100,000 and will be depreciated for 5 years on a straight-line basis. No salvage value is expected at the end of the machine's life. Income tax rate Is 20%. of income, 1 REQUIRED: Determine the net cash inflows that will be generated by the project. 5. PAYBACK PERTOD & ARR (WITH EVEN CASH FLOWS) Green-Niché Company considers the replacement of some old equipment. The cost of the new equipment is P 90,000, with a useful life estimate of 8 years and a salvage value of P 10,000. The annual pre-tax cash savings from the use of the new equipment is P 40,000. The old equipment has zero market value and is fully depreciated. The company uses a cost of capital of 25%. REQUIRED: Assuming that the income tax rate Is 40%, compute: ‘A) Payback period 8) Accounting rate of return on original investment C) Accounting rate of retum on average investment 6. PAYBACK PERIOD & ARR (WITH UNEVEN CASH FLOWS) Pole-Land Company has an investment opportunity costing P 90,000 that is expected to yield the following cash flows over the next five years: (assume a hurdle rate of 30%) Year Amount 1 P-40,000 2 35,000 . 3 30,000 4 20,000 5 10,000 P 135,000 REQUIRED: 'A)_ Payback period in months 8) Book rate of return BAIL-OUT PAYBACK PERIOD ‘A project costing P 180,000 will produce the following annual cash flows and salvage value: Year Cashflows Salvage value 1 P 50,000 60,000 2 P 50,000, 55,000 3 P 40,000 50,000 4 40,000 45,000 REQUIRED: Bail-out payback period, Page 5 of 8 pagesReSU - The Review School of Accountancy MS-10 CAPITAL BUDGETING 8. NET PRESENT VALUE (WITH UNIFORM CASH FLOWS) Bull-Can Company plans to buy a new machine costing P 28,000. The new machine is expected to have ‘a salvage value of P 4,000 at the end of its economic life of 4 years. The annual cash inflows before income tax from this machine are estimated at P 11,000. The tax rate is 20%. The company desires a minimum return of 25% on invested capital. REQUIRED: ‘Determine the net present value. (Round-off factors to three decimal places) SOLUTION GUIDE to Items Cash inflows before tax ~ Depreciation’ Earnings before tax ~Tax (20%) Earnings after tax + Depreciation Cash inflows after tax PV factor Year 1 Year2 Year 3 Year 4 Ye. Yr. Yr. Yr Yr. Yr. NPV “eunroe 9. NPV, PROFITABILITY INDEX & IRR (EVEN vs. UNEVEN CASH FLOWS) Can-Yeah Corporation gathered the following data on two capital invest ment opportunities Project 1 Project 2 Cost of investment P'195,200 Pp 150,000 Cost of capital 10% 10% Expected useful life 3 years years Net cash inflows 100,000 —P 100,000¢ * This amount is to decline by P 20,000 annually thereafter. REQUIRED: Round-off factors to three decimal places in all cases, Fill-in the blanks. Project 1 NPV; A) P. Index: ¢) E) What is project 1's internal rate of return? a. 23% b. 27% a F) What is project 2's time-adjusted rate of return? a. Below 30% Between 31% and 32% b.» Between 30% and 31% d. Above 32% 10. CAPITAL BUDGETING TECHNIQUES Mall-Asia Company |s considering buying 4 new machine, requinng an immediate P 400,000 cash ‘outlay. The new machine is expected to increase annual net after-tax cash receipts by P 160,000 in each of the next five years of its economic life, No salvage value is expected at the end of 5 years. The company desires a minimum return of 14% on invested capital. REQUIRED; Round-off factors to three decimal places 11) all cases ‘A) Payback period B)_ ARR (based on original investment) ©) Net present value 1D) Profitability index £) Internal rate of return 1 ‘A) Payback period: 400,000 = 160,000 = 2.5 years 'B) Accounting rate of return (based on original investments) 80,000 + 400,000 C) Net present value: 160,000 (3.433) » 400,000 = P 149,280 D) Profitability index: 549,280 = 400,000 ~ 1.37 mes. £) Internal rate of return: 28.65% (approximation thirough tvial and error or interpolation)ReSQ - The Review School of Gccounitomeg MS-10 CAPITAL BUDGETING i 11, PAYBACK RECIPROCAL Live-Biz Company is planning to buy an equipmenit costing P 640,000 with an estimated life of 30 years and Is expected to produce after-tax net cash inflows of P 128,000 per year REQUIRED: Without using present value factors, what is the best estimate of the IRR? 12. RELATIONSHIPS - DISCOUNTED TECHNIQUES Fill in the blanks for each of the following independent cases, In all cases, the investment has a useful life of ten (10) years and no salvage value, Round off factors to three decimal places, Project Annual Cash Flow —lovéstment Cost of Capital IRR ‘Ney 1 P 45,000. P 188,640 14% Gee's S512) 2 P 75,000, Ree ee eat 12% 18% (4) Say (SY a TR eo ees OOD CB) baa! 16% P'8i,440 4 GE) 22 P 450,000 12% (8) P 115,000 13. CAPITAL RATIONING ~ RANKING PROJECTS Case-Zone Corporation is considering five different investment opportunities. The company’s cost of capital is 12%, Project Investment PV-CashFlow NPY IRR(%) _P. Index 1 P35,000 39325 «P4325 16 1.12 2 20,000 22,930 2.930 35 115 3 25,000 27/453, 254314 1.10 4 40,000 10/858 854. 18 1.09 5 9,000 8,749 51) 11, 097 REQUIRED: A) Rank the projects in descending order of preference according to NPV, IRR and profitability index. 8) [fonly a budget of P 55,000 is available, which projects should be chosen? SOLUTION GUI Project NPV IRR P. index 1 al iin 2 a come gees 3 Peake a 4 an A 5 oY, Saou WRAP-UP EXERCISES (TRUE or FALSE; MULTIPLE-CHOICE) L.A project’s salvage value, realizable at the end of life of the project, is considered in the computation of the project's net investments for decision-making purposes. 2. The payback period emphasizes the profitability of a capital project while the accounting rate of return, on the other hand, emphasizes the project's liquidity. 3. Annual cash inflows from the capital projects are measured in terms of a. Income after depreciation and taxes b. Income before depreciation and taxes €. Income before depreciation but after taxes, d. Income after depreciation but before taxes 4, When computing for the accounting rate of return (ARR), which of the following Is used? 8. Income after depreciation and taxes b. Income before depreciation and taxes c. Income before depreciation but after taxes . Income after depreciation but before taxes 5, What technique does not use cash flow for capital investment decisions? a. Payback ARR bo NPV 4. IRR 6, Which of the following groups of capital budgeting techniques uses the time value of money? 2. Book rate of return, payback and profitability index b. IRR, payback and NPV IRR, ARR and profitability index d. IRR, NPV and profitability index Page 7 of 8 pagesReSU - the Review School of Accoweitaney MS-10 CAPITAL BUDGETING : 7. Cost of capital is 3%; economic life in years ~ 4 years; what is the simple PV factor for year 4? a 0,915 © 0.455 b. 0.888 d. 0.350 ‘8. Discount rate is 11%; economic life in years = 3 years; what is the PV annuity factor for 3 years? a: 0.731 G 2484 bo t7i3 d. 3.102 9. As the discount rate increases, 2. Present value factors increase . Present value factors decrease Present value factors remain constant 4d. Itis impossible to tell what happens to the factors. 10. What is the PV factor of any amount at year zero or zero percent? a. Zero b. 0.50 © 100 . An amount that cannot be determined without more information 11, The present value of P 50,000 due in five years would be highest if discounted at a rate of a 0% b. 10 15% d, 20% 12. A capital project with a positive NPV also has 3. A profitability index of one b. A positive profitability index ©. A profitability index less than one 4. A profitability index greater than one 13. A capital project that has a positive NPV based on a discount rate of 12% also has an IRR of a. Zero b. 12% Less than 12% d. Greater than 12% 14, Which of the following combinations is possible? Profitability Index NPV IRR a. Greater than 1 Positive Equals cost of capital b. Greater than 1 Negative _Less than cost of capital ¢ Less than 1 Negative Less than cost of capital d, Less than 1 Positive Less than cost of capital 15. The net present value method assumes that the project's cash flows are reinvested at the a. Internal rate of return b. Simple rate of return Cost of capital d. Payback period 16. The internal rate of return method assumes that the project’s cash flows are reinvested at the 2. Required rate of return b. Internal rate of return c. Simple rate of return d. Payback period 17, Which one of these methods is a project ranking method rather than a project screening method? ‘a, Net present value b. Profitability index c. Simple rate of return d. Sophisticated rate of return 18. If the IRR on an investment is zero, a. Its NPV is positive b. [tis generally a wise investment * ¢. Its cash flows decrease over its life 4. Its annual cash flows equal its required investment: Page 8 of 8 pagesRGU. The Review Schoob of Wccorn taney « Momogemenit Services . MS-11: FINANCIAL MANAGEMENT ~ FINANCIAL MANAGEMENT - concerns the duties of the financial manager, who is responsible for making ‘significant corporate investment and financing decisions GOAL OF FINANCIAL MANAGEMENT * Modern managerial finance theory works under the. premise that the primary goal of the firm is to maximize shareholders’ wealth, rather than to maximize profit. The financial manager acts in the shareholders’ best interests by making decisions that maximize the market value of the company's shares of stock. ROLE OF FINANCIAL MANAGERS EIEN The role of a financial manager may include, but is not limited to, the following tasks: 1. Financial analysis and planning. Determining the proper amount of funds to employ in the firm through liquidity and profitability analysis of the company’s financial statements. (related topics budgeting, financial statement analysis and additional funds needed) 2. Investment decisions, Selecting the best projects in which to Invest firm resources, based ‘on Cortsideration of risks and returns. (related topic: capital budgeting) 3. Financing and capital structure decisions. Outsourcing company funds (mix of debt and equity financing) to support frmn’s operations and investment programs, (related topic: costs of capita) 4, Management of financial resources, Managing the firm's current assets and source of short-term Credit in the most efficient manner. (related topic: working capital management) . Risk management. Managing the firm's exposure to all types of risk. (related topic: leverage) ‘No single person is tasked for all the responsibilities of a financial manager, These tasks are dispersed throughout the firm. In large firms, financial responsibilities are usually carried out by the treasurer and/or the controller. while the chief financial officer (CFO) usually, oversees. the work of both treasurer and controller. 4 % BASIC PRINCIPLES IN MANAGERIAL FINANCE ‘ ‘Most techniques and tools in finance are based on the following theoretical axioms or principles: + Risk-return trade-off. “we won't take on additional risk unless we expect to be compensated with additional return’ Time value of money: a peso received today is worth more than a peso received in the future, “Cash = not profit = 1s king. Incremental cash flows ~ it’s only what changes that counts Tax consideration: virtually all financial decisions are influenced by the effect of taxes, Ethical behavior ~ doing the right thing ~ /s-always relevant. WORKING CAPITAL MANAGEMENT = WORKING CAPITAL MANAGEMENT ~ involves managing the firm's current assets and liabilities to achieve 2 balance between profitability and risk that contributes positively to the firm’s value EXERCISE: WORKING CAPITAL Given the following information of Ana Company: Cash ‘ 18,000, ‘Accounts Payable P 10,000 ‘Accounts Receivable 12,000 ‘Accrued Payroll 3,000 Inventory | © 20,000 Current Tax Liability 7,000 Fixed Assets: 50,000 Bonds Payable 40,000 NOTE: Bonds will mature in 10 years. ¢ REQUIRED: & 1, What is the net working capital? Hwee CA-CL 4 50000-2000 300 2) Determine the companys current ratio. ck~ cA /cl'y Sov (2000 + 3) If only the quick assets are considered, then what ls the r VW, 4 Assuming the entre accounts payable arg paid in cash, what fs the new current ratio? 4900 /iec “j, 5 Assuming short-term fan of 10,000 is obtained om a bank, what the new Curent Ft? py FACTORS TO CONSIDER IN MANAGING WORKING CapiTAL ALS « Bee cs + APPROPRIATE LEVEL, This refers to adequacy of working capital ee x, Consider: Nature of business and feng of operating cycle + STRUCTURAL HEALTH This refers to composition of working capital i 4 > Consider: Need for cash and stock of inventory units ; + uQUiDITy This refers to the relative transformation (and its rate) of current assets into more liquid current assets (e.9., cash and marketable securities). Page 1 of 12 pages aiageenseky ag:

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