Part I

Foundations of
Management Accounting

Chapter 1 • Introduction to Management Accounting

Chapter 2 • Management Accounting and Decision-making

Chapter 3 • Financial Statements for Manufacturing Businesses

Chapter 4 • Classification of Manufacturing Costs and Expenses

Chapter 5 • Management Accounting Theory of Cost Behavior

Chapter 6 • Direct Costing Financial Statements

 Management Accounting |1

Introduction to Management Accounting

Introduction
Managerial accounting may be regarded as a body of knowledge that is
concerned with concepts and decision-making tools that enable management to
make better decisions and to evaluate results. As a body of technical knowledge,
management accounting primarily consists of certain decision‑making techniques or
tools drawn from financial and management theory and practice. A basic premise is
that the primary task of management is to make decisions and that this task is greatly
improved by the knowledge and skills of the management accountant. A corollary
premise is that the management accountant’s ability to serve management is greatly
enhanced by a knowledge of management and, in particular, a sound knowledge of
the fundamentals of marketing, production, and finance.
This book is based on the assumption that the accountant in the role of advisor
to management must understand basic management concepts, particularly those
concepts embedded in the function of decision‑making. Only if the accountant has
a proper understanding of management’s needs will he or she be able to furnish
the data and special analyzes that will enable management to make consistently
good decisions. Conversely, this book assumes that management must understand
accounting and the type of information that the accountant can provide. Without
an understanding of some accounting, the manager or decision‑maker may fail to
request information or seek help at a critical time. Therefore, this book is written for
two groups of individuals: accountants and managers. The accountants, of course,
are expected to acquire a higher degree of proficiency in the use of the planning and
control techniques presented.
2 | CHAPTER ONE • Introduction to Management Accounting

Definition of Management Accounting

What is accounting? A very old but frequently used definition states: “Accounting is
the art of recording, classifying, and summarizing in a significant manner and in terms
of money, transactions, and events, which are, in part at least of a financial character,
and interpreting the results thereof.” (AIA Bulletin No. 1 ‑ Review and Resume)
A more recent definition states: “Accounting is a service activity. Its function is to
provide quantitative information, primarily financial in nature, about economic entities
that is intended to be useful in making economic decisions–in making reasoned
choices among alternative courses of action.” (APB Statement No. 4) This latter
definition is more appropriate to managerial accounting because of its emphasis on
decision‑making.
Management accounting may be simply defined as a body of accounting knowledge
primarily consisting of concepts and techniques (tools) useful to management in
making better decisions and evaluating performance. Most managerial accounting
theorists and writers agree that the following concepts and tools represent the
foundation of management accounting:
Decision-making Tools Concepts
1. Cost‑volume‑profit analysis 1. Fixed and variable costs
2. Comprehensive budgeting 2. Escapable and inescapable costs
3. Flexible budgeting 3. Relevant costs
4. Incremental analysis 4. Incremental costs
5. Return on investment 5. Sunk costs
6. Direct costing 6. Opportunity costs
7. Capital budgeting 7. Common costs
8. Inventory models 8. Direct and indirect cost
9. Cost analysis for marketing 9. Contribution margin
production, and finance 10. Planning
10. Segmental income statements 11. Control
11. Financial statement ratio analysis 12. Standards
13. Organization
From the above listing, it is apparent that the subject matter of management
accounting has little to do with transactions analysis and the preparation of statements
from historical data. However, management accounting is not independent of financial
accounting. Financial accounting is a foundation requirement for management
accounting and a study of financial accounting must precede the study of management
accounting. The basic carryover from the study of financial accounting is a solid
understanding of financial statements. An understanding of how to analyze and
record the effects of individual transactions of assets, liabilities, capital, and revenue
is helpful but not essential.
Management: The Focal Point of Management Accounting
The term management accounting obviously consists of two words each of which
represents highly developed areas of study. The term management accounting
suggests an important relationship between management and accounting.
 Management Accounting |3

Furthermore, there is implied an area of common interests. Management accounting

is not merely the application of accounting to management; rather it is a study of
analytical techniques that result from the combining of accounting fundamentals with
the fundamental concepts of management.
The student that is planning a professional career in accounting must develop
an appreciation and understanding of management. It is management that guides
the business and makes the decisions which determine the success or failure of a
business. The accountant serves in a staff or advisory function under management.
On the other hand, those students planning a professional career as managers
need to understand and appreciate that a knowledge of accounting is critically
important. Although accountants use technical accounting expertise to prepare
financial statements, it is management that receives and uses financial statements.
Management, not accountants, has the need and responsibility to read and understand
financial statements. Financial statements, in one sense, are summary reports of
how well management has performed (made decisions) for a given period of time.
For management to have a negative attitude towards accounting is tantamount to
being negative towards their own responsibilities and accomplishments.
Certain concepts of management are essential to a study of management
accounting. The following concepts will be employed throughout this text as important
in understanding the technical aspects of management accounting.
Planning
Control (performance evaluation)
Organization
Standards
Decision‑making
Feedback
Goals and objective
Strategy
These terms will be explained in the chapters where they can be logically
associated to the management accounting tools that make them relevant.
Accounting as an Organizational Function
Management accounting techniques are useful in all types of businesses.
Managers of service, merchandising, manufacturing, banks, insurance companies,
etc. all can benefit from the use of management accounting. Management accounting
is frequently associated with fairly large corporate businesses; however, it is equally
useful to small businesses.
When a business reaches a certain size, then the accounting activity is of such a
volume that the accounting activity must be organized and managed. Consequently,
accounting in larger businesses can be thought of as a departmentalized function
appearing on the organization chart as a staff function. While the term management
accounting implies to individuals possessing specialized knowledge of management
and accounting, the term can also be applied to the accounting department as a whole.
A simple model of the accounting function is shown in Figure 1.1. The management
techniques presented in this book would primarily be used in the budgeting and
revenue and cost analysis section of the accounting department.
4 | CHAPTER ONE • Introduction to Management Accounting

From a departmental viewpoint, all accounting activities are management in nature.

The accounting department exists to serve the financial data needs of management.
The controller or head of the accounting department in many companies is considered
to be a part of the decision‑making team. Therefore, from an organizational viewpoint,
the distinction between financial accounting and managerial accounting is somewhat
artificial. The controller, the chief executive officer of the accounting department, is
always serving as an management accountant, regardless of what type of accounting
is being done. However, the majority of accounting activities he or she supervises
would from an academic viewpoint be classified as financial accounting as opposed
to management accounting.
Relationship of Financial and Managerial Accounting
The study of accounting is normally divided into two broad categories: financial
and managerial. This division is somewhat arbitrary in that the study of managerial
accounting requires a strong foundation in financial accounting. However, there is a
definite difference in orientation and methodology which needs to be understood.
Accounting exists in a network of complex business relationships both internal
and external. In management accounting, the focal point is the role of management
within the organizational structure. Both the financial accountant and the managerial
accountant need a knowledge of external factors and relationships as well as a
conceptual knowledge of accounting principles and procedures. Accounting as a
function within a business organization is service oriented. Accounting serves the
financial information needs of many different types of groups including investors,
governments, customers, employees, unions, and bankers. Most importantly, it serves
the internal information needs of management. Figure 1.2 illustrates the environment
in which management and the management accountant operate.

FIGURE 1.1 • Diagram of the Accounting Function

Board of
Directors

President

Marketing Production Finance

Department Department Department

Accounting
Department
 Management Accounting |5

In a broad sense, financial accounting, as a branch of accounting in general,

serves all types of users. Management accounting, on the other hand, is intended
to serve primarily management’s internal information needs; therefore, managerial
accounting is not governed by strictly defined and publicly promulgated principles
and standards. Financial accounting is concerned with the reporting of operations
to external parties; whereas, management accounting is internal in direction and is
primarily concerned with serving the decision‑making needs of management.
Management accounting as a body of technical knowledge is, in fact, a synthesis
of various disciplines. Many of the techniques such as capital budgeting models and
EOQ models have been borrowed from other disciplines. The conceptual framework
of management accounting, then, has building blocks in its foundation from:
1. Management theory ( planning, control, organization)
2. Financial accounting (financial statements)
3. Finance theory (capital budgeting, working capital)
4. Economic theory (pricing, forecasting, supply, demand, cost behavior)
5. Marketing theory (order getting, order processing, order delivery)
6. Mathematics (algebra, calculus)
Therefore, an understanding of management accounting is greatly enhanced, if
preceded by a knowledge of the fundamentals of management, finance, production,
marketing, economics, and mathematics.
Environmental Structure of Accounting
Accounting is a complex body of knowledge and procedures that has evolved
over the last few hundred years. The complexity of accounting in the last fifty years
has greatly accelerated as more complex financial transactions have been developed
and regulatory agencies, both private and non private, have come into existence.
Voluminous rules and regulations, (for example, Financial Accounting Standards)
have been written and put into practice. Also, the rapid development of personal
computers and very powerful accounting and systems software has had its impact
in accelerating the complexity of accounting. Within accounting, there are highly
developed specialized areas such as the following:
Tax accounting Accounting Information Systems
Financial auditing Internal auditing
Management accounting Financial accounting
Not-for-profit accounting Governmental accounting
Accounting as a profession employs hundreds of thousands of individuals who
serve both in public accounting and private accounting. As of 2006, there were
approximately 650,000 CPAs in the USA. Accounting is needed in every type of
business and organizations including state and federal governments, banks, not-for-
profit businesses, manufacturing and retail businesses of all types, and labor unions.
The professional accountant needs to have an awareness and knowledge of how
the financial and economic environment has an impact on business. Also, an acute
awareness of the many different types of organizations that a business interacts with
is crucial to being a successful management accountant.
6 | CHAPTER ONE • Introduction to Management Accounting

Comparison to Financial Accounting

The differences between financial and managerial accounting can be effectively
illustrated by using (1) an input and output approach and (2) a financial statement
approach. Both approaches will be illustrated.
Input/output Approach - Although narrower in scope of users, management
accounting, nevertheless, is broader in scope in the type of data used in the models
through which data is processed and analyzed. The input and output diagrams
illustrated in Figures 1.3 and 1.4 reveal the differences in the nature of inputs and the
mode of processing between financial and management accounting.
The input/output diagram shown in Figure 1.4 reveal that management accounting
deals with a wider range of inputs and outputs. Also, the methodology of processing
data involves numerous types of mathematical model. The inputting, processing, and
outputting of data in management accounting is not limited to a prescribed set of
rules dealing only with historical data as is the case in financial accounting.
Financial Statement Approach
Both financial accounting and management accounting are concerned with financial
statements. The financial accountant is concerned with analyzing and recording the
historical transactions (past decisions) of the business. A primary objective of the
financial accountant is to fairly present financial statements based on past events (see
Figure 1.3). The management accountant is primarily concerned with desired future

Figure 1.2 • Accounting Environment

ORGANIZATIONS

Governments Financial Business

Business Firms Labor Unions Consumers Investors
(States & Federal) Instiltutions Professions

President

Financial Accounting Accounting System

Marketing Production Finance

Balance Income Cash Flow General Ledger

Jourlnals
Sheet Statement Statement
Accounting
Special Journals

Auditing Systems Payroll General

Cost Accounting Budgeting
Accounting

Accounting Theory and Methodlogy

Theory Assumptions Standards and Recording Rules Statistical and Mathematical Techniques
 Management Accounting |7

events. Future events will be the results of decisions to be made by management.

The management accountant, then, is also concerned with financial statements
(e.g. budgeted financial statements) that reflect the anticipated consequences of
planned decisions (planned transactions). For example, the financial accountant is
concerned with questions such as: What is the amount of cash on hand? What is the
cost of inventory on hand? The management accountant, however, is concerned with
questions such as: What amount of cash should be on hand? What is the desired
level of inventory? Figure 1.5 summarizes the differences in viewpoint for each item
on the balance sheet and income statement.

Figure 1.3 • Financial Accounting

Inputs
Accounting Transactions
(Historical Data)

Accounting Department
Accounting transactions are processed by means
of journals, accounts and ledgers. Now done
primarily by use of accounting software and computers.

Outputs
Income Statement
Balance Sheet
Statement of Cash Flows
Other types of financial reports

Figure 1.4 • Managerial Accounting

Inputs
Planned data, Statistical data, Future costs.
Standards, Historical accounting data, if relevant

Accounting Department
Data for decision-making and performance
evaluation are processed by means of budget
models, forecasting models, cost analysis
techniques, etc.

Outputs
Operating budgets
Capital budgets
Flexible budgets
Special reports (graphic, tables)
Summaries and Schedules
Segmental income statement
8 | CHAPTER ONE • Introduction to Management Accounting

Figure 1.5

Summary of Financial And Managerial Accounting Points of View

Financial Accounting Viewpoint Managerial Accounting Viewpoint

1. CASH 1. CASH
What is the balance? How much cash should be on hand?
Emphasis is on: Emphasis is on:
General journal entries, Cash budgeting, cash flow, alternative
bank reconciliations, petty cash. uses of cash.

2. ACCOUNTS RECEIVABLE 3. ACCOUNTS RECEIVABLE

What is the amount that is collectible? What should the credit terms be?
Emphasis is on: Emphasis is on:
Estimation of bad debts, factoring, Effect of different credit terms, bad debt
recording of collections. factors, analysis of credit revenue and
expenses.

3. INVENTORY 3. INVENTORY
What is the historical dollar amount that What is the optimum level of inventory?
should be assigned to inventory? Emphasis is on:
Emphasis is on: EOQ models, safety stock, quantity
Inventory cost methods, methods of discounts.
estimating inventory.

4. FIXED ASSETS 4. FIXED ASSETS

What is the unamortized amount? How much plant and equipment is
Emphasis is on: needed?
Depreciation methods, journal entries or Emphasis is on:
trades and retirements. Capacity requirements, capital
budgeting, replacement of equipment.

5. SHORT-TERM DEBT 5. SHORT-TERM DEBT

What amount is owed? How much short-term debt is needed?
Emphasis is on? Emphasis is on:
Recording accrued liabilities and interest Cost of capital, debt/equity ratios, cash
expense. budgeting, and risk.

6. LONG-TERM DEBT 6. LONG-TERM DEBT

What amount is owed? How much long-term debt should be
Emphasis is on: issued?
Amortization of bond premium and Emphasis is on:
discount, accrued interest, and bond Cost of capital, debt/equity ratio, cash
refunding. budgeting, issuance of different types
of securities.
 Management Accounting |9

7. STOCKHOLDERS’ EQUITY 7. STOCKHOLDERS’ EQUITY

What is the amount of stock issued? How much stock should be issued?
How should different types of stock What kind of stock security should be
transactions be recorded? issued?
Emphasis is on: Emphasis is on:
Recording different types of stock Cost of capital, debt/equity ratio, cash
transactions, recording of different types flow, and amount of dividends.
of dividends.

8. SALES 8. SALES
How much were sales? What will the amount of sales be?
Emphasis is on: Emphasis is on:
Recording of sales and purchases Sales forecasting, pricing, cash
transactions. budgeting, methods of increasing
sales.

9. EXPENSES 9. EXPENSES
How much were expenses? What should the amount expenses be?
Emphasis is on: Emphasis is on:
Journal entries, accrued expenses, Budgeting, flexible budgeting cost-
depreciation, bad debts. volume-profit analysis.

The Management Accountant

The management accountant is a professional accountant just like the CPA. He
or she is likely to possess a degree in accounting. However, unlike the CPA, the
management accountant is more likely to work for an industrial firm rather than an
accounting firm. In a manner similar to the CPA, he or she may even be certified.
The Institute of Management Accountants which is the professional organization of
management accountants has over 70,000 members. The IMA gives twice a year a
comprehensive three day exam over the knowledge expected of the management
accountant. Individuals passing all parts of the exam are awarded a Certificate in
Management Accounting (CMA). CMA’s are governed by a set of ethical rules and
are also required to accumulate a certain number of CPE hours each year. The exam
is a difficult test with less than 20% of those taking the exam passing in one setting.
The exam is given in five parts covering the following subject areas: (1) managerial
economics and business finance, (2) organization and behavior, (3) public reporting
standards, auditing and taxes, (4) periodic reporting for internal and external purposes,
and (5) decision analysis, including modeling and information systems. If you are
interested in learning more about the IMA, visit their web site, IMA.COM.
Management Accounting Conceptual Framework
The real business world is extremely complex. The environment in which the
accountant and manager operates has myriads of components which are highly
10 | CHAPTER ONE • Introduction to Management Accounting

interrelated. A successful approach in dealing with complexity is to develop a model

which contains the components of reality that need to be studied and understood.
Most management accounting books have some underlying model; unfortunately,
these authors’ use of the model is seldom well‑defined or clearly presented. This
book is based on a well defined model, somewhat traditional in nature, but different
in approach in that it is explicitly defined and consistently used throughout the book.
Furthermore, a comprehensive management accounting simulation based on the
same model accompanies the book. This management accounting model will facilitate
the understanding of how accounting and management are interrelated and how they
have a mutual dependency upon each other. Furthermore, this model clarifies the
relationship of financial and managerial accounting. This conceptual management
accounting framework is presented in chapter 2.
Summary
Management accounting consists of a body of knowledge that consists of tools
capable of helping management make better decisions. The tools require special
types of information not normally found in the traditional records of the accounting
system. In management accounting, the accounting function is required to provide
a much broader range of information. Also, in management accounting, the role of
the accountant is perceived to be much broader. Consequently, the accountant is
expected to have a much better understanding of marketing, production, and finance
fundamentals. Management accounting is a subject that should be understood by
both management and accountants.

Q.1.1 List six examples of tools that the management accountant could use
to help management to make decisions.
Q.1.2 List several features of management accounting that make it different
from financial accounting.
Q.1.3 What types of activities both financial and managerial does the
accounting department within a business provide?
Q.1.4 In terms of financial statements and from a management accounting
point of view, what kinds of questions does the management accountant
ask?
Q.1.5 In the study of management accounting, what kind of concepts would
you be likely to encounter that are more important than in financial
accounting?

Exercise 1.1 • Financial and Management Accounting Compared

For each item or statement listed below, indicate (4) whether this item or statement
pertains more to financial accounting or to management accounting.
 Management Accounting | 11

Financial Management
Statement/item
Accounting Accounting

Information is made available to management to make a

1
purchase decision.

2 Use of the sales journal to record sales on credit.

“Accounting is the art of recording, classifying, and

3
summarizing transactions and event…”
Use of fixed and variable costs to develop standards for
4
evaluating performance.

5 “Accounting is a service activity…”

Preparation of a segmental contribution income

6
statement.

7 Installation of a payroll accounting system.

8 Installation of a profit planning system.

Installation of a cost system for material, labor, and

9
overhead.
A body of knowledge that uses concepts and techniques
10 from management, marketing, and financial theory and
also uses techniques from economics and mathematics.
More likely to ask the question, what is the correct cash
11
balance?
More likely to ask the question, what is correct cost
12
amount to assign to inventory?
More likely to ask the question, what amount of inventory
13
should be on hand?
More likely to ask the question, how much plant capacity
14
is needed?
Concerned with the procedures for recording issue of
15
stocks and bonds.
Concerned with determining whether to issue stocks or
16
bonds.
The body of knowledge that must be learned to become
17
a CPA.

The body of knowledge that must be learned to become

18
a CMA.

More likely to be concerned with future events and also

19
with the internal events of a company.

More likely to be concerned with historical external

20
events such as transactions already completed.
12 | CHAPTER ONE • Introduction to Management Accounting

Exercise 1.2 • Financial and Management Accounting Compared

For each item or statement listed below, indicate (4) whether this item or statement
pertains more to financial accounting or to management accounting.

Financial Management
Statement/item
Accounting Accounting

The IRS has requested certain invoices and documents

1
to support certain expenses deducted for tax purposes.

The vice president of marketing has requested certain

2
cost estimates concerning a new proposed product.

A customer returned a defective product purchased the

3
previous day. An entry to his account was made.

A significant increase in advertising has been made and

4 a request has been made concerning by how much sales
much increase to offset the increase in advertising.

An income statement showing segmental contribution

5
and segmental net income has been requested.

An analysis of operating expenses in terms of fixed and

6
variable expenses has been requested.

A physical inventory of raw materials has been made and

7
the count compared to perpetual inventory records.

A new sales people compensation plan has been

8 proposed and an analysis of the effect on sales and total
sales people compensation has been requested.

Two supplier have made a proposal concerning the sale

9 and installation of new production equipment. Only one
proposal will be accepted.

10 A new computerized accounting system was installed.

 Management Accounting | 13

Exercise 1.3 • Financial and Management Accounting Compared

For each item or statement listed below, indicate (4) whether this item or statement
pertains more to financial accounting or to management accounting.

Financial Management
Statement/item
Accounting Accounting

1 General Ledger

2 Cost-volume-profit tool

3 Accounts

4 Comprehensive business budgeting

5 Inventory costing using FIFO

6 Recordings sales in the sales journal
7 Making end-of-year adjusting entries
8 Preparing segmental income statements

9 Comparing actual results against standards

10 Preparing income tax forms

11 Preparing manufacturing overhead rates
12 Subsidiary ledgers

13 Use of ratios to evaluate performance

14 Recording materials issued in a materials used summary

Preparing financial statements from an adjusted trial

15
balance
Using incremental analysis to evaluate which equipment
16
to purchase

17 Recording labor incurred in a labor cost summary

Installing a perpetual inventory system to control raw

18
materials

19 Preparing a cost of goods manufactured statement

20 Sending the annual report to stockholders

14 | CHAPTER ONE • Introduction to Management Accounting
 Management Accounting | 15

Management Accounting and Decision-Making

Management accounting writers tend to present management accounting as a

loosely connected set of decision‑making tools. Although the various textbooks on
management accounting make no attempt to develop an integrated theory, there is
a high degree of consistency and standardization in methodology of presentation.
In this chapter, the concepts and assumptions which form the basis of management
accounting will be formulated in a comprehensive management accounting decision
model.
The formulation of theory in terms of conceptual models is a common practice.
Virtually all textbooks in business administration use some type of conceptual
framework or model to integrate the fundamentals being presented. In economic
theory, there are conceptual models of the firm, markets, and the economy. In
management courses, there are models of organizational structure and managerial
functions. In marketing, there are models of marketing decision‑making and channels
of distribution. Even in financial accounting, models of financial statements are used
as a framework for teaching the fundamentals of basic financial accounting. The
model, A = L + C, is very effective in conveying an understanding of accounting.
Management accounting texts are based on a very specific model of the business
enterprise. For example, all texts assume that the business which is likely to use
management accounting is a manufacturing business. Also, there is unanimity in
assuming that the behavior of variable costs within a relevant range tends to be
linear. The consequence of assuming that variable costs vary directly with volume
is a classification of cost into fixed and variable. A description of the managerial
accounting perspective of management and the business enterprise will help put in
focus the subject matter to be presented in later chapters.
16 | CHAPTER TWO • Management Accounting and Decision-Making

The Management Accounting Perspective of the Business Enterprise

The management accounting view of business may be divided into two broad
categories: (1) basic features and (2) basic assumptions.
Basic Features
The business firm or enterprise is an organizational structure in which the basic
activities are departmentalized as line and staff. There are three primary line functions:
marketing, production, and finance. The organization is run or controlled by individuals
collectively called management. The staff or advisory functions include accounting,
personnel, and purchasing and receiving. The organization has a communication or
reporting system (e.g. budgeting) to coordinate the interaction of the various staff
and line departmental functions. The environment in which the organization operates
includes investors, suppliers, governments (state and federal), bankers, accountants,
lawyers, competitors, etc.)
The organizational aspect of the business firm is illustrated in Figure 2.1. This
descriptive model shows that there are different levels of management. A commonly
used approach is to classify management into three levels: Top management, middle
management, and lower level management. The significance of a hierarchy of
management is that decision‑making occurs at three levels.
Basic Assumptions in Management Accounting
The framework of management accounting is based on a number of implied
assumptions. Although no single work has attempted to identify all of the assumptions,

Figure 2.1 • Conventional Organizational Chart

Board of
Directors

President

Vice-President Vice-President Vice-President

Marketing Production Finance

Manager Manager Manager

Cutting Dept Finishing Dept. Finishing Dept.

Accounting
Department

Income
Statement

Balance Sheet
 Management Accounting | 17

the major assumptions will be detailed below. Five categories of assumptions will be
presented:
1. Basic goals
2. Role of management
3. Nature of Decision‑making
4. Role of the accounting department
5. Nature of accounting information

Basic Goal Assumptions - The basic goals or objectives the business enterprise
may be multiple. For example, the goal may be to maximize net income. Other goals
could be to maximize sales, ROI, or earnings per share. Management accounting
does not require a specific of type of goal. However, whatever form the goal takes,
management will at all times try to achieve a satisfactory level of profit. A less than
satisfactory level of profit may portend a change in management.

Role of Management Assumptions - The success of the business depends

primarily upon the skill and abilities of management–which skills can vary widely
among different managers. The business is not completely at the mercy of market
forces. Management can through its actions (decisions) influence and control events
within limits. In order to achieve desired results, management makes use of specific
planning and control concepts and techniques. Planning and control techniques
which management may use include business budgeting, cost‑volume‑profit
analysis, incremental analysis, flexible budgeting, segmental contribution reporting,
inventory models, and capital budgeting models. Management, in order to improve
decision‑making and operating results, will evaluate performance through the use of
flexible budgets and variance analysis.
Decision‑making Assumptions ‑ A critical managerial function is decision‑
making. Decisions which management must make may be classified as marketing,
production, and financial. Decisions may also be classified as strategic and tactical
and long‑run and short‑run. A primary objective of decision‑making is to achieve
optimum utilization of the business’s capital or resources. Effective decision‑making
requires relevant information and special analysis of data.

Accounting Department Assumptions ‑ The accounting department is a primary

source of information necessary in making‑decisions. The accounting department
is expected to provide information to all levels of management. Management will
consider the accounting department capable of providing data useful in making
marketing, production, and financial decisions.
Nature of Accounting Information - In order for the accounting department to
make meaningful analysis of data, it is necessary to distinguish between fixed and
variable costs and other types of costs that are not important in the recording of
business transactions. Some but not all of the information needed by management can
be provided from financial statements and historical accounting records. In addition to
historical data, management will expect the management accountant to provide other
types of data, such as estimates, forecasts, future data, and standards. Each specific
18 | CHAPTER TWO • Management Accounting and Decision-Making

managerial technique requires an identifiable type of information. The accounting

department will be expected to provide the information required by a specific tool. In
order for the accounting department to make many types of analysis, a separation of
costs into fixed and variable will be required. The management accountant need not
provide information beyond the relevant range of activity.
Implications of the Basic Assumptions
The assumption that there are three types of decisions,( marketing, production,
and financial) requires that management identify the specific decisions under each
category. The identification of specific decisions is critical because only then can the
appropriate managerial accounting technique be properly used.
Some typical management decisions of a manufacturing business include:

Marketing Production Financial

Pricing Units of equipment Issue of bonds
Sales forecast Factory workers’ wages Issue of stock
Number of sales people Overtime, second shift Bank loan
Sales people compensation Replacement of equipment Retirement of bonds
Number of products Inventory levels Dividends
Advertising Order size Investment in securities
Credit Suppliers

An understanding of financial statements is critical to the ability of management

to make good decisions. Financial statements, although prepared by accountants,
are actually created by management through the implementation of decisions. The
historical data from which accountants prepare financial statements result from actual
management decisions. The reader and user of financial statements is not primarily
the accountant but management. From a management accounting point of view, it is
management rather than accountants that needs to have the greater understanding
of financial statements.
The income statement and the balance sheet can be viewed as a descriptive
model for decision‑making. Financial statements reflect success or lack of success
in making decisions. Management can be deemed successful when the desired
income has been attained and financial position is considered sound. To achieve
managerial success management must manage successfully the assets, liabilities,
capital, revenue and expenses. Financial statements, then, serve as a ready and
convenient check list of decision‑making areas.
The basic balance sheet equation, of course, is A = L + C. A management
accounting interpretation is that the assets or resources come from the creditors
(liabilities) and the owners (capital). It is management responsibilities to manage
both sides of the equation. That is, management must make decisions about both the
resources (assets) and the sources of the assets (liabilities and capital).
Each item on the balance sheet is an area of management. Stated differently each
item on financial statements represents a critical area sensitive to mismanagement.
 Management Accounting | 19

Cash, accounts receivable, inventory, fixed assets, accounts payable, etc. can be too
large or too small. Given this fact, then, for each item there must be the right amount
or optimum. It is management’s responsibility to make the best decision possible
regarding each item on the financial statements. Gross mismanagement of any single
item could either result in the failure of the business or the downfall of management.
Following are some examples of decisions associated with specific financial
statement items:
Balance Sheet Items Decision
Cash Minimum level
Accounts receivable Credit terms
Inventory Order size
Fixed asset Capacity size
Bonds payable Amount and interest rate
Income Statement Items
Sales Price, number of products, number
of sales people
Salesmen compensation Salaries and commission rate
Advertising Media, advertising budget

The statement that the management accountant will be required to furnish

information not of a historical nature means that the accountant will have to deal
with planned and estimated or future data. Furthermore, much of this data will be
not be found in the historical data bank from which the accountant prepares financial
statements. The management accountant may be required to do analysis requiring
data of an economic nature. For example, analysis of pricing may require data
about the company’s demand curve. Labor cost analysis may require estimating the
productivity of labor relative to various wage rates.
Decision-making in Management Accounting
In management accounting, decision‑making may be simply defined as choosing
a course of action from among alternatives. If there are no alternatives, then no
decision is required. A basis assumption is that the best decision is the one that
involves the most revenue or the least amount of cost. The task of management with
the help of the management accountant is to find the best alternative.
The process of making decisions is generally considered to involve the following
steps:
1 Identify the various alternatives for a given type of decision.
2. Obtain the necessary data necessary to evaluate the various alternatives.
3. Analyze and determine the consequences of each alternative.
4. Select the alternative that appears to best achieve the desired goals or
objectives.
5. Implement the chosen alternative.
6. At an appropriate time, evaluate the results of the decisions against
standards or other desired results.
20 | CHAPTER TWO • Management Accounting and Decision-Making

From the descriptive model of the basic features and assumptions of the
management accounting perspective of business, it is easy to recognize that
decision‑making is the focal point of management accounting. The concept of
decision‑making is a complex subject with a vast amount of management literature
behind it. How businessmen make decisions has been intensively studied. In
management accounting, it is useful to classify decisions as:
1. Strategic and tactical
2. Short‑run and long-run
Strategic and Tactical Decisions
In management accounting, the objective is not necessarily to make the best
decision but to make a good decision. Because of complex interacting relationships,
it is very difficult, even if possible, to determine the best decision. Management
decision‑making is highly subjective.
Whether a decision is good or acceptable depends on the goals and objectives of
management. Consequently, a prerequisite to decision‑making is that management
have set the organization’s goals and objectives. For example, management must
decide strategic objectives such as the company’s product line, pricing strategy,
quality of product, willingness to assume risk, and profit objective.
In setting goals and objectives, it is useful to distinguish between strategic and
tactical decisions. Strategic decisions are broad‑based, qualitative type of decisions
which include or reflect goals and objectives. Strategic decisions are non quantitative
in nature. Strategic decisions are based on the subjective thinking of management
concerning goals and objectives.
Tactical decisions are quantitative executable decisions which result directly from
the strategic decisions. The distinction between strategic and tactical is important in
management accounting because the techniques of management accounting pertain
primarily to tactical decisions. Management accounting does not typically provide
techniques for assisting in making strategic decisions.
Examples of strategic decisions and tactical decisions from a management
accounting point of view include:
Decision items Strategic Decisions Tactical Decisions
Cash Maintain minimum level
without excessive risk Specific level of cash
Accounts receivable Sell on credit Specific credit terms
Inventory Maintain safety stock Specific level of inventory
Price Be volume dealer by Specific price
setting price lower than
competition

Once a strategic decision has been made, then a specific management tool can be
used to aid in making the tactical decision. For example, if the strategic decision has
been made to avoid stock outs, then a safety stock model may be used to determine
the desired level of inventory.
 Management Accounting | 21

The classification of decisions as strategic and tactical logically results in thinking

about decisions as qualitative and quantitative. In management accounting, the
approach to decision‑making is basically quantitative. Management accounting deals
with those decisions that require quantitative data. In a technical sense, management
accounting consists of mathematical techniques or decision models that assist
management in making quantitative type decisions.
Examples of quantitative decisions include:
Decision Quantitative Criterion
Price Maximum income
Inventory order size Minimum total inventory cost
Purchase of new equipment Lowest operating costs
Credit terms Maximum net income/sales
Sales people compensation Minimum total compensation

Short‑run Versus Long-run Decision‑making

The decision‑making process is complicated somewhat by the fact that the horizon
for making decisions may be for the short‑run or long‑run. The choice between the
short‑run or the long‑run is particularly critical concerning the setting of profitability
objectives. A fact of the real business world is that not all companies pursue the same
measures of success. Profitability objectives which management might choose to
maximize include:
1. Net income
2. Sales
3. Return on total assets
4. Return on total equity
5. Earnings per share
The decision‑making process is, consequently, affected by the profitability
objective and the choice of the long-run versus the short-run. If the objective is to
maximize sales, then the method of financing a new plant is not immediately important.
However, if the objective is to maximize short‑run net income, then management might
decide to issue stock rather than bonds to avoid interest expense. In the short‑run,
profits might suffer from expenditures for preventive maintenance or research and
development. In the long run, the company’s profit might be greater because of
preventive maintenance or research and development.
Although the interests of management and the organization may be presumed
to coincide, the possibility of making decisions for the short‑run may cause a conflict
in interests. An individual manager planning to make a career or job change might
have a tendency to make decisions that maximize profitability in the short‑run. The
motivation for pursuing short‑run profits may be to create a favorable resume.
The tools in management accounting such as C-V-P analysis, variance analysis,
budgeting, and incremental analysis are not designed to deal with long range
objectives and decision. The only tools that looks forward to more than one year
22 | CHAPTER TWO • Management Accounting and Decision-Making

are the capital budgeting models discussed in chapter 12. Consequently, the results
obtained from using management accounting tools should be interpreted as benefits
for the short‑run, and not necessarily the long-run. Hopefully, decisions which clearly
benefit the short‑run will also benefit the long‑run. Nevertheless, it is important for the
management accountant, as well as management, to beware of possible conflicts
between short‑run and long‑run planning and decision‑making.
Management Accounting Decision Models
Management accounting consists of a set of tools that have been proven to be
useful in making decisions involving revenue and cost data. Even though many of
the techniques appear to be simplistic in nature, they have proven to be of consider‑
able value. A comprehensive list of the tools and their mathematical nature which
constitute management accounting appears in Appendix C of this book.
The techniques which are also listed in Figure 2.2 are all based on mathematical
equations or mathematical relationships. All of the techniques may be regarded
as mathematical decision‑making models. For example, the foundation of C-V-P
analysis is the equation: I = P(Q) ‑ V(Q) - F. The mathematical models which form the
foundation of every tool are summarized in Appendix C to this book.
The approach described above concerning the use of financial statements as a
check list to identify decision‑making areas may also be used to identify the appropriate
management accounting technique. For every item on financial statements, there is
one or more appropriate management accounting technique.
The following illustrates the association of management accounting tools with
specific financial statement items.

Financial Statement Items Management Accounting Tools

Balance Sheet:
Cash Cash budget
Capital budgeting models
Accounts receivable Incremental analysis
Inventory EOQ models, Safety stock model
Fixed assets Incremental Analysis, Capital budgeting
Income Statement:
Sales C-V-P analysis, Segmental reporting
Incremental analysis
Expenses C-V-P analysis, Incremental analysis
Net income Direct costing
 Management Accounting | 23

Figure 2.2 • Management Accounting Tools

1. Comprehensive business budgeting

2. Flexible budgeting and variance analysis
3. Variance analysis
4. Capital budgeting
5. Incremental analysis
Keep or replace
Additional volume of business
Credit analysis
Demand analysis
Sales people compensation analysis
Capacity analysis
6. Cost-volume-profit analysis
7. Cost behavior analysis
8. Return on investment analysis
9. Economic order quantity analysis
10. Safety stock/lead time analysis
11. Segmental reporting analysis

Decision‑making and Required Information

The assumption that management will use management accounting tools in
making decisions places a burden on the management accountant. Each tool
requires special information. The management accountant will be asked to provide
the specialized information needed. Management accounting texts have traditionally
emphasized the mechanics of techniques with little emphasis on how to obtain the
necessary data. In many cases, the inability to obtain the required information has
rendered a particular technique useless.
The following illustrates the kind of information required for certain selected
tools:

Tools Required Information

Flexible budget Variable cost rates
Variance analysis Standard costs
EOQ models Purchasing cost, carrying cost
Incremental analysis Opportunity cost, escapable costs
Capital budgeting models Future cash inflows, future cash
outflows
Cost‑volume‑profit analysis Variable cost percentage, fixed cost,
desired income
24 | CHAPTER TWO • Management Accounting and Decision-Making

Comprehensive Management Accounting Decision Model

As the above discussion should make clear, decision‑making is a complex network
of interrelated decision variables. Management can face an overwhelming task if it tries
to identify every variable and minute decision relationship. One approach to dealing
with complexity is the development of models, both mathematical and descriptive for
the purpose of simulating only the relevant or more important variables. Management
accounting is, therefore, one approach to simplifying complex relationships by dealing
with key variables and models based on restricting assumptions.
The decision‑making process discussed in this chapter leads to the conclusion
from a management accounting perspective that there is a connecting link between
the following:
1. Financial statement items
2. Strategic and tactical decisions
3. Management accounting techniques
4. Decision‑making information

The relationships among these elements may be summarized by the following

diagram:

Financial Strategic Tactical Management

Statement Items Decisions Decisions Accounting
Tools Information

These relationship as discussed may be used to develop a comprehensive

management accounting decision model for a manufacturing business. The complete
version of this model as it applies to a manufacturing firm from a management
accounting viewpoint is illustrated in the appendix to this chapter as Exhibits I, II, and
III.
Summary
From a management accounting point of view the primary purpose of management
is to make decisions that may be classified as marketing, production, and financial.
The tactical decisions which must be preceded by strategic decisions provide the
historical data from which the accountant prepares financial statements. In addition
to being statements summarizing historical transactions, financial statements may be
regarded as a descriptive model for decision‑making. Every item or element on the
financial statements is the result of a decision or decisions. For each decision, there
exists a management accounting tool that may be used to make a good decision.
However, the management accounting tools can be used only if the management
accountant is successful in providing the information demanded by the particular
tool.
 Management Accounting | 25

Appendix: Management Accounting Decision-Making Model

Exhibit 1 Balance Sheet Model

Strategic Tactical Management Required

Decisions Decisions Accounting Tool Information

Assets

Cash Risk Minimum Cash budget Cash inflows

balance Cash outflows
Amount needed

Accounts Credit Credit terms Incremental analysis Additional sales

receivable Additional ex‑
penses

Inventory Risk Order size, no. of EOQ model Purchasing cost

Materials Quality orders Carrying cost
Risk Supplier Demand
Finished Goods Safety stock Safety models Probability
­distributions

Fixed Assets Capacity Depreciation Capital budgeting Cash inflows/out‑

Purchase/ methods flows
lease Rate of return Present value
tables

Investments Risk/ Number of Capital budgeting Potential dividends

diversification shares / earnings

Liabilities

Accounts pay‑ Leverage Amount to pay/ Cost analysis Interest rate

able not pay Terms of credit

Notes payable Leverage Amount borrow/ ROI analysis Interest rate

Short-term vs. repay Incremental analysis Cost of capital
long-term Interest rate/
lender

Bonds payable Leverage Shares to issue ROI analysis Interest rate

Short-term Shares to retire Incremental analysis Cost of capital
versus Cost of capital ROI data
long-term analysis

Stockholders’
Equity

Common stock Leverage / risk Shares to issue ROI analysis Cost of capital
Amount needed Incremental analysis Cost of issuing
Cost of capital ROI data
analysis

Retained Internal Amount of Incremental analysis ROI data

earnings financing dividend Cost of capital Cost of capital
Risk Type of dividend analysis
26 | CHAPTER TWO • Management Accounting and Decision-Making

Exhibit 2 • Income Statement Model

Strategic Tactical Management Required

Decisions Decisions Accounting Information
Tool

Sales Market share Price Incremental Demand curve

Growth Number of analysis Fixed & variable
territories C-V-P analysis costs
Credit Cost behavior
Additional
volume

Cost of goods sold (See exhibit 3) Amount of EOQ model Probability of

Beginning inventory Risk safety stock Safety stock stock out
Cost of goods mfd. model Purchasing costs
Ending inventory Carrying costs

Gross profit

Expenses

Selling Motivation/turnover Salary Incremental Price of product

Sales people salaries Number of analysis Calls per month
Commissions Motivation/turnover sales people C-V-P analysis Fixed and vari‑
Sales people training Commission able costs
Travel Risk/volume rate Sales forecast
Advertising Number of new Market potential
Packaging Risk people Bad debt prob‑
Bad debts ability
Sales office rentals Amount of
Office operating advertising
Home office
Bad debt
estimate

General and Admin. Effective service Amounts of C-V-P analysis Fixed and vari‑
Executive salaries Turnover salaries able costs
Secretaries
Supplies
Depreciation
Travel

Net income
 Management Accounting | 27

Exhibit 3 • Cost of Goods Manufactured Model

Strategic Tactical Management Required

Decisions Decisions Accounting Tool Information

Materials Used

Materials (BI) Safety stock model Lead time

Demand

Material Quality Budgeted pro‑ Budgeted production Carrying cost

Purchases Standards duction Incremental analysis Purchasing cost
Suppliers EOQ model Demand
Order size
Number of orders
Sales forecast

Freight-in Suppliers Incremental analysis Quantity discount

schedule
List prices

Direct labor Productivity Wage rate Incremental analysis Fixed and variable
Motivation Number of Business budgeting costs
Capacity workers C-V-P analysis Relevant costs
Industry repu‑ Second shift/ Wage rates
tation overtime Productivity rates
New equipment

Variable Capacity Keep or replace Incremental analysis Variable cost rates

manufacturing Wage rates Cost factors
overhead Physical factors

Fixed Manufacturing Overhead

Fixed direct labor Capacity Keep or replace Incremental analysis Fixed and variable
C-V-P analysis product cost

Utilities Capacity Keep or replace Incremental analysis Fixed and variable

product cost

Production Capacity Incremental analysis Fixed and variable

planning product cost

Purchasing & Capacity Incremental analysis Fixed and variable

receiving product cost

Factory Capacity Incremental analysis Fixed and variable

insurance product cost

Depreciation, Capacity Keep or replace Incremental analysis Fixed and variable

equipment product cost

Deprecation, Capacity Incremental analysis Fixed and variable

building product cost

Factory supplies Capacity Incremental analysis Fixed and variable

­product cost
28 | CHAPTER TWO • Management Accounting and Decision-Making

Q. 2.1 List four examples of strategic decisions.

Q. 2.2 List six examples of tactical decisions.
Q. 2.3 What type of financial goals may management set for the business?
Q. 2.4 What is the primary role of management in a business from a
management accounting point of view?
Q. 2.5 In what different ways may decisions be classified?
Q. 2.6 What kinds of information can the management accountant be expected
to provide to management?
Q. 2.7 Explain how financial statements can be used to identify the decisions
that management is required to make.
Q. 2.8 Management accounting consists of a set of tools. For each of the
following tools list the basic information required.
1. Business Budgeting
2. Cost-volume-profit analysis
3. Flexible budgeting
4. Return on investment analysis
5. Segmental contribution income statements
6. Economic order quantity model
7. Incremental analysis
 Management Accounting | 29

Exercise: 2.1 • Strategic and Tactical Decisions

For each item listed below, indicate (4) whether that decision is primarily strategic
in nature or primarily tactical in nature.

Classifying Management Decisions

Strategic Decision Tactical Decision

1 Management has decided to sell on credit.

2 Management has decided to keep the cash balance as

low as possible.

3 Management has set a minimum balance of $100,000

for the cash account.

4 Management has decided to keep the turnover ratio of

management as low as possible.

5 Management has decided for this quarter that an

inventory turnover ratio of 12 is desirable.

6 Management has decided to determine the correct

order size by use of an EOQ model.

7 Management for the current quarter set the safety

stock of raw materials at 1,000 units.

8 Management has decided to use internal financing as

a means of expending the business.

9 Management has decided to issue $10,000,000 in 10

year bonds.

10 Management has decided it wants to be a high volume

seller by setting price to be the lowest in the industry.

11 Management for the current quarter set price at $300.

12 Management has decided to compensate sales people

with an above industry average commission rate.

13 Management for the current quarter set the sales

people commission rate at 10%.

14 Management has decided to motivate factory workers

with a wage rate that is above the industry average.

15 Management has decided that the current quarter

wage rate should be $15 per hour.
30 | CHAPTER TWO • Management Accounting and Decision-Making

Exercise 2.2
In the left hand column is a list of decisions. In the right hand column is a list of
different types of information. For each decision in the left hand column, identify from
the right hand column the type of information that would be helpful in making that
decision.

Decision-making Information

Decision Helpful information Types of Information

1. Increase in price A. Fixed expenses

2. Increase in advertising B. Variable cost rates

3. Increase in material order size C. Demand curve

4. Purchase of new plant and D. Carrying cost of materials

equipment

5. Addition of a new territory E. Purchasing cost of materials

6. Closing of a territory F. Maximum capacity required

7. Increase in credit terms G. Calls per month-sales people

8. Replacement of old equipment H. Escapable expenses

9. Increase in sales people I. Inescapable expenses

commission rate

10. Issue of bonds J. Cost of capital

K. Direct costs

L. Indirect costs

M. Price of product

N. Quantity discount schedule

O. Cost of equipment- different

suppliers
 Management Accounting | 31

Financial Statements for Manufacturing Businesses

Importance of Financial Statements

Accounting plays a critical role in decision-making. Accounting provides the
financial framework for analyzing the results of an executed set of decisions and
makes possible the continuous success of a business or improvement in operations.
Secondly, accounting provides much of the necessary information needed in making
good decisions. Thirdly, the management accountant provides a knowledge of basic
decision-making tools that helps find the best alternative in decision-making.
It is the accountant’s knowledge about preparing financial statements and his or
her abilities to analyze and interpret financial statements that makes the controllership
function in a business so valuable to management. However, it is also important for
management to have a fundamental knowledge of financial statements, particularly
regarding the analysis and evaluation of financial statements to make decisions.
A primary objective of a business is to increase the assets from operations. By
operations is meant all the revenue and expense transactions of a business for a
defined period of time. Since the excess of revenue over expenses (net income)
increases the equity of a business, it is often said that the primary objective is to
increase stockholders’ wealth, assuming the business is a corporation. The success
of a business in financial terms, then, depends on how well management manages
revenues and expenses. In other terms, the decisions that management makes
concerning the operations of the business are of paramount importance. Management
has the responsibility to make the kinds of decisions that generates net income.
Revenues are the inflow of assets caused by the operations of the business. The
term revenue necessarily implies increases in assets. If a transaction does not cause
an increase in an asset, then that transaction is not a revenue transaction. Following
is a list of several types of items that fall under the category of revenue:

Revenue Asset Inflow

Sales Cash or Accounts receivable
Interest Income Cash or interest receivable
Rental income Cash or rent receivable
32 | CHAPTER THREE • Financial Statements for Manufacturing Business

Expenses are the outflow of assets from the operations of the business. Expenses
are caused by activities necessary to generate revenue. When revenues exceeds
expenses as is the goal, the difference is called net income. If a transaction does not
cause a decrease in an asset, then that transactions is not an expense. Following
is a list of several expenses and the asset decrease associated with that particular
expense.

Expense Asset outflow

Cost of goods sold Prepaid insurance
Salaries Expired life of the service value
Supplies expense Supplies
Depreciation, building Expired cost of a building

Technically, the asset outflow associated with salaries is not cash. Payments are
made to workers and other employees because they create something of value. In
more technical terms an expense is the expired value of an asset. A janitor is paid
to clean floors. The thing of value acquired is a clean floor and as long as the floor
remains clean, it is something of value. However, when the clean floor becomes dirty
again, then the value of the clean floor asset has expired. Because many assets have
a very short life, the accountant often simply records the expense even though the
value of the assets at the time of recording has not yet expired.
Often the acquisition of an asset is not paid for immediately and the amount then
owed is called a liability. Liabilities are debts or obligations to pay at some future date
and are a common form of financing in a business. There are three primary sources
of assets in a business: (1) revenues (2) liabilities (3) capital. The five key words
from an accounting viewpoint and also from a management viewpoint are assets,
liabilities, capital, revenue, and expenses.
In one sense, the purpose of management is to make asset, liabilities, capital,
revenue, and expense decisions. Since the income statement shows revenues,
expenses and net income and the balance sheet shows assets, liabilities, and capital,
we can say that the purpose of management is to manage assets, liabilities, capital,
revenue, and expenses. Stated simply, the purpose of management is to manage
financial statements.
Because of the importance of sound operations and financial condition, it is criti-
cally important for both management and accountants to have a sold understanding
of financial statements. While accountants prepare financial statements, it is manage-
ment that creates financial statements through the decisions it makes. Because of
the importance of financial statements, the rest of this chapter is concerned with
presenting the fundamentals of financial statements for a manufacturing business.
The four financial statements of critical value in this text are as follows:
1. Balance sheet
2. Income statement
3. Cost of goods manufactured statement
4. Statement of cash flow
 Management Accounting | 33

Financial statements are based on well defined accounting concepts and

standards, some of which are fairly technical and require some concentrated study to
learn and use. The following is a list of accounting terminology and concepts important
in understanding financial statements for a manufacturing business.

Accounting Terminology
Amortization Depreciation Material used
Accounts receivable Direct cost Net income
Accounts payable Dividends Net operating income
Bonds Finished goods Net income after taxes
Bad debts Fixed assets Perpetual inventory
Credit Factory labor Periodic inventory
Capital Fixed cost Retained earnings
Cash Gain/loss on sale Premium/discount on stock
Common stock Gross profit Premium/discount on bonds
Contribution margin Indirect cost Stockholders’ equity
Cost Inventory Tax expense
Current assets Income taxes Treasury stock
Cost of goods sold Investment Trade-in value
Cost of goods manufactured Manufacturing overhead Variable cost

Hopefully, you have learned these terms in a previous accounting course and
only some review of these terms is needed.
In addition to terminology, there are some accounting concepts and conventions
of a broader nature that involve theory and even, in some cases, considerable
differences of opinion. Some of the important concepts involved in this book are
shown as follows.

Accounting Concepts
Absorption costing Earned/unearned revenue
Accrual basis accounting Inventory costing methods
Accounting control Matching
Cash basis accounting Planning
Cost Standards/principles of accounting
Control Full costing reporting
Deferred charges Contribution basis reporting
Direct costing
Accounting Financial Statement Relationships
In addition to important financial statement terminology, there are a number of
manufacturing financial statement relationships critical to understanding and using
financial statements. These relationships may be summarized as simple mathematical
equations. The most important of these relationships are the following:
34 | CHAPTER THREE • Financial Statements for Manufacturing Business

Cost of Goods Manufactured Statement

Material used = materials (beginning) + material purchases - materials inventory
(ending)
Cost of goods manufactured = materials used + factory labor + manufacturing
overhead + work in process (beginning) - work in process (ending)
Income statement
Cost of goods sold = finished goods (beginning) + cost of goods manufactured
- finished goods (ending)
Finished goods (beginning) plus cost of goods manufactured is often called
goods available for sale.
Net income = sales - cost of goods sold - operating expenses
The difference between sales and cost of goods sold is often reported as gross
profit.
Balance Sheet
Assets = liabilities + stockholders’ equity
Assets = current assets + fixed assets + other assets
Liabilities = current liabilities + long-term liabilities
Stockholders’ equity = common stock + premium/discount on common stock +
retained earnings

Statement of Cash Flow

Change in cash = sources and uses from operations + sources and uses from
financing activities + sources and uses from investing activities.
While the above equations may seem a bit complex and imposing, these
relationships still, nevertheless, form the foundation of financial statements for
a manufacturing company. Since it is critical that managerial decision-makers
understand and use financial statement information, it is essential that the serious
student of management understand these basic financial statement relationships.
A complete set of financial statements for the last period of operations may be
found in chapter 9 of The Management/Accounting Simulation. However, often a
summarized version is easier understand and use for some purposes. Therefore, a
summarized version of the financial statements for the V. K. Gadget Company is now
presented in Figure 3.1.
Analyzing Financial Statements
Understanding financial statements is only the first step in using them. The second
step is to analyze them in order to discover any existing or potential problem areas of
profit performance or financial conditions that needs corrective action. Several tools
exist that may be used including the following:
1. Comparative statements
2. Financial statement ratios
 Management Accounting | 35

Figure 3.1 • Financial Statements

V. K. Gadget Company V. K. Gadget Company
Cost of Goods Manufactured Statement Income Statement
For the 4th Quarter, Year 1 For the 4th quarter, Year 1

Materials Inventory (B) $1,940,160 Sales $17,123,428

Material Purchases 4,892,160 Cost of goods sold 7,878,470
__________ ––––––––––
6,832,320 Gross profit 9,244,958
Materials Inventory (E) 2,065,114 Expenses
__________ Selling 8,733,425
Material used 4,767,206 General and Admin. 924,313
Factory labor 2,787,840 Fixed mfg. overhead 1,889,574
––––––––––
Manufacturing Overhead (V) 323,424
Total expenses 11,547,312
__________ ––––––––––
$7,878,470
___
_________
________ Net operating income (2,302,354)
Other income & expenses 112,500)
Units manufactured 57,027 Income taxes (965,941)
––––––––––
Cost per unit $138.16
___
_________
________
Net loss ($1,448,912)
––––––––––
––––––––––

V. K. Gadget Company V. K. Gadget Company

Balance Sheet Statement of Cash Flow
Dec. 31, year 1 For the quarter Ended, Dec. 31, year 1
Assets
Current Assets $3,731,277 Cash flow from Operating Activities
Fixed assets 6,400,000 Sources $ 17,123,428
Other assets -0- Uses 17,123,428
–––––––––––
–––––––––––
Total Assets $10,131,277
––– Excess of uses over sources -0-
––––––––––
–––––––––
Liabilities
Current liabilities 5,630,523 Cash flow from Investing activities
Long-term -0- Sources -0-
––––––––––– Uses -0-
Total liabilities $5,630,523 –––––––––––
–––––––––––
Stockholders’ Equity -0-
Common stock $6,000,000 Cash flow from financing activities
Premium on common stock 1,000,000 Sources -0-
Retained earning (2,499,246) Uses -0-
––––––––––– –––––––––––
Total stockholders’ equity $4,500,754 -0-
–––––––––––
–––––––––––
Total liabilities and equity $10,131,277 Net decrease in cash $ -0-
–––––––––––
–––
––––––––––
–––––––––
36 | CHAPTER THREE • Financial Statements for Manufacturing Business

The use of ratios is a commonly used method to determine conditions that might
be a current or future problem. The current ratio can be computed to determine if
current assets are sufficient to make payments of current liabilities. The debt/equity
ratio is a good indicator of whether the company is too heavily burdened with debt.
The profit margin percentage is a good measure of the adequacy of net income to
sales. The computation of the return on investment ratio is an excellent benchmark
for determining whether net income is satisfactory or unsatisfactory. Numerous other
ratios may be computed and most elementary accounting textbooks do an excellent
job of discussing the more important ratios. A detailed discussion of ratios is presented
in chapter 17.
Financial Statements: A Model of Decision-making
Also, financial statements may be used as a guide to identifying what financial
statements elements are directly affected by a specific decision. This approach is not
commonly used, but because it is helpful in understanding how decisions affect the
various items of financial statements, it is discussed here now in some detail. For
example, every item on the balance sheet such as accounts receivable or inventory
is the result of the execution of one or more identifiable decision. It is management’s
primary responsibility to manage each element of a given financial statement. Financial
statements, in one sense, are a check list of what management is to manage. This
approach states rather explicitly, as previously discussed, that a primary purpose of
management is to manage assets, liabilities, capital, revenue, and expenses.
To clarify the above statements, the following financial statements of the V. K.
Gadget Company are presented in terms of decisions and required information.
Figure 3.2 •

Cost of Goods Manufactured Statement

Cost Element Decision(s) Information

Required
Material Supplier A, B, C, or D List prices
Order size, material X Quantity discounts
Number of orders, material X Carrying cost
Order size, material Y Cost of placing an order
Number of orders, material Y

Direct labor (variable) Number of factory workers Units of equipment

Wage rate Wage rate function
Budgeted production Production budget

Manufacturing overhead Type of finishing department Capacity required

equipment
Order size of material Carrying cost of inventory
Factory labor compensation Overhead rate
Variable cost rates
Salaries, supervisors
 Management Accounting | 37

These financial statement models presented in terms of decisions and required

information rather than actual values clearly indicate an important point. It is
management rather than accountants that actually creates financial statements. The
financial well being of the company’s operations is clearly the full responsibility of
management.
Accounting Policies and Procedures
While the operating and financial success of a company falls squarely on the
shoulders of management, there is still considerable latitude on the part of accountants
in preparing financial statements. Any accounting system involves rules, standards,
and procedures that can vary from company to company. The overall guiding principle

Figure 3.3 •

Income Statement

Item Decisions Information Required

Sales Price Demand schedule

Credit terms Sales-calls function
Advertising Advertising rates
Commission rate Commission rate function
No. of sales people Calls per quarter
Sales people salary

Cost of goods sold Same as cost of goods Same as cost of goods

manufactured (see above) manufactured and sales
Sales decisions (see above) decisions
Expenses
Advertising Advertising budget Advertising cost

Sales people Number of sales people Demand curve

compensation Commission rate Sales people compensation
Sales people salaries function
Credit expense Credit terms Credit terms function
Credit department expenses
Depreciation Units of equipment and Operating costs
finishing
Department equipment Depreciation rates
replacement

Bad debts Credit terms Credit terms function

Interest expense Bank loans Interest rate

Issue of bonds Cost of capital
Line of credit Discount rate
38 | CHAPTER THREE • Financial Statements for Manufacturing Business

is that once rules, standards, and procedures have been adopted, they should be
consistently applied. In the V. K. Gadget Company, the following procedures and
methods have been adopted.
Figure 3.4 •

Accounting Policies and Procedures

Item Procedure
Material costing method Average costing

Finished goods costing method Average costing

Bad debt method Percentages of sales method

Depreciation of equipment Straight-line

Income format Segmental income statement

Manufacturing overhead costing Direct costing (variable costing)

method

Treatment of common expenses Allocation by sales orders

Income taxes Net income is shown net of taxes

Bond discount Scientific amortization method

Management Accounting Systems

In addition to understanding and utilizing financial statements and financial
accounting tools, it is important that both accountants and management have a good
understanding of management accounting concepts and tools. One of the most
effective tools is comprehensive business budgeting. The objective of comprehensive
budgeting is to prepare a set of financial statements in advance. The end result of the
budgeting process is a planned set of financial statements. A comprehensive budgeting
system for the V. K. Gadget company, the simulated company in The Management/
Accounting Simulation, has been developed and is ready for use. Whether or not
this system should be used is a decision that you would make, assuming you are a
participant in the simulation, and serving in the role of new management. In addition
to the comprehensive budget, other computerized management accounting tools are
available for use. These tools include:
1. Business budgeting
2. Cost behavior
3. Cost-volume-profit analysis
4. Capital budgeting analysis
5. Credit analysis
6. Demand sensitivity analysis
7. Direct costing analysis (variable costing)
 Management Accounting | 39

8. Incremental analysis
9. Inventory management analysis
10. Keep or replace analysis
11. Performance evaluation
13. Return on investment
14. Sales people compensation analysis
15. Segmental contribution reporting
16. Wage rate analysis

If your instructor has adopted this simulation in connection with this text book,
then hopefully your participation in The Management/Accounting Simulation
will give you an experience that will solidly persuade you that in any business the
accounting department is a vital function in the process of decisions being made
and executed. With a proper attitude on the part of accounting towards management
and management towards accounting, the likelihood of better decisions and a more
successful business is greatly increased.
Comparison of Merchandising and Manufacturing Businesses
In order to understand financial statements for a manufacturing business, as a
student you first need a good understanding of financial statements for a merchandising
business. In general, merchandising and manufacturing statements are the same, In
fact, in terms of basic components they are identical.

Figure 3.5 •

Retail Business Manufacturing Business

Income Statement Income Statement

The five basic elements of the income The five basic elements of the income
statement for a retail business are: statement for a manufacturing business are:

1. Sales $100,000 1. Sales $100,000

2. Cost of goods sold 60,000 2. Cost of goods sold 60,000
––––––––– –––––––––
3. Gross profit 40,000 3. Gross profit 40,000
4. Expenses 10,000 4. Expenses 10,000
––––––––– –––––––––
5. Net income $ 30,000 5. Net income $ 30,000
–––––––––
––––––––– –––
––––––––
–––––––

The major difference is in the need to know how to compute cost of goods
manufactured as seen in the following comparison.
40 | CHAPTER THREE • Financial Statements for Manufacturing Business

Figure 3.6 •

Merchandising Manufacturing

Cost of goods sold Cost of goods sold

1. Merchandise inventory (B) $15,000 1. Finished goods inventory (B) $15,000
2. Merchandise purchases 75,000 2. Cost of goods manufactured 75,000
– – –––––– ––––––––
Available for sale 90,000 Available for sale 90,000
3. Merchandise inventory (E) 30,000 3. Finished goods inventory (E) 30,000
– – –––––– – –––––––
$60,000 $60,000
–– –– ––––––
–––––– –– –––––––
–––––––

The Cost of Goods Manufactured Statement

The major difference here is obviously in the need to know how to compute cost
of goods manufactured. A second difference is that in a manufacturing business
inventory that is sold is called finished goods rather than being called merchandise
inventory and cost of goods manufactured has replaced merchandise purchases.
Rather than purchasing goods from another company, the company manufactures
what it sells. The accounting for finished goods is far more complicated than the
accounting for merchandise purchased.
Figure 3.7 •

Cost of goods manufactured

The five basic elements of cost of goods manufactured are:

1. Materials used $ 20,000

2. Factory labor 35,000
3. Manufacturing overhead 25,000
––––––––
Manufacturing costs incurred this period 80,000
4. Work in process inventory (B) 20,000
– –––––––
Total manufacturing costs to be acct. for 100,000
5. Work in process inventory (E) 25,000
– –––––––
$ 75,000
–– –––––––
–––––––

The purpose of the cost of goods manufactured statement is to compute the cost
of goods completed or finished in a given time period. The cost of goods manufactured
is the cost of goods finished this period. Cost of goods manufactured consists of three
basic cost elements: (1) materials, (2) factory labor, and (3) manufacturing overhead.
Materials used is a computation:
 Management Accounting | 41

Materials Used
1. Materials inventory (B) $  5,000
2. Material purchases 25,000

Materials available 30,000
3. Materials inventory (E) 10,000

$20,000

There are two types of inventory systems that may be used in a manufacturing
business: (1) periodic and (2) perpetual. If a periodic inventory system is used, then it
is necessary to compute materials used. If perpetual inventory is used, the inventory
system keeps an accurate perpetual record of materials used and, consequently, it
is not necessary to compute materials used. A record in the cost accounting system
called Materials Used Summary is to record each use of material.
Balance Sheets: Merchandising and Manufacturing Compared
The balance sheet of a manufacturing business in terms of basic elements is
identical to the balance sheet of a merchandising business. The only difference
is in one area, the current asset section. Instead of one inventory account, the
manufacturing business has three inventory accounts:

Merchandising Business Manufacturing Business

1. Assets 1. Assets
Current assets Current assets
Cash $ 50,000 Cash $ 50,000
Accounts receivable 30,000 Accounts receivable 30,000
Merchandise inventory 65,000 Inventory
Fixed assets $ 55,000 Work in process 25,000
–––––––– Materials 10,000
$200,000 Finished goods 30,000
––––––––
–––––––– Fixed assets 55,000
–––––––––
2. Liabilities $200,000
Current liabilities $ 20,000 –––––––––
–––––––––
Long-term liabilities 30,000 2. Liabilities
3. Stockholders’ Equity Current liabilities $ 20,000
Paid-in capital 30,000 Long-term liabilities 30,000
Retained earnings 120,000 3. Stockholders’ Equity
–––––––– Paid-in capital 30,000
$200,000 Retained earnings 120,000
––––––––
–––––––– –––––––––
$200,000
–––––––––
–––––––––
42 | CHAPTER THREE • Financial Statements for Manufacturing Business

Manufacturing Business Transactions and Journal Entries

The manufacturing business has a number of unique transactions not found in a
merchandising business. These transactions as a whole all fall into the manufacturing
costs category. Basically, there are three types of manufacturing transactions:
1. Material
2. Factory labor
3. Manufacturing overhead
The most common of these three types of transactions are the following:
1. Purchase of raw materials
2. Freight on material purchased
3. Material returns and allowances
4. Incurrence of direct factory labor
5. Incurrence of manufacturing overhead
Examples of manufacturing overhead incurred include:
1. Indirect factory labor and indirect material
2. Factory utilities
3. Repairs and maintenance on factory equipment
4. Factory insurance
5. Depreciation on factory equipment
Examples of how to record material, factory labor, and manufacturing overhead
transactions are now presented. These transactions are reflected in the adjusted trial
balance on the next page.
Journal Entries for Basic Manufacturing Transactions
Transaction Journal Entry Debit Credit

1 10,000 units of material X were purchased Material purchases 120,000

for $12 per unit. Accounts payable 120,000

2 Invoice on freight received for material X, Freight-in - materials 2,000

$2,000. Accounts payable 2,000

3 Damaged material X returned, $5,000. Accounts payable 5,000

Material returns 5,000

4 Factory workers paid: Factory labor - Direct 200,000

Direct factory workers $200,000 Mfg. overhead - Indirect labor 50,000
Indirect factory labor $50,000 Payroll payable 250,000

5 Other Manufacturing overhead for the Manufacturing overhead 13,000

month was as follows: Accounts payable 13,000
Factory utilities $5,000 Factory utilities $5,000
Factory repairs and Repairs and main. $3,000
maintenance $3,000 Factory insurance $4,000
Factory insurance $4,000 Factory supplies $1,000
Factory supplies $1,000

6 Depreciation on plant & equipment, $2,000 Mfg. overhead - plant deprec. 2,000
Allowance for depreciation 2,000
 Management Accounting | 43

Manufacturing End-of-Period Journal Entries

R and K Widget Company
December 31, 20xx
Adjusted Trial Balance
Debit Credit

Cash 177,000

Accounts receivable 4,000

Materials inventory 6,000

Work in Process Inventory 8,000

Finished goods Inventory 12,000

Plant and equipment 50,000

Accumulated depreciation, plant and equipment 5,000

Accounts payable 9,000

Common stock 40,000

Retained earnings 100,000

Sales 500,000

Material purchases 120,000

Materials returns 5,000

Freight-in materials 2,000

Direct factory labor 200,000

Manufacturing overhead 65,000

Rent, administrative building 8,000

Salaries, general and administrative 2,000

Office Supplies, general and administrative 5,000 –––––––

– –––––––

659,000 659,000
–– –––––––
––––––– –––––––
–––––––

Additional information:
Materials inventory (ending) $  8,000
Work in Process (ending) $12,000
Finished goods (ending) $11,000
In addition to these normal reoccurring periodic transactions, there are unique
manufacturing end-of-period entries that must be made.
44 | CHAPTER THREE • Financial Statements for Manufacturing Business

End-of-period entries must be made to record:

1. Transfer of materials inventory balance to cost of goods manufactured
2. Transfer of beginning material purchases to cost of goods manufactured
3. Transfer of materials freight-in to cost of goods manufactured
4. Transfer of manufacturing overhead incurred to cost of goods
manufactured
5. Recording of ending balance of material inventory
6. Transfer of cost of goods manufactured account to cost of goods sold
account
7. Transfer of finished goods account balance to cost of goods sold account
8. Recording of ending finished goods inventory
Based on this adjusted trial balance, the end-of-period entries for manufacturing
costs would be as follows:

General Journal - End of Period Entries

Date Debit Credit
Dec. 31 Cost of good manufactured 131,000
Materials return 5,000

Materials inventory 6,000

Materials purchases 120,000

Materials - freight in 2,000

Work in process 8,000

Dec. 31 Cost of goods manufactured 200,000

Direct factory labor 200,000

Dec. 31 Cost of goods manufactured 65,000

Manufacturing overhead 65,000

Dec. 31 Materials inventory 8,000

Work in process 12,000

Cost of goods manufactured 20,000

Dec. 31 Cost of goods sold 388,000

Finished goods 12,000

Cost of goods manufactured 376,000

 Management Accounting | 45

Date General Journal Debit Credit

Dec. 31 Finished goods 11,000

Cost of goods sold 11,000

Dec. 31 Sales 500,000

Income Summary 500,000

Dec. 31 Income Summary 452,000

Cost of goods sold 377,000

Rent - administrative building 50,000

Salaries - general and administration 20,000

Office supplies 5,000

Dec. 31 Income Summary 48,000

Retained earnings 48,000

While the mechanics of preparing financial statements are important to the

accountant, they are not that important to management. It is important that management
understands financial statements in order to use information and relationships on
the financial statements to make better decisions. As discussed at the beginning of
this chapter, each element of financial statements has to be managed and for each
element there are one or more identifiable set of decisions that affects that element.
The important objective is for management to be able to associate certain decisions
with assets, liabilities, capital, revenue, and expenses.
The Accounting Cycle for a Manufacturing Business
The accounting cycle for a manufacturing business is basically the same as the
accounting cycle for a merchandising businesses. The major difference concerns how
certain end-of-period journal entries are made for the manufacturing transactions. As
illustrated above, a cost of goods manufactured account was used in the recording
process. This particular account does not necessarily have to be used; however, if
not used, some other account such as work-in-process has to be used for the same
purpose. The accounting cycle may be summarized as follows:

Step 1 Make journal entries for regular during-the-period transactions including

the transactions for manufacturing costs and post to the accounts in the
general ledger.
Step 2 At the end of the operating period, prepare a trial balance.
Step 3 Make adjusting entries and post to the general ledger.
46 | CHAPTER THREE • Financial Statements for Manufacturing Business

Step 4 Prepare an adjusted trial balance.

Step 5 Prepare financial statements.
Step 6 Make end-of-the-period journal entries:
a. Make entries to transfer appropriate manufacturing costs to the
cost of goods manufactured account.
b. Make regular closing entries for revenue and expense
accounts.

Step 7 Prepare a post closing trial balance.

Please note that the above steps assume that making journal entries and posting
are part of the same step.

Summary
In many respects, the financial statements of a manufacturing firm are similar
to those of a retail type business. However, the existence of certain transactions
concerning material, labor and overhead means that a manufacturing firm does
have basic differences concerning inventory. Whereas a retail firm has one inventory
account, typically called merchandise inventory, a manufacturing business has three
basic inventory accounts: raw materials, work in process, and finished goods. In
addition, because the cost of goods manufactured is critical, a manufacturing firm
typically has a statement called cost of goods manufactured. The accounting for
overhead in a manufacturing firm involves many complexities. The theory of accounting
for manufacturing overhead is usually taught in courses in cost accounting. Except
when necessary, the complexities of manufacturing overhead are not discussed in
this text

Q. 3.1 What three elements are necessary to compute cost of goods sold in a
retail business?
Q. 3.2 What three elements are necessary to compute cost of goods sold in a
manufacturing business?
Q. 3.3 What are five items of information are necessary to compute cost of
goods manufactured?
Q. 3.4 What elements are necessary to compute materials used?
Q. 3.5 What does cost of goods manufactured represent?
Q. 3.6 As the income statement is typically prepared, what are the main
elements that make up the income statement?
Q. 3.7 How does the current asset section of the balance sheet for a
manufacturing business differ from the current asset section of the
balance sheet for a retail business?
 Management Accounting | 47

Exercise 3.1 • Cost of Goods sold

You have been provided the following information:
Retail Business Manufacturing Business
Cash $ 10,000 Cash $ 20,000
Accounts receivable $ 50,000 Accounts receivable $ 60,000
Merchandise inventory (BI) $ 12,000 Cost of goods manufactured $ 150,000
Freight-in $ 1,000 Finished goods (beginning) $ 25,000
Merchandise purchases $ 200,000 Finished goods (ending) $ 15,000
Merchandise inventory (EI) $ 20,000 Selling expenses $ 60,000
Selling expenses $ 50,000

Based on the above information, compute cost of goods sold for both types of
businesses. Some of the above information is not required.

Exercise 3.2 • Cost of Goods Manufactured

Based on the following information, prepare a cost of goods manufactured
statement.
Material purchases $90,000
Factory labor $60,000
Manufacturing overhead $30,000
Materials inventory (beginning) $25,000
Materials inventory (ending) $10,000
Freight-in, Materials $ 5,000
Selling expenses $85,000
General and administrative expenses $30,000
Work in process inventory (beginning) $15,000
Work in process inventory (ending) $20,000
48 | CHAPTER THREE • Financial Statements for Manufacturing Business

Exercise 3.3 • Income Statement

Based on the following information, prepare an income statement. Note: Some of
the information provided is not needed.
Sales $ 300,000
Sales returns $ 50,000
Finished goods inventory (beginning) $ 30,000
Finished goods inventory (ending) $ 25,000
Materials used $ 70,000
Factory labor $ 45,000
Manufacturing overhead $ 30,000
Work in process (BI) $ 11,000
Work in process (EI) $ 5,000
Cash $ 40,000
Selling expenses $ 35,000
General and administrative expenses $ 25,000
Accounts receivable $ 15,000

Exercise 3.4 • Balance Sheet

Based on the following information, prepare a balance sheet. Note: Some of the
information provided is not needed.
Accounts receivable $ 60,000
Plant and Equipment $ 100,000
Allowance for depreciation, P & E $ 10,000
Cash $ 80,000
Finished Goods inventory (ending) $ 15,000
Notes payable (5 year note) $ 55,000
Accounts payable $ 15,000
Bonds payable $ 60,000
Retained earnings $ 80,000
Common stock $ 120,000
Payroll payable $ 20,000
Materials inventory (ending) $ 20,000
Work in process inventory (ending) $ 15,000
Furniture and equipment $ 80,000
Allowance for depreciation, F & F $ 10,000
 Management Accounting | 49

Exercise 3.5 • Financial Statements and Closing Entries

R and K Widget Company

December 31, 20xx
Adjusted Trial Balance
Debit Credit
Cash 11,700
Accounts receivable 400
Materials inventory 2,600
Work in process inventory 1, 800
Finished goods inventory 1,200
Plant and equipment 5,000
Accumulated depreciation, plant and equipment 500
Accounts payable 8,600
Common stock 6,000
Retained earnings 11,000
Sales 40,000
Direct factory labor 13,600
Material purchases 11,900
Depreciation, plant and equipment 2,000
Freight-in materials 1,100
Insurance and taxes, plant and equipment 200
Indirect factory labor 5,800
Rent, administrative building 5,500
Salaries, general and administrative 2,300
Office supplies, general and administrative 1,000
–––––– ––––––

66,100 66,100
––––––
–––––– ––––––
––––––

Additional information:
Materials inventory (ending) $ 2,800
Work in Process (ending) $ 3,200
Finished goods (ending) $ 2,100

Continued on following page

50 | CHAPTER THREE • Financial Statements for Manufacturing Business

Required:
From the above adjusted trial balance, prepare:
1. A cost of goods manufactured statement
2. An income statement
3. A balance sheet

Also, make the journal entries necessary to close the accounts.

 Management Accounting | 51

Classification of Manufacturing Costs and Expenses

Introduction
Management accounting, as previously explained, consists primarily of planning,
performance evaluation, and decision‑making models useful to management in
making better decisions. In every case, these tools require cost and revenue infor‑
mation. A basic assumption of management accounting is that it is the responsibility
of the management accountant to provide the needed cost and revenue information.
Consequently, the management accountant needs a complete understanding of the
different types of costs required by the various models. In Figure 4.1, the major costs
associated with each management accounting tool is listed.
In management accounting, as in financial accounting, it may be said that a major
building block in the conceptual foundation is cost. Both the financial and manage‑
ment accountant must have a sound understanding of the varied and complex rami‑
fications of cost. From a financial accounting viewpoint, a faulty understanding of
cost may cause financial statements to be incorrectly prepared. From a management
accounting viewpoint, an inadequate understanding or use of costs will result in poor
decisions.
There are two broad aspect of the term cost that needs to be understood: cost
classification and cost behavior. Cost classification refers to the separation of costs
into categories for proper preparation of financial statements or for use in deci‑
sion‑making models. Cost behavior refers to the effect that volume (production or
sales ) has on total expenses or costs. In this chapter, both aspects will be discussed
in some depth.
52 | CHAPTER FOUR • Classification of Manufacturing Costs and Expenses

Cost Classification
In accounting, the term cost refers to the expenditure or sacrifice made to acquire
something of value. In financial accounting, all transactions are recorded in terms
of historical cost; that is, the money expended or to be expended at the date of the
transaction. The monetary value associated with an asset acquired is said to be its
cost. Cost is the sacrifice made in resources to acquire another resource. Cost is
measured in monetary units which in the United States is the dollar. For example, a
machine is purchased by paying $4,000 in cash and trading in an old machine having
a sales value of $1,000. The cost of the new machine is $5,000 because resources
worth a total of $5,000 were given in the exchange. Stated differently, resources
worth $5,000 were sacrificed.

Figure 4.1

Tools Cost Information Required

Flexible Budget Fixed and variable costs

Cost‑volume‑profit analysis Fixed and variable costs
Direct costing Fixed and variable costs
Budgeting Planned data, fixed and variable costs
Variance analysis Fixed and variable costs
Incremental analysis Escapable , opportunity, relevant
Segmental reporting Indirect costs, direct costs
Inventory models Purchasing cost, carrying cost
Present value models Cash inflows, cash outflows

Depending on the type of activity and the passage of time, the cost of an asset in
accounting can be classified in several ways. Proper financial reporting and correct
decision‑making require an understanding of the different ways in which costs can
be classified. In Figure 4.2 is a list of costs that pertain to both financial statement
preparation and decision‑making analysis.
For purposes of management accounting, there are three important dual classifica‑
tions of cost that require some understanding: Expired and unexpired, manufacturing
and non manufacturing, and fixed and variable. These three classifications are
somewhat interrelated, particularly concerning financial statements.

Expired and Unexpired Costs

Expired costs or expenses are the used up value of assets. Expired costs are
always shown on the income statement as deductions from revenue. Expired costs
may be thought of as that portion of the asset value benefitting current operations.
It is helpful to think of expired costs as former assets values. To illustrate, supplies
expense is an expired cost. The cost allocated to supplies expense, of course, is
the used portion of supplies, an asset. The relationship between asset values and
expired costs is further illustrated in Figure 4.3.
 Management Accounting | 53

Figure 4.2

Financial Statements Cost Concepts Management Accounting Cost Concepts

(Decision‑making Cost Concepts)
Direct and indirect Relevant and irrelevant
Prime Escapable and inescapable
Joint Sunk
Fixed and variable Fixed and variable
Manufacturing and non manufacturing Opportunity and sunk
Expired and unexpired Incremental
Expenses Direct and indirect
Fixed and variable expenses Mixed, semi-variable
Carrying cost, purchasing cost

Manufacturing Costs/Expenses
The difference between a cost and an expense is frequently misunderstood.
Because the terms variable costs and variable expenses will be used later in this
chapter, and also throughout this book, the difference in meaning between a cost and
a expense will now be clarified.
Technically, there is a difference between a manufacturing cost and a manufac‑
turing expense. The term manufacturing costs usually refers to material used, direct
labor incurred, and overhead incurred in a manufacturing business. Material used,
direct labor, and manufacturing overhead at the time incurred are not expenses; rather
they incurred costs. In the manufacturing process, material, labor, and overhead do
not expire; rather through manufacturing activity they become transformed from one
type of utility to another.
In a manufacturing business, the accountant will debit work in process for mate‑
rials used, direct labor incurred, and manufacturing overhead. Since work in process
is an asset account, it would not be logical to regard material used, direct labor, and
manufacturing overhead as expenses. Expenses cannot be transformed back into
asset values.

Figure 4.3
Asset Values and Related Expenses
Asset Expired
Accounts receivable Bad debts expense
Finished goods Cost of goods sold
Prepaid insurance Insurance expense
Supplies Supplies expense
Building Depreciation

Manufacturing costs, however, do eventually become manufacturing expenses

Material used, direct labor incurred, and manufacturing overhead are first recorded
54 | CHAPTER FOUR • Classification of Manufacturing Costs and Expenses

in inventory accounts (work in process and finished goods) and then become an
expense when finished goods are sold. In a manufacturing business, only the cost
of goods sold account can properly be called a manufacturing expense. Prior to the
sale of finished goods, all manufacturing expenditures remain as unexpired costs.
In order to understand the transformation of manufacturing costs into manufacturing
expenses, you should fully understand the flow of cost as taught in cost accounting.
The flow of cost diagram is shown in Figure 4.4.
The term, variable cost, then primarily refers to the manufacturing costs that are
reflected in the inventory accounts: materials, work in process, and finished goods.
The term, variable expenses, refers to cost of goods sold and to other variable
non manufacturing expenses such as sales people’s commissions. As a student
of management accounting, you should understand, however, that the two terms,
variable expenses and variable costs, are sometimes used interchangeably. Some
writers use the term variable costs to include variable expenses. The technical differ‑
ence is ignored because the theory underlying the use of variable expenses is the
same as for variable costs.
There is one instance in which manufacturing costs and manufacturing expenses
(cost of goods sold) are the same in amount. When sales equal production, that is, all
units manufactured are sold, then manufacturing costs (materials used, direct labor
incurred, and manufacturing overhead incurred) and the manufacturing expense (cost
of goods sold) are equal. Under these conditions, all manufacturing costs including
fixed manufacturing overhead incurred will be included in cost of goods sold.
In terms of financial statements, manufacturing costs appear on the cost of goods
manufactured statement while manufacturing expenses are shown on the income
statement. However, the amount of manufacturing costs are not necessarily reported
on the income statement in the period incurred. Some of the current period manufac‑
turing cost may still reside in finished goods inventory until the inventory is sold.
Figure 4.4 • Flow of Manufacturing Cost

Materials Finished Goods

Direct Labor Work in Process

Manufacturing Overhead
Cost of Goods Sold

Note: The flow lines denote journal entries at the end of the
accounting period to transfer cost.
 Management Accounting | 55

Manufacturing and Non Manufacturing Costs

The distinction between manufacturing and non manufacturing costs is important
because this dual classification is reflected in different types of financial statements
for the manufacturing business: the income statement and the cost of goods manu‑
factured statement. The cost of goods manufactured statement shows all the current
period manufacturing costs while the income statement shows all the current non
manufacturing expenses. In order to understand the direct relationship of the income
statement and the cost of goods manufactured statement, it is necessary to under‑
stand the distinction between manufacturing and non manufacturing costs.
Manufacturing costs may be simply defined as materials used, direct labor
incurred, and manufacturing overhead incurred. These are the costs that are found
on the cost of goods manufactured statement. Non manufacturing costs (techni‑
cally, expenses) are those expenses commonly called selling and administrative.
These are the expenditures incurred in the current period directly for the benefit of
generating revenue. Non manufacturing expenses should not be included in the cost
of inventory. The term is somewhat misleading because the “cost” part of the term
implies unexpired costs when it fact it has reference to expenses. Since “non manu‑
facturing costs” are, in fact, expired costs (expenses), then technically a better term
would be “non manufacturing expenses.”
After some costs have been classified as manufacturing, they are normally further
classified as direct and indirect. Materials used in the manufacturing process are
either used directly or indirectly. Direct material is material that becomes part of the
finished product and, therefore, significantly adds to the weight or size of the product.
If the final product, for example, is a wooden chair, then the wood used to make the
legs, seat, and back is a direct use of material. Materials such as glue and screws,
usually not significant in amount, are often regarded as an indirect use. Also material
issued but not becoming a part of the final product and used for manufacturing objects
such as saw horses or shelves to store paint or other incidental materials would be
regarded as an indirect use of material.
In a similar manner, factory labor is normally classified as either direct or indirect.
Consequently, two types of labor are recognized: direct factory labor and indirect
factory labor. Direct factory labor is the cost of labor incurred while work is done on
the product itself. Normally, in one way or another, direct labor affects the physical
appearance of the product. Some factory workers do not actually work on the product
itself but provide services necessary to the over-all manufacturing process. Janitorial
services, repair and maintenance service, supervision of direct workers, and computer
support are examples of labor incurred that would be regarded as indirect.
The significance of classifying material and labor as an indirect cost is this: indirect
material and indirect factory labor are recorded as manufacturing overhead and,
therefore, becomes a part of the cost of the final product through the use of overhead
rates. The recording of direct and indirect manufacturing cost may be illustrated as
the following journal entry:
56 | CHAPTER FOUR • Classification of Manufacturing Costs and Expenses

Date Accounts Debit Credit

Dec. 31 Work in process (direct material) 100,000

Work in process (direct factory labor) 250,000

Manufacturing overhead (indirect material) 20,000

Manufacturing overhead (indirect labor) 50,000

Materials inventory 120,000

Factory labor 300,000

Although the classification of costs as manufacturing and non manufacturing is

very important in preparing financial statements, this distinction is not essential from
a decision‑making viewpoint. The important point is that the tools of management
accounting are equally important in both categories of cost. Important decisions in
both areas can benefit from the use of management accounting tools. Figure 4.5
shows examples of specific decisions in both classifications.
Fixed and Variable Cost
The most volatile variable in a business is considered to be volume. A funda‑
mental fact of all businesses is that some costs change (increase or decrease) with
changes in volume (activity). The costs or expenses that change with volume are
called variable while those that do not change with changes in activity are called
fixed. The classification of costs as fixed and variable is by far the most useful and
helpful classification of costs in management accounting. Furthermore, the recogni‑
tion of fixed and variable costs has resulted in several mathematical models useful in
analyzing cost data for decision‑making purposes.
Some decisions such as a decrease in price or an increase in advertising can
have an immediate impact on volume. In most instances, management will want to

Figure 4.5
Relationship of Cost Classification and Decision-making
Classification of Costs Example of Decisions
Manufacturing
Material Suppliers, quality of material
Labor Wage rate, number of hours
Manufacturing Overhead Cost of equipment, repairs and maintenance

Non Manufacturing Costs (expenses)

Sales People Compensation Commission rate
Advertising Media, advertising budget
Staff salaries Salary, working hours
 Management Accounting | 57

test decisions before execution. In management accounting, a number of planning,

evaluating, and decision‑making models have been developed to account for the
effect that a change in volume has on total costs. The decision‑making models in
this text that require fixed and variable costs inputs are: cost‑volume‑profit, direct
costing, flexible budgeting, variance analysis, and profit planning (budgeting). Other
tools such as incremental analysis and present value models may benefit from a
classification and measurement of costs as fixed and variable.
The detailed study of fixed and variable costs in management accounting is
commonly called the study of cost behavior. Since cost behavior, or the study of
fixed and variable costs, is so fundamental to many management accounting tools,
it represents the first area of management accounting that must be studied in depth.
The next chapter will be devoted to the study of cost behavior. The study of cost
behavior will be divided into two parts: (1) theory of cost behavior and (2) techniques
of measuring cost behavior.
Illustrative Problem
Figures 4.6, and 4.7 present a type of income statement, cost of goods manufac‑
tured statement, and balance sheet commonly used in manufacturing businesses.
Certain income statement and balance sheet items have been identified by number.
Fourteen items have been selected. To test your understanding of each cost selected,
categorize the selected costs as follows:
1. Manufacturing
2. Non Manufacturing
3. Expired
4. Unexpired
5. Variable cost
6. Variable expense
7. Fixed cost
8. Fixed expense

Figure 4.6

Acme Manufacturing Company

Cost of Goods Manufactured Statement

Material used (1) $3,000

Direct labor (2) 4,000
Manufacturing overhead (3) 5,000
Work in process 2,000
________
Total manufacturing costs 14,000
Work in process (ending) 1,000
________
Cost of goods manufactured (4) $13,000
___
_______
______
58 | CHAPTER FOUR • Classification of Manufacturing Costs and Expenses

Figure 4.7

Acme Manufacturing Company Acme Manufacturing Company

Income Statement Balance Sheet
Sales $20,000 Assets
Cost of goods sold: (5) Cash $ 1,500
Finished goods (B) 2,000 Materials (11) 500
Cost of goods manufactured 13,000 Work in process (12) 1,000
Finished goods (13) 3,000
15,000
Plant and equipment (14) 10,000
Finished goods (E) 3,000
Total assets $16,000
12,000

Gross profit 8,000 Liabilities

Accounts payable 2,000
Expenses
Bonds payable 5,000
Selling
Sales people commissions (6) 2,000 $ 7,000
Advertising (7) 800
Rent (8) 200 Stockholders’ equity
Common stock $ 8,000
3,000
Retained earnings 1,000
Administrative
Salaries (9) 1,500 9,000
Supplies (10) 500
Total liabilities and
2,000
stockholders’ equity $16,000
Total expenses 5,000

Net income $ 3,000

The importance of understanding the classification of cost can be best appre‑

ciated by examining the financial statements of a manufacturing business. An
examination of the above statements shows that the classification of costs as expired
and unexpired, manufacturing and non manufacturing, and fixed and variable are
highly interrelated.
1. Manufacturing costs ‑ Items 1, 2, 3 ,4
2. Non manufacturing costs ‑ Items 6, 7, 8, 9, 10
3. Expired costs ‑ Items 5, 6, 7, 8, 9, 10
4. Unexpired costs ‑ Items 11, 12, 13, 14
5. Variable costs ‑ Items 1, 2, 3 (only the variable portion)
6. Variable expenses ‑ Items 5, 6
7. Fixed costs - Item 3 (only the fixed portion)
8. Fixed expenses ‑ Items 7, 8, 9, 10
 Management Accounting | 59

Summary
The importance of understanding different kinds of cost in management
accounting can not be understated. Management accounting, as stated several times
before, consists of various decision-making tools. Each tool requires different kinds
of cost information. Without a good understanding of different kinds of cost and cost
behavior, it is highly unlikely any specific tool could be used in a meaningful way to
improve the quality of decisions.
The cost concepts that need to be understood in order to fully understand and be
able to use the various management accounting tools are the following:
1. Relevant and irrelevant 6. Fixed and variable
2. Direct and indirect 7. Manufacturing and non manufacturing
3. Prime costs 8. Expired and unexpired
4. Escapable and inescapable 9. Opportunity and sunk costs
5. Joint costs 10. Mixed and semi-variable

Q. 4.1 List the ways in which costs and expenses can be classified.
Q. 4.2 Explain the difference between:
a. Direct material and indirect material
b. Direct labor and indirect labor
c. Manufacturing and non manufacturing costs
d. Fixed and variable costs
e. Expired and unexpired costs

Q. 4.3 What are the two primary measures of volume or activity in a

business?
Q. 4.4 Why is an understanding of cost behavior and cost classification
important in management accounting?
Q. 4.5 Explain how manufacturing costs become an expense.

Exercise 4.1 • Classification of Costs/Expenses

In the course of running the operations of a business, many different kinds of

transactions take place. In a manufacturing business, transactions are often classi‑
fied as manufacturing or non manufacturing. In making decisions, it is important to
distinguish between manufacturing accounts and non manufacturing accounts. This
distinction is necessary in order to prepare the cost of goods manufactured statement
and the income statement.
A list of account items is given below. For each account item, indicate by a check
mark ( 4 ) the category in which the account item is normally classified. There are
60 | CHAPTER FOUR • Classification of Manufacturing Costs and Expenses

a few items in the list that do not fall into the manufacturing and non manufacturing
categories and should not be checked. Only one column for each item should be
checked.

Manufacturing Non Manufacturing

Cost/expense item Materials Factory Manufacturing Selling General and

Labor Overhead Expenses Administrative

Executive salaries ( ) ( ) ( ) ( ) ( )

Material X purchases ( ) ( ) ( ) ( ) ( )

Factory supplies ( ) ( ) ( ) ( ) ( )

Advertising ( ) ( ) ( ) ( ) ( )

Depreciation, factory ( ) ( ) ( ) ( ) ( )
equipment

Freight-in - material X ( ) ( ) ( ) ( ) ( )

Finished goods ( ) ( ) ( ) ( ) ( )

Factory labor, cutting ( ) ( ) ( ) ( ) ( )

department

Sales people training ( ) ( ) ( ) ( ) ( )

cost

Supervision labor- ( ) ( ) ( ) ( ) ( )
factory

Sales people salaries ( ) ( ) ( ) ( ) ( )

Factory labor, ( ) ( ) ( ) ( ) ( )
assembling department

Secretarial salaries ( ) ( ) ( ) ( ) ( )

Home office expense ( ) ( ) ( ) ( ) ( )

Utilities, factory ( ) ( ) ( ) ( ) ( )

Material Y purchases ( ) ( ) ( ) ( ) ( )

Sales people travel ( ) ( ) ( ) ( ) ( )

expense

Cash ( ) ( ) ( ) ( ) ( )

Allowance for bad debts ( ) ( ) ( ) ( ) ( )

Factory workers training ( ) ( ) ( ) ( ) ( )

cost
 Management Accounting | 61

Exercise 4.2 • Expired and Unexpired Costs

For each item listed below check ( 4 ) whether the item is an expired cost or an unexpired
cost.

Item Expired cost Unexpired Cost

1. Interest expense
2. Supplies
3. Insurance expense
4. Building cost
5. Accounts receivable
6. Prepaid property tax
7. Bad debts
8. Depreciation expense, building
9. Prepaid insurance
10. Supplies expense
11. Prepaid Interest

Exercise 4.3 • Fixed and Variable Costs/expenses

For each item listed below check ( 4 ) whether the item is a variable cost or a fixed cost.

Item Variable Cost/expense Fixed Cost/expense

1. Direct material issued
2. Direct factory labor incurred
3. Salaries of executives
4. Compensation of accountants
5. Sales people commissions
6. Materials used to package finished
goods
7. Executives compensation
8. Monthly rent on building
9. Electric power used to run A/C
units in the summer time
10. Advertising expense for the year
62 | CHAPTER FOUR • Classification of Manufacturing Costs and Expenses
 Management Accounting | 63

Management Accounting Theory of Cost Behavior

Management accounting contains a number of decision‑making tools that require

the conversion of all operating costs and expenses into fixed and variable components.
The responsibility for providing this cost behavior information falls squarely upon
the shoulders of the management accountant. The conversion of ordinary financial
data as typically found in the general ledger accounts requires that the management
accountant have a thorough understanding of cost behavior theory.
The identification and measurement of fixed and variable costs is somewhat
complicated by the fact that some costs are fixed or variable at the discretion of
management, while other costs are not. Furthermore, for those expenditures that are
inherently variable, management has the ability, within limits, to control the magnitude
of the variable cost factors. In order to exercise this control, management also needs
a solid understanding of the nature of cost behavior.
In management accounting, the classification and measurement of fixed and
variable cost is based on a body of knowledge that involves a number of assumptions.
In many cases, the usefulness of fixed and variable cost data depends on the validity
of these assumptions. In order to avoid poor operating results and faulty decision-
making that is likely to occur when false cost assumptions are made, the ability to
recognize and measure cost behavior is essential. The remainder of this chapter will
examine in some depth the theory of cost behavior.
Management Accounting Theory of Variable Costs
The most volatile variable in any business is volume; that is, units produced or
units sold. A change in volume has an immediate impact on variable costs. Variable
costs are those costs that increase or decrease with corresponding changes in
volume. However, the exact relationship between total variable cost and volume in
practice is not always easy to describe or measure. Therefore, in both management
accounting and economic theory, the relationship between volume and total variable
cost is often determined by assumption.
64 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

In management accounting theory, the relationship between volume and total

variable cost is presented as a continuous linear function; that is, a straight line when
plotted on a graph. In economic theory, the relationship is assumed to be curvilinear.
These differences in assumptions, which are illustrated in Figure 5.1, need to be
clearly understood.
Figure 5.1
Management Accounting Economic Theory

Total Variable Cost - Management Accounting Total Variable Cost - Economic Theory

120000 250000
100000 200000
80000 150000
Cost

Cost
60000 100000
40000
50000
20000
0
0
0 5000 10000 15000

00
00

00

00

00
30
10

50

70

90
Volume Volume

The assumption of a curvilinear relationship is probably more realistic; however,

there are special reasons why the relationship is assumed linear. The reasons for
use of straight‑line relationships will be explained later in this chapter. At this point,
you should keep in mind that all management accounting models requiring fixed and
variable cost data assume that the relationship between total cost and volume is direct
and proportionate; that is, on a graph the relationship is seen as a straight‑line.
Variable costs are those costs that increase or decrease in direct proportion to
changes in activity or volume. Variable costs are caused by activity. In other words,
at zero activity there would be no variable costs. Some typical examples of variable
costs and expenses directly resulting from either production or sales activity would
include the following:
Manufacturing Variable Costs Selling Variable Expenses
Material used Commissions
Direct labor Supplies
Manufacturing overhead Salesmen travel expense
Utilities for machines Packaging
Supplies Travel

The ability to identify and measure variable costs from historical cost data is often
important. The measurement of variable cost is enhanced by an understanding of why
some costs are variable in nature. Variable costs increase or decrease with activity
because there is a fixed relationship between a single unit of output and certain
 Management Accounting | 65

physical and cost factors. For example, assume that a furniture manufacturer makes
a table consisting of four 30” legs and a plywood top measuring 3’x 5’. Each leg costs
$2 and the plywood top can be purchased for $4.00. Therefore, due to the material
design specifications of the table, the material cost of each table manufactured is
$12( 4 legs x $2 + $4 for top). Assuming production increments of 100, at different
levels of production total material cost would be:
Cost per Total Material
Production Unit Cost
100 $12 $1,200
200 $12 $2,400
300 $12 $3,600
400 $12 $4,800
Notice that the increase in total cost is directly proportionate to the increase
in volume. For example, an increase from 200 to 400 units (a 100% increase)
would result in a corresponding 100% increase in total cost. The physical material
specifications of the table design create a fixed relationship between a unit of product
( the table) and the amount of material used. As unusual as it may sound, it is this
fixed relationship that causes the direct variability of cost. For other types of variable
costs such as direct labor, there are similar fixed relationships.
Methods of Explaining and Presenting Cost Behavior
The concept of variable cost is obviously important to both accountants and
management. Communication of cost behavior from the accountant to management
is also critically important. The presentation of cost behavior may be done in three
ways: tabular, mathematical, and graphical.
Tabular presentation - A common method is to present cost behavior in the form of
a table. For example, in the illustration above cost behavior was presented in tabular
form. In terms of including more manufacturing costs at different levels of activity, the
table on the next page is an example of the tabular method.
The advantage of this method is that the variable cost at set intervals of activity
can be seen without first doing any math. However, some computations are necessary
when cost is needed at an activity level for which a special column does not exist.
Mathematical Presentation - Because in management accounting the relationship
between variable cost and volume is assumed, linear total variable cost may be
defined by the following equation:
TVC = V(Q) (1)
Where:
V = variable cost rate and Q = quantity (units sold or units manufactured).
Mathematically, TVC represents the dependent variable and Q or quantity
represents the independent variable. Mathematically speaking, V may be called
the constant of variation.
Let V = $12 and Q = 1,000
Then TVC = 12(1,000) = $12,000
66 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

Given a rate of $12 per unit and at a volume of 1,000, total variable cost is
$12,000.

Manufacturing Variable costs

Variable
Cost Volume (units of product)
Rate

1,000 2,000 3,000 4,000 5,000

Material $10 $10,000 $20,000 $30,000 $40,000 $50,000
Factory Labor $ 8 $ 8,000 $16,000 $24,000 $32,000 $40,000
Manufacturing overhead $ 5 $ 5,000 $10,000 $15,000 $20,000 $25,000

Total variable cost is completely determined by the variable cost rate and the level
of activity. Given a specified value for V, total variable cost for any level of activity can
be easily computed.
The key to understanding variable cost behavior is a knowledge of V, the variable
cost rate. V represents the average variable cost rate. The major assumption
underlying the equation, TVC = V(Q), is that regardless of the level of activity the
average variable cost rate will remain the same. From this assumption results the
linear relationship between volume and total variable costs. As long as V remains
unchanged, the effect of changes in volume will be direct and proportionate. In other
words, the relationship is linear. Regardless of how cost behavior is communicated,
the foundation of cost behavior remains at its core mathematical in nature.
Graphical Presentation ‑ The behavior of variable cost can be illustrated graphically.
As true of all mathematical equations, by assigning different values to Q, the
independent variable, the resulting dependent values can be plotted on a graph. To
illustrate, assume a variable cost rate of $12 and activity increasing in increments of
100. The graph in Figure 5.2 may be drawn:

Figure 5.2

Variable Cost Graph

7,200
Q V TVC
4,800
100 $12 1,200
Cost

2,400
200 $12 2,400
300 $12 3,600 0
0 200 400 600
400 $12 4,800
Volulme (quantity)

2A 2B
 Management Accounting | 67

In Figure 5.2A, the relationship between volume and variable cost is shown
in tabular form. In many cases, management prefers to see costs is this fashion.
However, the graphical portrayal is more effective in demonstrating the theoretical
nature of variable costs from a management accounting viewpoint. The increase in
cost resulting from increases in volume can easily be visualized. It is interesting to
note that V, the variable cost rate, from a mathematical viewpoint measures the slope
of the total variable cost line. The greater the value of V the steeper the slope. The
affect on slope of the line for different values of V is illustrated in Figure 5.3. As the
rate increases, the slope also become steeper.

Figure 5.3

Variable Cost: Effect of change in slope of line

200000

150000
V = 12
Cost

100000 V= 14
V = 16
50000

0
0 5000 10000 150000

Volume (quantity)

As explained previously, V may be interpreted as the average variable cost rate.

One method of computing V is to divide the total variable cost by the related level of
activity; that is, AVC = TVC / Q. Graphically, average variable cost may be illustrated
as shown in Figure 5.4.

Figure 5.4 A Figure 5.4 B

Accounting Theory:Graph of Average Economic Theory: Average Fixed Cost

Variable Cost
6.00 7.00
6.00
5.00
5.00
4.00
Cost

4.00
Cost

3.00 3.00
2.00 2.00
1.00
1.00
0
0
1000

2000

3000

4000

5000

6000

7000

8000

9000

10000
0

1000

2000

3000

4000

5000

6000

7000

8000

9000

Volume (quantity) Volume (quantity)
68 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

Graph A visually illustrates an important management accounting assumption

concerning variable cost: changes in volume have no effect on the average variable
cost rate. In contrast, the average variable cost curve in economic theory is presented
as a U‑shaped curve as illustrated in Figure 5.4B. The justification of a constant
average variable cost will be explained in a later section of this chapter.
Variable Cost Rate Components ‑ Variable costs can be discussed at two levels:
the aggregate and micro levels. At the aggregate level, V represents the sum of the
individual variable costs rates. Variable costs/expenses are commonly classified as
material, labor, overhead, selling, and administrative. Consequently, from a micro or
analytical viewpoint, V is the aggregate of these individual rates. Mathematically, the
average variable cost rate or V may be defined as:

V = V  m + V  l + V  o + V  s + V  a

Where:
V  m - variable material cost rate
V  l - variable labor cost rate
V  o - variable overhead rate
V  s - variable selling expense rate
V  a - variable administrative rate

In theory the variable cost rate, or V, also may be computed from historical data
by dividing the total variable cost by the related level of activity; that is, from a macro
point of view V = TVC / Q. However, in practice the computation of V in this manner
is not always easy. Very seldom is the total variable cost known without considerable
analysis of cost data at a subclassification or micro level. The computation of V is,
therefore, likely to be preceded by an analysis of variable cost in terms of material,
labor, manufacturing overhead, selling, and administrative costs. After measurement
of the individual rates, the aggregate rate is simply the sum of the individual variable
cost rates.
Illustration of Using Cost Behavior
The management of K. L. Widget Company is considering closing out a plant
that has been operating at a loss. Management is tentatively planning to increase
advertising and certain other fixed expenses that should increase sales to $300,000
or 15,000 units. The selling price of the Widget is currently $20.00. Fixed expenses
including the proposed increases is $110,000.
Variable costs have been determined to be:
Material (V m) ‑ $5
Labor (V l) ‑ $3
o
Variable M/O (V  ) - $1
Selling (V s) ‑ $3
a
Administrative (V  ) ‑ $1
If the increased expenditures do not result in a profit, then the plant will be closed.
Should the proposed expenditures be made and the plant kept open?
 Management Accounting | 69

Analysis:

V = V m + V l+ V o + V s + V a = ($5 + $3 + $1 + $3 + $1) = $13

TVC = V(Q) = $13(Q)
Sales (15,000 units) $300,000

Variable costs ($13 x 15,000) $195,000

Fixed expenses $110,000
Total expenses $305,000
Net loss ($ 5,000)

Decision: Close the plant as the plant would still operate at a loss. The computation
of total cost at the new level of activity is still greater than revenue.
Managerial Decisions and Variable Costs
An important point that needs understanding is that some costs are not inherently
fixed or variable but become one or the other by management exercising its
decision‑making powers. Management has the discretionary power to make some
costs either variable or fixed. For example, sales people compensation can be either
fixed or variable. If management decides to reward sales people on the basis of a
commission, then sales people’s compensation is variable. If the basis for rewarding
sales effort is a salary, then sales people’s compensation is a fixed expense. If factory
workers are paid a wage rate, then factory workers’ compensation is variable. The
decision to pay workers a salary would make the factory labor compensation a fixed
cost in the short- run.
Some expenditures are unavoidably variable. For example, the direct use of
material will always be a variable cost. However, this per unit cost of material is to a
large extent controllable by the decision‑making powers of management. The total
material variable cost may be defined by the equation:
TVMC = V m(Q) (2)
In this equation V m, represents the variable material cost rate. V m is the amount
of material cost incurred per unit of product manufactured. The variable material rate,
V m,; however, is the result of two factors: units of material per unit of product and the
cost per unit of material. For example, if a product requires 6 units of material and the
material cost per unit is $2, then the material variable cost rate would be $12. V m,
then, may be defined by the following equation:
V m = U m x C m
Where:
U m = number of units of material and C m = cost per unit of material.
As this example illustrates, the number of units and the cost per unit are, within
limits, controllable by management. For example, in the manufacture of furniture the
variable cost rate for material could be decreased by the decision to use less material.
70 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

Management might use 1/2 inch wood rather than 3/4 inch. Also management could
lower the variable cost rate by deciding to purchase from another seller of material
whose price is lower or management might decide to use a lower quality material
such as particle board.
As will be explained later, the average variable cost can be computed from
historical data, however, you should remember that at any given moment management
can change the variable cost rate by making decisions directly affecting the physical
and cost factors that determined the variable cost rate.
Another example of an cost that is unavoidably variable is direct labor when the
method of compensation is a wage rate. The equation for direct labor is:
TVLC = V L(Q) (3)
In this equation,V Lrepresents the variable labor cost rate. It is the dollar amount
of labor incurred each time one unit of product is manufactured. As in the case of
material, V L is the result of two factors–labor hours per product and the wage rate.
For example, if a product requires two hours of labor and the wage rate is $10 per
hour, then the variable direct labor rate would be $20. V L then may be defined by the
following equation:
V L = H L x R L
Where:
H L denotes the standard hours per product and R L the wage rate.
The important principle to remember is that for most types of variable costs,
the factors that determine the variable cost rates can be identified. Furthermore,
in all cases these fixed factors, within limits, can be changed by explicit decisions
on the part of management. In Figure 5.5, a summary of the fixed factors for the
five classifications of variable costs is presented. In addition, management’s ability
to affect the magnitude of the variable cost rates through decision-making is also
revealed. For example, management may be able to reduce the variable cost rate
for material by finding a supplier willing to sell the same grade of material at a lower
price.
Variable Cost Behavior and Linearity
In management accounting, the relationship between activity and total variable
cost is assumed to be linear. There are several reasons for this assumption.
First, mathematical equations involving curvilinear relationships can be quite
complex. Furthermore, fitting cost data to nonlinear equations may be difficult.
Although the use of nonlinear equations may be preferable, the use of linear equations
which are much easier to use has been found to be useful.
Also, in many cases, actual cost behavior for a significant portion of the activity
range tends to be linear. The use of standard measurements and automated equipment
in many cases results in a uniform rate of output. Within a relevant range of activity,
the cost per unit of output is the same. Consequently, the use of linear relationships
in management accounting is justified only in what is called the “relevant range of
activity.” If the cost per unit of output sharply changes outside of this range of activity,
 Management Accounting | 71

Figure 5.5

Variable Cost Factors

Variable costs Fixed factors per Variable cost Rate
unit of product
(physical and cost)

Material units of material (U m) V m = U m x C m

cost per unit (C m)

Direct labor hours per unit (H L) V L = H L x R L

wage rate per hour  
(R L)

Overhead * units of service (U o) V o = U o x C s

cost per unit of service (C s)

Selling ** units of service (U s) V s = U s x C s

cost per unit of service (C s)

Administrative units of services (U a) V a = U a x C s

cost per unit of service (C s)

* Examples of units of overhead service include factory supplies, quarts of oil, kilowatt hours,
repair hours, etc.
** Examples of selling service units include supplies, credit checking time, wrapping
or packaging, accounting time, etc.

then the use of a constant average cost per unit values should be avoided. The
concept of the relevant cost range is illustrated in Figure 5.6.
Management Accounting Theory of Fixed Costs
In order to be used, many management accounting decision-making models
explicitly require that all costs be classified as either fixed or variable. On the surface,
it would appear that the measurement and use of fixed costs is fairly simple matter.
After variable costs have been measured, the remaining costs may be treated as
fixed. However, the very nature of fixed costs presents conceptual problems that far
exceeds those pertaining to variable costs.
While direct material and direct labor are variable in nature, manufacturing
overhead may be both variable and fixed. The accounting for fixed costs is at the same
time a problem of accounting for manufacturing overhead. An understanding of fixed
manufacturing overhead also requires an understanding of the concepts underlying
the setting of fixed overhead rates. Because of the complexity of accounting for fixed
manufacturing costs, two theories exist, absorption costing and direct costing. These
two approaches treat fixed manufacturing overhead quite differently.
Fixed costs provide capacity to manufacture or to sell. When actual activity is
less than capacity available, a major problem exist. Theoretically, the portion of
unused capacity cost should be measured as idle capacity cost and not treated as
72 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

a production cost. In practice, many firms do not measure idle capacity cost. The
consequence is that the per unit cost of goods manufactured varies significantly with
the percentage of capacity utilized. For example, assume that the fixed cost of the K.
L. Widget Manufacturing Company is $10,000, and that the firm has the capacity to
manufacture 10,000 units. When the firm manufactures 1,000 units, the cost per unit
is $10. However, when only 500 units are manufactured the cost per unit is $20 and
when volume is 10,000 the cost is $1 per unit
A second serious problem exists concerning the measurement of fixed costs.
The term “fixed” costs implies that changes in volume have no effect on the costs
classified as such. Certain management accounting models previously identified in
this book are based on the assumption that the costs identified as fixed hold constant
over a range of activity. However, the assumption that these costs remain constant
from zero activity to the limit of capacity is not always true.
In reality, costs defined as fixed seldom hold constant over the entire range of
activity. Only in very small businesses with limited changes in activity would some
fixed costs not vary. In most businesses, and in large businesses in particular, fixed
costs classified as fixed in management accounting are actually step cost. When
significant increases in activity occur, additional staff, equipment, and other resources
involving fixed costs must be acquired.
A graphical illustration of fixed and step cost is shown in Figure 5.6 (A and B).
Figure 5.6

$ $ Relevant Range

Relevant Range

Q Q

A Fixed B Step
Despite the more realistic portrayal in Figure 5.6B, fixed costs are usually
illustrated as shown in Figure 5.6A. To justify the assumption of non variation of fixed
costs as illustrated in Figure 5.6A, the concept of the relevant range is used. As long
as activity remains within the relevant range, no harm is done by portraying step
costs as fixed over the entire range of activity. The relevant range may be defined as
that range of activity in which actual sales or production are likely to occur. Outside
of this range, fixed costs on the lower end of volume are smaller and outside of the
high end of the relevant range fixed costs are higher. However, the magnitude of
these costs outside the relevant range is not likely to be known; and even if known,
 Management Accounting | 73

they are irrelevant. Consequently, to draw fixed costs as in Figure 5.6A is a matter of
convenience rather than a portrayal of reality. In the following discussion, therefore,
you should remember that the definition and discussion of fixed costs actually refers
to the costs incurred within the relevant range of activity.
Another interesting aspect of fixed costs is that as soon as fixed costs exist, a
business automatically has a break even point. Conceptually, no business can report
net income until all fixed costs have been covered. Break even point analysis will be
discussed in detail in the next chapter.
Fixed costs are those cost that do not change with increases or decreases in
volume, that is, sales or production. In the short run, fixed costs such as rent and
salaries remain the same regardless of the level of activity. Fixed costs, unlike
variable costs which relate to activity, are time‑related costs. For example, rent is
always for a period of time such as a month or year. Likewise salaries also relate to
a period of time such as a month or year. Consequently, fixed costs are commonly
called period charges because these costs expire in the same time period in which
they are incurred.
While variable costs are incurred directly as activity takes place, fixed costs are
incurred in anticipation of providing services for an estimated level of activity, and,
consequently, the expenditure is contractually made or committed prior to actual
activity. Fixed cost expenditures are determined prior to the period of activity for a
defined quantity of service potential. Building rent, for example, reflects the right to
use a defined amount of floor space. The lease of equipment provides the right to
a defined number of operating hours per period. Fixed cost expenditures are then
capacity costs. An understanding of fixed costs requires an understanding of the
different facets of capacity. Fixed costs, therefore, make a range of production activity
possible.
The term capacity in the singular is somewhat misleading. Rather than use the
term “capacity”, a more accurate statement would be that fixed costs provide the
“capacities” to produce. Each type of fixed cost provides a different capacity service
and, unless management has exercised exceptional care in planning, the capacity
related to each cost might not be in balance. Imbalance in capacities created by fixed
costs can create bottlenecks or constraints in both production and sales.
Examples of different fixed costs and the corresponding capacities provided are
shown in Figure 5.7.

Figure 5.7 • Examples of Fixed Cost and Capacities Provided

Type of Fixed Cost Service Provided
Manufacturing:
Equipment lease/rent Material processing services
Utilities Heat, power, lights
Insurance Financial protection
Indirect labor Supervision of factory workers
continued on next page
74 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

Building rent Shelter and auxiliary equipment space

Selling:
Salesmen salaries Order taking services
Automobile lease/rent Transportation
Telephone Order taking
Advertising Customer product awareness
Administrative
Management salaries Supervision and planning
Utilities Lighting, heating, air conditioning
Telephone Communication of information
Computer lease Processing of information

As implied in the discussion above, fixed costs are those expenditures that are
not caused by activity but rather make activity or production possible. Fixed cost
provide both the ability or capacity to manufacture and also determine the limits to
production. For example, without the services provided by buildings, equipment, and
supervision production could not take place. Expenditures for fixed costs represent
the acquisition of the various capacities necessary for actual activity to take place.

The K. L. Widget Company has 15 machines capable of producing a total

of 15,000 units per quarter. One production supervisor is required for every
5 machines. Currently two supervisors are each paid a $10,000 salary. Five
machines are not in use because of a lack of a supervisor. The building which
the company rents has enough space to hold 20 machines. Consequently,
the company has a machine capacity of 15,000 units while it has supervision
capacity of 10,000 units. The building space capacity is adequate to manufacture
20,000 units.

This example illustrates that different types of fixed costs provide different types of
production services each of which provides a different capacity level. In this example,
there are three capacities: machine, supervision, and space. A major concern of
management is to have a balance or equality among the different ranges of capacity
services. Also, in this example, each type of fixed cost provide different output limits.
Actual production is limited to the lower of the three levels. Furthermore, production
cannot exceed 10,000 units, even though machine and space capacity is larger. A
major responsibility of management is to make those fixed cost decisions that create
a balance among the different types of capacity services.
In contrast to variable costs, fixed costs expire with the passing of time. Fixed
costs are expenditures that contractually provide services for a defined period of
time. At the end of the contract period, the services are no longer available without a
new contract or time commitment of resources by management.
For example, the decision to rent ten automobiles for a year provides management
with transportation services for a year. If one auto has the potential to be driven 200
miles a day, then ten autos for a year provide a capacity of 730,000 miles (200 x 365
x 10). At the end of the year, the year’s purchase of transportation has fully expired.
 Management Accounting | 75

The unused portion of miles driven cannot be transferred to the next year. The rent
expenditure for autos is the same whether or not the potential services are used.
The passing of each day proportionately reduces the service potential regardless of
whether activity is ongoing.
Inherent in the nature of fixed cost is the potential for idle capacity. Consequently,
from a management accounting viewpoint, the measurement of idle capacity is
important. The cost of idle capacity cannot be transferred to another period in the
manner in which unused material can be stored and used in a later period. The
constant relationship between fixed costs and capacity or volume can be explained
and illustrated from three points of view: tabular, mathematical, and graphical.
Tabular Presentation - The presentation of fixed costs in a table at different levels
of activity is basically unnecessary for the reason that regardless of the level of
activity the cost is the same. However, for illustrative purposes, a simple table of fixed
costs will be presented for three types of fixed costs common in all manufacturing
businesses:
Table of Fixed Costs
Volume (units of product)
1,000 2,000 3,000 4,000
Manufacturing $ 50,000 $ 50,000 $ 50,000 $ 50,000
Selling expenses $180,000 $180,000 $180,000 $180,000
General and Administrative $ 90,000 $ 90,000 $ 90,000 $ 90,000

Mathematical Presentation - Fixed costs may be defined mathematically in terms

of total costs and in terms of average cost. On a total cost basis, volume or quantity,
Q, is not a determining factor; however, for average cost quantity or Q is the important
factor in the equation. Total fixed cost may be mathematically defined:
TFC = F (4)
Where:
TFC represents total fixed cost and F is the amount or magnitude of fixed costs for a
given period of time such as a quarter or a year.
The interpretation of this equation is that regardless of the level of activity, the
amount of fixed cost is totally independent of actual quantity. The importance of
defining fixed cost mathematically as presented in the above equation will be appre‑
ciated in a later section when fixed and variable cost are combined in a total cost
equation.
For some decisions such as price, a knowledge of cost per unit or average cost is
very important. Mathematically, average fixed cost may be defined as follows:
AFC = F/Q (5)
where AFC represent average fixed cost and Q is the current level of activity; that is,
units manufactured or units sold. In the following section, the importance of average
fixed cost will be discussed and illustrated.
76 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

Graphical Presentation - The behavior of both total fixed cost and average fixed
cost can be effectively illustrated graphically. In the following illustration, TFC and AFC
are dependent variables while quantity or Q is the independent variable concerning
the computation of average fixed cost. Consequently, values assigned to Q for TFC
and AFC can be plotted graphically. To illustrate, assume that fixed cost is $10,000
and activity increases in increments of 100. The following graphs may be drawn:

Figure 5.8
$ $
Q TFC AFC

100 10,000 100.00

200 10,000 50.00
300 10,000 33.33
Q Q
400 10,000 25.00
Total Fixed Cost Average Fixed Cost

These graphs effectively display the relationship of volume to total costs.

In the case of total fixed costs, there is no effect or change. However, regarding
average fixed cost, the opposite is true. As quantity increases, the average fixed
costs becomes less. The effect of different levels of quantity on average fixed cost
is extremely important and requires an in-depth understanding. Without a complete
understanding of the impact of different capacity levels on average fixed costs, poor
decisions e.g., the pricing decision, could have severe profitability consequences.
Fixed Cost Components- As the case for variable costs, fixed costs can be analyzed
at two levels: the aggregate level and the micro level. At the aggregate level, F
represents the sum of all the individual fixed costs. Fixed costs can be divided into
subclassification levels: labor, manufacturing overhead, selling, and administrative.
From a micro or analytical viewpoint, F is the aggregate of these individual rates.
Mathematically, then F may be defined as:
F = F L + F o + F s + F a (6)

Where:
F L - fixed labor cost F s - fixed selling expenses
F o - fixed overhead costs F a - fixed administrative expenses
In practice, the amount of total fixed cost, F, will simply be the sum of the individual
fixed cost elements. Some of the techniques used to measure the individual fixed
rates will be discussed later in this chapter.
Management Control of Fixed Costs - An important point that must be understood
by both management and management accountants is that fixed costs are subject
to a high degree of control. The management accountant as well as management
must understand the consequences of making a cost fixed or variable. In order to
 Management Accounting | 77

understand the consequences of decisions that convert variable costs to fixed costs,
a more detailed discussion of capacity is required.
To illustrate the importance of the decision to make a cost either fixed or variable, the
following example is presented.

The Acme Retail Company is a new retail company. Ten sales people are required
to sell the product. The sales forecast indicates that average sales per sales person
should be $200,000. Management is contemplating a 10% commission versus a
salary of $20,000. How should sales people be compensated?

This is not an easy decision. There are important cost and psychological factors
involved. A commission is likely to motivate sales people, but at the same time for
an individual inexperienced sales person, the inability to attain sufficient sales may
result in discouragement and thus quitting. Sales people content with a salary of
$20,000 may never be tempted to quit, but because of the lack of motivation may
never reach their quota. If sales due to a recession or competition decreases, then
the sales people’s compensation remains the same. With a commission, a decrease
in sales would be accompanied with a proportionate decrease in compensation. A
fixed salary would increase the risk of operating at a loss, but in times of prosperity
and easy sales, compensation of sales people on a salary basis might maximize
net income. In practice, management often compromises by paying sales people a
combination of salary and commission.
As another example, management might be able to control the nature of costs by
changing the type of equipment. Current production equipment that now requires a
high degree of direct labor might be replace with automated equipment that requires
considerable less direct labor and more indirect labor. For example, in many compa‑
nies computerized tooling and machining equipment have replaced direct labor. The
effect on cost behavior has been a shift from a variable cost to a fixed cost.
Control over Capacity Limits - As true of variable costs, fixed costs are also
subject to the decision‑making powers of management. Fixed costs and their related
capacities provide some difficult choices concerning the amount of capacity that is
available at any given time. The greater the expenditure the greater the capacity. For
example, the lease on a medium size computer might be $500 per month, but for a
larger computer the cost might be $1,500. The capacity of the larger machine might
be five times greater. However, now only the smaller machine is needed. Would
management be better off to invest in the larger machine in anticipation of growth?
For the short run, profits might be less, but in the long run profits might be greater, if
the machine with the greater capacity is purchased.
Definition of Capacity - A major task of management is to manage the level of
expenditures for fixed cost; that is, to make decisions determining the capacity to
manufacture and to sell. Therefore, a major question is: what is capacity? This concept
is without question the most important concept related to fixed cost. Unfortunately, the
concept is elusive and very difficult to define quantitatively. In cost accounting, various
degrees of capacity are recognized and defined: theoretical, practical, normal, and
78 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

expected actual. In a general sense, capacity refers to the maximum number of units
that can be manufactured in a given time period. However, this concept of capacity is
a flexible quantity when such factors as overtime, employee training, second shifts,
speed of equipment, holidays, and vacations are taken into account.
In management accounting, capacity is a strictly a short‑run notion that imposes
limits on sales and production capacity. Consequently, any increase in the spending
for fixed manufacturing costs will normally increase capacity. For example, the
leasing of additional equipment or the hiring of an additional production supervisor
will increase capacity. In this sense, the short run is that length of time in which
expenditures cannot be immediately increased.
Other costs such as rent are inherently time‑oriented and, consequently, fixed
in nature. The production services provided do not easily, if at all, divide into small
discrete units. Material, for example, is easily divided and associated with individual
units; however, the services of a manufacturing plant, is not easily unitized and
allocated to individual units of finished product. The major problem created by fixed
costs is that for costing and pricing purposes fixed costs must be converted to a per
unit basis. Various methods of unitizing fixed costs have been developed including
various allocation and overhead rate methodologies. The following table indicates
some possible bases for allocation of various types of fixed costs.

Cost Item Service Provided Basis of Allocation

Building rent Shelter, protection Space
Equipment Processing of material Direct labor hours
Indirect labor Supervisor Number of workers
Insurance Financial protection Value of equipment
Computer Cost Processing time CPU time
Staff E.g., secretarial services Hours of service
Utilities Lighting Floor space
Preventive maintenance Efficiency and safety Value of equipment

Total Fixed and Variable Costs

Based on the above discussions, we have arrived at a point where we can now
talk about total fixed and variable costs. For the moment, we will assume that in a
given operating period production equals sales. Therefore, the problems associated
with inventory increasing or decreasing from period to period can be avoided. Given
this assumption, we can now define total costs by the following equation:
TC = F + V(Q) (7)
Where:

TC - total cost
V - variable cost rate
Q - quantity
F - fixed cost
 Management Accounting | 79

Given that we know V, the variable cost rate and F, the amount of total fixed cost,
we are able to compute total cost at any level of activity. For example, if we assume
that V = $10.00 and F = $100,000, then total fixed cost at different assumed levels of
activity would be as shown in the following table. The change in costs is due to the
increase in the variable costs. The change in activity had no affect on total fixed cost.
If fixed costs change, it is because of the change in some other factor than volume,
for example, an increase in monthly rent of equipment.

Volume V TVC F TC
10,000 $10.00 $100,000 $100,000 $200,000
20,000 $10.00 $200,000 $100,000 $300,000
30,000 $10.00 $300,000 $100,000 $400,000
40,000 $10.00 $400,000 $100,000 $500,000

Total costs can sometimes be better understood when presented graphically as shown in
Figure 5.9 and Figure 5.10:

Figure 5.9 • Total Fixed and Variable Cost

$
g

a c e

b d f h

Figure 5.10 • Total Variable and Fixed Cost

$
g
e

c
f

a
d

b
h

Q
80 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

In Figure 5.9, fixed cost is shown first and the distances a - b, c - d, and e - f are
the same at their respective volume. In this graph, the fixed nature of fixed costs is
easily grasped. Line g - h represents total fixed and variable cost.
Total cost may also be defined as follow:
TC = V(Q) + F (8)
In this equation, we start with total variable cost and add to this amount total fixed
cost. It might seem trivial whether we define total cost using equation 7 or equation
8. However, the two equations are quite different when it comes to showing total cost
graphically.
Most students have difficulty in visualizing the graph shown in Figure 5.10 because
it seems that fixed cost is increasing with volume. Admittedly, Figure 5.9 is easier to
understand because the top line of the fixed cost is horizontal. However, it is not the
line that is fixed in amount but rather the distance from the horizontal line as shown
in Figure 5.9 to the base line that is fixed. As shown in Figure 5.10, the lines a - b,
c - d and e - f are equal in length, and are also the same length as the same lines
in Figure 5.9. Line g - h in Figure 5.10 represents total cost and is the same as line
g - h in Figure 5.9.
It would seem that it is irrelevant which graph is used to portray fixed and variable
costs. Figure 5.9 which shows the top line of total fixed cost as a horizontal line might
be to be the preferred method. However, in fact, this is not the case. The preferred
method is to graphically show fixed and variable cost as shown in Figure 5.10. The
reason is that when total sales is introduced, as will be discussed in the next chapter,
it is possible then to illustrate an important concept, total contribution margin, which
can not be illustrated if Figure 5.9 is used. Cost-volume-profit analysis (chapter 7)
can be more effectively presented graphically using the graph as shown in Figure
5.10.
Average Total Cost
The use of averages to communicate information and greater understanding
is quite common in business, economics, and also government issued statistics.
Relationships are often easier to understand when averages are used. For example,
rather than say that disposable net income in the USA is $600,000,000,000, it is easy
to understand if one were to say that the average disposable income per person in
the USA is $20,000 per person.
In equation (5), average fixed cost was defined as follows:
AFC = F / Q
It is also possible to define average variable cost as follows:
AVC = V(Q) / Q = V (9)
The variable cost rate as previously discussed earlier in this chapter is simply
average variable cost under the condition that regardless of the change in volume the
average remains constant; that is, the total variable cost line is linear.
Consequently, average total cost now may be defined mathematically as
follows:
AVC = V + F/Q
 Management Accounting | 81

To illustrate, assume the following data:

V = $10,000
F = $200,000
Now at volumes of 10,000, 20,000, 30,000, and 40,000 we get the following
results.
Volume Variable Average Average
Cost Fixed Total
Rate Cost Cost
10,000 $10.00 $20.00 $30.00
20,000 $10.00 $10.00 $20.00
30,000 $10.00 $ 6.67 $16.67
40,000 $10.00 $ 5.00 $15.00

The above analysis reveals a very important business principle. The cost of a
product per unit is highly dependent on volume when the fixed cost in a business
represents a major portion of the total cost. As volume (production) increases, the
total cost per unit of output decreases and as the volume decreases the total cost per
unit of output increases. In modern business where fixed costs tend to be very high
relative to variable costs, the key to getting a low production cost per unit is to have
a high volume of production and sales. Many products in our modern economy are
available to consumers as a whole only because of mass production.
Since the middle of the 19th century, in large businesses the fixed costs of
production have become dominant while the variable costs associated with materials
and labor have decreased significantly in total amounts. This shift in costs where
fixed costs are significantly greater percentage wise means that the break even point
in these businesses have become much greater. Consequently, a high volume of
sales and production is required first to break even and secondly, required to make a
reasonable profit. The benefit to customers is that at high volumes the cost per unit
becomes relatively low. Therefore, because of this fact, it is absolutely critical that
management has a good understanding of average fixed and average variable cost.
Like total fixed and variable cost, average fixed and variable cost may be presented
graphically.
Figure 5.11 • Graph A
$

C
Q
82 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

In the above graph (Graph A), line B - C represents average variable cost and line
A - B represents average fixed cost. Line A - C then represents total average cost.
This graph portrays effectively that as volume increases the total average cost of the
product decreases. The consequence of operating at less than full capacity is a much
higher per unit cost of the product.
As with total fixed and variable cost (see page 79), it is possible to present a
graph where average fixed cost is shown first and average variable cost is shown as
an addition to average fixed cost.
Figure 5.12 • Graph B
$

C
Q

In Figure 5.12, graph B, we again show average fixed and variable cost. As before,
line A - C represents total average cost. However, now line B - C represents average
fixed cost whereas in graph A line B - C represents average variable cost. Similarly,
in Figure 5.12 now line A - B represents average variable cost.
Strange as it may sound, it is correct to say that in terms of average costs, it is
the variable costs that are constant and the fixed costs that are variable. Increases
in volume have no effect on the average variable cost, but do decrease the average
fixed cost with each successive increase in volume.
Illustrative Problem
The K. L. Widget Company’s fixed manufacturing costs including depreciation,
supervisor salaries, and equipment leasing costs total $100,000. Material and
direct labor cost $12 per unit. Currently the company has the potential capacity to
manufacture 1,000 units, but is actually operating at an 80% level or 800 units. The
company can sell 200 units of its product to the Ace Retail Company which has
offered to pay $120 per unit. If the company accepts this special offer, would a profit
be made?
Obviously the company should charge $12 to recover its variable cost. The problem
is: how much should be charged for fixed expenses? The obvious answer is to divide
fixed cost by capacity. However, there are two levels of capacity: actual capacity
utilized and full capacity. If the company divides fixed cost by actual capacity utilized,
the charge for fixed expenses would be $125 ($100,000/800) per unit; whereas the
charge for fixed expenses based on maximum capacity, the charge would be $100. If
the company sells to the Ace Retail Company and uses actual activity, a loss would
 Management Accounting | 83

of $17 a unit would be reported. On the other hand, charging fixed costs on the basis
of maximum capacity would result in a gain of $8 per unit.
Full Actual
Capacity Capacity used
(1,000) (800)

Sales price $120 $120

Variable cost $  12 $  12
Fixed overhead $100 $125
Total cost $112 $137
Profit per unit (special offer) $   8 $ (17)

Therefore, for many businesses the accounting for fixed costs determine whether
or not new business is obtained. However, as discussed in a later chapter, an incorrect
treatment of fixed manufacturing overhead can result in a wrong decision. In the
above example, fixed manufacturing overhead is actually irrelevant to the decision,
if it can be assumed that the difference between 1,000 units and 800 units is idle
capacity
Separating Fixed and Variable Costs
In many cases, identifying what costs are fixed and variable is fairly easy. For
example, regarding sales people commissions, if the price of the product is $300
and the commission rate is 10%, then it is fairly obvious that the variable rate is $30
per unit of product sold. Similarly for many expenses, it is obvious that the expenses
are fixed in nature. For example, assume that the monthly lease on equipment is
$5,000 per month. Again, it is fairly obvious that the annual cost of $60,000 is a fixed
expense. However, some expenses contain both elements and are, therefore, both
fixed and variable in nature.
Expenses that are both fixed and variable in nature are commonly called mixed
expenses or semi-variable. A cursory examination of these types of expenses does
not reveal what amount is fixed and what amount is variable. For example, it is not
uncommon for utility charges for electricity or for water to contain a fixed charge for
the service and a variable charge for usage. If, as a consumer, you were able to not
use any electricity for a month, you would still receive a bill of a set amount for the
fact that the service was available. The same principle is true of many expenses in
business.
If the mixed expenses are important in terms of amounts, then it is important that
the fixed and variable portions be measured and separated. Three methods exists
for separating fixed and variable components from mixed expenses. These methods
are :
1. Scatter graph method
2. High-low method
3. Least-squares regression equation method
Scatter graph Method - The scatter graph method requires that actual cost values
from preferably four or more operating periods be obtained and then plotted on a
graph. Since is it highly unlikely that the plotted points will fall in a straight line, the
graph is called a scatter graph. The remaining steps are to identify fixed and variable
costs:
84 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

Step 1 Draw a straight line of best fit.

This line should be drawn so that the data points (the scatter) is about
equally divided on both sides of the line. Also, the line should touch
the Y axis of the graph.

Step 2 Determine the amount of fixed expense.

Where the line touches the Y axis, the distance from this point to the
base line of the graph is the amount of fixed expense.

Step 3 Determine the total cost on the line of best fit by selecting any point on
the line of best fit other than the point on the Y axis.
This point will then be a measure of the total expense which includes
both the variable and fixed portion.

Step 4 Compute the amount of the variable expense.

The variable expense can be found by subtracting the fixed expense
measured in step 2 from the total expense measured in step 3.

Step 5 Compute the variable cost rate.

The variable cost rate can be easily computed by dividing the amount of
variable cost by the activity level indicated in step 3.

To illustrate, assume the following:

The K. L. Widget Company wants to estimate the total utility cost next year at a
planned volume of 3,500 units of product. Last year’s utility cost for each quarter of
the year was as follows:
Volume Utility Cost
1st 2,000 $12,500
2nd 4,000 $20,000
3rd 3,000 $13,500
4th 1,000 $ 8,500

A scatter graph and line of best may be prepared as follows:

Scattergraph-Utility Cost
25000

20000

15000
Volume
Cost

10000

5000

0
0 1000 2000 3000 4000 5000

Volume
 Management Accounting | 85

1. Total fixed = $5,000

2. Cost on line of best fit at 3,000 units = $15,000
3. Variable cost ( $15,000 - $5,000) = $10,000
4. Variable cost rate = $10,000/3000 = $3.33
TC = $5,000 + $3.33 (Q)
5. Total cost at 3,500 units of product
TC = $5,000 + $3.33 (3,500) = $16,655.00
The disadvantage of this method is that the line of fit is somewhat arbitrary. How
the line is drawn can make a significant difference in the fixed cost amount and the
variable cost rate.
High-low Method - The high-low method is an easy to use and effective method for
separating the variable component of a mixed cost from the fixed cost. The high-low
method is based on the realization that from period to period any change in total
cost is presumed to be caused by a change in volume. The fixed portion of the cost
is assumed to remain the same. Therefore, the variable portion can be computed by
using the cost at two different levels of activity.
The steps of this method are as follows:
Step 1 Obtain data points (volume and related cost) from several periods of
operations.
Step 2 Select two different levels of activity and arrange the data as follows:
(Values here are assumed for illustrative purposes.)
Volume Cost
High 10,000 $50,000
Low 5,000 $30,000

Step 3 Compute the difference in volume and costs.

Volume Cost
High 10,000 $50,000
Low 5,000 $30,000
–––––– ––––––––
5,000 $20,000
This computations shows that a 5,000 increase in volume caused a
$20,000 increase in variable costs.

Step 4 Compute the variable cost rate by dividing the difference in cost by the
difference in volume.
Variable cost rate = ($20,000 / 5,000) = $4.00

Step 5 Compute the amount of fixed cost by first selecting a level of activity
(either the high or the low) and then compute the total variable cost at
that level of activity (e.g., $10,000 x $4.00). Secondly, subtract the total
variable cost from the total cost at that level of activity (e.g., ($50,000 -
$40,000). In this example, total fixed cost is $10,000.
86 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

The high-low method is an easy method of computing the fixed and variable
components in a mixed cost. However, depending on what high and low data points
are selected, a different in answers can be obtained. The values selected should
appear to be representative and not be the most extreme values.
Least Squares Regression Method - The least squares method is a more scientific
and accurate approach to determining values for fixed and variable costs from mixed
costs. The method is a statistical method for computing the two key variables of a
straight line. The assumption is that from an array of data points there is one best line
of fit. The least squares method is able to find the A and b values of a straight line
where A is the value at the y-intercept and b is the slope of the line.
The equation for a straight line is generally defined as follows:
Y = A + b(X)
If the values for A and b are known, then Y, the value of the dependent variable,
can be computed for any given value of X.
The total cost equation, equation (7), was previously presented as follows:
TC = F + V(Q)
It is apparent by inspection that the two equations are equivalent. Fixed costs or F
is equivalent to A and V, the variable cost rate, is equivalent to b. Consequently, the
least squares method can be used to find the values for F and V.
The least squares method will not be illustrated here. Any introductory statistics
book will explain how the method works. Also, the management accounting tools in
The Management/Accounting Simulation contains the least squares method as
one of its computer-based management accounting tools.

Summary
An understanding of cost behavior is critical in management accounting because
several of the management accounting tools require using fixed and variable costs.
Since the general ledger does not contain separate accounts for fixed and variable
costs nor labels them as such if a cost is clearly all fixed or all variable, it is necessary
by one method or another to determine what costs are fixed and what are variable.
The assumption that costs are either pure fixed or pure variable is an arbitrary
assumption. In fact, costs in some businesses may be curvilinear in nature or mixed
as previously discussed. The assumption that costs are linear in nature makes it
much easier to use various management accounting tools. The question is whether
this simplicity in assumption causes the results of analysis to be inaccurate and
misleading. The argument generally is that as long as the user of management
accounting tools stays within a relevant range of activity, the use of linear fixed costs
and variable costs will produce very useful results. When using tools that require fixed
and variable costs, it is important to realize there will always be a margin of error.
 Management Accounting | 87

Q. 5.1 Explain the difference between cost classification and cost behavior.
Q. 5.2 Explain the difference between a variable cost and a variable
expense.
Q. 5.3 Explain the technical difference between a fixed cost and a fixed
expense.
Q. 5.4 What are the two primary measures of volume that determine total
costs and expenses.
Q. 5.5 What is the equation for total variable cost?
Q. 5.6 What is the total cost equation?
Q. 5.7 List some of the management accounting tools that require knowing
fixed and variable costs or expenses.
Q. 5.8 What is a mixed or semi-variable expense?
Q. 5.9 What techniques may be used to separate fixed and variable cost
components of mixed costs?
Q. 5.10 In the high-low method, which cost is first computed?
Q. 5.11 In the scatter graph method, which cost is first computed?
Q. 5.12 Define the following terms:
a. Variable cost
b. Fixed cost
c. Average fixed cost
d. Average variable cost
Q. 5-13 Identify the following:
a. V(Q)
b. F/Q
c. F + V(Q)
d. V

Exercise 5.1 • Graphical Illustration of Cost Behavior

You have been provided the following information

Total fixed costs $100,000
Variable cost per unit $   20.00
Sales price $   80.00
continued on next page
88 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

Required:
Based on the above information, prepare a graph showing:
a. Total fixed costs. (Start with 1,000 units and show increases in activity
in increments of 1,000 units up to 10,000 units.)
b. Prepare a graph showing average fixed costs. (Start with 1,000 units
and show increases in activity in increments of 1,000 units up to
10,000 units.)
c. Prepare a graph showing total variable costs. (Start with 1,000 units
and show increases in activity in increments of 1,000 units up to
10,000 units.)
d. Prepare a graph showing average variable cost. (Start with 1,000
units and show increases in activity in increments of 1,000 units
up to 10,000 units.)
e. Prepare a graph showing total cost, both fixed and variable. (Start
with 1,000 units and show increases in activity in increments of
1,000 units up to 10,000 units.)

Exercise 5.2 • Identifying Cost Behavior

Following are some graphs that show different kinds of cost behavior that are
commonly found in various businesses.

A B C

D A F

Required:
Select the appropriate graph to illustrate the costs listed on the next page.
continued on next page
 Management Accounting | 89

Cost Behavior
Cost Items Graph
1. Total factory workers’ wages
2. Salaries of production engineers
3. Salaries of management
4. Total material cost (cost per unit is same at any quantity of
output)
5. Average fixed manufacturing overhead
6. Average direct labor cost (assume constant wages)

7. Total cost of fuel consumption (Assume increase in activity is

due to increases in running speed of machines.)
8. Total clerical salaries (A new clerk is hired each time activity
increases by 1,000 units of product.)
9. Average sales people commissions

Exercise 5.3 • Computing Fixed and Variable Costs

The K. L. Widget Company has decided to open a new territory. The company is
not sure what the customer response will be when their product is introduced in the
new territory. The company wants to set the price high enough so that a profit results.
This price, therefore, must cover the costs of manufacturing and selling.
The company’s controller knows that a significant portion of the manufacturing
and selling costs are fixed in nature. The cost per unit then can vary depending
on how many units are sold in the new territory. The following cost information is
available to the controller:
Material
Units of material per unit of product 4
Cost per unit of material $2.00
Factory labor
Labor required per unit of product (hours) 1.5
Wage rate per hour $15.00

Variable overhead last years (50,000 units) $250,000

Selling variable cost( sales = 45,000 units) $270,000

Fixed manufacturing cost $500,000

Fixed selling expenses $800,000
Required:
Assume that you are the controller of the company and that you have been asked
to compute the cost per unit of manufacturing and selling the product.
continued on next page
90 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

You have decided to use the following work sheet to make your computations.
Since sales have varied between 40,000 and 60,000 units in the past few years, you
have decided to make cost per unit computations in increments of 5,000 units.

Cost Item Computation Cost per Unit

Material
Factory Labor
Variable manufacturing
overhead
Variable selling
Total variable cost per
unit
Fixed cost:
Manufacturing
40,000 units
45,000 units
50,000 units
55,000 units
60,000 units
Selling
40,000 units
45,000 units
50,000 units
55,000 units
60,000 units

Cost Per Unit Summary

Activity Level Variable Cost Per Unit Fixed Cost Per Unit Total Cost per Unit
(production)
40,000
45,000
50,000
55,000
60,000
 Management Accounting | 91

1. Which type of cost is responsible for total cost per unit to vary with
production?
2. If cost varies with production and production will vary with sales demand,
then what cost figure should be used to determine price?

Exercise 5.4 • Computing Variable Cost Rates

You have been provided the following information:

Variable Costs
Material
Cost per unit of material $ 2.00
Units of material required per unit of product 6
Factory labor
Wage rate per hour $ 12.00
Labor hours required per unit of product 4

Manufacturing overhead
Utilities
Cost per kilowatt hour $ .06
Number of kilowatt hours per unit of product 10
Supplies
One unit of supplies 2
Cost per unit of supplies $ 4.00
Repairs and maintenance
Hours of maintenance per unit of product .5
Repair cost per hour $ 15.00
Selling
Commission rate (price of product - $300) 10%
Packaging cost per unit of product $ 2.00
General and administrative
Clerical and staff (hours) 1.50
Average wage rate $10.00

Fixed costs/expenses
Manufacturing overhead
Production salaries $ 100,000
Equipment depreciation $ 10,000
Insurance and taxes $ 5,000
Selling
Advertising $ 50,000
General and administrative
Salaries $ 80,000

continued on next page

92 | CHAPTER FIVE • Management Accounting Theory of Cost Behavior

Required:

(1) Compute the variable rate for

a. Material
b. Factory labor
c. Manufacturing overhead
d. Selling expenses
e. Administrative expenses

(2) What is the total amount of fixed expenses?

(3) Prepare a simple income statement showing net income at the follow‑
ing levels of sales (assume production = sales). Price of the product is
$300.00.
a. 10,000 units of sales
b. 20,000 units of sales
c. 30,000 units of sales
d. 40,000 units of sales

Exercise 5.5 • High-low and Scatter Graph Methods

The K. L. Widget Company in connection with its cost accounting and budgeting
system classifies its cost as either fixed or variable. However, some of the company’s
manufacturing costs are in fact semi-variable in nature. In order to prepare a flexible
budget for manufacturing expenses, it is necessary to separate these costs into their
fixed and variable components. The cost accounting records for the year just ended
showed the following data.
Repairs and
Maintenance
Units of product Utilities expense Expense
1st quarter 10,000 $40,000 $ 82,000
2nd quarter 15,000 $56,000 $115,000
3rd quarter 18,000 $65,000 $133,000
4th quarter 8,000 $36,000 $ 64,000

Required:
Based on the above data, compute the fixed and variable cost components of the
above costs/expenses:
1. Assuming the high-low method is used
2. Assuming the scatter-graph method is used.
 Management Accounting | 93

Direct Costing Financial Statements

Purpose
Accounting has evolved slowly over many centuries. The first important complete
treatise on the principles of accounting and bookkeeping was a book by Pacoli in the
1490s. The development of accounting principles and procedures are still continuing
to evolve. In the early 1900s, many controversial issues were debated and some
were resolved. In the 1950s and 1960s here in the USA, the lack of standardization
in accounting was of primary concern.
One of controversial areas debated extensively in the 1930s and 1940s was the
treatment of manufacturing overhead in the costing of inventory and cost of goods
sold. The controversy was commonly labeled absorption costing versus direct
costing. To understand the issues involved, a good understanding of the principles
of cost accounting is helpful. The purpose of this chapter is to provide a conceptual
foundation for understanding the effect that absorption costing and direct costing
have on net income.
In direct costing, fixed manufacturing overhead is treated as an operating expense
(period charge). Absorption costing regards fixed manufacturing overhead as a
manufacturing cost properly included in inventory and cost of goods sold. Because
of the difference in the treatment of fixed manufacturing overhead, a substantial
difference in the measurement of net income can result.
Accounting for Manufacturing Overhead
Manufacturing overhead is one of the three major manufacturing costs. For the
most part, materials and labor are considered direct costs and can be easily associated
with a specific product or job. However, manufacturing overhead tends to be more
intangible and difficult to trace to a product or job. For example, utility cost such as
power and light is necessary to the production process, but it is not easily assignable
to a product, job, or department. The main solution to distributing overhead cost has
been the use of overhead rates. Rates are typically determined by dividing estimated
overhead cost by some estimated measure of activity. Consequently, the rates are
often called predetermined overhead rates. Activity bases for overhead typically used
94 | CHAPTER SIX • Direct Costing Financial Statements

are direct labor hours, direct labor cost, machine hours, and units of product. The
conventional theory is that direct labor which is easily capable of being measured
correlates directly with the amount of overhead being incurred. If product A has labor
cost of $100,000 and product B has labor cost of $200,000, then 1/3 of the overhead
would be allocated to product A and 2/3 to product B.
However, accountants quickly realized that manufacturing overhead varies in
nature in that some overhead tends to be fixed and some tends to be variable. Variable
cost was recognized to be caused by activity and to vary directly with changes in activity.
If production doubled, for example, the variable overhead likewise doubled. However,
fixed manufacturing as the term “fixed” implies remained the same regardless of the
level of activity. A theory of accounting for fixed manufacturing overhead developed
which stated that fixed overhead provides the capacity to produce and that the bases
for application of fixed manufacturing overhead should be some estimate of capacity.
The cost of buildings, machines, power plants, and some supervisory labor were
labeled capacity costs. Consequently, in cost accounting theory four levels of capacity
were developed: expected actual, normal, practical, and theoretical. Overhead
rates for fixed manufacturing overhead were developed by dividing estimated fixed
manufacturing overhead by some estimated capacity level. Because the selected
measure of capacity was likely to be much greater than capacity actually utilized, the
use of an overhead rate for fixed manufacturing overhead gave rise to under-applied
fixed manufacturing overhead.
The methods developed for overhead, particularly fixed manufacturing overhead,
at times can have a profound effect on net income. The choice of a capacity base and
the method of application can cause significant variations in net income. Among cost
accountants, it became quickly recognized that net income was not only a product
of sales but also of the accounting for overhead. If production exceeded sales, then
this difference caused cost of goods sold to be less and net income greater. If the
difference between sales and production decreased, then this fact alone could cause
net income to decrease compared to the previous year.
To illustrate, assume fixed manufacturing overhead is $1,000,000 and the
company is debating whether to make 50,000 units or 100,000 units of product. The
estimated fixed manufacturing overhead cost per unit of product would, therefore, be
either $10.00 or $20.00. If the company were to actually manufacture 50,000 units
of product, then income would be less because cost of goods sold would be $10 per
product greater. If management is only concerned about short-term maximization of
net income, then the obvious decision would be to make 100,000 units. However,
if sales are only 50,000 and 100,000 units of product are manufactured, an excess
inventory of 50,000 would exist. If the excess inventory is never sold or has to be
sold at a big price decrease, then in the long-term the potential inventory loss could
easily more than offset any short-term benefit of over producing. The problem is that
the excess inventory is subject to a carrying cost which over time can be a significant
out of pocket cost.
The traditional method of accounting for overhead just described is called
absorption costing. The term absorption implies that fixed manufacturing is absorbed
 Management Accounting | 95

into the cost of inventory and cost of goods sold by means of using manufacturing
overhead rates. Absorption costing as pointed out by advocates of direct costing has
an inherent and potentially serious flaw in that it is possible to manipulate net income
by deliberately manufacturing more units than is required to meet the needs of the
production budget. This flaw exists only in regard to fixed manufacturing overhead. In
a company with only variable manufacturing overhead, the deliberate act of increasing
production in excess of sales can not cause net income to become larger.
Some accounting theorists in the 1930s and 1940s began suggesting an
alternative method of applying fixed overhead to inventory. It was argued that fixed
manufacturing costs were not true inventory costs but were periodic costs and that
this charge should be shown on the income statement as an operating expense. Fixed
manufacturing overhead, it was argued, was not caused by the act of producing and,
therefore, could not properly be called a production cost. Since fixed manufacturing
overhead tends to remain the same from period to period, treating it as a periodic
charge on the income statement is more appropriate. The proposed solution to the
problem of absorption costing was called direct costing and in some cases variable
costing. The term variable costing was often used because the argument now was that
only variable manufacturing overhead was properly allocated to inventory. However,
the real problem was not variable costs but fixed manufacturing overhead.
Most text books on cost accounting have a chapter devoted to discussing
absorption costing versus direct costing. However, it should be pointed out now that
the conflict between the two theories for the most part has been resolved in favor
of absorption costing. Authoritative bodies such as the IRS and the FASB have not
approved direct costing as an acceptable alternative for external financial statement
reporting. However, direct costing is acceptable as part of an internal reporting system
to management. The question that remains today is: is the use of direct costing a
better means of reporting financial results to management for the purpose of making
decisions?
Absorption Costing Versus Direct Costing
While the main difference between absorption costing and direct costing lies in
the treatment of fixed manufacturing overhead, there are consequences that makes
the two methods different in other respects:
Basis Features of Absorption Costing - Absorption costing which is traditional cost
accounting may be summarized as follows:
1. Both fixed and variable overhead are applied to inventory (work in
process).
2. Manufacturing overhead is usually applied by means of a predetermined
overhead rate. The single rate, in fact, consists of two rates: a fixed
overhead cost rate and a variable overhead cost rate.
3. The use of a predetermined overhead rate generally will result in
manufacturing overhead being over-applied or under-applied.
4. Under-applied overhead is generally charged to cost of goods sold or
shown on the income statement as a separate line item.
96 | CHAPTER SIX • Direct Costing Financial Statements

5. The actual level of production then has an impact on net income. The
greater the level of production relative to sales the less is under-
applied overhead and the greater is net income.
6. The cost of inventory properly includes both fixed and variable manu-
facturing overhead.
7. Manufacturing overhead, except for under-applied overhead, therefore,
becomes an expense only when the goods manufactured (finished
goods) are sold.
8. Under absorption costing, net income is a function of both production
and sales.

The advocates of absorption costing, by far the majority viewpoint, argue

strenuously that fixed manufacturing cost is a necessary production cost because it
makes production possible and, therefore, must be include in determining the cost
of inventory. To not include fixed manufacturing overhead means that the cost of
inventory is understated.
Absorption Costing can be diagramed in T-accounts as follows:

Material

Factory Labor

Work in process Finished goods Cost of goods sold Income summary

Variable Overhead

Fixed Overhead

This diagram shows that before fixed manufacturing can be a deduction from net
income it must first flow through the work in process and finished goods account. To
the extent that finished goods is not sold, the amount of fixed manufacturing overhead
in finished goods has been absorbed off the income statement.
Basis Features of Direct Costing - The basic points of direct costing or variable
costing as it is often called may be summarized as follows:
1. Fixed manufacturing overhead is not considered to be a production
cost properly included in the cost of inventory.
2. Fixed manufacturing overhead is regarded as a periodic charge, an
operating expense. Regardless of the level of activity, it remains the
same in a given time period.
 Management Accounting | 97

3. Fixed manufacturing is not caused by production. Even at zero level of

activity, the cost would still remain.
4. An overhead rate is only needed for variable overhead.
5. Because it is a cost of each accounting period and remains the same
independent of production activity, it should be treated as an
expense on the income statement.
6. The treatment of fixed manufacturing overhead as a periodic charge
eliminates the distortion to net income caused by fluctuations in
production relative to sales.
7. The cost of inventory should only consist of variable manufacturing
costs. Variable overhead should be included in inventory, but not
fixed manufacturing overhead.
Direct Costing can be diagramed in T-accounts as follows:

Material

Factory Labor

Work in process Finished goods Cost of goods sold Income summary

Variable Overhead

Fixed Overhead

This cost flow diagram shows that fixed manufacturing overhead does not
flow through inventory but rather is a direct charge against revenue on the income
statement. When both cost flow diagrams are compared, the only difference between
direct costing and absorption become quite obvious. The observed difference clearly
is how fixed manufacturing overhead is handled. The accounting for variable costs
including variable manufacturing overhead is also obviously the same as in direct
costing.
Effect of Variations in Production Units and Sales Units
In order to fully understand the difference consequences of using absorption
costing as opposed to using direct costing, the effect of production being more or
less than units sold needs to be clearly understood. Some important relationships
are the following:
1. When production units equals sales units, there is no difference in net
income between absorption costing and direct costing. Under this
98 | CHAPTER SIX • Direct Costing Financial Statements

condition, there is no change in the number of units of beginning

and ending inventory.
2. When production (units) is greater than units sold, absorption costing
will show greater net income than direct costing. In this instance, the
inventory of finished goods has increased compared to beginning
inventory Consequently, some fixed manufacturing overhead has
been absorbed into inventory.
3. When production is less than units sold, absorption costing will show
less net income than direct costing. In this instance, ending inventory
in terms of units has decreased relative to beginning finished goods
inventory.
4. Under direct costing, assuming sales is constant from period to period,
net income will be the same regardless of the level of production.
5. Under absorption costing, even assuming sales is constant from period
to period, net income will vary directly with changes in production.
If production is increased, then net income will increase and if
production is decreased net income will decrease.
Illustration of Effect of Production Changes on Net Income
In order to illustrate the impact of changes in production on net income, it is
necessary to assume some production data as follows:
Price $40 Variable Cost per unit:
Sales (units) 70 Material $3
Production (units) 80 (case 1) Direct labor $5
Normal capacity 100 units Manufacturing overhead:
Fixed overhead rate ($1,000/100) Variable $2
Other operating expenses $50 Fixed manufacturing overhead $ 1,000
(actual o/h = planned)

A number of important observations can be made from a careful examination of

the income statements for both direct costing and absorption costing (see Figure
7.1).
1. As production increased by 10 units while sales remained constant,
net income under absorption costing increased by $100 (cases
1 - III). In case IV, net income decreased because production was
less than sales. An increase in production of 10 units causes a $100
decrease in under-applied overhead.
2. Under direct costing, net income remained the same at in all four cases
at $1,050. In direct costing the differences between production and
sales had no effect on net income.
3. In absorption costing, the manufacturing cost per unit is $20 while under
direct costing it is $10. In absorption costing, the total cost includes
$10 per unit for fixed manufacturing overhead while in direct costing
none of the fixed overhead is included.
 Management Accounting | 99

Figure 7.1
Absorption Costing Direct Costing
I II III IV I II III IV
Production (units) 80 90 100 60 Production (units) 80 90 100 60
Sales (units) 70 70 70 70 Sales (units) 70 70 70 70

Sales $2,800 $2,800 $2,800 $2,800 Sales $2,800 $2,800 $2,800 $2,800
Variable Expenses
Expenses Cost of goods sold 700 700 700 700
Cost of goods.sold $1,400 $1,400 $1,400 $1,400 Other variable 0
______ 0 _ ____0
______ _____0
Other expenses 50 50 50 50 $ 700 $700 $ 700 $700
Under-applied o/h 200 100 0 400 ______ ______ _ ____ ______

______ ______ _______ _______ Contribution margin $2,100 $2,100 $2,100 $ 2,100

Total expenses $1,650 $1,550 $1,450 $1,850

Fixed expenses
Manufacturing $1,000 $1,000 $1,000 $1,000
Other operating ______
50 50 _ ____
______ 50 50
______
$1,050 $1,050 $1,050 $1,050
______ ______ _ ____ ______
Net income $1,150 $1,250 $1,350 $950 Net income $1,050 $1,050_ $1,050_ $1,050
–––––– –––––– ––– ___
_____ ______ __ ____
____ ___
_____
–––––– –––––– –––––
–––– ––––––
–––––– ____ ______ ____

Ending inventory $200 $400 $600 $200) Ending inventory $ 100 $ 200 $ 300 ($ 100)

Cost per unit Cost per unit

Material $ 3 Material $ 3
Direct labor $ 5 Direct labor $ 5
Manufacturing: Manufacturing (variable) $ 2
Variable rate $ 2
Fixed rate $10


$20 $10

4. Ending inventory is greater under absorption costing than direct costing

by $10 per unit, the amount of the fixed overhead rate. In absorption
costing, fixed overhead is included in the cost of inventory whereas
in direct costing it is excluded.
5. The direct costing income statement above was based on cost-
volume-profit principles and clearly delineated all variable and fixed
expenses. However, the point needs to be made that this separation
of fixed and variable expenses is not a requirement and is strictly an
optional choice. As a matter of practice when direct costing is used,
a separation of fixed and variable cost is made and contribution
margin is shown. However, even under absorption costing, variable
and fixed costs may be shown.
100 | CHAPTER SIX • Direct Costing Financial Statements

Mathematical Equations for Direct Costing Absorption Costing

In chapter 7, the principles of cost-volume-profit analysis are presented
mathematically. The cost-volume-profit net income equation was presented as
follows:
I = P(Q s) - V d(Qs) - (F m + F ga + F s)
V d = V m + V l + V o + V s + V ga
V d - Variable cost rate in direct costing

This equation is, in fact, the equation for the direct costing viewpoint. In order to
easily compute break even point and target income point, it is necessary to adopt
a direct costing approach to income measurement. The basic assumption of cost-
volume-profit analysis is that during the period of analysis production units equals
sales units. Otherwise, it is necessary to assume direct costing when there is a
difference in production and sales. A similar equation for absorption may be created;
however, because fixed overhead is considered to be a production cost and because
there is the possibility of a variation in production units and sales units, the equation
is considerably more complex.
The mathematical model for absorption costing is:
F m
I = P(Q s) - V a(Q s) - F gas - (F m - (Q m) –––)
Q p
V a = V m + V l + V o + (F m/Q p) + V s + V ga

I - net income F m - fixed manufacturing

P - price F gas - fixed gen., admin., and selling
expenses
Q s - quantity sold V a - absorption costing Variable cost
rate
Q m - quantity manufactured (Note: V a includes the fixed
manufacturing overhead rate)
Q p - quantity planned (capacity)
V m - variable material rate V ga - variable gen. & admin. exp. rate
V o - variable overhead rate

V s - variable selling exp. rate

V d - direct costing variable cost rate

F m
The expression, (F m - (Q m) ––– ) is under-applied fixed manufacturing overhead.
Q p
Important Concepts in Direct Costing and Absorption Costing
The study of absorption costing and direct costing is rich in accounting concepts.
 Management Accounting | 101

The study of absorption costing versus direct costing should be based on an

understanding of the following concepts:
1. Absorption costing 10. Quantity manufactured
2. Direct costing (variable) 11. Fixed overhead rate
3. Capacity 12. Variable overhead rate
4. Inventory changes 13. Period charges
5. Quantity sold 14. Cost of inventory
6. Planned quantity 15. Under-over-applied overhead
7. Variable costs (direct) 16. Contribution margin
8. Fixed expenses 17. Fixed manufacturing cost
9. Manufacturing costs

Since direct costing is not an acceptable method for external reporting to

stockholders and other external parties, the question of its value must be raised.
When used it must be done only internally and for some perceived benefit to
management in their role as decision makers. Advocates of direct costing believe (1)
that direct costing eliminates misleading fluctuations in net income caused by using
absorption costing and (2) eliminates the tendency on the part of some management
to deliberately over produce to gain only a temporary boost in net income. A third
advantage is that the use of direct costing will encourage management to use income
statements that show all expenses as fixed and variable and to rely more on the
concept of contribution margin in their decision-making.

Examination of Effect of Direct Costing on Inventory Cost

The main argument against direct costing is that it understates the value of ending
inventory. It is true that direct costing creates a smaller inventory value. Proponents of
absorption costing argue that fixed manufacturing overhead is a true production cost
because it makes production possible. The effect on inventory value can seen more
clearly if we create a hypothetical company that has only fixed manufacturing over
head and no variable costs at all. That is, the product can be manufactured without
any paid labor or any need to buy raw materials. For example, let’s assume that the
product is made of rocks which are in abundance for free and that the business is
family run where family members work free. Furthermore, to complete this extreme
example the following is assumed:
Fixed manufacturing overhead $1,000
Production capacity 100 units
Price of product $15

Period 1 Period 2
Production 100 units 0 units
Sales 0 units 100 units

Based on this information income statements for periods 1 and 2 would show the
following
102 | CHAPTER SIX • Direct Costing Financial Statements

Period 1 Income Statements

Absorption Costing Direct costing
Sales -0- Sales -0-
Cost of goods sold -0- Cost of goods sold -0-
______ _ _____
Gross profit -0- Gross profit -0-
Expenses Expenses
Selling -0-
______ Selling -0-
-0- Fixed manufacturing overhead $1,000
_ _____
Net
income -0-
______ $1,000
______
Net income (loss) ($1,000)
__ _____
_____
Inventory (100 units) $1,000 Inventory -0-

For the period 1, two completely different net income pictures are painted.
Absorption costing shows income to be zero and ending inventory to be $1,000.
Direct costing shows the business operating at a loss of $1,000 and that the ending
inventory has a zero cost. Which point of view is correct many years ago was the
subject of considerable debate.

Period 2 Income Statements

Absorption Costing Direct costing
Sales $ 1,500 Sales $ 1,500
Cost of goods sold ______
1,000 Cost of goods sold -0-

––––––
Gross profit 500 Gross profit 1,500
Expenses Expenses
Selling -0- Selling -0-
Under-applied fixed overhead 1,000
______ Fixed manufacturing overhead 1,000
1,000 ––––––
______ 1,000
Net income (loss) 500)
($______ ______
______
Net income $ 500
––––––
Inventory (0 units) -0- Inventory ( 0 units) -0-

In period 2, direct costing shows net income to be $500 and under absorption
costing a net loss of $500 is reported. Absorption costing shows the loss to be
greater when the company had sales. As long as it is manufacturing at capacity
under absorption costing, the company will not show a loss. Proponents of direct
costing would point out this does not seem to be reasonable. However, proponents
of absorption costing would argue that in period 1, direct costing shows the value
of inventory to be zero. They would argue that a zero value assigned to inventory is
unrealistic. Both absorption costing and direct costing show that for the two periods
combined the company lost $500.
 Management Accounting | 103

Reconciling Absorption Costing and Direct Costing Net Incomes

As the difference between production and sales increases, the difference in net
incomes between absorption costing and direct costing increases. The reason, as
explained previously, concerns the amount of fixed manufacturing overhead being
absorbed into inventory. The difference in net incomes can easily be reconciled by
the following procedure:

Step 1 For absorption costing and direct costing separately compute the change
in inventory:
Absorption costing Direct Costing

Ending inventory $_ ____________ $______________

Less Beginning inventory $_ ____________ $______________
Change in inventory $_ ____________ $______________

Step 2 Compute the difference in the change in inventory:

Absorption costing change $______________
Direct costing change $______________
Difference in the change $______________

The difference in the change in inventory will be equal to the difference in net
incomes. In short, as the amount of fixed overhead in inventory increases the difference
in net income increases. The above calculation is simply a method of computing the
amount of fixed manufacturing overhead in inventory.

To illustrate assume the following:

Variable costs (per unit of product)

Cost of goods manufactured $ 10
Selling $ 20
Price $ 100
Capacity 2,000 units

Beginning inventory
Units 100
Absorption costing $ 3,500
Direct costing $ 1,000
Fixed manufacturing overhead $ 50,000
Production 1,500 units
Sales 1,000 units
104 | CHAPTER SIX • Direct Costing Financial Statements

Figure 7.2
Absorption Direct
Costing Costing
Sales (1,000 x $100) $ 100,000 $ 100,000
Variable expenses:
Cost of goods sold ($10 x 1,000) 10,000 10,000
Selling (1,000 x $20) 20,000 20,000
–––––––– ––––––––
$ 30,000 $ 30,000
–––––––– ––––––––
Contribution margin $ 70,000 $ 70,000
Fixed expenses
Cost of goods sold (1,000 x $25) $ 25,000 $ -0-
Under-applied F M/O (500 x @ $25) 12,500 -0-
Fixed manufacturing overhead -0- 50,000
–––––––– ––––––––
$ 37,500 $ 50,000
–––––––– ––––––––
Net income $ 32,500 $ 20,000
–––––––– ––––––––
Beginning inventory $ 3,500 $ 1,000
Ending inventory $ 21,000 $ 6,000

In this example, the difference in net income is $12,500 ($32,500 - $20,000) (see
Figure 7.2). This difference in net incomes can be reconciled as follows:
Absorption Costing Direct Costing
Ending inventory $21,000 $6,000
Beginning inventory $ 3,500 $1,000
––––––– ––––––
Change in inventory $17,500 $5,000
Difference in change
Absorption costing change $17,500
Direct costing change $ 5,000
_______
Change in difference $12,500
––––––
––––––
The difference can also be explained as the increase in fixed manufacturing
overhead in inventory:
Increase in inventory (units) 500
Fixed manufacturing overhead rate $25
––––––
Increase in fixed mfg. overhead $12,500
––––––
––––––
Income Statement Formats for Absorption Costing and Direct Costing
As can be seen from the above illustrations, different formats for both absorption
costing and direct costing have been used. The contribution margin format in most text
books is generally used with direct costing. However, this is not a requirement. Other
 Management Accounting | 105

than showing fixed manufacturing overhead as a separate line item on the income
statement, there is no requirement to show any other costs as fixed or variable.
However, the general practice in preparing direct costing is to identify all costs are
fixed and variable. Nevertheless, as shown above even with absorption costing, it
is also possible to show all costs as either fixed or variable. Which format to use is
determined at the discretion of the management accountant and the preference of
management.
Summary
The issue of absorption costing versus direct costing for purposes of external
reporting has long been settled in favor of absorption costing. Financial reports to
stockholders, banks, Internal Revenue Service, and other regulatory agencies are
required to be based on absorption costing. However, for purposes of reporting to
management, direct costing may be used. If the business in question is subject to
considerable variation in production and sales from period to period and the amount
of fixed manufacturing overhead is quite large, then management may prefer for
internal reporting purposes to have income reported based on direct costing. If there
is little or no significant variation in sales and production from operating period to
period, then either method will result in approximately the same net incomes. Only
when inventory fluctuates greatly will direct costing make a real difference in the
amount of net income reported. Whether or not direct costing is used, it is still possible
to identify and use fixed and variable cost on the income statement.

Q. 6.1 What are the major characteristics of absorption costing?

Q. 6.2 What are the major characteristics of direct costing?
Q. 6.3 What is the fundamental weakness of absorption costing, according to
the advocates of direct costing?
Q. 6.4 What argument is made to support the idea that fixed manufacturing
overhead is not a manufacturing cost?
Q. 6.5 What is the main difference in the treatment of cost between absorption
costing and direct costing?
Q. 6.6 Draw a cost flow diagram of absorption costing.
Q. 6.7 Draw a cost flow diagram of direct costing.
Q. 6.8 In comparing absorption costing and direct costing, explain the effect of
the following:
a. Production is greater than sales
b. Production is equal to sales
c. Production is less than sales
Q. 6.9 What are the main arguments against direct costing?
106 | CHAPTER SIX • Direct Costing Financial Statements

Q. 6.10 The term “absorption” has reference to what specific manufacturing

cost?
Q. 6.11 Prepare an outline of the income statement for absorption costing:
a. Using a conventional format
b. Using a cost-volume-profit format
Q. 6-12 Prepare an outline of the income statement for direct costing:
a. Using a conventional format
b. Using a cost-volume-profit format
Q. 6.13 Explain why absorption costing causes net income to increase as
production become larger relative to sales.
Q. 6.14 How can the difference in net income between absorption costing and
direct costing be reconciled?

Exercise 6.1 • Direct Costing Versus Absorption Costing

You have been given the following information:

Beginning inventory (units) 0
Units sold this year 10,000
Units manufactured this year 15,000
Capacity to manufacture 20,000

Material used $ 30,000

Direct factory labor $ 45,000
Variable manufacturing overhead $ 60,000
Fixed manufacturing overhead $ 140,000
Selling expenses $ 60,000
General and administrative expenses $ 30,000
Sales $ 400,000

Required:
Based on the above information, prepare income statements assuming both
direct costing and absorption costing. The fixed overhead rate is to be based on
capacity to manufacture.
Income Statements
Direct Costing Absorption
Costing
 Management Accounting | 107

2. Compute the cost of ending inventory under both direct costing and
absorption costing.

__________________________________________________________
__________________________________________________________
__________________________________________________________

3. The difference in net income between absorption costing and direct

costing can be explained by computing the difference in
__________________________________________________________
__________________________________________________________

4. What would be the difference in net income had actual sales been
15,000 rather than 10,000?
__________________________________________________________

Exercise 6.2

The K. L. Widget Company just completed its first year of operations. The following
was presented by the company’s accountant:
Fixed manufacturing overhead $5,000
Normal capacity 1,000 units
Variable overhead rate $6.00
Actual production 1,000 units
Units sold (price per unit - $50.00) 800 units
Direct labor per unit $10.00
Material cost per unit $5.00
Expenses (selling and general & admin.) $10,000

Required:

Compute net income first assuming absorption costing and then direct costing.
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
__________________________________________________________
108 | CHAPTER SIX • Direct Costing Financial Statements

Acme Manufacturing Company

Income Statement

Absorption Costing Direct Costing

Sales $2,800 Sales $2,800
Expenses Variable expenses:
Cost of goods sold 1,120 Cost of goods sold 420
Selling 350 Selling 200
U/A fixed mfg. o/h 200 ––––– ______
620
______ _______
Total expenses $1,670 Contribution margin $2,180
Fixed expenses
Fixed mfg. overhead 1,000
Selling 150 1,150
––––– –––––
Net income $1,130 Net income $1,030
–––––––
––––––– ––––––
––––––

Ending inventory $ 160 Ending inventory $ 60

The Acme Manufacturing Company started operations on January 1. On

December 31, the above comparative income statements were presented by the
company’s management accountant to management. The above statements were
prepared based on the following data.

Revenue data:
Sales 70 units
Price $40
Beginning inventory:
units 0
cost 0
Manufacturing data:
Manufacturing costs per unit:
Direct material $1
Direct labor $2
Variable overhead $3
Fixed manufacturing overhead $1,000
Capacity 100 units
Units manufactured 80 units
Operating expenses:
Variable selling (total) $200
Fixed selling $150
 Management Accounting | 109

Required:
1. Compare net income under direct costing with absorption costing net
income. Which is greater?__________________________________
List all the differences that you observe in the direct costing income
statement:
_ _______________________________________________________
_ _______________________________________________________
_ _______________________________________________________
_ _______________________________________________________
_ _______________________________________________________
2. Now use the direct costing/absorption costing tool. Enter the above data
as requested by the program. (If the software package is not available,
then you will have to manually make the required computations.)
3. Change units manufactured to 90 units. What effect did this change
have on net income under:
a. Absorption costing?_ __________________________
b. Direct costing?_______________________________
4. Now change the units manufactured to 60 units. What effect did this
change have on net income under:
a. Absorption costing?_ __________________________
b. Direct costing?_______________________________
5. Using the direct costing/absorption costing tool, enter the starting level
of activity as 60. Set the increment in production at 10 units.

What happen to net income as production increased but sales remained

the same?
______________________________________________
______________________________________________
6. Explain why net income increased under absorption costing?
______________________________________________
7. What general rules can be stated concerning net income, production,
and sales?
a. ____________________________________________
b. ____________________________________________
c. ____________________________________________
110 | CHAPTER SIX • Direct Costing Financial Statements

8. What is the manufacturing cost per unit under?

a. Absorption costing _ ___________________________
b. Direct costing ________________________________
9. What general rule can be given regarding the difference in net income
between absorption costing and direct costing, assuming no beginning
inventory?
______________________________________________
______________________________________________

10. Assume that on January 1, the Acme Company had 20 units of inventory
on hand. Costs of these units were:
Absorption Costing Direct Costing
Number of units 20 20
Total cost 320 120
Now compute net income again assuming absorption costing and direct
costing. What is the difference in absorption costing and direct costing
income?
______________________________________________

______________________________________________

What general rule can be given to explain the difference in net

income?
______________________________________________
______________________________________________
 Part II
Management Accounting
Decision-Making Tools

Chapter 7 • Cost-Volume-Profit Analysis

Chapter 8 • Comprehensive Business Budgeting

Chapter 9 • Incremental Analysis and Decision-making Costs

Chapter 10 • Incremental Analysis and Cost-Volume-profit Analysis:

Special Applications

Chapter 11 • Economic Order Quantity Models

Chapter 12 • Capital Budgeting Decisions Tools

Chapter 13 • Pricing Decision Analysis

 Management Accounting | 113

Cost-Volume-Profit Analysis

The success of a business as measured in terms of profit depends upon

adequate sales; that is; the volume of sales must be sufficient to cover all costs
and allow a satisfactory margin for net income. When the proportion of fixed costs
in a business becomes large in relation to total costs, then volume becomes an
extremely important factor in achieving profitability. For example, a business with
only variable costs would be able to report net income at any level of sales as long
as price exceeds the variable cost rate. However, a business with only fixed costs
cannot show a profit until the contribution from sales is equal to the amount of fixed
expenses. Therefore, a minimum level of sales is absolutely essential in a business
that incurs fixed expenses.
Because changes in volume can have a profound impact on the profits of a
business, cost-volume-profit analysis has been developed as a management tool to
enable analysis of the following variables:
1. Price
2. Quantity
3. Variable costs
4. Fixed costs

The focal point of cost-volume-profit analysis is on the effect that changes in

volume have on fixed and variable costs. Volume may be regarded as either units
sold or the dollar amount of sales. Typically, the theory of cost-volume-profit analysis
is explained in terms of units. However, using units as the measure of volume for
computing break even point or target income point requires that the business sell
114 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

only a single product. Since all businesses from a practical viewpoint sell multiple
products, the real world use of cost-volume-profit analysis requires that volume be
measured in terms of sales dollars.
Cost-volume-profit analysis may be used as (1) a tool for profit planning and
decision-making and (2) as a tool for evaluating the profitability of proposed business
ventures. In this chapter, the discussion of profit analysis shall be limited to its use as
a current period profit and decision-making tool.
Nature of Cost-Volume-Profit Analysis
In chapter 5, the subject of cost behavior was discussed. The point was made that
the costs of a business could be classified as either fixed or variable. Mathematically,
it was stated:
TC = V(Q) + F (1)
TC - total costs
V - variable cost rate
Q - quantity
Revenue or sales may be defined as:
S = P(Q) (2)
S - sales
P - price
Income may be defined as:
I = R - E (3)
R - revenue
E - expense
I - income
When equations (1) and (2) are substituted into equation (3), equation (3) becomes
I = P(Q) - V(Q) - F (4)
Equation (4) is recognized in this chapter as the foundation of cost-volume-
profit analysis. Quantity (Q) is generally treated as the independent variable; that is,
income is regarded as a function of quantity (Q). The variable cost rate (V) and fixed
expenses (F) are assumed to be constants. However, for certain analytical purposes,
the values of V and F may be assigned different values in order to determine the
effect of the changes in these values on net income.
Equation 4, it should be noted, may be used as a tool of analysis only for a single
product business. For firms that have more than one product, another equation which
emphasizes sales as volume in dollars must be used:
I = S - v(S) - F (5)
S - sales in dollars
v - variable cost percentage

In a multiple product business, it is necessary to express variable cost as a

percentage of sales. This percentage will be discussed in detail in a later section of
this chapter.
 Management Accounting | 115

Cost-volume-profit Analysis for a Single Product Business

Frequently, it is necessary to ask the question: how many units must be sold in
order to attain a given level of net income? Equation (4) may be used to answer this
question; however, in order to do so it is necessary to solve for quantity, Q.
I = Q(P - V) - F

I + F = Q(P - V )
I+F
Q = ––––– (6)
P-V

Equation (6) may be used to determine the quantity of sales required to attain
any desired level of income. For example, assume that the Acme Company’s selling
price is $10 and its variable cost rate is $8. Also, assume that it has fixed expenses of
$5,000. Suppose that management desires to earn $8,000 for the period. How many
units must the company sell in order to attain the desired net income?

Answer: This question may be answered simply by substituting these given rev-
enue and cost values into equation 6:

I + F $8,000 + $5,000 $13,000

Q = –––– = ––––––––––––– = ––––––– = 6,500 units
P - V $10 - $8 2

Therefore, the Acme Company must sell 6,500 units to earn $8,000. The validity
of this answer can be demonstrated as follows:
Sales (6,500 x $10) $65,000
Expenses:
Variable (6,500 x $8) $52,000
Fixed 5,000
_______
Total expenses $57,000
_______
Net income $ 8,000
–––––––
–––––––
In management accounting literature, considerable emphasis is given to the
concept of a break even point. While it is an interesting academic exercise to compute
break even point, it should be stressed that a company does not set a goal to break
even. The primary object of management in using cost-volume-profit analysis is to
determine target income point and not break even point.
Nevertheless, assuming for some reason that it is considered desirable to know
the break even point of a business, the break even point is calculated exactly in the
same way as target income point. Equation (6) may be used to compute break even
point. Break even point is simply the quantity of sales that achieves zero net income.
It is that level of sales where total sales equals total expenses.
Using the same data from the example above, break even point may be computed
as follows:
116 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

I + F 0 + 5,000 5,000
Q = ––––– = –––––––– = ––––– = 2,500 units
P - V 10 - 8 2

The correctness of this answer may be demonstrated as follows:

Sales (2,500 x $10) $25,000
Expenses:
Variable (8 x 2,500) $20,000
Fixed 5,000
––––––– 25,000
–––––––
Net income $       0
–––––––

Cost-volume-profit Analysis for a Multiple Product Business

A company with more than one product cannot use equations (4) or (6) as illustrated
and discussed above. It is not possible to logically add different quantities of product.
The saying that “you can’t add apples and oranges” applies here. However, it is
possible to meaningfully add the dollar value of oranges to the dollar value of apples.
In a multiple product business, it is necessary to use the dollar value of sales as the
measure of volume.
Equation 5, as previously indicated, is the basis of cost-volume-profit analysis for
a multiple product business.
I = S - v(S) - F
S - sales in dollars
v - variable cost percentage
The expression v(S) represents total variable expenses. It may be calculated by
simply dividing total variable expenses or cost by total sales:
TVE
v = –––– (7)
S
Where:
v - variable cost percentage
TVE - total variable expenses
S - sales ($)
The variable, v, requires an explanation. As used in the above equation, it is the
variable cost percentage; that is, it represents the percentage that total variable cost
bears to total sales. The variable cost percentage is assumed to be constant at all
levels of activity. For example, assume that v = 70%. Total variable costs would vary
with sales as illustrated:
Q v TVC
–––––––– –– ––––––––
$  10,000 .7 $   7,000
$100,000 .7 $  70,000
$200,000 .7 $140,000
$400,000 .7 $280,000
 Management Accounting | 117

In order for the variable cost percentage to hold constant in a multiple product
business, it is necessary for the sales mix ratio to remain the same. The sales mix
ratio is discussed later in this chapter.
As in the case of a single product firm, it is desirable to ask the question: how
many units must be sold in order to attain a desired income level? Equation 5 may
be used to answer this question; however, it is first necessary to solve for S (sales)
as follows:
I = S - v(S) - F
S(1 - v) - F = I
S(1 - v) = I + F
I+F
S = –––––– (8)
1-v
This equation may be used to compute the dollar level of sales required to attain
a desired level of income. For example, assume that the Barton Company’s variable
cost percentage is 80% and its fixed cost is $10,000. Furthermore, assume that
management has set a profit goal of $50,000. What must the dollar volume of sales
be in order to attain the $50,000 income objective?
Answer:
I + F 50,000 + 10,000 60,000
S = –––––– = –––––––––––––– = –––––– = $300,000
1 - v 1 - .8 .2
The correctness of this answer can be demonstrated as follows:
Sales $300,000
Expenses:
Variable ($300,000 x .8) $240,000
Fixed 10,000
250,000
– ––––––– – –––––––
Net income $ 50,000
– –––––––
The Contribution Margin Concept
The study and use of cost-volume-profit analysis requires understanding the
concept of contribution margin. The study of this unique concept contributes greatly
to an understanding of the importance of changes in volume. In an aggregate sense,
contribution margin is simply total sales less total variable costs. From a decision-
making tool perspective, it is also necessary to understand the concept mathematically.
Variation of this concept include:
Single product business:
Total contribution margin - P(Q) - V(Q) or Q(P - V)
Contribution margin rate (per unit of product) - ( P - V)
Multiple product business
Total contribution margin - S - v(S) or S(1 - v)
Contribution margin percentage - ( 1 - v)
118 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

The contribution margin rate (per unit) and the contribution margin percentage
are often called the contribution margin ratio. A ratio may be expressed on a unit
basis or a percentage basis.
The concept of contribution margin provides a rather unique way of interpreting
the activity of a business. At the start of the operating period, a business with fixed
expenses would show a loss. At zero sales, the loss would be equal to total fixed
expenses. As each unit of product is sold, the loss is gradually reduced by the
contribution margin of each unit sold. No profit can be reported until total contribution
equals total fixed expenses. After break even point, each unit sold contributes to net
income an amount equal to the contribution margin per unit of product.
Total Contribution Margin - As previously defined, total contribution margin is
total sales less total variable costs. Mathematically, in terms of the profit equation
for a single product business, total contribution margin is equal to P(Q) - V(Q). It
is important to understand that the term “contribution” means a contribution first to
fixed expenses. As previously mentioned, there can be no profit in a business until
total contribution equals total fixed expenses. When this occurs, the business has
reached break even point. Break even point is that quantity of sales that causes total
contribution margin to be exactly equal to total fixed expenses.
Contribution Margin Per Unit of Product - The use of cost-volume-profit analysis
as a decision-making tool also requires understanding of the concept of contribution
margin per unit of product. The contribution margin rate is simply price less the
variable cost rate. Mathematically, the contribution margin rate is P - V.
The use of the contribution margin rate is obvious in equation 6:
I + F
Q = –––––––
P - V
The denominator in this equation, P - V, is the contribution margin rate and, I +
F, is the total contribution desired. An important question is: how much contribution is
required in any business? The answer is that the contribution required must be enough
to pay fixed expenses and then be sufficient to allow the firm to attain the desired
level of income. Consequently, I + F, represents the total required contribution.
Illustration
The Acme Company’s accountant provided the following cost-volume-profit
data:
P - $10.00
V - $8.00
F - $5,000
I - $25,000

The company’s contribution margin rate is $2 ($10 - $8). Each sale contributes
$2. If the company sells 1,000 units, then the total contribution would be $2,000. The
company obviously needs an additional $3,000 of contribution to reach break even
point. When sales reach 2,500 the total contribution is $5,000 which is equal to fixed
expenses. Break even point has been reached. Each additional units sold after break
 Management Accounting | 119

even point contributes $2 to income. If 2,600 units are sold, net income would be
$200 ($2 x 100).
Contribution Margin Percentage - In a multiple product firm, it is necessary to talk
in terms of contribution as a percentage. Mathematically, the contribution margin
percentage rate is 1 - v. The contribution margin percentage requires that the
variable cost percentage be first computed. If the variable cost percentage is 70%,
then the contribution margin percentage would be 30% (1 - .70). The importance of
the contribution margin percentage is apparent from examining equation 8:
I + F
S = –––––––
1 - v
The contribution margin percentage is the percentage that each dollar of sales
contributions towards fixed expenses and desired net income. The total contribution
required to attain the desire income goal can be computed by simply dividing total
desired contribution by the contribution margin percentage.
Contribution Margin Income Statement - Cost-volume-profit analysis may be
made an integral part of financial reporting. Companies who do this generally prefer
to prepare income statements in which fixed costs, variable cost, and contribution
margin are explicitly shown. For example, assume that during the year the Acme
Company had sales of $50,000 and fixed and variable costs as follows:
Fixed Expenses Variable Expenses
Selling Selling
Advertising $5,000 Sales people commissions $ 5,000
Sales people salaries $3,000 Sales people travel $ 2,000
Supplies $ 500 Cost of goods sold $20,000
General & Admin. General & Admin.
Utilities $ 500 Supplies $ 5,000
Supplies $ 500 Other $ 2,000
Executive salaries $2,000
Depreciation $1,000
Based on the above data, the following income statement may be prepared as
shown in Figure 7.1.
Graphical Illustration of Cost-volume-profit Analysis
Because the fundamental relationships of cost-volume-profit analysis are basically
mathematical in nature, the elements of cost-volume-profit analysis can be illustrated
graphically. The general procedure is to plot the revenue and cost functions on the
same graph. In order to illustrate the cost-volume-profit graphically, the following data
has been assumed:
Price $10
Variable cost rate $6
Fixed expenses $20,000
For purposes of preparing the graph, assume different levels of quantity starting
with 1,000 units and increasing activity by increments of 1,000 units. The following
calculations are helpful in plotting the graph.
120 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

Figure 7.1

Acme Manufacturing Company

Income Statement, Contribution Basis
For the Year Ended, Dec. 31, ____

Sales $50,000
Variable costs:
Selling:
Cost of goods sold $20,000
Sales people commissions 5,000
Sales people travel 2,000 $27,000
–––––––
General & Admin.
Supplies $  5,000
Other 2,000 7,000 $34,000
––––––– –––––– –––––––
Contribution Margin $16,000
Fixed Expenses:
Selling:
Advertising $  5,000
Sales people salaries 3,000
Supplies 500 $8,500
–––––––
General & Admin.
Executive salaries $  2,000
Utilities 500
Supplies 500
Depreciation 1,000 4,000 $12,500
––––––– –––––– –––––––
Net income $ 3,500
________
________

Revenue (sales) Total Variable Costs

–––––––––––––––––––––––––––– – ––––––––––––––––––––––––––––––
Q P Total Sales Q V Total Variable Costs
– –––– –––– –––––––––– – –––– ––– –––––––––––––––––––
1,000 $10 $10,000 1,000 $6 $ 6,000
2,000 $10 $20,000 2,000 $6 $12,000
3,000 $10 $30,000 3,000 $6 $18,000
4,000 $10 $40,000 4,000 $6 $24,000
5,000 $10 $50,000 5,000 $6 $30,000
The procedure for preparing the cost-volume-chart is as follows:
(1) Plot the data for total fixed costs (See Figure 7.2a)
(2) Plot the data for total variable expenses (See Figure 7.2b)
(3) Plot the data for total sales (See Figure 7.2c)
 Management Accounting | 121

Figure 7. 2
2a 2b
Fixed Cost Total Fixed and Variable Cost
60000

50000
40000
40000
Cost $

Cost $
30000
20000
20000

10000

0
0 2000 4000 6000 8000 0 2000 4000 6000 8000
Volume Volume (Quantity)

2c
Cost-Volume-Profit Chart
70000

60000
Sales/Cost ($)

50000

40000

30000

20000

10000

0
0 2000 4000 6000 8000

Volume (Quantity)

Figure 7.2c represents the completed cost-volume-profit graph. The graph

represents an excellent visual means of presenting the basic concepts and cost
behavior relationships inherent in cost-volume-profit analysis. An enlarged version of
Figure 7.2c is presented is Figure 7.3. Notice that the Acme Company’s break even
point can easily be seen to be 5,000 units. Assume that the Acme Company desires
to attain an income level of $7,000. The level of sales that will result in this amount of
income is $67,500. The graph can be easily used to shown net income and net loss
as has been done in Figure 7.3a.
In addition, the concept of contribution margin can be visually represented in
Figure 7.3. Notice that in Figure 7.3 that variable cost has been plotted before fixed
cost. Note that in Figure 7.3B, the total contribution margin area is indicated by an
arrow. By definition total contribution margin is simply total sales less total variable
expenses, and this is exactly what is shown in Figure 7.3B. Also, notice that at break
even point, the total contribution margin is equal to fixed costs, as illustrated by chart
7.3B. The break even point may be defined in several ways. One definition defines
break even point as that level of sales where total contribution margin is equal to
total fixed expenses as illustrated in 7.3B. Another definition defines break even point
as that level of sales where sales = total expenses (Figure 7.3A). Obviously, in both
definitions, net income is zero at break even point.
122 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

Figure 7.3 • Graphical Illustration of Contribution Margin

(000) (000)

80 80

70 70

60 60 Contribution
margin
Net Income
50 50

40 Net Loss 40

30 30
Contribution margin =
fixed expenses
20 20

10 10

0 0
2,500 5,000 6,750 2,500 5,000 6,750
A Volume (units)
B Volume (units)

Basic Assumptions of Cost-volume-profit Analysis

In the next section, illustrations will be given on how cost-volume-profit analysis
may be used as a profit planning and decision-making tool. However, effective use of
cost-volume-profit analysis for planning purposes requires understanding of certain
basic assumptions. Unless the following assumptions are substantially met, any
attempt to use cost-volume-profit analysis in a real world situation may prove to be
inaccurate and misleading.
Cost-volume-profit analysis assumptions may be summarized as follows:
1. Within a relevant range of volume, the variables price, quantity,
fixed costs, and variable costs are subject to managerial control.
2. Price and the variable cost rate are constant within the relevant
range of activity.
This assumption simply means that variable costs and revenues are
assumed to vary linearly with changes in volume. State differently,
changes in volume have no effect on price, the variable cost rate,
and fixed costs.
3. In a multiple product company, the sales mix ratio remains constant
with changes in total sales.
 Management Accounting | 123

4. In a company that uses absorption costing, unless sales equals

production, there exists no unique break even point. When direct
costing is used, no problems arise when production varies from
sales. In direct costing, fixed manufacturing overhead is treated
as a period charge. Direct costing and absorption are discussed in
some depth in chapter 6.
Cost-Volume-Profit Analysis: A Decision-making Analysis Tool
Previous discussion of C-V-P was based on the assumption that price, the variable
cost rate, and fixed costs remain constant with increases or decreases in quantity.
Changes in quantity do not cause changes in the other variables. However, price,
the variable cost rate, and fixed costs can change for reasons other than changes in
volume. Management can at any time decide to increase or decrease price. Suppliers
at any time can increase or decrease the cost per unit of materials. Many, if not most,
variable costs and expenses can be changed by management simply by making the
decision to do so.
Since price, variable costs, and fixed costs can be increased or decreased at the
will of management, the cost-volume-profit equations can be used to perform what-
if analysis. In broad terms, six basic questions may be asked regarding changes in
revenues and costs:

Price
What is the effect on break even point and target income point of an increase
in price?
What is the effect on break even point and target income point of a decrease in
price?

Variable cost rate

What is the effect on break even point and target income point of an increase in
the variable cost rate?
What is the effect on break even point and target income point of a decrease in
the variable cost rate?

Fixed Expenses
What is the effect on break even point and target income point of an increase in
fixed costs?
What is the effect on break even point and target income point of a decrease in
fixed costs?
An effective way to answers these questions is to use a P/V graph. A P/V graph
shows the relationship of net income to volume (sales dollars or units). A P/V graph
is shown in Figure 7.4. In this graph, volume is the independent variable and net
income the dependent variable. To illustrate how a P/V graph is constructed, assume
the following:
124 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

Figure 7.4
P/V Chart
Price (P) $10
Variable cost rate (V) $8 6000

Fixed Costs (F) $5,000 5000

Net Income $
4000
Based on this data, the table below
may be prepared. 3000

2000

1000
Q P(Q) V(Q) F NI 0
–––––––––––––––––––––––––––––––––––––––– 2000 4000 6000
-1000
1,000 10,000 8,000 5,000 (3,000)
-2000 Q
2,000 20,000 16,000 5,000 (1,000)
-3000
3,000 30,000 24,000 5,000 1,000 -4000

4,000 40,000 32,000 5,000 3,000 Volume (units)

5,000 50,000 40,000 5,000 5,000 Net Income

Figure 7.5 • Changes in Net Income Line

$ $ $
Net Income

Net Income
Net Income

Q Q Q

Increase in Price Decrease in Price Increase in Variable Cost

A B C
$ $ $
Net Income
Net Income

Net Income

Q Q Q

Decrease in Variable Cost Increase in Fixed Cost Decrease in Fixed Cost

D E F

In Figure 7.5 is illustrated the effect on break even point and net income of changes
in price, variable cost, and fixed expenses. In chart A, an increase in price shifts the
line upwards and to the left. The result is a decrease in break even point. In Chart B,
a decrease in price has the opposite effect. Break even point has increased in chart
C. The increase in variable expenses caused the income line to shift downwards and
to the right. The opposite is true of a decrease in the variable expense rate. Break
even point has decreased. An increase in fixed expenses will cause the income line
to shift to the left and upwards. The result is a decease in break even point. The
 Management Accounting | 125

opposite is true for an increase in fixed expenses. Whether a given change is good
or bad for fixed expenses such as advertising can not be stated. For example, an
increase in advertising might cause an increase in sales with a resulting increase in
net income.
The P/V graph can effectively be used to illustrate changes in price, the variable
cost rate, and fixed costs. A change in one of these variables will cause a shift or
movement in the net income line.
Changes in Price - An increase in price will most likely result in a decrease
in sales. However, a decrease in sales does not necessarily mean a decrease in
net income. Regarding the units that are sold, the contribution margin is greater.
Consequently, less units of sales are required to attain a profit goal. Given an increase
in price, management will probably want to ask the question: how many units of sales
can be lost and the same net income earned?
This question can be answered by using the following equation:
I + F
Q = ––––––– Figure 7.6 • P/V Chart
P - V
The procedure is simply to $ P/V Chart
compute Q, or quantity, at the new P=$12.00 P=$10.00
price and then subtract this quantity 10000

from the quantity of sales before

7500
the price change.
Illustration 5000

Last year, at a sales volume of 5,000

2500
units, the Ace Manufacturing Company’s
income statement show the following: 0
1,250 2,500 3,750 5,000 units
Sales (5,000 x $10) $50,000
-2500
Expenses
Variable ($8 x 5000) 40,000 -5000
Fixed 5,000
������
-7500
45,000
������
Net income $  5,000
–––––––
–––––––

Management is considering increasing price to $12 per unit. At the new price, the
quantity necessary to earn the same income would be:
5,000 + 5,000 10,000
Q = ––––––––––––– = ––––––– = 2,500
12 - 8 4
At the new price, only 2,500 units need to be sold to earn $5,000. The company
can lose one half of its sales without suffering any loss in income. The effect of the
change in price on break even point and net income at different levels of sales is
shown in Figure 7.5A. Note that in Figure 7.6, the income function shifts upward and
to the left. BEP point is now 1,250 units and the income previously earned at 5,000
units can now be earned at 2,500 units.
126 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

Multiple Product Business and Sales Mix

The break even point and target income point for a multiple product business
can be computed using equation 8. This equation requires that variable cost be
expressed as a percentage of sales. A number of questions arise unique to multiple
product business. One of these problems pertains to the fact that the sale of multiple
products give rise to a sales mix ratio. The term sales mix refers to the ratio of the
units sold for each product. If product A is sold at the rate of 10,000 units per year and
product B at the rate of 20,000 per year, then the sales mix ratio is 1:2.
There are two methods for computing the variable cost percentage in a multiple
product business. The first method was previously discussed and presented as
equation 7
TVE
v = –––––
S
The second method involves using the sales mix ratio and knowing the variable
cost rates of each product: Mathematically, this method may be defined as follows:
∑ ViQi
v = –––––––– (9)
∑ PiQi

i = 1, n
Where:
v - aggregate percentage variable cost
Vi - variable cost rate of product i
Qi - quantity of product i
Pi - price of product i
To illustrate, assume the following:
Product A Product B
Price $12.00 $  8.00
Variable cost $ 8.00 $  2.00
Quantity 1,000 400
Fixed cost $300 $1,000

Based on the above information, the variable cost percentage may be calculated
as follows:
∑PiQi = 12(1,000) + 8(400) = 12,000 + 3,200 = 15,200
∑ViQi ) = 8(1,000) + 2(400) = 8,000 + 800 = 8,800
∑ ViQi 8,800
v = ––––– = –––––– = .5789
∑ PiQi 15,200
Changes in the Sales Mix Ratio
A number of questions arise concerning changes in the sales mix ratio:
1. Does a change in the sales mix ratio have an affect on the variable
cost percentage?
2. Can a separate break even point be computed for each product?
 Management Accounting | 127

3. Is the most profitable product the product with largest contribution

margin?
4. Should the product that generates the highest volume of sales dollars
also be the product that is promoted the most?
5. Is it possible for sales to increase and costs per unit to remain the
same and yet for net income to decrease?

Effect of a Change in the Sales Mix Ratio on the Variable Cost Percentage
Computing a break even point in a multiple product business is based on the
assumption that the sales mix remains the same. In the above example, the sales
mix ratio was 2.5 to 1. Based on this ratio, the break even point is:
1,300 1,300
BEP = ––––––––––– = ––––––– = 3,087
1 - .5789 .4211

Suppose, in fact, the ratio become the opposite; that is 1:2.5. The variable cost
percentage then becomes.
8.00(400) + 2.00(1000) 5,200
v = –––––––––––––––––––– = ––––––––– = .40625
12.00(400) + 8.00(1000) 12,800
The break even point is now:
1,300 1,300
BEP = –––––––– = ––––––––– = 2,189
1 - .40625 .59375
If a significant change is the sale mix ratio occurs, then the previous computation
of the break even point based on the original sales mix is unreliable.
Computing Break even Point for each Product - It is still possible to compute a
break even point for each product separately; however, now care must be taken to
not include common fixed costs in the total fixed costs for each product. Common
fixed costs are those costs that occur whether or not the particular product is sold.
For example, salaries to top management are most likely to be common in nature.
Assuming there are no common costs in the fixed costs of products A and B, then the
individual product break even points may be computed as follows:
Product A Product B
300 300 1,000 1,000
BEP = ––––– = –––– = 900 BEP = –––––– = ––––– = 1,333
1 - .67 .33 1 - .25 .75
Contribution Margin Rate Differences - It is highly unlikely that the contribution
margin rate of each product will be the same. The question is: will the product with the
largest contribution margin rate be the most profitable? The answer is no. Net income
also depends on the quantity sold. Because the contribution rate is the greatest, this
is no guarantee that this product will even be profitable. Using the same data as
previously, net income for products A and B may be computed as shown in Figure
7.7:
As can clearly be seen, product B which has a greater contribution margin rate
128 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

Figure 7.7 • Effect of Different Contribution Margin Rates

Product A Product B
Income Statement
Income Statement
Sales ($8 x 400) $3,200
Sales ($12 x 1,000) $12,000
Variable expenses ($2 x 400) 800
Variable expenses ($8 x 1000) 8,000 ––––––
–––––––
Contribution margin 2,400
Contribution margin 4,000
Fixed Expenses 300
Fixed Expenses 1,000 ––––––
–––––––
Net income $2,100
Net income $ 3,000 –––––––
–––––––
–––––––
–––––––

($6.00 versus $4.00 for product A) is not the most profitable product. While product
A does have the greater sales volume in dollars this does not mean that the product
with the highest sales volume will be the most profitable. Profitability also depends on
the contribution margin rate and the amount of fixed expenses.
Increasing Sales, Constant Costs, and Decreasing Net Income - One of the
unusual phenomenons in a business is that sales can be increasing and costs can
be constant yet the business is experiencing a decrease in net income. This situation
can happen when there is a substantial shift in the sales mix from the product with
the greatest contribution margin rate to the products with a lower contribution margin
rate.
To illustrate, assume that all costs remain the same in our example except that
the sales mix becomes 1,100 to 300. Based on this mix, net income for each product
may be computed as seen in Figure 7.8:

Figure 7.8 • Effect of a Change in Sales Mix Ratio

Product A Product B
Income Statement Income Statement
Sales ($12 x 1,100) $13,200 Sales ($8 x 300) $2,400
Variable expenses ($8 x 1100) 8,800 Variable expenses ($2 x 300) 600
––––––
–––––––
Contribution margin 1,800
Contribution margin 4,400
Fixed Expenses 300
Fixed Expenses 1,000
––––––
–––––––
Net income $  3,400 Net income $1,500
–––––––
––––––– –––––––
–––––––
 Management Accounting | 129

Combined income then is:

Income Statement
Sales $15,600
Variable expenses 9,400
––––––––
Contribution margin 6,200
Fixed Expenses 1,300
––––––––
Net income $  4,900
––––––––
Previously, combined sales was $15,200 ($12,000 + $3,200). Now combined
sales is $15,600 ($13,200 + $2,400); however net income is now $4,900 ($3,400
+ $1,500) whereas it was previously $5,100 ($3,000 + $2,100). Even though sales
increased by $400, net income has decreased by $200. This decrease in net income
happened despite that fact that price, the variable cost rates, and fixed costs remained
the same.
A multiple product business requires close monitoring of the profitability of each
product. General rules for managing and promoting each product based on price,
variable cost rates and fixed cost are difficult to formulate. The computation of break
even or target income point does not tell management which product will be become
the most profitable. However, the effect of changes or shifts in the sales mix can
easily be calculated.
The best approach to evaluating multiple products is to prepare segmental income
statements. This management accounting tool is discussed in depth in chapter 15.
A product that is not making a significant contribution to fixed expenses should
be a candidate for discontinuance. If after all attempts to increase the segmental
contribution have failed, the only course of action is to discontinue the product.
Adding and discontinuing products is a constant and ongoing process. The role of
the management accounting and the use of the appropriate management accounting
tools becomes extremely important in a multiple product business.

Computing Target Income Point After Taxes

In order to compute a target income point, it is necessary to specify the desired
level of income. However, the concept of net income is somewhat ambiguous. Net
income can be before taxes or after taxes. Up to this point in this chapter, it has been
assumed that the desired level of net income is net income before taxes, although
this assumption was never explicitly made.
Net income after income taxes in many instances is more useful in making
decisions. For example, a dividend policy is easier to formulate based on net income
after taxes. Also, in planning cash flow, net income after taxes is more useful. However,
net income before tax and after tax are obviously not independent of each other. In
order to specify net income after tax as the goal in computing target income point, it
is still necessary to know net income before tax. To illustrate, assume that the goal is
130 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

to earn $120,000 after tax and that the tax rate is 40%. The equation for converting
after tax income to before tax income is:
NI bt = NI at / (1 - T)
Where:
NI bt - net income before tax
NI at - net income after tax
T - tax rate

If the desired net income after tax is $120,000 and the tax rate is 40%, then net
income before tax is:
Ni bt = $120,000 / ( 1 - .4) = $120,000 / .6 = $200,000

If price is $100, V is $70,00, and fixed expenses $400,000, then we can compute
target income point using a slightly modified version of equation 6.
I+F
Q = ––––– (6)
P-V
NI AT / (1 - T) + F
Q = ––––––––––––––––––
P - V
Based on this equation, then target income point maybe be computed as
follows:
120,000 /( 1 - .4) + 400,000 200,000 + 400,000
Q = –––––––––––––––––––––– = ––––––––––––––––– =
100 - 70 30

600,000
–––––––– = 20,000
30
The correctness of this computation can be demonstrated as follows:
Sales $2,000,000
Variable expenses 1,400,000
––––––––––
Contribution margin $   600,000
Fixed expenses $   400,000
––––––––––
Net income before taxes $   200,000
Tax expense 80,000
––––––––––
Net income after taxes $   120,000
––––––––––
 Management Accounting | 131

Summary
Cost-volume-profit analysis is a powerful analytical tool. It can be effectively used
in many different kinds of decisions. Cost-volume-profit analysis is based on the
theory of cost behavior and as such it is imperative that the management accounting
and also management have a good understanding of cost behavior. Because
cost-volume-profit analysis is based on a number of critical assumptions, it is also
important to recognize when the use of this tool is valid and when it is not. If the data
used in cost-volume-profit analysis extends too far beyond the relevant range, the
results obtained can be inaccurate and misleading. Nevertheless, as long as the
assumptions on which cost-volume-profit analysis is based hold true, then the tool
can provide very useful information concerning decisions to be made and the evalu-
ation of results already obtained.

Q. 7.1 Define the following terms:

a. Fixed cost i. Contribution margin rate
b. Variable cost j. Variable cost rate
c. Semi-variable cost k. Break even point
d. Step cost l. Target income point
e. Average fixed cost m. Contribution margin income
f. Average variable cost statement
g. Relevant range n. Sales mix
h. Contribution margin o. Net income before tax
Q. 7.2 Define the following mathematically.
a. Sales
b. Total variable cost
c. Total fixed cost
d. Net income
Q. 7.3 What are the two basic equations from which formulas for break even
point or target income point may be derived?
Q. 7.4 Explain how cost-volume-profit analysis may be used as a tool for
decision-making. (Give several examples.)
Q. 7.5 What are the basic assumptions that underlie cost-volume-profit
analysis?
Q. 7.6 What equation may be used to answer the question: how many units
must be sold in order to attain a desired level of net income?
What equation may be used to answer the question: how many
dollars of sales are required in order to attain a desired level of
net income?
Q. 7.7 Draw a graph illustrating break even point. On this chart, show total
sales, total variable cost, and total fixed costs. Shade in the areas of net
loss and net income.
132 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

Q. 7.8 Define the following mathematical expressions:

a. P(Q) - V(Q)
b. P-V
c. 1-v
d. Q(P - V )
Q. 7.9 If total contribution margin is $100,000 and fixed expenses is $80,000,
then the difference ($100,000- $80,000 = $20,000) is called?
Q. 7.10 When total fixed expenses equals total contribution margin, then this
point is called?
Q. 7.11 What effect do the following changes have on break even point:
a. Increase in price
b. Decrease in price
c. Increase in the variable cost rate
d. Decrease in the variable cost rate
e. Increase in fixed expenses
f. Decrease in fixed expenses
Q. 7.12 What assumption must be made in order to use cost-volume-profit
analysis in a multiple product business?
Q. 7.13 What effect does a change in the sales mix ratio have on the variable
cost percentage?
Q. 7.14 Assume a business has three products. What equation may be use to
compute the variable cost percentage?
Q. 7.15 Draw a chart that illustrates the use of this equation:
I = P(Q) - V(Q) - F
Note: ( use only one line to prepare this chart)
Explain how this chart shows break even point.
Q. 7.16 Given that price, the variable cost rates, and fixed costs have not
changed, explain how net income can decrease even though total sales
has increased.
 Management Accounting | 133

Exercise 7.1 • Contribution Margin Income Statement

The management accountant has done an analysis of costs and has arrived at
the following cost-volume-profit analysis data based on general ledger information for
the year ended December 31, 20xx.
Sales $ 100,000
Variable expenses
Selling $ 20,000
General and administrative $ 10,000
Cost of goods sold $ 50,000
Fixed
Selling $ 5,000
General and administrative $ 2,000
Cost of goods sold $ 10,000

Units sold 1,000

Desired level of income $ 50,000

Required:

1. Prepare a contribution margin income statement.

2. Determine the units that must be sold to attain the desired level of net in-
come.

Exercise 7.2 • Preparing a Break even Graph

Based on the following information, prepare a break even chart.

Price $ 80.00
Variable cost rate $ 60.00
Fixed expenses $ 50,000
Desired net income $ 80,000

Exercise 7.3 • Contribution Margin Income Statement

Income Statement
(Sales - 10,000 units)
Sales $200,000
Expenses $150,000
––––––––
Net income $ 50,000
––––––––
134 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

It has been determined that of the $150,000 of expenses, $100,000 were fixed.
The desired company net income is $150,000.
Required:
1. Based on the above information, prepare a contribution margin income
statement.
2. Answer the following:

a. Contribution margin per unit of product – ––––––––––––––––––––

b. Variable cost rate – ––––––––––––––––––––
c. Total desired contribution – ––––––––––––––––––––
d. Break even point – ––––––––––––––––––––
e. Target income point – ––––––––––––––––––––
– ––––––––––––––––––––
Exercise 7.4 • Cost-Volume-Profit Relationships

Cost-Volume-Profit Chart
$
K
I

E
M
J

N
L
C
G

A
D

F H
Q

Based on the above cost-volume-profit chart, identify the following line segments:
Line Segments
– –––––––––––––––
1 A - B ––––––––––––––––––––––––––––––––––––––––––
2 C - D ––––––––––––––––––––––––––––––––––––––––––
3 E - F ––––––––––––––––––––––––––––––––––––––––––
4 G - H ––––––––––––––––––––––––––––––––––––––––––
5 I - J ––––––––––––––––––––––––––––––––––––––––––
6 K - L ––––––––––––––––––––––––––––––––––––––––––
7 M - N ––––––––––––––––––––––––––––––––––––––––––
 Management Accounting | 135

Exercise 7.5 • Computing New Target Income Point

The owner of the Brown Retail Company believes that current sales volume is less
than potential because of inadequate advertising. He has tentatively decided to
increase his advertising budget by $2,000. Last year’s income statement was as
follows:
Sales (1,000 units @ $20.00) $20,000
Variable expenses $10,000
–––––––
Contribution margin $10,000
Fixed expenses $ 6,000
–––––––
Net income $ 4,000
–––––––
Advertising, if increased, will change from $2,000 to $4,000. The maximum market
potential is probably between 1,300 and 1,400 units of product.
Required: Evaluate this proposed increase in advertising. To offset the increase in
advertising, by how much must sales increase in units.

Exercise 7.6 • Computing Break even point and Target Income Point

The following information from the records of the Ajax Manufacturing Company has
been provided to you:
Sales price:
Product A $ 60.00
Product B $ 40.00
Product C $ 100.00

Variable costs:
Product A $ 45.00
Product B $ 30.00
Product C $ 40.00

Units sold:
Product A $ 1,000
Product B $ 2,000
Product C $ 3,000

Fixed costs for each product was determined as follows:

Product A $ 40,000
Product B $ 30,000
Product C $ 80,000

Common fixed costs of the business are $200,000.

136 | CHAPTER SEVEN • Cost-Volume-Profit Analysis

Required:
1. Compute the variable cost percentage for each product.
2. Compute the contribution margin percentage for each product.
3. Compute the break even point of each product.
4. Compute the break even point of the business as a whole.
5. Explain how it is possible for each product to break even yet the business
as a whole is operating at a loss.
6. Suppose the sales mix ratio rather than 1:2:3 becomes 3:1:2. How would
this change in the sales mix ratio affect the variable cost percentage?

Exercise 7.7 • Computing Target Income Point After Taxes

The Acme Manufacturing Company income statement for the year ended was as
follows:
Sales (10,000 units) $ 200,000
Variable expenses 120,000
_ _______
Contribution margin $ 80,000
Fixed expenses 60,000
_ _______
Net income $ 20,000
Tax expense 8,000
_ _______
Net income after taxes $ 12,000
_ _______

Required:
The company would like to have an after tax income of $50,000. What level of sales
is required to attain this level of after tax net income?
 Management Accounting | 137

Comprehensive Business Budgeting

Goals and Objectives

Profit planning, commonly called master budgeting or comprehensive business
budgeting, is one of the more important techniques or tools in the management
accountant’s tool box. Although budgeting is actually an activity performed by
management, the management accountant’s assistance is required because the
final budget is presented in the form of planned financial statements. The process
for budgeting requires from management a set of carefully planned decisions. There
are two primary phases in the budgeting process: (1) planning and (2) control. The
first phase is the primary subject matter of this chapter. The second phase, control
or performance evaluation as it is recognized in accounting, is the primary subject
matter of chapter 14
The budgeting process is an all encompassing task that brings in focus all short
and long run goals and objectives of the business. The process of preparing a
budget compels management to explicitly recognize and assign quantitative values
to all marketing, production, and financial decisions. A major reason for preparing a
comprehensive budget is to obtain a measure of the impact of interrelated decisions
on net income, financial position, and cash flow. However, the benefits of budgeting
extend beyond the expression of decisions into numbers. Benefits often cited for
budgeting include:
1. Recognition/improvement of organizational structure
2. Increased emphasis on setting of long-term objectives
3. Increased motivation to achieve objectives
4. Explicit recognition of important decision relationships
5. Better coordination of activities by managers
6. Improved profit performance
7. Better performance evaluation
138 | CHAPTER EIGHT • Comprehensive Business Budgeting

The end result of the budgeting process is a set of balanced and coordinated
decisions quantitatively presented as a set of budgeted financial statements. For a
manufacturing business, the final product of budgeting is a:
1 Budgeted balance sheet
2 Budgeted income statement
(Including cost of goods manufactured statement)
3 Cash budget
4 Capital expenditures budget
The preparation of a complete budget usually involves the preparation of several
sets of tentative budgets. The final product is often the result of trial and error
procedures. The first completed budget may not reflect the amount of desired profit.
Consequently, management in an attempt to budget better performance may change
one or more decisions during the budgeting process. The consequence of a single
change can easily require computational changes in all budgets and supporting
schedules.
The modern use of computers and special financial software removes the
drudgery and tediousness of preparing a revised budget. The value and usefulness
of a computerized budget programs is that it allows the user to change any decision
so that an immediate updating of all budgeting elements is accomplished.

Comprehensive Business Budgeting and Organizational Structure

Effective budgeting requires participation at all levels of management and most
particularly of managers as defined in the formal organizational structure. All busi-
nesses of any significant size have a formal organizational structure. Decision makers
in all departments will be involved in either making decisions or making recommen-

Figure 8.1 • Simple Organizational Chart

Board of
Directors

President

Vice-President Vice-President Vice-President

Marketing Production Finance

Manager Manager Manager

Cutting Dept Finishing Dept. Finishing Dept.

Accounting
Department

Income
Statement
Balance Sheet
 Management Accounting | 139

dations for decisions to be approved at a higher level. Because all businesses have
three primary functions, marketing, production and finance, top management in each
of these areas has primary responsibility for the final stages of the budgeting process.
A business that is well organized and has well planned channels of communication is
more likely to achieve the standards set forth in a comprehensive budget.
A simple but typical organization charge for a manufacturing business is as shown
in Figure 8.1. Each vice president has the major responsibility in his or her own
area. The vice presidents, however, will involve his or her managers below them to
participate in the budgeting process and provide much of the needed information.
Because medium to large businesses tend to be very complex in organizational
structure, the comprehensive business budget can be an excellent means of
coordinating various activities and facilitating communication among managers at the
same level and also at different levels of management. It is essential after a business
budget has been finally approved that management at all levels give full support to
the profit plan.

The Comprehensive Business Budgeting Process

The process of preparing a budget is somewhat complex. Actually, there are two
major activities that more or less happen at the same time in the budgeting process.
The sales forecast which is the first component requires that a set of tentative basic
marketing decisions have been made. Other components such as the direct labor
budget require specific decisions. In other words, the final budgeting product consists
of various components each of which require certain tentative decisions at a minimum
to have been made. Otherwise, without these decisions the process can not continue
further. The first phase is making decisions and the second major process involves
preparing the final budget documents.
In a manufacturing business, the formal components of the comprehensive
budget beyond the sales forecast consists of the following:

Operating Budgets
1. Sales budget
2. Ending inventories budget
3. Production budget
4. Materials purchases budget
5. Direct labor budget
6. Manufacturing overhead budget
7. Manufacturing overhead budget
8. Cost of goods manufactured
9. Operating expense budget

Financial Budgets
10. Income statement
11. Cash Budget
12. Capital expenditures budget
13. Budgeted balance sheet
140 | CHAPTER EIGHT • Comprehensive Business Budgeting

A diagram of the budget components is shown in Figure 8.3 This figures shows
the logical order in which the budget process must follow. The budgeting process
begins as shown in the diagram with the sales forecast and ends with the budgeted
balance sheet. However, the preparation of the final budgeting documents is not
the real budgeting. The real budgeting is the process of decision-making; that is,
the process of identifying alternative decisions and then choosing the best decision
under the given circumstances.
Decision-making and Comprehensive Business Budgeting
The main two parties in the budgeting process are management and the
management accountant. As used here, the term management accountant could
be the accounting department or the function within the accounting department that
has been designated as management accounting. Budgeting in one sense is not
an accounting activity but rather a management activity. It is not the management
accountant that budgets but rather it is management’s responsibility to budget.
Because the budgeting process involves considerable accounting and finance and
because the management accountant possesses considerable skill in decision-
making tools, the accountant is usually required to participate in the process. The
most important and also prerequisite activity in the process is the making of an initial
set of decisions.
As discussed in chapter 2, decisions can be classified in different ways. The
decision classification that is of critical importance in the budgeting process is strategic
and tactical. Strategic decisions are broad‑based, qualitative type of decisions which
include or reflect goals and objectives. Strategic decisions are non quantitative in
nature. Strategic decisions are based on the subjective thinking of management
concerning goals and objectives.
Tactical decisions are quantitative executable decisions which result directly from
the strategic decisions. The distinction between strategic and tactical is important in
management accounting because the techniques of management accounting pertain
primarily to tactical decisions. Management accounting tools are designed primarily
to be used in making tactical decisions. However, business budgeting can be of value
in helping management set strategic decisions.
The strategic decisions while not quantitative in nature can have a tremendous
impact on the type of tactical decisions made. Among the more important strategic
decisions are the company’s profit goals. If the goal is to maximize sales, then one
type of decisions would be made while if the goal is to maximize profit or return on
investment, then a different set of tactical decisions is likely to emerge.
The preparation of the formal budget documents requires that specific decisions
be made at certain stages in the process. Without these decisions having been
made at the right time some components of the comprehensive budget can not be
completed. The basic required decisions of each component is illustrated in Figure
8.2. As seen in this figure, each component has certain decisions identified with it.
A major objective of the budgeting process is to plan the highest attainable level
of profit that is consistent with all of the organization’s goals and objectives. Although
 Management Accounting | 141

Figure 8.2 • Required Decisions for each Budget

1. Sales Forecast 2. Sales Budget

Required Decisions (No new decisions are required)
1 Price
2 Advertising
3 Credit terms
4 Sales people compensation plan
5 Number of products
6 Number of territories
7 Special Offers

3. Ending Inventory Budget 4. Production Budget

Required Decisions (No new decisions are required)
1 Safety stock required
2 Materials cost per unit

5. Materials Purchases Budget 6. Factory Direct Labor Budget

Required Decisions Required Decisions
1 Order size 1 Wage rate
2 Number of orders 2 Labor productivity
3 Spoilage factor 3 Overtime/second shift

7. Ending Inventory Budget 8. Cost of Goods Manufactured

Budget
Required Decisions
1 Various overhead cost factors (No new decisions are required)

9. Expense Budget 10. Income Statement Budget

Required Decisions (No new decisions are required)
1 Estimates of various expenses at the
budgeted level of sales

11. Cash Budget 12. Capital Expenditures Budget

Required Decisions Required Decisions (Examples)
1 Desired ending cash balance 1 Purchase of computers
2 Issue of stock 2 Purchase of delivery equipment
3 Issue of bonds 3 Purchase of sales vehicles
4 Bank loans 4 New production equipment
5 Payment of accounts payable
6 Payment of dividends
7 Investment in stock

13.Budgeted Balance Sheet

(No new decisions required)
142 | CHAPTER EIGHT • Comprehensive Business Budgeting

Figure 8.3 • Comprehensive Business Budgeting Components

1 5 10
8
Materials Income
Sales Forecast Cost of Goods
Purchase Budget Statement
Manufactured
Budget

3 4 6 11 13

Ending Direct
Production Cash Budget Balance
Inventory Factory
Budget Sheet
Budget Labor 9

Expense
Budget

2 7 12

Manufacturing Capital
Sales
Overhead Expenditures
Budget
Budget Budget

admirable, profit maximization is not necessarily the goal because of the extreme
difficulty of obtaining all the required information. A more realistic and attainable goal
is to construct a business budget that will result in a satisfactory profit. Profit can be
considered satisfactory when the planned profit stated as a rate of return is equal to
or greater than the rate of return desired by management. The basic fundamentals of
return investment are discussed in chapter 16.
An important assumption in management accounting is that the value of a budget
can be greatly enhanced by the use of all relevant management accounting tools.
Management accounting tools such as cost-volume-profit analysis and incremental
analysis make possible effective what-if analysis. Also, management accounting
tools when used properly compel management and the management accountant
to acquire the relevant data needed by the tool. The proper use of management
accounting tools make the budget more realistic and attainable.
In order for management to effectively engage in the total budgeting process, it is
helpful and perhaps necessary that management have some knowledge of accounting
fundamentals. That the accountant has this knowledge is a given. However, on the
part of management, some knowledge and understanding of the following would be
very helpful:
1. Financial statement relationships
2. Absorptions costing and direct costing fundamentals
3. Cost behavior (fixed and variable costs)
4. Fundamentals of accounting for overhead
5. Accrual basis and cash basis accounting
Sales Forecasting
The starting point of preparing a comprehensive business budget is a sales
forecast. Sales forecasting can be a challenging but somewhat less than a scientific
 Management Accounting | 143

process. A sales forecast is an estimate of future sales in units and dollars for a given
time period. Budgets are often prepared on an annual basis and then sub divided into
quarters. The key to making a successful forecast is to first understand the factors,
particularly marketing decision variables, that directly impact sales. These factors
can vary widely among different types of businesses and, consequently, one of the
first prerequisites to a good sales forecast is an understanding of the business and
the market in which the business operates.
To a large extent, sales are controllable by management. Certain marketing
decisions, if made correctly, can cause significant changes in sales almost immediately.
Some of the more important decisions that affects directly the sales forecast are the
following:
1. Price
2. Advertising
3. Number of sales people
4. Sales people effectiveness and motivation
5. Credit Terms
6. Number of territories (opening or closing)
7. New products

In The Management/Accounting Simulation, all of the above are factors which

determine sales and, consequently, the sales forecast.
The sales forecast is of critical importance for several reasons. First, the production
budget depends on a reasonably accurate sales forecast. Without a sales forecast,
the number of units manufactured could easily be far too low with costly stock outs
occurring. Furthermore, production could just as easily be too large with unnecessary
carrying costs being incurred or losses being recorded because of inventory that
can not be sold. The sales forecast is important to other budget elements such as
material purchases, number of sales people to hire, production capacity, and number
of factory workers to hire and train.
There are two approaches to making the sales forecast: (1) those methods that
make use of sophisticated statistical and mathematical forecasting models, and (2)
analytical methods or models. The analytical approach attempts to identify the factors
that create demand and can cause demand to change and then assign values to the
factors considered to be of primary importance These factors can vary from industry
to industry and company to company. For example, in one business advertising might
be extremely important but not in another. Additionally, sales people in one company
might be heavily intensive but in another company outside sales reps are not used
at all. Other factors that might be used in making a sales forecast include estimated
market potential, percentage of customers requesting demonstration, sales-calls
ratios, and economic index.
In the V. K. Gadget Company, the name of the company in The Management/
Accounting Simulation, these factors are important in determining demand and
consequently, the sales forecast. The following factors are involved in the sales
forecast:
144 | CHAPTER EIGHT • Comprehensive Business Budgeting

1. Normal market potential

2. Percentage of potential customers requesting a demonstration
3. Growth rate
4. Seasonal indices
5. Sales -calls ratio
6. Credit terms

In the V. K. Gadget Company advertising, also plays an important role. If

advertising is inadequate, then some potential customers will not be informed and,
therefore, will not request a demonstration. If advertising is too much, then the some
part of the advertising budget will be of little or no value.
The analytical method in one company might not work at all in another company.
The first perquisite to a good sales forecast is an in depth understanding of the
business and its economic environment. A second perquisite is the ability to estimate
values for the various parameters. To some extent, past experience can be a good
guide.
The sales forecast formula in the V. K. Gadget Company is as follows:
(Note: numbers are assumed and may be different from those in The Management/
Accounting Simulation.)

Territory 1 Territory 2 Territory 3 Territory 4

a. Normal market potential 100,000 150,000 75,000 100,000

adjusted for growth

b. Estimated percentage .20 .25 .15 .22

of market requesting
demonstration at current
price

c. Estimated potential 20,000 37,500 11,250 22,000

customers requesting
demonstration before
seasonal variation
v(a x b)

d. Seasonal index 1.2 1.2 1.2 1.2

e. Estimated customers 24,000 45,000 13,500 26,400

requesting demonstration
(c x d)

d. Estimated percentage .3 .3 .3 .3
purchasing (sales-calls ratio)

e. Sales forecast (d x e) 7,200 13,500 4,050 7,920

 Management Accounting | 145

Comprehensive Business Budgeting Components

Sales Budget
The sales budget is primarily based on the sales forecast. The main task is
simply to convert units to total sales dollars. In a multiple product business, the sales
budget could be a rather thick document. Ideally, it is desirable to budget sales on
a segmental basis. Sales may be segmented in many ways so, consequently, how
to segment sales is an individual decision of each business. For simplicity purpose
here, a single product business is being assumed and no specific segments are
being illustrated.
Ending Inventory Budget
The ending inventory budget consists of two parts:
Finished Goods
Materials
The desired finished goods inventory is important in preparing the production
budget and the desired ending materials inventory is important in preparing the
materials purchases budget. At this stage of budget preparation, the dollar amount of
finished goods cannot be determined until the budgeted cost of goods manufactured
statement is finished. The ending inventory budget does require that management
have made decisions regarding the seller of material and the cost per unit of material.
Given the availability of quantity discounts, management must at this time make some
tentative decisions regarding order size.
Production Budget
Once the sales forecast has been made, the next major decision to be made is the
amount of production. In absence of substantial beginning finished goods, production
at a minimum must be equal to the sales forecast. However, there is a second
reason to have production. Because actual sales can be greater than the forecast, it
is generally believed that carrying some safety stock is desirable. Consequently, in
absence of any beginning inventory, the production budget would be:
Sales forecast (units) 10,000
Desired finished goods (El) 2,000
______

12,000
______

However, there is no need to manufacture what already exists and, therefore, the
number of units in beginning inventory should be deducted from the above total:
Sales forecast (units) 10,000
Desired finished goods (EI) 2,000
______
12,000
Finished goods inventory (BI) 1,000
______

11,000
______
146 | CHAPTER EIGHT • Comprehensive Business Budgeting

In the V. K. Gadget Company, the possibility of undelivered sales exists. In this

event, the production budget must include these future deliveries. The production
budget represents a critical decision important to budgeting the following:
1. Materials purchases budget
2. Direct labor budget
3. Manufacturing overhead budget.

Because the material purchases budget and the direct labor budget represent
variable costs and the manufacturing overhead budget includes variable costs, the
level of planned production directly affects the totals of various budgets.
Materials Purchases Budget
The materials purchases budget is important because in budgeting net income
it is necessary to know materials used. Materials used was discussed in chapter 3.
At this stage in the budget process, both materials (BI) and materials (EI) are now
known. Only the amount of materials purchases remains to be determined.
In absence of any beginning inventory for materials, the amount of material to be
purchased would be equal to the material needed to meet the needs of the production
budget. If one unit of finished goods, for example, requires 4 units of raw material
and the production budget is 11,000 units, then 44,000 units of material at a minimum
should be purchased. Assuming that the cost of one unit of material is $5.00 and that
500 units of material are in beginning inventory, then the materials purchases budget
would be prepared as follows:
Production budget 11,000
Units of material per unit of product 4
––––––
44,000
Desired materials inventory (EI) 4,000
––––––
48,000
Less: Materials inventory (BI) 500
––––––
47,500
Cost per unit of material $5.00
––––––
Planned purchases $237,500
––––––––
In the V. K. Gadget Company, for material X there is a spoilage factor. Although
each unit of the Gadget requires 4 units of raw material, the required material that
must be purchased per unit of finished goods is slightly more than 4. The purchase of
material X, therefore, should include an allowance for spoilage or defects.
Direct Labor Budget
The direct labor budget is important because direct labor cost is one of the three
major elements of the cost of goods manufactured statement. Direct labor is normally
regarded to be a variable cost and, therefore, very sensitive to the planned level of
production. In reality, a product may require many kinds of labor, some very skilled
and some not so skilled. However, to simplify the fundamentals of the direct labor
 Management Accounting | 147

budget only one type of labor will be assumed. Assume for the moment that the
product being budgeted requires 2 hours of labor and that the wage rate is $12.00 per
hour. The direct labor budget basically involves the following formula:
Production budget 11,000
Direct labor hours required per product 2
–––––––
Total hours required 22,000
Wage rate $ 12.00
–––––––
$264,000
–––––––
The wage rate in theory should include an allowance for payroll taxes and fringe
benefits. However, in practice these are treated as manufacturing overhead.
Manufacturing Overhead Budget
The manufacturing overhead budget consists of two types of overhead cost:
fixed and variable. Manufacturing overhead can consist of a myriad of items. Major
examples include expenditures such as utilities like electricity and gas. If the company
has elected to measure net income based on direct costing, then fixed manufacturing
overhead would be treated as an operating expense. If absorption costing is being
used, then fixed manufacturing overhead is a production cost that is properly included
in inventory. Even under absorption costing, it is helpful to separate fixed and variable
overhead. A vary simple overhead budget might be as follows:
Manufacturing Overhead Budget
Variable overhead $200,000
Fixed overhead 400,000
––––––––
Total $600,000
––––––––
Cost of Goods Manufactured Budget
The format of the cost of goods manufactured statement was discussed in
detail in chapter 3 and there is no need to discuss it again in detail at this time.
However, it should be pointed out that the preparation of the budgeted cost of goods
manufactured statement involves no new decisions. The preparation of this budget
merely involves using data from the previous budgets just discussed. The only new
calculation is materials used and the information required is found in the beginning
balance sheet and materials purchases budget. Materials used as discussed in
chapter 3 is simply:
Materials (BI) $ 10,000
Material purchases budget 237,500
–––––––
247,500
Materials (EI) 20,000
–––––––
$ 227,500
–––––––
148 | CHAPTER EIGHT • Comprehensive Business Budgeting

In the event of freight-in charges, the cost per unit of one unit of material should
include an allowance for freight.
Based on the assume values just used cost of goods manufactured would be:
Materials used $ 227,500
Direct labor 264,000
Manufacturing overhead 600,000
–––––––––
$ 1,091,500
–––––––––
Assuming the business is a single product business, only one step remains
regarding this budget. It is necessary to divide the total cost of goods manufactured
by the units to be manufactured as shown in the production budget. In our example
this per unit cost would be ($1,091,500 /11,000) $99.22. The dollar amount of
desired finished goods can now be computed. It is necessary now to go back to the
ending inventory budget and compute the total cost of desired finished goods ending
inventory.
Selling and General Administrative Expense Budget
The expense budget obviously can include many items and requires that
considerable attention be devoted to many different kinds of expenses. In preparing
this budget, theoretically a distinction should be made between those expenses that
are variable and those that are fixed. In practice, this distinction is often not made.
Budgeted Income Statement
The budgeted income statement is now simply a matter of obtaining data from the
other budgets now The only new calculation is cost of goods sold. The information
for cost of goods sold is obtained from the beginning balance sheet and the budgets
now completed to this point.
The only expense item that is uncertain at this point would be interest expense.
The amount of interest expense is not known until after the cash budget has been
prepared. After the income statement has been nearly completed, the only remaining
budgets are the following:
1. Capital expenditures budget
2. Cash budget
3. Budgeted balance Sheet
The capital expenditures budget is concerned primarily with expenditures for new
projects which may represent a planned expansion of the business. The principles
underlying the capital expenditures budget are discussed in detail in chapter 12.
Cash Budget
The information for the cash budget comes from the other budgets discussed
above. It does not involve any additional decision-making. However, careful attention
must be paid to adjustments for revenue and expense items in these budgets that do
not involve cash received or paid in the period for which the budget is being prepared.
For example, assume that the sales budget is $600,000 and that also all sales are
 Management Accounting | 149

initially made on credit. Furthermore, assume that of this amount only 70% will be
collected. The following calculation is then necessary to determine the amount of
cash collected from sales.

Accounts receivable (beginning balance) $150,000

Collection of budgeted sales (70% x 600,000) $430,000
––––––––
$580,000
––––––––
In addition, regarding the manufacturing overhead budget and the operating
expense budget, non cash items such as depreciation must be subtracted.
Budgeted Balance Sheet
The last budget to be prepared is the balance sheet. Obviously the information
for this budget is based on the information available in all of the other budgets. To
correctly prepare this budget, a high degree of understanding of accounting principles
is required. The accountant and ideally management also must understand the
following relationships:
1. Depreciation and book value of assets
2. Effect of revenues and expenditures on the cash balance
3. The effect of selling on credit on accounts receivable
4. Net income after tax
4. Net income and retained earnings
5. Dividends paid and retained earnings
6. Difference between cash basis accounting and accrual basis accounting

Concepts in Budgeting
Because business budgeting is based solidly on accounting and the end result
of the budgeting process is simply a set of planned (pro forma) financial statements,
there are not many new concepts or terms to learn. The following represent concepts
that should be understand by management. It should be taken more or less for
granted that the accountant has a solid understanding of the following:
1. Assets 14. Cash budget
2. Liabilities 15. Budgeted balance sheet
3. Capital 16. Budgeted income statement
4. Revenue 17. Cost of goods manufactured
5. Expense 18. Capital expenditures budget
6. Net income 18. Direct costing
7. Sales forecast 19. Absorption costing
8. Production Budget 20. Inventory costing methods
9. Purchases budget 21. Decisions
10. Direct labor budget 22. Accrual basis accounting
11. Manufacturing overhead budget
12. Depreciation
13. Accrued expenses
150 | CHAPTER EIGHT • Comprehensive Business Budgeting

Cost Behavior in Comprehensive Business Budgeting

As previously discussed in chapter 5, the use of the cost behavior tool can be very
effective in the planning and control of business operations. Since comprehensive
business budgeting is for the most part a process of planning and controlling financial
statements, the use of cost behavior in the budgeting process is quite logical. The
analysis of manufacturing costs and operating expenses into fixed and variable
components makes the comprehensive budget an even more effective tool for
decision making and performance evaluation. Converting variable costs into variable
cost rates makes possible the preparation of flexible budgets. As chapter 14 will
explain in some detail, flexible budgets are the foundation of the how accountants
implement the concept of control over operations.
Comprehensive Business Budgeting Illustration
Assume that you are the budget director of the K. L. Widget Company. The K. L.
Widget Company is a single product company. The following information based on a
tentative set of decisions has been provided to you:
Planning Data - Sales
Sales forecast 12,000 units
Price $40

Planning Data - Production

Material Inventory:
Units Cost
––––– –––––
Beginning Inventory:
Raw materials 7,000 $35,000
Finished goods 1,000 $31,500

Units
–––––
Desired Ending Inventory:
Raw materials 5,000
Finished goods 2,000
Materials Standards:
Units of material per product 2
Material cost per unit $4
Labor:
Labor Standards:
Labor hours per product 2
Labor rate per hour $7
Manufacturing Overhead:
Fixed: Variable: (per unit)
Utilities $ 3,000 Utilities $ .50
Insurance $ 1,000 Repairs & main. $ 2.00
Depreciation $ 6,000 Supplies $ 1.50
 Management Accounting | 151

Selling Expenses General and administrative

Advertising $40,000 Executive salaries $ 5,000
Sales people travel $14,000 Secretarial salaries $ 2,000
Sales people training $ 5,000 Depreciation, bldg. $ 5,000
Sales people compensation $ 16,000
Planned Data - Financial
Desired ending cash balance - $200,000
Accounts receivable collection rate - 60% of sales first quarter
Remainder next quarter
Accounts payable payment rate - 80% first quarter
Remainder next quarter
Interest rate of bonds - 8%
Additional financing, if needed - Sale of stock

Beginning balance sheet:

K L Widget Company
Balance Sheet
For the Quarter Ended, Dec. 31, 20xx
Assets
Current
Cash $100,000
Accounts receivable 50,000
Materials inventory 35,000
Finished goods inventory 31,500
–––––––– $216,500
Fixed
Plant and equipment $250,000
Accumulated depreciation 30,000
–––––––– 220,000
–––––––
$436,500
Liabilities
Accounts payable $  40,000
Bonds payable 100,000
–––––––– $140,000
Stockholders’ Equity
Common stock $200,000
Retained Earnings 96,500
–––––––– 296,500
Total Liabilities and Equity ––––––––
$436,500
–––––––––
152 | CHAPTER EIGHT • Comprehensive Business Budgeting

Comprehensive Budgeting
2 Sales Budget 3 Ending Inventory Budget

Price $ 40.00 Finished Goods

Units 2,000
Units 12,000 Unit cost $27.3076
––––––– –––––––
Total $480,000 $ 54,615

–––––––
–––––––
–––––––––
–––––––––
Materials Inventory
Units 5,000
Unit cost $ 4.00
–––––––
$20,000

–––––––
–––––––

4 Production Budget 5 Materials Purchases Budget

Sales (units) 12,000 Production 13,000

Finished goods (EI) 2,000 Units per product 2
______ _______
14,000 26,000
Finished goods (BI) 1,000 + Materials (EI) 5,000
_______ _______
13,000 31,000
–– –––––––
––––––– - Materials (BI) 7,000
–––––––
24,000
Cost per unit $ 4. 00
_______
$96,000

–––––––
–––––––
6 Direct Labor Budget 7 Manufacturing Overhead Budget

Production (units) 13,000 Fixed overhead

Standard hours 2 Utilities $ 3,000
–––––––
Insurance 1,000
26,000
Depreciation 6,000
Standard wage rate $ 7.00 –––––––
–––––––
$10,000
$182,000

–––––––
––––––– Variable overhead –––––––
Utilities ( $.50) $ 6,500
Repairs & Main. ($2.00) 26,000
Supplies ($1.50) 19,500
–––––––
$52,000
–––––––
$62,000

–––––––
–––––––
 Management Accounting | 153

8 Cost of Goods Manufactured 9 Selling Expense Budget

Materials used: Advertising $40,000

Materials (BI) $ 35,000 Sales people travel 14,000
Purchases 96,000 Sales people training 5,000
–––––––
$131,000 Sales people compensation 16,000
Materials (EI) $ 20,000 ––––––
–––––––
111,000 $75,000

––––––
––––––
Direct labor $182,000
Mfg. Overhead 62,000
–––––––
$355,000 Administrative Expense Budget
Goods in process (BI) -0-
–––––––
$355,000 Executive salaries $ 5,000
Goods in process (EI) -0- Secretarial salaries 2,000
––––––– Depreciation, building 5,000
$355,000 ––––––

–––––––
–––––––
$12,000
CPU $27.3076
––––––
––––––

10 Income Statement Budget 11 Cash Budget

(Absorption Costing)
Beginning Cash Balance $100,000
Sales $480,000 Cash Receipts
Cost of goods sold Collection of1
Finished goods (BI) 31,500 Accounts. received. $338,000
Cost of goods mfd. 355,000 Other $0
–––––––
__338,000
______
386,500 $438,000
Finished goods (EI) 54,615 Cash expenditures
–––––––
Materials purchases2 $116,800
331,885
––––––– Manufacturing labor 182,000
Gross profit $148,115 Manufacturing overhead
3
56,000
Expenses Selling expenses 75,000
Selling $ 75,000 Administrative expenses
4
7,000
Bond interest 2,000
Administrative 12,000
––––––– Other -0-
$87,000 $438,800
–––––––
________
Net operating income $ 61,115
Ending cash before financing: $ (800)
Interest 2,000 Bank loan 0
–––––––
Sale of stock 200,800
Net income $ 59,115

–––––––
––––––– Sale of bonds 0
$200,800
________
Ending cash balance _$200,000
_______
________
154 | CHAPTER EIGHT • Comprehensive Business Budgeting

13 Budgeted Balance Sheet

Assets
Current:
Cash $200,000
Accounts receivable 192,000
Inventories:
Materials 20,000
Finished goods 54,615
________
$466,615

Fixed
Plant and equipment (net) $209,000
________

Total assets __$675,615
_
_______
______
Liabilities
Current
Account payables $119,200
Long-term
Bonds payable 100,000
$ ______
119,200
Stockholders’ Equity
Common stock $400,800
Retained earnings 155,615
________
556,415
________
Total stockholders’ equity & liabilities
$675,615
___
_______
______

1 Accounts receivable collections:

Accounts receivable collection (beginning balance) $ 50,000
Collection of current quarter sales (60% x $480,000) $ 288,000
––––––––– $338,000
2 Payments on accounts payable:
Payment of beginning accounts payable $ 40,000
Payment on current quarter purchases (80% x $96,000) $ 76,800
––––––––– $116,800
3 Manufacturing overhead:
Total budgeted overhead $ 62,000
Less: Depreciation $ 6,000
––––––– $ 56,000

4 Administrative expenses budgeted $ 12,000

Less: Depreciation on building $ 5,000
–––––––– $ 7,000
 Management Accounting | 155

Summary
Of all the management accountings tools, comprehensive business budgeting
is one of the most powerful and useful in making decisions. No other tools is as
comprehensive in scope and touches directly and indirectly all the decisions made in
a business. Comprehensive business budgeting brings into the planning process a
logical and orderly procedure to decision-making. The second phase of the budgeting
process is often called the control phase. The use of budgets and budgets standards
to evaluate performance as reflected in the actual financial statements is discussed
in some depth in the chapter 14.

Q. 8.1 Explain the purposes or objectives of comprehensive business

budgeting.
Q. 8.1 How does comprehensive business budgeting facilitate planning and
control?
Q. 8.3 List the basic management concepts that are explicitly used in the
business budgeting process.
Q. 8.4 What prerequisites must exist within the internal structure of a business
in order for business budgeting to work?
Q. 8.5 “The foundation of a budget must be based on a set of planned
decisions.” What does this statement mean?
Q. 8.6 What accounting fundamentals must be understood in order to prepare
a comprehensive business budget?
Q. 8.7 What is the starting point for preparing a budget?
Q. 8.8 What importance do flexible budgets play in the over-all budgeting
process?
Q. 8-9 Explain how a comprehensive business budget can be used to compute
variances at the end of the budgeting period.
Q. 8.10 Explain the importance of the production budget.
Q. 8-11 Give a examples of how the amount of cash received or spent is
determined for the following:
a. Material purchases
b. Sales
Q. 8-12 When the comprehensive business budget is completed, what four
documents make up the final product of the budget?
156 | CHAPTER EIGHT • Comprehensive Business Budgeting

Exercise 8.1 • Sales Budget

Based on the following information prepare the sales budget:
Sales forecast (units) 10,000
Sales (last period) 8,000
Budgeted price $40
Finished goods inventory (beginning) 500

Exercise 8.2 • Production Budget

Based on the following information prepare the production budget:
Sales forecast (units) 10,000
Finished goods inventory (beginning) 3,000
Desired finished goods inventory (ending) 1,000
Raw materials inventory (beginning) 2,000

Exercise 8.3 • Materials Purchases Budget

Based on the following information prepare the purchases budget:
Sales forecast (units) 10,000
Budgeted production 9,000
Material required per unit of product 2
Raw materials inventory (beginning) 1,000
Desired raw materials inventory (ending) 800
Material cost per unit $2.00

Exercise 8.4 • Direct Labor Budget

Based on the following information prepare the direct labor budget:
Sales forecast (units) 10,000
Budgeted production (units) 9,000
Raw materials inventory (beginning) 1,000
Labor hours per product 4.00
Wage rate per hour $15.00

Exercise 8.5 • Cost of Goods Manufactured

Based on the following information prepare the cost of goods manufactured
statement:
Sales forecast (units) 10,000
Budgeted production (units) 9,000
Direct labor cost $108,000
Material cost per unit of product $2.00
Budgeted manufacturing overhead:
Fixed $ 20,000
Variable rate $8.00
Note: Some of the above data may not be relevant to the budgeted cost of goods
manufactured statement.
 Management Accounting | 157

Exercise 8.6 • Budgeted Income Statement

Based on the following information prepare a budgeted income statement:

Sales budget $800,000

Finished goods beginning inventory $50,000
Desired finished goods inventory (units) 3,000
Budgeted expenses:
Selling $100,000
General and administrative $ 60,000
Budgeted cost of goods manufactured $600,000
Production budget (units) 20,000
Tax rate 40%

Exercise 8.7 • Cash Budget

Based on the following information prepare a budgeted cash flow statement:

Sales budget $400,000

Beginning accounts receivable $ 60,000
Beginning accounts payable $ 3,000
Beginning cash balance $ 20,000
Materials purchases budget $ 19,000
Direct labor budget $108,000
Budgeted manufacturing overhead:
Fixed $ 20,000
Variable $ 72,000
Budgeted operating expenses:
Selling $ 30,000
General and administrative $ 25,000
Capital expenditures budget $ 50,000
Dividends to be paid $ 10,000
Depreciation included in budgeted expenses:
Selling $ 5,000
General and administrative $ 10,000

Percentage of accounts receivable to be collected 80%

Percentage of purchases to be paid 60%
158 | CHAPTER EIGHT • Comprehensive Business Budgeting

Problem 8.1 • Comprehensive Business Budgeting

Assume that you are the budget director of the K L Widget Company. The K. L.
Widget Company is a single product company. The following information based on a
tentative set of decisions has been provide to you.
Planning Data - Sales
Sales forecast 15,000 units
Price $40
Planning Data - Production
Materials Inventories:
Units Cost
––––– –––––––
Beginning:
Raw materials 8,000 $40,000
Finished goods 3,000 $16,000

Units
–––––
Desired Ending Inventory:
Raw materials 5,000
Finished goods 2,000
Materials Standards:
Units of material per product 2
Material cost per unit $4
Labor:
Labor Standards:
Labor hours per product 2
Labor rate per hour $8

Manufacturing Overhead:
Fixed: Variable: (per unit)
Utilities $4,000 Utilities $  .50
Insurance $2,000 Repairs & maintenance $2.00
Depreciation $9,000 Supplies $1.50
Selling Expenses General and administrative
Advertising $35,000 Executive salaries $6,000
Sales people travel $12,000 Secretarial salaries $3,000
Sales people training. $  4,000 Depreciation, bldg. $4,000
Sales people compen. $14,000
Planned Data - Financial
Desired ending cash balance - $300,000
Accounts receivable collection rate - 60% of sales first quarter
Remainder next quarter
Accounts payable payment rate - 80% first quarter
Remainder next quarter
Interest rate of bonds - 8%
Additional financing, if needed - Sale of stock
 Management Accounting | 159

Beginning balance sheet:

K L Widget Company
Balance Sheet
For the Quarter Ended, Dec. 31, 20xx
Assets
Current
Cash $110,000
Accounts receivable 50,000
Materials inventory 40,000
Finished goods inventory 16,500
–––––––– $216,500
Fixed
Plant and equipment $250,000
Accumulated depreciation 30,000
220,000
–––––––
$436,500
–––––––––

Liabilities
Accounts payable $ 40,000
Bonds payable 100,000
–––––––– $140,000
Stockholders’ Equity
Common stock $200,000
Retained Earnings 96,500
–––––––– 296,500
––––––––
Total Liabilities and Equity $436,500
–––––––––
Required:

Based on the above information, prepare a comprehensive business budget for

the K. L. Widget Company for the first quarter of the year.

Problem 8.2 • Comprehensive Business Budgeting Components and Decisions.

Below are listed the major components of a business budget. Each component
requires that certain decisions have been made in order for that budget component
to be prepared. In the column to the right is a list of the decisions required in a
comprehensive business budget. For each separate component of the comprehensive
budget, identify the decision or decisions that must be made. If a decision has been
listed in a previous budget, then do not list it again.
Some budget components may not require any new decisions. The number
of parentheses does not necessarily indicate the number of decision items to be
selected. In addition to decisions, data about certain key parameters and constraints
are required. Also, for each budget, indicate what parameters and constraints are
necessary.
160 | CHAPTER EIGHT • Comprehensive Business Budgeting

Comprehensive Business Budgeting

(1) Sales forecast Decisions
( ) ( ) ( ) ( ) ( ) ( ) ( ) Marketing decisions

(1) Price
(2) Sales budget (2) Advertising
( ) ( ) ( ) ( ) ( ) ( ) ( )
(3) Credit terms
(4) Sales people compensation plan
(3) Ending Inventory Budget (5) Number of products
( ) ( ) ( ) ( ) ( ) ( ) ( ) (6) Number of territories
(7) Special offer
(8) Number of sales people
(4) Production Budget
Production Decisions
( ) ( ) ( ) ( ) ( ) ( ) ( )
(9) Wage rate
(10) Labor productivity
(5) Materials Purchases Budget (11) Materials inventory (ending)
( ) ( ) ( ) ( ) ( ) ( ) ( ) (12) Finished goods inventory ( ending)
(13) Overtime/second shift
(6) Direct Labor Budget (14) Purchased of additional equipment
( ) ( ) ( ) ( ) ( ) ( ) ( ) (15) Variable Manufacturing Overhead
Rates
(16) Fixed Manufacturing Overhead
(7) Manufacturing Overhead Budget estimates
( ) ( ) ( ) ( ) ( ) ( ) ( ) (17) Materials order size
(18) Number of materials order
(8) Cost of Goods Manufactured (19) Units of material per product
( ) ( ) ( ) ( ) ( ) ( ) ( ) (20) Suppliers of material
Financial Decisions
(21) Desired ending cash balance
(9) Expense Budget (22) Direct Costing or Absorption Costing
Selling
(23) Issue of stock
( ) ( ) ( ) ( ) ( ) ( ) ( )
(24) Issue of bonds
General and Administrative
( ) ( ) ( ) ( ) ( ) ( ) ( ) (25) Bank loans
(26) Investment in stock
(27) Accounts payable payments
(10) Income Statement
( ) ( ) ( ) ( ) ( ) ( ) ( ) (28) Dividends
Parameters and Constraints
(29) Material spoilage factor
(11) Cash Budget (30) Need for Capacity
( ) ( ) ( ) ( ) ( ) ( ) ( ) (31) Depreciation rates
(32) Tax rates
(12) Capital Expenditures Budget (33) Collection of A/R rate
( ) ( ) ( ) ( ) ( ) ( ) ( ) (34) Payment of accounts payable rate
(35) Production potential of existing
equipment
(13) Budgeted Balance Sheet (36) Quantity discount schedules
( ) ( ) ( ) ( ) ( ) ( ) ( ) (37) Various expense cost factors
(38) Various overhead cost factors
(39) Bad debt rates
 Management Accounting | 161

Incremental Analysis and Decision-making Costs

Nature of Incremental Analysis

Decision-making is essentially a process of selecting the best alternative given
the available information for comparison of strengths and weaknesses of each
alternative. If there exists no alternative to the current course of action, then there
is no decision to be made. However, it is rare regarding any course of action for
there not be alternatives. In personal decision-making, factors other than income and
expenses such as qualitative factors may be more important than cost in deciding.
However, in business decisions are generally made by identifying the alternative with
the most revenue or the least cost.
Incremental analysis is a decision-making tool in which the relevant costs and
revenues of one alternative are compared to the relevant costs and revenues of
another alternative. Relevant costs may be defined as those future costs that are
different between alternatives. Costs that are the same are considered irrelevant.
Incremental analysis is sometimes called differential costing, marginal costing, or
relevant costing.
Incremental analysis is basically a worksheet technique in which the relevant
costs of one alternative are listed in one column and the relevant costs of another
alternative are listed in an adjacent column. Frequently, an optional third column is
used to show the difference in the costs. The differences in relevant costs are called
incremental costs. Technically, incremental cost may be defined as the difference
between the sum of the relevant costs of two alternatives. In short, it is a tool for
choosing between two alternatives. The best decision is the one with the least amount
of relevant costs or the greatest relevant revenue.
Incremental analysis is not an optimization technique. Rather it is a tool for using
appropriate cost concepts to measure and evaluate the relevant cost inputs. It is
basic tool for measuring the difference in revenues or costs between two alternatives.
Incremental analysis is a tool which first requires that the appropriate costs be
identified and then measured.
162 | CHAPTER NINE • Incremental Analysis and Decision-making Costs

Under appropriate circumstances, incremental analysis is a tool for evaluating

decision alternatives such as:
• Keep or replace
• Make or buy
• Sell now or process further
• Lease space or continue operations
• Continue or discontinue product line
• Accept or reject special offer
• Change credit terms
• Open new territory
• Buy or lease
As a tool, incremental analysis can be used in all areas of a business. The tool is
just as useful in the area of marketing as it is in the area of production.
The objective in using incremental analysis is to identify the alternative with the
least relevant cost or the most relevant revenue. The difference in the sum of relevant
costs is either called incremental cost or net benefit. Consequently, the alternative
with a favorable incremental cost (sometimes called net benefit) is the desirable
alternative.
Since this tool relies strictly on estimated costs/revenues and because the margin
of error can be significant, different computations of incremental cost should be made
based on different cost assumptions. Both optimistic and pessimistic arrays of cost
data should be used. Incremental analysis is an ideal tool for what-if analysis.
The basic problem with incremental analysis, as commonly used, is that the
time period in which costs are incurred or revenue realized is usually ignored.
Consequently, a major weakness of the technique is that the time value of money is
not considered. Technically, there is a major different between two identical costs if
one is incurred at the beginning of a period and the other is incurred at the end of the
period. For many of the decisions listed above, the use of present value concepts may
be appropriate. Therefore, The Management/Accounting Simulation incremental
analysis software program that comes with the student software package is innovative
in that it has present value and net-of-tax cash flow options. The use of present value
with incremental analysis is discussed more in depth at the end of this chapter. Also,
chapter 12 presents an in depth discussion of using present value in incremental
analysis.
Relevant and Irrelevant Costs
The most important concept to understand in using incremental analysis is
relevant costs. In any decision involving two alternatives, the irrelevant cost may
always be ignored. Only relevant costs must be identified and included in the analysis.
Relevant costs are often defined as follows:
1. Those future costs that will be different under available alternatives.
2. Those costs that would be changed by making the decision.
3. Costs that will be different between two alternatives.
 Management Accounting | 163

The key element in these definitions of relevant costs is that between the two
alternatives each cost should be different in amount. Secondly, the cost must be a
future cost. Historical costs, as will be explained, are always irrelevant and may be
safely excluded from the analysis;
To illustrate, suppose a company is about to make a decision to purchase six
months of office supplies. The needed supplies can be purchased from supplier A for
$5,000 and from Supplier B for $4,800. However, Supplier B is in another state and, if
the purchase is made from supplier B, the company must pay freight in the amount of
$300. Also, the company has $500 of supplies on hand. One approach is to include
all costs including irrelevant costs:

Supplier A Supplier B Difference

––––––––– ––––––––– –––––––––
Cost of supples to be purchased $5,000 $4,800 $200
Cost of supplies on hand 500 500 -0-
Freight 300 (300)
______ ______ _____
$5,500 $5,600 ($100)
______ ______ _____

In the above analysis, the cost of supplies to be purchased is relevant because

there is a difference of $200 in favor of buying from supplier B. The cost of supplies
on hand is irrelevant for two reasons: (1) the cost is the same and (2) it is a past cost
already made. Supplies on hand are not a future cost, even though it will be a future
expense. Regardless from which supplier the supplies are purchased, the same
amount of past supplies cost will appear as an operating expense in the future.
In a similar manner, incremental revenue is the difference in future revenue that
would result by choosing one alternative over another. Again, the revenue must
be a future revenue and the revenue between the two choices must be different in
amounts.
To illustrate, assume that we have the opportunity to rent some unused office space
for $500 a month to two prospective tenants, Tenant A and Tenant B. Prospective
Tenant A is willing also to pay for an estimated utility bill of $50 per month but tenant
B is not.

Tenant A Tenant B Difference

–––––––– –––––––– –––––––––
Monthly rental revenue $500 $500 $ 0
Payment of utilities $ 50 0 $ 50
––––– ––––– –––––
$550 $500 $ 50
––––– ––––– –––––

The above comparison of revenue clearly shows the monthly rental revenue of
$500 to be irrelevant as to which tenant is accepted for occupancy because it is rent
that is the same between both alternatives. The inclusion of the monthly revenue
164 | CHAPTER NINE • Incremental Analysis and Decision-making Costs

does not help make the decision; otherwise the amount is still important. However,
the payment of utilities is clearly relevant because of the difference in willingness to
pay between prospective tenant A and tenant B.
The decision criterion when using incremental analysis is simply this: the alternative
should be chosen that has the least total relevant cost or the greatest total relevant
revenue. The key to using incremental analysis correctly is the ability to distinguish
between relevant costs and revenues. Examples of relevant and irrelevant costs are
the following:

Relevant Irrelevant
––––––––– ––––––––––
Future costs that are not the same Allocated fixed cost
Opportunity costs (e.q., depreciation)
Trade-in allowance Future costs that are the same
Cost of new assets Historical costs (Sunk costs)
Sunk Costs - Two costs that are often misunderstood or used incorrectly in
incremental analysis are sunk costs and opportunity costs. Sunk costs are, first of
all, always irrelevant costs. They maybe excluded in any analysis or cost comparison
review. Sunk costs are historical costs; that is, past expenditures. Because they
are expenditures already made the expenditure can not be changed. To incur or not
incur is not an option now. Examples of a sunk cost are cost of fixed assets such as
buildings or equipment. By the same token, depreciation is also a sunk cost. The
book value of a fixed asset (cost - accumulated depreciation) is also a sunk cost.
To illustrate, assume that an asset currently in use (old asset) has a book value of
$1,000 and that this piece of equipment is tentatively under review for replacement.
The purchase price of the new asset is $5,000 and is estimated to have a useful life
of 10 years. The old asset can also last 10 years with some repairs now and then.
The operating expenses of the old asset is now $800 per year but the new asset
is projected to have only an operating expenses of $200 per year. The old asset
has no trade-in value. The alternatives are to keep the old asset or to replace it.
The replacement should take place if the relevant costs of replacing is less than the
relevant costs of keeping.
10 Years Basis
–––––––––––––– ––––––––––––––––– –––––––––
Keep Old Asset Purchase New Asset Difference
Cost of new asset $ 5,000 ($5,000)
Book value of old asset $ 1,000 1,000 0
Operating expenses $ 8,000 2,000 6,000
–––––– ––––––– ––––––
$ 9,000 $ 8,000 $1,000
–––––– ––––––– ––––––

The difference of $1,000 is a net benefit of purchasing and replacing the old asset
with the new asset. However, since the book value of the old asset is shown in both
columns and is, therefore, the same between both alternatives, the book value of the
old asset is irrelevant. You may wonder how this is so? If the old asset is kept, then
 Management Accounting | 165

the book value of $1,000 will be shown on the books as depreciation cost over the
remaining life of the old asset. If the new asset is purchased, then the book value of
the old asset will be recorded as a $1,000 loss. In either event, an expense of $1,000
during the next 10 years will be recorded. Whether the old asset is replaced or not,
the cost of the old asset results in a deduction from revenue in the same amount
either as depreciation or a loss from the trade-in.
Opportunity Costs - Opportunity costs are always relevant to making decisions;
however, the concept of opportunity cost is somewhat abstract and difficult to
understand because it is not an out-of-pocket cost. Following are some commonly
used definitions of opportunity cost:
1. Earnings that would be realized if the available resources would be put to
some other use.
2. Alternative earnings that might have been obtained if the productive good,
service, or capacity had been applied to some other alternative use.
The definition preferred in this chapter is the following: opportunity cost is
the amount of revenue forgone (given up) by not choosing one alternative over
another.
The key word for understanding opportunity cost is not “cost” but “revenue
forgone”. For example if you decide to take a vacation rather than invest $5,000 in a
savings account that earns 6% per annum, then the opportunity cost is the interest
you could have earned. At 6% interest you could have earned $300 for a full year.
Therefore, the decision to take a vacation should include as a cost the interest that
was not earned
Other examples of opportunity cost may be given. If you have been given a choice
of two jobs and job A pays $60,000 per year and job B pays $55,000 per year, then
the opportunity cost of accepting job A is $55,000. Other things equal, you are only
$5,000 better off financially with job A.
If you own land that could be sold for $100,000 and the land is not now earning
any income other than appreciation in value, then there is an opportunity cost of not
earning interest. Assuming you could earn at a minimum 6% interest in a CD, the
opportunity cost of keeping the land and not selling is $6,000 per year. Interest in
the amount of $6,000 is being forgone each year in favor of the land appreciating in
value.
You own a building that you can easily rent for $10,000 a month. If you decide to
use the building to open a business for yourself, then you incur an opportunity cost in
the amount of $10,000, (rent given up, forgone, or sacrificed) by going into business.
If you are a student and you spend 30 hours a week in class and in studying, there is
an opportunity cost of being a student. The opportunity cost is the income you could
be earning by working rather than attending class or studying.
Fixed and Variable Costs - Costs in management accounting are often assumed
to be either fixed or variable. The classification of a cost as either fixed or variable
does not necessarily mean the cost is relevant or irrelevant. Whether a fixed cost or
a variable cost is relevant or irrelevant depends on the whether the cost is different
166 | CHAPTER NINE • Incremental Analysis and Decision-making Costs

between the two alternatives. However, variable costs are always relevant, if there is a
different in volume between the two alternatives. For example, assume that machine
B is being considered to replace machine A and that the purchase of machine B
would increase production capacity and also sales by 50%. If current production and
sales is 1,000 units (full capacity) and selling price is $100, then production and sales
would increase to1,500 units. Currently, cost of goods sold is $80 per unit. Based on
these assumptions, the following analysis may be prepared:
Machine A Machine B Difference
(Volume = 1,000) (Volume = 500) (500)
––––––––––––– ––––––––––– –––––––––
Sales ($10,000) ($15,000) $5,000
Cost of goods sold $ 8,000 $12,000 ( $4,000)
––––––– –––––––– –––––––
($ 2,000) ($ 3,000) $1,000
––––––– –––––––– –––––––
Note: For simplistic purposes, the cost of machine B was ignored. However, in order to make
the decision, the cost of machine B must be included as a relevant cost.

In this particular case, both sales and cost of goods sold are relevant. However,
had volume not been greater with the machine B, then sales and cost of goods sold
would have been the same and, therefore, irrelevant. Then other cost or revenue
factors would have had to be found to make the decision. Whether a fixed cost or
variable cost is relevant then depends more on the circumstances than the nature of
the cost.

Incremental Analysis Model

The basic incremental analysis model used in this program may be mathematically
summarized as follows:

IC = ∑RCia - ∑RCib
i = 1,n
RCia - relevant costs of alternative A
RCib - relevant costs of alternative B
n - number of relevant cost items

Incremental analysis is a flexible tool. Data may computed and presented for
the life of a decision alternative on a per period basis such as a month or year.
This procedure would require the relevant cost items to be divided either by the
number of years of the number of months in the life of the assets under consideration.
Incremental analysis does not require that irrelevant data be included. However, at
the option of the analyst irrelevant costs may be included. The inclusion of irrelevant
data will in no way affect the ultimate decision.
The action of classifying an expense as irrelevant or relevant does not mean that
the irrelevant cost is not important. In fact, in the execution of the decision, it may
be very important. To illustrate, assume that you are about to go to a movie and you
are in the midst of choosing which movie theater to attend. You have narrowed your
 Management Accounting | 167

choices to movie A and movie B and you want to see the movie which will cost the
least. You have made the following cost analysis:
Movie A Movie B Difference
––––––– ––––––– –––––––––
Cost of popcorn $3.00 $3.50 ($ .50)
Large drink $3.50 $4.25 ($ .75)
Transportation cost $1.00 .75 $ .25
––––– ––––– ––––––
$7.50 $8.50 ($ 1.00)
––––– ––––– ––––––
The net benefit of attending movie A is $1.00. The cost of tickets is $8.00, the
same at each movie theater. Therefore, since the ticket cost is the same, you have
correctly omitted this irrelevant cost from your analysis. Consequently, you decide in
favor of movie A and you put $7.50 in your pocket. However, at this point taking only
$7.50 would be a mistake since the total cost of attending movie A would be $15.50.
The execution of the decision requires this amount. The cost of the tickets is only
irrelevant in making the decision but not irrelevant in the execution of the decision.

Use of Present Value in Incremental Analysis

The above discussion of incremental analysis was based on the assumption that
the timing of expenditures was not important and, therefore, can be ignored. In most
instances, this is most likely true, however, there may be decisions where even though
two alternatives involve identical future costs, the timing of when the expenditures
are actually made is the important factor. The student software package for The
Management/Accounting Simulation contains a set of management accounting
tools. One of these tools is an incremental analysis tool that contains a present value
option.
When present value and net-of-tax options are selected, this program becomes
a highly sophisticated tool requiring considerable skill to use. Each cost or revenue
must be analyzed in terms of the following questions:

1. Does this cost affect both pre-tax net cash flow and taxable income?
For example, a disallowed expense for tax purposes would affect pre-tax net
cash flow but not taxable income. For example, the incurrence of a $200 dis-
allowed expenditure for tax purposes would decrease pre-tax net cash flow.
However this disallowance would not cause a change in taxable income. In
other words, additional expenditures for disallowed tax deductions would not
change taxable income.
2. Does this cost affect only taxable income? Some cost items such as depre-
ciation or losses have no affect on pre-tax net cash flow. However, after-tax
net cash flow is increased by such items. Also, tax credits affect net cash
flow after-tax but not before. Items that affect only taxable income must be
explicitly designated as having such affect.
Since the present value calculations are always based on cash flows, then the
tax treatment of cost items is critically important. Tax treatment of items can either
168 | CHAPTER NINE • Incremental Analysis and Decision-making Costs

increase or decrease the amount of cash after tax. The effect of taxes on cash flows
and cash flows before and after taxes is discussed in chapter 12.
The Keep or Replace Decision
The keep or replace decision is very common in most businesses. Some examples
of the keep or replace decision are the following:
1. Keep old car or replace with a new car
2. Keep old computer or buy a new computer
3. Keep old copy machine or buy a new copy machine
4. Keep old factory equipment or replace with new

If replacements results in an substantial increase in net income immediately or

within a few years, then replacement should be seriously considered and most likely
made. In making this kind of decision, the following steps are involved:
Step1 Obtain cost data for both the Keep Decision and the Replace
Decision.
a. Cost of old (book value)
b. Cost of new equipment
c. Trade-in allowance of old equipment
d. Salvage value of new equipment
e. Operating costs of old and new equipment
Step 2 Prepare a work sheet with columns showing the relevant costs of
the Keep decision and the Replace decision.
Step 3 Compute incremental cost (sometimes called net benefit).

Only relevant costs need be included in the analysis; however, no harm is done
by including the irrelevant costs. The book value of the old asset is always irrelevant
and may be excluded, if desired. Trade-in allowance is always relevant. The analysis
may be made on a per year basis or a total years basis. If made on a per year basis,
then the cost of the new asset must be divided by its useful life.
An illustrative Example of the Keep or Replace Decision
The K. L. Widget company is seriously contemplating replacing some old cutting
department equipment with more modern and efficient equipment. The book value of
the old equipment is $50,000. The new equipment, if purchased, will cost $100,000.
A $10,000 trade-in allowance will be granted by the seller of the new equipment. The
salvage value of the new equipment at the end of its life in 10 years is estimated to
be $5,000. The salvage value of the old asset, if kept, is $2,000. The operating cost of
the old equipment has been averaging around $13,000 per year. The new equipment
is expected to reduce the operating cost to an average of $2,000 per year. The new
equipment, if purchased, will be purchased totally on credit and the total amount of
interest that would be paid in 10 years is approximately $25,000.
 Management Accounting | 169

One approach to using incremental analysis would be as follows:

Total Life Basis (10 years)

–––––––––––––––––––––––––––––––––––––
Keep Old Buy New
Equipment Equipment Difference
––––––––– ––––––––– –––––––––
Cost of old equipment (book value) $ 50,000 $ 50,000 0
Cost of new equipment $ 100,000 ($ 100,000)
Trade-in allowance ($ 10,000) $ 10,000
Salvage value ($ 2,000) ($ 5,000) $ 3,000
Operating costs (total 10 years) $ 130,000 $ 20,000 $ 10,000
Interest on loan $ 25,000 ($ 25,000)
––––––– –––––––– –––––––––
$ 178,000 $ 180,000 ($ 2,000)

In the above example, notice that the book value of the old equipment was included.
However, this cost may be excluded since it is irrelevant to the decision.
In the above example:
a. The relevant costs of keeping is $128,000.
b. The relevant cost of buying new equipment is $130,000.
c. The irrelevant cost included in both alternatives is $50,000
d. The net benefit or incremental cost of keeping the old equipment is
$2,000.
e. Sunk cost in the analysis is $50,000 (book value of old equipment).

Suppose in the above example management had decided to use cash on hand
to buy the new equipment. Would the answer be different concerning interest. No, if
internal financing is used, then the opportunity cost of the on hand cash used must
be included. Let us assume that the company can earn 6% interest. In this event,
the interest given up or sacrificed would approximately be the same as the interest
paid.
Practical Applications of Incremental Analysis
Incremental analysis is a practical and commonly used tool by both individuals
and businesses regarding many different kinds of decisions. As individuals, we weigh
the cost of many decisions such as what car to buy, whether or own a home or rent,
and continue to paint our house or put on vinyl siding. The same is true in business.
Incremental analysis is used in all functions of the business on a daily basis both
formally and informally. The use of incremental analysis does not guarantee that the
best decision has been made; However, it does provide a framework for organizing
relevant data and looking at the decision to be made from a broader and more
analytical perspective.
Summary
Incremental analysis can be a powerful tool in evaluating various type of decisions.
Incremental analysis in a way of presenting relevant information in a direct comparison
mode so as show the net benefit of making a particular decision. It is should be
170 | CHAPTER NINE • Incremental Analysis and Decision-making Costs

remembered that incremental analysis is no better than the quality of information

available for analysis. Incremental analysis is a tool that focuses on certain basic
concepts including the following:
Incremental analysis Relevant and irrelevant costs
Opportunity costs Sunk costs
Depreciation Fixed and variable costs
Direct and indirect Common costs
Salvage value Trade-in allowance
Net benefit

It is important that accountants and management have a basic understanding

of these concepts.

Q. 9.1 Define the following terms:

a. Relevant cost
b. Irrelevant cost
c. Incremental analysis
d. Sunk cost
e. Incremental cost
f. Opportunity cost
g. Direct cost
h. Indirect cost
Q. 9.2 Explain the steps in using incremental analysis.
Q. 9.3 Give at least three examples of opportunity cost.
Q. 9.4 Give several examples of sunk costs.
Q. 9.5 Explain the difference between the majority and minority view of sunk
costs.
Q. 9.6 List at least eight types of decisions for which incremental analysis an
appropriate tool.
Q. 9.7 If new equipment is purchased, then the old equipment will be sold for
$10,000 and a loss of $2,000 will in incurred. Is the loss a relevant
cost? Is the proceeds from the sale of the old machine relevant?
Q. 9.8 If a new territory is opened the company will use a warehouse in this
territory that it owns. The company now receives annual rental revenue
of $50,000. Is the rental value of the warehouse relevant or irrelevant?
Why?
Q. 9.9 Under what circumstances is it important to know the amount of
irrelevant costs?
Q. 9.10 Explain how the introduction of income taxes into the analysis can make
a historical cost relevant.
 Management Accounting | 171

Exercise 9.1 • Matching of Cost Concepts and Costs

Required: Match each cost with the appropriate cost. More than one cost concept
may be applicable.

Cost Concepts Costs

1. Inescapable A. President’s salary
2. Escapable B. Factory workers’ wages
3. Incremental C. Installation cost of new machine
4. Sunk D. Cost of old machine
5. Opportunity E. Monthly rental value of warehouse
6. Variable F. Repairs and maintenance
7. Fixed Machine A $2,000
8. Relevant Machine B $2,000
9. Irrelevant G. Utilities
10. Semi-variable Machine A $1,500
Machine B $2,000

Exercise 9.2 • Keep or Replace

You have been provided the following keep or replace decision information:
Old Machine New Machine
Cost $ 50,000 $ 100,000
Salvage value $ 10,000 $ 5,000
Trade-in allowance $ 15,000 –––––
Remaining useful life 10 years 10 years
Labor costs (annual) $ 20,000 $ 5,000
Repairs and maintenance $ 5,000 $ 6,000
Utilities $ 1,000 $ 2,000
Interest rate* - 6%

* Assume installment financing and estimate interest by computing average size of loan
over life of machine.
Required:
Determine whether or not the old machine should be replaced.

_____________________________________________________________________

_____________________________________________________________________

_____________________________________________________________________
172 | CHAPTER NINE • Incremental Analysis and Decision-making Costs

Exercise 9.3 • Own or Lease

You have been provided the following information concerning a lease or own decisions.
If equipment is owned:
Purchase price of equipment $ 50,000
Repairs and maintenance (monthly) $ 100
Utilities (monthly) $ 200
Interest on financing (annual) $ 1,500
Useful life of equipment (years) 10
If equipment is leased:
Monthly lease payments $ 600
Repairs and maintenance
(Cost is included in lease agreement)
Utilities (monthly) $ 150

Required:

Determine which is more desirable, own or lease?

Exercise 9.4 • Sell now or Process Further

You have been provided the following information concerning the sell now or
process further decisions.
Current production method cost data:
Selling price $ 20
Units manufactured 100
Production capacity (units) 150
Labor hours required (per unit) 2
Manufacturing costs:
Material (per unit) $ 1.00
Factory labor (per unit) $ 15.00
Fixed manufacturing overhead $ 5.00
Variable manufacturing cost (per hour) $ .50
Costs of Additional Processing:
Labor hours (per unit) 1.0
Labor rate (per hour) $ 7.50
New selling price $ 30.00

*If the additional processing is undertaken the variable manufacturing cost rate
will remain the same.
Required:

Use incremental analysis to determine whether processing further should be

undertaken.
 Management Accounting | 173

Problem 9.1 • Incremental Analysis Problem: Keep or Replace

The vice president of finance for the Acme Manufacturing Company authorized
the company’s management accountant to collect data pertaining to the purchase
of new manufacturing equipment. If purchased, the new equipment will replace old
equipment. The following information was obtained from various sources by the
accountant:
Old Equipment New Equipment
––––––––––––– ––––––––––––––
Book value of old equip. $ 50,000
List price of new equipment $ 150,000
Life of equipment (years) 5 5
Trade-in allowance (old) $ 15,000
Operating expenses (per year) $ 50,000 $ 5,000
Salvage value (end of life) $ 5,000 $ 10,000

If purchased, a 10%,5 year installment loan will be obtained. Interest will be paid
annually.
Required:

1. What is the incremental cost (net benefit) of the replace decision (purchasing
the new equipment?) $_ ______________________________________
2. What is the total relevant cost of the keep decision?
_ $_________________________________________________________

3. What is the total relevant cost of the replace decision?

_ $_________________________________________________________

4. What amount of cost in this problem may be considered to be sunk cost?

_ $_________________________________________________________
5. Assume that the company’s marginal tax rate is 40%. What is the incremental
cost on an after-tax basis? $

_ __________________________________________________________

_ __________________________________________________________

_ __________________________________________________________

_ __________________________________________________________

_ __________________________________________________________
174 | CHAPTER NINE • Incremental Analysis and Decision-making Costs

Problem 9.2 Make or Buy

The Acme Manufacturing Company manufactures a product which requires

component X. However, a supplier has offered to sell component X at $4.00 per
unit. Acme’s cost in manufacturing 1,000 units this past year was reported by the
management accountant as follows:
Material $ 2,000 Insurance $200
Direct labor $ 1,000 Power and lights $500
Indirect labor $ 500 Depreciation (bldg.) $400
Gen. & admin. sal. $ 500
Note: all costs are presented on a per year basis.
If the component is purchased, then material, direct labor, and indirect labor
costs would be eliminated. Insurance and power and lights would be reduced by $50
and $100 respectively. General and administrative salaries would not change. The
building in which component X is now manufactured can be leased for $1,000.
Required:

1. What is the incremental cost if component X is purchased?

$ ___________________________________________________

2. What is the total relevant cost of the make decision?

$ _ __________________________________________________

3. What is the total relevant cost of the purchase decision?

$ _ __________________________________________________

4. What is the amount of the opportunity cost? $ ___________________

_ _____________________________________________________

5. What is the total amount of escapable cost? $_ __________________

6. What is the amount of opportunity cost in this analysis?
$____________________________________________________

_____________________________________________________
 Management Accounting | 175

Incremental Analysis and Cost Volume Profit Analysis:

Special Applications

Incremental analysis is a flexible decision-making tool that may be used in making

many different kinds of decisions. Some of the decisions for which incremental
analysis is appropriate include the following:
1. Open a new territory
2. Sell on credit
3. Sales people compensation
4. Additional volume of business

These four items are marketing decisions that may be made in The Management/
Accounting Simulation. Consequently, incremental analysis is an important
decision-making tool in this simulation.
Opening a New Territory
The opening of a new territory decision is a common and important decision.
Opening a new territory can bring in substantial additional revenue and net income.
However, expanding a business too fast in a territory not responsive to the company’s
product can have the opposite effect. Before a decision is made to expand the
business into a new territory, the potential revenues and expenses should be analyzed
at different levels of estimated sales. If the use of incremental analysis shows that
substantial sales and additional income is likely to result, then the expansion of the
business into a new territory may be a wise decision.
Examples of expanding into new territories are granting of new franchises in areas
where none exist, expanding the operations of the business into an adjacent state,
and entering a foreign market. Although the same product is being marketed in each
territory, it does not follow that all territories are equally profitable. The extent to which
a new territory might be profitable must be explored very carefully. Distance from
the main distribution center in many cases is a major problem. Territories can vary
176 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

substantially in population density and income distribution. Also, cultural differences

regarding tastes and preferences can play an important role in whether to expand or
not expand the business. For example, while catfish restaurants are very popular in
the South they are not likely to be equally received in the Northeast. Differences in
laws, state regulations, and tax structures also can have a bearing on the decision.
Incremental analysis can be used either to measure segmental net income or
segmental contribution. The advantages and disadvantages of using segmental net
income and segmental contribution is discuss in some depth in chapter 15. Which
measure is best is somewhat controversial; however, in the example to follow
segmental contribution will be the criterion. Segmental net income requires the
allocation of common expenses and all allocations of costs tend to be somewhat
arbitrary and can obscure the potential profitability of a segment. The segmental
contribution approach is favored here. However, if done properly, both approaches
can be used in the same analysis.
In using incremental analysis to evaluate potential decision, irrelevant revenue and
expenses may be omitted in the final analysis. Irrelevant revenues and expenses are
those items that will not be affected or changed by the making of the decision. What
is relevant or irrelevant depends on the particular circumstances under investigation
and can vary from situation to situation. For this reason, providing examples of
irrelevant revenues or expenses is not always easy. However, in most cases, for
example, it would be difficult to see how in the short run opening a territory would
affect the salaries of top management Therefore the salaries of top management are
likely to be irrelevant.
The evaluation of the opening of a new territory generally involves the following
steps:

1. Gather all relevant revenue information. An initial but tentative price should
be set. The normal market potential should be estimated. Normal market
potential can be defined as the number of customers likely to benefit from
purchasing the product.
2. Factors that directly impact sales volume should be evaluated. These factors
include such decisions as selling on credit, compensation of sales people,
and advertising.
The economic environment should be carefully evaluated. The impact
that seasonal factors have on sales is important and should be examined.
Analysis should be made in terms of quarters and some attempt should be
made to estimate an seasonal index for each quarter. Based on the vari-
ous market demand factors identified, a sales forecast of sales in units and
dollars should be made.
If sales of the product in the territory being evaluated tends to be seasonal
in nature, then this fact can also have a major impact on available capacity.
Opening a new territory must be based on the premise that the capacity
to manufacture is adequate, given the increased demand from opening a
new territory.
 Management Accounting | 177

3. Analysis should be made of the sensitivity of customers to changes in price.

Is it best to lower price and go after higher volume or is it better to have a
higher price with lower volume?
4. Gather all the relevant information concerning operating expenses in the new
territory. The territorial expenses should be also be measured in terms of
fixed and variable components. Expense factors such as number of sales
people needed, compensation plan for sales people, cost of credit terms,
and the need for additional advertising should be analyzed in some depth
5. After all relevant information about revenue and expenses has been gathered
and the analyzed data has been converted to variable cost rates and total
fixed expenses, then a work sheet similarly to the one shown in Figure 10-1
should be prepared.
Figure 10-1

Opening New Territory

Sales (units)
50,000 100,000 150,000 200,000
Sales (price - $100) $ 5,000,000 $ 10,000,000 $ 15,000,000 $ 20,000,000
Variable Expenses
Cost of goods sold ($60) $ 3,000,000 $ 6,000,000 $ 9,000,000 $ 12,000,000
Sales people travel expense ($5) 250,000 500,000 750,000 1,000,000
Sales commissions ($10) 500,000 1,000,000 1,500,000 2,000,000
Credit expenses ( $3) 150,000 300,000 450,000 500,000
Total variable expenses ($78) 3,900,000 7,800,000 11,700,000 15,600,000
Contribution margin $ 1,100,000 $ 2,200,000 $ 3,300,000 $ 5,000,000
Fixed expenses (direct)
Salaries (additional factory workers) $ 2,000,000 $ 2,000,000 $ 2,000,000 $ 2,000,000
Advertising 500,000 500,000 500,000 500,000
Sales people salaries 1,000,000 1,000,000 1,000,000 1,000,000
Credit department salaries $ 150,000 $ 150,000 $ 150,000 150,000
Other fixed expenses1 350,000 350,000 350,000 350,000
Total fixed expenses 4,000,000 4,000,000 4,000,000 4,000,000
Total expenses $ 7,900,000 $ 11,800,000 $ 15,700,000 $ 19,600,000

Segmental contribution ($2,900,000) ($1,800,000) ($ 700,000) $1,000,000

1
Other fixed expenses could include such expenses as additional home office staff needed such as accounting,
credit department, marketing department employees, additional staff needed in the production department.
178 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

The above analysis reveals the following:

1. At the sales volume range of 50,000 - 150,000 the territory is not profitable.
2. At a volume of 200,000 or greater the territory appears to be profitable. The
question that must be asked and answered is this: Does a sales level of
200,000 appear reasonable or likely to happen? If the most optimistic esti-
mate is that sales will not in the distance future ever exceed 150,000, then
the decision not to open the territory would be the right decision.
Illustrative Problem
The management of the L. K. Widget Company is considering opening a new
territory to be called the Western Territory. In the last quarter, the company’s sales of
8,500 units were far below the volume required to make the company profitable. The
marketing department through marketing research and analysis of internal financial
data has made available the following information relevant to the opening of the
Western Territory.

Direct Costs
Selling: General and administrative
Variable Per Unit Variable
Cost of goods sold $ 69.00 Travel $2.20
Packaging $ 2.00 Supplies $1.00
Sales people travel $ 5.40
Sales people commission $ 20.00
Bad debts expense 1.5% of sales
Credit department $ 1.00
Direct fixed (Selling) Direct fixed (Manufacturing) none
Salaries of sales people $ ______ (Opening this territory will not
Sales people training $ ______ require any new plant capacity
Advertising $ ______
Territorial office operating $ 50,000
Home office sales expense $ 30,000

If the Western Territory is opened, then approximately 600 sales people would
be hired at a per quarter salary of $2,000 per sales person. The training of each
new sales person will cost $200. After the initial hiring of the full sales force, it is
expected each quarter, because of some sales people quitting for various reasons
that on the average 50 new sales people will be hired each quarter. The market
potential of this territory is estimated to be 110,000 customer per quarter. On the
average, each customer will purchase one Gadget a a price of $200. An analysis
of demand indicates approximately 28% of the potential customers would request
demonstrations per quarter.
If the Western territory is opened, management will seriously consider granting
customers three months of credit. These credit terms would be offered in all territories.
If three months credit is granted, then sales should increase at least 20%. Last quarter
 Management Accounting | 179

the sales-calls ratio without credit was 30%. The amount budgeted for advertising
would be $1.20 per potential customer and the selling price of the Gadget would be
$200.
Based on the information provided, a what-if profitability analysis as shown above
may be made. It is important for management to estimate sales for the first operating
period. Based on the provided information above, this estimate may be computed
as follows:
Normal market potential 110,000
Percentage requesting demonstration .28

Number requesting demonstration 30,800
Sales-calls ratio (.30 x 1.20) .36
–––––––
Estimated sales (units) 11,088
–––––––
This estimate of 11,088 units for the first quarter of operations falls between the
range of 10,000 and 15,000 unit. As the above analysis shows, at a sales level of
15,000 units, segmental contribution is a negative $66,000. At sales of 11,088, it can
easily be computed that a net loss of $443,177 would be experienced. Based on the
initial analysis of the available data, it appears that opening the territory might not
be a wise decision. However, if it is expected that the required sales level can be
attained through rapid growth in sales because of advertising and an effective sales
force, perhaps the territory should be opened. The break even point for this territory
is 15,684 units (1,512,000/ (200 - 103.60). All decisions involve a degree of risk and
there is never a 100% certainty a profit goal can be achieved, even if the analysis is
positive at all volume levels of operation.
Selling on Credit
In today’s modern economy, selling on credit is hardly a choice but a necessity.
However, a business does not directly have to run a credit department. Practically all
businesses can now sell indirectly on credit by accepting credit cards. Until recently
some restaurants did not accept credit cards but required a purchase of a meal to be
paid for in cash. For example, Waffle House recently began to accept credit cards
for the first time. The discussion here, however, pertains more to the decision to sell
on credit by granting and maintaining credit internally rather than to the use of credit
cards. When credit cards are accepted, cash flow is not affected adversely in the
short run or substantially decreased as in the case of granting credit for three months
or longer. Also, a number of other problems inherent in the offering of credit internally
are avoided such as bad debts.
When a company begins to sell on credit, a number of activities have to take
place regularly. One of the first major activities, and not an inexpensive one, is to
establish a credit department including hiring a credit manager and a staff to perform
the duties of a credit department. Some of the periodically occurring activities not
existing before granting credit include the following:
1. Requiring a prospective credit customer to fill out a credit application
form
180 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

Figure 10-2

Opening New Territory

Sales (units)
10,000 15,000 20,000 25,000
Sales (Price -$200 ) $ 2,000,000 $ 3,000,000 $ 4,000,000 $ 5,000,000
Expenses:
Variable
Cost of goods sold ($69.00) $ 690,000 $ 1,035,000 $ 1,380,000 $ 1,725,000
Commissions ($20.00) 200,000 300,000 400,000 500,000
Packaging ($2.00) 20,000 30,000 40,000 50,000
Travel ($5.40) 54,000 81,000 108,000 135,000
Bad debts ($3.00) 30,000 45,000 60,000 75,000
Credit ($1.00) 15,000 20,000 25,000
Travel - G & A ($2.20) 22,000 33,000 44,000 55,000
Supples - G & A ($1.00) 10,000 15,000 20,000 25,000
Total ($103.60) $ 1,036,000 $ 1,554,000 $ 2,072,000 $ 2,590,000
Fixed-direct
Sales people salaries $ 1,200,000 $ 1,200,000 $ 1,200,000 $ 1,200,000
Sales people training 100,000 100,000 100,000 100,000
Advertising 132,000 132,000 132,000 132,000
Office operating 50,000 50,000 50,000 50,000
Home office 30,000 30,000 30,000 30,000
Total $ 1,512,000 $ 1,512,000 $ 1,512,000 $ 1,512,000
Total expenses $ 2,548,000 $ 3,066,000 $ 3,584,000 $ 4,102,000
Segmental contribution ($548,000) ($ 66,000) $ 416,000 $ 898,000

2. Running a credit check

3. Giving final approval to the credit application
4. Receiving and processing payments
5. Sending out statements and notice of payments due
6. Recording payments
7. Making bank deposits of installments collected
8. Determining and accounting for bad debts

Improper management of credit can lead to uncollectable accounts and substantial

write-offs. One of the better ways to minimize bad debts is to initially screen poor
 Management Accounting | 181

credit risks. The screening of customers, of course, can be time consuming and it is
not necessarily inexpensive. Third party companies may be hired to evaluate credit
risks. However, this service still involves a cost.
One of the first important steps is to analyze the impact that offering credit will
have on sales. The normal expectation is that the granting of credit will increase
sales. However, since credit also increases operating expenses, an increase per se
in sales is not necessarily enough. The increase must be sufficient to cover the cost
of maintaining a credit department and the other costs associated with credit and at
the same time make a major contribution to the over-all net income of the business.
Consequently, it is imperative that the percentage effect on sales be somewhat
accurately measured. Given a reliable estimate of the increase in sales, the variable
expenses associated with an increase in sales from offering credit can then be
determined. Following is an example of the type of analysis required in evaluating
the credit decision:
The following analysis (Figure 10.3) shows that unless sales increase by nearly
2,000 units, the granting of credit will have a detrimental affect on net income. The
contribution margin without credit was approximately $27.00 ($100 - $73.00) The
contribution margin with credit decreased to $17.05 ($27.00 - $9.95). To recover
the increase in fixed credit department expense, sales must increase by at least
1,715 units per quarter (29,250 / 17.05). The decision to sell on credit then depends
on management’s estimate of by how much credit will increase sales and by
management’s willingness to assume risk.
Sales People Decisions
Sales reps or sales people, as they are called in The Management/Accounting
Simulation, are a necessary part of most businesses. However, the nature of the
services that sales people perform can vary greatly from business to business. In
some instances, sales people simply serve as a order taker and may simply ring up
the sale. In other cases, they perform a series of related services and the last step
in this process is the closing of the sale. In the first instance, the customer more or
less makes the decision to purchase with little or no persuasion and simply expects
someone to take payment. In the second instance, the potential customer is found
by the sales person and then the product is displayed or demonstrated and a sales
pitch is made to convince the customer to buy. In this instance, a highly trained and
skilled sales person is needed.
Services performed by sales people in general include the following
1. Finding new customers
2. Meeting with potential customers to introduce or demonstrate the
product
3. Answer all questions concerning the product
4. Explain the terms of financing, if that is required
5. Closing the sale
6. Deliver the product
7. Completing the paper work involved in the sale
8. Calling upon existing customers
182 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

Figure 10-3
Increase in Sales
1,000 2,000 3,000 4,000
Sales ($100) $ 100,000 $ 200,000 $ 300,000 $ 400,000
Expenses
Variable Credit
Bad debts ($3.00) $ 3,000 $ 6,000 $ 9,000 $ 12,000
Credit check ($5.00) 5,000 10,000 15,000 20,000
Bookkeeping ($1.00) 1,000 2,000 3,000 4,000
Statement preparation ($0.15) 150 300 459 600
Postage and stationery ($0.30) 300 600 750 1,000
Payments processing ($.50) 500 1,000 1,500 2,000
Payment processing _______ _______ _ ______ ________
Total variable (credit) $ 9,950 $ 19,900 $ 29,209 $ 39,600

Variable Non Credit

Cost of goods sold ($60.00) $ 60,000 $ 120,000 $ 180,000 $ 240,000
Commissions ($10.00) 10,000 20,000 30,000 40,000
Packaging ($2.00) 2,000 4,000 6,000 8,000
Travel ($1.00) 1,000 2,000 3,000 4,000
_______ _______ _ ______ ________
Total variable (non credit) $ 73,000 $ 146,000 $ 219,000 $ 292,000

Total variable expenses $ 82,950 $ 165,900 $ 248,209 $ 331,600

Fixed Credit
Salary Manager $ 15,000 $ 15,000 $ 15,000 $ 15,000
Salaries-staff 12,500 12,500 12,500 12,500
Equipment expense 1,250 1,250 1,250 1,250
Other fixed 1,000 1,000 1,000 1,000
_______ _______ _ ______ ________
$ 29,250 $ 29,250 $ 29,250 $ 29,250
Fixed non Credit 0 0 0 0
_______ _______ _ ______ ________
Total direct expenses $ 112,200 $ 195,150 $ 277,459 $ 321,250

Increase in net income
$ 12,000)
_______
_______ $ 4,950
_______
_______ _$ 22,541
_ ______
______ $ 78,750
________
________

9. Keep customers informed as to new models or problems that

might later arise

The hiring and maintenance of a sales force is a process that involves the
following
1. Hiring
2. Training
3. Compensation
4. Evaluation
5. Termination
 Management Accounting | 183

In each step of this process expenses are incurred. While a sales force is expected
to generate revenue, the maintenance of a sales force also involves considerable
expense. A sales force should be neither too small nor too large. Lost sales from an
inadequate sales force or unnecessary expenses from too large a force can equally
be detrimental to the success of a business. The evaluation of the effectiveness
of a sales force in terms of sales generated and expenses incurred is a periodic
requirement.
Expenses created from creating and maintaining a sales force includes the
following activities:
1. Hiring costs
2. Training costs
3. Supervision cost
4. Compensation of sales people
5. Travel costs
6. Termination costs
Two of the more important costs concern (1) sales people compensation and (2) number
of sales people needed.

Number of Sales People

Many factors can affect the number of sales people needed in a business. If
customers are simply expected to walk in and browse on their own and then on their
own walk to a check out stand to pay, then only a few sales people at any given
time are needed. However, if the customer must be found and then persuaded to
purchase, then a much larger sales force may be needed.
If the a full range of sales services as listed above is required of a sales person,
and assuming the prospective customer must be found and called upon, then perhaps
only one or two calls a day at most can be made. The complexity of the product, the
number of competing similar products, and the sales resistance of the customer are
factors that may cause each sale to require considerable time to initiate and close.
The number of calls that a sales person can make in a given period of time and
the sales-calls ratio, then, are important factors in determining the need for sales
people. If a sale person can make four calls a day and each call results in a sale,
then the number of sales people needed should greatly be reduced. However, if the
only one call can be made per day and the sales-calls ratio is only 25%, then more
sales people undoubtedly would be required. However, as the number of calls per
period and the sales-calls ratio gets smaller, the dollar amount of sale when it is made
would be expected to be much greater. If the price of a product is fairly low, then the
investment of considerable time in personal sales is most likely not economically
wise.
When a lot of personal sales effort is required to close a sale, the number of
sales people to hire depends to a large extent on how many calls a sales person can
make in a given period of time. The motivation of sales people to makes calls is also
extremely important. Consequently, the prospect for financial reward when a sale is
made is also an important in motivating factor.
184 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

Assume that the K. L. Widget Company has determined that the number of
potential customers per quarter is 100,000 and at the current price of the product
20% of these potential customers will request a demonstration or will listen to a sales
pitch. A sales person on the average can make 120 calls per quarter. The number of
sales people required can be computed as follows:

Potential customers x requesting percentage

Number sales people required = –––––––––––––––––––––––––––––––––––––––
Calls per quarter

100,000 x .2
Number sales people required = ––––––––––––– = 167
120
Compensating Sales People
The number of call per month is not independent of motivation. A highly motivating
factor is the method of compensating sales people. Compensation of sales people
may involve one or more of the following:
1. Salary
2. Commission
3. Reimbursement of sales expenses
4. Fringe benefits

Of the four items above, it is generally believed that a sales commission is the
method most likely to motivate sales people. If a high salary is paid, then the motivation
to increase the number of calls is minimal. Consequently, in some instances, sales
people compensated only on the basis of a salary may result in disappointing sales.
On the other hand, if a reasonably high commission per sale is paid, then the limit to
compensation is simply the sales person ability to make calls and close sales. The
potential for a high reward for being highly motivated is critical. A commission rate in
itself is not necessarily a motivating factor, if it is too low. In general, one may assume
that up to a point the higher the commission rate the greater is the motivation.
A common practice is to reward sales people by a combination of salary and a
sales commission. Given a higher commission rate, then the salary most likely will be
lower. If the decision has been made to pay both a salary and a commission to sales
people, then the next decision is to decide the amount of salary and commission
rate.
A salary tends to be a fixed expense while sales commission is a variable expense.
If for a given quarter of operations, 100 sales people are hired at a salary each of
$5,000, then the fixed salary expense would be $500,000. However, if instead of a
salary of $5,000 sales people are paid a commission of 10% and price is $100, then a
commission of $10 would be paid for each unit sold. At a commission rate of 10% and
sales of 10,000 units, the total compensation would be $100,000. However, if sales
turned out to be only 8,000 units, then the total compensation would be $80,000.
In contrast, regardless of sales in the quarter, the compensation based on salary
would be $500,000. Because there is a limit to the number of calls an individual sales
 Management Accounting | 185

person can make and given a growth in the business, in the long run total salaries
can increase because the number of sales people is increasing.
Rewarding sales people in the form of a commission may provide an incentive for
sales people to make more calls and, consequently, create more sales. The potential
for reward is much greater, particularly in the event there is a substantial increase
in demand for the product. However, in the event of a temporary decline in demand,
the compensation of sales people can substantially decline when based solely on a
commission rate. As a result of a decline in compensation sales people may quit.
The proper balance of a salary and a sales commission is a challenging decision
and one that is often difficult to make. The commission rate should not be so high as
to unduly compensate sales people to the detriment of the company nor too low so
as to discourage sales people and, therefore, cause a high turnover rate. Also, the
payment of a salary should not be so high as to adversely affect the motivation to sell.
Since many combinations of salaries and commission rates are possible, the various
mix of these two means of compensation should be analyzed. The job of analyzing
various sales compensation plans may by request of management fall into the hands
of the management accountant.
Use of Management Accounting Tools in Making Sales People Decisions
The management accountant is an expert is the use of various decision making
tools. Three tools that the management accountant can used in analyzing the sales
compensation plan are:
1. C-V-P Analysis
2. Incremental Analysis
3. Segmental reporting

C-V-P Analysis-Cost-volume-profit analysis can answer questions such as the

following: Given an increase in the number of sales people, by how much must sales
increase in order to make the same income as before.
For example, assume the following information has been provided to you.
Price of the product $300
Current sales (per quarter) 10,000 units
Variable cost rate (includes commissions) $180
Fixed expenses $800,000
Salary per sales person $5,000
Proposed number of new sales people 100
Commission rate 10%

Analysis: - An increase in sales of people by 100 means that fixed expenses would
increase by $500,000 (100 x $5,000). The question to be answered is: by how much
must sales increase if 100 new sales people are hired and for net income to not be
less?
Based on the above information, the company’s contribution margin is $120
($300 - $180). The increase in sales necessary to offset the $500,000 increase in
fixed expenses can be computed as follows:
186 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

$500,000
Quantity (increase in sales) = ––––––––– = 4,160
$120
Will this plan work? Further analysis reveals the following:
4,160
Sales (units) per sales person = ––––––– = 41.6
100

This analysis shows that on the average new sales people must average
approximately 42 sales per quarter.
Total compensation per sales person:
Salary $   5,000
Commissions($30 x 41.6) 1,248
______
$   6,248
______
Total sales people compensation:
Salaries $500,000
Total commissions 124,800
_______
$624,800
_______

The average compensation then would be approximately, $6,248. Is this sufficient

compensation to avoid a high turnover rate of sales people?
The above results show only what is needed to maintain net income at the current
level. The purpose of increasing the number of sales people is to increase net income.
Assume management wants an increase in net income by the amount of $240,000.
By how much must sales increase. The answer can be computed as follows:
$500,000 + $240,000
Quantity (increase) = –––––––––––––––––––– = 6,167
$120

6,167
Sales per sales person = –––––––– = 61.67
100

The compensation now per sales person would be:

Salary $5,000
Sales commissions( 61.67 x $30) 1,850
______
$6,850

In order to earn an additional $240,000 of net income, sales people must average
approximately 62 sales per quarter. This required level of sales is almost 1 sale per
day.
To effectively evaluate this plan further, an analysis should be made of the sales
effort and compensation of currently hired sales people. If the average sales for current
 Management Accounting | 187

sales people last quarter was 30 units per person, then the desired profitability from
hiring of new sales people does not seems appears to be a bit optimistic. However,
if the sales per sales person last quarter was 70 or more, then the plan to hire 100
new people might work, given that the market potential in the area in which new sales
people will work is equal to the market potential of current territories. While cost-
volume-profit can not predict what will happen, this tool can provide a bench mark for
what must happen in order for a plan to work.
Incremental Analysis - Another valuable tool for evaluating decisions such as the
sales compensation decision is incremental analysis. This tool is basically a work
sheet method in which the relevant costs/expenses and revenues of each alternative
are compared.
In order to illustrate the use of this method, assume that you have been provided
the following information:
Market potential 1,00,000
Price $300
Percentage requesting demonstration 30%
Sales-calls ratio 25%
Credit terms 3 months

In addition, six compensation plans for sales people have been developed as
follows:
Salary Commission Calls per quarter
Rate
Plan A $4,000 2% 60
Plan B $3,500 6% 100
Plan C $3,000 10% 150
Plan D $2,500 14% 200
Plan E $2,000 25% 225
Plan F $1,500 30% 250

The essence of the above plans is that as the commission rate increases the
salary will be decreased. In addition, the assumption is that as the commission rate
increases, the sales people will be motivated to make more calls. Furthermore, as
the commission rate increases the number of sales people needed is less with the
consequence that total salaries paid will be less.
To evaluate these six plans, the following must be computed.
1. Number of sales people needed
2. Sales (units per quarter)
3. Total salaries for each sales compensation plan
4. Total commissions paid for each compensation plan
5. Total compensation for each plan
6. Compensation per sales person
7. Sales compensation cost per unit sold (optional)

The number of sales people need may be computed as follows:

188 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

Customers requesting demonstration

Sales people needed = ––––––––––––––––––––––––––––––––
Calls per quarter
The analysis on pages 214 and 215 reveals several interesting points. First, from
the company’s point of view the best plan in terms of cost per unit is Plan F. Total
sales people compensation is lowest under Plan F. However, the difference between
Plan E and Plan F is only $3.00 per unit sold. Secondly, the total compensation per
sales person under Plan F is $6,000. If sales people are content with this level of
compensation per quarter, then Plan F should minimize sales turnover. Under plans
A and B, compensation per sales person is $4,900 and $3,886 respectively. These
two plans fall way short of meeting the financial needs of sales people, assuming the
desired level of compensation is around $6,000 per quarter. Plan F is very optimistic
in that the expectations are that sales people will make 250 call per quarter. Given
that are only 66 working days in a quarter, this means that sales people are expected
to make on the average almost 4 calls per day. That a sales person can average this
many calls per day is subject to question.
Additional Volume of Business (Accept or Reject Offer)
One of the interesting decision in a business is often called additional volume of
business or the accept or reject special offer decision. This decision opportunity may
take a number of forms. If a business has surplus inventory, it may reduce the price
considerably for the purpose of quickly reducing inventory, recovering some invested
capital, and also, if possible, increase net income.
In some cases, buyers will offer to purchase a much larger quantity, but only at a
significantly lower price. For example, assume that the normal selling price is $300.
A potential buyer offers to buy 1,000 units at a price of $200 per unit. The question
comes into play then is: can a profit be made if the offer is accepted? The answer
depends on how much fixed and variable costs are involved in the production and
sale of the product. If the variable cost of selling and producing are say $120 and $60
respectively, then each unit sold would contribute $$20 per unit to overall income.
However, if the prospective buyer is a regular customer, then acceptance of the offer
is fraught with many dangers. Making a one time sale to a regular customer at a
price below the price necessary to be profitable in the long run is an invitation to
bankruptcy.
This special offer decision is discussed in more detail in chapter 13. The special
offer involves factors involved in the price decision, and therefore is discussed in
some detail on the chapter concerning the price decision.
Summary
The three decisions discussed in this chapter: (1) opening a new territory, (2)
selling on credit, and (3) compensating and hiring sales people are critically important
in many businesses. Cost-volume-profit analysis and incremental analysis are two
tools that can be effectively used to evaluate and make these types of decisions.
Good management of the sales force is critically important. Decisions pertaining
to the number of sales people needed and the compensation of sales people need
constant attention. The sales force decisions made last period may not be the right
 Management Accounting | 189

Analysis of Sales Compensation Plans

Plan A Plan B Plan C Plan D Plan E Plan F
Computation of
Total Salaries
Customers 300,000 300,000 300,000 300,000 300,000 300,000
requesting
demonstrations
Calls per quarter 60 100 150 200 225 250
Sales people needed 5,000 3,500 3,000 2,500 2,000 1,500
Salary $4,000 $3,500 $3,000 $2,500 $2,000 $1,500
Total salaries $20,000,000 $9,000,000 $6,250,000 $4,000,000 $2,250,000

Computation of Total
Commissions

Sales (units) 75,000 75,000 75,000 75,000 75,000 75,000

Sales (dollars) $22,500,000 $22,500,00 $22,500,000 $22,500,000 $22,500,00 $22,500,000
Commission rate .02 .06 .10 .14 .25 .30
Total commissions $450,000 $2,250,000 $3,150,000 $5,625,000 $6,750,000
$1,350,000

Incremental Analysis - Cost Comparison of Sales Compensation Plans

Plan A Plan B Plan C Plan D Plan E Plan F

Salary $4,000 $3,500 $3,000 $2,500 $2,000 $1,500

Sales Commission .02 .06 .10 .14 .25 .30
Total Salaries $20,000,000 $12,250,000 $9,000,000 $6,250,000 $4,000,000 $2,250,000
(see above)
Total Commissions $450,000 $ 1,350,000 $2,250,000 $3,150,000 $5,625,000 $6,750,000
(see above)
Total sales people $20,450,000 $13,600,000 $11,250,000 $9,400,000 $9,625,000 $9,000,000
compensation
Compensation $4,090 $3,886 $3,750 $3,760 $4,813 $6,000
per sales person
Compensation $273 $!81 $150 $125 $128 $120
per unit sold

decisions for the current period. Because the management accountant has knowledge
of tools useful in making these decisions, it is important for the management accountant
to have a solid grasp of the basic fundamentals and problems in the making of sales
190 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

force decisions. Tools such as cost-volume-profit analysis, incremental analysis, and

segmental contribution reporting can be useful in making these decisions.

Q. 10.1 In opening a new territory, what steps should be taken to determine

whether or not the territory should be opened?
Q. 10.2 Explain the difference between contribution margin and segmental
contribution.
Q. 10.3 What costs are incurred by the granting of credit that would not otherwise
be incurred?
Q. 10.4 What services are sales people in general likely to perform?
Q. 10.5 How can cost volume profit analysis be used to help make the credit
decision?
Q. 10.6 How can cost volume profit analysis be used to help make the open a
new territory decision?
Q. 10.7 Which goal should a business pursue?
1. Minimize sales compensation without regard to total
compensation per sales person.
2. Maximize sales compensation per sales person.
Q. 10.9 What problems are likely to be encountered if only a salary is paid to
sales people?
Q. 10.10 What problems, if any, are likely to be encountered if only a commission
is paid to sales people?

Exercise 10.1 • Opening a New Territory

The management of the K. L. Widget Company is considering opening a new

territory called the Midwest territory. Last year’s sales of 96.000 units were far below
the volume required to make the company profitable. The company’s goal is for the
new territory to earn $400,000 annually. The marketing department through marketing
research and analysis of internal sales and financial data has made available the
following information relevant to the opening of this territory.

Direct expenses:
Selling:
Variable Per Unit
–––––––––
Cost of goods sold $ 69.00
Packaging $ 2.00
 Management Accounting | 191

Sales peoples commissions (10%) $ 20.00

Sales people travel expense $ 6.00
Bad debts $ 3.00
Credit department $ 1.00

Direct Fixed (Annual)

Salaries of sales people $ 4,500,000
Sales people training $ 124,000
Advertising $ 1,380,000
Territory sales office lease $ 60,000
Office operating expense $ 240,000
Home office sales expense $ 96,000

General and administrative

Variable
Travel $ 2.50
Supplies $ 1.00

Direct fixed None

Indirect costs:
Selling
Credit $ 96,000
General and administrative
Executive salaries $ 1,080,000
Secretarial & clerical salaries $ 240,000
Supplies $ 60,000
Deprecation, building $ 18,000
Depreciation, furniture and fixtures $ 30,000
Fixed manufacturing overhead $ 3,600,000

Note: the indirect costs/expenses are expenses that were incurred last year. The opening
of the Midwest territory will have no effect on these expenses.

The market potential of the Midwest territory on an annual basis is estimated to

be about 1,000,000 potential customers On the average a customer purchases 1
Gadget. An analysis of demand indicates that approximately 30% of the potential
customers would request a demonstration.
If the Midwest territory is opened, management will consider granting the
customers three months of credit. Given these credit terms, it is estimated that 35%
of the customers requesting a demonstration will purchase. The price of the product
in the Midwest territory will be $165.00
The company believes it has sufficient production capacity to meet the increased
sales, if the Midwest territory is opened. No increase in fixed manufacturing overhead
is anticipated.
192 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

Required:

1. Prepare an income statement for the Midwest territory based on direct costing.
Also, show segmental contribution.
2. Compute the break even point of the Midwest territory.
3. Compute the target income point of the Midwest territory.

Exercise 10.2 • Credit Analysis

The management of the K. L. Widget Company has tentatively decided to offer

its customers credit. The management believes that credit will increase sales as
follows:
3 months credit 20%
6 months credit 35%
12 months credit 50%
Selling on credit will increase the salesmen’s sales-calls ratio. Extending credit
will not result in an increase in demonstrations or an expansion of market potential.
Therefore, the offering of credit terms does not increase the need for more sales
people to call on customers.
In addition to increasing revenue, selling on credit will also increase operating
expenses. Excessive credit terms could have the negative effect of decreasing net
income. If credit terms are extended to customers, then a credit department would
have to be established to handle the administration of credit processing and collection.
Estimated cost of operating a credit department include the following:
Salary (annual) of a credit manager $35,000
Salary (annual) of an assistant manager $25,000
Hourly wages of two clerks $ 12.00
(The number of working hours in a typical year is 2,112)

Selling on credit requires that a credit check be run on each purchaser. The cost
of this credit check will average $5.00 per application. In addition, selling on credit
involves additional bookkeeping. Credit terms of 3 months involves four basic journal
entries while 12 months credit would result in 13 entries. The average cost per entry
is estimated to be $.15.
Even though credit is offered to all, some customers will still prefer to pay cash.
Also, some customers that can afford to pay cash will choose credit simply because
it available. Consequently, the percentage of customers using credit may be higher
than the percentage increase in sales due to credit. The percentage of customers
that will buy on credit is estimated as follows;
3 months credit 30%
6 months credit 50%
12 months credit 80%
 Management Accounting | 193

Selling on credit will inevitably involve uncollectable accounts. Based on the

experience of other firms in the industry, management has estimated that the bad
debt percentage as follows:
3 months credit 3 % of credit sales
6 months credit 6 % of credit sales
12 months credit 15 % of credit sales

Other information and data relevant to an incremental approach for analyzing the
credit decision include:
Sales last year (units) 104,000
Sales price $200
Variable costs (per unit):
Manufacturing costs $ 69.00
Selling expenses (other than
cost of goods sold) $ 31.00
General and administrative $ 3.40

Fixed expenses:
Selling expenses $ 10,800,000
General and administrative $ 1,400,000
Fixed manufacturing costs $ 3,600,000

Required:
1. Prepare a work sheet with the following headings:

Credit Terms
3 Months 6 Months 12 Months

2. Using the work sheet prepared in requirement 1, compute the incremental

income/loss that would result from offering customers different credit
terms. Only relevant costs and revenues need be included in the analysis.
Assume that Territory 4 has not been opened.

3. Identify and briefly discuss decisions that could be made that would make
selling on credit more desirable.
194 | CHAPTER TEN • Incremental Analysis and Cost Volume Profit Analysis: Special Applications

Exercise 10.3 • Sales People Compensation

The K. L. Widget Company has developed two plans for compensation of its
sales people. However, only one plan can be implemented. The two plans, labeled
plan A and Plan B are as follows:

Plan A Plan B
Salary $12,000 $24,000
Commission rate 12% 6%
Sales-calls ratio 30% 30%
Number of calls per sales person 1,000 600

The marketing department believes that in the coming year plan A will result in
more calls per sales person. However, if insufficient calls are made or sales resistance
is greater than anticipated, then the turnover of sales people will be greater under
plan A.
Analysis by the marketing department of past sales and the exiting marketing
environment projects the potential number of customers per year at 1,000,000. Of
this number 30% will be receptive to a call and a sales pitch by the sales people.
Under plan A less sales people will be needed; however, the commissions paid will
be much greater.
The price of the production is currently $200 and will remain the same throughout
the coming year.
Required:
Compute the cost sales people compensation cost under each plan.

What is the break even point of each plan?

 Management Accounting | 195

Inventory Decision-Making

To be successful, most businesses other than service businesses are required

to carry inventory. In these businesses, good management of inventory is essential.
The management of inventory requires a number of decisions. Poor decision making
regarding inventory can cause:
1. Loss of sales because of stock outs.
2. Depending on circumstances, inadequate production for a period of time.
3. Increases in operating expenses due to unnecessary carrying costs or
loss from discarding obsolete inventory.
4. An increase in the per unit cost of finished goods.

Of all the activities in a manufacturing business, inventory creation is the most

dynamic and certainly the most visible activity. In one sense, inventory involves all
production activity from the purchase of raw materials to the delivery of finished goods
inventory to the customer. The financial accounting for inventory is concerned primarily
with determining the correct count and the assignment of historical cost. However,
from a management accounting viewpoint, the central focus is on manufacturing the
right amounts at the lowest cost consistent with a quality product. From a financial
viewpoint, poor management of inventory can adversely affect cash flow. Also,
excessive inventory can cause a decrease in ROI. An over stock of inventory causes
total assets to be larger and certain expenses to increase. Consequently, in addition
to a reduced cash flow, the effect of poor inventory management can be a lower rate
of return.
196 | CHAPTER ELEVEN • Inventory Decision-Making

Finished goods inventory represents the company’s product for available for sale
at a given point in time. A certain amount of inventory must be available at all times in
order to have an effective marketing operation. The poor management of inventory,
including finished goods, is often reflected in the use of terms such as such as stock
outs, back orders, decrease in inventory turnover, lost sales, and inadequate safety
stock.
The existence of inventory results in expenses other than the cost of inventory
itself which typically are categorized as:
1. Carrying costs
2. Purchasing costs.

Inventory is a term that may mean finished goods, materials, and work in process.
In a manufacturing business, there is a logical connection between these three types
of inventory:

Materials
Labor Æ Work in Process Æ Finished goods Æ Cost of goods sold
Overhead

To have finished goods inventory, production must take place at a rate greater
than sales. Inventory decisions have a direct impact on production. For example, a
decision to increase safety stock means that the production rate must increase until
the desired level of safety stock is achieved.
From an accounting standpoint, there are two main areas of concern. First, from
a financial accounting viewpoint, the main accounting problems concern:
1. The flow of costs (FIFO, LIFO, average cost)
2. Use of a type of inventory costing method (periodic or perpetual)
3. Taking of physical inventories.
4. Techniques for estimating inventory

From a financial accounting viewpoint, the cost assigned to inventory directly

affects net income. If ending inventory is overstated, then net income is overstated
and conversely, if ending inventory is understated then net income is understated.
Also, the use of direct costing rather than absorption costing can affect net income
as discussed in chapter 6. From a management accounting viewpoint, there are
variety of inventory decisions that affect net income. Decisions regarding inventory
can be placed in two general categories: (1) those decisions that affect the quantity
of inventory and (2) those decisions that affect the per unit cost of inventory.
Decisions that affect the quantity of inventory
1. Order size
2. Number of orders
3. Safety stock
4. Lead time
5. Planned production
 Management Accounting | 197

Decisions that affect the cost per unit of inventory

1. Suppliers of raw material (list price and discounts)
2. Order size (quantity discounts)
3. Freight
In addition, decisions pertaining to labor and overhead also indirectly affect the per
unit cost of inventory. In a manufacturing business, the costs of labor and overhead
do not become operating expenses until the manufacturing costs appear as part
of cost of goods sold. Labor and overhead costs are deferred in inventory until the
inventory has been sold.
In this chapter, the main focus of discussion will be the following inventory
decisions:
1. Production budget
2. Order size for raw materials
3. Number of times to order for raw materials
4. Reorder point
5. Safety stock

Production Budget Decision

The production budget was discussed in some detail in chapter 8. The production
budget decision is of utmost importance. If the production budget is inadequate, then
stock outs will occur. If the production budget is too large, then unnecessary carrying
costs will be incurred. The production budget format as presented previously was:

Production Budget
For the Quarter Ending March 31, 20xx

Sales forecast $100,000

Back orders 5,000
Desired
ending Finished Goods Inventory 20,000
________
25,000
Finished goods (BI) 10,000
________
$115,000

The key to a good production management is an accurate sales forecast. Without

a reliable sales forecast, the production process is likely to be chaotic and have a
significant negative impact on sales. A good production budget is one that meets the
current sales demand plus provides for an adequate planned safety stock. Also, in
the preparation of the purchases budget, decisions for the desired levels of safety
stock in materials must be made. The production budget determines the need for
plant capacity. If the current production budget exceeds existing plant capacity, then
ways to increase plant capacity must be considered. Increasing plant capacity may
involve scheduling overtime or a second shift or even purchasing and installing more
production equipment and hiring additional labor.
198 | CHAPTER ELEVEN • Inventory Decision-Making

Purchase of Materials Decision

The main management accounting tool that may be used to make inventory
purchase decisions is the EOQ model. This tool recognizes that there are two major
decisions regarding the materials inventory: (1) orders size and (2) number of orders.
There are consequently two major questions:
1. How many units should be purchased each time a purchase is made
(order size)?
2. How many purchases should be made (number of orders)?

To understand an EOQ model, it is essential that the concept of average inventory

be understood. Inventory is never static and is constantly rising and falling over time,
even in the very short term. Inventory, for example, rises when raw materials are
purchased and falls when raw material is used. Because inventory in a business is
constantly changing, it is necessary to think in terms of average inventory levels.
The high points and low points of inventory are easy to explain and illustrate, if
a purchasing policy is consistently applied and the rate of usage of raw material
is uniform. Inventory is at its highest and lowest levels when a new shipment of
material arrives. Theoretically, in absence of a need for safety stock, a new shipment
should arrive at the moment inventory reaches zero. Immediately, upon arrival of a
new shipment, inventory is then at its highest level again. To illustrate, assume that
each purchase order placed is for 18,000 units at $5.00 per unit and that usage of
raw materials is uniform at 300 units of material per day. If production and usage
of material takes place every day, then a shipment of material should last 60 days.
These conditions may be illustrated as follows:
Figure 11-1 • Graphical Illustration of Average Inventory

Units

18,000

Average
9,000
Inventory

0
60 120 180 240 300 360 Work Days

In terms of dollars, the amount invested in inventory would fluctuate between

$90,000 and zero. In this example, the average inventory would be 9,000 computed
as follows:
Order size
Average Inventory = ––––––––– (1)
2
 Management Accounting | 199

At its highest level inventory would be 18,000 units and at its lowest level inventory
would be 0. Based on the above equation average inventory is:
AI = (18,000 + 0)/ 2 = 9,000
The major factor here that affects the level of inventory is order size ( the number
of units purchased in each order). If demand for materials for a full year is 108,000
units, then the extremes for purchasing could be one large order of 108,000 or
108,000 orders of one unit per order. Given these extremes, then average inventory
could be as low as .5 unit (1 /2) or as large as 54,000 (108,000 / 2). The best order
size, as will be explained and illustrated now, is determined by the cost of ordering
(purchasing) and the cost of carrying inventory.
Purchasing Cost
The purchase of materials or parts necessary to make a finished product
involves a process that needs to be understood. The process begins with a purchase
requisition and finally ends with payment of the materials purchases. This process
may be illustrated as follows:

Purchase Purchase Delivery Receiving and Preparation Payment of

Requisition Order of Inspection of of Voucher Purchase
Æ Æ Æ Æ Æ
Order order and
Accounting

The cost of placing an order, therefore, consists of the following:

1. Cost of preparing purchase requisition
2. Cost of preparing purchase order
3. Delivery of order (postage, telephone time, filing)
4. Receiving of purchased materials (inspection, storing, receiving
report.
5. Accounting costs (preparing vouchers and recording time)
It is important to remember that the cost of the inventory itself is not a purchasing
cost. The purchase of inventory is typically recorded to the materials purchases
account and is treated as a separate and distinct cost.
The number of times an order is placed is to some extent discretionary. To illustrate,
assume that the K. L. Widget Company has determined that for the current quarter
100,000 units of raw material Y need to be purchased. Two extreme possibilities
present themselves. The first one is to simply buy one unit at a time and purchase
100,000 times. The second extreme is to make 1 large order of 100,000 units.
Between purchasing one unit at a time or buying one unit at a time 100,000 times,
there is a large number of possibilities between an order size of 1 and 100,000.
It is obvious that each time an order is placed some purchasing costs are incurred,
and that as the number of orders placed increases, the total cost of purchasing
increases. To use a simple example, if you enjoy eating a sandwich at lunch each
200 | CHAPTER ELEVEN • Inventory Decision-Making

day and you make your own sandwiches, then you must purchase bread and say a
package of sliced ham. Then, at a minimum, you must purchase one loaf of bread
and a package of sliced ham which, for example purposes here, can last for one
week. You must then visit your grocery store once a week. This means that for a
full year you would make a minimum of 52 trips a year. However, the other extreme
alternative would be to purchase a full year’s worth of bread and ham and, therefore,
make only one trip per year. If the grocery store was 5 miles away and at a cost
of 50¢ per mile, each trip will cost you $5.00 per trip or $260 per year. However,
purchasing one time per year, then means you have a carrying or storage problem.
You would have to have space to store 52 loaves of bread and packages of sliced
him. Assuming you had this space, then you face the problem of spoilage which for
bread is most likely to happen within a few weeks, unless you had a freezer which
had sufficient space for 52 loaves of bread and sliced ham. The cost of storing a
year’s supply would most likely exceed the reduced cost in purchasing. In business,
the same principle applies. As the size of the order increases, the cost of carrying or
storing inventory increases in total.
The basic principle of purchasing then is this: Given the amount of material or
parts that are needed for a specified period of time, for example a year, as order
size increases the number of times required to purchase decreases. To illustrate
mathematically
Let:
A represent the total material in units needed for a defined period
of time
E represent the order size.

The number of orders that would result may be computed as follows;

A
Number of orders = –– (2)
E

If order size were 1,000 and the annual requirement for materials is 120,000, then
the number of orders would 120 (120,000 / 1,000). If we assume that each order has
a measurable cost, and if we let this cost be represented by the letter P, then the total
cost of purchasing may be computed as follows:
A
TPC = ––– (P) (3)
E
TPC - total purchasing cost
A - periodic demand for material
P - cost of placing each order

This equation may be read as the number of orders times the cost of placing one
order.
If P is $100, then given that the number of orders is 120, then total purchasing
cost would be $12,000. If the same values assumed before are used and, if 10,000
units were purchased each time then only 12 orders would be placed and the total
purchasing cost would be $1,200 (120,000/10,000 x $100).
 Management Accounting | 201

The cost of various order sizes may be illustrated as follows:

A = 120,000
P = $100

Order Size
Order size 1 10,000 30,000 50,000 70,000 90,000 10,000 120,000

Number of orders 120,000 12 4 2.4 1.7 1.33 1.09 1

Total purchasing $12,000,000 $1,200 $400 $240 $170 $133 $109 100
cost

Graphically, the cost of purchasing may be presented as follows:

Figure 11-2 • Graph of Total Purchasing Cost

Total Purchasing Cost

7000

6000

5000

4000
$ Total
3000
Purchasing
Cost
2000

1000

0
0 20000 40000 60000 80000 100000 120000 140000

Order Size

An order size of one unit per order results in a total and most likely unacceptable
cost of $12,000,000. While an order size of 120,000 minimizes total purchasing cost
at $100, this order size is also most likely to be unacceptable, because of the high
carrying cost that would inevitably result due to the high average carrying cost that
would invariably follow. The main point to observe is that as order size increases total
purchasing cost decreases.
There has been developed a tool that can determine the right order size and,
therefore, the right number of times to purchase. This tool is commonly called an
EOQ model. However, before this tool is mathematically introduced, it is necessary
to first discuss carrying costs.
Carrying Cost
The purchase of materials or the production of finished goods normally requires that
the materials or finished goods be stored until used or sold. The storage of materials
202 | CHAPTER ELEVEN • Inventory Decision-Making

or finished goods obviously requires storage space. The greater the purchase lot
at any given time, the greater is the storage space required. How long inventory
is stored varies directly with the rate at which it is used. In a restaurant where one
loaf of bread is purchased each time and a new loaf immediately purchased when
the last loaf is used up, not much space would be require. On the other hand, if 144
loaves are purchased at a time, then considerably more space would be required.
Depending on the type of raw materials, some or all of the carrying costs could be
incurred:
1. Interest (a big order size requires an investment of money).
2. Taxes (inventory is typically subject to a property tax).
3. Insurance (inventory is always at risks like theft or fire or damage).
4. Storage costs (inventory requires building space and is subject to the
costs associated with a building such as depreciation,
5. Salary of storekeeper and helpers, if required.
6. Spoilage.
The basic principle of carrying inventory may be explained as follows: At a certain
level of inventory (reorder point), a new order must be placed. The inventory at its
maximum would be equal to the order size and at a minimum would be zero if no
safety stock is being carrying. Inventory is at a maximum when a new shipment
is received, and at its lowest moments before the new order arrives. As explained
earlier in this chapter, the inventory is not a constant amount and is best numerically
described as an average.
Mathematically, total carrying cost is simply the average inventory for a period of
time times the cost of carrying a single unit of inventory: Therefore, mathematically,
Order size
Carrying cost = –––––––––– x (Carrying cost per unit)
2
If
E - represents order size
S - represents carrying cost per unit
TCC - denotes total carrying cost
then:
E
TCC = ––––– (S) (4)
2
The cost of carrying inventory sizes may be illustrated the following table:
A = 120,000
S = $5.00

Order Size
Order size 1 10,000 30,000 50,000 70,000 90,000 110,000 120,000

Average inventory .5 5,000 15,000 25,000 35,000 45,000 55,000 60,000

Total carrying cost $2.50 $25,000 $75,000 $125,000 $175,000 $225,000 $275,000 $300,000
 Management Accounting | 203

Total carrying cost may be graphically illustrated as shown in figure 11.3:

Figure 11-3 • Graph of Total Carrying Costs

Total Carrying Cost

350000

300000

250000

200000
$ Total
150000
Carrying
Cost
100000

50000

0
0 50000 100000 150000

Order Size

Figure 11-4 • Graph of Total Inventory Costs

EOQ Costs
35000

30000

25000 Total
Purchasing
20000
Cost
$ Total
15000 Carrying
Cost
10000
Total Cost
5000

0
0 1000 2000 3000 4000 5000

Order Size

As order size increases, the total carrying cost increases. With an order size of
1 unit carrying cost for the entire period is only $2.50. However, if the entire periodic
need for material is purchased one time, then the total carrying cost is $300,000, the
maximum cost that can be incurred.
Close observation of the above schedule reveals that as order size increases,
total carrying cost also increases directly, just the opposite of total purchasing cost.
A paradox then exists. Any attempt to minimize total purchasing cost, then increases
total carrying cost and vice versus. The goal of inventory management becomes
apparent: The goal should be then to minimize total purchasing cost and carrying cost
and not each cost separately. The two illustrations above concerning total purchasing
cost and total carrying cost can now be combined as follows:
204 | CHAPTER ELEVEN • Inventory Decision-Making

Order Size

Order size 1 10,000 30,000 50,000 70,000 90,000 110,000 120,000

Total purchasing $12 M $1,200 $400 $240 $170 $133 $109 100
cost

Total carrying $2.50 $25,000 $75,000 $125,000 $175,000 $225,000 $275,000 $300,000
cost

Total cost $12 m $26,200 $75,400 $125,240 $175,170 $225133 $275,109 $300,100

It is apparent by observation that the order size of 10,000 shows the lowest total
cost of carrying and purchasing inventory. However, whether an order size of 10,000 is
the best order size has not been yet determined. An order size less than 10,000 might
result in lower costs. This table may be graphically presented as shown above.
From this graph the following observations may be made
1. As order size increases, total purchasing cost decreases.
2. As order size increases, total carrying cost increases
3. Total cost is minimized where total purchasing cost equals total carrying
cost.

The observation that total cost of managing inventory can be minimized where
total purchasing cost equals total carrying cost allows us later to derive a formula for
determining the best economic order size.
EOQ Formula
Earlier total purchasing cost was defined as follows:

A
TPC = ––– (P)
E

TPC - total purchasing cost

A - periodic demand for material
P - cost of placing each order
E - order size

Also, earlier total carrying cost was defined as follows:

E
TCC = ––– (S)
2
S - carrying cost per unit of inventory

Total cost can then be defined as follows:

A E
TC = –––– (P) + –––– (S) (5)
E 2
 Management Accounting | 205

Since the best order size is where TPC = TCC, we can mathematically solve for
the best order size as follows:
A E
–––– (P) = –––– (S)
E 2

Solving for E using basic algebra (see appendix to this chapter), we then get:

2 A P
E = (6)
2

Given the same values used previously as follows:

A = 120,000
P = $100
S = $5.00

The order size that minimizes total cost then is :

2 (120,000) ($100)
E = = 2,191
$5.00

If this is the correct answer, then TPC should equal TCC

120,000
TPC = –––––––– ($100) = $5,475
2,190.9

2,190
TCC = –––––––– ($5) = $5,475
2

Since TPC = TCC, the best order size is 2,191 units.

Illustrative Problem
The L. K. Widget Company’s accountant presented the following information
based on a cost analysis:
Annual demand for materials (units) (A) 100
Cost of placing an order (P) $10.00
Cost per unit of carrying inventory (S) $5.00

Based on the above information, economic order quantity may be computed as

follows:
206 | CHAPTER ELEVEN • Inventory Decision-Making

2 (100) ($10)
E = = 20
$5.00

Using the same values given above, the following schedule may be prepared:

Schedule of Costs of Carrying and Purchasing Inventory

Order Number of Average Total Total Total
size Orders Inventory Purchasing Carrying Cost
1 100.00 .50 $ 1,000.00 $ 2.50 $ 1,002.50
2 20.00 1.0 $ 200.00 $ 12.50 $ 212.50
10 10.00 5.0 $ 100.00 $ 25.00 $ 125.00
15 6.67 7.5 $ 66.67 $ 37.50 $ 104.17
20 5.00 10.0 $ 50.00 $ 50.00 $ 100.00
25 4.00 12.5 $ 40.00 $ 62.50 $ 102.50
30 3.30 15.0 $ 33.00 $ 75.00 $ 108.00
35 2.85 17.5 $ 28.50 $ 87.50 $ 116.00
40 2.22 20.0 $ 22.00 $ 100.00 $ 122.00
45 2.50 22.5 $ 25.00 $ 112.50 $ 137.50
50 2.00 25.0 $ 20.00 $ 125.00 $ 145.00

The most economical order size is 20. When order size is 20, then total carrying
cost equals total purchasing costs and total cost is minimized at $100.
The EOQ formula just discussed is based on several assumptions which if not
true may result in values that are not helpful in making order size decisions. First, this
EOQ model requires an accurate estimate of demand under conditions of certainty.
Extreme and frequent fluctuations in demand requires other approaches to the order
size decision. Secondly, The EOQ model requires fairly accurate estimates of carrying
and purchasing costs. Multiple products and numerous types of material for a single
product may make the computation of these costs very difficult.
Making the Reorder Point Decision
When to reorder materials or parts is a decision that must be thoughtfully
considered. If the decision to reorder is made too late, then undesirable consequences
such as stock outs and delays in production may happen. If the decision to reorder
is made too soon, then unnecessary carrying costs will be incurred. The important
question then concerning reordering is: at what level of inventory should a new order
be placed? Obviously, if inventory has reached zero, then the time to place an order
has been missed. In formulating an answer to this question, a number of factors must
 Management Accounting | 207

be considered including:
1. Lead time
2. Average usage per day
3. Desired safety

Lead Time -Lead time is time between placing and order and receiving an order. Lead
time can vary greatly depending on a number of factors. It could be as little as a few
hours or as great as many months. Lead time can be affected by factors or conditions
such as bad weather, strikes on the part of the supplier’s workers, production problems
on the part of the suppliers, and unexpected problems in shipping. Because lead time
can vary with each order placed, the normal approach to developing a reorder point
is to use average lead time. When the variations are small, the use of average lead
time is workable. Lead time should be measured in terms of work days rather than
calendar days. If lead time is one day but the supplier of the material in question
is closed on Saturdays and Sundays, then a order placed on Friday might not be
received until Tuesday of the next week. The problem of unpredictable variations in
lead time can usually be solved by carrying safety stock.
Average Usage per Day - It goes without saying that some level of materials inventory
is required to manufacture finished goods. A primary objective in the management
of the production process is to main a steady flow with minimal interruptions. A
consistent daily production rate is highly desirable. If this goal is achieved, then the
amount of material used each day is easily computed. Average usage per day will
tend to be the same.
To illustrate, if the production budget shows a planned production of 50,000
widgets per year and each widget requires 10 units of material Z, then 500,000 units
of material Z need to be purchased annually. If the year consists of 250 work days,
then the following simple equation can be used to compute average usage per day
Annual requirement for material 500,000
AUPD = –––––––––––––––––––––––––––– = –––––––– = 2,000
Work days 250

There is a connection between lead time and average usage per day. To avoid
a stock out, the level of inventory at the time an order is placed must be sufficient to
last until the new shipment arrives. This level of inventory, assuming no safety stock,
can be computed simply by multiplying lead time times average usage per day
Reorder point = Lead time x Average Usage per Day (7)
Safety Stock - Because both lead time and average usage per day can vary
significantly in the short run and to avoid stock outs during a critical time in the
production process, it is normally desirable to carry some safety stock. The question
as to how much safety stock to carry is a difficult question to answer. If safety stock is
too small, then stock outs can still occur. If safety stock is to large, then unnecessary
carrying cost will be incurred. When average usage during lead time tends to be
volatile, safety stock models tend to be based on probability theory and requires
knowing the probability of different levels of demand during lead time. The use of
probability models for safety stock is beyond the scope of this chapter.
208 | CHAPTER ELEVEN • Inventory Decision-Making

However, giving that a decision had been made regarding safety stock by whatever
method, the equation for reorder point then becomes:

Reorder point = Lead time x Average Usage Per Day + Safety Stock (8)

Illustrative Problem
Assume the following:
Annual demand for raw materials 25,000
Number of work days 250
Desired safety stock level 100
Lead time (days) 5

Computing the reorder point requires, first of all, determining the average usage
per day:
25,000
AUPD = ––––––– = 100
250

Reorder point then may be computed as follows:

RP = AUPD x Lead time + safety stock = (100 x 5) + 100 = 600

When inventory level becomes 600, then a new order should be placed.
Theoretically, the new order should be received on the day the inventory reaches the
safety stock level of 100 units.
Economic Order Quantity and Quantity Discounts
The previous discussion on order size was based on the assumption that quantity
discounts were not available. The EOQ formula as explained above is not able to
determine the most economic order size, given the availability of quantity discounts.
Suppliers will often provide incentives to purchasers to buy in bigger quantities. A
typical discount schedule might look as follows:

Quantity Discount Schedule for Material Z

Order Size Price
1 - 99 $5.00
100 - 199 $4.00
200 - 299 $3.00
300 + $2.50

When quantity discounts are available, the basic EOQ formula can not be used
to directly solve for the best order size. However, it must be used on an iterative (trial
and error) basis to find the best order size.
When quantity discounts were not available, the cost of inventory itself,
(purchases), was not relevant and could be ignored. However, because now the
order size affects the cost per unit, the total cost of inventory purchases must be
 Management Accounting | 209

taken into account. Without quantity discounts, the total cost of inventory purchased
remained the same regardless of order size. In order to solve for the best order size,
the following equation must be used.
A E
TC = –––– (P) + –––– (S) + C(A) (9)
E 2
The EOQ formula now has C(A), the total inventory purchase cost, as a cost element.
When quantity discounts exists, the cost of inventory becomes relevant in the order
size decision. C represents the cost of one unit of inventory. The other mathematical
symbols have the same meaning as before:
E - represents order size
S - represents carrying cost per unit
TCC - denotes total carrying cost
TPC - total purchasing cost
A - periodic demand for material
P - cost of placing each order
Equation (9) above cannot be used to directly solve for order size (E). The reason
is that there are two unknowns: (1) order size and (2) cost per unit of inventory.
Order size affects cost per unit and cost per unit affects order size. Because of the
dependency of price on order size and order size on cost per unit of inventory, the
total carrying cost curve and the total cost curve is now discontinuous as shown in
figures 11-7 and 11-8.
The trial and error procedure based on equation 9 that must be used is as
follows:

Step 1 Prepare a work sheet based on the total cost equation.

Step 2 Compute total cost at each price break, including an order size of one
unit.
Step 3 Determine the order size range which minimizes total cost. (In many
cases the best order size is a price break quantity.)

Figure 11.5 • Total Purchasing Cost Figure 11.6 • Total Carrying Cost

$ Total Purchasing Cost $

4,000 4,000
Total Carrying Cost
3,500 3,500

3,000 3,000

2,500 2,500

2,000 2,000

1500 1500

1,000 1,000

500 500

50 100 150 200 250 300 50 100 150 200 250 300
Order Size Order Size
210 | CHAPTER ELEVEN • Inventory Decision-Making

Figure 11-7 • Cost of Purchases Figure 11-8 • Total Cost

Total Purchasing Cost

$ $
4,000 4,000
Total Cost
3,500 3,500

3,000 Purchases 3,000 Purchases

2,500 2,500

2,000 2,000

1500 1500

1,000 1,000
Total Carrying Cost
500 500

50 100 150 200 250 300 50 100 150 200 250 300
Order Size Order Size

Step 4 Use the basic EOQ model to see if a better order size exists.
Illustration

The K. L. Widget Company may purchase Material Z at a quantity discount. The

company annually purchases 100 units. The cost of placing 1 order is $1. Carrying
cost is $2.00 per unit. The following discount schedule is available:

Quantity Discount Schedule for Material Z

Order Size Price
1 - 19 $5.00
20 - 29 $4.90
30 - 49 $4.80
50 + $4.70

Work Sheet for Determining Best Order Size (Quantity Discounts Available)

Order Number Total Average Total Inventory Total

Size of Purchasing Inventory Carrying Cost Cost
(E) Orders Cost ( E/2) Cost C( A)
(A/E) (A/E) P (E/2)S

1 100 $ 100.00 .5 $ 1.00 $500 $601.00

20 5 $ 5.00 10 $ 20.00 $490 $515.00

30 3.3 $ 3.30 15 $ 30.00 $480 $513.30

50 2 $ 2.00 25 $ 50.00 $470 $522.00

EOQ 10 $ 10.00 5 $ 10.00 $500 $520.00

Order size
 Management Accounting | 211

Step 1 Based on equation (2) the above work sheet was prepared.
Step 2 The price break quantities are 1, 20,30 and 50. For example, when 20
units or more are ordered, then price decreases from $5.00 to $4.90 per
unit. In the above work sheet, then at each price break quantity, total cost
was computed.
Step 3. The range that results in the lowest cost is the range between 30 and 50
units. At an order size of 30 units, the total cost is $513.30. Normally, in
this range the lowest cost results in the smallest order size in this range,
which in this case would be 30 units.
Total cost if order size is 30 $514.22
Total cost if order size is 31 $525.12
If an order size greater than 30 is used, then the total cost is
greater as seen above.
Step 4 Occasionally, the best order size can be found by using equation (6). In
other words, a better solution can be found than the one indicated by the
trial and error work sheet method.

2 (100) ($1.00)
E = = 10
$2.00

However, if an order size of 10 is made, the total cost is $520. Clearly, this is not
the best solution since at an order size of 30 units the total cost is less ($513.30). The
use of the equation (1), therefore, did not find a better solution.
Summary
Good inventory decisions are critical to the success of a business. Excessive
inventory levels may lead to inventory write-off losses, and even if eventually sold,
excessive inventory levels will result in unnecessary carrying costs. Inadequate
inventory on the other hand can result in stock outs and production delays. In
modern business, some products involve hundreds of different parts and material.
Consequently, the purchasing of parts and materials at the appropriate time is highly
critical. The purchasing function in many business is extremely important.
Order size is one of the more important inventory decisions. Improper management
of the order size will result in excessive total inventory management costs. The use
of EOQ models provide a valuable insight as to factors that must be considered
in making inventory decisions. Both management and the management accountant
need a solid understanding of inventory management principles.
Making good inventory decisions required considerable knowledge and skill. To
make good inventory decisions requires understanding of the follow terms.
1. Carrying cost 8. Safety stock
2. Purchasing costs 9. Reorder point
212 | CHAPTER ELEVEN • Inventory Decision-Making

3. Inventory cost 10. Lead time

4. Demand for inventory 11. Average usage per day
5. Number of orders 12. Work days
7. Average inventory
Appendix: Derivation of the EOQ Formula

Derivation of EQO Formula

Algebraic Derivation Calculus Derivation
AP ES
TIC = –––– + ––––
AP ES E 2
–––– = ––––
E 2
d(TIC) d(AP/E) d(.ES)
AP E 2S ––––– = ––––––– + ––––––
–––– = –––– d E dE dE
1 2
d(TIC) d (APE-1) ) d(.5ES)
2AP ––––– = –––––––– + –––––––
–––– = E2 d E dE dE
S
d(TIC) d- (APE-2) ) d(.5ES)
––––– = ––––––––– + ––––––
d E dE dE
2AP
E =
S d(TIC)
–––––– = - (APE-2) ) + (.5S)
dE

- (APE-2) ) + (.5S) = 0

- (APE-2) ) = - (.5S)

AP .5S
–––– = - ––––
E-2 AP

AP
–––– = E2
.5S

2AP
E =
S

As illustrated above the EOQ formula can be derived using either calculus or
algebra. Actually, for his version of the EOQ formulas using simply algebra is much
easier. The algebra approach begins with recognizing that optimum order size is
where total purchasing cost = total carrying cost. The calculus approach finds the
first derivative of the total cost equation and then sets that equation to zero in order
to solve for E, the order size.
 Management Accounting | 213

Q. 11.1 Define the following terms:

a. Purchasing cost
b. Carrying cost
c. Economic order quantity
d. Safety stock
e. Reorder point
f. Average lead time
g. Average usage during lead time
h. Workdays per year
i. Average inventory
j. Forgone discounts
k. Stock outs
Q. 11.2 What are four basic decisions that must be made concerning
inventory?
Q. 11.3 Explain how the order size decision determines average inventory?
Q. 11.4 Defined mathematically the total cost of carrying and purchasing
inventory
Q. 11.5 Illustrate graphically total carrying cost.
Q. 11.6 Illustrate graphically total purchasing cost.
Q. 11.7 List five examples of purchasing cost.
Q. 11.8 List six examples of carrying cost.
Q. 11.9 Explain the effect that quantity discounts have on the EOQ model.
Q. 11.10 Draw a graph showing or illustrating economic order quantity, reorder
point, lead time, and safety stock.
Q. 11.11 Identify these equations:
a. A/E
b. A/E (P)
c. E/2
d. E/2 (S)
e. C(A)
f. E/2(IC)
f. AUPD x LT
Q. 11.12 What inventory management cost is relevant when quantity discounts
are available that is otherwise irrelevant?
Q. 11.13 What is the total cost equation when quantity discounts are available?
Q.11.14. What is the major disadvantage of taking a quantity discount?
214 | CHAPTER ELEVEN • Inventory Decision-Making

Q.11.15 Explain why a basic EOQ equation can’t be derived when quantity
discounts are available.
Q.11.16 What procedure must be used to identify the best order size when
quantity discounts are available?
Q. 11.17 Prepare a work sheet with the proper headings that may be used to find
the optimum order size when quantity discounts are available.
Q. 11.18 For what order sizes should total cost be computed on the work
sheet?

Exercise 11.1 • Optimum Order Size-No Quantity Discounts

You have been provided the following information:
Material requirements (units) 6,000
Carrying cost (per unit) $ .50
Purchasing cost (per order) $5.00

Required:

1. Determine the optimum order size that minimizes total purchasing and carrying
cost.
2. Prepare a graph illustrating the behavior of total carrying cost, total purchasing
cost, and total cost.
Exercise 11.2 • Optimum Order Size-No Quantity Discounts

You have been provided the following information:

Material requirements (units) 8,000
Carrying cost (per unit) $ .85
Purchasing cost (per order) $10.00

Required:
1. Determine the optimum order size that minimizes total purchasing and carrying
cost.
2. Prepare a graph illustrating the behavior of total carrying cost, total purchasing
cost, and total cost.

Exercise 11.3 • Optimum Order Size-No Quantity Discounts

The Acme Manufacturing Company does not have a systematic or scientific

approach to the planning and control of inventory; however, the Acme Manufacturing
Company is considering installing a formal planning and control system which includes
the use of economic order quantity models. In regard to a proposed procedure for
the control of raw materials, the following cost study was made:
 Management Accounting | 215

Annual required units of material 10,000

Cost of placing each order:
Stationery $ .10
Clerical $ .30
Basic time preparing for loading/storing $2.00
Carrying costs per unit (annual)
Taxes $ .05
Insurance $ .10
Storage $ .45
Interest $ .20

Required:
1. Compute the optimum order size that minimizes total cost.
2. Graphically illustrate the above data.

Exercise 11.4 • Optimum Order Size-Quantity Discounts

Single Discount
The ABC Manufacturing Company annually purchases 10,000 units of material
X. The company’s accountant has determined that it costs the company $10.00 each
time an order is placed and that the cost of carrying inventory is $1.00 per unit per
year. ‘The company has been purchasing material X at a cost of $25.00 per unit.
If material X is purchased in quantities of 5,000 or more, then material X can be
purchased at $20.00 per unit..
Required:

Determine whether the company should take advantage of the quantity discount?
Exercise 11.5 • Optimum Order Size-Quantity Discounts

The ABC Manufacturing Company annually purchases 10,000 units of material

Y. The company’s accountant has determined that it costs the company $5.00 each
time an order is placed and that the cost of carrying inventory is $ .30 per unit. The
company has been purchasing material Y at a cost of $.20 per unit; however, the
supplier of Y has offered the following discounts:
Quantity Range Price
1 - 1,499 $.20
1,500 - 2,999 $.19
3,000 - 4,999 $.18
4,500 + $.17

Required:
In what quantities should the ABC Manufacturing Company order?
216 | CHAPTER ELEVEN • Inventory Decision-Making

Exercise 11.6 • Reorder Point and Safety Stock

You have been provided the following information:

Order size 200
Lead time 10 days
Number of work days per year 250
Annual material requirements 2,000
Safety; stock (units) 20

Required:
1. Based on the above information (assuming conditions of certainty)
compute the following:
a. The number of orders per year
b. Average usage per day
c. Average inventory
d. Number of work days between orders
e. Usage during lead time
2. Prepare a graph which shows (1) maximum level of inventory, (2) lead
time and (3) reorder point.
 Management Accounting | 217

Capital Budgeting Decisions Tools

In many businesses, growth is a major factor to business success. Substantial
growth in sales may eventually means a need to expand plant capacity. In order to
expand plant capacity, the company will have to invest considerably in more capital
on a long term basis. A new assembly line or a chemical processing plant can cost
millions or even hundreds of millions of dollars. An investment of large amounts of
money on a long term basis should be founded on a thorough analysis of economic
and financial conditions to determine that the prospects for success are favorable.
The analysis should include computations that indicate the kind of return to expect.
The project should return the invested capital in a reasonable length of time and also
provide at a minimum the desired rate of return. The process of analyzing the future
prospect of a project and using the appropriate tools to determine the rate of return is
commonly called capital budgeting.
Nature of Capital Budgeting
Capital budgeting is a system of long term financial planning involving:
1. Identifying investment opportunities (long term projects)
2. Determining profitability of investment projects
3. Ranking projects in terms of profitability
4. Selecting projects
218 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

Step 1 Identifying projects

The object of capital budgeting is typically called a project. An invest-
ment project may be a:
a. New plant or equipment
b. Expansion of existing plant and equipment
c. Investment in information technology equipment
d. Purchase of an existing business
e. Opening a new territory
f. Development of a new product
A potential project has the following characteristics that must be recog-
nized:
1. An initial outlay of cash which is simply called the cost of the
project. This cost is incurred in the time period that is commonly
called period zero.
2. The project has a useful life which can be typically from five years
or more to fifty years.
3. The project will generate in each period of its life starting with
period 1 a net cash flow.
4. A desired rate of return for the project is set by management.
5. At the end of the life of the project, some residual value may exist.
This residual value or salvage value must be estimated because
it is equivalent to a net cash flow amount in the year in which the
project ends.
Step 2 Determining or measuring profitability
The most critical step is to measure the potential profitability of the
project. In general, two measures of future profitability are available:
(1) accounting net income and (2) net cash flow.
The process of determining profitability at a minimum involves the follow-
ing steps:
1. Determine the cost of the project.
2. Determine the revenue expected in each period of the life of the
project.
3. Determine the cash expenses for each year of the life of the
project.
4. Determine the net cash flow for each period of the projects useful
life (cash revenue less cash expenses).
Step 3 Rank the projects in order of profitability. The term “profitability” is an am-
biguous term and, consequently, has different meanings. For this reason
different techniques of measuring profitability have been developed. The
more important of these techniques include the following:
a. Average rate or return method (accounting method)
 Management Accounting | 219

b. Payback method
c. Time adjusted rate of return method (Internal rate of return)
d. Net present value method
The selection of a project should be taken very carefully. The project should fall
within the experience and capabilities of management. New products are conse-
quently being developed everyday. If a company is in the restaurant business, then
it is highly unlikely management would want to expand into the electronics business.
However, having a diversified business with different products or divisions can under
the right circumstances be a good strategy. All projects involve risk and the risk poten-
tial in a given project should be evaluated. An important question is: if the project is
undertaken, will failure of the project risk putting the company into bankruptcy?
Evaluating the profitability of a project perhaps is the most important and difficult
task. First of all, it is important to have an accurate estimate of the cost of the project.
Under estimating the cost can cause the eventual actual rate of return to be far less
than the desired rate of return. Secondly, the expected net cash flow for each period
of the life of the project must be measured. It is normal to expect that the farther the
estimates are made into the future, the less reliable the will be estimates.
After the cost and future net cash flows have been determined, the next step is to
actually compute the resulting rate of return. If the methods used are present value
methods, then a discount rate must be determined. Theory holds that the discount
rate should not be less than the company’s cost of capital. Because companies use
a combination of different sources of capital such as both debt and equity and use
both internal financing and eternal financing, the company’s cost of capital is usually
an average. Computing cost of capital is a fairly complex subject and the techniques
for doing so are beyond the scope of this book.
When several investment opportunities are being evaluated and the source
of funds to invest is limited, then a decision has to be made concerning which of
the available projects are the most profitable and most affordable. Modern capital
budgeting theory maintains that the tools used to evaluate projects should be present
value based. The two tools have received the most attention in the capital budgeting
literature are the following:
1. Net present value method
2. Time adjusted rate of return method.
The Basic Present Value Equation
The basic fundamentals of present value are explained in Appendix B. If you have
forgotten the basic fundamentals of computing present value, it is recommended that
you first read and study this appendix before proceeding further. In order to under-
stand the basic principles of capital budgeting, a sound understanding of present
value is required.
When using present value methods, the net cash flows of the project is regarded
as a series of future amounts. Because they are future amounts, the process of
discounting these amounts is logical. The cost of the project is an outlay in period
zero and, therefore, does not require any discounting, After the individual future net
220 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

cash flows have been discounted and the sum of these amounts found, the compari-
son of the sum of the discounted amounts to the cost of the project is appropriate.
The basic present value equation is as follows:
FV1 FV2 FVN
PV = ––––– + –––––– +… –––––––
(1 + i) (1 + i)
1 2
(1 + i)N
Where:
PV - present value
FVi - future value at time period i.
N - life of project
i - interest rate (discount rate)
Because we are now using present value fundamentals in the framework of
capital budgeting, the equation will be revised as follows:
NCF1 NCF2 NCFN
PV = ––––––– + ––––––– + … ––––––––
(1 + R)
1
(1 + R)
2
(1 + R)N
In principle, this equation is exactly the same. The net cash flows values of the
project have been substituted for FV. Also, the desired rate of return for the project,
R, is used as the discount rate. This equation can be used to compute the present
value of net cash flows that are equal, unequal, or zero in some years.
There are two methods of computing net cash flows. The first method which is
the more logical method simply involves subtracting from cash revenues the cash
expenses.
NCF = CR - CE

Where
NCF - net cash flow
CR - cash revenue
CE - cash expenses
The second method involves starting with net income and adding back deprecia-
tion.
NCF = NI + D
Where
NI - net income
D - depreciation
Illustration of Computing Present Value
From an accounting viewpoint, depreciation is a necessary expense in determin-
ing net income. In most business, it is the primary non cash expense. In the period in
which depreciation is recorded, no cash outlay is involved. The cash outlay related
to depreciation was incurred at the time the asset was purchased or at the time the
debt incurred was paid. As used in capital budgeting the term net cash flow simply
means cash revenue less cash expenses and starting with net income and adding
back depreciation is simply a short cut method. Examples of computing present value
using this basic equation will now be presented:
 Management Accounting | 221

Example 1
Equal periodic net cash flows where the desired rate of return is 10% and the life
of the project is 4 years:
100 100 100 100
PV = ––––– 1 + –––––– + –––––– + ––––––– = $316.98
(1 +.1) (1 + .1) (1 +.1)
2 3
(1 +.1)4
Example 2
One net cash flow amount at the end of 4 years where the desired rate of return
is 10%:
0 0 0 100
PV = –––––– + –––––– + ––––––– + –––––– = $68.30
(1 +.1)1 (1 + .1)2 (1 +.1)3 1+.1)4

In this example, it is easy to recognize that the present value of a zero amount is
zero.
Example 3
Unequal net cash flows where the desired rate of return is 10% and the life of the
project is 4 years:
100 200 300 400
PV = –––––– + ––––––– + –––––– + –––––– = $754.80
(1 +.1) (1 + .1) (1 +.1)
1 2 3
(1 +.1)4

If net cash flows are equal, then the net cash flows may be treated as though they
are an annuity and the use of present values of an annuity of $1 tables may be used
to compute the answer. An annuity may be defined as a series of equal payments at
equal intervals of time.
As explained in chapter 8, Comprehensive Business Budgeting, the capital
expenditures budget was one of the four elements of the final product of the total
budget. The capital expenditures budget affects the following:
Cash balance
Amount of stock issued or debt incurred
Interest expense, if debt financing is used
The size of the plant and equipment accounts
Future depreciation
Net income
In Figure 12.1 a diagram of capital budgeting as discussed above is illustrated.
Net Present Value Method
The net present value method is commonly used to evaluate capital budgeting
projects. The steps involved in this method are the following:

Step 1 Determine the net cash flows for each period (normally each year) of the
life of the project. This step involves estimating both cash inflows and
cash outflows. Net cash flow is simply Cash inflows less cash outflows.
Step 2 Determine the cost of the project. The cost of the project might be a
single contracted amount or the sum of many individual expenditures.
222 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

A clear distinction should be made between cost expenditures made in

period zero and expenditures that represent operating expenses during
the life of the project.
Step 3 Compute the present value of the project using the net cash flows as the
future amounts. The discount rate is the desired minimum rate of return
as determined by management.
Step 4 Determine whether the project is acceptable. In the net present value
method, the present value computed is compared to the cost of the proj-
ect. If the present value exceeds the cost, then the project is acceptable.
If the net present value is positive, then this means the rate of return of
the project is greater than the discount rate. If the net present value in
negative, then the rate of return of the project is less than the discount
rate.
The net present value does not tell us what the true rate of return is unless the
net present value is zero. In other words, if the present value is exactly equal to the
cost of the project, then we know that the true rate of return is equal to the discount
rate.
Illustration - In order to illustrate the net present value method, let’s assume we
have been provided the following information.
Cost of project $250,000
Life of project (years) 5
Estimated net cash flow:
Year 1 $ 50,000
Year 2 $100,000
Year 3 $150,000
Year 4 $ 75,000
Year 5 $ 25,000
Desired rate of return 10%

Periods Net Cash Flow Present Values

(Years) PV Factor Net Cash Flow
1 $ 50,000 .909090 $ 45,454.54

2 $ 100,000 .826446 $ 82,644.62

3 $ 150,000 .751314 $ 112,697.72

4 $ 75,000 .683013 $ 51,225.99

5 $ 25,000 .620921 $ 15,523.27

Total present value $ 307,546.14

The present value of each net cash flow is computed by multiplying the present
value factor times each net cash flow amount. The present value of the project is,
therefore, the sum of the individual present values. The present values could have
been easily computed without the use of tables. For example, the present value of
 Management Accounting | 223

the net cash flow in year 2 ($100,000) could have been calculated as follows:
$100,000 $100,000
PV = –––––––– = –––––––– = $82,644.62
( 1.1)2 1.21

A simple four function calculator makes the computation of present value fairly
easy. Is the project in the illustration above acceptable? The answer is yes as the
following comparison shows.
Present value of project $ 307,546.14
Cost of project 250,000.00
–––––––––––
Net present value $ 57,546.14
–––––––––––
The true rate of return of this project is greater than the discount rate because the
net present value is positive.
The main disadvantage of this method is that the true rate of return is not
computed. This method only determines the present value of the project and indi-
cates whether or not the project is acceptable. For this reason, many analysts prefer
the time adjusted rate of return method.
Time Adjusted Rate of Return Method
The time adjusted rate of return method is a present value method that deter-
mines the true rate of return of a project. If the true rate of return is equal to or greater
than the desired rate of return, then the project is acceptable. This method works

Figure 12.1 • Outline of Capital Budgeting

CAPITAL BUDGETING

EVALUATION CONCEPTS
Cost of capital
TECHNIQUES Depreciation
Accounting rate of Desire rate of return
return Net cash flows
Payback period Present value
Timed adjusted rate Future value
of return Discount rate
Net present value

Quantity factors
TYPES OF EVALUATION Cash inflows
PROJECTS OF INDIVIDUAL Cash outflows
New products PROJECTS Useful life
Replacement of assets Present value
New plants and Recoverable value
Qualitative factors
equipment
Management ability
Opening a new territory
Management experience
Purchase of an existing Economic enviroment
business Risk
224 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

because the objective is to find the present value of the project that is exactly equal
to the cost of the project. The cost of the project is considered to be the present value
of the project. The problem is that this method has to be used on an iterative basis,
that is a trial and error basis.
In using this method, it makes no difference whether the net cash flows are equal
or unequal in amounts. If they are equal, the process is a bit easier because a present
value of $1 annuity table may be used.
This method is also based on the same equation that was used in the net present
value method, with the exception that cost now represents the present value of the
project. In this method, we know at the start what the present value is. The problem
is to find the rate that will generate this present value. Therefore, the goal is to solve
for R.
NCF)1 NCF2 NCFN
Cost = ––––– + ––––– + … –––––
(1+R) (1+R)2 (1+R)N
1

Net Cash Flows Unequal - The procedure for finding R or the true rate of return is
as follows:

Step 1 Select any interest rate to begin the process. The only guideline is to
select a rate you intuitively think might be close to the answer.
Step 2 Using the selected rate in step 1, compute the present value of the proj-
ect in the same manner used in the net present value method.
Step 3 Compare the computed present value to the cost of the project. If the
present value if greater than the cost, then the true rate is greater than
the discount rate used. If the present value is less than cost, then the
true rate is less than the rate used.
Step 4 If the present value did not equal cost, then select a second rate. This
rate should be greater or less than the rate first used according to the
rules specified in step 3. A smaller rate will increase the present value
while a greater rate will make the present value smaller.
Step 5 Again, compare the resulting present value computed to cost. If the
two amounts are not substantially close, then a third attempt should be
made.
The trial and error process should be repeated until there is no significant differ-
ent between cost and the last present value amount computed. When the present
value is equal or very close to cost, then the true rate of return has been found.
Illustration-This method will now be illustrated using the same problem used for the
net present value method.
Cost of project $250,000
Life of project (years) 5
Estimated net cash flow:
Year 1 $ 50,000
Year 2 $100,000
 Management Accounting | 225

Year 3 $150,000
Year 4 $ 75,000
Year 5 $ 25,000
Desired rate of return 10%
The first step is to compute present value using the first estimated rate. Since the
desired rate of return is 10% this rate will be used. However, the use of the desired
rate of return is an arbitrary decision. Any rate, however, may be used.
First Attempt- Discount rate is 10%
Present Value

Year Net cash flow Factor Net cash flow

Year 1 $ 50,000 .909090 $ 45,454.54

Year 2 $ 100,000 .826446 $ 82,644.62

Year 3 $ 150,000 .751314 $ 112,697.72

Year 4 $ 75,000 .683013 $ 51,225.99

Year 5 $ 25,000 .620921 $ 15,523.27

Present Value $ 307,546.14

Cost $ 250,000.00
––––––––––
$ 57,545.14

The present value exceeds the cost by $57,545.14.This excess of present value
over cost means the true rate of return is greater than 10%. A second attempt to find
the true rate should be made now. This time the selected rate used will be 15%.
Second Attempt- Discount rate is 15%
Present Value

Year Net cash flow Factor Net cash flow

Year 1 $ 50,000 .869565 $ 43,478

Year 2 $ 100,000 .075614 $ 75,614

Year 3 $ 150,000 .657516 $ 98,627

Year 4 $ 75,000 .571753 $ 42,881

Year 5 $ 25,000 .497176 $ 12,294

Present Value $ 272,894.00

Cost $ 250,000.00
––––––––––
$ 22,894.00

In this second trial, our computations come up with an answer greater than cost.
So we now know that the true rate of return is greater than 15%, however, we still do
not know the true rate of return. Consequently, a third trial is required, and this time
the discount rate used will be 20%.
226 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

Third Attempt- Discount rate is 20%

Present Value
Year Net cash flow Factor Net cash flow
Year 1 $ 50,000 .833333 $ 41,666.00
Year 2 $ 100,000 .694444 $ 69,444.00
Year 3 $ 150,000 .578704 $ 86,805,00
Year 4 $ 75,000 .482253 $ 36,169.00
Year 5 $ 25,000 .401877 $ 10,047.00
Present Value $ 244,131.00
Cost $ 250,000.00
––––––––––––
($ 5,869.00)

The true rate of rate is a bit less than 20%. If more accuracy is desired than
another trial would be necessary. All we can say after three trials is that the true rate
of return is between 15% and 20%. The true rate is actually between 19% and 20%.
The internal rate of return method as this method is often called is based on a
critical assumption. The true rate is earned only if the periodic net cash flows are
reinvested as a rate equal to the true rate. For example, assume that the net cash
flows are reinvested at 10%

Net cash flow FA at end of 5th year

Year 1 $ 50,000 (1.1)4 x $ 50,000 $ 73,205
Year 2 $ 100,000 (1.1)3 x $ 100,000 $ 133,100
Year 3 $ 150,000 (1.1) x $ 150,000
2
$ 181,500
Year 4 $ 75,000 (1.1)1 x $ 75,000 $ 82,500
Year 5 $ 25,000 $ 25,000 $ 25,000
––––––––
Sum of Future amount at the end of 5 years $ 495,305

Given that our original investment was $250,000 and given that the true rate of
return is approximately 19%, we would expect the future amount of our investment at
the end of 5 years to be $595,588 ( $250,000 x (1.19)5. However, the future amount
turns out to be only $495,305 when the net cash flows are reinvested at an interest
rate of 10%. However, this method does allow us to correctly rank projects in the
order of profitability, if more than one project is being evaluated with the internal rate
of return method. For the purpose of ranking projects, the issue of re-investing can
be ignored.
Accounting Rate of Return Method
The accounting rate of return method or the average rate of return method, as it
is sometimes called, is strictly an accounting method and based on net income. This
method does not involve computing present value. The method is base on:
 Management Accounting | 227

1 Average book value

2. Average net income
The method does not take into account the time value of net cash flows and by
computing average net income treats the project as having the same net cash flow
each year, even when, in fact, this is not the case.
The AROR method is based on this simple equation:
Average net income
AROR = ––––––––––––––––
Average investment
Average net income may be defined as the total income over the life of the project
divided by the life of the project.
Total net income
ANI = ––––––––––––––––
Life of project

Average investment (book value) may be computed:

Cost of Project
AI = –––––––––––––
2

Illustration of Average Rate of Return Method - In order to illustrate this, method

the following information is assumed:
Cost of project $80,000
Life of project (years) 5
Net cash flows of project:
Year 1 $10,000
Year 2 $20,000
Year 3 $30,000
Year 4 $40,000
Year 5 $50,000

Total net income is the sum of the net cash flows less the cost of the project.
Therefore, average net income per year is:
(10,000 + 20,000 + 30,000 + 40,000 + 50,000) - 80,000) 70,000
ANI = –––––––––––––––––––––––––––––––––––––––––––– = –––––– = $14,000
5 5

$80,000
AI = ––––––– = $40,000
2

$14,000
AROR = –––––––– = 35%
$40,000

If more than one project is under evaluation, then the most profitable project is the
one with the greater rate of return.
The major weaknesses of this method are the following:
228 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

1. The AROR method does not take into account the time value of money.
Consequently, the project that appears to have the greatest rate of return
may not actually be the most profitable in the long run.
2. Using average net income as the measure of profitability ignores the fact that
two projects may have unequal net cash flows in a totally different pattern.
These points may be illustrated as follows:

Project A Project B
Cost $ 50,000 Cost $ 50,000
Life of project (years) 5 Life of project (years) 5
Net cash flow: Net cash flow:
Year 1 $ 5,000 Year 1 $ 25,000
Year 2 $ 10,000 Year 2 $ 20,000
Year 3 $ 15,000 Year 3 $ 15,000
Year 4 $ 20,000 Year 4 $ 10,000
Year 5 $ 25,000 Year 5 $ 5,000
ANI = $ 5,000 ANI = $ 5,000
AROR = 20% AROR% = 20%

In the above example, both projects have the same average net income and
same AROR. However, the projects are quite different. In project A, the net cash flow
increases each year and in project B, the projects decrease each year. If we compute
the present value of both projects using a 10% discount rate we learn the following:
Present value of project A: $52,969.93
Present value of project B $60,460.65
Project B is the better project when present value is computed because it has the
greater present value. Also project B is the better project in terms of the true rate of
return.
True Rate of Return
Project A 12.0%
Project B 20.0%

Clearly when timing and the pattern of net cash flow are considered, it is clear
that the AROR method can be very misleading.

Payback Method
One of the basic concerns of investors in a project is the return of the capital
invested in the project. If a project, even if profitable eventually, requires a long period
of time for the capital invested to be recovered, then investors are inclined to not
invest. They will seek out projects with a much shorter payback period even though
the other projects do not initially promise to be as profitable. A payback period of ten
years is considered too long. A payback period of three years is often considered
ideal.
 Management Accounting | 229

The payback method is not a present value method nor a method that requires
that accounting net income be computed. The payback period is that period of time it
takes to recover the cost of the project. After the cost of the project has been recov-
ered, any net cash flow from then is considered as profit. Payback has been reached
when the accumulated net cash flows from the project equals the cost of the project.
The basic payback period formula is as follows:
Cost of project
Payback period = –––––––––––––––––
Average net cash flow

The steps involved in using the payback method are as follows:

Step 1 The cost of the project and the net cash flow of the project
for each year of its life must be determined.
Step 2 The next step is to compute the average net cash flow.
Step 3 Now that the cost and the average net cash flow is known,
the payback period can be computed.
Illustration of Using the Payback Method-This method will now be illustrated using
the same data as used for the net present value method and the time adjusted rate
of return method.
Cost of project $ 250,000
Life of project 5 years
Estimated net cash flow:
Year 1 $ 50,000
Year 2 $ 100,000
Year 3 $ 150,000
Year 4 $ 75,000
Year 5 $ 25,000
Desired rate of return 10%

The average net cash flow may be computed as follows:

ANCF = ($50,000 + $100,000 + $150,000 +$75,000 +$25,000) / 5 =
(400,000 / 5) = $80,000

$250,000
Payback period = –––––––– = 3.125 Years
$80,000

In addition to not being a present value method, the method just illustrated also
ignores the pattern of net cash flows. This use of average net cash flow has the
same weakness as the use of average accounting net income. Unless the cash flows
are uniform from year to year, a more refined procedure for computing the payback
period is to not use average net cash flows but to accumulate the net cash flows until
the sum of the net cash flows equal the cost of the project.
The use of a work sheet is helpful when using this method:
230 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

Computation of Payback Period

Year Net Cash Flow Cumulative
Net Cash Flow
1 $ 50,000 $ 50,000
2 $ 100,000 $ 150,000

3 $ 150,000 $ 300,000

Using this approach, it is clear that the payback period is more than 2 years and
less than three years. The fractional part of year 3 can be computed as follows:
Cash needed in the third year to reach payback period - $100,000
The payback period then is:
$100,000
2 + : ––––––– = 2 .67 years.
$150,000

Another weakness of the payback method is that the method does not measure
profitability. Two projects can have the same payback period, but one can be
completely superior to the other.
Project C Project D
Cost of project $8,000 Cost of Project $8,000
Life of project (years) 4 Life of project (years) 8
Net cash flow per year $2,000 Net cash flow per year $2,000

Payback period (years) 4 Payback period (years) 4

At the end of 4 years, project C has recovered the capital invested. However,
the project has also reached the end of its life. Project C is obviously not profitable.
Project D which also has a payback period of 4 years. However, Project D continues
to generate income in years 5 through 8.
Net Cash Flow After Taxes (NCFat)
In this chapter to this point, it was not specified whether net cash flow was before
or after taxes. When the objective is to use net cash flow after tax in computing
present value, some additional fundamentals must be considered and understood.
In the simplest terms possible, net cash flow after tax is:
NCFat = NCFbt - T
Where:
T - tax expense

Basically, net cash flow after tax is net cash flow before tax less the tax liability.
When net cash flow before tax is used, obviously taxable income is not a factor
to be considered. However, when the goal is to use net cash flow after tax, then
 Management Accounting | 231

various provisions of the tax law become important. Important factors that must be
considered in determining taxable income include the following:
1. Depreciation and the selection of a depreciation method
2. Disallowed expenditures
3. Tax credits
4. Rules regarding capitalization and recording of expenses
5. Capital gains
In order to compute net cash flow after tax, it is necessary to compute the effect
of a tax rate on net cash flow. The most obvious way is to compute taxable income
and then compute the amount of tax. Then the tax determined must be subtracted
from net cash flow before taxes. While tax laws can be exceedingly complex, the
goal in capital budgeting is not necessarily to be 100% accurate in computing the tax,
but to derive a tax amount that is basically in the ball park. Some simplified methods
have been developed to allow the analyst to quickly determine the amount of tax.
The basic difference in many cases between net cash flow before taxes and taxable
income is deprecation. For this reason, the effect of depreciation on net cash flow
must be considered.
Depreciation - Depreciation is a recognized expense in accounting theory and must
be taken into account when computing net income. However, students learn from
the study of accounting that depreciation is not an expense that involves an outlay of
cash in the period in which it is recorded. The outlay of cash occurs at the time the
depreciable asset is purchased or the incurred liability is paid. In capital budgeting,
the cost of the depreciable asset is strictly the cost of the project at time period zero.
Depreciation in each year of the life of the project is a non cash expense. It is simply
an amortized historical cost. In addition, depreciation has no effect on net cash flow
before tax regardless of the amount of depreciation. However, depreciation has a
profound impact on net cash flow after taxes. The greater the depreciation charge for
tax purposes, the larger is net cash flow after taxes.
Depreciation is always an allowable deduction in computing taxable income. The
relationship between net cash flow before taxes and taxable income can be stated
mathematically as follows:
TI = NCFbt - D.

Where:
TI - Taxable income
NCFbt - Net cash flow before tax
D - Depreciation

The tax would then be: T = R (TI)

Where:
R - Tax rate
In other words, the tax is simply the rate times taxable income. Also, this equation
assumes that depreciation is the only major non cash item.
232 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

The tax treatment of depreciation can have a profound effect on the pattern of net
cash flows after tax. If the net cash flows before tax are uniform, then it is possible
on an after tax basis for net cash flows to be non uniform. Any change in the pattern
of cash flows can have a significant impact on present value. The tax laws allow for
the taxpayer to select different deprecation methods. For tax purposes, accelerated
depreciation methods are very popular with business owners. Business owners in
general prefer to pay less taxes in the early years and postpone a greater tax liability
to later years.
Illustration- To see how uniform cash flows can become nonuniform consider the
following illustration:
Cost of Project $12,000
Life of project 4 years
Net cash flow (before tax) $8,000
Discount rate 10%

In case A, straight line depreciation will be used. In case B, the sum of the year’s
depreciation method will be used.
When case B is examined carefully, we see that the net cash flow after tax pattern
is, first of all, nonuniform and secondly, is decreasing each year. The accelerated
deprecation method has caused net cash flow to be the greatest in the first year
and, thereafter, progressively less each year. In each period, depreciation, taxable
income, tax, and net cash flow is different. ‘However, it is extremely important to
notice in terms of totals the following:
A. Taxable income is the same, regardless of the method of depreciation
B. Total depreciation is the same
C. Total net cash flow after tax is the same
D. Total tax is the same.
In the long term, the use of accelerated depreciation does not decrease the total
amount of tax owed and paid. The question then becomes: what is the advantage of
accelerated depreciation? The answer is that is can increase the present value of a
project: For example, present value in case A is:
$6,000 $6,000 $6,000 $6,000
PV = –––––– + –––––– + –––––– + –––––– = $19,019.19
(1.1)1 (1.1)2 (1.1)3 (1.1)4

Case A Straight line Depreciation Case B Sum of the years= Digits Depreciation

Years NCFbt Deprec- Taxable Tax NCFat Years NCFbt Deprec- Taxable Tax NCFat
iation. Income iation. Income

1 $ 8,000 $ 3,000 $ 5,000 $2,000 $ 6,000 1 $ 8,000 $ 4,800 $ 3,200 $1,280 $ 6,720

2 $ 8,000 $ 3,000 $ 5,000 $2,000 $ 6,000 2 $ 8,000 $ 3,600 $ 4,400 $1,760 $ 6,340

3 $ 8,000 $ 3,000 $ 5,000 $2,000 $ 6,000 3 $ 8,000 $ 2,400 $ 5,600 $2,240 $ 5,760

4 $ 8,000 $ 3,000 $ 5,000 $2,000 $ 6,000 4 $ 8,000 $ 1,200 $ 6,800 $2,720 $ 5,280

Totals $32,000 $12,000 $20,000 $8,000 $24,000 Totals $32,000 $12,000 $20,000 $8,000 $24,000
 Management Accounting | 233

In case B, the present value of the project is:

$6,720 $6,340 $5,760 5,280
PV = –––––– + ––––––– + ––––––– + –––––– = $19,282.64
(1.1)1 (1.1)2 (1.1)
3
(1.1)4

Net-of-Tax Approach
Another approach to computing net cash flow after tax is to use the net-of-tax
approach. In most businesses, if not all, profitable businesses have to pay income
tax. In the long term, a tax liability is inescapable. If the tax rate is 40%, and the
business’s sales is $100,000, then the amount of sales net-of-tax is $60,000. Forty
per cent has to be used to pay the tax on the revenue and, therefore, only 60%
remains. If expenses are $60,000, then net-of-tax the expense is $36,000. Of the
total expenditure of $60,000 , 40% or $24,000 is an offset to the $40,000 tax on
the revenue. Therefore, the net liability would be ($40,000-24,000) = $16,000. The
same answer could have been derived by multiplying 40% x $40,000 ( $100,000 -
$60,000).
Rather than compute the tax effect by first computing taxable income and then
computing the total tax, net cash flow after tax can be computed on a net-of tax basis
by applying the net-of-tax idea to each individual item that affects net cash flow. This
idea can be seen mathematically as follows
The amount of tax equals the rate times taxable income and taxable income
equals revenue less expenses. Let Revenue = S and expenses = E1 + E2 + E3.
Then the tax would be R( S - E1 - E2 - E3) = R(S) - R(E1) - R(E2) - R(E3)
We see here mathematically that the tax rate can also be logically applied to each
separate tax item. Assuming the tax rate is 40% and if we let S = $10,000 and E1, E1,
and E3 be $1,000, $2,000, and $3,000 respectively, then we have the following:
T = .4($10,000) - .4($1,000) - .4($2,000) - .4($3,000) =
$4,000 - $400 - $800 - $1,200 = $1,600
The same answer results if we use a more traditional approach
T = ($10,000 - $6,000).4 = $1,600.
It is clear that, if we choose to do so, that we can apply the tax rate to each
individual item that makes up taxable income. The same amount of tax will result.
Under some circumstances, the analyst may find this method easier to use, even it is
conceptually more difficult to understand.
Mathematically, the net of tax approach can be presented as follows;
NCFat = S(1 - R) - E(1 - R) + R(D)
Where:
S - Revenue (sales)
E - Cash expenses
D - Depreciation
T - Amount of tax
R - Income tax rate
234 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

The derivation of this equation is shown in the Appendix to this chapter.

It is interesting to note that the term R(D) reveals that as the depreciation expense
in any time period is increased the net cash flow after tax increases.
The net-of-tax approach can be illustrated as follows:
Illustration of Net-of-tax Method - The same example used previously (case A) will
be used again, except that the amount of cash revenue and cash expenses will be
separately listed rather than shown as a net.
Cost of Project $12,000
Life of project 4 years
Cash revenue (before tax) $12,000
Cash expenses (before tax) $ 4,000
Discount rate 10%

NCF after tax for Years

Item Amount Net-of-tax 1 2 3 4

per year NCF
(before percentage
taxes)

Cash revenue 12,000 .6 7,200 7,200 7,200 7,200

Cash expenses - 4,000 .6 - 2,400 -2,400 -2,400 -2,400

Depreciation:

Year 1 3,000 .4 1,200

Year 2 3,000 .4 1,200

Year 3 3,000 .4 1,200

Year 4 3,000 .4 1,200

Total NCFat 6,000 6,000 6,000 6,000

Present value 5,454.54 4,958.67 4,507.88 4,098.08

Sum of present value of net cash flows $19,019.19

Cost of project $12,000.00
–––––––––
Net present value $ 7,019.19

Since the net cash flows after tax remains the same, then the present value
remains the same at $19,019.16. The net-of-tax method does not give a different
answer. It is simply a different approach to determining tax and net cash flow after
taxes.
 Management Accounting | 235

Summary
Capital budgeting involves a body of literature that has grown and developed in the
last fifty years. In finance, a significant body of literature has developed which dwells
heavily on using present value concepts to make capital budgeting decisions and to
measure the value of a firm. To understand this body of theory, a good knowledge of
the following terms is necessary.
1. Simple interest 9. Depreciation and net cash flow
2. Compound interest 10. Minimum desired rate of return
3. Principal 11. Internal rate of return
4. Future amount 12. Discounting
5. Present value 13. Discounted cash flow
6. Annuity 14. Cost of capital
7. Present value of a future amount 15. Net present value
8. Net cash flow

Appendix: Derivation of the Net-of-Tax approach to computing

net cash flow after taxes:

The computation of tax can be done in two different ways:

1. It can be computed on taxable income which is in simple terms:
taxable income = S - E - D
Tax = R(S - E - D)
Where :
S - Sales
E - Cash expenses
D - Depreciation
R - tax rate
2. It can be computed where the tax rate is applied individually to each revenue
and to each expense:
Tax = R(S) - R(E) - R(D)
Based on this approach NCFat is :
NCFat = S(1- R) - E(1 - R) + RD
Why is this true?: We can demonstrate this mathematically as follows:
NCFat = (S - E) - (R (S - E - D))
NCFat = (S - E) - (RS - RE - RD)
NCFat = S - E - RS + RE + RD
NCFat = S - RS - E + RE + RD
NCFat = S(1- R) - E(1 - R) + RD
So we have two basic equations for net cash flow after taxes:
236 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

(1) NCFat = (S - E) - (R (S - E - D))

This equation determines net cash flow after taxes by applying the tax rate
to taxable income and then subtracting the tax from net cash flow before
tax.
(2) NCFat = S(1- R) - E(1 - R) + RD
This method applies the tax rate to revenue, cash expenses and deprecia-
tion separately.
Illustration:
Sales = $100
Cash expenses = $ 70
Depreciation = $ 20
Tax rate = .4

Applying the rate to taxable income:

(1) NCFat = (S - E) - (R (S - E - D))
NCFat = (100 - 70) - (.4 (100 - 70 - 20)
NFCat = (30) - .4 (10)
NCFat = 30 - 4 = 26
Applying the rate to each element of net income separately:
(2) NCFat = S(1- R) - E(1 - R) + RD
NCFat = 100 (1 - .4) - 70 (1-.4) + .4(20)
NCFat = 100 (.6) - 70 (.6) + 8
NCFat = 60 - 42 + 8
NCFat = 26

Q. 12.1 Define capital budgeting.

Q. 12.2 What steps are involved in the capita budgeting process?
Q. 12.3 What tools may be used to evaluate capital budgeting projects?
Q. 12.4 Explain the importance of net cash flow in capital budgeting.
Q. 12.5 What is the basic present value equation used in capital budgeting?
Q. 12.6 In the accounting rate of return method (average rate of return), what is
used as the measure of profitability?
Q. 12.7 Explain how net cash flow may be easily converted to net income?
Q. 12.8 Explain how the average book value of a project may be computed?
Q. 12.9 Define what is meant by the payback period?
Q. 12.10 What are the major weaknesses of the payback method?
 Management Accounting | 237

Q. 12.11 What is the major disadvantage of the net present value method?
Q. 12.12 When using the net present value method, how does one know whether
the true rate of return is greater or less than the discount rate?
Q. 12.13 When using the time adjusted rate of return method, how does one
know when the true rate of return has been found?
Q.12.14 What factors must be considered that otherwise may be ignored when
the objective is to discount net cash flow after taxes?

Exercise 12.1 • Compound Interest

Problem A Problem B Problem C Problem D
Principal $10,000 $50,000 $5,000 $100,000
Interest rate 8% 10% 6% 20%
Future years 4 6 8 5
Required:
Compute the future amount at the end of the stated number of years.

Exercise 12.2 • Present Value

Problem A Problem B Problem C Problem D
Future Amount $5,000 $8,000 $20,000 $1,000,000
Desired rate 8% 10% 12% 15%
Future years 10 12 10 40

Required: Compute the present value of each problem.

Exercise 12.3 • Present Value of an Annuity

Problem A Problem B Problem C Problem D
Annual Payment $5,000 $8,000 $20,000 $1,000,000
Desired rate 8% 10% 12% 15%
No. of payments 10 12 10 40

Required:

Compute the present value of each annuity.

Exercise 12.4 • Net Cash Flow

Problem A Problem B Problem C Problem D
Cash revenue $1,000 $2,000 $8,000 $15,000
Cash expenses $ 600 $1,200 $2,000 $10,000
Depreciation $ 200 $ 500 $1,000 $ 3,000

Required:
Compute the net cash flow in each problem.
238 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

Exercise 12.5 • Net Present Value Method (Uniform net cash flows)

You have been provided the following information:

Cost of project $15,000
Useful life (years) 5
Annual net cash flow $  4,000
Desired rate of return 10%

Required:
1. Based on the above information compute the present value of the
project.
2. Is the true rate of return greater than or less than the discount rate?

Exercise 12.6 • Net Present Value Method (Uniform net cash flows)

You have been provided the following information:

Cost of project $20,000
Useful life (years) 8
Annual net cash flow $  4,000
Desired rate of return 12%
Required:
1. Based on the above information compute the present value of the
project.
2. Is the true rate of return greater than or less than the discount rate?

Exercise 12.7 • Net Present Value Method (Nonuniform net Cash Flows)

You have been provided the following information:

Problem A Problem B Problem C Problem D
Cost of project $15,000 $18,000 $40,000 $10,000
Useful life 5 8 4 6
Discount rate 12% 8% 10% 6%
Net cash flow:
Year 1 $2,000 $1,000 $ 6,000 $5,000
Year 2 $3,000 $3,000 $ 8,000 $4,000
Year 3 $4,000 $5,000 $10,000 $3,000
Year 4 $5,000 $7,000 $20,000 $2,000
Year 5 $8,000 $3,000 $1,000
Year 6 $2,000 $ 500
Year 7 $1,500
Year 8 $1,000

Required:
1. Based on the above information compute the present value of the
project.
2. Is the true rate of return greater than or less than the discount rate?
 Management Accounting | 239

Exercise 12.8 • Time Adjusted Rate of Return Method (Uniform Net Cash Flows)
Problem A Problem B Problem C Problem D
Cost of Project $15,000 $50,000 $20,000 $100,000
Useful life (years) 5 15 8 10
Net cash flows (annual) $5,000 $6,000 $4,000 $15,000

Required:
For each problem, compute the project’s internal rate of return.
Exercise 12.9 Time Adjusted Rate of Return Method (Nonuniform Net Cash Flows)

You have been provided the following information:

Problem A Problem B Problem C Problem D
Cost of project $15,000 $18,000 $40,000 $10,000
Useful life 5 8 4 6
Net cash flow:
Year 1 $2,000 $1,000 $ 6,000 $5,000
Year 2 $3,000 $3,000 $ 8,000 $4,000
Year 3 $4,000 $5,000 $10,000 $3,000
Year 4 $5,000 $7,000 $20,000 $2,000
Year 5 $8,000 $3,000 $ 1,000
Year 6 $2,000 $ 500
Year 7 $1,500
Year 8 $1,000

Required:

Based on the above information compute the true rate of return of each product.
Exercise 12.10 • Average Rate of Return Method
Problem A Problem B Problem C Problem D
Cost of Project $30,000 $75,000 $60,000 $125,000
Useful life (Years) 4 5 6 5
Depreciation per year $ 7,500 $15,000 $10,000 $25,000
Net Cash Flow
Year 1 $10,000 $18,000 $15,000 $30,000
Year 2 $10,000 $20,000 $15,000 $35,000
Year 3 $10,000 $25,000 $15,000 $40,000
Year 4 $10,000 $30,000 $20,000 $45,000
Year 5 ––– $25,000 $50,000 $50,000
Year 6 ––– $60,000 –––

Required:
For each problem, compute the average rate of return.
240 | CHAPTER TWELVE • Capital Budgeting Decisions Tools

Exercise 12.11 Payback Method (Uniform Cash Flow)

Problem A Problem B Problem C Problem D
Cost of Project $30,000 $75,000 $60,000 $125,000
Useful life (Years) 4 5 6 5
Depreciation per year $7,500 $15,000 $10,000 $25,000
Net income per year:
Year 1 $10,000 $20,000 $15,000 $30,000
Year 2 $10,000 $20,000 $15,000 $30,000
Year 3 $10,000 $20,000 $15,000 $30,000
Year 4 $10,000 $20,000 $15,000 $30,000
Year 5 $15,000 $15,000 $30,000
Year 6 $15,000

Required:

For each problem, compute the payback period.

Exercise 12.13 • Payback Method (Nonuniform Cash Flow)

Problem A Problem B Problem C Problem D
Cost of Project $30,000 $75,000 $60,000 $125,000
Useful life (Years) 4 5 6 5
Depreciation per year $7,500 $15,000 $10,000 $25,000
Net income per year:
Year 1 $10,000 $20,000 $15,000 $32,000
Year 2 $12,000 $22,000 $14,000 $34,000
Year 3 $14,000 $24,000 $13,000 $36,000
Year 4 $16,000 $26,000 $12,000 $38,000
Year 5 ––– $28,000 $11,000 $40,000
Year 6 ––– $10,000 –––

Required:

For each problem, compute the payback period using the cumulative cash flow
method.
 Management Accounting | 241

Exercise 12.14 • Net Cash Flow After Taxes

Case 1 Case 2 Case 3

Item Income Net- of- Tax Income Net-of-tax Income Net-of-tax
Statement Approach Statement Approach Statement Approach
Approach Approach Approach

Sales $12,000
Cash expenses $ 7,000
Depreciation $ 2,000
Total expenses $ 9,000
Net income (BT) $ 3,000
Tax
Net cash flow (BT) $ 5,000
Net cash flow (AT) $ 3,800

Assume that the tax rates are as follows:

Tax rate
Case 1 40%
Case 2 30%
Case 3 20%

Required:

Compute the net cash flow after tax in each case using the net-of-tax method.
In case 1 the net cash flow after tax has already been computed in the traditional
manner. Enter the income statement data in case 1 also in the appropriate
columns for cases 2 and 3.
242 | CHAPTER TWELVE • Capital Budgeting Decisions Tools
 Management Accounting | 243

Pricing Decision Analysis

The setting of a price for a product is one of the most important decisions and
certainly one of the more complex. A change in price not only directly affects revenue
but has major consequences on other decisions. If price is lowered, for example,
then sales is most likely to increase. Therefore, additional production is needed with
all its attendant requirements concerning material, labor and overhead. Any student
who has completed a course in principles of economics understands that the theory
of price is at the center of economic thought.
In management accounting, the analysis of price is not as nearly complex or
mathematically sophisticated as in economic theory. The assumptions in management
accounting are much simpler and more practical oriented.
The focus of this chapter will be on the following:
1. Review of some basic economic fundamentals
2. Pricing using cost-volume-profit analysis
3. The special offer decision
244 | CHAPTER THIRTEEN • PRICING DECISION ANALYSIS

Basic Economic Fundamentals

The economists have theorized that firm is subject to the economic laws of supply
and demand. Each firm has a demand curve that it must consider in setting price.
In addition, the economists have identified four major types of markets a firm may
operate in:
1. Pure competition
2. Monopoly
3. Oligopoly
5. Monopolistic competition
The main tenet of demand is that as price is lowered, consumers will purchase
more goods. To assist in analysis and understanding, economists often portray the
demand curve as a straight line sloping downward and to the right as shown here
in Figure 13.1. Because the demand curve has many mathematical properties,
economists frequently use mathematics to explains the meaning and importance of
demand.
FIGURE 13.1 • Example of a Demand Curve

Price $

110
100
90
80
70
60
50
40
30
20
10
0
200 400 600 800 1,000 Quantity

When three or more firms compete in the same market and basically sell the same
product, the market is called an oligopolistic market. How price is set in this type of
market has been and still continues to be the subject of much debate. In general, it is
believed that eventually the firms will come to an equilibrium price. Any firm then that
significantly raises its price will face a large loss of sales. If a firm attempts to gain
greater profits and market share by lowering price, then the other firms in the industry
will also immediately lower their price. The consequence of all firms lowering price
will eventually be an overall decrease in industry net income.
 Management Accounting | 245

While the exact nature or slope of the demand curve is seldom known in a given
industry, the academic question still remains: what is the best price assuming the
demand curve is known? As indicated in Figure 13.1, assume that we have the
following demand schedule
Price Quantity Revenue
$ 100 100 $10,000
$ 90 200 $18,000
$ 80 300 $24,000
$ 70 400 $28,000
$ 60 500 $30,000
$ 50 600 $30,000
$ 40 700 $28,000
$ 30 800 $24,000
$ 20 900 $18,000
$ 10 1,000 $10,000
The above schedules seems to indicate that the best price is either $60 or $50. In
each case, sales is maximized at $30,000. However, the objective of a business is not
to maximize sales dollars but to maximize net income. In this instance, an expense or
cost function is needed. In management accounting, as in economics, it is assumed
that there are two types of expenses: fixed and variable: Fixed and variable expenses
in management accounting may be graphically presented as shown in Figure 13.2

Figure 13.2 • Illustration of Total Expenses

Expenses

(000)
20

15

10

0
300 600 900 1,200 1,400 Quantity
Fixed = $5,000
Variable = $10.00

Based on the demand schedule and the expense function, it is possible to

present total revenue and expenses in the same graph as shown in Figure 13.3. By
combining the demand schedule and cost function, we can derive a profit equation
as will now be demonstrated.
246 | CHAPTER THIRTEEN • PRICING DECISION ANALYSIS

Figure 13.3 Graph of Revenue and Expenses

$
40

30
Sales

20
Net Income

Total cost
10

300 500 700 900

Quantity

The demand curve in Figure 13.1 and the expense function shown in figure 13.2
can be mathematically defined as follow:
P = Po - k(Q)
P - Price
Po - Price at the Y-intercept
k - The slope of the demand curve line
If we solve for Q, then we the get the following:
Po - P
Q = ––––––––– (1)
k

TC = F + V(Q) (2)
F - Total fixed expenses
V - Variable cost rate
Q - Quantity of goods
Revenue may be defined simply as follows: S = P(Q). Based on this revenue
equation and equations (1) and (2) net income may be computed as follows:
I = P(Q) - V(Q - F (3)
Consequently, using equation (1), we can now define net income as:
Po - P Po - P
I = P ––––––– - V ––––––– - F (4)
k k
If the goal is to maximize net income, then the price that maximizes net income
can be found by finding using calculus and finding the first derivative of equation 3.
The first derivative of equation 4 using turns out to be:
 Management Accounting | 247

1
––– (Po - 2P + V) (5)
k
Profit is maximized at the point where the slope of equation 5 is zero. So if we set
the first derivative to zero we have the following:
1
––– (Po - 2P + V) = 0
k
Solving for P we get
Po + V
P = ––––––––– (6)
2
This equation allows us to determine the best price without preparing a complete
schedule of price, quantity, and net income as has been done in Figure 13.4.
In Figure 13.4, the best price is shown as $60. This price agrees with the price
determined by our price formula derived above:
110 + $10 $120
P = ––––––––––– = ––––– = $60
2 2
A company’s marketing strategy can have a profound effect on its demand curve.
Even though the demand curve is not known with any precision, it is still generally
recognized by economists and marketing analysts that the following marketing
decisions can shift the demand curve upwards and to the right.
1. Advertising
2. Increase in size of sales force
3. Increase in sales people’s compensation
4. Increase in the quality of the product
However, any change in the above must be approached cautiously and also be
based on adequate analysis of the known economic and marketing environment.
Even though changes in these marketing factors may increase sale, any increase in
sales can be easily offset by increases in the associated expenses.
Figure 13.4
Price Quantity Revenue Total Expenses Net income
$ 100 100 $10,000 $ 6,000 $ 4,000
$ 90 200 $18,000 $ 7000 $ 11,000
$ 80 300 $24,000 $ 8,000 $ 16,000
$ 70 400 $28,000 $ 9,000 $ 19,000
$ 60 500 $30,000 $ 10,000 $ 20,000
$ 50 600 $30,000 $ 11,000 $ 19,000
$ 40 700 $28,000 $ 12,000 $ 16,000
$ 30 800 $24,000 $ 13,000 $ 11,000
$ 20 900 $18,000 $ 14,000 $ 4,000
$ 10 1,000 $10,000 $ 15,000 ($ 1,000)
Note: Total fixed cost $5,000, variable cost rate $10,000
248 | CHAPTER THIRTEEN • PRICING DECISION ANALYSIS

Cost-volume-profit Analysis Approach to Setting Price

Since the demand curve is seldom known accurately in the real world of business,
equation (6) is not likely to be used. Pricing is more likely to be based on cost plus a
reasonable markup. Cost volume profit analysis may be used to compute a tentative
price.
I = P(Q) - V(Q) - F
We may solve for P or price as follows:
I + F = P(Q) - V(Q)
I + F = Q(P - V)
I F
–– + –– = P - V
Q Q
I F
P = ––– + ––– + V (7)
Q Q
The above equation may be interpreted as follows
I / Q - Denotes desired income per unit of product
F/Q - Denotes the amount from each sale that is necessary to cover
the fixed expenses of the business. It is equivalent to an
overhead rate.
V - Represents that portion of each sale that must be used to pay
the variable expenses.
This equation, then, points out that price must be sufficient to cover three
elements:
1. Desired net income
2. Variable expenses
3. Fixed expenses
Assume the following:
Fixed expenses $ 500,000
Variable cost rate $ 60
Desired net income $1,000,000
Quantity 10,000
Based on equation 7, the required price to attain the net income goal of $1,000,000
may be computed as follows:
$1,000,000 $500,000
P = ––––––––– + –––––––– + $60 = $100 + $50 + $60 = $210
10,000 10,000
The major fault of this approach is that it does not necessarily follow that customers
will pay $210 per unit and that at this price 10,000 units can be sold. In order to lower
price, management has four options:
1. Set a lower net income goal
2. Reduce fixed expenses
 Management Accounting | 249

3. Reduce the variable cost per unit of product

4. Sell more units than originally desired
The Special Offer Decision (Additional Volume of Business)
Frequently, a business will be asked to sell a larger than normal quantity at a
price considerably lower than the normal selling price. The offered price may be even
below the average cost per unit. Oddly enough, It is possible to increase net income
by selling below average cost. Given that this is true, the question becomes: under
what conditions may such a price offer be accepted? The general rule is that the offer
may be accepted, if the special price is greater than the average variable cost rate of
manufacturing.
If a company has significant manufacturing costs that are fixed in nature and the
company has excess capacity, then the manufacturing of additional units does not
cause any increase in the fixed costs. The only costs that increase are the variable
manufacturing costs. So theoretically, as long as the offered price is above the
average variable manufacturing costs, an increase in net income can take place.
To illustrate, consider the following example:
The ABC company is currently manufacturing and selling 100 units. The selling
price is $40 per unit. The company has the production capacity to make 150 units. A
special offer has been received from a company to purchase 30 units at $22 per unit.
The company making the offer is not a regular customer and will not be in competition.
Other information was provided by the company’s accountant is as follows:
Variable costs:
Manufacturing cost per unit $12
Selling $5
Fixed $1,000
If the offer is accepted, the $5 per unit of selling cost will still be incurred.
Analysis using the Full Income Approach
In this approach, the revenue and expenses from total sales ( regular sales +
special offer sales) are included in the analysis.

Reject Offer Accept Offer

S = 100 S = 130
–––––– ––––––
Sales $ 4,000 $ 4,660
Expenses:
Cost of goods sold ($12) $ 1,200 $ 1,560
Selling ($5) 500 650
Fixed 1,000 $ 1,000
–––––– ––––––
$ 2,700 $ 3,210
–––––– ––––––
Net income $ 1,300 $ 1,450
–––––– ––––––

If the offer is accepted, net income should increase by $150.

250 | CHAPTER THIRTEEN • PRICING DECISION ANALYSIS

Analysis using the Incremental Analysis Approach

In this approach, the regular sales are treated as irrelevant because whether or
not the special offer is accepted, the regular sales will remain the same.
Increase in Revenue (30 x $22) $660
Increase in Expenses
Cost of goods sold $360.00
Selling expenses 150.00
______ 510
–––––
Increase in net income $ 150
–––––
The acceptance of the special offer is strictly a short term decision and should
not become a regular pricing practice. The conditions which should exist in order to
accept a special offer include:
1. The sale must be legal
2. The sale should not be to a regular customer
3. The sale should not be to a competitor
4. The purchaser should not be led to believe that future sales will be
at the same price
5. Excess capacity exists
Another reason that a large special offer might be accepted is to keep factory
workers on the production line. Laying off workers and then retooling for production
can be expensive.
While the acceptance of an offer now and then can add to company profits, the
practice of selling below total average cost can not work, if that practice becomes the
rule rather than the exception. Consider the following examples which in each case
the price is just above the variable costs
Sales Sale Sale Sale Total
No. 1 No. 2 No. 3 No. 4
________ _______ ________ _______ _______
Sales $1,000 $ 800 $1,200 $ 500 $3,500
Variable expenses 800 640 $ 960 400 2,800
–––––– –––––– –––––– –––––– ––––––
Contribution $ 200 $ 160 $ 240 $ 100 $ 700
Fixed expenses $1,000
––––––
Net loss ($ 300)
––––––
In this example, all sales make a contribution and without any one of the four
sales the loss would be even greater. However, the fact that all the sales make a
contribution does not mean the company will be profitable, as is clearly illustrated
above. Even though all sales make a contribution, the company is still operating at
a loss.
Accepting offers at less than normal price should not become a regular practice.
Eventually, all customers will expect preferential treatment. In the short run and for
 Management Accounting | 251

several reasons, it might be prudent to accept such an offer to add to overall net
income or to keep factory workers employed. In the long, run such a practice will not
make a company profitable that is already operating at a loss.

Summary
Because pricing is such an important decision, any change in price should be
approached cautiously and should be based on an analysis of all available economic
and marketing information. Even though a demand curve may exist is a general
way, the lack of specific information on its exact nature means that in many if not
most cases price tends to be based on cost. When price is based on cost, hopefully
the company’s marketing strategy will generate the sales required to cover cost and
generate the desired net income.
Cost-volume-profit analysis can be used to set a tentative price. However, the
major flaw in this approach is that the required volume to attain the desired net
income at that price may not happen. Assuming some type of demand curve exists,
the volume indicated by the C-V-P price may not occur.

Q. 13.1 Explain why it is difficult for a company to just set any price and have
the volume necessary to make the company profitable.
Q. 13.2 Explain how a demand curve could be used to set price.
Q. 13.3 In a absence of any knowledge of its demand curve, how may a
company go about setting price?
Q. 13.4 Explain how it is possible for a company to accept a price offer that
is below the company’s average manufacturing cost and still for the
company to increase net income.
Q. 13.5 A special offer has been made to the Acme Company. However, the
company does not have excess capacity and to accept the offer it
would have to decrease its sales to regular customers. If this offer is
accepted, what would be the effect on net income?
‘ Q. 13.6 Explain how the cost-volume-profit equation may be used to compute
with a tentative price.
Q. 13.7 Based on the cost volume profit equation, what are the three elements
that management must consider in setting price?

Exercise 13.1 • Additional Volume of Business

Your company has received an offer to buy 1,000 units of your product, however,
the offer is to purchase at $12.00 per unit rather than at the normal selling price of
$20.00. You have been provided the following information:
252 | CHAPTER THIRTEEN • PRICING DECISION ANALYSIS

Production (units) last period 10,000

Fixed costs:
Manufacturing $50,000
Selling $30,000
Variable costs (last period)
Manufacturing $80,000
Selling $20,000
Selling price (regular) $  20,00
Buyer’s offered price $  12.00
Increase in expenses other than
variable expenses, assuming offer is
accepted. $  2,000
Full capacity (units)* 12,000
* Production cannot exceed this amount
If the offer is accepted, no additional variable selling expenses will be incurred
such as commissions or shipping charges.
Required:

Show using incremental analysis form whether the buyer’s offer, if accepted, will
contribute to net income of the company.

Exercise 13.2 • Special Price Offer

The K. L. Widget company has received an offer from the Ajax Retail company.
The Ajax Company has offered to purchase 1,000 units of its product at $60 per
unit.
The cost of manufacturing and selling the Widget are as follows:
Variable costs
Manufacturing $      18
Selling expenses $      25
Gen. and admin. $      10
Fixed
Manufacturing $160,000
Selling $200,000
General and admin. $ 40,000
The current selling price is $180. If the offer is accepted the variable selling
expenses would be reduced to $5.00 per unit. No variable general and administrative
expenses would be incurred.
The company is currently manufacturing 8,000 units of product per quarter. Sales
have also averaged 8,000 units per quarter. Current levels of fixed costs will not be
affected by the acceptance of the offer.
The company has capacity to make 10,000 units. The average cost of
manufacturing 8,000 units is $103 ($53.00 + 400,000 /8,000).
 Management Accounting | 253

Required:

If the offer is accepted, then by how much will net income increase or decrease?
(Show your analysis in detail.)

Exercise 13.3 • Schedule of Net Income Based on Demand Curve and Cost
Function

The K. L. Widget Company has determined its demand curve and cost function
as follows:
P = $1,000 - .1(Q)
TC = $80(Q) + $500,000
Required:

Using a work sheet with the headings as suggested below, determine net income at a
price of $1,000 and decrement the price by $100 until price is equal to $100.

Price (P) Quantity(Q) Revenue Variable Fixed Total Net

P(Q) Cost Cost Cost Income

Exercise 13.4 • Cost-Volume-Profit Pricing

The R. K. Manufacturing Company has developed a new product. Estimated

costs of manufacturing and selling were provided as follows:
Variable costs:
Manufacturing $   12.00
Selling $    8.00
Fixed costs:
Manufacturing $  50,000
Selling $100,000
The company plans to make 10,000 units hopes to sell the same amount per
year. The company’s goal is to earn $80,000 per year by selling this product.
Required:
Use the cost-volume-profit equation to compute a price necessary to attain the
desired level of income.
254 | CHAPTER THIRTEEN • PRICING DECISION ANALYSIS
 Part III
Management Accounting
Performance Evaluation Tools

Chapter 14 • Performance Evaluation Using Flexible Budgeting

Chapter 15 • Segmental Profitability Analysis Evaluation

Chapter 16 • Return on Investment

Chapter 17 • Financial Statement Ratio Analysis

Chapter 18 • Statement of Cash Flow

 Management Accounting | 267

Performance Evaluation Using Flexible Budgeting

Purpose and Nature of Standards

In management accounting, performance evaluation usually refers to the process
of controlling costs through the use of standards. The terms “performance evalua-
tion” and “control of costs” are often used interchangeably; however, performance
evaluation may be used in a broader sense to also include all revenue and operating
expenses. Performance evaluation is a process that involves:

Step 1 Setting standards for all revenues, manufacturing costs, and operating
expenses.
Step 2 Measuring actual revenues and costs/expenses (last period’s financial
statement).
Step 3 Computing variances by subtracting standards from actual results.
Step 4 Analyzing variances into component parts (compute detailed vari-
ances).
Step 5 Reporting results of variance analysis to appropriate managers.
Step 6 Investigating significant variances and cause of variances and taking
corrective action (this step is done by management.)
The key to an effective use of the performance evaluation tool is a solid under-
standing of the nature and purpose of standards. Terms sometimes substituted
for standards are planned values and budgeted values. Many companies use the
planned values appearing on their comprehensive budgets as benchmarks for
268 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

evaluating actual results. However, the concept of what constitutes a proper standard
is somewhat technical and requires careful explanation. The theory of standards in
management accounting usually revolves around the concepts of flexible budget
standards and static budget standards.
Flexible and Static Budget Standards
In management accounting, two types of standards are recognized: flexible
budget standards and static budget standards. Standards based on flexible budgets
are theoretically preferably; however, to fully understand the concept of flexible budget
standards some understanding of static budget standards is necessary.
Static budget standards as implied by the word “static” are standards that when
set are not changed regardless of the difference between planned and actual levels
of activity. When static budget standards are used, it is necessary to compute volume
variances caused by a difference in actual and planned activity. The foundation of
static budget standards is always planned activity and, therefore, the standards
created at the beginning of the planning period are the same standards used at the
end of the planning period.
Flexible budget standards attempt to overcome misleading inferences that can
easily arise from the use of static budget standards. The major weakness of static
budget standards is that they are only appropriate to one level of activity–the planned
level. Actual costs are almost always caused by a level of activity that may be signifi-
cantly different from planned activity. For example, to compare actual material costs
incurred at a production level of 1,000 units against a standard based on planned
activity of 500 could be misleading. Management might be mislead into thinking that
material usage costs are out of control. An increase in material cost is inevitable when
volume increases and does not necessarily mean that a problem of control exists.
A major advantage of using flexible budget standards is that volume variances
are automatically eliminated since actual costs and standards are based on the same
level of activity–that is, actual output activity. A flexible budget is generally defined as
a budget that shows total standard cost (or revenue) at different levels of potential
activity. A flexible budget is actually a set of possible standards. The exact standard
that will be used is not determined until the end of the period when actual activity
is known. The flexible budget standards used are always based on actual output
activity (e.g., production/sales).
Although flexible budgets typically show both fixed and variable costs, a flexible
budget is only required for variable costs and revenues. Only variable costs/revenues
are affected by changes in volume. Fixed costs may be included for purposes of
disclosing the total cost picture. In other words, the standards for fixed costs are the
same in both static budgeting and flexible budgeting. Other things equal, a change in
volume should have no effect on fixed costs.
Conceptual Foundation of Flexible and Static Budget Standards
A standard is a bench mark, a type of yard stick, for evaluating performance.
In many ways standards are also goals or objectives. Standards should not be set
so high as to be unattainable. Standards also should be a motivating factor that
 Management Accounting | 269

encourage improvement in efficiency and productivity. The basic assumption under-

lying the use of standards is that costs or revenues are controllable through manage-
rial decision-making.
The value of using standards is not without some differences in approach and
theory. A general theory of using standards, however, has evolved and the rest of
this chapter is concerned with setting forth this theory and illustrating the application
of standards. As mentioned above, two types of standards are generally recognized:
static budget standards and flexible budget standards.
A conceptual foundation underlies both these types of standards. The major
components of this foundation are the following:
1. The most important classification of costs when it comes to standards is
fixed and variable costs.
2. The concept of the activity variable, Q (quantity), is of critical importance
in setting standards and computing variances.
3. Q (quantity) is an activity variable that may either have as its frame of
reference units sold or units produced. Q as used here refers to the
quantity of output.
4. There are two types of activity whether the frame of reference is units sold
or units produced.
a. Planned quantity of output
b. Actual quantity of output
5. The question that has received considerable attention and debate is:
Should the standards for computing variances be based on actual
quantity or planned quantity of output?
6. Static budget standards are always based on planned quantity of output.
Flexible budget standards are always based on actual quantity of
output.
7. The use of flexible budgets automatically removes volume variances that
is created when static budget standards are used. In terms of units, the
volume variance is simply actual output less planned output.
8. In addition to total cost or total revenue standards, standards should also
be set for the individual factors that create the total cost standards.
9. The purpose of performance evaluation is to identify problems in cost or
revenue causing activities. A problem is indicated when a variance is
considered significant. Variances are commonly labeled as favorable and
unfavorable. The fact that a variance has been identified as favorable
does not mean the absence of problems. For example, a favorable
variance for material usage could mean that the workers are causing the
product to be of lower quality.
In order to understand these general principles, a detailed discussion of flexible
budgeting and static budgeting follows:
270 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Static Budget and Flexible Budget Standards Equations

As previously discussed in chapter 7, the aggregate total cost equation was given
as:
TC = V(Q) + F (1)
TC - total costs
V - variable cost rate
Q - quantity
In equation (1), Q or quantity may be either units sold or units produced.
Furthermore, the aggregate variable cost rate, V, may be defined in terms of indi-
vidual components as previously discussed in chapter 6.
V = V M + V L + V O + V S + V A (2)
Where:
V M - variable material cost rate
V L - variable labor cost rate
V O - variable overhead rate
V S - variable selling expense rate
V A - variable administrative rate
In a similar manner the aggregate fixed cost standard, F, may be defined in terms
of its individual components:
F = F L + F O + F S + F A (3)
Where:
F L - fixed labor cost
F S - fixed selling expenses
F O - fixed overhead costs
F A - fixed administrative expenses
The process of setting standards is, therefore, larger in scope than simply
setting a standard for the aggregate variable rate and the aggregate amount of fixed
expenses/costs. In less mathematical terms, standards for a manufacturing business
need to be set for the following:
Manufacturing Costs Operating Expenses
1. Material (variable) 4. Selling (fixed and variable)
2. Direct labor (variable) 5. General and administrative
3. Manufacturing overhead (Fixed and variable)
(Fixed and variable)
The above general theory can be summarized mathematically as follows:
Flexible budget standard equation: TC = V S(Q A) + F
Static budget standard equation: TC = V S( Q P) + F
TVC - total cost
V S - aggregate standard variable cost rate
F - planned fixed cost
 Management Accounting | 271

Q A - actual quantity (output)

Q P - planned quantity (output)
The equations for flexible budget and static budgeting are obviously the same,
except that in flexible budgeting the standard is based on actual quantity of output
whereas in static budgeting the standard is based on planned quantity of output. In
terms of individual cost/expenses components of which five have been now identi-
fied, the static and flexible budget equations for these components are:

Figure 14.1

Type of Cost Flexible Budget Static Budget Equation

Equation

1. Material TSVMC = VSM(Q A) TSVMC = VSM(Q P)

2. Direct labor TSVLC = VSL(Q A) TSMLC = VSL(Q P)

3. Manufacturing Overhead TSVMO = VSO(Q A) TSVMO = VSO(Q P)

4. Selling expenses TSVSE = VSS(Q A) TSVSE = VSS(Q P)

5. General and administrative TSVGA = VSG(Q A) TSVGA = VSG(Q P)

Note: TSV stands for “total standard variable”.

The only difference in flexible budget and static budget standards, as explained
before, is quite obvious. Flexible budget standards are based on actual quantity of
output, Q A, and static budget standards are based on planned quantity of output, Q P.
Standards for manufacturing costs are based on production quantity while operating
expenses such as selling expenses are based on sales quantity. The difference in
planned Q and actual Q output is now critically important.

Setting Standards for Individual Flexible Budget Factors

Setting standards for total costs is important; however, the first step is to set stan-
dards for the factors that make up the component parts as discussed in this chapter.
Setting standards for the variable cost rates is the first and most difficult step. This
step is actually done at the beginning of the operating period. The factors involved
that create the variable cost rates for manufacturing costs are easier to identity than
the factors for selling and general and administrative expenses. The table on the
next page shows the factors typically associated with manufacturing and operating
expenses.
Because selling and general and administrative expenses cover a much wider
range of items, it is not as easy to identify specific factors that require standards.
However, for some items such as sales people commissions, the factors can be
easily identified. For example, if the sales commission rate is 10% and the price
of the product is $300. In this instance, the cost factor is $30 and the unit factor is
simply 1.
272 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Figure 14.2

Variable Cost Factors

Item Factors Legend

Material VSM = USM x CSM USm - standard units per product

CSm - standard cost of one unit

Direct labor VSL = HSL x RSL HSL - standards hours per product
RSL - standard labor rate per hour

Overhead (V) VSO = USO x CSO USO - standard units of overhead service
CSO - standard cost of 1 unit of service

Selling VSS = USS x CSS USS - service units

CSS - standard cost of one service unit

Gen. & Admin. VSG = USG x CSG USG - service units

CSG - standard cost of one service unit

Although the foundation of flexible budgets are always the equations for variable
costs as just explained, the preferred practice for purposes of reporting to manage-
ment is to present flexible budgets in tabular form. The following is an example of a
tabular flexible budget:
Figure 14.3 • Flexible Budgeting- Manufacturing Costs

VM = $ 2 Units of Product Manufactured

VL = $3
100 200 300 400 500 600
VO = $4
TVMC $200 $ 400 $ 600 $ 800 $1,000 $1,200
TVLC $300 $ 600 $ 900 $1,200 $1,500 $1,800
TMVO $400 $ 800 $1,200 $1,600 $2,000 $2,400
Total $900 $1,800 $2,700 $3,600 $4,500 $5,400

If actual units manufactured were 500, then the standard cost for material would
$ 1,000 ($2.00 x 500). For variable manufacturing overhead, the standard would be
$2,000 ($4.00 x 500).
Comprehensive Illustration of Variance Analysis
The K. L. Widget company’s controller after considerable analysis put together
the following information:
Planned Actual
Production 7,000 units 7,800 units
Sales 6,000 units 6,500 units
Planned Price $300 $310
 Management Accounting | 273

Manufacturing Cost Information

Materials Labor
–––––––––––––– –––––––––––––––
Planned Actual Planned Actual
Units of material per product 5 5.4 Hours of labor 2 2.5
Cost of material per unit $3.00 $3.20 Wage rate $15.00 $16.00

Manufacturing overhead
Planned Actual
–––––––– –––––––
Variable overhead rate (per unit) $5.00 $5.60
Fixed manufacturing overhead $200,000 $250,000

Operating expenses Information

Planned Actual
–––––––– –––––––
Selling:
Variable
Commissions $195,000 $201,500
Packaging $ 30,000 $ 39,000
Travel $ 12,000 $ 14,300

Fixed
Advertising $100,000 $125,000
Sales people salaries $500,000 $550,000

General and Administrative

Planned Actual
–––––––– –––––––
Variable
Supplies $6,000 $8,450
Postage $3,000 $4,225
Fixed
Executive salaries $200,000 $220,000
Building rent $  50,000 $  80,000

Step 1 The first step in the evaluation process is to create the flexible budgets
from the planned data provided. Typically, this would be done at the
beginning of the operating period. Based on the above information,
flexible budgets are shown in Tables 1 and 2.
274 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Table 1 Flexible Budget-Manufacturing Cost

(Units of Product)
Variable costs Rate 2,000 4,000 6,000 8,000 10,000
Materials $ 15.00 $ 30,000 $ 60,000 $ 90,000 $ 120,000 $ 150,000
Factory Labor 30.00 60,000 120,000 180,000 240,000 300,000
Manufacturing 5.00 10,000 20,000 30,000 40,000 50,000
Total variable mfg. costs $ 50.00 $ 100,000 $ 200,000 $ 300,000 $ 400,000 $ 500,000
Fixed Costs

Manufacturing $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000

Total costs $ 300,000 $ 400,000 $ 500,000 $ 600,000 $ 700,000

Table 2 Flexible Budget- Income Statement

Sales (units)

Revenue Rate 2,000 4,000 6,000 8,000 10,000

Sales $ 300 $ 600,000 $ 1,200,000 $ 1,800,000 $ 2,400,000 $ 3,000,000

Variable Costs

Selling

Commissions $ 30.00 $ 60,000 $ 120,000 $ 180,000 $ 240,000 $ 300,000

Packaging 5.00 10,000 20,000 30,000 40,000 50,000

Travel 2.00 4,000 8,000 12,000 18,000 24,000

Gen. and administrative

Supplies $ 1.00 $ 2,000 $ 4,000 $ 6,000 $ 8,000 $ 10,000

Postage 0.50 1,000 2,000 3,000 4,000 5,000

Total variable $ 38.50 $ 77,000 $ 154,000 $ 231,000 $ 310,000 $ 389,000
Fixed

Selling

Advertising $ 100,000 $ 100,000 $ 100,000 $ 100,000 $ 100,000

Sales people’s salaries 500,000 500,000 500,000 500,000 500,000

Gen. & administrative.

Executive salaries $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000

Building rent 50,000 50,000 50,000 50,000 50,000

Total fixed 850,000 850,000 850,000 850,000 850,000

Total expenses $ 927,000 $ 1,004,000 $ 1,081,000 $ 1,160,000 $ 1,209,000
 Management Accounting | 275

Table 3
Variance Analysis- Cost of Goods Manufactured
Planned Production - 7,000
Actual Production - 7,800
Actual Standard Variance
Materials used (V) $ 134,784 $ 117,000 $ 17,784 U

Direct Factory Labor (V) 312,000 234,000 78,000 U

Manufacturing (V) 43,680 39,000 4,680 U

Manufacturing (F) 250,000 200,000 50,000 U

Total cost of goods manufactured $ 740,464 $ 590,000 $ 150,464 U

Table 4 Variance Analysis - Income Statement (Direct Costing)

Planned activity 6,000 units Actual activity 6,500

Actual Standard Variance

Sales $ 2,015,000 $ 1,950,000 $ 65,000 U

Variable expenses

Selling

Cost of goods sold $ 408,720 $ 325,000 $ 83,720 U

Commissions $ 201,500 $ 195,000 $ 6,500 U

Packaging 39,000 32,500 6,500 U

Travel 14,300 13,000 1,300 U

General and administrative

Supplies $ 8,450 $ 6,500 $ 1,950 U

Postage 4,225 3,250 975 U

Total variable selling 676,195 575,250 100,945 U

Contribution margin $ 1,338,805 $ 1,374,750 $ 35,945 U

Fixed expenses

Selling

Advertising $ 125,000 $ 100,000 $ 25,000 U

Sales peoples’ salaries 550,000 500,000 50,000 U

General & administrative

Executive salaries 220,000 200,000 20,000 U

Building rent 80,000 50,000 30,000 U

Other (fixed manufacturing overhead) 250,000 200,000 50,000 U

Total fixed expenses $ 1,275,000 $ 1,050,000 $ 225,000 U

Net Income $ 63,805 $ 324,750 $ 260,945 U

276 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Step 3 The third step is to identify the proper standards to be entered into the
standards column. In our example here, actual production output was
7,800 and sales output was 6,500. The planned values were 7,000 units
of production and 6,000 units of sales. These two values are no longer
of any importance and it is the actual outputs that are used to set the
flexible budget standards. For example, the standard for material is:
SMVC = $15.00 (7,800) = $117,000. In flexible budgeting, the standard
is always based on actual output which in this case for production is
7,800.
Step 4 The 4th step is to compute the total variances by subtracting from actual
values the standard values. The differences should be labeled favorable
or unfavorable as shown in Tables 3 and 4.
Analyzing The Total Variances
After total variances have been determined based on using the flexible budget
standards, the next step it to determine the causes of the total variances. Analyzing
total variances can be the most challenging and difficult part of performance evalua-
tion. Identifying the factors that cause the variances requires analyzing the underlying
causes or reasons for variances. In this regard, accounting theorists many years ago
focused on the variance factors that exist in material, labor and overhead. For this
reason, in management accounting texts, the analysis of total variances has tended
to center on the analysis of material, labor, and overhead.
Identifying the factors that cause variances is not so difficult, but developing
the procedures for computing these variance factors has resulted in some chal-
lenging variance equations. Several different methods have evolved with some
resulting conflicts in terminology and answers. Students tend to find manufactur-
ing cost variance analysis one of the more difficult topics in cost and management
accounting.
Our objective now is to look at some commonly used techniques for analyzing
the total variances for material, labor, and overhead. There are some alternative
procedures available to the ones discussed here, but the student is referred to a text
on traditional cost accounting, if the desire exists to look at other procedures.
Analyzing the Total Material Variance - Regarding material, it is clear that
an increase in material price above the standard price will result in an unfavorable
variance. Furthermore, if more material per unit was used than planned , then this
extra usage of materials also adds to the unfavorable variance. The standard variable
cost rate for materials as previously explained is: V MS = U MS x C MS where U MS is
the number of units of material required per product and C MS is the cost per unit of
material. After the total material variance has been determined, then the question
becomes: how much of the total variance is due to price or cost of the material and
how much due to usage or quantity?
In the analysis of total variances, particularly regarding material and labor, it is
important to distinguish between quantity of inputs and quantity of outputs. The term
“output” refers to the quantity of finished goods. The term “input” refer to the quantity
 Management Accounting | 277

material and labor required or used. For example, if 1,000 chairs are made, then
output is 1,000 and if each chair requires 6 units of material, then the quantity of
material inputs would be 6,000. When the term “quantity” is being used in computing
variance, it is important to realize at all times whether the term “quantity” is referring
to outputs or inputs.
The total material cost variance equation is simply:
Total material variance = actual material cost - standard material cost
The actual material cost is: AMC = V MA (QA)
Where:
AMC - actual material cost
V MA - actual variable material cost rate
QA - actual output
In order to know the quantity of materials used, the company must have a good
system for tracking usage of inventory. The system used most likely will be some type
of perpetual inventory system. The quantity used per product then is simply the total
quantity of material used divided by the actual output.
Actual material cost is the number of units of product (output) times the actual
material cost per unit of product or alternatively, it can be computed by multiplying
the actual quantity of material used times the cost of one unit of material. In this type
of analysis, there are two variable cost rates, actual and standard. The standard
material cost is the number of actual units of output times the standard variable cost
per unit of product. The total variance computed from using a flexible budget standard
can be analyzed into the two factors:
1. Price
2. Quantity (per units of product)
There, consequently, exists two variances commonly called:
Material price variance
Material quantity variance
The material cost variance is more commonly called the material price variance.
In terms of variance analysis for materials, the term “price” almost always means the
price of one unit of raw material. In the analysis that follows, the term “price” will be
used rather than “cost” in order to be consistent with the use of the term in manage-
ment and cost accounting literature generally.
The mathematical definitions of these variances are as follows:
Material Price Variance:
MPV = (P MA - P MS) Q MA
Where:
MPV - material price variance
P MA - actual price of one unit of material
P MS - standard price of one unit of material
Q MA - actual quantity of material
278 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Material Quantity Variance:

MQV = (Q MA - Q MS )P MS
Where:
MQV - material quantity variance
Q MA - actual quantity of material used
Q MS - standard quantity of material
To illustrate the procedure for computing material variances, assume the
following:
Planned Actual
–––––––– –––––––
Production 1,000 1,200
Units of material per product 4.0 4.2
Cost per unit of material $2.00 $2.50
Analysis of Material - Based on this information, the flexible budget standard
equation is:
TSMC = $8.00 (QA)
The actual variable material cost rate is $10.50 (4.2 x $2.50).

Step 1 The first step is to compute the total material cost variance
based on the definitions: AMC = V  MA (QA) and TSMC =V MS (QA)
(QA represents the actual output of goods)
Actual material cost ($10.50 x 1,200 ) $12,600
Standard material cost ($8.00 x 1,200 ) $ 9,600
_______
Material cost variance $3,000
–––––––
Step 2 The second step is to compute the total material price
variance based on the definition: MPV = (P MA - P MS)Q MA
Actual price $2.50
Standard
price $2.00
_____
.50
Actual quantity of materials used (1,200 x 4.2) 5,040
–––––
Material price variance $2,520

Step 3 The third step is to compute the quantity variance:
based on the definition: MQV = ( Q MA - Q MS) P  MS
Actual quantity of materials used (1,200 x 4.2)
5,040
Standard quantity of material (1,200 x4)
4,800
–––––
240
Standard price $2.00
––––––
Material quantity variance $ 480
–––––––
$3,000
–––––––
 Management Accounting | 279

Analyzing the Total Labor Cost Variance - It is clear regarding labor that an
increase in the wage rate above the standard wage rate will result in an unfavorable
variance. Furthermore, if the number of actual labor hours incurred are greater
than planned, then these additional labor hours also add to the unfavorable total
labor variance. The standard variable cost rate for labor, as previously explained, is:
VLS = HSL x RSL where HSL is the number of labor hours required per unit of product
and RLS is the standard wage rate per hour. After the total labor cost variance has
been determined, then the question becomes: how much of the total variance is due
to the labor wage rate and how much is due to labor hours usage?
As mentioned previously, it is also important in analyzing labor to distinguish
between quantity of inputs and quantity of outputs. Labor hours incurred is a measure
of input quantity. Output still remains the quantity of finished goods.
The total labor cost variance equation may be defined as:
Total labor cost variance = actual labor cost - standard labor cost
The actual labor cost is: ALC = V LA (QA)
Where:
ALC - actual labor cost
V LA - actual variable labor cost rate (per unit of product)
QA - actual output (units of product)
In other words, actual labor cost is the number of units of product (output) times
the actual labor cost per unit of product. In this type of analysis, there are two variable
cost rates, actual and standard. The standard labor cost is the number of units of
product (output) times the standard variable labor cost per unit of product. The total
labor variance computed from using a flexible budget standard can be analyzed into
two factors:
1. Wage rate
2. Number of labor hours (per unit of product)
There, consequently, exists two variances commonly called:
1. Labor rate variance
2. Labor hours variance
The mathematical definitions of these variances are as follows:
Labor Rate Variance:
LRV = (R LA - R LS) H LA
Where:
LRV - labor rate variance
R LA - actual labor wage rate per hour
R LS - standard labor wage rate per hour
H LA - actual labor hours
Labor Hours Variance:
LHV = ( H La - H Ls)R Ls)
280 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Where:
LHV - labor hours variance
H LA - actual labor hours
H LS - standard labor hours
To illustrate the procedure for computing material variances, assume the
following:
Planned Actual
–––––––– ––––––
Production 1,000 1,200
Labor hours per product 2.0 2.5
Wage rate $10.00 $12.00
Based on this information, the flexible budget standard for labor is:
TSLC = V LS (QA ) = $20.00 (1,200) = $24,000
The actual variable labor cost rate is $30.00 (2.5 x $12.00).

Step 1 The first step is to compute the total labor cost variance:
Actual labor cost ($30.00 x 1,200 ) $36,000
Standard
labor cost ($20.00 1,200 ) $24,000
_______
Labor
cost variance $12,000
–––––––
Step 2 The second step is to compute the labor rate variance
based on the definition: LRV = (R LA - R LS) H LA
Actual labor rate $12.00
Standard labor rate $10.00
––––––
Price variance per unit $ 2.00
Actual labor hours incurred (2.5 x 1,200 ) 3,000
––––––
Labor rate variance $  6,000

Step 3 The third step is to compute the labor hours variance:

based on the definition: LHV = ( H LA - H LS)R LS This
variance is equivalent to the material quantity variance.
Actual labor hours incurred (1,200 x 2.5) 3,000
Standard labor hours (1,200 x 2.0) 2,400
–––––
Total variance (hours) 600
Standard wage rate 10.00
––––––
Labor hours variance $  6,000
––––––
$12,000
–––––––
Analysis of Total Variance for Overhead - One of the more difficult and
challenging areas of analysis is manufacturing overhead. Accountants decades ago
developed some sophisticated procedures for analyzing the manufacturing overhead
account. The procedure adopted was to analyze the balance of the account rather
than simply analyze the charges to the account. The balance of the manufacturing
overhead account represents under- or over-applied overhead. However, since
 Management Accounting | 281

different methods may be used to apply manufacturing overhead, several different

approaches to overhead analysis resulted. The discussion that follows assumes that
overhead was applied based on a standard level of activity such as direct labor hours.
Based on this assumption, a three-way analysis results. If overhead is applied based
on actual direct labor hours, then only two variances are required. The efficiency
variance then does not exist.
In order to identify the principles involved, the following manufacturing overhead
account is assumed.
Manufacturing Overhead
Actual 330,000 240,000 applied (80,000 x $3.00)
Balance 90,000

The analysis of this account can get very complex depending on what assumptions
are made. Generally, overhead is applied based on an overhead rate. An overhead
rate requires:
1. An assumed capacity level on which the rate is based
2. A basis of application such as direct labor hours
Technically, overhead should be applied based on standard hours at actual output.
This will be the assumption in this discussion.
The above account was based on the following assumptions:
Capacity (normal) 100,000 DLH
Standard fixed overhead $200,000
Variable rate $1.00 per DLH
Actual output 16,000 units of product
Full capacity 20,000 units of product
Standard DLH per product 5
Actual direct labor hours 85,000
The total overhead rate would be:
Fixed rate (200,000/100,000) $2.00 per DLH
Variable rate $1.00 per DLH
––––––––––––
$3.00 per DLH
Based on output of 16,000 units of product, the standard direct labor hours would
have been 80,000 hours (16,000 x 5)
There are three possible explanations for the balance of $90,000. These reasons
are commonly called:
1. Spending variance
2. Efficiency variance
3. Volume variance
The spending variance is defined:
Spending variance = actual overhead - budgeted overhead at actual
output (e.g., hours)
282 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

The Efficiency variance is defined as:

Efficiency variance = budgeted overhead at actual hours - budgeted
overhead at standard hours
The volume variance is defined as:
Volume variance = budgeted overhead at standard hours - applied
overhead
Budgeted overhead is defined as consisting of fixed and variable manufacturing
overhead.
Example of Analyzing the Manufacturing Overhead Variance
Spending variance:
Actual overhead $330,000
Budgeted overhead at actual hours
Budgeted fixed $200,000
Budgeted variable ( $1.00 x 85,000) 85,000
––––––– $285,000
–––––––
$45,000
Efficiency variance:
Budgeted overhead at actual direct labor hours $285,000
Budgeted overhead at standard hours (80,000)
Budgeted fixed $200,000
Budgeted variable (80,000 x $1.00) $  80,000 $280,000
–––––––– –––––––– $  5,000
Volume variance
Budgeted overhead at standard hours $280,000
Less: Overhead applied (80,000 x $3.00) $240,000
––––––––
$40,000
–––––––
$90,000

–––––––
The spending variance is caused for two reasons:
1. The actual variable manufacturing overhead is more or less than
standard variable overhead rate at actual output.
2. The actual fixed manufacturing overhead is more or less than the
standard fixed manufacturing overhead.
In other words, the expenditures for these two types of overhead were greater
than planned at the beginning of the operating period.
The efficiency variance is the result of the variable overhead rate being more or
less than planned. If the actual manufacturing overhead rate is equal to the planned
variable manufacturing overhead rate, then the efficiency variance is zero. The
efficiency variance is strictly a variable cost variance. An alternative definition is:
EV = (actual direct labor hours - standard direct labor hours) x standard
variable overhead rate
EV = (85,000 - 80,000) $1 = $5,000
 Management Accounting | 283

The volume variance is strictly a fixed manufacturing overhead variance. It exists

when the hours used to apply overhead are more or less than capacity hours. When
standard hours equals capacity hours, the volume variance is zero. An alternative
definition is:
V V = (H c - H s) R f (R f - fixed overhead rate)
VV = (100,000 - 80,000) $2.00 = $40,000

Graphical Analysis of Variances

Some students find it helpful to see variance analysis presented visually in the
form of graphs. It is possible to present material and labor variances graphically. Most
school children learn at an early age that area of a rectangle is simply length times
width: A = L x W. Total cost in principle is based on the same equation: Cost = units
x price (C = U x P). Therefore, cost can be represented on a graph as the area of a
rectangle as has been done in graph 1 (see Figure 14.4).
The actual material cost is shown in graph 1, (area A, the outer large rectangle).
The area of rectangle A is Pa x Qa. Area B (standard material cost) represents standard
material cost. Standard material cost or area B is Ps x Qs. The difference between
rectangle A and rectangle B would be the sum of area C and D. This difference
represents total material cost variance. Rectangle C represents the material price
variance (Pa - Ps) Qa. The area of rectangle D represents the material quantity
variance (Qa - Qs) Ps. In this graph, all the variances illustrated are unfavorable
variances. The same type of graph may be prepared for labor cost variances.

Figure 14.4 • (Graph 1) Graphical Illustration of Material Cost Variances

$
A Actual Material Cost

Pa
C Material Price Variance
Ps
Standard Material
Material cost Quantity
B Variance
D

Material
Qs Qa
Quantity

Graphical Illustration of Manufacturing Overhead Variances

In addition to showing material and labor graphically, it is possible to show
manufacturing overhead variances graphically.
284 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Graph 2 is based on the following data:

Actual production 8,000 units
of product
Full capacity production 10,000 units
Direct labor hours per product 2
Full capacity direct labor hours 20,000
Actual hours worked 18,000
Standards direct labor hours 16,000
Planned fixed manufacturing overhead $100,000
Variable overhead per direct labor hour $8.00
Overhead application rate:
Fixed ($100,000 / 20,000) $  5.00
Variable overhead rate $  8.00
––––––
Total overhead rate per dlh $13.00
Actual manufacturing overhead $275,000

The balance of the manufacturing overhead account is $67,000 ($275,000 -

$208,000) In other words actual overhead minus applied overhead. This graphical
illustration above makes visible the following points:
1. At 18,000 actual hours of direct labor, the budgeted overhead (fixed plus
variable) is $244,000.
2. At 16,000 standard hours (the hours used to apply overhead), the
budgeted overhead (fixed plus variable) is $228,000.
Figure 14.5 (Graph 2) Graphical Illustration of Manufacturing Overhead Variances

$300,000

$275,000 SV
$260,000
$244,000
$228,000
EV
VV
$208,000

$100,000

Hs Ha Hc
4,000

8,000

12,000

16,000

18,000

20,000

Direct Labor Hours

 Management Accounting | 285

3. At 20,000 hours (full capacity) the budgeted overhead (fixed plus variable)
is $260,000.
4. The actual overhead is $275,000.
5. The spending variance is $31,000 ($275,00 - $244,000).
6. The efficiency variance is $16,000 ($244,000 - $228,00).
7. The amount of applied manufacturing overhead is $208,000.
8. The volume variance is $20,000 ($228,000 - $208,000).
Flexible Budgeting and Static Budgeting Variances Compared
The computation and analysis of variances is an important step in finding the
underlying causes of significant variations in actual results and planned results. The
use of flexible budgeting makes the understanding of variances easier because the
effect of a change in volume (quantity of output) is removed from the total variances.
If static budgeting is used, then a volume variance would have to be computed. For
example, the analysis of the total material cost variance based on static budgeting
would have been as follows (see page 278 for data):
Total material cost variance
Actual material cost ($10.50 x 1,200 ) $12,600
Standard material cost ($8.00 x 1,000 ) $ 8,000
______ $4,600
–––––––
Material Volume variance
Based on the definition: MVV = (QA - QP) V MS
Standard material cost at actual activity $ 9,600
Standard material cost at planned activity $ 8,000
Volume variance –––––– $1,600
Material price variance
Based on the definition: MPV = (P MA - P MS)Q MA
Actual price $ 2.50
Standard price $ 2.00
––––––
$ .50
Actual quantity of materials used (1,200 x 4.2) 5,040
Material price variance –––––– $2,520
Material Quantity Variance
Based on the definition: MQV = ( QMA - Q MS ) P MS
Actual quantity of materials used (1,200 x 4.2) 5,040
Standard quantity of material (1,200 x4) 4,800
––––––
240
Standard price $ 2.00
Material quantity variance $ 480
–––––––
Sum of material variances $4,600
–––––––
286 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Whether static or flexible budgeting is used, it is should be noticed that the

material price and material quantity variances are calculated exactly in the same
way. The same is also true for the labor rate variance and the labor hours variance.
Following is a comparison summary of the analysis based on both static budgeting
and flexible budgeting.
Comparison of Static and Flexible Budgeting Variance Analysis
Static Budgeting Flexible Budgeting
Total material cost variance $4,600 Total material cost variance $3,000
–––––––
––––––– –––
––––––
–––––

Material volume variance $1,600

Material price variance $2,520 Material price variance $2,520
Material quantity variance $ 480 Material quantity variance $ 480
–––––– ––––––
$4,600 $3,000
–––––––
––––––– –– ––––––
––––––

Summary
Variance analysis can be highly effective in highlighting areas of decision-making
that need improvement. Traditionally, the discussion of variances has been in the
framework of a manufacturing business and in particular to material, labor, and
overhead. However, variance analysis can be used in any type of business and can
be applied not only to manufacturing costs but also to all types of expenses. Flexible
budgeting can be used in all types of businesses, because all businesses have
variable costs and expenses.
In order to be able to understand the differences between flexible budgeting and
static budgeting, the following terminology must be understood:
1. Variance analysis 11. Direct labor volume variance
2. Flexible budgeting 12. Material price variance
3. Static budgeting 13. Material price variance
4. Standard material cost 14. Labor rate variance
5. Standard labor cost 15. Labor hours variance
6. Inputs 16. Variable costs
7. Outputs 17. Fixed costs
8. Total material variance 18. Planned quantity
9. Total direct labor variance 19. Actual quantity
10. Material volume variance
Appendix - Graphical Analysis of Variances
The approach to variance analysis in cost and management accounting text
books is almost always based on flexible budgeting. Standard costs are, therefore,
based on the actual quantity of output rather than the planned quantity of output.
Regarding material, for example, there are two values that require the use of flexible
budgeting values:
1. Standard units of material allowed (at actual output)
2. Total standard cost (at actual output)
 Management Accounting | 287

Unless these two values are computed, a complete variance analysis of material
and direct labor cannot be accomplished.
Standard units of material allowed is simply: U mS (QA0). In other words, standard
material allowed is the material required per unit of product times the number of units
manufactured commonly called output. Total standard cost is V MS(QA0), where V MS
is the standard material cost per unit of output. Stated more simply, V MS(QA0), is the
equation for computing flexible budgeting standards for material.
The material variance equations presented in this chapter may be expanded as
follow:

Material Variances
Material Price Variance
(P MA - P MS) Q MA = P MA( Q MA) - P MS (Q MA)

Material Quantity Variance

(Q MA - Q MS)P MS = P Ms(Q MA) - P MS(Q MS )
If we take the variance analysis equations for material on the right hand side and
place them in close proximity, then we can easily see that the price variance and the
quantity variance have one term in common.
MPV = P MA ( Q MA ) - P MS (Q MA )
MQV = P Ms (Q MA ) - P MS(Q MS )
The term P MS(Q MA ) may be read as the cost of material actually used at standard
price. This cost value would be the same as the flexible budgeting standard cost
value only when there is no variance in the quantity of material used. Because of the
difficulty in following the logic of these right hand definitions, most cost accounting
text authors present the following graphical analytical tool.

Figure 14.6 • Material Variance Graph

Standard
Actual Material Standard Cost of Material Cost
Cost Actual Material used (Flexible Budget)

$3,410 $3,300 $3,000

MPV MQV

$110 $300

TMCV
PMA(QMA) - QMS(PMS)
$410
288 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

The above diagram was based on the following data:

Actual output 500
Standard units of material per unit of output 2
Standard material price $3.00
Actual material price $3.10
Actual quantity of material used 1,100
Labor Variances

In a similar manner, the definition of labor variances may be expanded:

LRV = (R LA - R LS )H LA = R LA (H LA) - R LS(H LA )

LHV = ( H LA - H LS)R LS = R LS(H LA ) - R LS(H LS )

As for the case with material, if we take variance equations for labor on the right
hand side and place them in close proximity we can easily see that the price variance
and the quantity variance have one term in common.
LRV = R LA (H LA ) - R LS (H LA )
LHV = R LS(H LA ) - R LS(H LS )
The term R LS(H LA ) may be read as the cost of labor hours actually incurred at
the standard wage rate. Thi cost value would be the same as the flexible budgeting
value only when there is no variance in the actual labor hours incurred. Because of
the difficulty in following the logic of these right hand definitions, most cost accounting
text authors present the following graphical analytical tool.
Figure 14.7 • Labor Variance Graph
Standard
Actual Labor Standard Cost of Labor Cost
Cost Actual Labor hours (Flexible Budget)

$18,900 $18,000 $15,000

LRV LHV

$900 $3,000

TMCV

$3,900

The above diagram was based on the following data:

Actual output 500
Standard labor hours required 3
Standard wage rate $10.00
 Management Accounting | 289

Actual material price $10.50

Actual labor hours incurred 1,800

Q. 14.1 What steps make up the management accounting concept of control?

Q. 14.2 What two values must be known in order to compute a variance?
Q. 14.3 Explain the difference between static budget standards and flexible
budget standards.
Q. 14.4 What type of cost or expense requires a flexible budget?
Q. 14.5 Why is a flexible budget not required for fixed cost/expenses?
Q. 14.6 What activity level must be known in order to select the correct standard
for purposes of computing variances?
Q. 14.7 If static budget standards are used to compute variances, what three
variances must be computed in order to explain the total variance?
Q. 14.8 If flexible budgeting is used, what two variances must be computed in
order to explain a total variance?
Q. 14.9 At what point in time are the standards under flexible budgeting actually
known for purposes of computing variances?
Q. 14.10 List three ways to show or display a flexible budget.
Q. 14 .11 Present examples of the three methods in question 10 for material
cost.
Q. 14.12 List five broad categories of variances that may be computed.
Q. 14.13 List the steps involved in analyzing the total variances for material and
labor.
Q. 14.14 List and mathematically define the variances that must be computed to
explain the total variances for material, labor, and overhead (assuming
the use of flexible budgets).
Q. 14.15 What type of cost does the manufacturing overhead spending variance
represent?
Q. 14.16 What type of cost does the manufacturing overhead efficiency variance
represent?
Q. 14.17 What type of cost does the manufacturing volume variance represent?
Q. 14 .18 Identify the following variances:
A. (P MA - P MS) QA
B. (Q MA - Q MS) P MS
C. ( R LA - R LS) HA
D. ( H LA - H LS) R LS
290 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Exercise 14.1 • Flexible Budget Standards for Material and Labor

The following information has been provided to you:

Actual production 2,500
Planned production 2,000
Material Data:
Actual:
Units of material used 5,200
Cost of material per unit $3.00
Material standards:
Cost of one unit of material $2.80
Units of material required per product 2
Labor Data:
Actual :
Actual labor hours 6,500
Wage rate per hour $15.00
Labor standards:
Labor hours per unit of product 3
Wage rate per hour $14.00
Manufacturing overhead Data:
Actual overhead incurred:
Fixed $60,000
Variable $25,000
Planned overhead:
Fixed $50,000
Variable $22,500
Capacity hours 10,000
Standard hours used to apply overhead 7,500
Actual direct labor hours 8,000
Required:
Based on the above information:
1. Compute the flexible budget standards for material and labor.
2. Compute the total variances for material and labor.
3. For materials compute the material price variance and the material quantity
variance.
4. For labor, compute the labor rate variance and the labor hours variance.
5. For manufacturing overhead, compute:
a. The spending variance
 Management Accounting | 291

b. The efficiency variance

c. The volume variance
Exercise 14.2 • Flexible Budget Standards for Material and Direct Labor
The Acme Widget Company on January 1 budgeted production to be 1,000
units. However, at the end of the fiscal year on December 31, actual production was
determined to be 1,500 units.
Standards for Material were set as follows:
Material cost per unit of product $  2.00
Material units per unit of product 4.00 ––––––––
Actual production results were as follows:
Material cost per unit of product $  3.00
Material units per unit of product 5.00 ––––––––
Standards for direct labor were set as follows:
Labor wage rate per unit of product $10.00
Labor hours per unit of product 3 ––––––––
Actual production results for labor were as follows:
Labor wage rate per unit of product $11.00
Labor hours per unit of product 2.5 ––––––––
Required:
1. Based on the above information, compute the following for material:
1. Actual material input (units) ( ) –––––––––––––––
2. Actual output (units) ( ) –––––––––––––––
3. Actual material cost $––––––––––––––
4. Standard material cost:
a. Flexible budgeting ( ) $––––––––––––––
b. Static budgeting ( ) $––––––––––––––
5. Standard material units
a. Flexible budgeting ( ) –––––––––––––––
b. Static budgeting ( ) –––––––––––––––

2. Based on the above information, compute the following for direct labor:
1. Actual direct labor hours (input) ( ) –––––––––––––––
2. Actual output (units) –––––––––––––––
3. Actual direct labor cost ( ) $––––––––––––––
4. Standard direct labor cost:
a. Flexible budgeting ( ) $––––––––––––––
b. Static budgeting ( ) $––––––––––––––
5. Standard labor hours
a. Flexible budgeting ( ) –––––––––––––––
b. Static budgeting ( ) –––––––––––––––
292 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

3. Based on the above information, compute the following based on flexible

budgeting:
Material:
Total material cost variance ( ) ––––––––––––––– ( )
Material price variance ( ) ––––––––––––––– ( )
Material quantity variance ( ) ––––––––––––––– ( )
––––––––––––––– ( )

4. Based on the above information, compute the following based on flexible

budgeting:
Direct labor:
Total direct labor cost variance ( ) –––––––––––––– ( )
Labor rate variance ( ) –––––––––––––– ( )
Labor hours variance ( ) –––––––––––––– ( )
–––––––––––––– ( )

5. Based on the above information, compute the following based on static

budgeting:
Material:
Total material cost variance ( ) –––––––––––––– ( )
Material volume variance ( ) –––––––––––––– ( )
Material price variance ( ) –––––––––––––– ( )
Material quantity variance ( ) –––––––––––––– ( )
–––––––––––––– ( )

6. Based on the above information, compute the following based on flexible

budgeting:
Direct labor:
Total direct labor cost variance ( ) ––––––––––––– ( )
Labor volume variance ( ) ––––––––––––– ( )
Labor rate variance ( ) ––––––––––––– ( )
Labor hours variance ( ) ––––––––––––– ( )
––––––––––––– ( )

Problem 1 • Flexible Budgeting

The V. K. Gadget Company has not implemented a formal budgeting process.

At the beginning of each quarter, the president of the company simply requests cost
estimates from each vice president. No attempt has been made to convert this data
into a formal budget. Consequently, the tentative decisions which form the basis of
these cost estimates are frequently not executed. In the past, the vice presidents and
other managers have felt that these cost estimates were meaningless for purposes
of performance evaluation.
 Management Accounting | 293

At the beginning of the first quarter, the vice presidents were asked to submit cost
estimates for their respective areas. Each vice president was informed that sales of
8,500 units was forecasted but that production would be 10,000 units. The following
reports were submitted to the president of the company.
Report from Vice President of Production
Cost Per Number of
Material: Units Units
Material X $6.00 4.0
Freight-in, material X $.50
Material Y $10.00 2.00

Labor (Variable): Rates Hours

Cutting department $8.00 1.2
Assembly department $7.00 0.9
Finishing department xxxxx xxxxx

Variable Manufacturing Overhead: Fixed Manufacturing Overhead:

Utilities $ 5,000 Fixed direct labor $120,000
Repairs and maintenance $23,000 Utilities $ 4,000
Supplies $ 9,000 Production planning &
Spoilage loss $12,000 control $ 8,000
Purchasing & receiving $ 75,000
Factory insurance $ 1,500
Depreciation, prod. equip. $ 21,125
Depreciation, building $ 4,000
Factory supplies $ 1,000
Worker’s training cost $ 8,250

Report of Vice President of Marketing:

Selling Expenses
Variable Selling: Fixed selling:
Sales people’s comm. $170,000 Sales people’s salaries $483,000
Sales people travel $ 51,000 Sales people training $ 30,600
Packaging $ 12,750 Advertising $280,000
Bad debts $ -0- Sales offices rents $ 9,000
Credit department $ -0- Terr. offices oper. exp. $ 65,000
Home office sales exp. $ 30,000
Report of Vice President of Finance:
General and Administrative Expenses
Variable General & Administrative Fixed General & Administrative
Supplies $ 8,500 Executive salaries $95,000
Travel $21,675 Secretarial and clerical $ 9,000
Supplies $14,253
Depreciation, building $ 1,667
Depreciation, F & F $ 2,500
294 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

At this date, the plan was to sell one unit of the Gadget for $180.
Other income and expenses was budgeted for $6,000.
Based on the information presented above, prepare the flexible budgets that
should have been made in prior to the start of the first quarter.
Required:
1. Convert all total variable data cost to a per unit basis. Use the work sheet (Form
A) that has been provided.
2. Prepare the flexible budget for manufacturing costs (Form B) and selling and
general and administrative expenses (Form C).
3. At the end of the first quarter, the actual number of units sold was 8,734. What
would be the total selling and total general and administrative cost standard at
this level of sales activity?
4. Assume that actual production for the first quarter was 14,960 units. What should
be the standard for variable manufacturing costs at this level of activity?
5. State mathematically the flexible budgets prepared on Forms B and C.
6. Discuss the benefits or advantages of using flexible budgeting as opposed to
static budgeting.
 Management Accounting | 295

Form A • Work Sheet for Requirement 1

Flexible Budget Work Sheet
Units of product sold – ––––––––––––––––––––
Units of product manufactured – ––––––––––––––––––––
Selling expenses - variable rates Estimated-Rate per
Total Cost Unit of Product
Cost of goods sold $ _____________ $ _____________
Sales people’s commissions $ _____________ $ _____________
Packaging $ _____________ $ _____________
Sales people travel $ _____________ $ _____________
Bad debts $ _____________ $ _____________
Credit department $ _____________ $ _____________
Total variable selling $ _____________ $ _____________
General & administrative expenses - variable rates
Travel $ _____________ $ _ ___________
Supplies $ _____________ $ _ ___________
Total variable G & A $ _____________ $ _ ___________
Material (rate per product):
Material X:
Cost per product (_ __ x ___ ) $ _____________
Freight-in (Mat. X) (_ __ x ___ ) $ _____________ $ ____________
Material Y:
Cost per product (_ __ x ___ ) $ _____________
Labor:
Cutting department (_ __ x ___ ) $ ____________
Assembly department (_ __ x ___ ) $ ____________
Finishing Dept. (labor is fixed in this department) $ xxxxx
____________
Manufacturing overhead - variable rates
Utilities $ _____________ $ ____________
Repairs & maintenance $ _____________ $ ____________
Supplies $ _____________ $ ____________
Material spoilage loss $ _____________ $ ____________
Total variable overhead $ _____________ $ ____________
Total variable mfg. cost $ _____________
296 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Form B • Work Sheet for Requirement 2

Flexible Budget-Manufacturing

Units of Products Manufactured

Rate 4,000 6,000 8,000 10,000 12,000 14,000

Material:
Material X
Material Y

Labor:
Cutting Dept.
Assembly Dept.

Variable Overhead:
Utilities
Repairs & Main.
Supplies
Material spoilage

Total variable mfg.

Fixed overhead:
Fixed direct labor
Utilities
Prod. plan. & cont.
Pur. and receiv. costs
Factory insurance
Deprec., prod. equip.
Depreciation, building
Factory supplies
Factory training cost

Total fixed
 Management Accounting | 297

Form C • Work Sheet for Requirement 2

Flexible Budgets - Selling, General & Administrative

Units of Product Sold

Rate 4,000 6,000 8,000 10,000 12,000 14,000
Variable Selling:
Cost of goods sold
Sales people’s commission
Packaging
Sales people travel
Bad debts
Credit department
Total variable selling
Variable General & Admin.
Travel
Supplies
Total variable G & A
Total variable
Fixed Selling:
Sales people’s salaries
Sales people training
Advertising
Territory sales offices rental
Territory offices operating expense.
Credit department
Home office sales expense
Total fixed selling
Fixed Gen. & Admin:
Executive salaries
Secretarial & Clerical
Supplies
Depreciation, building
Depreciation, furniture
Total general & administrative
Total fixed expenses
Total expenses
298 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

Problem 2 • Performance Evaluation of Decision-making

Standards used in this problem should be computed based on the flexible

budgets prepared in problem no.1; consequently, problem no. 1 should be worked
first. The purpose of this problem is to give you practice in performance evaluation by
experiencing the process of setting standards and computing variances for the cost
of goods manufactured statement and the income statement.
Actual first quarter material and labor cost data that are necessary to this problem
but not directly found on the company’s financial statements include the following:
Material Used Data:
Material X
Units of material used 61,336
Cost per unit $ 6.90
Freight-in per unit $ .60
Material Y
Units of material used 32,912
Cost per unit $ 10.08
Freight paid by seller none
Direct Labor Cost Data:
Cutting Department
Direct labor hours 17,600
Wage rate per hour $ 8.50
Actual direct labor $149,600
Assembly Department
Direct labor hours 13,876
Wage rate per hour $ 6.50
Actual direct labor $90,194
Finishing Department -0-
Variable Overhead Cost Data:
Utilities $ 5,000
Repairs and maintenance $ 23,000
Supplies $ 9,000
Material spoilage $ 12,000
In the first quarter of the year, the V. K. Gadget Company operated at a loss. The
following is a summarized version of the company’s income statement:
 Management Accounting | 299

V. K. Gadget Company
Income Statement
For the quarter ended March 31, 20xx
(Direct Costing Basis)
Sales $1,746,800

Variable Expenses:
Cost of goods sold $605,669
Selling expenses 274,489
General and administrative 30,344
_ _______ $910,502
Fixed Expenses:
Selling $887,735
General and Administrative 109,107
Fixed manufacturing overhead 310,149
________ 1,306,991
_________
Total Operating expenses 2,217,493
_________
Net operating loss ($  470,693)
Other income -0-
Other expense (interest) 28,181
Income taxes -199,454
________ 171,273
Net loss $(299,420)
__________
Actual units sold - 8,734
Actual units manufactured - 14,960

Required:

1. Based on the above information, compute total variances for all items which
appear on the cost of goods manufactured statement and income state-
ment. Standards for purposes of this analysis should be based on the use
of the flexible budgets prepared in problem 1. Use Forms A and B to com-
pute total variances.
2. Based on the flexible budgets prepared in problem 1 compute:
a. Total material variance
b. Material price variance
c. Material quantity variance
d. Total labor variance
e. Labor rate variance
f. Labor efficiency variance

3. If static budgeting concepts had been used, what level of activity would have
been the basis of the standards used for computing variances?
300 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting

4. Explain or give reasons why in the real world of business actual results would
differ from planned values for each of the following:
a. price
b. cost of one unit of material
c. wage rate per hour
d. labor hours per unit of product
e. number of sales people hired
f. number of factory workers hired
g. selling variable cost rate
h. variable overhead rate

Form A • Work Sheet for Requirement 1

PERFORMANCE EVALUATION - INCOME STATEMENT ACCOUNTS

Units Sold
Actual Standard Variance
Sales
Expenses
Variable:
Selling:
Cost of goods sold _____________ _____________ _____________
Selling _____________ _____________ _____________
General and administrative _____________ _____________ _____________

Total variable expenses _____________ _____________ _____________

Fixed:
Selling _____________ _____________ _____________
General and administrative _____________ _____________ _____________
Fixed manufacturing _____________ _____________ _____________

Total fixed _____________ _____________ _____________

Total expenses _____________ _____________ _____________

Operating net income/loss _____________ _____________ _____________

Other income _____________ _____________ _____________
Other expense _____________ _____________ _____________
Net income/loss _____________ _____________ _____________
 Management Accounting | 301

Form B • Work Sheet for Requirement 1

PERFORMANCE EVALUATION - COST OF GOODS MANUFACTURED

Units Manufactured

Actual Standard Variance

Material used:
Materials used: X _____________ _____________ _____________
Materials used: Y _____________ _____________ _____________

Direct variable labor: _____________ _____________ _____________

Cutting department _____________ _____________ _____________
Assembly department _____________ _____________ _____________

Variable mfd. overhead:

Utilities _____________ _____________ _____________
Repairs & maintenance _____________ _____________ _____________
Supplies _____________ _____________ _____________
Material spoilage loss _____________ _____________ _____________
Total _____________ _____________ _____________
Cost of goods manufactured _____________ _____________ _____________
Number of units manufactured _____________ _____________ _____________
Cost per unit _____________ _____________ _____________
302 | CHAPTER FOURTEEN • Performance Evaluation Using Flexible Budgeting
 Management Accounting | 303

Segmental Profitability Analysis and Evaluation

Unless a business is a not-for-profit business, all businesses have as a primary
goal the earning of profit. In the long run, sustained and satisfactory profit requires good
decision-making and performance evaluation. The income statement, while serving
many purposes, is a primarily a tool of performance evaluation from a management
point of view. When prepared on a segmental basis, the use of the income statement
for evaluation purposes can be highly effective.
Businesses tend to be complex and varied in nature. It is highly unlikely that
a business will have only one product. Single product businesses exist only in
text book theory for illustrative purposes of certain business principles. Many U.S.
corporations have hundreds of products and also operate in different territories or
regions. In today’s business environment, the majority of enterprises are likely to be
global in nature. Given the existence of many products and many different areas of
operations, it is unlikely that over time all products or areas will be profitable. The
need to evaluate profit performance systematically and regularly on a segmental
basis has been recognized and has been a common practice since the early 1900s.
Even if a company had a single product, the need for segmental performance
would still exists. The product may be sold in different markets and in different areas
of the country. A single product business can be segmented in many different ways.
For example, assume that the Widget Company operates in four territories. Does
this mean that sales and, consequently, profit is equal in all territories? The obvious
answer is, of course not. Many factors can contribute to why one territory is profitable
and another is not. It logically follows that evaluation of profit in each segment is
highly desirable. Unprofitably segments, if they can not be made profitable, should
be discontinued.
A business can segment its operations in many different ways. Some of the more
common ways of segmentation include the following:
1. Product lines 5. States
2. Departments 6. Plants
3. Divisions 7. Sales people
4. Territories 8. Operating hours
304 | CHAPTER FIFTEEN • Segmental Profitability Analysis and Evaluation

There has over a considerable period of time developed two primary ways of
performing segmental analysis: (1) the full cost approach and (2) the contribution
approach. The full cost approach attempts to measure the net income of each segment
while the contribution approach attempts to measure the segmental contribution of
each segment.

Full Cost Approach

On the surface, the full cost approach seems to be the logical method because of
the fact that ultimately a business can not be successful without profit (net income).
However, when the attempt to measure net income of a segment is made some
problems come into existence that are not present when the objective is to simply
measure the over-all net income of a business. From a segmental perspective, there
are two types of expenses, (1) direct and (2) indirect. Direct expenses are those
expenses of a segment that are caused by the existence of the segment and can,
therefore, be eliminated by the closing of the segment. Indirect expenses or common
expenses as they are sometimes called are those expenses that are not directly
caused by any one particular segment. The key characteristic of indirect expenses
from a segmental viewpoint is that they must be allocated in order to measure the net
income of a segment. Examples of indirect expenses include the following:
1. Salaries of top management, for example the president’s salary
2. Home office operating expenses
3. Insurance on home office and home office equipment
4. Salaries of home office staff
The theory underlying the full cost approach is that all expenses regardless of
where and why incurred must be charged to the segments that benefit directly and
indirectly. In order to do this, these types of expenses must be allocated. Because
various methods of allocation are available and because different methods results
in different allocation percentages, the allocated cost may be perceived to be
somewhat arbitrary. Some of the methods used to allocate indirect expenses include
the following:
1. Sales dollars 3. Number of employees
2. Units of dollars 4. Floor space occupied
Whatever method is used, it should appear to be logical and fair. An improper use
of an allocation method can cause one segment to appear to be more profitable than
another when in fact this is not the case. The basic principles of the full cost approach
may be summarized as follows:
1. The objective is to measure net income of each operating segment.
2. Over-all net income of the business is the sum of the segmental net
income.
3. All indirect expenses (common) must be allocated.
4. Allocation of indirect expenses involves selecting bases of allocation.
5. The segmental net income approach may be defined mathematically as
follows:
 Management Accounting | 305

Segmental net income = segmental sales - direct expenses - allocated indirect

expenses, or in more symbolical terms
SNI = S - DE - AIE (1)
Direct expenses are those expenses that can be eliminated by the closing of a
segment. These types of expenses are also sometimes called escapable and indirect
expenses called inescapable. Variable expenses because they are activity expenses
are always considered escapable. For example, if in a clothing store the decision
has been made to no longer sell children shoes, then the cost of goods sold for
children shoes would no longer exist. Cost of costs sold, a variable expense, is a
good example of an escapable segmental expense.
Fixed expenses may either be direct or indirect depending on the circumstances.
If a store is closed but the contract for rent is a five year lease and only one year has
expired on the lease, then for the next four years the rent is inescapable. However,
if the sales manager of the store is let go, then his or her salary, a fixed expense, is
escapable. The contractual nature of fixed expenses must be examined carefully to
determine whether or not the expense is direct.

Segmental Contribution Approach

The major problem of the full cost approach is that it is technically possible for
a segment to show an operating loss yet at the same time be making a positive
contribution to net income. In other words, if the seemingly unprofitable segment is
closed, then the overall net income of the business will decrease. The paradox will be
examined more closely later in this chapter.
To overcome this adverse feature of the full cost approach, many businesses
prefer to use the contribution approach to measuring segmental profitability. The
segmental contribution approach as indicated by its name measures segmental
contribution. Segmental contribution may simply be defined as sales less direct
expenses. As a student, you should be careful to distinguish between segmental
contribution and contribution margin. Contribution margin, which was discussed and
defined in chapter 7, is sales less variable expenses. Because some fixed expenses
can be direct expenses, segmental contribution and contribution margin are not the
same.
The basic principles of computing segmental contribution may be outlined as
follows:

1. Only the contribution of each segment is computed. No attempt is made

to compute the net income of the segment.
2. Indirect or common expenses of each segment are not allocated.
3. Indirect or common expenses, however, are usually deducted from to-
tal segmental contribution in order to arrive at overall business net in-
come.
4. A segment is considered profitable if sales of the segment exceed the
direct expenses of the segment.
306 | CHAPTER FIFTEEN • Segmental Profitability Analysis and Evaluation

5. The segmental contribution approach may be presented mathemati-

cally as follows:
Segmental contribution = segmental sales - direct expenses
In more symbolical terms:
SC = S - DE (2)
D
DE = V(Q) + F  (3)
S = P(Q) (4)
Where:
DE - direct expenses
P - price of the product in the segment
V - variable cost rate for the segment
Q - units of sales in a specific segment
F D - direct fixed expenses of the segment

Therefore, equation (2) may be restated as follows:

D
SC = P(Q) - V(Q) - F  (5)
It is apparent from equation (3) that the principles of cost-volume-profit analysis
covered in chapter 7 apply to segmental decision-making. Variable costs are always
direct costs. When activity ceases variable costs cease. When activity increases,
variable costs by definition increase. Indirect expenses are almost always fixed
expenses.
The indirect expenses of a segment will continue to be incurred regardless of
whether the segment is continued or not continued. Therefore, as long as the segment
is making a contribution towards indirect fixed expenses, continuing operations at
least in the short run makes the business better off.
The following example illustrates the basic principles of the full cost and segmental
contribution approaches.

Full Cost Approach Segmental Contribution Approach

Widget Company Widget Company

Segmental Income Statement Segmental Income Statement
A B Total A B Total
Sales $30,000 $20,000 $50,000 Sales $30,000 $20,000 $50,000
Expenses Direct expenses:
Cost of goods sold 15,000 12,000 27,000 Cost of goods sold 15,000 12,000 27,000
Sales Salaries 7,000 5,000 12,000 Sales salaries 7,000 5,000 12,000
_______ _______ _______
Executive salaries 6,000 4,000 10,000
Total direct expenses $22,000 $17,000 $39,000
______ _ _____ _ _____
Total expenses $28,000 $21,000 $49,000 Segmental

contribution _______
8,000 $_____
_______ ___
3,000 11,000
______

Indirect expenses:

Net income /loss $ 

___ 2,000 ($1,000)
______ _______ $ ___
_____ _______
1,000
______
_____
Executive salaries

10,000
_______
Net Income/loss
$ 1,000
_______
_______
 Management Accounting | 307

In the above example, cost of goods sold and sales salaries are direct expenses
of each segment. Executive salaries, an indirect expense, consequently were
charged to the segments by being allocated. In the segmental contribution approach,
executive salaries are not allocated.
A number of observations from the above example should be made. First, the full
cost approach shows that segment B is operating at a net loss of $1,000. It would
appear that the business would be better off by $1,000 if this segment is closed.
However the segmental contribution approach shows that segment B is making
a contribution of $3,000. Secondly, it should be observed that executive salaries
were allocated in the ratio of 60:40. The allocation percentages were determined by
dividing segmental sales by total sales.
The question that needs to be asked and analyzed is this: will the company be
better off if segment B is closed, or stated differently, will overall net income of the
business increase by $1,000? The answer is NO. To prove this answer, suppose
segment B is closed and, therefore, the company’s entire operations consists only of
segment A. The company’s income statement would, therefore, be as shown below.
Surprisingly, rather than net income increasing by $1,000, the closing of segment
B causes the company to be operating at a total net loss of $2,000.The company is
worse off without segment B in the short run than with the segment closed. Eliminating
the $1,000 loss of segment B had the opposite effect of the desired result. Rather
than increasing net income of the business, it caused the income of the business to
substantially decline.

Widget Company
Income Statement
(Segment A Only)
Sales $30,000
Expenses
Cost of goods sold 15,000
Sales salaries 7,000
Executive salaries 10,000
_ ______
32,000
_______
Net
loss $ 2,000
_______

The obvious reason why net income did not increase is that executive salaries
are an inescapable expense. Where before $4,000 had been allocated to segment
B, segment A must now be charged with the entire $10,000 of executive salaries.
The $3,000 contribution of segment B towards common expenses was lost when
this segment was closed. The loss of $3,000 segmental contribution means that the
overall net income of $1,000 now becomes an overall company loss of $2,000.
However, the segmental contribution approach to measuring segmental profitability
is not without its own flaws. The questions needs to be asked: is it possible for each
308 | CHAPTER FIFTEEN • Segmental Profitability Analysis and Evaluation

segment to be making a contribution and yet at the same time for the company as a
whole to be operating at a loss? The answer is YES.
In the above example, assume that the executive salaries are increased to
$12,000 The company as a whole would then be operating at a net loss of $1,000
even though both segment A and B are still making a contribution. In the above
example, the total contribution of segment A and segment B was $11,000. Now with
executive salaries at $12,000, the net company loss would be $1,000 rather than a
company income of $1,000.
Total contribution (A and B) $11,000
Executive
salaries 12,000
________
Net
loss ($ 1,000)
________

A better example of why segmental contribution in all segments is not enough to

make a business profitable is the following:
A B C Total
Sales $200,000
________ $100,000
________ __$50,000
______ $350,000
________
Variable expenses 150,000 60,000 30,000 240,000
Direct fixed expenses   20,000
________ 30,000
________ 15,000  
________ 65,000
________
170,000
________ 90,000 ________
________ 45,000
305,000
________
Segmental contribution ________
$  30,000 $  10,000
________ __$  5,000 $  45,000
______
Indirect expenses $  50,000
_________
Net
loss $   5,000
_________

The question then remains: which method is best for evaluating overall profitability
of a segment? To answer this question, another question needs to be asked. What
does net loss mean when a segment is shown to be operating at a loss under the full
cost approach?
Assuming the allocation of indirect expenses has been done as fairly as possible,
a segmental net loss means that the contribution of the segment is not considered
adequate. In the long run, each segment should make a fair share contribution to
the indirect expenses. In the short run, the segment clearly should not be closed,
if segmental contribution is positive. The existence of segmental net loss is a clear
signal that ways should be found to increase the segmental contribution. If this can
not be done in the long run, then it might be wise to consider closing the segment and
devoting the resources, both financial and human, to another segment.
Improving Segmental Contribution
When the use of the full cost approach reveals that a segment is operating at
a loss, the first step is not to discontinue the operations but to search for ways to
increase the amount of contribution. There are two rather obvious ways to increase
contribution: (1) increase sales and (2) decrease direct expenses. In order to increase
 Management Accounting | 309

segmental contribution, whether concentrating on sales or direct expenses or both

methods, considerable detailed analysis is required.
There are two ways to increase sales. One is to increase the sales volume and
the other is to change price without affecting volume. However, changing price
without affecting volume is not likely. The interdependence of price and volume
must be recognized in most instances. Some avenues for increasing sales include
more effective advertising, a more motivated sales force, and perhaps a better or
more effective use of credit. Sales people training and more effective means of
compensating sales people are obvious decision areas to study.
If sales can not be increased while holding expenses down, a second approach
would be to look for ways to decrease direct expenses. Direct expenses as pointed out
before may be either variable or fixed in nature. As discussed in chapter 5, aggregate
fixed and variable costs may be defined as follows:
m
V = V  + V l + V o + V s + V a
Where:
m
V  - variable material cost rate
V l
- variable labor cost rate
o
V  - variable overhead rate
s
V  - variable selling expense rate
a
V  - variable administrative rate
Also, in chapter 5, fixed expenses were mathematically defined as follows:
F = F 1 + F o + F s + F a
Where:
l
F  - fixed labor cost V s - fixed selling expenses
o
F  - fixed overhead costs F a - fixed administrative expenses
Equations (1) and (2) reveal that each type of cost/expenses consist of components
that need to be examined separately. These equations indicate that opportunities for
expense/cost reductions exist in five cost areas:
1. Materials 4. Selling
2. Factory labor 5. General and administrative
3. Manufacturing overhead
Material cost may decreased in several ways. A search for a different supplier
with a lower cost might be in order. Also, purchasing in larger quantities might be
considered. Furthermore, the amount of material put into a product might be examined.
A more efficient use of material with less waste might be explored. Ways to increase
the productivity of labor should be considered .
Reduction in fixed expenses should also be considered. Those fixed expenses
that are considered to be direct in nature should be analyzed. Advertising obviously
could be cut to zero, but the consequences might be a substantial decrease in sales.
However, the advertising budget still needs to be examined closely and the budget
spent wisely in advertising media that will be the most effective for the company.
310 | CHAPTER FIFTEEN • Segmental Profitability Analysis and Evaluation

Using Management Accounting Tools In Segmental Decision-making

The management of a segment requires careful attention to many kinds of
decisions and an array of different kinds of expenses. Periodic evaluation of each
segment is required. The management accountant with his or her knowledge of various
decision-making and performance evaluation tools should be involved continually
in the evaluation process and should be a valuable resource to management. The
following tools, if used properly, should be valuable in finding ways to improve
segmental contribution.

1. Business budgeting
2. Incremental analysis
3. Segmental contribution reporting
4. Cost-volume-profit analysis
5. Cost behavior analysis
6. ROI analysis
7. Flexible budgeting and variance analysis
8. Economic order quantity models
One of the more effective tools is cost-volume-profit analysis which was discussed
in some depth in chapter 7. Earlier in this chapter, the contribution approach to
segmental evaluation, was presented in the form of the following equation:
D
SC = P(Q) - V(Q) - F (5)
This equation mathematical states that segmental contribution is simply sales
less direct expenses where direct expenses can be either variable or direct fixed
expenses. An important question in any segmental operations is: how many units
must be sold to attain a desired amount of contribution? The answer can easily be
found by solving for quantity (Q):
D
P(Q) + V(Q) = SC + F

Q(P - V) = SC + FD

SC + FD
Q = –––––––––– (6)
P - V
To illustrate, assume that the following information was taken from the K & L
Widget Company for one of its segments:
Price $ 100
Variable cost rate $ 80
Direct fixed expenses $ 5,000
The company has set a target segmental contribution at $10,000. How many
units must be sold to attain this desired level of contribution? Equation (6) above may
be used to answer this question:
10,000 + 5,000 15,000
Q = –––––––––––––––– = –––––––– = 750
100 - 80 20
 Management Accounting | 311

At sales of 750 units, the segment in question would make a contribution of

$10,000. However, how to increase volume to this level without increasing either
the variable cost rate or the amount of direct fixed expenses might be a substantial
challenge. Segmental contribution can be presented graphically as shown in Figure
15.1.

Summary
Segmental statements, if properly used, can be a powerful tool in evaluating
profitability of various segments of the business. Even evaluating segments in terms
of operating hours can be very useful. If staying open from 9:00 p.m. to 12:00 midnight
does not show a contribution, then these hours should be discontinued. This tool can
highlight products that have ceased to be profitable and also highlight products that
need, perhaps, to be more aggressively promoted. There are many ways to increase
segmental contribution. The use of segmental reporting does not preclude the use
of other tools. Both the full cost approach and the segmental contribution approach
can be useful in identifying segments that need attention. A good understanding of
these two approaches to measuring profitability requires understanding the following
terminology:
1. Segments 7. Inescapable expenses
2. Segmental reporting 8. Escapable expenses
3. Full cost approach 9. Allocated costs
4. Contribution approach 10. Contribution margin
5. Indirect costs/expenses 11. Segmental net income
6. Common costs/expenses 12. Segmental contribution

Figure15.1 • C-V-P Analysis applied to segmental operations

($000’s)

90 Positive
Segmental
80 Contribution
70
60 Direct Fixed
Negative
50 Segmental Expenses
Contribution
40
30 Variable
Expenses
20
10
0
0 100 300 500 700 900
Volume (units)
312 | CHAPTER FIFTEEN • Segmental Profitability Analysis and Evaluation

Q. 15.1 List eight ways to segment a business.

Q. 15.2 What two methods may be used to evaluate segmental profitability?
Q. 15.3 What is the measure of profitability under the full cost approach?
Q. 15.4 What is the measure of profitability under the contribution approach?
Q. 15.5 What is the basic profitability formula for the full cost approach?
Q. 15.6 What is the basic profitability formula for the segmental contribution
approach?
Q. 15.7 What is the main weakness of using segmental contribution to measure
the profitability of a segment?
Q. 15.8 What is the main weakness of using segmental net income to measure
the profitability of a segment?
Q. 15.9 Under the full cost approach, what type of costs require allocation?
Q. 15.10 Under the segmental contribution approach, how are indirect or common
costs handled?
Q. 15.11 What terms may be used as synonyms for direct and indirect costs?
Q. 15.12 Identify these two equations:
SNI = S - DE - AIE
SC = S - DE
 Management Accounting | 313

Exercise 15.1 • Segmental Contribution

The following income statement was given to you:
Segment A Segment B Total
Sales $ 75,000 $100,000 $175,000
Expenses
Cost of goods sold $30,000 $ 60,000 $  90,000
Selling $20,000 $ 35,000 $  55,000
General and administrative $15,000 $ 10,000 $  25,000
_ ______ ________ _______
Total expenses $65,000 $105,000 $170,000
_ ______ ________ _______
Net
income $10,000
_ ______ ($ 5,000)
________ $ 5,000
________

An analysis of the expenses revealed the following:

Variable Direct Fixed Common (Indirect)
Segment A
Cost of goods sold $30,000 –––––– ––––––
Selling $10,000 $6,000 $4,000
Gen. and administrative $ 8,000 $2,000 $5,000
Segment B
Cost of goods sold $60,000 ––––––– –––––––
Selling $20,000 $8,000 $7,000
Gen. & administrative $ 6,000 $2,000 $2,000
Required:
Should segment B be closed? (Show computations in detail.)

Exercise 15.2 • Computing Segmental Contribution

Case I Case II Case III Case IV

Dept. W Dept. X Dept. Y Dept. Z
Sales $50,000 $50,000 $50,000 $50,000
Cost of goods sold: 45,000 45,000 55,000 40,000
–––––––– ––––––– –––––––– –––––––
Gross profit $ 5,000 $ 5,000 ( $ 5,000) $10,000
Operating expenses* 8,000 8,000 6,000 5,000
–––––––– ––––––– –––––––– –––––––
Gross profit ($3,000) ($ 3,000) ($11,000) $ 5,000
–––––––– ––––––– –––––––– –––––––
* Escapable expenses $ 1,000 $ 6,000 $ 4,000 $ 2,000
Required:
For each case, show whether or not the department is making a contribution to
the business.
314 | CHAPTER FIFTEEN • Segmental Profitability Analysis and Evaluation

Problem 1 • Segmental Profitability Reporting

The Acme Manufacturing Company manufactures and sells four different

products. Each product is sold in a separate territory by a different set of sales people.
Segmental net income statements prepared each year by the accounting department
consistently reveal that territories 1 and 3 operate at a loss. Management is seriously
contemplating closing these “unprofitable” territories.
Detailed operating data on a territorial basis was made available as follows:

Terr. 1 Terr. 2 Terr. 3 Terr. 4

–––––– –––––– – ––––– – –––––
Price $20 $55 $75 $55
Quantity 2,000 4,000 3,500 3,000
Direct expenses:
Variable expense rates:
Cost of goods sold (cgs) $12 $19 $28 $25
Packaging (s) $ 2 $ 3 $ 1 $ 3
Travel (s) $ 1 $ 2 $ 2 $ 3
Commissions (s) $ 2 $ 3 $ 5 $ 4
Fixed costs/expenses:
Advertising(s) $20,000 $25,000 $45,000 $26,000
Sales people salaries (s) $14,000 $21,000 $18,000 $15,000
Salaries (g & a) $ 2,000 $ 3,000 $ 2,000 $ 3,000

Indirect Costs\Expenses:
Building rent (g&a) $15,000
Executive salaries (g&a) $35,000
Staff salaries (g&a) $25,000
Sales managers salaries (s) $40,000
Manufacturing $12,000
The allocation base for indirect costs should be the sales measured in dollars.
Required:

1. Compute the segmental net income of each territory.

Terr. 1 _ _____ Terr. 2 _______ Terr. 3 ________ Terr. 4 _______

Which territories, if any, are operating at a loss?_____________________
Explain the meaning of segmental net loss._________________________
___________________________________________________________
 Management Accounting | 315

2. Compute the segmental contribution of each territory.

Terr. 1 _ _____ Terr. 2 _______ Terr. 3 ________ Terr. 4 _______

Explain the meaning of segmental contribution if the contribution is:

a. Positive________________________________________________
______________________________________________________

b. Negative_______________________________________________

______________________________________________________
3. If the “unprofitable” territory 4 were closed, what would be:
a. total net income of the business? __________________________
b. total segmental contribution of the business?_ _________________
Explain why the net income of the business decreased when territories 4 was
closed:


4. If the “unprofitable” territory 1 were closed what would be:
a. total net income of the business? $ _______________
b. total segmental contribution of the business? $ _______________
Explain why the net income of the business increased when territory 1 was
closed:
__________________________________________________________
__________________________________________________________
5. Assume that in territory 1:
Price is increased to $25, cost of goods sold is reduced to $10, and that
advertising is increased by $5,000. As a consequence of these decisions,
assume that sales will increase to 3,000 units. Given these changes:
a. segmental contribution would be: $ _______________
b. segmental net income would be: $ _______________
6. List the conditions under which a segment should be closed:
__________________________________________________________
__________________________________________________________
316 | CHAPTER FIFTEEN • Segmental Profitability Analysis and Evaluation

Problem 2 • Segmental Reporting: Products and Operating Hours

The L. J. Widget Company has two products, A and B. The company’s current
operating hours are from 8:00 a.m. until 9:00 p.m . The two products are sold in the
same store building and occupy about the same amount of space.
An analysis of the store’s average sales for the two products is as follows:
Product A $123.07 per hour
Product B $102.31 per hour
Sales records on an operating hours basis shows average sales per hour
to be:
Hours Product A Product B
8:00 a.m. to 10:00 p.m. $30 $20
10:00 a.m. to 5:00 p.m. $180 $150
5:00 p.m. to 9:00 p.m. $ 40 $30
The following information was provided concerning operating expenses:

Utility expense per hour $ 8.00

Salary per hour of clerks (1 clerk per product) $ 10.00
Managers salary $ 5,000 per month
Monthly cost of leasing store building $ 1,500 per month
Advertising per month:
Product A $ 500
Product B $ 800

The store on the average is open 22 days of the month.

Cost of goods sold is as follows:

Product A 60% of sales

Product B 45% of sales

Required:

1. Determine of the segmental contribution of products A and B.

2. Determine the segmental contribution of operating hours for both products.
 Management Accounting | 305

Return on Investment

Profit or net income without question is a primary goal of any business. Any
business that fails to be profitable in the long run will not survive or will find itself in
bankruptcy. However, the mere existence of profit alone can not guarantee continuity
of a business. Profit must be satisfactory from the viewpoint of the investors and,
for this reason, profit while a measure of success itself must be evaluated. For
example, if company A has net income of $100,000 and company B has net income
of $1,000,000, which company is the most successful? It appears Company B
might be more successful, however, the size of net income is not the measure of
satisfactory. If company A’s total assets is $1,000,000 while company B’s total assets
is $100,000,000, the rate of return respectively for companies A and B is 10% and
1%. Company A is, therefore, more likely to be evaluated favorably.
In order to compare companies in terms of profitability, net income must be
expressed as a rate of return. To start a business, an entrepreneur must raise
“capital”. The term capital is a somewhat ambiguous term which can either refer to
the investment of money or funds in assets (plant and equipment) or to the source
of the funds. The use of the term “capital” tends to have a more narrow meaning in
accounting than in finance. In accounting, the term “capital” refers to the contribution
of assets by the owners (either a proprietor, partners, or stockholders.)
In finance, the term capital is employed to encompass all sources of funds
including both creditors and owners. The terms “debt capital” and “equity capital”
are commonly employed. The accounting equation is typically expressed: Assets =
Liabilities + Capital. In finance terms, the same equation would be Assets = Debt
Capital + Equity capital. Regardless of how the equation is expressed, the fact remains
that the two primary sources of assets are debt capital and equity capital. In other
words, a business looks to both creditors and owners for initial financial support.
Both parties, creditors and owners, expect a return of the capital that they have
invested in the business. The creditors expect a reward in the form of interest and the
306 | CHAPTER SIXTEEN • Return on Investment

amount of return expected periodically is determined by the agreed upon interest rate.
The owners also expect a return in the form of net income. While the interest rate is a
contractual rate, there is generally no rate of return agreement between contributors
of equity capital and the business. The one exception is the issue of preferred stock
such as 6% nonparticipating preferred stock. However, equity investors do expect
a certain rate of return and, therefore, commonly compute a return on investment
percentage wise. Good profit performance can not be measured in absolute dollars,
but must be measured on a relative basis in terms of a rate by comparing the return
on capital to the amount investment in capital.
Return on Investment Formula
The return on investment ratio equation in simple terms may be defined as
follows:
Earnings
ROI = ––––––––––
Investment
It is apparent that there are basically two terms that must be understood: (1)
earnings and (2) investment. Both terms are ambiguous and, therefore, both require
explanation. As it turns out, both terms have two different meanings.
The term “earnings” is often used in relationship to stock shares issued and
outstanding. Earnings per share is a frequently used ratio in financial statement
analysis. However, the terms earnings in evaluating the adequacy of profit refers
to net income. Earnings may either mean net operating income or net income. The
following simple income statement is a format used by many businesses:

K. L. Widget Company
Income Statement
For the Year Ended December 31, 20xx

Sales $1,000,000
Expenses
Selling $600,000
Administrative 200,000 800,000
––––––––– ––––––––––
Net operating income $ 200,000
Interest $100,000
Taxes 40,000 140,000
––––––––– ––––––––––
Net income $ 60,000
––––––––––
This particular format clearly shows two types of earnings: net operating income
and net income.
The management of a business has a responsibility to see that investors recover
the investment they have in the business. Net operating income represents the total
return in a given period of time before any distribution is made to investors and other
 Management Accounting | 307

claimants. Creditors have first claim on net operating income. If interest is equal to net
operating income, then net income is zero and there is nothing that can be claimed by
governments in the form of taxes and the return to equity capital providers would be
zero. In the above example, the return to creditors is $100,000 and the share of net
operating income to governments (state and federal) is $40,000. The return to equity
investors is $60,000. In order to state net income as a rate of return, it is necessary
to know how much has been invested in the business.
Investors, both owners and creditors, have defined investment in two different
ways. Some investors have defined investment as meaning total assets while others
define investment to mean total equity. Either definition is acceptable, however, care
must be taken to use the right measure of earnings. When investment is defined as
total assets, then the correct measure of earnings is net operating income. When
investment is defined as total equity, then the correct measure of earnings is net
income. Net income is the amount of net operating income remaining exclusively for
the equity capital providers.
Consequently, in the real world of business and finance, two concepts of return
on investment have emerged: (1) return on investment-assets and (2) return on
investment - equity. Mathematically, we have:
Net operating income
ROIa = ––––––––––––––––––– (1)
Total assets

Net income
ROIe = ––––––––––– (2)
Total equity

Net operating income is frequently defined as follows:

NOI = Net income + taxes + interest (3)
Net operating income is Revenue less all expenses except taxes and interest. It
is rather obvious that net operating income can be computed by simply starting with
net income and adding back taxes and interest. This can be demonstrated by using
the data from the above income statement.
Net operating income = $1,000,000 - $800,000 = $200,000
or
Net operating income = $60,000 + $100,000 + $40,000 = $200,000
The concept of return on investment-assets should be used when the objective
is to evaluate management’s performance for the whole business. Management has
a responsibility to provide a return on all of the assets intrusted in its care regardless
of their source. In one sense, management’s first responsibility is to see that net
operating income is sufficient to pay the creditors the interest contractually owed. If net
income is not adequate for this purpose, then the creditors could force the company
into bankruptcy and eventual failure. When net operating income is sufficient for this
purpose, then management must consciously strive to make net operating income
sufficient to provide the equity investors the rate of return they also expect. If the
308 | CHAPTER SIXTEEN • Return on Investment

rate of return to owners is inadequate, then the investors can punish management
by causing the value to the stock to decline. In many cases, the owners of stock also
serve on the board of directors and can cause management to be replaced for an
inadequate return. At all times, in order for the business to survive or for the current
management to survive, a conscientious effort must be made to earn an adequate
rate of return however measured.
The concept of return on investment-equity is a measure more likely to be used
by the equity investors rather than management. Net income is the residual after
creditors have received their share of net operating income and after the government
has been paid its claim again profit. To a large extent, it makes sense for equity
investors to regard investment as being total equity. However, when such defined,
the correct measure earnings is net income. However, as will be explained in the next
section, using ROIe has a fundamental weakness in that management can use the
principle of leverage to artificially inflate ROIe.
A refinement to the definition of return on investment is to use average investment
. The average investment, whether total assets or total equity, is to use the average
of the beginning and ending balances.
Return on Investment and Leverage
The use of ROIe to evaluate whether net income is satisfactory has an inherent
weakness in that by increasing debt relative to equity management can increase the
return even though net income has in fact decreased. The concept of using debt to
leverage the rate of return is a well known technique. To illustrate how the principle of
leveraging works, assume the following:

Balance Sheet Income Statement

December 31, 20xx For the year ended, 20xx

Current asset $ 4,000 Sales $ 10,000

Fixed assets 6,000 Cost of goods sold 7,000
–––––––– –––––––––
$ 10,000 Gross profit $ 3,000
Expenses
Liabilities $ 2,000 Operating $ 700
Interest 200
Capital 8,000 Taxes 100
–––––––– ––––––––
$ 10,000 $ 1 ,000
––––––––
–––––– ––––––––
Net income $ 2,000
––––––––
Interest rate = 10%
Using both equations for ROI we get:

2,300 2,000
ROIa = –––––– = 23% ROIe = –––––– = 25%
10,000 8,000
 Management Accounting | 309

It is apparent that ROIe is larger than ROIa. Now suppose management decides
to replace $3,000 of equity with debt. In this event, total liabilities would be $5,000
and total capital would be $5,000. With a debt of $5,000 at 10% interest rate, total
interest becomes $500 and net income becomes $1,700. Based on these numbers,
ROI becomes:

2,300 1,700
ROIa = –––––– = 23% ROIe = –––––– = 34%
10,000 5,000
Even though net income decreased by $300, the rate of return on equity
increased substantially from 23% to 34%. The problem with this strategy is that
the risk of bankruptcy increases as the amount of debt increases relative to equity.
Clearly this strategy increases the return to the remaining equity holders but this
strategy also puts the business at greater risk. Notice that the ROIa did not change.
It remained at 23%. The use of ROIa to evaluate the adequacy of net income
reduces the temptation to incur debt for the single purpose of increasing the rate
of return.
The principle of leverage does not always work. In order for the principle to
increase ROI, the necessary condition is that the rate of return on assets must be
greater than the interest rate. If not, then the principle will have the opposite effect.
The return on investment-equity will be less. In the above example, the interest
rate was 10%, but the return on assets was 23%. In this instance, the principle of
leverage can be applied effectively.
Return on Investment and the duPont Approach
There is another approach to ROI analysis that was made popular in the 1940s
by the duPont company. This approach introduced into ROI analysis two factors
considered important at that time: (1) Profit margin percentage and Investment
turnover. This modified ROI equation can be stated as follows:

Earnings Sales
ROI = ––––––––– x –––––––––
Sales Investment
Apparently, many companies at that time regarded a company or a division
of a company superior if the gross margin percentage was higher than any of its
competitors or internally the division in a company that had a higher gross margin
percentage was superior. This reasoning was basically fallacious and the duPont
ROI formula was a good way to point this out. Profit margin percentage alone
is not an indicator of satisfactory profit performance. Another important factor is
investment turnover. A company with a higher profit margin percentage could very
well have a much lower ratio of sales to investment. A high level of investment
relative to a lower amount of sales will reduce ROI.
For example, assume that two companies, A and B are being evaluated for
good management in terms of gross profit percentage. The rate of return for both
companies has been computed as follows:
310 | CHAPTER SIXTEEN • Return on Investment

Company A
300,000 1,000,000
ROI = –––––––– x –––––––– = 30% x 2 = 60%
1 ,000,000 500,000

Company B
200,000 1,000,000
ROI = ––––––––– x ––––––––– = 20% x 4 = 80%
1,000,000 250,000
Based on profit margin percentage, company A appears to be the better company;
however, this is misleading because company B, in fact, has the higher rate of return
(60% vs 80%). Company B has a higher investment turnover rate because of less
investment in assets.
It is well recognized among those professionals that analyze financial statements
that different industries have different profit margin percentages. A furniture store
would have a high gross margin percentage but a much lower investment turnover
than many other companies in different industries. Using profit margin percentage or
investment turnover alone to evaluate profit is not a good idea. Some typical gross
margin percentages of different industries are the following:
Supermarkets 1.0%
Furniture stores 2.5%
Discount stores 2.0%
Gasoline stations 4.5%
Petroleum refining 7.0%
If ROIa is the means of evaluating profit, then the ROI formula can be stated as
follows:
Net operating income Sales
ROIa = ––––––––––––––––––– x ––––––––––
Sales Total Assets

Using the numbers above in the discussion on leverage we have:

2,000 10,000
ROIa = –––––– x –––––– = .2 x 1 = 20%
10,000 10,000
The duPont formula reveals two important weaknesses of relying on profit margin
percentage as the sole criterion of evaluating net income. The first weakness is the
failure to consider the amount of investment in the business and the second weakness
is the failure to consider the impact of volume (sales) on the rate of return. The use
of this approach does not change the ROI answer. Rather it breaks the rate down
into two major components that many believe are important factors in evaluating net
income.
Return on Investment Weaknesses
While ROI formulas of the type discussed so far are useful, they do have a
recognized weakness. The return on investment equation is also often used to evaluate
future business opportunities. To do this it is necessary to project net income into the
future for the estimated life of the projects. Assume that two business projects are
 Management Accounting | 311

being evaluated and that each opportunity as a useful life of 5 years. The cost of each
project is $40,000. Net income for each project has been estimated as follows:
Proposed Project Net income
1 2 3 4 5 Total
Project A $10,000 $10,000 $10,000 $10,000 $10,000 $50,000
Project B $20,000 $15,000 $10,000 $ 2,500 $ 2,500 $50,000
Both projects have the same total net income and the same average net income
per year of $10,000. The annual average rate of return for both projects is 25%
(10,000/40,000). But the question is: are both projects in fact equal in terms of
profitability? Project A has the same net income each year but project B has more
net income in years 1 and 2 and less in years 4 and 5. If net income is the same as
net cash flow (this would be the case if there is, for example, no depreciation), then
project B is the better project. The reason is that if the present value of each project
is computed, then project B has a larger present value and, consequently, a higher
time adjusted rate of return. The time adjusted rate of return method is presented in
chapter 12. The average rate of return method ignores the difference in the timing of
net income. For this reason, many theorists argue that using present value methods
is the better approach to evaluating profitability.
Planning and Control Approach to Return on Investment
Formal profit planning (comprehensive business budgeting) results in a set of
planned financial statements and, as a consequence, also results in a planned return
on investment. After the budget is completed, the planned rate of return can be
computed by dividing planned net operating income by planned total assets.
However, a more insightful and analytical approach is to consider the following:
Previously net income was defined as:
I = P(Q) - ) - F
In addition, total assets maybe defined as working capital and fixed capital.
Working capital tends to vary directly with volume and, therefore, maybe defined as
follows:
WC = C(Q)
where C is the rate of increase in working capital per dollar change in sales
volume.
Total assets therefore may be defined as:
TA = C(Q) + FC
where FC represents total investment in fixed capital.
Given the equation for ROI as ROI = E/I, we now have the following
equation:
P(Q) - V(Q) - F
ROI = ––––––––––––––––
C(Q ) + FC
312 | CHAPTER SIXTEEN • Return on Investment

From this equation, we can see that there are six primary variables that determine
return on investment:
1. Price
2. Volume (quantity)
3. Variable cost rate
4. Fixed expenses
5. Working capital rate
6. Total fixed capital.
To illustrate, the use of this ROI equation assume the following
Price - $100 Sales forecast - $  10,000
Variable cost rate - $  80 Fixed expenses - $100,000
Working capital rate - $  12 Total fixed capital - $500,000
Based on the above planned rate of return would be:

100(10,000) - 80(10,000) - 100,000

ROI = ––––––––––––––––––––––––––––––––––– =
12(10,000) + 500,000

1,000,000 - 800,000 - 100,000 100,000

–––––––––––––––––––––––––––––– = ––––––– = 16.12%
120,000 + 500,000 620,000

This formula makes clear that a rate of return is dependent on many different
kinds of decisions. To achieve a satisfactory rate of return, management must make
good decisions in all aspects of the business including good management of working
capital and investment in plant and equipment.
Summary
Return on investment is primarily a performance evaluation tool. As a decision-
making tool it is somewhat limited. However, for certain decisions such as starting
a new business or expanding an existing businesses, ROI can be very helpful. If
management has a goal or objective of earning no less than a return of 20% and
under the most optimistic of assumptions, the return will not be greater than 15%, then
proposed venture should not be taken. Return on investment is also an excellent tool
to use in connection with comprehensive business budgeting. Every comprehensive
budget has inherent within it a planned rate of return. This rate of return should be
explicitly recognized.
The terminology that is important in this chapter is the following:
1. Earnings 8. Debt capital
2. Return on investment-assets 9. Equity capital
3. Return on investment-equity 10. Total assets
4. Interest 11. Leverage
5. Net income 12. Profit margin percentage
6. Net operating income 13. Investment turnover
7. Working capital
 Management Accounting | 313

Q. 16.1 What is the purpose of computing a rate of return?

Q. 16.2 What is the basic return on investment equation?
Q. 16.3 If investment is defined as total assets, then earnings should be defined
how?
Q. 16.4 If investment is defined as total equity, then earnings should be defined
how?
Q. 16.5 If earnings is defined as net income then investment should be defined
how?
Q. 16.6 If earnings is defined as net operating income, then investment should
be defined how?
Q. 16.7 What adjustments should be made to net income in order to arrive at
net operating income?
Q. 16.8 Which concept of ROI eliminates the effect of leverage?
Q. 16.9 What is the du Pont ROI formula?
Q. 16.10 Explain the meaning of profit margin percentage.
Q. 16.11 Explain the meaning of the investment turnover ratio.
Q. 16.12 Explain the meaning of the following:
A. E/I
B. NI/TE
C. NOI/TA
D. E/S
E. S/I
314 | CHAPTER SIXTEEN • Return on Investment

Exercise 16.1 • Computing Return on Investment

You have been provided the following information:

Balance Sheet

Assets $1,000
Liabilities $ 100
Capital $ 900

Income Statement

Sales $2,000
Operating expenses $ 1,850
Interest 10
Taxes 56
–––––––
Total expenses $1,916
–––––––
Net income $ 84
–––––––
Required:
1. Compute ROIa
2. Compute ROIe
3. What effect does the amount of debt relative to equity have on return on
investment (equity)?
4. What effect does the amount of debt relative to equity have on return on
investment (assets)?
 Management Accounting | 315

Exercise 16.2 • Computing Return on Investment

You have been provided the following information:

Balance Sheet Income Statement
Assets $100,000 Sales $500,000
Liabilities $ 20,000 Expenses:
Stockholders’ Equity $ 80,000 Selling $300,000
Administrative 100,000
Taxes 36,000
Interest 2,000
438,000
––––––––
Net income $62,000
––––––––
Interest rate on debt is 10%.
Required
Based on the above information compute the following

1. Return on investment-assets ______________________________________

2. Return on investment-equity _ _____________________________________
3. Assuming return on investment-assets: ______________________________
Profit margin percentage _________________________________________
Investment turnover ____________________________________________

4. If equity is reduced by $60,000 and debt is increased by $60,000 net income

would then become $ ___________________________________________ ?
Return on investment-equity then becomes _ _____________________ ?
316 | CHAPTER SIXTEEN • Return on Investment

Exercise 16.3 • Computing Return on Investment

You have been provided the following information:
Balance Sheet
Assets $1,000
Liabilities $ 900
Capital $ 100
Income Statement
Sales $2,000
Operating expenses $1,850
Interest
__$_____
90

Total expenses _$1,940

_ _____
Net income __ $ 60
_______
_____
Required:

1. Compute ROIa
2. Computer ROIe
3. What effect does the amount of debt relative to equity have on return on investment
(equity)?
What condition is necessary in order for the principle of leverage to increase the
rate of return.
4. What effect does the amount of debt relative to equity have on return on investment
(assets)?
 Management Accounting | 317

Problem 16.1 • Return on Investment

Case I
Assets Sales ($20 x 100) $2,000
Current $600 Variable cost ($12 x 100) $1,200
Fixed 400 $1,000 Fixed expenses 650
______ ___
_____
____ _______
Liabilities 1,850
Current $ 0 _______
Long term 100 $ 100 Net operating income 150
______
Interest 10
Capital
_______
Common stock 900
Net income $ 140
Retained earnings _______
_______
900 Interest rate = 10%
_ _____
$1,000

______
______

Required:

1. Based on the information presentation in Case I, compute the following:

Return on Investment (equity) Return on Investment (assets)
ROIe __________ ROIa __________
Profit margin % __________ Profit margin% __________
Investment turnover __________ Investment turnover __________
2. Assume that long term liabilities originally were $900 and that common stock was
$100.
Based on these changes, compute the following:
Return on Investments (equity) Return on Investment (assets)
Net income __________ Net operating income __________
ROI(e) __________ ROI(a) __________
Profit margin % __________ Profit margin % __________
Investment turnover __________ Investment turnover __________
Explain why there is a change in ROIe but not ROIa.

3. Assume that units sold are increased by 50%. Compute the following:
Return on Investments (equity) Return on Investment (assets)
Net income __________ Net operating income __________
ROIe __________ ROIa __________
Profit margin % __________ Profit margin % __________
Investment turnover __________ Investment turnover __________
Observations:______________________________________________________

_____________________________________________________________________
318 | CHAPTER SIXTEEN • Return on Investment

Case II

Assets Sales ($20 x 100) $2,000

Current $600
Fixed 400 $1,000 Variable cost ($12 x 100) 1,200

______ _______
_______
Fixed expenses 700
Liabilities _______
Current 0 1,900
_ ______
Long term 100 100
Net operating income 100
Capital
Interest 10
Common stock $900 _______
Retained earnings _$______
900 Net income $ 90
_______
_______

__$______
1,000
______

Based on the information in Case II, compute the following:

Return on Investments (equity) Return on Investment (assets)
Net income _________ Net operating income ________
ROIe _________ ROIa ________
Profit margin% _________ Profit margin % ________
Investment turnover _________ Investment turnover ________

Explain why there is no difference in ROIe and ROIa.

_____________________________________________________________________
_____________________________________________________________________
 Management Accounting | 319

Financial Statement Ratio Analysis

Financial statements as prepared by the accountant are documents containing

much valuable information. Some of the information requires little or no analysis to
understand. If the income statement show an operating loss, the seriousness of that
problem is fairly self evident. However, for the most, part some analysis is required
to fully understand the financial condition of a company. In this chapter, an important
tool of financial statement analysis will be presented, ratio analysis. Another financial
statement analysis tool, the statement of cash flow will be presented in the next
chapter.
Ratio Analysis of Financial Statements
There are three groups of individuals that have a keen interest in financial
statement analysis: (1) Investors are interested in financial statements to evaluate
current earnings and to predict future earnings. Financial statements influence
greatly the price at which stock is bought and sold. (2) Bankers before granting loans
usually require that financial statements be submitted. Whether or not a loan is made
depends heavily on a company’s financial condition and its prospects for the future.
(3) Perhaps the group that has the most interest in financial statement analysis is
management. Management needs to discover quickly any area of mismanagement
so that corrective action can be quickly taken. Also, financial statement analysis can
provide support that the past decisions made have been the right decisions.
Financial statements in addition to showing the results of operations also show
the effect of specific decisions. Each element of the financial statement as discussed
320 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis

in chapter 2 has one or more decisions underlying it. Financial statement analysis is
one approach to identifying and evaluating these decisions.
If profit is adequate or more than adequate, is it still necessary for management
to analyze the financial statements closely? The answer is yes. Even though profit
is satisfactory or excellent, this year’s set of decisions may have set in motion
forces which, unless counteracted, may have future disastrous consequences on
profit and survival success. Also, poor performance in just one area could eliminate
any future profit. Unless corrected, mismanagement in just one area will eventually
result in poor performance in other areas. In Figure 17.1, the consequences of poor
mismanagement is indicated:
Figure 17.1 • Consequence of Poor Decision-making
Business Function Nature of Mismanagement Possible Consequences in other
Functions
Production Inadequate capacity Marketing - loss of sales
Poor quality of material Marketing - loss of sales
Marketing Inadequate credit Production
Excessive prices Unused plant capacity
Inadequate advertising Unused plant capacity
Excess inventory
Finance
Funds shortage
Finance Excessive debt Finance - decreased ROI
Finance - poor credit
Marketing - loss of sales
Production - inadequate inventory;

The survival of the business in the long run requires a balanced and coordinated
effort in all business functions. Broadly speaking, it is management’s task to manage
the capital of the business; that is, the resources, (assets) and the sources of assets
(debt and equity capital). In general, there are five broad areas as indicated by
financial statements that must be managed: assets, liabilities, capital, revenue, and
expense.
What are the financial statement tools that are available to discover broad areas of
mismanagement that need corrective action? The major tools as typically presented
in books on financial statement analysis are:
1. Ratios analysis
2. Trend analysis
3. Common size statements
In this chapter, we are primarily concerned with ratio analysis. The ratios that
have been recognized to be of value or are following:
Income Statement Ratios
Operating ratio
 Management Accounting | 321

Profit margin percentage

Gross profit percentage
Balance Sheet Ratios
Current ratio
Debt/equity ratio
Inter statement ratios
Return on investment (assets)
Return on Investment (equity)
Investment turnover ratio
Inventory turnover
Accounts receivable turnover
Earnings per share
Price earnings ratio
Management should be concerned with good management and decision making
in every element of financial statements. For example, the appropriate use of ratios
is indicated in Figure 17.2

Figure 17.2 • Matching of Ratios and Decisions

Decision Area Where Specific Ratios May be Used

Areas of “Capital”: Management Ratios that may be used

ASSETS

Current assets Current ratio

Quick ratio
Inventory turnover
Fixed assets

LIABILITIES

Current liabilities Current ratio

Long term liabilities Debt/equity ratio

CAPITAL

Contributed capital Earnings per share

Book value per share
Price earnings ratio
Net income Return on investment (assets)
Return on investment (equity)
Profit margin percentage
Gross profit percentage

A ratio is a quotient of one magnitude divided by another of the same kind. It is

the relation of one amount to another. A ratio may be expressed in different ways. For
322 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis

example, if an a given organization the number of men and women are 80 and 20,
then respectively we could say:
Men are 80% of the organization (80/100)
Men are .8 of the organization
The ratio of men to women is 4:1
Men are 4/5ths of the organization
Concerning financial statements absolute values are often difficult to grasp and
remember. Amounts on financial statements in many cases are more meaningful when
compared with other amounts. For example, if the number of men in an organization
is 4,092 and the women are 1,023, it would be easier to say that men are 80% of the
organization (4,092/5,115) or that they out number the women 4 to 1.In some cases
ratios make predictions possible. Some ratios tend to remain constant from year to
year. If variable expenses have averaged 80% of sales and if we predict sales will be
$1,000,000 next year, then we are able to say that we expect variable expenses to
be $800,000.
Our objective now will be to define and discuss some of the more important
ratios.
Current ratio - The current ratio is:

Current assets
Current ratio = –––––––––––––––
Current liabilities
This ratio is almost always of critical importance. It provides an indicator of the
ability to pay short-term debt. In accounting, the different between current assets and
current liabilities is call working capital. If current liabilities exceed current assets,
then at that moment in time the company is not able to pay in full its current debts.
Inadequate working capital has been cited as one of the major reasons businesses
fail. That the ratio should be greater than 1 is universally agreed upon. But how much
greater than 1 remains the question. A general rule of thumb is that the ratio should
be at least 2:1. However, differences in industries and management decision-making
may require a considerably different standard ratio.
It is possible to approach the current ratio from two different viewpoints:
1. A banker’s viewpoint
2. A management viewpoint
From a banker’s viewpoint the higher the ratio the better the ratio. A high ratio
indicates a high degree of liquidity and a better ability to repay short term debt.
From a management point of view, the real issue is not the ratio itself but the
factors that create the ratio. Accountants tend to define working capital as current
assets less current liabilities. From a management’s viewpoint, the questions are:
(1) What are the decisions that directly affect current assets and (2) what are the
decisions that affect current liabilities?
Concerning current assets, the major elements are cash, accounts receivable,
and inventory. The decisions that affect current assets most directly were discussed
 Management Accounting | 323

in chapter 2. Accounts receivable are created by the use of credit terms and inventory
levels are largely determined by order size and safety stock decisions.
In most cases, the most important short term debt is accounts payable. The
amount of accounts payable is generally determined by the credit terms that supplier
offer. If a company, for example, purchases $1,200,000 in raw materials each year
and the creditor offers 30 days to pay, then the on the average we would expect
accounts payable to be $100,000.
A business that has a considerably higher current ratio than another company
is not necessarily in a better financial condition. To illustrate, let us assume the
following:
Company A Company B
Current Assets
Cash $  1,000 $20,000
Accounts receivable $  9,000 $15,000
Merchandise inventory $30,000 $  5,000
––––––– –––––––
Total $40,000 $40,000
––––––– –––––––
Current Liabilities
Accounts payable $15,000 $  5,000
Notes payable $  5,000 $25,000
––––––– –––––––
$20,000 $30,000
––––––– –––––––
Current ratio 2 1.33
Company A with the better current ratio is not superior to company B regarding
its ability to pay short term debt. For this reason, the quick ratio (cash + receivables /
current liabilities) is often regarded as a better measure to pay short term debt. In the
above example, the quick ratios are;
Company A Company B
Quick ratio .5 1.1667

Debt/Equity Ratio - The debt/equity ratios is:

Total debt
D/E ratio = –––––––––––
Total equity
The debt/equity ratio is an important ratio in that it provides a measure of the
risk assumed in a given business. As the amount of debt capital increases relative
to equity capital, the greater is the risk. The term “risk” here refers either to the risk
of not being able to repay principal or the ability to pay interest. Studies have shown
that a major factor for businesses failing or going into bankruptcy is because these
businesses assumed too much debt and have yet to earn a satisfactory profit or no
profit at all. Many start up businesses are undercapitalized meaning that the major
source of financing was short term debt.
A high debt/equity ratio can mean that when a company issues bonds, it may
have to pay a must higher interest rate. If stock is being issued, then the investors
324 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis

may require a higher rate of return and try to achieve this higher rate by offering to
buy at a much lower price per share. Also, a high debt/equity, it is believed by many
financial theorists, will increase a firm’s cost of capital. Consequently, the investors
will pay less for a share of common stock. It is in the interest of the company both
in the short run and long run to keep the relationship of debt to equity in balance
consistent with current profit performance.
As discussed in chapter 16, a company can increase its rate of return by employing
the principle of leveraging. However, this strategy should be employed cautiously, if
at all. Furthermore, the employment of this principle should be founded on a track
record of successfully profits.

Operating Ratio- The operating ratio is:

Total expenses
Operating ratio = ––––––––––––––
Sales
This ratio simply indicates what percentage of sales must be used to pay the
expenses. The ratio standing alone is probably of little value. There are two ways
this ratio can be made useful. First, the company should compare the operating ratio
to past ratios. In this manner, a possible trend can be detected. If the operating
expenses as a percentage of sales is increasing from year to year, then reasons for
the increases should be found. Secondly, the company should compare its operating
ratio to other companies in the industries. If other similar companies have a lower
ratio, then an investigation into the causes of the company’s higher ratio should be
undertaken.
Profit Margin Ratio - Profit margin is simply another term for net income. The
profit margin percentage is:
Net income
Profit margin % = ––––––––––––
Sales
This ratio was discussed in some depth in chapter 16. The duPont ROI formula
discussed in chapter 16 makes use of the ratio. The duPont ROI formulas is
basically:
Sales Earnings
ROI = –––––––––– x –––––––
Investment Sales
This ROI formulas may be read as investment turnover times profit margin
percentage. In the past, many companies looked upon the profit margin percentage
as a measure of operating success. However, some critics many years ago pointed
out a company with the higher profit margin percentage did not necessarily have the
higher rate of return. The weakness of the profit margin percentage standing alone is
that it fails to take into account the amount of investment that is necessary to achieve
a satisfactory rate of return.
Inventory turnover - There are a number of important inventory decisions as
discussed previously in chapter 2 and chapter 11. The periodic analysis of inventory
 Management Accounting | 325

is important. One of the tools that is commonly used is the inventory turnover ratio
which may be defined as follows:
Cost of goods sold
Inventory turnover = –––––––––––––––––
Average inventory
This ratio may be applied to either finished goods or raw materials.
As discussed in chapter 11, it is important to understand that cost of goods sold
is simply in the current period is the cost of finished goods sold. If the cost of one
unit of finished goods is $30.00 and 1,000 units are sold, then cost of goods sold is
$30,000, assuming no beginning inventory. This fixed relationship between inventory
and costs of goods sold makes possible for a meaningful inventory turnover ratio
to be computed. Assume for the moment that cost of goods sold was $360,000
and that average inventory is $30,000. Consequently, the inventory ratio is 12
($360,000/30,000). What does this turnover number mean?
First of all, if the company was open for business during the year for 360 days,
then this means that on the average sales at cost were $1,000 or $30,000 per month.
A turnover of 12 means it takes 30 days (one month) to sell $30,000 of finished
goods. A turnover ratio expressed in calendar days is easier to understand.
The following schedule shows the calendar days associated with different
inventory rates:
Inventory Turnover Calendar Days
1 360
2 180
4 90
6 60
9 40
12 30
One of the important questions is: what is the ideal turnover rate? In general, it
is believed the higher the turnover rate the better has been the control of inventory
by management. A rapid turnover of inventory is thought to be generally desirable.
However, a higher turnover rate is not always desirable. Inventory levels are primarily
determined by order size and the amount of safety stock. In terms of the affect on
profit, it might be better to have a lower turnover rate.
To illustrate, assume that the K. L. Widget Company may, if it chooses to do so,
purchase material as a discount if it purchases in larger quantities:
Order Size Price
1 - 10,000 $10.00
10,001 + $  6.00
For the moment, let us assume that material is the only cost and that 1 unit of
finished goods requires only 1 unit of material. Price of the product is $20 per unit
and the company produces and sells 20,000 units at this price.
Based on this information, we can prepare the following revenue and cost
comparisons:
326 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis

Material Cost -$10.00 Material Cost $6.00

(Number of orders - 5) (Number of orders - 2)
Sales (20,000 units) $400,000 Sales (20,000 units) $400,000
Cost of goods sold $200,000 Cost of goods sold $120,000
–––––––– ––––––––
Gross profit $200,000 Gross profit $280,000
–––
–––––––
–––––– ––––––––
––––––––
Average inventory $  20,000 Average inventory $  30,000
Inventory turnover 10 Inventory turnover 4

We see in this example that a lower turnover is far more profitable. However,
unless the additional carrying cost caused by the higher levels of inventory offsets
any advantage, the best decision is to take advantage of the quantity discount, even
though doing so lowers the inventory turnover.
Accounts Receivable Turnover-
Accounts receivable are generally considered a fairly liquid asset. They rank
number two behind cash which is obviously the most liquid of assets. However, if
accounts receivable are not paid on a timely basis or not collected at all, then they
can easily become an expense. Poor management of accounts receivable can quickly
become a signal that management is doing a poor job of running the business. It is
commonly believed that the accounts receivable turnover ratio is an indicator of how
well accounts receivable are being managed. The accounts receivable turnover ratio
is:
Credit sales
Accounts receivable turnover = –––––––––––––––––––––––––––
Average accounts receivable

The general belief is that this ratio measures the number of times that accounts
receivable are collected in a years times. However, this point of view is a bit difficult
to grasp. In fact, the collection of receivables is an ongoing process. In order to make
this ratio more understandable most writers then discuss how this turnover ratio can
be used to compute how long it would take to collect the accounts receivables in
days.
This procedure is based on this equation:
365
Number of days in A/R = –––––––––––––––––––––––––––––
Accounts receivable turnover
To Illustrate:
Assume that the average balance of accounts receivable was $100,000 and that
annual credit sales were reported as $1,200,000. The turnover ratio is therefore:
$1,200,000
A/RTO = ––––––––––––– = 12
100,000
The number of days in accounts receivable therefore is:
360*
Number of days = –––––– = 30
12
*A year of 360 days for used for convenience.
 Management Accounting | 327

The author, however, prefers another point of view regarding the meaning of this
ratio. The turnover ratio is an indicator of the credit terms the company is offering.
If credit terms are three months, then one would expect from the time the sale is
made to the time of payment that the amount due would be paid in full when 90
days have passed. A accounts receivable turnover of 12 should imply credit terms
of 1 month. As just demonstrated, it is fairly easy to convert the turnover to days.
The following schedule shows what credit terms may be associated with different
accounts receivable turnover ratios:

A/R turnover Ratios Days Credit terms

12 30 days 1 months
9 40 days 1 /4 months
1

6 60 days 2 months
3 120 days 4 months
2 180 days 6 months
1 360 days 2 months
If a company is offering standard credit terms of 2 months and the actual
turnover rate is 5 then this means that some customers are lagging behind in making
payments. A turnover rate of 6, given that credit terms are 2 months, means that on
the average customers are making payments in time. Without a recognition of the
credit terms and a comparison to these credit terms, the accounts receivable ratio
has little value.
To fully understand the accounts receivable ratio, it is necessary to understand
how different types of credit affect the ratio. Two types of credit will be briefly
considered here:
1. Standard credit
2. Installment credit
Standard credit is simply the granting of a deferred period of time for payment
and at the end of this time the full amount of the purchase price is due. In business,
this type of credit typically ranges from 30 days to a year. A common practice is to
grant terms of 2/10;n/30. This means that payment within 10 days receives a 2%
discount or if the discount is not taken, then the full amount is due within 30 days. As
given above, credit terms of 30 days should create an accounts receivable turnover
of 12.
In today’s modern retail economy, the type of credit that is frequently used is
called installment credit. In this type of credit, the customer is required to make
monthly payments of equal amounts until the balance is paid in full. Installment credit
has a different affect on the accounts receivable turnover from standard credit.
To illustrate the effect of installment credit, assume that we have two companies
that are identical except that company A offers 3 months of standard credit and
company B offers installment credit. Monthly sales of both companies are $3,600.
In Figure 3 is show the corresponding days in inventory for credit terms of 3, 6, 9
and 12.
328 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis

Figure 17-3 Comparison of Standard Credit and Revolving Credit

Company A Company B
(Standard Credit) (Installment Credit)
monthly sales - $3,600

Credit Maximum A/R TO Days Credit Maximum A/R TO Days

Terms A/R Terms A/R
(months) Balance (months) Balance

3 $10,800 4.00 90 3 $  9,000 4.8 75

6 $21,600 2.00 180 6 $12,600 3.42 105

9 $32,400 1.23 270 9 $18,000 2.40 150

12 $43,200 1.00 360 12 $23,400 1.846 195

In this example, the use of installment credit increases the accounts receivable
turnover. In other words, the average balance is less and the balance is collected on
the average sooner. This is true even though monthly sales are the same and the
length of time to pay the full amount of purchase is the same.
The question is whether the traditional interpretation of the accounts receivable
turnover ratio is valid concerning installment credit. In the above example, company
B’s accounts receivable turnover was 4.8 indicating a turnover every 2.5 months (75
days). However, in fact, the full length of time to collect a sale is 3 months. Since
payments are being made each month, the average balance of accounts receivable
will be lower than under standard credit terms. In addition, the above example did
not take into account an interest charge that is usually added to the account balance
each month on the unpaid balance. In this event, the addition of interest would cause
the principal payments to be smaller in the early payments and greater with the latter
payments.
The value of measuring accounts receivable turnover is not in examining just
the ratio of one operating period, but in comparing the current turnover ratio to prior
ratios. If the ratio is getting smaller, this may mean that the customers are not making
regular payments or are skipping some payments.
Other Ratios
In a corporation, one of the objectives of management is to increase the value
of the stockholder’s stock. Two ratios are commonly used to provide a gauge of
performance regarding common stock:
1. Price earnings ratio
2. Earnings per share
The price earnings ratio is:
Market value of stock
Price earnings ratio = –––––––––––––––––––
Net income per share
 Management Accounting | 329

The earnings per share ratio is

Net income
Earnings per share = –––––––––––––––––––––––––––––––––
Shares of commons stock outstanding

The larger these ratios the more favorable will the stockholders approve of the
current management.
Summary
The use of ratios to evaluate operating and financial performance is important
and is a universally used practice. While the use of ratios may highlight problems
in certain performance areas, they are not able to actually provide solutions or
suggest what decisions should be made to correct the problem or problems. If the
problem appears to be a low inventory turnover rate, one approach might be to look
at inventory models. As with other tools, the use of a particular tool might have to be
supplemented with the use of other tools.
The ratios discussed in this chapter having relevance to evaluating operating
performance were the following:
Income Statement Ratios
Operating ratio
Profit margin percentage
Gross profit percentage
Balance Sheet Ratios
Current ratio
Debt/equity ratio
Inter statement ratios
Return on investment (assets)
Return on Investment (equity)
Investment turnover ratio
Inventory turnover
Accounts receivable turnover
Earnings per share
Price earnings ratio
The prerequisite to understanding these ratios is a solid understanding of the
nature and purpose of financial statements.

Q.17-1 List some ratios that are strictly income statement ratios.
Q. 17-2 List some ratios that are strictly balance sheet ratios.
Q. 17-3 List some ratios that are inter-statement ratios.
Q 17-4 The accounts receivable turnover ratio for the Ajax Manufacturing
Company was determined to be 6. What does a turnover of 6 mean?
330 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis

Q. 17-5 The inventory turnover ratio of the Ajax Manufacturing Company was
determined to be 4. What does a turnover of 4 mean?
Q. 17-6 If a company has a current ratio of less than one, what kinds of problems
are suggested by this extremely low ratio:
Q. 17-7 How is working capital defined in accounting?
Q. 17-8 What financial problems are suggested by a high debt/equity ratio?
Q. 17-9 The Ajax manufacturing company earned $1,000,000 last year. Should
management be content with earnings of this amount? What ratio
would you suggest be used to determine if this amount of income is
satisfactory?
Q. 17-10 The management of the Ajax Manufacturing Company realizes it is over
stocked in finished goods inventory. What ratio would reveal this fact?
Q. 17-11 The management of the Ajax Manufacturing Company realizes that it
has a problem collecting accounts receivable. Customers for the most
part are paying but typically they have been paying a month late. What
ratio would reveal this fact?
Q.17-12 The management of the Ajax Manufacturing Company is concerned that
the market value of its stock has declined in the past several months.
What ratios might indicate why this has happened?

Exercise 17.1 • Ratio Analysis

You have been provided the following comparative balance sheet and income
statement.
K. L. Widget Company
Income Statement
For the Year Ended, December 31, 2008

Sales $150,000
Expenses
Cost of goods sold $ 80,000
Operating expenses 30,000
Interest 8,000
Income tax 13,000
––––––––
Total expenses $131,000
–––––––––
Net operating income $  19,000
–––––––––
Other Income:
Gain on sale of equipment 10,000
–––––––––
Net income $29,000
–––––––––
Note: All sales were made on credit.
 Management Accounting | 331

K. L. Widget Company
Balance Sheet
Dec. 31, 2008 Dec. 31, 2007
Assets
Current
Cash $  95,000 $  78,000
Accounts receivable 60,000 82,000
Finished goods 25,000 50,000
Materials inventory 110,000 80,000
––––––––– –––––––––
Total current assets $290,000 $290,000
––––––––– –––––––––
Plant and Equipment
Plant and equipment $100,000 95,000
Allowance for deprecation 20.000 18.000
––––––––– –––––––––
Total plant and equipment $80,000 $  77,000
––––––––– –––––––––
Total assets $370,000 $367,000
––––––––– –––––––––
Liabilities
Current
Accounts payable $150,000 $  60,000
Notes payable 20,000 30,000
Taxes payable 8,000 13,000
––––––––– –––––––––
Total current $  78,000 $103,000
Long term:
Bonds payable $150,000 $  90,000
––––––––– –––––––––
Total Liabilities $250,000 $190,000
Stockholders’ Equity
Common stock $100,000 $120,000
Retained earnings 12,000 44,000
––––––––– –––––––––
$112,000 $164,000
––––––––– –––––––––
Total liabilities and stockholders’ equity $370,000 $367,000
––––––––– –––––––––
The company common stock has a market value per share of $20.
The company has 10,000 shares of stock outstanding.
Required
Based on the above financial statements, compute the following ratios for the year
2008:
1. Profit margin percentage
2. Operating ratio
3. Return on investment (assets)
4. Current ratio
332 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis

5. Debt/equity ratio
6. Accounts receivable turnover
7. Finished goods inventory turnover
8. Earnings per share
9. Price earnings ratio
Exercise 17.2
As one of the accountants for the K. L. Widget Company, you have you been
provided the following comparative financial statements. You have been asked to
computer various ratios based on these statements.

K. L. Widget Company
Income Statement
For the Year Ended, December 31, 2008

Sales $200,000
Expenses
Cost of goods sold $90,000
Operating expenses 35,000
Interest 13,000
Income tax 15,000
––––––––

Total expenses $153,000

–––––––––

Net operating income $ 47,000

Other Income/expenses
Loss on sale of equipment 8,000
–––––––––
Net income $39,000
–––––––––
Note: All sales were made on credit.
K. L. Widget Company
Balance Sheet

Dec. 31, 2008 Dec. 31, 2007

Assets
Current
Cash $100,000 $  82,000
Accounts receivable 80,000 92,000
Finished goods 51,000 40,000
Materials inventory 90,000 100,000
––––––––– ––––––––
Total current assets $321,000 $314,000
––––––––– ––––––––
Plant and Equipment
Plant and equipment $150,000 125,000
Allowance for deprecation 30.000 25,000
––––––––– ––––––––
 Management Accounting | 333

Total plant and equipment $180,000 $150,000

––––––––– ––––––––
Total assets $501,000 $464,000
––––––––– ––––––––
Liabilities
Current
Accounts payable $160,000 $100,000
Notes payable 20,000 50,000
Taxes payable 15,000 13,000
––––––––– ––––––––
Total current $195,000 $163,000
Long term:
Bonds payable $180,000 $100,000
––––––––– ––––––––
Total Liabilities $375,000 $263,000
Stockholders’ Equity
Common stock $100,000 $90,000
Retained earnings 26,000 11,000
––––––––– ––––––––
$126,000 $101,000
––––––––– ––––––––
Total liabilities and stockholders’ equity $501,000 $464,000
––––––––– ––––––––
The company common stock has a market value per share of $5.
The company had 10,000 shares of stock outstanding in 2007 and
11,000 shares in 2008.
Required:

Based on the above financial statements, compute the following ratios for the year
2008:

1. Profit margin percentage

2. Operating ratio
3. Return on investment (assets)
4. Current ratio
5. Debt/equity ratio
6. Accounts receivable turnover
7. Finished goods inventory turnover
8. Earnings per share
9. Price earnings ratio
334 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis

Exercise 17.3
The Ace Manufacturing Company has since its beginning experienced considerable
financial problems. Following is the company’s last two balance sheets and income
statements.
Based on these statements identify the various problems the company has
experienced by computing various ratios.
Ace Manufacturing Company
Balance Sheets
Dec. 31, 2007 Dec. 31, 2008
Assets
Cash $30,000 $  15,000
Accounts receivable 100,000 120,000
Merchandise inventory 40,000 100,000
Store building 500,000 500,000
Accumulated depreciation (20,000) (40,000)
Furniture and Fixtures 100,000 100,000
Accumulated depreciation (5,000) (10,000)
________ ________
Total assets $745,000 $785,000
________ ________
Liabilities
Accounts payable $80,000 $150,000
Notes payable (6 month note) 50,000 75,000
Bonds payable 200,000 200,000
Note payable (10 year note) 150,000 250,000
________ ________
Accrued taxes payable
Total liabilities 480,000 675,000
________ ________
Stockholders’ Equity
Common stock 300,000 300,000
Retained earnings (35,000) (190,000)
________ ________
Total liabilities & Equity 265,000 110,000
________ ________
$745,000 $785,000
________ ________
Ace Manufacturing Company
Income Statements

2007 2008
–––––––––– ––––––––––
Sales $1,001,000 $  900,000
Cost of goods sold 400,000 390,000
–––––––––– ––––––––––
 Management Accounting | 335

Gross margin $  601,000 $  510,000

–––––––––– ––––––––––
Operating expenses
Selling expenses 450,000 300,000
General and administrative 200,000 315,000
–––––––––– ––––––––––
$  650,000 $  615,000
–––––––––– ––––––––––
Net operating income/(loss) ($  49,000) ($105,000)
Income tax expense -0- -0-
Interest $   38,000 $  50,000
–––––––––– ––––––––––
Net income/(loss) ($  77,000) ($155,000)
–––––––––– ––––––––––
336 | CHAPTER SEVENTEEN • Financial Statement Ratio Analysis
 Management Accounting | 337

Statement of Cash Flow

Cash is obviously an important asset to all, both individually and in business.

A shortage or lack of cash may mean an inability to purchase needed inventory
or equipment or to pay debt. A sustained period of a cash shortage can result in
bankruptcy. Cash, unlike some assets such and plant and equipment, is not an
unchanging asset in the short run. Rather it is an asset that is constantly changing
on a daily basis. Cash is subject to an inflow and an outflow. The balance of cash
rises and cash falls with changes in the rates of inflow and outflow. The management
of cash is critical and the amount of cash is affected directly by many different
management decisions.
Nature and Purpose of the Statement of Cash Flow Statement
For many years accountants tended to downplay the importance of cash flow. It
is only recently that a statement of cash flow has been required. In 1987, the FASB
issued FAS 95 and in that release the statement of cash flow was made mandatory.
Prior to this, a Statement of Changes in Financial Position was recommended in
APB opinion 19 (although not absolutely mandated) This statement was oriented to
explaining changes in working capital rather than cash flow. However in the decade
338 | CHAPTER EIGHTEEN • Statement of Cash Flow

prior to the 1980s, many financial analysts began to argue that periodic cash flow
was more useful than the measurement of net income in making many investment
decisions. It was argued rather fervently by some financial analysts and theorists
that depreciation was a source of funds. Accountants just as fervently argued that
depreciation was never a source of funds. However, financial analysts adopted the
practice of approximating cash flow by adding back to net income depreciation and
other non cash amortized items. Consequently, the formula, NCF = net income +
depreciation, was frequently seen in finance articles and finance textbooks.
The management of cash flow is a critical function of management. In this regard,
it also important for the accountant to provide timely information about cash flow. The
information required for the cash flow statement can be found in the cash account;
however, in practice the cash account is not actually the direct source of information
used to prepare the statement of cash flow. The source is actually the current income
statement plus a comparative balance sheet as of the end of the current year.
However, in order to understand how the statement is prepared, some discussion
of the cash account is required. It is helpful to understand what transactions directly
increase or decrease cash.
The items listed below are some of the main categories of business transactions
that affect cash flow.
Cash

Debit Credit

Sales Purchases
Sale of property Operating Expenses
Receipt of dividends Purchase of materials
Issue of stock Purchase of property
Issue of bonds Payment of dividends
Issue of stock Payment of expenses
Receipt of interest income Purchase of investments
Purchase of treasury stock
Retirement of bonds
Purchase of treasury stock
Payment of interest

The technical aspects of preparing a statement of cash flow can be quite complex
and initially rather intimidating. A variety of methods and work sheet techniques can
be found that suggest how to prepare the cash flow statement. The purpose here
is not to make you an expert in preparing the statement, but rather the purpose is to
help the you as a student understand the issues and problems involved in preparing
the statement. There are two methods used to prepare the statement. Depending on
which method is used, the appearance of the statement can be quite different. These
two methods are commonly called the:
a. Direct method
b. Indirect method.
Figure 18.1
Statement of Cash Flow (Direct Method) Statement of Cash Flow (Indirect Method)

Cash flow from operating activities Cash flow from operating activities
Sources: Net income: $42,000
Cash Sales and collections of A/R $128,000 Adjustments to net income:
Add:
Uses:
Decrease in materials inventory $30,000
Cost of goods sold 165,000
Depreciation 25,000
Cash operating expenses 24,000
Deduct:
Interest expense 8,000
Decrease in accounts payable 90,000
–––––––
Increase in finished goods 25,000
Net cash flow from operations ($69,000)
Gain on sale of equipment 10,000
Cash flow from financing activities Increase in accounts receivable 22,000
Sources: $20,000 ––––––– ($111,000)
–––––––––
Sale of bonds 10,000 Net cash flow from operating activities ($69,000)
Loan from bank 20,000
Cash flow from financing activities
Issue of stock
Sources:
Uses: 5,000
Sale of bonds
Payment of dividends –––––––
Loan from bank
Net cash flow from financing activities $45,000 Issue of stock $20,000
Uses: 10,000
Cash flow from investing activities Payment of dividends 20,000
Sources: 32,000
Net cash flow from financing activities 5,000
Sale of plant equipment
Cash flow from investing activities –––––––- $45,000
Uses: 25,000
Sources:
Purchase of plant equipment –––––––
Sale of plant equipment $32,000
Net cash flow from investing activities $  7,000 Uses:
––––––– Purchase of plant equipment 25,000
Decrease in cash ($17,000) –––––––-
Net cash flow from investing activities $ 7,000
Beginning cash balance 95,000 –––––––-
–––––––- Decrease in cash ($17,000)
Ending cash balance $78,000 Beginning cash balance 95,000
–––––––-
–––––––- –––––––-
Ending cash balance $78,000
Management Accounting

–––––––-
–––––––-
| 339
340 | CHAPTER EIGHTEEN • Statement of Cash Flow

Figure 18.1 shows both of these methods. Before commenting on the similarities
and differences in these two formats, the purpose and nature of the statement needs
to be discussed first. The FASB in promulgating standards and guidelines required
that cash flow transactions and events be categorized under three headings:
1. Cash flow from operating activities
2. Cash flow from financing activities
3. Cash flow from investing activities
In this regard, the two cash flow statements in Figure 18.1 are exactly the same.
The major difference is then in how cash flow from operating activities are determined
and shown. The amount of cash flow from operating activities is exactly the same;
however, the methodology and format are quite different.
The objective of the statement of cash flow is to show the three types of activities
on a pure cash basis. However, the income statement, which is a major source of
cash flow information, is prepared on an accrual basis. Logically, cash flow from
operations should be:
Change in cash = Cash revenue less cash expenses.
The problem is that the income statement which is based on accrual basis
accounting principles includes non cash revenues and expenses. However, given
a comparative balance sheet, the cash revenues and cash expenses can be fairly
accurately determined. By analyzing the changes in the accounts that are most
directly affected by accrual basis accounting, cash revenue and cash expenses can
be determined.
The accounts directly affected by accrual basis accounting are:
1. Sales
2. Purchases
3. Operating expenses
4. Accounts receivables
5. Accounts payable
6. Prepaid expenses
7. Accrued liabilities such as accrued wages payable
8. Accrued assets such as accrued interest receivable
In the indirect method, the starting point for cash flow from operating activities
is net income. Even though net income is not the correct measure of net cash flow,
it has been found that it is much easier to start with net income and then make
certain necessary adjustments for items that did not affect net income but that cause
change in cash flow. By carefully measuring the changes in these current asset and
current liability accounts, the proper adjustments can be made to sales, purchases,
and operating expenses
Figure 18.2 are shown some selected accrual basis individual transactions that
require adjustment. How these items are recorded under accrual basis accounting
and cash basis accounting is shown, and then the adjustment required to convert the
 Figure 18.2

Transactions Accrual basis Entry Cash Basis Entry Adjustments(Converting accrual basis
to cash basis)

1. Sales for the Cash $80,000 Cash $80,000 Direct Method:

year in the amount Accounts receivable $20,000 Sales $80,000 Sales $ 100,000
of $100,000 is Sales $100,000 Less: Increase in A/R 20,000
–––––––––
recorded. Of this
Cash sales $ 80,000
amount on 80%
was collected. Indirect Method:
Net income $ 100,000
Less: Increase in A/R $ 20,000
–––––––––
Cash flow -oper. Activities $80,000

2. The company Materials inventory $12,000 Materials expense $60,000 Direct Method:
purchased Finished goods $48,000 Cash $60,000 Cost of goods sold 0
$60,000 of raw Cash $60,000 Deduct: Increase in Mat. $12,000
material. Of this Deduct Increase in FG $48,000
–––––––––
amount only Note: Material purchased will be in the course of
Cash paid for materials ($60,000)
80% was used in a period be:
current production. 1. Not used Indirect Method:
Assume no sales 2. Become part of finished goods Net income 0
were made. 3. Become part of cost of goods sold Deduct: increase in Mat $12,000
Deduct: Increase in FG $48,000
–––––––––
Cash flow-oper. Activities ($60,000)
Management Accounting
| 341
3 The company Materials inventory $60,000 Materials expense $45,000 Direct method:
purchased Cash $45,000 Cash $45,000 Cost of good sold ($36,000)
$60,000 in Accounts payable $15,000 Add: Increase in A/P $15,000
materials. Only Deduct: increase in mat. $24,000
–––––––––
75% was paid in Cost of goods sold $36,000
Cash expended for mat. ($45,000)
cash. Sixty per Material inventory $36,000
Indirect method:
cent was used
Net loss ($36,000)
and sold as part of
Add: increase in A/P $15,000
production.
Deduct: incr. In Material $24,000
–––––––––
Cash flow-oper. Activities ($45,000)

4. The company Materials inventory $60,000 Materials expense $45,000 Direct Method:
purchased Cash $45,000 Cash $45,000 Cost of goods sold 0
$60,000 in Accounts payable $15,000 Deduct: Increase in Mat. $12,000
materials. Only Deduct Increase in FG $48,000

75% was paid Finished goods 48,000
342 | CHAPTER EIGHTEEN • Statement of Cash Flow

$60,000
in cash. Of the Material inventory $48,000 Add: increase in A/P $15.000
60,000 only –––––––––
80% was used Cash expended for material ($45,000)
in production. Indirect Method:
Assume none was Net income 0
sold. Deduct: increase in Mat $12,000
Deduct: Increase in FG $48,000

($60,000)
Add: increase inA/P $15,000
–––––––––
Cash flow-oper. Activities ($45,000)
5. Depreciation Operating expenses $10,000 No entry Direct method:
in the amount Allow. for depreciation $10,000 Operating expenses ($ 10,000)
of $10,000 was Less: depreciation ( $10,000)
–––––––––
recorded
Cash operating exp. 0
Indirect method:
Net loss ($10,000)
Deduct depreciation ($10,000)
–––––––––
Cash flow -oper. Activities 0

6. Plant and Cash $12,000 Cash $12,000 Direct Method

equipment which Pant and equipment $10,000 Cash–sale of P&E $12,000 Other income $2,000
had a book Value Gain on sale $ 2,000 Deduct: gain on sale $2,000
–––––––––
of $12,000 was
Cash flow-oper activities 0
sold for $12,000.
Indirect Method:
Net income $2,000
Deduct: gain on sale $2,000
–––––––––
Cash flow -oper. Activities 0

Cash from sale would in the amount of

$12,000 be shown as a source in the
cash flow from investing section for both
methods.
Management Accounting
| 343
344 | CHAPTER EIGHTEEN • Statement of Cash Flow

accrual basis recording to a cash basis is illustrated. Each transaction is presented

as a stand alone transaction, and net income for illustrative purposes is computed as
though that was the only transaction is the accounting period.
Regarding the transactions in Figure 18.2:

1: Under the direct method, there is a need to adjust the sales account to a cash
basis.
Sales is overstated by $20,000 in terms of cash collected because not all
sales were collected immediately.
Under the indirect method, net income is overstated in terms of cash flow. A
deduction from net income in the amount of $20,000 for the increase in accounts
receivable is required.

2. In the direct method, cost of goods sold which is zero in this example under-
states the amount of cash expended for materials. The adjustment required
is to deduct the increase in materials from cost of goods sold and also de-
duct the $48,000 increase in finished goods.
Under the indirect method, the zero amount of net income is not the correct
measure of cash expended during the period. The required adjustment is
to deduct from the zero net income the amount of increase in materials
and finished goods inventory

3. The material expenditure of $60,000 for materials under accrual basis account-
ing is 60% used and sold and 40% not used. Cost of goods sold in the
amount of $36,000 does not accurately represent the cash actually ex-
pended for materials. The end result is a $24,000 increase in materials
and a $15,000 increase in accounts payable. The required adjustment then
under the direct method is to deduct from cost of goods sold $24,000 for
the increase in materials inventory and to add $15,000 for the increase in
accounts payable.
Under the indirect method, net income would actually be a loss of $36,000.
The required adjustment is to deduct the $24,000 increase in materials
inventory to cost of goods sold and to add the $15,000 increase in accounts
payable to cost of goods sold.

4. Under direct costing, the item that requires adjustment is cost of goods sold.
However, since in this stand alone example, it was assumed that no sales
were made, the cost of goods sold amount is zero. This item, however,
still needs adjusting. The $12,000 increase in materials inventory and the
$48,000 increase in finished goods should be deducted. In addition, the
increase of $15,000 in accounts payable needs to be added. The net result
is then that the total payment to suppliers of material is $45,000.
Under the indirect method, the net income which is zero should be adjusted
The increases in materials inventory and finished goods inventory which
total $60,000 should be deducted and the increase in accounts payable
should be added.
 Management Accounting | 345

5. Under the direct method, the operating expense category needs to be adjusted
since it contains charges for depreciation under accrual basis accounting.
The adjustment is simply to deduct the amount of depreciation from the
amount total operating expenses. Since we are assuming the deprecia-
tion is the only transaction for the period, operating expenses would be
$10,000. After the adjustment, it would be zero.
Under the indirect method, net income would actually be a loss of $10,000.
Adding back depreciation to the net loss then the cash flow for the period
is zero.

6. In this investing transaction the amount of cash inflowing is $12,000 and is

required to be shown as a source of funds in the Cash Flow from Investing
Activities and not the operating activities section. Since the gain on loss
appears as part of net income, the gain needs to be deducted in both the
direct method and the indirect method as illustrated. The gain is actually
reflected in the $12,000 sales price. Of the $12,000, $10,000 is actually a
recovery of the cost of the old asset and $2,000 is a gain. To not deduct the
gain in the operating activities section would be tantamount to showing the
gain twice.
Indirect Method for computing Cash Flow from Operations
The indirect method is the generally used method to prepare the cash flow
statement. The starting value in this method is net income. While net income could
be the correct measure of the increase in cash flow from operating activities, this is
highly unlikely for the following reason: Accrual basis accounting requires that many
types of revenues and expenses to be recorded, even though no cash has yet been
received or paid. Accrual based entries affect the following accounts:
Depreciation Materials inventory
Accounts receivable Accrued wages payable
Accounts payable Accrued interest payable
Prepaid expenses Accrued interest receivable
Figure 18.3 identifies the net income adjustments required when various accrued
items increase or decrease.
Classification of Transactions:
The FASB chose to place all transactions that affect cash into three categories,
as previously mentioned. While for the most part the classification scheme is logical,
there are several areas of difficulty. Interest paid on debt is clearly a type of financing
activity; however, interest paid is shown as an operating activity. The reason is that
interest paid is an expense and directly affects net income. Obviously, the expense
can not be shown in two different categories. Consequently, the Board chose to let the
item remain an operating activity. Also, it appears at first rather strange that dividend
income is treated as an operating activity item while dividends paid is a financing
activity item. Figure 18.4 shows how various transactions are categorized:
346 | CHAPTER EIGHTEEN • Statement of Cash Flow

Figure 18.3

Indirect method: Required Adjustments

Add to Net Deduct from

Net Income Adjustment Items
Income Net Income
Increases:
1. Increase in accounts receivable -
2. Increase in materials -
3. Increase in finished goods -
4. Increase in prepaid expenses -
5. Increase in accounts payable +
6. Increase in accrued expenses (e.g.,wages) +
Decreases:
7. Decrease in accounts receivable
8. Decrease in materials +
9. Decrease in finished goods +
10. Decrease in prepaid expenses +
11. Decrease in accounts payable +
12. Decrease in Accrued expenses (e.g. wages)
Non Cash Expenses and Revenues:
13. Depreciation -
14. Loss on sale of fixed asset + -
15. Gain on sale of fixed asset +

-
Figure 18.4
Operating transactions
Revenue from sales
Operating expenses
Dividend income
Interest expense
Financing transactions
Issue of stock
Issue of bonds
Bank loans
Purchase of treasury stock
Retirement of bonds
Payment of dividends
Investing transactions
Purchase of stock in other companies
Purchase of bonds
Purchase of plant and equipment
Sale of plant and equipment
 Management Accounting | 347

Preparing the Statement of Cash Flow

Various procedures and work sheets methods have been proposed to make the
preparation of the statement an orderly process. These worksheets vary in complexity
and in nature. In this chapter, a simple work sheet is shown in Figure 18.5.The primary
objective here is not to teach the mechanics of work sheet preparation, but rather
give an understanding of the procedure.

Step 1 The first step is have the a copy of income statement and a compara-
tive balance sheet at hand. If a work sheet approach is desired, then
the comparative balance sheet data should be copied onto a work sheet
having at least 6 columns. The first two columns should contain the bal-
ance sheet data.
Step 2 The difference in the first two columns should be determined and copied
into the third column. It is these differences that are used to make the
necessary adjustments to net income or income statement items.
Step 3 Regarding the plant and equipment account, the examination of the ac-
count itself and other sources, the major transactions affecting this ac-
count should be identified. The difference between the 2008 plant and
equipment amount and the 2007 plant and equipment amount may be
a $5,000 decrease. However, this difference does not reveal the cause
of the decrease. Similarly, the retained earnings account should be ex-
amined for entries other than net income such as dividends paid or other
special transaction credited or debited to this account.
Step 4 Given the changes in balance sheet items and a list of important events
not directly revealed on the balance sheet, the statement of cash flow
may be prepared. A complete work sheet is not necessary but many
might find it helpful. However, since this chapter is primarily concerned
with understanding the statement rather than preparing the statement,
preparing the statement of cash flow from a total work sheet approach
will not be illustrated. Those students who understand the nature and
purpose of adjustments to net income should not have any difficulty in
preparing the cash flow statement without a total work sheet.
What Does the Statement of Cash Flow Reveal?
The statement of cash flow obviously explains what events caused changes in
the cash account. But the question then is: knowing why changes took place, how
does that help management to make decisions or evaluate current performance?
Two reasons here will be suggested:

1. The cash flow statement reveals how much cash came from financing activi-
ties. These activities affect the debt/equity ratio discussed in the previous
chapter. A major concern might be: Is management placing too much reli-
ance on debt capital to grow or to survive when net income is not ad-
equate?
2. The ideal form of financing a business is from internal sources. If cash flow
348 | CHAPTER EIGHTEEN • Statement of Cash Flow

from financing activities greatly exceed cash flow from operations, then
one needs to ask the question: ”Why?”
The statement of cash flow is more of a reflection of what management has done
or been doing. As a tool for making future decisions, this statement has limited value.
However, for external parties such as investors who buy the company’s stock, the
statement may be valuable in determining the direction in which current management
is taking the company.
Summary
The statement of cash flow is not that difficult to understand in most respects.
However, in terms of preparing the statement, particularly the section dealing
with cash flow from operating activities, a solid understanding of basic accounting
fundamentals and an excellent ability to think out the consequences of various
transactions from both a cash basis and an accrual basis is required. The students
who struggle to understand how to prepare the cash flow statement most likely need
a better understanding of basic accounting fundamentals. From a management
decision-making or performance evaluation viewpoint, there is very little, if any, need
to be able to prepare the statement. But on the other hand some understanding of
how accrual basis accounting works and makes the net income statement initially an
unreliable measure of net cash flow is essential.
Based on the work sheet in figure 18.6, the following statement of cash flow
maybe prepared.
Figure 18.5
Statement of Cash Flow Work Sheet
Comparative Balance Use/ Class
Sheets Source
2008 2007 Difference

Assets
Current
Cash 80,000 95,000 -15,000
Accounts receivable 82,000 60,000 +22,000 U Operating
Finished goods 50,000 25,000 +25,000 U Operating
Materials inventory 80,000 110,000 -30,000 S Operating
Fixed Assets
Plant and equipment 95,000 100,000 -5,000 S Investing
Total assets 367,000 370,000
Liabilities
Current:
Accounts payable 60,000 150,000 -90,000 U Operating
 Management Accounting | 349

Notes payable 30,000 20,000 +10,000 S Financing

Long term
Bonds payable 100,000 80,000 +20,000 S Financing.
Total liabilities 190,000 250,000
Stockholders’ Equity
Common stock 120,000 100,000 +20,000 S Financing.
Retained earnings 52,000 20,000 +32,000 S/U Operating/
Financing
Total equity 177,000 120,000
Total liabilities and equity 367,000 370,000
Note: In this example, net income was $42,000 for the year 2008. Cash dividend paid was $5,000.

Q. 18.1 What basic information does the statement of cash flow provide that is
not found on a balance sheet or income statement?
Q. 18.2. What are the activity categories that the statement of cash flow uses to
classify cash events?
Q. 18.3 What two methods are used to determine cash flow from operating
activities?
Q. 18.4 Why does accrual basis accounting make net income initially an
inaccurate measurement of cash flow from operations?
Q. 18.5 Regarding increases in current asset accounts, what adjustment must
be made to net income, assuming the use of the indirect method?
Q. 18.6 Regarding increases in current liability accounts, what adjustments must
be made to net income, assuming the use of the indirect method?
Q. 18.7 If the notes payable account increases, is an adjustment required to net
income? If yes, why? If not, why?
Q. 18.8 Regarding decreases in current asset accounts, what adjustments must
be made to net income?
Q. 18.9 Regarding decreases in current liability accounts, what adjustments
must be made to net income.
Q. 18.10 Why is depreciation added back to net income in determining cash flow
from operating activities?
Q. 18.11 Why is a gain on the sale of equipment or other assets subtracted from
net income?
Q. 18.12 In what activity category is dividends declared and paid shown?
Q. 18.13 Equipment which has a book value of $50,000 is sold for $55,000. How
350 | CHAPTER EIGHTEEN • Statement of Cash Flow

much is shown in the cash flow from investment activities? How much
is subtracted from net income in the cash flow from operating activities
section?
Q.18.14 When all the transactions and events that affect cash flow have been
accounted for, what on the latest balance sheet serves as a check
figure?

Exercise 18.1 • Classification of Cash Flow Transactions

Indicate by check mark ( 4 ) the classification each transaction would directly

affect:
Classification of Cash Flow Transactions
Cash Flow
Cash Flow
Transaction from Cash Flow from
from Investing
Operating Financing Activities
Activities
Activities

1. Common stock was issued

2. Merchandise inventory was sold

3. Plant property was sold

4. Bonds were issued

5. Land for business was

purchased

6. Cash dividends were received

7. Cash dividends were paid

8. Treasury stock was purchased

9. Marketable securities were

purchased

10. Paid a loan that came due

11. A loan was obtained from a bank

12. A loan to a customer was made

13. Paid employees salaries and

wages

14. Marketable securities were sold

15 Paid interest that was due on a

bank loan.

16. Equipment was sold at a loss

 Management Accounting | 351

Exercise 18.2 • Determining net cash Flow from Operating Activities (indirect
method)

For the following item current asset current liabilities changes indicate by
( 4 ) whether the item should be deducted or added to net income.

Changes in Current Assets

Item Add Deduct

Increase in accounts receivable

Decrease in finished goods

Increase in materials inventory

Decrease in accounts receivable

Decrease in materials inventory

Increase in finished goods

Changes in Current Liabilities

Item Add Deduct

Increase in accounts payable

Decrease in accrued wages payable

Decrease in accrued interest payable

Decrease in accounts payable

Increase in accrued wages payable

Increase in income taxes payable

Increase in accrued interest payable

352 | CHAPTER EIGHTEEN • Statement of Cash Flow

Exercise 18.3
You have been provided the following information:
K. L. Widget Company
Comparative Balance Sheets
2008 2007 Change

Assets
Cash $  69,000 $  12,500
Accounts receivable 21,000 26,000
Prepaid expenses 4,100 2,600
Materials inventory 33,400 36,400
Finished goods 10,000 12,000
Plant and equipment 75,000 60,000
Allowance for depreciation (9,000) ( 5,000)
Total assets $183,500 $144,500
Liabilities
Accounts payable $  13,000 $  14,000
Income taxes payable 1,200 1,800
Notes payable (long term) 47,000 35,000
Stockholders’ Equity
Common Stock 115,000 90,000
Retained earnings 27,300 3,700
Total Liabilities and Stockholders’ $183,500 $144,500

Net income for the year 2008 was $27,900

Additional information:
A. Issued a $20.000 note payable for the purchase of plant and
equipment
B. Sold furniture that cost $5,000 with accumulated deprecation of $1,500
at carrying value (book value)
C. Recorded depreciation on plant and equipment during the year,
$5,500
D. Repaid a note in the amount of $8,000 and issued $25,000 of common
stock at par value.
E. Declared and paid a dividends of $4,300.
Required:
Prepare a statement of cash flow using the indirect method.
 Management Accounting | 353

Exercise 18.4 • Preparing a Cash Flow Statement

K. L. Widget Company
Comparative Balance Sheet
Dec. 31, 2008 Dec. 31, 2007 Change

Assets
Cash $72,400 $23,200
Accounts receivable 28,000 26,000
Prepaid expenses 2,000 2,600
Materials inventory 40,000 36,000
Finished goods 15,000 12,000
Plant and equipment 100,000 80,000
Allowance for depreciation (15,000) (10,000)
Total assets $242,400 $169,800
Liabilities
Accounts payable $15,000 $8,000
Income taxes payable 2,400 1,800
Notes payable (long term) 50,000 35,000
Stockholders’ Equity
Common Stock 145,000 115,000
Retained earnings 30,000 10,000
Total Liabilities and Stockholders’ $242,400 $169,800

Net income for the year 2008 was $28,000

Additional information:
A. Purchased plant and equipment for $30,000.
B. Sold plant and equipment that cost $10,000 with accumulated
deprecation of $6,000 for $7,000.
C. Recorded depreciation on plant and equipment during the year,
$11,000
D. Borrowed money from the bank in the amount of $15,000
E. Declared and paid a dividends of $8,000.
F. Issued common stock for $30,000.
Required:
Prepare a statement of cash flow using the indirect method.
354 | CHAPTER EIGHTEEN • Statement of Cash Flow