1.

Cost-Volume-Profit Analysis, Absorption, and Variable Costing

1.1. Absorption versus Direct Costing
There are three types of inventory costing methods: absorption costing, variable costing, and throughput
costing. The two most common methods of costing inventories in manufacturing companies are variable
costing and absorption costing.
Variable Costing
Variable costing is a method of inventory costing in which all variable manufacturing costs (direct and
indirect) are included as inventorial costs. All fixed manufacturing costs are excluded from inventorial
costs and are instead treated as costs of the period in which they are incurred. The variable costing is a
less than perfect term to describe this inventory-costing method, because only variable manufacturing
costs are inventoried. Variable nonmanufacturing costs are still treated as period costs and are expensed.
Another common term used to describe this method is direct costing. This is also a misnomer because
variable costing considers variable manufacturing overhead (an indirect cost) as inventorial, while
excluding direct marketing cost. Variable costing facilitates the use of models for analyzing break-even
point, cost-volume-profit relationships, margin of safety, and the degree of operating leverage.

Variable costing is a cost accumulation method that includes only variable production costs (direct
material, direct labor, and variable overhead) as product or inventoriable costs. Under this method, fixed
manufacturing overhead is treated as a period cost. Like absorption costing, variable costing treats costs
incurred in the organization’s selling and administrative areas as period costs. Variable costing income
statements typically present expenses according to cost behavior (variable and fixed), although they may
also present expenses by functional classifications within the behavioral categories. Variable costing has
also been known as direct costing.
Absorption Costing
Absorption costing is a method of inventory costing in which all variable manufacturing costs and all
fixed manufacturing costs are included as inventorial costs. That is, inventory “absorbs” all
manufacturing costs. Absorption costing is the traditional approach to product costing. The job costing
system is an example of absorption costing. Under both variable costing and absorption costing, all
variable manufacturing costs are inventorial costs and all nonmanufacturing costs in the value chain
(such as research and development and marketing), whether variable or fixed, are period costs and are
recorded as expenses when incurred. Absorption costing treats the costs of all manufacturing
components (direct material, direct labor, variable overhead and fixed overhead) as inventoriable or
product costs. Absorption costing is also known as full costing.
Under absorption costing, costs incurred in the nonmanufacturing areas of the organization are
considered period costs and are expensed in a manner that properly matches them with revenues.
Absorption costing presents expenses on an income statement according to their functional
classifications. A functional classification is a group of costs that were all incurred for the same
principal purpose. Functional classifications include categories such as cost of goods sold, selling
expense, and administrative expense.
Basic difference between Absorption and variableCosting
1. The way fixed overhead (FOH) is treated for product costing purposes.

Page 1 of 65
  Under absorption costing, FOH is considered a product cost; under variable costing, it is
considered a period cost.
 Absorption costing advocates contend that products cannot be made without the capacity
provided by fixed manufacturing costs and so these costs are product costs.
 Variable costing advocates contend that the fixed manufacturing costs would be incurred
whether or not production occurs and, therefore, cannot be product costs because they are not
caused by production.
2. The second difference is in the presentation of costs on the income statement.
 Absorption costing classifies expenses by function; whereas variable costing categorizes
expenses first by behavior and then may further classify them by function.
 Variable costing allows costs to be separated by cost behavior on the income statement or
internal management reports. Cost of goods sold, under variable costing, is more appropriately
called variable cost of goods sold (CGS), because it is composed only of variable production
costs.

Comparing Variable and Absorption Costing

The easiest way to understand the difference between variable costing and absorption costing is with an
example. We will study ABC Company, an optical consumer-products manufacturer, in this chapter. We
focus in particular on its product line of high-end telescopes for aspiring astronomers.
ABC compaany uses standard costing:
 Direct costs are traced to products using standard prices and standard inputs allowed for actual
outputs produced.
 Indirect (overhead) manufacturing costs are allocated using standard indirect rates times standard
inputs allowed for actual outputs produced.
ABC management wants to prepare an income statement for 2023 (the fiscal year just ended) to evaluate
the performance of the telescope product line. The operating information for the year is as follows:
A B
Units
Beginning inventory 0
Production 8,000
Sales 6,000
Ending inventory 2,000
Selling price $ 1,000
Variable manufacturing cost per unit
Direct material cost per unit $110
Direct manufacturing labor cost per unit 40
Manufacturing overhead cost per unit 50
Total variable manufacturing cost per $200
unit
Variable marketing cost per unit sold $185

Page 2 of 65
 Fixed manufacturing costs (all indirect) $1,080,000
Fixed marketing costs (all indirect) $1,380,00

Based on the preceding information, ABC inventorial costs per unit produced in 2023 under the two
inventory costing methods are as follows:
Variable costing Absorption Costing
Variable manufacturing cost per unit produced:
Direct materials $110 $110
Direct manufacturing labor 40 40
Manufacturing overhead 50 $200 50 $200
Fixed manufacturing cost per unit produced — 135
Total inventoriable cost per unit produced $200 $335
 To summarize, the main difference between variable costing and absorption costing is the
accounting for fixed manufacturing costs. Under variable costing, fixed manufacturing costs are
not inventoried; they are treated as an expense of the period.
Under absorption costing, fixed manufacturing costs are inventoriable costs. In our example, the
standard fixed manufacturing cost is $135 per unit ($1,080,000 ÷ 8,000 units) produced.

1.2. The concept of profit contribution

The concept of contribution is a crucial one in business. It focuses on the returns (contribution) a
business makes from each unit of product sold and whether that return is enough to allow the business to
make money overall after taking account of its fixed costs. Contribution profit means an amount equal to
the direct revenues of the Division less direct operating expenses before any allocation of corporate
overheads as calculated by the Company.

Sales (S) minus variable cost of goods sold is called product contribution margin (PCM) and indicates
how much revenue is available to cover all period expenses and potentially to provide net income.
Variable, nonmanufacturing period expenses (VNME), such as a sales commission of product selling
price, are deducted from product contribution margin to determine the amount of total contribution
margin (TCM). Total contribution margin is the difference between total revenues and total variable
expenses. This amount indicates the dollar figure available to “contribute” to the coverage of all fixed
expenses, both manufacturing and nonmanufacturing. After fixed expenses are covered, any remaining
contribution margin provides income to the company. A variable costing income statement is also
referred to as a contribution income statement. A formula representation of a variable costing income
statement follows:
S — CGS = PCM
PCM — VNME = TCM Fixed Expenses
Income before Taxes

Page 3 of 65
Major authoritative bodies of the accounting profession, such as the Financial Accounting Standards
Board and Securities and Exchange Commission, believe that absorption costing provides external
parties with a more informative picture of earnings than does variable costing.
 By specifying that absorption costing must be used to prepare external financial statements, the
accounting profession has, in effect, disallowed the use of variable costing as a generally accepted
inventory method for external reporting purposes.
 Additionally, the IRS requires absorption costing for tax purposes.

1.3. Cost-volume-profit (CVP) analysis

Cost-volume-profit (CVP) analysis is one of the most powerful tools that managers have at their
command. It helps them understand the relationships among cost, volume, and profit by focusing on
interactions among the following five elements: - Prices of products, Volume or level of activity, per
unit variable costs, Total fixed costs and Mix of products sold.
The basic CVP model can be written as follows:
Profit = (p - v)q – F or Profit = cm x q - F
Where:
 p is the unit selling price,

 v is the variable cost per unit,

 q is the unit sales,

 F is the fixed cost, and

 cm is the unit contribution margin.

Contribution Margin Vs. Gross Margin

The form of income statement used in CVP analysis is shown in Exhibit 1.1, i.e., the projected income
statement of Sample Merchandising Company for the month ended January 31, 20x3. This income
statement is called contribution approach to income statement. The contribution income statement
emphasizes the behavior of the costs and extremely helpful to manager in judging the impact on profits
of changes in selling price, cost, or volume.
Exhibit 1.1
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31,20x3

Total Unit
Sales (10, 000 units) Br. 150, 000 Br.15.00
Variable Expenses 120, 000 12.00
Contribution Margin Br. 30, 000 Br.3.00
Fixed Expenses 24, 000

Page 4 of 65
Net Income Br. 6, 0000
In the income statement here above, sales, variable expenses, and contribution margin are expressed on a
per unit basis as well as in total. This is commonly done on income statements prepared for
management’s own use since it facilitates profitability analysis. The contribution margin represents the
amount remaining from sales revenue after variable expenses have been deducted. Thus, it is the amount
available to cover fixed expenses and then to provide profit for the period. Notice the sequence here-
contribution margin is used first to cover the fixed expenses, and then whatever remains goes toward
profit. In the Sample Merchandising Company income statement shown above, the company has a
contribution margin of Br. 30, 000. In this case, the first Br.24, 000 covers fixed expenses; the remaining
Br. 6, 000 represents profit.

The per unit contribution margin indicates by how much birrs the contribution margin is increased for
each unit sold. Sample Merchandising Company’s contribution margin of Br.3.00 per unit indicates that
each unit sold contributes Br.3.00 to covering fixed expenses and providing for a profit. If the firm had
sold 5, 000 units, this would cover only Br.15, 000 of their fixed expenses (5, 000 units x Br.3.00 per
unit). Therefore, the firm would have a net loss of Br.9, 000.
Contribution margin Br.15, 000
Fixed expenses 24, 000
Net loss Br.(9, 000)
If enough units can be sold to generate Br.24, 000 in contribution margin, then all of the fixed costs will
be covered and the company will have managed to show neither profit nor loss but just cover all of its
cost. To reach this point (called break even point), the company will have to sell 8, 000 units in a month,
since each unit sold yield Br. 3.00 in contribution margin.
Total Per Unit
Sales (8, 000 units) Br.120, 000 Br.15.00
Variable expenses 96, 000 12.00
Contribution margin Br.24, 000 Br.3.00
Fixed expenses 24,000
Net income Br. 0

Computations of the break-even point are discussed in detail later in this unit. For the moment, note that
the break even point can be defined as the point where total sales revenue equals total expenses (variable
plus fixed) or as the point where total contribution equals total fixed expenses. Too often people confuse
the terms contribution margin and gross margin. Gross margin (which is also called gross profit) is the
excess of sales over the cost of goods sold (that is, the cost of the merchandise that is acquired or
manufactured and then sold). It is a widely used concept, particularly in the retailing industry.

Contribution Margin Ratio (CM-Ratio)

In addition to being expressed on a per unit basis, revenue, variable expenses, and contribution margin
for Sample Merchandising Company can also be expressed on a percentage basis:

Page 5 of 65
 Total Per Unit Percentage
Sales (10, 000 units) Br.150, 000 Br.15.00 100%
Variable expenses 120, 000 12.0 80%
Contribution margin Br.30, 000 Br.3.00 20%
Fixed expenses 24,000
Net income Br. 6, 000
The percentage of the contribution margin to total sales is referred to as the contribution margin ratio
(CM-ratio). This ratio is computed as follows:
CM-ratio = Contribution Margin
Sales

Contribution margin ratio = 1 – variable cost ratio. The variable-cost ratio or variable-cost percentage
is defined as all variable costs divided by sales. Thus, a contribution margin of 20% means that the
variable-cost ratio is 80%.
In the example here below, the contribution margin percent or contribution margin ratio, also called
profit/volume ratio (p/v ratio) is 20%. This means that for each birr increase in sales, total contribution
margin will increase by 20 cents (Br.1 sales x CM ratio of 20%). Net income will also increase by 20
cents, assuming that there are no changes in fixed costs.
As this illustration suggests, the impact on net income of any given birr change in total sales can be
computed in seconds by simply applying the contribution margin ratio to birr change.

Once the break-even point has been reached, net income will increase by the unit contribution margin
for each additional unit sales. If 8001 units are sold in a month, for example, then we can expect that the
Sample Merchandising Company’s net income for the month will be Br. 3, since the company will have
sold 1 unit more than the number needed to break even:
Total Per Unit
Sales (8, 000 units) Br.120, 01 Br.15.00
Variable expenses 96, 012 12.00
Contribution margin Br.24, 003 Br.3.00
Fixed expenses 24,000
Net income Br. 3
If 8002 units are sold (2 units above the break-even point), then we can expect that the net income for
the month will be Br.9, and so forth.
Cost-Volume-Profit Assumptions
CPV analysis to be applied, there are assumptions including:
1. Changes in the levels of revenues and costs arise only because of changes in the number of products (or
service) or units sold. The number of units sold is the only revenue driver and the only cost driver.
2. Total costs can be separated into two components: a fixed component that does not vary with units sold
and a variable component that changes with respect to units sold.

Page 6 of 65
3. When represented graphically, the behaviours of total revenues and total costs are linear (meaning they
can be represented as a straight line) in relation to units sold within a relevant range (and time period).
4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and time period) are
known and constant.
Expressing CVP Relationships
There are three related methods to deal with the model CVP relationships:
1. The equation method
2. The contribution margin method
3. The graph method
The equation method and the contribution margin method are most useful when managers want to
determine operating income at few specific levels of sales (for example 5, 15, 25, and 40 units sold). The
graph method helps managers visualize the relationship between units sold and operating income over a
wide range of quantities of units sold. However, different methods are useful for different decisions.
A. Equation Method
Revenues - Variable costs - Fixed costs = Operating income Note:
*Revenues = Selling price (SP) × Quantity of units sold (Q)
*Variable costs = Variable cost per unit (VCU) × Quantity of units sold (Q) Thus:
(SP× Q) – (VCU×Q) – fixed cost = operating income………………………Equation 1
Equation 1 becomes the basis for calculating operating income for different quantities of units sold.
B. Contribution Margin Method
Rearranging equation 1, (SP-VCU) × (Q) – fixed cost = operating income
= (Contribution margin× Q) – fixed cost
= operating income………………..Equation 2
C. Graph Method
In the graph method, we represent total costs and total revenues graphically. Each is shown as a line on a
graph.
Example:
If ABC Company sold one unit of paper at $ 200, variable cost per unit $120, and also fixed cost is $
2,000, what will be the amount of break-even quantity?
Equation method
➢ Recall the equation method (equation 1):
(SP× Q) – (VCU×Q) – fixed cost = operating income
➢ At breakeven point,
(SPXQ) - (VCUXQ) + FC = 0
= ($200×Q) - ($120×Q) - $2,000= 0
= $80× Q = 2,000
= Q = 2,000 ÷ 80 per unit
= 25 units Interpretation:

Page 7 of 65
If the company sells fewer than 25 units, it will incur a loss; if it sells 25 units, it will be at breakeven; and
if it sells more than 25 units, it will make a profit. While this breakeven point is expressed in units, it can
also be expressed in revenues (Dollar): 25 units × $200 selling price= $5,000.
Contribution margin approach
➢ Recall the contribution margin method (Equation 2):
(Contribution margin× Q) – Fixed cost= operating income,
(SP x Q) – (VCU x Q) – FC= OI
Re-written equation takes the following format:
(SP-VCU) x Q = FC + OI that is, Q= FC + OI/ (SP-
VCU)
The difference between unit selling price and unit variable cost is termed as unit contribution margin.
You can replace the (P-V) by the term "Contribution Margin per Unit (CMU),
Q= FC + OI/CMU
As you know from the discussion above at breakeven point the target operating income is Birr 0, so
replacing OI by 0, you will get,
Q= FC/ (SP-VCU)
Breakeven number of units = Fixed cost ÷ contribution margin per unit = $2,000÷ $80= 25 units
Breakeven revenues = Breakeven number of units × Selling price
= 25 units × $200 per unit = $5,000
In practice (because they have multiple products), companies usually calculate breakeven point directly
in terms of revenues using contribution margin percentages.
To find the breakeven sales value, you can use contribution margin percentage in place of contribution
margin per unit in the formula you used in the determination of breakeven units. Contribution margin
percentage is simply the ratio of contribution margin per unit to selling price.
CM% = CMU/USP
80/200=0.4 or 40%
This can be interpreted as, units sold cover variables costs and contribute 40 percent to cover fixed cost
and increase in profit.
The break-even sales amount (Birr) = FC/CM% = 2000/0.40 = Br 5,000
Graphical Approach
You have seen how solutions to break-even problems are determined using an algebraic formula.
However, sometimes managers need information in more visual format, such as graphs. The breakeven
point is found at the intersection point of total revenue and total cost lines.

Page 8 of 65
 Birr Total Revenue
Operating profit
Operating loss

5000 Variable Cost

Break-even point
2000
Fixed cost
25 Units
1.4. The use of linear, curvilinear and step functions and how their calculations are used
to analyze cost behavior
Linear function: It is important to note that when we speak of a cost as being variable, we mean the
total rises and fall as the activity level rises and falls. This idea is presented below, assuming that a
company's products cost $24:
Units produced cost per unit Total variable
1 $24 $24
500 24 12,000
1,000 24 24,000

TVC
24,000
VC/U
12,000
500 1000 1500 500 1000 1500
Volume of cost driver Volume of cost driver

As the above graphs show, total varisable cost increases proportionately with activity. When the volume
of activity (units produced) doubles from 500 to 1000 total variable cost doubles from birr 12000 to
24000. In contrast, a variable cost on a per unit basis remains constant birr 24 as the volume of output
increases. The following formula can used to show total variable and unit variable costs respectively.
TVC=UVC x A,
Where,
TVC-Total variable cost
UVC-unit variable cost
A-activity volume
UVC=TVC/A
Non liner costs: A non-linear cost is a cost that varies with the volume of activity but not proportionally
or consistently. Non-linear costs may increase at a decreasing rate or at an increasing rate. Exhibit shows
a non-linear cost that increases at a decreasing rate. This type of cost is referred to as a learning curve

Page 9 of 65
cost. The terms originate from the observed decrease in labor costs that sometimes occurs, as employee
becomes familiar with a new task.

Average
DL
Hours
Per unit Average cost
Cumulative units
The behavior of non-linear cost
As the graph above shows, the unit variable cost declines as activity increase. Put differently, this cost
exhibit decreasing marginal costs (the cost of producing the next unit) or this type of cost behavior is
characterized by smaller cost per unit of output as activity level increases.

Step costs: A step cost is fixed for a given amount of production and then rises in a constant amount at a
higher production level. For example, in a manufacturing concern, one supervisor is needed at a salary
of Br 20,000 p.m. for every 50 workers. So long as 50 workers or less than that are working, the
supervision costs will be Br. 20,000 p.m. But, as soon as the 51st worker is employed, the cost of
supervision rises by Br. 20,000 p.m. and will be Br. 40,000. Up to 100 workers the cost of supervision
remains fixed at Rs. 40,000. But, if more than 100 workers are employed the cost of supervision will go
up further. The following figure can be used to explain this concept:

Other classification of cost

 Marginal cost: is cost incurred to manufacture one more product.
 Out of pocket cost: is cash expenditure associated with a particular decision alternative.
 Opportunity cost: is the cost of an opportunity for gone when one course of action is chosen
over another. Opportunity cost is not an out-of-pocket cost but represents an opportunity
associated with each of the alternatives that are rejected.

Manufacturing cost
In manufacturing enterprises production costs are grouped in to three categories.
 Direct material

Page 10 of 65
  Direct labor and
 Manufacturing overhead cost
Prime cost and conversion costs are two other terms used to describe production cost.
 Prime cost: are the most important or significant costs traceable to unit of finished product.
They include direct material and direct labor cost.
Prime cost= Direct material cost + Direct labor cost
 Conversion costs are those required to convert raw material in to finished product and consists
of direct labor and manicuring and manufacturing overhead cost.
Conversion cost = Direct labor cost + Manufacturing overhead cost

1.5. The concepts of cost units, cost centers and profit centers
A cost center is a department or a unit that supervises, allocates, segregates, and eliminates all sorts of
costs related to a company. The cost center’s prime work is to check the cost of an organization and to
limit the unwanted expenditure that the company may acquire. The cost can be the determination of both
people and location. In multinational companies, the cost center is authorized to decrease and manage
the cost. These costs are generally monitored by analyzing and deducting the actual cost incurred with
the standard cost.
 Types of cost centers are:

 Production cost center

 Personal cost center
 Service cost center
 Impersonal cost center
 Process cost center
 Operation cost center
For example, the customer service department may not generate direct profits for a business, but it helps
to control the expenses of the business (by conceptualizing what customers want) and also aids in
reducing the costs of the company.

Profit Centre Meaning

A profit center is a division or department of a company that operates for the calculation of profit. In an
organization, different profit centres are managed by managers who identify profits on the basis of costs
and revenues. The profit center is accountable for all the actions associated with the sale of goods and
production. The principal object of a profit centres is to generate and maximize the profit by minimizing
the cost incurred and increasing sales. This objective helps to uplift the profit-making capability of a
company. The accomplishment of a profit centres is estimated in terms of profit growth during a definite
period. The achievement of a profit center is examined by subtracting the actual cost from the budgeted
cost.

Page 11 of 65
The difference between a cost center and a profit center
Cost center Profit center
Definition
A cost centre is a company’s department that A profit centre is a company’s department that
supervises all the costs of the company. is responsible for the profits of the company.
Responsibilities
Reducing costs and effective cost control Helping in earning profits and maximizing
within the organization revenue
Complexity involved
A cost centre has lesser complexity as the only A profit centre is more complex as it has to
focus in on costs. focus on costs, profits, and revenue.
Approach followed
Short term approach Both short and long term approaches are
followed
Scope of operations
Comparatively narrow Comparatively wide

Page 12 of 65
 Chapter II: Relevant information and Decision Making
2. Relevant and irrelevant information
Decision-making is a fundamental part of management. Managers are constantly faced with problems of
deciding what product to sell, what production method to use, whether to make or buy component parts,
what prices to charge, what channels of distribution to use, whether to accept special orders at special
prices, and so forth. This chapter covers the role of management accounting information in a variety of
marketing and production decisions.
2.1The Concept of Relevance
Accountants have an important role in the decision-making process, not as a decision maker but as
collectors and reporters of relevant information. What makes information relevant to a decision
problem? Relevant information is the predicted future costs and revenues that will differ among the
alternatives. These two criteria are discussed here under:
Bearing on the Future: To be relevant to a decision, cost or benefit information must involve a future
event. Relevant information is a prediction of the future, not a summary of the past. Historical (past)
data have no bearing on a decision. Such data can have an indirect bearing on a decision because they
may help in predicting the future. But past figures, in themselves, are irrelevant to the decision itself.
Because of the decision-making affects the future but not the past. Nothing can alter what has already
happened.

Different under Competing Alternatives: Relevant information must involve future costs or benefits
that differ among the alternatives. Costs or benefits that are the same across all the available alternatives
have no bearing on the decision. For example, if the management is evaluating the purchase of either a
manual or an automated drill press, both of which require skilled labor costing Br. 10 per hour, the labor
rate is not relevant because it is the same for both alternatives.
Why Isolate Relevant Information?
Why is it important for the management accountant to isolate the relevant costs and benefits in a
decision analysis? The reasons are twofold. First, generating information is a costly process. The
management accountant can simplify and shorten the data gathering process by focusing on only
relevant information. Second, people can effectively use only a limited amount of information. If a
manager is provided with irrelevant revenues and costs, these figures can cause information overload,
and decisionmaking effectiveness of the manager declines.
Example (1) Marina Company, a manufacturer of a line of ashtrays, is thinking of using aluminum
instead of copper in the manufacture of its product. Historical direct material costs were Br. 0.30 per
unit. The company expected future costs for aluminum is Br 0.20 and it is unchanged for copper. Direct
labor cost was Br. 0.70 per unit and will not be affected by the switch in materials. The analysis in a
nutshell is as follows.

Copper Aluminum Difference

Page 13 of 65
Direct material Br. 0.30 Br. 0.20 Br. 0.10
Direct labor 0.70 0.70 -
Required: Given the above-summarized data identify the relevant data for the decision on hand.
2.1 Alternative Choice Decisions
Many of the decisions described in this chapter are frequently referred to as alternative choice decision.
Alternative choice decisions are situations with two or more courses of action from which the decision
maker must select the best alternative. The variety of alternative choice decisions is limitless. Some
business example follows:
 Should we accept a special order for a product below our normal selling price?
 Should we raise the price of a product or maintain the current price?
 Should we make or buy a component part?
 Should we sell a joint product at the split off point or process it further?
 Should we keep our copying machine or acquire a faster one?
The analyses of these and other types of alternative choice decisions are aided by relevant cost and
benefit data.
2.1.1 Marketing Decisions
The discussions that follow illustrate a variety marketing and production decisions. The marketing
decisions for which we examine relevant information include special order decisions, addition or
deletion, and optimal use of limited resources.
2.1.1.1 Special Order Decisions
A special order is a one-time order that is not considered part of the company’s normal ongoing
business. For example, a discount department store chain planning a big spring sale offers to make a
large one-time purchase of a firm’s product but wants a reduced price. In general, a special order is
profitable as long as the incremental revenue from the special order exceeds the incremental costs of the
order. The incremental revenue in this decision will be the price per unit offered by the potential
customer times the number of units to be purchased. The incremental costs will be the amount of the
expected cost increase if the offer is accepted. The incremental cost usually includes variable
manufacturing costs of producing the units. Since the units being sold in the special order are not being
sold through the firm normal distribution channel, the firm may or may not incur variable selling and
administrative expenses in conjunction with the special order.

The incremental costs usually do not include fixed manufacturing costs. Although the fixed costs must
be incurred to permit production, the amount of fixed costs incurred by the firm usually will not increase
if the special order offer is accepted. For the same reason, other fixed expenses, such as fixed selling and
administrative expenses, are usually not relevant in the special order price. However, management must
also be assured that it has sufficient capacity to produce the special order without affecting normal sales.
When there is no excess capacity, the opportunity cost of using the firm’s facilities for the special order
are also relevant to the decision. The opportunity cost would be the contribution margin forgone on
regular sales that have to be reduced to accommodate the special order. The relevant costs to accept the
special order, therefore, would include a forgone contribution margin on regular sales that could not be

Page 14 of 65
made in addition to the incremental costs associated with the special order that have already been
discussed.

Example-1: Consider the following details of the income statement of Samson Company for the year
just ended December 31, 20 x 3.
Sales (1,000,000 units) Br. 20,000,000
Manufacturing cost of goods sold 15,000,000
Gross margin Br. 5,000,000
Selling and administrative expenses 4,000,000
Operating income Br. 1,000,000

Samson’s fixed manufacturing costs were Br. 3 million and its fixed selling and administrative costs
were Br. 2.9 million. Near the end of the year, Ethio Company offered Samson Br. 13 per unit for
100,000 unit special order. The special order would not affect Samson’s regular business in any way.
Furthermore, the special sales order would not affect total fixed costs and would not require any
additional variable selling and administrative expenses.
Instruction: Should Samson accept or reject the special order? By what percentage the operating
income decreases or increases if the order had been accepted? Assume that the company would utilize
its idle manufacturing capacity to accept the special order.
Example-2: Lucy Company has the capacity to produce 15,000 units per month. Current regular
production and sales are 10,000 units per month at a selling price of Br. 15 each. Based on the current
production level, the following costs are to be incurred per unit:
Direct materials Br. 5.00
Direct labor 3.00
Variable factory overhead (FOH) 0.75
Fixed FOH 1.50
Variable selling expense 0.25
Fixed administrative expense 1.00

Lucy Company has received special order from a customer that wants to purchase 4,000 units at Br. 10
each. There would be no selling expense in connection with this special order.
Instructions:
a. Should Lucy Company accepts or rejects the special order? Why or Why not? Assume that the
special order should not disturb regular business.
b. Suppose that the special order was for 8,000 units instead of 4,000 units. Thus, regular business
would be reduced by 3,000 units to accept the special order because production capacity cannot
be expanded in the short run. What would be the overall profit of the firm if it accepts this
order?
c. Refer the data given in requirement (b) above. At what selling price per unit from the customer
would the Lucy Company be economically indifferent between accepting and rejecting the
offer?

Page 15 of 65
Example-3: ABC Company makes and sells 10,000 units of a certain product. The total manufacturing
cost of goods made is Br 400,000. Suppose XYZ Company offered Br 38 per unit for 1,000 units special
order that:
 Would not affect the regular business in any way
 Would not affect fixed costs
 Would not require any additional variable selling and administrative expenses
 Would use some other wise idle manufacturing capacity
Required
Should ABC Company accept the special order?
The income statement of the company for the most recent period is given below:
Sales-------------------------------------------------------------500,000
Variable costs
Manufacturing----------------------------360,000
Selling and admin-------------------------30,000-----------390,000
Contribution margin-----------------------------------------110,000
Fixed costs
Manufacturing------------------------------40,000
Selling and admin--------------------------50,000-----------90,000
Operating income----------------------------------------------20,000

2.1.1.2 Deletion or Addition of Products or Departments

Decisions relating to whether old product lines or other segments of a company should be dropped and
new ones added are among the most difficult that managers have to make. In such decisions, many
factors must be considered that are both qualitative and quantitative in nature. Ultimately, however, any
final decision to drop an old segment or to add a new one is going to hinge primarily on the impact the
decision will have on net operating income. To assess this impact, it is necessary to make a careful
analysis of the costs involved. To this end, let us try to distinguish the difference between avoidable and
unavoidable fixed expenses.

Fixed costs are divided into two categories, avoidable and unavoidable. Avoidable costs are costs that
will not continue if an ongoing operation is changed, deleted or eliminated. These costs are relevant
costs in decision-making. Examples of avoidable costs include departmental salaries and other costs that
could be avoided by not operating the specific department. Unavoidable costs are costs that continue
even if a subunit or an activity is eliminated and are not relevant for decision. The reason for this is that
such costs are not affected by a decision to delete a particular activity. Unavoidable costs include many
common costs, which are defined as those costs of facilities and services that are shared by users.
Examples are store depreciation, heating, air conditioning, and general management expenses.

Page 16 of 65
Example-1: Eyoha Department Store has three major departments: groceries, general merchandise, and
drugs. Management is considering dropping groceries, which have consistently shown a net loss. The
following table reports the present annual net income (in thousands).

DEPARTMENTS
Groceries General merchandise Drugs Total
Sales Br. 1,000 Br. 800 Br. 100 1,900
Variable COGS* & 800 560 60 1,420
Expenses
Contribution margin Br. 200 Br. 240 Br. 40 Br. 480
Fixed expenses
Avoidable Br. 150 Br. 100 Br. 15 Br. 265
Unavoidable 60 100 20 180
Trial fixed expenses Br. 210 Br. 200 Br. 35 Br. 445
Operating income (loss) Br. (10) Br. 40 Br. 5 Br. 35
*COGS denote cost of goods sold.
Instructions:
a. Which alternative would you recommend if the only alternatives to be considered are dropping
or continuing the grocery department? Assume that the total assets would be unaffected by the
decision and the space made available by dropping groceries would remain idle.
b. Refer the income statement presented above. However, assume that the space made available by
dropping groceries could be used to expand the general merchandise department. The space
would be occupied by merchandise that would increase sales by Br. 500,000, generate a 30%
contribution margin percentage and have additional avoidable fixed costs of Br. 70,000. Should
Eyoha discontinue grocery and expand merchandise department?

2.1.1.3 Optimal Use of Limited Resources

Managers are routinely faced with the problem of deciding how scarce resources are going to be
utilized. A scarce resource or a limiting factor refers to any factor that restrict or constraint the
production or sale of a product or service. It include the following, among others, labor hours, machine
hours, square feet of floor space, cubic meters of display space .A department store, for example, has a
limited amount of floor space and therefore cannot stock every product that may be available. A
manufacturing firm has a limited number of machine- hours and a limited number of direct labor-hours
at its disposal.

When capacity becomes pressed because of scarce resource, the firm is said to have a constraint. When a
plant that makes more than one product is operating at capacity, managers often must decide which
orders to accept. The contribution margin technique also applies here, because the product to be
emphasized or the order to be accepted is the one that makes the biggest total profit contribution per unit
of the limiting factor. Fixed cost are usually unaffected by such choices. In such kind of decision, the

Page 17 of 65
contribution margin technique must be used wisely. Managers sometimes mistakenly favor those
products with the biggest contribution margin or gross margin per sales birr, without regard to scarce
resources.

Example (1): Wajo Company has two products: a plain cellular phone and a fancier cellular phone with many
special features. Unit data follow:
Plain Phone Fancy Phone
Selling price Br.80 Br.120
Variable costs 64 64
Contribution margin Br.16 Br.36
Contribution margin 20% 30%
ratio
Instructions:
a. Which product is more profitable? On which should the firm spend its resources? Assume that
sales are restricted by demand for only a limited number of phones.
b. Now suppose that annual demand for phones of both types is more than the company can
produce in the next year and the major constraint is the availability of time on a processing
machine. Plain Phone requires one hour of processing on the machine, Fancy Phone requires
three hours of processing. Which product is more profitable? Assume that only 10, 000 machine
hours of capacity are available.

2.1.2 Production Decisions

This part and the preceding one illustrate relevant costs for many types of decisions. Does this mean that
each decision requires a different approach to identifying relevant costs? No. The fundamental principle
in all decision situations is that relevant costs are future costs that differ among alternatives. The
principle is simple, but its application is not always straightforward. Managers must have tools at their
disposal to assist them in distinguishing relevant and irrelevant costs so that the latter can be eliminated
from the decisions framework. What costs are relevant in decision-making? The answer is easy. Any
future cost that makes a difference between decisions alternative is relevant for decision purpose. All
costs are considered relevant, except.
a. Sunk costs. A sunk cost is a cost that has already been incurred and that cannot be avoided
regardless of which course of action a manager may decide to take. As such, sunk costs have no
relevance to future events and must be ignored in decision-making.
b. Future costs that do not differ between the alternatives at hand.
Relevant costs are avoidable costs. An avoidable cost can be defined as cost that can be eliminated as a
result of choosing one alternative over another in a decision-making situation. In management
accounting, the term avoidable is synonymous with differential cost. These terms are frequently used
interchangeably. To identify the costs that are avoidable (differential) in a particular decision situation,
the manager’s approach to cost analysis should include the following steps:
 Assemble all of the costs associated with each alternative being considered.

Page 18 of 65
  Eliminate those costs that are sunk.
 Eliminate those that do not differ between alternatives.
 Make a decision based on the remaining costs. These costs will be the differential or
avoidable costs, and hence the costs relevant to the decision to be made.
2.1.2.1 Make or Buy Decisions
Managers in manufacturing companies are often faced with the problem whether to manufacture a
component used in manufacturing a product or to purchase from the outside. Production of such basic
materials as screws, nails, washers, sheet metal and so on is not usually economical owing to
specialization and returns to scale. These materials can almost always be acquired more cheaply from
outside suppliers. But for many materials, such as subassemblies and special parts, it is not always clear
which is least costly means of acquisition. The cost and management accounting system assist managers
in arriving at a correct decision by presenting suitable analysis of the cost of production and comparing
it with the purchase price of the product.
In make or buy decisions, the appropriate means of analysis is to compare the relevant cost of buying the
part with the relevant cots of making the part. Here relevant cost of buying the component is typically
the amount paid to supplier. It may also include transportation costs incurred to get the component to the
company’s plant and costs incurred to process the part upon receipt.

The relevant cost of making the component is often the variable costs incurred to produce the
component. In some cases, however, the company will need to acquire special equipment to produce the
product or will hire additional supervisory personnel to assist with making the product. These
incremental fixed costs will be part of the relevant cost of making the part. The alternative chosen make
or buy, is typically the one with the lowest cost. In the final decision regarding make or buy qualitative
factors, besides the quantitative data, should be considered as part of the decision. In make or buy
decision, the following qualitative factors, besides the quantitative considerations may favor the decision
to “buy”:
 Advantage of long-term relationship with suppliers.
 Possibility of shortage of material or labor for making the component.
 Uninterrupted supply of requisite quality from reliable suppliers.
 The internal demand for the product under consideration is small and, as such, it is no use to set
up manufacturing facilities for it and so forth.
On the contrary, the following qualitative factors may favor the decision “to make”:
 The quality of the product is decided to be controlled.
 If the purchase price is likely to rise due to increased demand in the market, it becomes
uneconomical to buy.
 Where the technical know-how is to be kept secret and not to be passed on to the suppliers and
so on.
Example-1: Great Company manufactures 60, 000 units of part XL-40 each year for use on its
production line. The following are the costs of making part XL-40:
Total Costs Cost per unit

Page 19 of 65
 60, 000 units
Direct material Br. 480, 000 Br.8
Direct labor 360, 000 6
Variable factory overhead (FOH) 180, 000 3
Fixed FOH 360, 000 6
Total manufacturing costs Br. 1, 380, 000 Br.23

Another manufacturer has offered to sell the same part to Great for Br.21 each. The fixed overhead
consists of depreciation, property taxes, insurance, and supervisory salaries. The entire fixed overhead
would continue if the Great Company bought the component except that the cost of Br. 120, 000
pertaining to some supervisory and custodial personnel could be avoided.
Instructions:
a. Should the parts be made or bought? Assume that the capacity now used to make parts internally
will become idle if the pats are purchased?
b. b) Assume that the capacity now used to make parts will be either (i) be rented to near by
manufacturer for Br. 60, 000 for the year or (ii) be used to make another product that will yield a
profit contribution of Br. 250,000 per year. Should the company purchase them from the outside
supplier?
Example-2: Assume that a division of Leranso Company makes an electric component for its speakers.
The management is trying to decide whether the division of the company should manufacture this
component part or purchase it from another manufacturer.

The following are production costs for 100,000 units of the component for the forth-coming year.
Direct material Br.500, 000
Direct labor 200,000
Factory overhead
Indirect labor Br. 32,000
Supplies 90,000
Allocated occupancy costs 50,000 172,000
Total cost Br.872, 000

A small local company has offered to supply the components at a price of Br.7.80 each. If the division
discontinued the production of its components it would save two thirds of the supplies cost and Br.22,
000 of indirect labor cost. All other overhead costs would continue regardless of the decision made.
Instruction: Should the parts be made or bought? Assume that the capacity now used to make the parts
will become idle if they are purchased from outside.
Example-3: Assume that the following data relate to Muna Company to make 10,000 units of product-X.
Total cost Unit costs
Direct material---------------------------------------40,000 4
Direct labor-------------------------------------------160,000 16
FOH-Variable-----------------------------------------80,000 8

Page 20 of 65
 FOH-Fixed -------------------------------------------160,000 16
Total----------------------------------------------------440,000 44

 An other manufacturer offers to sell Muna Company the same part for Br40 per unit.
 Note that Br40, 000 of the fixed cost will be eliminated if the parts are bought instead of made
and released facilities will be left idle.
Required: Should the company make or buy the part?
 Assume that the released facilities can be used for other purposes say:
 In some activity to generate a contribution to profit of Br110, 000
 Renting out for Br70,000
Required: Which alternative is the best alternative?
2.1.2.2 Joint Product Decisions: Sell or Process Further
Often a firm manufactures several different products from a common input and a common production
process. In some cases of such multiple products processing, only one product is of major importance.
The other products are incidental to production. For example, processing of log in a wood industry
produces lumber and saw dust where the latter is produced incidentally. In other cases, several products
of comparable value or importance emerge from a single process. For example, gasoline, jet fuel, and
lubricants all result from petroleum refining. The accountant classifies multiple products according to
their relative importance. The principal product is called the main product. Incidental products of lesser
value are usually called by – products. Products of nearly equal value are usually called joint products,
or co-products.

When two or more manufactured products have relatively significant sales values and are not separately
identifiable as individual products until their split off, they are called joint products.
 Split –off point- is the juncture in manufacturing where the joint products become individually
identifiable.
 The costs of manufacturing joint products before the split – off are called joint costs. The costs of
further processing beyond the split-off are separable costs.
Firms that produce several end products from a common input are faced with the problem of deciding
whether it is more advantageous to sell the products at split- off point or process them further. When
such a choice is available, managers must be familiar with the relevant cost and revenue data to reach a
correct decision.
Here, the decision whether to sell or process further will be taken by comparing the additional cost of
processing with the incremental revenue obtainable from the product processed further. This decision
will not be influenced either by the size of the joint cost or the portion of the joint cost allocated to the
product which is to be processed further. Thus, joint product costs are irrelevant in decision regarding
what to do with a product from the split-off point forward, the joint product costs have already been
incurred and therefore are sunk costs. However, allocation of joint product costs is need for some
purposes, such as balance sheet inventory valuation. In case joint products are on hand at the end of an

Page 21 of 65
accounting period, some value must be assigned to them. To do so, joint product costs must be allocated
to specific units of inventory.
 As a general rule, it will always be profitable to continue processing a joint product after the split
–off point so long as the incremental revenue from such processing exceeds the incremental
costs.

Example-1: GREAT Co. uses a common direct material R that has a joint product cost of Br. 16,000
and yields 6,000 pounds of product X selling for Br. 3 per pound and 4,000 pounds of product Y selling
for Br. 3.50 per pound. Product X can be processed further into XP at an additional cost of Br. 8,000,
and product Y can be processed further into YP at an additional cost of Br. 6,000. The new products, XP
and YP, can then be sold for Br. 4 and Br. 6 per pound, respectively.
Instruction: Which product (s) should be sold at split off and which should be sold after processed
further? Why? Assume no loss of input in further processing.
Example-2: UNITED Chemical Company produces three chemical products, x, y and z, as a result of a particular
joint process. The joint process cost is Br. 105,000. This includes raw material costs and the cost of processing to
the point where these joint products go their separate ways. These products were processed further and sold as
follows:
Chemical Products Sales Additional Processing Costs
X Br. 260,000 Br. 220,000
Y 330,000 300,000
Z 175,000 100,000

The company has had an opportunity to sell at split-off directly to other processors. If that alternative
had been selected, sales would have been: X, Br. 56,000, Y, Br. 28,000 and Z, Br. 54,000. The company
expects to operate at the same level of production and sales in the forth-coming year. Consider all the
available information, and assume that all costs incurred after split-off are variable.
Instruction:
a. Which products should be processed further and which should be sold at split-off?
b. Could the company increase operating income by altering its processing decisions? If so, what
would be the expected overall operating income?
2.1.2.3 Keep or Replace Equipment Decisions
Care must be taken to select only the data that are relevant for a decision whether to replace or keep the
old equipment. In such kind of decision, the book value of the old equipment is not a relevant
consideration, for instance. In deciding whether to replace or keep existing equipment, four commonly
encountered items differ in relevance:
(i) Book value of old equipment: Irrelevant, because it is a past (historical) Cost. Therefore,
depreciation on old equipments irrelevant.
(ii) Disposal value of old equipment: Relevant, because it is an expected future inflow that
usually differs among alternatives.

Page 22 of 65
 (iii) Gain or loss on disposal: This is the algebraic difference between book value and disposal
value. It is therefore, a meaningless combination of irrelevant and relevant items.
Consequently, it is best to think of each separately.
(iv) Cost of new equipment: Relevant, because it is an expected future outflow that will differ
among alternatives. Therefore depreciation on new equipment is relevant.
Example-1: Consider the data regarding Success co. photocopying requirements:

Old Equipment Proposed Replacement

Equipment
Useful life, in years 5 3
Current age, in years 2 0
Useful life remaining, in years 3 3
Original cost Br. 25,000 Br. 15,000
Accumulated depreciation 10,000 0
Book value 15,000 Not acquired yet
Disposal value (in cash) now 3,000 Not acquired yet
Disposal value in 2 years 0 0
Annual cash operating costs for power,
maintenance, toner and supplies Br. 14,000 Br.7, 500

The administrator is trying to decide whether to replace the old equipment. Because of rapid changes in
technology, he expects the replacement equipment to have only a three-year useful life. Ignore the
effects of taxes.
Instruction: Should SUCCESS keep or replace the old equipment? Compute the difference in total cost
over the next 3-years under both alternatives that is, keeping the original or replacing it with the new
machine.

Example-2: Awash Co. has just today paid for and installed a special machine for polishing cars at one
of its several outlets. It is the first day of the company's fiscal year.

Page 23 of 65
The machine cost, Br. 20,000. Its annual cash operating costs total Br. 15,000, exclusive of depreciation.
The machine will have a 4-year useful life and a zero terminal disposal price. After the machine has
been used for a day, a machine salesperson offers a different machine that promises to do the same job at
a yearly cash operating cost of Br. 9,000, exclusive of depreciation. The new machine will cost Br.
24,000 cash, installed. The "old" machine is unique and can be sold outright for only Br. 10,000 minus
Br. 2000 removal cost. The new machine, like the old one, will have a 4-year useful life and zero
terminal disposal prices. Sales, all in cash, will be Br. 150,000 annually, and other cash costs will be Br.
110,000 annually, regardless of this decision.
Instructions:
a. Prepare a summary income statement covering the next four years under both alternatives (when
the new machine is not purchased and when the new machine is purchased). What is the
cumulative difference in operating income for the 4 years taken together?
b. Determine the desirability of purchasing the new machine using only relevant costs in your
analysis?

Chapter III:- Information for budgeting, planning and control purposes

3.1 Objectives and concepts of budgetary systems

Page 24 of 65
Introduction to Budget and Budgetary Control
Budget of a business firm serve much the same purpose as the budget prepared by an individual. The
business budgets are, however, prepared in detail and involve more work unlike personal budgets.
Success of a business does not come by accident. That is why all commercial and service organizations
need budgeting. A budget is a formal expression of the management’s plans for the future and how these
plans are to be accomplished. The act of preparing a budget is called Budgeting. An organization may
attain certain degree of success without budget, but it cannot reach that height that could have been
reached with a well-coordinated budgeting system. Budgeting is the most common, useful and widely
used standard device of planning and control. The budgetary control has now become an essential tool
of the management for controlling costs and maximizing profit. Costs can be reduced, wastage can be
prevented and proper relationship between costs and incomes can be established only when the various
factors of production are combined in profitable way.

Definitions of Budget
Budget is a plan quantified in monetary terms prepared and approved prior to a defined period of time
usually showing planned income to be generated and/or expenditure to be incurred during that period
and the capital to be employed to attain a given objective. A budget may be expressed in monetary as
well as non-monetary terms. Example units of time, units of products, number of employees, and etc.

The main features of budgetary control are:

 Establishing budgets for each functional area e.g., sales, production, purchase, etc., the
policies and various activities which might be adopted for achieving them.

 Recording actual performance of each functional area.

 Analyzing the reasons of variances and identifying the persons responsible.

The main objectives of budget are as follows:

 Planning
 Coordination
 Provide motivational impetus
 A good device for communicating plans to various manager
 Controlling
 Uncertainty and budgeting,
Uncertainty and Budgeting
An uncertainty budget is an itemized table of components that contribute to the uncertainty in
measurement results. It reveals important information that identifies, quantifies, and characterizes each
source of uncertainty. The goal of an uncertainty budget is to effectively calculate measurement
uncertainty using a well-organized, structured approach. The benefit is it provides the laboratory with a
formal record of the uncertainty analysis process which can be shared with other professionals who can
validate the results.

Page 25 of 65
 3.2 Types of Budgetary System
Budgetary Control means laying down monetary and quantitative terms of what exactly has to be done,
how it is to be done, the actual results should not deviate much from the budgeted results, a course of
action if results deviate and also fixing the responsibilities for various levels of management.

Budgetary control methods

a) Budget: is a formal statement of the financial resources set aside for carrying out specific activities in
a given period of time. It helps to co-ordinate the activities of the organization. An example would be an
advertising budget or sales force budget.

b) Budgetary control: is a control technique where by actual results are compared with budgets. Any
differences (variances) are made the responsibility of key individuals who can either exercise control
action or revise the original budgets.

Budgetary control and responsibility centers:

These enable managers to monitor organisational functions. A responsibility centre can be defined as

any functional unit headed by a manager who is responsible for the activities of that unit. There are four
types of responsibility centres:

 Revenue centres
 Expense centres

 Profit centres

 Investment centres

Advantages of budgeting and budgetary control

 Promotes coordination and communication.

 Clearly defines areas of responsibility.

 Provides a basis for performance appraisal (variance analysis).

 Enables remedial action to be taken as variances emerge.

 Motivates employees by participating in the setting of budgets.

 Improves the allocation of scarce resources.

Characteristics of a budget

Page 26 of 65
  A good budget is characterized by the following:
 Participation: involve as many people as possible in drawing up a budget.
 Comprehensiveness: embrace the whole organization.
 Standards: base it on established standards of performance.
 Flexibility: allow for changing circumstances.
 Feedback: constantly monitor performance.
 Analysis of costs and revenues: this can be done on the basis of product lines, departments or
cost centres.

There are four common types of budgets that companies use: 

a) Incremental,
b) activity-based,
c) Value proposition, and
d) Zero-based.

A. Incremental budgeting

An incremental budget is a budget that is prepared by taking the current period’s budget or actual
performance and using it as a base and then adjusting it by incremental amounts. This is typically
accomplished by taking the prior year’s budget and adjusting for some increase in costs.

Important of incremental budgeting

This approach to budgeting is perhaps the most widely adopted and practiced in the modern business
setting. One of the biggest benefits of the incremental budget is that it is easy to use and less
intimidating to approach. Having a basic understanding of how incremental budgeting works will help
you feel more confident when entering the finance profession. If you are new to budgeting, it is also the
easiest budgeting methodology to practice and understand making it good for many small business
applications. 

B. Activity- based budgeting:

Activity- based budgeting is a budgeting system in which you record and analyze every activity that
creates a cost to find areas for improving efficiencies. After analyzing costs, you can create a budget
based on your findings. Activity-based budgeting is more comprehensive than traditional budgeting
since it involves additional calculations. This budgeting type aims to reduce costs and improve
efficiency, not just track expenses or adjust information based on inflation or other related occurrences.

The main objective of activity-based budgeting is to cut down on costs. It's an in-depth analysis of
expenses and how they may affect a company's performance. This gives better insight into both specific

Page 27 of 65
and overall operational expenses. These evaluations may be helpful throughout company departments
for determining how to improve aspects of individual processes to make them more efficient.
How to conduct activity-based budgeting
1. Identify cost drivers
2. Compute the baseline units necessary for each activity
3. Compute the total cost of each activity

C. Value proposition
A value proposition is a simple statement that clearly communicates the product or service benefit you
promise to deliver to your customers. It's ultimately what makes your product attractive to your ideal
customer.
Components of value propositions
 Identify a specific problem being dealt with by a specific audience.
 Articulates how the product/service being sold solves this specific problem.
 Communicate the audience-specific intangible and quantifiable benefits of the solution.

D. Zero Based budget:

This deviates from the other basic approach to budgeting, the zero-based budget, in that each cost is not
necessarily scrutinized and justified, but simply adjusted for expectations in the coming period. That is
not to say that expenses and revenue are not scrutinized in incremental budgets, because they are. 

3.3 Monitoring and controlling performance; the calculation of variances; the determination
of the causes of variances
Variance Analysis

A variance is the difference between an actual result and an expected result. The process by which the
total difference between standard and actual results is analyzed is known as variance analysis. When
actual results are better than the expected results, we have a favorable variance (F). If, on the other hand,
actual results are worse than expected results, we have an adverse (A).

1. Variable cost variances

Direct material variances: The direct material total variance is the difference between what the output
actually cost and what it should have cost, in terms of material. It can be divided into two sub-variances.

a. The direct material price variance: This is the difference between what the actual quantity of
material used did cost and what it should have cost. Favorable (F) when unforeseen discounts received,
greater care taken in purchasing, change in material standard and Actual (A) when Price increase,
careless purchasing, change in material standard.

Page 28 of 65
b. The direct material usage variance: This is the difference between how much material should have
been used for the number of units actually produced and how much material was used, valued at
standard cost. The direct material price variance is calculated on material purchases in the period if
closing stocks of raw materials are valued at standard cost or material used if closing stocks of raw
materials are valued at actual cost (FIFO). Material usage is favorable (F) if material used of higher
quality than standard, more effective use made of material but actual (A) when defective material,
excessive waste, theft, stricter quality control.

Direct labour total variance: The direct labour total variance is the difference between what the output
should have cost and what it did cost, in terms of labour.

Direct labour rate variance: This is the difference between what the actual number of hours worked
should have cost and what it did cost. Labour rate (F) is the use of workers at rate of pay lower than
standard and (A) is occur when the wage rate increase.

The direct labour efficiency variance: The is the difference between how many hours should have
been worked for the number of units actually produced and how many hours were worked, valued at the
standard rate per hour. When idle time occurs the efficiency variance is based on hours actually worked
(not hours paid for) and an idle time variance (hours of idle time x standard rate per hour) is calculated.
Labour efficiency (F) is the output produced more quickly than expected because of work motivation,
better quality of equipment or materials but (A) is a lost time in excess of standard allowed, output lower
than standard set because of deliberate restriction, lack of training, sub-standard material used.

2. Variable production overhead total variances

The variable production overhead total variance is the difference between what the output should have
cost and what it did cost, in terms of variable production overhead.

The variable production overhead expenditure variance: This is the difference between what the
variable production overhead did cost and what it should have cost. Under Overhead expenditure (F) is
savings in cost incurred, more economical use of services. And (A) is increase in cost of services used,
excessive use of services, change in type of services used.

The variable production overhead efficiency variance: This is the same as the direct labour efficiency
variance in hours, valued at the variable production overhead rate per hour. For Overhead volume (F) is
indicate production greater than budgeted and (A) is the result of production is less than budgeted.

3. Fixed production overhead variances

The total fixed production variance is an attempt to explain the under- or over-absorbed fixed production
overhead.

Page 29 of 65
Remember that overhead absorption rate = Budgeted fixed production overhead
Budgeted level of activity

4. The fixed production overhead variances are calculated as follows:

Fixed production overhead variance: This is the difference between fixed production overhead
incurred and fixed production overhead absorbed (= the under- or over-absorbed fixed production
overhead).

Fixed production overhead expenditure variance: This is the difference between the budgeted fixed
production overhead expenditure and actual fixed production overhead expenditure.

Fixed production overhead volume variance: This is the difference between actual and budgeted
production volume multiplied by the standard absorption rate per unit.

Fixed production overhead volume efficiency variance: This is the difference between the number of
hours that actual production should have taken, and the number of hours actually worked (usually the
labour efficiency variance), multiplied by the standard absorption rate per hour.

Fixed production overhead volume capacity variance: This is the difference between budgeted hours
of work and the actual hours worked, multiplied by the standard absorption rate per hour.

4. Selling price variance

The selling price variance is a measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have been
for the actual quantity sold, and what it was.

Sales volume variance: The sales volume variance is the difference between the actual units sold and
the budgeted quantity, valued at the standard profit per unit. In other words it measures the increase or
decrease in standard profit as a result of the sales volume being higher or lower than budgeted.

 Budgeting as a multi-purpose activity,

 Budgeting and behavioral influences,
 Quantitative aids in budgeting: learning curve theory and application; limiting factors and
linear programming,
 Activity-based budgeting,
 Control theory and budgeting,
 Identification of relevance, strengths and weaknesses of budgeting and budgetary control
3.4 Types of budgetary systems: fixed and flexible budgets, zero-based budgets, and
incremental, periodic and continuous budgeting, Short-term vs. long-term budgets

Page 30 of 65
 A budget may be expressed in relation to:
 Period – Short-term and Long-term Budget;

 Behavior – Fixed and Flexible Budget; and

 Functions – Sales Budget, Production Budget, Cash Budget, etc.

A periodic budget, as the name suggests, involves dividing the annual budget into smaller periods. It is
more useful to refer to pay periods since money coming in and out centres around them. To establish a
periodic budget, you have to know the available amount of your cash assets when creating the budget.
The short term budget is more reliable and accurate. The long term budget is prepared for a long term
that is more than one year. It covers three years to 10 years of planning. The short term budget
is prepared for a period of one month to one year. A long-range budget is a financial plan that extends
for more than one year into the future. This type of budget typically covers a five-year period and is
focused on the strategic direction of the business.

Fixed budgets
Fixed budgets are useful for measuring effectiveness, i.e., achievement of goal. In some cases, however,
fixed budgets do not identify the question, “what should the result be, given the actual level of activity”.
A fixed budget is a budget which is used unaltered during the budget period. It is prepared for a
particular activity level and it does not change with actual activity level being higher or lower than
budgeted activity level. In other words, this budget does not highlight the ‘activity variance’, i.e., the
change accountable for actual activity level being different from budgeted activity level. The most
Difference between Flexible Budgets and Fixed Budgets are; under fixed budgets, budgeted cost as per
budgeted activity is compared with actual cost as per actual activity. Under flexible budgets, budgeted
cost as per actual activity is compared with actual cost as per actual activity. This point constitutes the
most vital difference between flexible budgets and fixed budgets.

Following are the disadvantages of fixed budget:

 It is misleading. A poor performance may remain undetected and a good performance
may go unrealized.

 It is inadequate for control purposes.

 It violates logic. Based on logic, comparison should be made between two things with a
like base. When fixed budget is used, budgeted costs at budgeted activity are compared
with actual costs at actual activity, i.e., two things with two different bases are compared.

2. Flexible Budget (Dynamic Budget)

A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to
change as volume of output changes. It is designed to furnish budgeted cost at any level of activity

Page 31 of 65
actually attained. Flexible budget is also known as variable or sliding scale budget. The main
characteristic of flexible budget is that it shows the expenditure appropriate to various levels of output.

Flexible budgeting helps both in profit planning and operating cost control. flexible budget (sometimes
called a variable budget) is budget that can easily be adjusted for differences in the level of activity.
Actual activity may differ significantly from budgeted activity because of an unexpected labor strike,
cancellation of an order, unexpected large new production contract, and other factors. When actual
results differ considerably from plans, a fixed or static budget may not be particularly effective in
supporting managers. In such cases several budgets prepared for a variety of activity levels may be more
useful. In contrast to the performance report based only on comparing the master budget to the actual
results, a more useful benchmark for analysis is the flexible budget. It provides managers more useful
information for planning and better basis for comparing performance than, a static or fixed budget.

Features of Flexible Budget

Flexible budgets have several desirable characteristics. They:
i. Cover a range of activity
ii. Are dynamic
iii. Facilitate performance measurement.
Flexible Budgeting Process
The following steps are needed to develop a flexible budget.
i. Determine the range of activity the budget should cover (because cost behavior patterns may
be different in different ranges of activity)
ii. Determine the cost behavior pattern for each cost included in the budget.
iii. Select the activity levels for which budgets will be prepared.
iv. Prepared a flexible budget using the cost behavior data and the selected activity level.

Example (2): Evergreen Company is planning to use a flexible budgeting system to plan and control its
operations. Evergreen made the following cost estimates for budgeting purposes:
Budget Formula Per Unit
Sales Br. 31.00
Variable Costs
* Manufacturing Br. 21.00
* Selling 0.60
* Administrative 0.20
Total Variable Costs Br. 21.80
Contribution Margin Br. 9.20
Budget Formula Per Month
Fixed Costs
* Manufacturing Br. 37,000
* Selling and administrative 33,000

Page 32 of 65
 Total fixed costs Br. 70,000

Instruction: Prepared a flexible budget for the next month using 7,000, 8,000, and 9,000 units as activity
level. Evergreen Company’s cost functions or flexible budget formulas are believed to be valid within
the range of 7,000 to 9,000 units. At what level of activity does the company breakeven?

Exhibit 2.2 Evergreen Co. Flexible Budget

Flexible Budgets For Various Activity Levels
7,000 units 8,000 units 9,000 units
Sales Br. 217,000 Br. 248,000 Br. 279,000
Variable Costs
* Manufacturing Br. 147,000 Br. 168,000 Br. 189,000
* Selling 4,200 4,800 5,400
* Administrative 1,400 1,600 1,800
Total Variable Costs Br. 152,600 Br. 174,400 Br. 196,200
Contribution margin Br. 64,400 Br. 73,600 Br. 82,800
Fixed costs
* Manufacturing Br. 37,000 Br. 37,000 Br. 37,000
* Selling and 33,000 33,000 33,000
administrative
Total fixed costs Br. 70,000 Br. 70,000 Br. 70,000
Operating income (loss) Br. (5,600) Br. 3,600 B. 12,800

BEP (in units) = Total fixed costs /Unit Contribution Margin

= Br.70, 000 /31-21.8
= 7609 units (approximation) BEP (in birrs)
= Total fixed costs =Br.70, 000 =Br.235,873(approximation)
=CM-ratio 9.2/31= 0.29
Comparing the flexible budget to actual results accomplishes an important performance evaluation
purpose. There are basically two reasons why actual results might not have conformed to the master
budget:
i. Sales and other cost-driver activities were not the same as originally forecasted.
ii. Revenues or variable costs per unit and fixed costs per period were not as expected.

3.5 Master budgets

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

Page 33 of 65
There are two major components of master budget. Such are operating budget and the financial budget.

Operating budget:- It focuses on income statement and supporting schedules. It is also called profit
plan. However, such budget may show a budgeted loss, or can be used to budget expenses in an
organization or agency with no sales revenues.
Financial budget:- It focuses on the effects that the operating budget and other plans will have on cash.
The usual master budget for a non-manufacturing company has the following components.
1. Operating budget includes: 2. Financial budget include:
a. Sales budget a. Capital budget
b. Purchases budget b. Cash budget
c. Cost of goods sold budget c. Budgeted balance sheets
d. Operating expense budget d. Budgeted statement of cash flows
In addition to the master budget there are countless forms of special budgets and related reports. For
example, a report might detail goals and objectives for improvements in quality or customer satisfaction
during the budget period.
Figure 3-1 Preparation of Master Budget (Non manufacturing Company)

Sales
Budget

Ending –inventory Purchase

Budget Budget

Operating Cost of Goods

Budget Sold Budget

Operating
Expenses Budget

Budgeted Statement
of Income

Financial
Budget

Capital Cash Budgeted

Budget Budget Balance Sheet

Exhibit 3-1 above show graphically the follow of process in development of the master budget for a
non-manufacturing firm. The master budget example that follows should clarify the steps required to

Page 34 of 65
prepare the budget package. After studying the entire example, return to Exhibit 1-1 and follow the
example through the flow diagram.
Operating Budget: The operating budget is composed of the income statement elements. A
manufacturing business budgets both manufacturing and non-manufacturing activities. Below the
various elements of the operating budget of a manufacturing firm have been discussed.

Sales Budget: The sales budget is the first budget to be prepared. It is usually the most important budget
because so many other budgets are directly related to sales. Inventory budgets, purchases budgets,
personnel budgets, marketing budgets, administrative budgets, and other budget areas are all affected
significantly by the amount of revenue that is expected from sales. Sales budgets are influenced by a wide
variety of factors, including general economic conditions, pricing decisions, competitor actions, industry
conditions, and marketing programs. In an effort to develop an accurate sales budget, firms employ many
experts to assist in sales forecasting. The sales budget is usually based on a sales forecast. A sales forecast
is a prediction of sales under a given conditions. The objective in forecasting sales is to estimate the volume
of sales for the period based on all the factors, both internal and external to the business that could
potentially affect the level of sales. Important factors considered by sales forecasters include:

a) Past patterns of sales: Past experience combined with detailed past sales by product line, geographical
region, and type of customer can help predict future sales.
b) Estimates made by the sales force: A company’s sales force is often the best source of information about
the desires and plans of customers.
c) General economic conditions: Predictions for many economic indicators, such as gross domestic product
and industrial production indexes (local and foreign), are published regularly. Knowledge of how sales relate
to these indicators can aid sales forecasting.
d) Competitive actions: Sales depend on the strength and actions of competitors. To forecast sales, a
company should consider the likely strategies and reactions of competitors, such as changes in their prices,
products, or services.
e) Changes in the firm’s prices: Sales can be increased by decreasing prices and vice versa. Planned
changes in prices should consider effects on customer demand.
f) Changes in product mix: Changing the mix of products often can affect not only sales levels but also
overall contribution margin. Identifying the most profitable products and devising methods to increases sales
is a key part of successful management.
g) Market research studies: Some companies hire market experts to gather information about market
conditions and customer preferences. Such information is useful to managers making sales forecasts and
product mix decisions.
h) Advertising and sales promotion plans: Advertising and other promotional costs affect sales levels. A
sales forecast should be based on anticipated effects of promotional activities.

Purchases Budget

Page 35 of 65
 After sales are budgeted, prepare the purchases budget. The total merchandise needed will be the sum of the
desired ending inventory plus the amount needed to fulfill budgeted sales demand. The total need will be
partially met by the beginning inventory; the remainder must come from planned purchases.
These purchases are computed as follows:
Budgeted Desired Cost of Beginning

Purchases = Ending inventory + Goods Sold - Inventory

Budgeted cost of goods sold: For a manufacturing firm cost of goods sold is the production cost of products
that are sold. Consequently, the cost of goods sold budget follows directly from the production budget.
However, a merchandising firm has no production budget. The cost of goods sold budget comes directly from
merchandise inventory and the merchandise purchases budget.
Operating Expense Budget: The budgeting of operating expenses depends on various factors. Month –
to – month fluctuation in sales volume and other cost-drivers activities directly influence many operating
expenses. Examples of expenses driven by sales volume include sales commissions and many delivery
expenses. Other expenses are not influenced by sales or other cost-driver activity (such as rent,
insurance, depreciation, and salaries) within appropriate relevant ranges and are regarded as fixed.
Budgeted Income Statement: The budgeted income statement is the combination of all of the
preceding budgets. This budget shows the expected revenues and expenses from operations during the
budget period.
A firm may have budgeted non-operating items such as interest on investments or gain or loss on the
sale of fixed assets. Usually they are relatively small, although in large firms the birr amounts can be
sizable. If non-operating items are expected, they should be included in the firm’s budgeted income
statement. Income taxes are levied on actual, not budgeted, net income, but the budget plan should
include expected taxes; therefore, the last figure in the budgeted income statement is budgeted after tax
net income.

Financial Budget
The second major part of the master budget is the financial budget, which consists of the capital budget,
cash budget, ending balance sheet and the statement of changes in financial position. Although there are
some differences in operating budgets of manufacturing, merchandising and service firms, very little
difference exists among financial budgets of these entities.
Capital expenditure budget: Capital budgeting is the planning of investments in major resources like
plant and equipment, and other types of long-term projects, such as employee education programs. The
capital expenditure budget or capital budget describes the capital investment plans for an
organization for the budget period. It contains some of the most critical budgeting decisions of the
organizations.

Cash budget
The cash budget is a statement of planned cash receipts and disbursements. The cash budget is
composed of four major sections:

Page 36 of 65
 (i) The receipts section: It consists of a listing of all of the cash inflows, except for financing,
expected during the budget period. Generally the major source of receipts will be from sales.
(ii) The disbursement section: It consists of all cash payments that are planned for the budget
period. These payments will include inventory purchases, wages and salary payments and so on.
In addition, other cash disbursements such as equipment purchases, dividends, and other cash
withdrawals by owners are listed.
(iii) The cash excess or deficiency section: The cash excess or deficiency section is
computed as follows:
Cash balance, beginning xxx
Add receipts xxx
Total cash available before financing xxx
Less disbursements xxx
Excess (deficiency) of cash available over disbursements xxx
If there is a cash deficiency during any budget period, the company will need to borrow funds. If there is
cash excess during any budget period, funds borrowed in previous periods can be repaid or the idle funds
can be placed in short-term or other investments.
(iv)The financing section: This section provides a detail account of the borrowing and repayments
projected to take place during the budget period. It also includes a detail of interest payments
that will be due on money borrowed.
Budgeted Balance Sheet: The budgeted balance sheet, sometimes called the budgeted statement of
financial position, is derived from the budgeted balance sheet at the beginning of the budget period and
the expected changes in the account balance reflected in the operating budget, capital budget, and cash
budget.
Budgeted Statement of Changes in Financial Position: The final element of the master budget
package is the statement of changes in financial position. It has emerged as a useful tool for managers in
the financial planning process. This statement is usually prepared from data in the budgeted income
statement and changes between the estimated balance sheet at the beginning of the budget period and the
budgeted balance sheet at the end of the budget period.

Preparing the Master Budget

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

Preparation of Master Budget (Manufacturing Company)

Example (2) Great Company manufactures and sells a product whose peak sales occur in the third
quarter. Management is now preparing detailed budgets for 20x4- the coming year and has assembled
the following information to assist in the budget preparation:

Page 37 of 65
 1) The company’s product selling price is Br. 20 per unit. The marketing department has
estimated sales as follows for the next six quarters.

20x4 Quarters 20x5 Quarters

1 2 3 4 1 2
Budgeted sales in units 10, 000 30,000 40, 000 20, 000 15, 000 15, 000
2) Sales are collected in the following pattern: 70% of sales are collected in the
quarter in which the sales are made and the remaining 30% are collected in the following
quarter. On January1, 20x4, the company’s balance sheet showed Br.90, 000 in account
receivable, all of which will be collected in the first quarter of the year. Bad debts are
negligible and can be ignored.
3) The company maintains an ending inventory of finished units equal to 20% of
the next quarter’s sales. The requirement was met on December 31, 20x3, in that the
company had 2, 000 units on hand to start the New Year.
4) Fifteen pounds of raw materials are needed to complete one unit of product.
The company requires an ending inventory of raw materials on hand at the end of each
quarter equal to 10% of the following quarter’s production needs of raw materials. This
requirement was met on December 31, 20x3 in that the company had 21, 000 pounds of raw
materials to start the New Year.
5) The raw material costs Br.0.20 per pound. Raw material purchases are paid
for in the following pattern: 50% paid in the quarter the purchases are made, and the
remainder is paid in the following quarter. On January 1,20x4, the company’s balance sheet
showed Br.25, 800 in accounts payable for raw material purchases, all of which be paid for in
the first quarter of the year.
6) Each unit of Great’s product requires 0.8 hour of labor time. Estimated direct labor cost per
hour is Br.7.50.
7) Variable overhead is allocated to production using labor hours as the allocation base as
follows:
Indirect materials Br.0.40
Indirect labor 0.75
Fringe benefits 0.25
Payroll taxes 0.10
Utilities 0.15
Maintenance 0.35
Fixed overhead for each quarter was budgeted at Br. 60, 600. Of the fixed overhead amount,
Br. 15, 000 each quarter is depreciation. Overhead expenses are paid as incurred.
8) The company’s quarterly budgeted fixed selling and administrative expenses are as follows:
20X4 Quarters
1 2 3 4

Page 38 of 65
 Advertising Br.20, 000 Br.20, 000 Br.20, 000 Br.20, 000

Executive salaries 55, 000 55, 000 55, 000 55, 000
Insurance - 1, 900 37,750 -
Property taxes - - - 18, 150
Depreciation 10, 000 10, 000 10, 000 10, 000

The only variable selling and administrative expense, sales commission, is budgeted at Br.1.80 per unit
of the budgeted sales. All selling and administrative expenses are paid during the quarter, in cash, with
exception of depreciation. New equipment purchases will be made during each quarter of the budget
year for Br. 50, 000, Br. 40, 000, & Br.20, 000 each for the last two quarter in cash, respectively. The
company declares and pays dividends of Br.8, 000 cash each quarter. The company’s balance sheet at
December 31, 20x3 is presented below:

ASSETS
Current assets:
Cash Br. 42, 500
Accounts Receivable 90, 000
Raw Materials Inventory (21, 000 pounds) 4, 200
Finished Goods Inventory (2, 000 units) 26, 000
Total current assets Br.162, 7 00
Plant and Equipment:
Land Br.80, 000
Building and Equipment 700, 000
Accumulated Depreciation (292, 000)
Plant and Equipment, net 488, 000
Total assets Br.650,
700 Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable (raw materials) Br.25, 800
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 449, 900
Total stockholders’ equity 624, 900
Total liabilities and stockholders’ equity Br.650, 700
The company can borrow money from its bank at 10% annual interest. All borrowing must be done
at the beginning of a quarter, and repayments must be made at the end of a quarter. All borrowings
and all repayments are in multiples of Br. 1,000.
The company requires a minimum cash balance of Br.40, 000 at the end of each quarter. Interest is
computed and paid on the principal being repaid only at the time of repayment of principal. The
company whishes to use any excess cash to pay loans off as rapidly as possible.

Page 39 of 65
Instructions: Prepare a master budget for the four-quarter period ending December 31. Include the
following detailed budget and schedules:
1. a) A sales budget, by quarter and in total
b) A schedule of budgeted cash collections, by quarter and in total
c) A production budget
d) A direct materials purchase budget
e) A schedule of budgeted cash payments for purchases by quarter and in total
f) A direct labor budget
g) A manufacturing overhead budget
h) Ending finished goods inventory budget
i) A selling and administrative budget
2. A cash budget, by quarter and in total
3. A budgeted income statement for the four- quarter ending December 31, 20x4
4. A budgeted balance sheet as of December 31, 20x4.
Preparation of Master Budget (Merchandising Company)
Example 1: Blue Nile Company’s newly hired accountant has persuaded management to prepare a
master budget to aid financial and operating decisions. The planning horizon is only three months,
January to March. Sales in December (20x3) were Br. 40, 000. Monthly sales for the first four months of
the next year (20x4) are forecasted as follows:
January Br. 50, 000
February 80, 000
March 60, 000
April 50, 000
Normally 60% of sales are on cash and the remainders are credit sales. All credit sales are collected in
the month following the sales. Uncollectible accounts are negligible and are to be ignored.
Because deliveries from suppliers and customer demand are uncertain, at the end of any month Blue
Nile wants to have a basic inventory of Br. 20, 000 plus 80% of the expected cost of goods to be sold in
the following month. The cost of merchandise sold averages 70%of sales. The purchase terms available
to the company are net 30 days. Each month’s purchase are paid as follows:
50% during the month of purchase and,
50% during the month following the purchases
Monthly expenses are:
Wages and commissions……………………………Br. 2, 500 + 15%of sales, paid as incurred.
Rent expense………………………………………..Br. 2, 000 paid as incurred.
Insurance expense…………………………………..Br.200 expiration per month
Depreciation including truck……………………….Br.500 per month
Miscellaneous expense…………………………….5% of sales, paid as incurred.
In January, a used truck will be purchased for Br. 3, 000 cash. The company wants a minimum cash
balance of Br. 10, 000 at the end of each month. Blue Nile can borrow cash or repay loans in multiples
of Br. 1, 000. Management plans to borrow cash more than necessary and to repay as promptly as
possible. Assume that the borrowing takes place at the beginning, and repayment at the end of the

Page 40 of 65
months in question. Interest is paid when the related loan is repaid. The interest rate is 18% per annum.
The closing balance sheet for the fiscal year just ended at December 31, 20x3,is:

Blue Nile Company

Balance Sheet
December 31, 20x3
ASSETS
Current assets:
Cash Br. 10, 000
Account receivable 16,000
Merchandise inventory 48, 000
Unexpired insurance 1, 800 Br.75,
800
Plant assets:
Equipment, fixture and other Br.37, 000
Accumulated depreciation 12, 800 Br.24, 200
Total assets Br.100,000
LIABILITIES AND OWNERS’ EQUITY
Liabilities:
Accounts payable Br.16, 800
Accrued wages and commissions payable 4, 250 Br.21,
050
Capital:
Owners’ equity 78, 950
Total liabilities and owners’ equity Br.100, 000
Instructions:
1) Using the data given above, prepare the following detailed schedules for the first quarter of the year:
b) Sales budget
c) Cash collection budget
d) Purchase budget
e) Disbursement for purchases
f) Operating expenses budget
g) Disbursement for operating expenses
2) Using the budget data given above and the schedules you have prepared, construct the following pro
forma financial statements
a. Income statement for the first quarter of the year.
b. Cash budget including receipts, payments, and effect of financing
c. Balance sheet at March 31, 20x3.

Solution-Preparation of Master Budget (Merchandising Company)

STEPS IN PREPARATION OF MASTER BUDGET

Page 41 of 65
 1. A) Sales budget

December* January February March Jan.-Mar.

Total
Cash sales (40%) Br.24, 000 Br.30, 000 Br.48, 000 Br.36, 000 Br.114, 000
Credit sales (60%) 16, 000 20, 000 32, 000 24,000 76, 000
Totals Br.40, 000 Br.50, 000 Br.80, 000 Br.60, 000 Br.190, 000

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

b) Cash collection budget

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

c) Purchase budget

January February March Jan.-Mar

Required ending inventory Br.64, 800 Br.53, 600 Br.48, 000
Cost of gods sold 35, 000 56, 000 42, 000 Br.133, 000
Total needed Br.99, 800 Br.109, 600 Br.90, 000
Beginning inventory 48, 000 64, 800 53, 600
Purchases budget Br.51, 800 Br.44, 800 Br.36,
400

d) Disbursement for purchases

January February March

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

e) Operating expense budget

January February March Jan.-Mar.

Wages and commissions Br.10, 000 Br.14, 500 Br.11, 500 Br.36, 000
Rent expense 2, 000 2, 000 2, 000 6, 000
Insurance expense 200 200 200 600

Page 42 of 65
 Depreciation expense 500 500 500 1, 500
Miscellaneous expense 2, 500 4, 000 3, 000 9, 500
Total Br.15, 200 Br.21, 200 Br.17, 200 Br.53, 600

f) Disbursement for operating expenses budget

January February March

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

2. A) Budget income statement

Blue Nile Company

Budget Income Statement
For the Quarter Ended, March 31, 20x4

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

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

*Interest expense computation

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

Page 43 of 65
 b) Cash budget including receipts, payments and effects of financing
January February March
Beginning balance Br.10, 000 Br.10, 550 Br.10, 750
Collections (Schedule1 (b)) 46, 000 68, 000 68, 000
Cash available for the use (x) Br.56, 000 Br.78, 550 Br.78, 750
Cash disbursements for:
Purchases (Schedule 1(d)) 42, 700 48, 300 40, 600
Operating expenses (Schedule1 (f)) 18, 750 20, 500 16, 500
Truck purchases 3, 000 - -
Total disbursement (y) Br.64, 450 Br.68, 800 Br.57, 100
Minimum cash balance required 10, 000 10, 000 10, 000
Total cash needed Br.74, 450 Br.78, 800 Br.67, 100
Cash excess (deficiency) Br.(18, 450) Br.( 250) Br.11, 650
Effects of financing
Borrowing 19, 000 1, 000 -
Payment of the principal - - (11, 000)
Payment of interest - - (495)
Net effect of financing (z) Br.19, 000 Br.1, 000 Br.(11, 495)
End cash balance (x+z-y) Br.10, 550 Br.10, 750 Br.10, 155

c) Budgeted balance sheet

Blue Nile Company
Budgeted Balance Sheet
March 31, 20x4
ASSETS
Current assets
Cash Br. 10, 155
Accounts receivable 24, 000
Merchandise inventory 48, 000
Unexpired insurance 1, 200
Br. 83, 355
Plant assets
Equipment, Fixture and others 40, 000
Accumulated depreciation 14, 300 25, 700
Total assets Br. 109, 055

LIABILITIES AND OWNER’S EQUITY

Liabilities
Accounts payable Br.18, 200
Loan payable 9, 000

Page 44 of 65
 Interest payable 390
Total liabilities Br.27, 590
Capital
Beginning owners’ equity Br.78, 950
Net income 2, 515
Ending capital balance 81, 465
Total equities Br.109, 055

Solution-Preparation of Master Budget (Manufacturing Company)

1. a) Sales Budget
Quarter
1 2 3 4
Expected sales in units 10, 000 30, 000 40, 000 20, 000
Selling price per unit x Br. 20 x Br. 20 x Br.20 x Br.20
Total sales Br.200, 000 Br.600, 000 Br.800, 000 Br.400, 000

b) Schedule of Expected Cash Collections

Quarter
1 2 3 4 Total
30% of the previous Br. 90, 000 Br.60, 000 Br.180, 000 Br.240, 000 Br.570, 000
quarter sales
70% of the current 140, 000 420, 000 560, 000 280, 000 1, 400, 000
quarter sales
Total collections Br.230, 000 Br.480, 000 Br.740, 000 Br. 520, 000 Br.1, 970, 000

c) Production Budget
After the sales budget has been prepared, the production requirements for the forth-coming budget period can
be determined and organized in the form of a production budget. Sufficient goods will have to be available to
meet sales and provide for the desired ending inventory. A portion of these goods will already exist in the form
of a beginning inventory. The remainder will have to be produced. Therefore, production needs can be
determined as follows:
Budgeted sales in units ………………………………………… xxxx
Add desired ending inventory……………….…………………. xxxx
Total needs……………………………………………………… xxxx
Less beginning inventory……………………………………….. xxxx
Required production……………………………………………. .xxxx
The schedule given below shows the production budget for Great Company. Note that the desired level
of the ending inventory influences production requirements for a quarter. Inventories should be carefully
planned. Excessive inventories tie up funds and create storage problems. Insufficient inventories can
lead to lost sales or crash production efforts in the following period

Page 45 of 65
 Quarter Total
Expected sales(units) 10, 000 30, 000 40, 000 20, 000 100, 000
Add: Desired Ending 6, 000 8, 000 4, 000 3, 000 3, 000
Inventory
Total needs 16, 000 38, 000 44, 000 23, 000 103, 000
Lees: Beginning Inventory 2, 000 6, 000 8, 000 4, 000 2, 000
Units to be produced 14, 000 32,000 36, 000 19, 000 101, 000
1 2 3 4

d) Direct Materials Budget

Returning to Great Company’s budget data, after the production requirements have been computed, a direct
materials budget can be prepared. The direct materials budget details the raw materials that must be purchased
to fulfill the production budget and to provide for adequate inventories. The required purchases of raw
materials are computed as follows:
Raw materials needed to meet the production schedule…………………………….xxxx
Add desired ending inventory of raw materials……………….……………………..xxxx
Total raw materials needs…………………………………………………… .xxxx
Less beginning inventory of raw materials………………………….………… xxxx
Raw materials to be purchased………………………………………………………. .xxxx
Quarter Total
1 2 3 4
Production needs(pounds) 210, 000 480, 000 540, 000 285, 000 1, 515, 000
Add: Desired ending inventory 48, 000 54, 000 28, 500 22, 500 22, 500
Total needs 258, 000 534, 000 568, 500 307, 500 1, 537, 500
Less: Beginning inventory 21, 000 48, 000 54, 000 28, 500 21, 000
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516,500
purchased(pounds)

Raw Materials to be purchased (in birrs)

1 2 3 4 Total
Raw materials to be purchased 237, 000 486, 000 514, 500 279, 000 1, 516, 500
Raw materials cost per pound x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20
Total Br.47, 400 Br.97, 200 Br.102, 900 Br.55, 800 Br.303, 300

e) Schedule of Expected Cash Disbursements (for Materials Purchase)

Quarter Total
1 2 3 4
50% of the previous quarter Br. 25, 800 Br.23, 700 Br.48, 600 Br.51, 450 Br.149, 550
50% of the current quarter 23, 700 48, 600 51, 450 27, 900 151, 650
Total cash disbursement Br.49, 500 Br.72, 300 Br.101, 050 Br.79, 350 Br.301, 200

Page 46 of 65
f) Direct Labor Budget
The direct labor budget is also developed from the production budget. Direct labor requirements must be
computed so that the company will know whether sufficient labor time is available to meet production needs.
By knowing in advance just what will be needed in the way of labor time throughout the budget year, the
company can develop plans to adjust the labor force as the situation may require. Firms that neglect to budget
run the risk of facing labor shortage or having to hire and lay off at awkward times. Erratic labor policies lead to
insecurity and inefficiencies on the part of employees. To compute direct labor requirements, the number of
units of finished product to be produced each produced each period (month, quarter, and so on) is multiplied by
the number of direct labor-hours required to produced a single unit. Many different types of labor may be
involved. If so, then the computation should be by type of labor needed. The labor requirements can then be
translated into expected direct labor costs. How this is done will depend on the labor policy of the firm. In
schedule given below, the management of Great Company has assumed that the direct labor force will be
adjusted as the work requirement change from quarter to quarter (for example as units produced changes from
l4, 000 units in quarter 1 to 32, 000 units in quarter 2 for Great Company, the direct labor work force will be
fully adjusted to the workload, i.e., total hours of direct labor time needed) . In that case, the total direct labor
cost is computed by simply multiplying the direct labor-hour required by the direct labor rate hour as was done
in the schedule here under.
Quarter Total
1 2 3 4
Direct labor time needed 11, 200 25, 600 28, 800 15, 200 80, 800
Direct labor cost per hour x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50
Total direct labor cost Br.84, 000 Br.192, 000 Br.216, 000 Br.114, 000 Br.606, 000
g) Manufacturing Overhead (MOH) Budget
The manufacturing overhead budget provides a schedule of all costs of production other than direct
materials and direct labor. These costs should be broken down by cost behavior for budgeting
purposes and a predetermined overhead rate developed. This rate will be used to apply
manufacturing overhead to units of product throughout the budget period.
A computation showing budgeted cash disbursement for manufacturing overhead should be made for
use in developing the cash budget. Since some of the overhead costs do not represent cash outflows,
the total budgeted manufacturing overhead costs must be adjusted to determine the cash disbursement
for manufacturing overhead. At Great Company, the only significant noncash manufacturing
overhead cost is depreciation. Any depreciation charges included in manufacturing overhead must be
deducted from the total in computing expected cash payments, since depreciation is a noncash charge.
Quarter Total
1 2 3 4
Variable overhead Br.22, 400 Br.51, 200 Br.57, 600 Br.30, 400 Br.161,600
Fixed overhead 60, 600 60, 600 60, 600 60, 600 242,400
Total MOH Br.83, 000 Br.111, 800 Br.118, 200 Br.91, 000 Br.404,000
Less: Depreciation 15, 000 15, 000 15, 000 15, 000 60, 000

Page 47 of 65
 Cash disbursements for Br.68, 000 Br.96, 800 Br.103, 200 Br.76, 000 Br.344, 000
MOH
h) Ending Finished Goods Inventory Budget
After completing schedules (a) to (g), the company had all of the data needed to compute unit product
costs. This computation was needed for two reasons: first, to know how much to charge as cost of
goods sold on the budgeted income statement; and second, to know what amount to put on the balance
sheet inventory account for unsold units. The carrying cost of the unsold units is computed on the
ending finished goods inventory budget
Budgeted Finished Goods Inventory 3, 000
Unit product cost Br.13
Ending Finished Goods Inventory in birrs Br.39, 000
Production cost per unit
Quantity (unit) Cost Total
Direct materials 15 pounds Br.0.20 per pound Br.3
Direct labor 0.8 hours 7.50 per hour 6
Manufacturing overhead 0.8 hours 5.00 per hour 4
Unit product cost Br.13
MOH rate= Total MOH = 404, 000 = Br.5.00
Direct labor hours 80, 800
i) Selling and Administrative Expenses Budget
Quarter Total
1 2 3 4
Variable selling expenses Br.18, 000 Br.54, 000 Br.72, 000 Br.36, 000 Br.180, 000
Fixed selling &
administrative expenses
Advertising 20, 000 20, 000 20, 000 20, 000 80, 000
Executive salaries 55, 000 55, 000 55, 000 55, 000 220, 000
Insurance - 1, 900 37, 750 - 39, 650
Property taxes - - - 18,150 18,150
Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total budgeted selling & Br.103, 000 Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
administrative expenses

Disbursement for Selling & Administrative Expenses

Quarter Total
1 2 3 4
Budgeted Selling & Br.103, Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
Administrative 000
Less: Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total Cash Disbursements Br.93, 000 Br.130, 900 Br.184, 750 Br.129, 150 Br.537, 800

Page 48 of 65
2. a) Cash Budget
Quarter Total
1 2 3 4
Cash balance, beginning Br.42, 500 Br.40, 000 Br.40, 000 Br.40, 500 Br.42, 500
Add : Collection from 230, 000 480, 000 740, 000 520, 000 1, 970, 000
customers
Total cash available before 272, 500 520, 000 780, 000 560, 500 2, 012, 500
financing
Less: Disbursements for
Direct materials 49, 500 72, 300 100,050 79, 350 301,200
Direct labor 84, 000 192, 000 216,000 114, 000 606,000
Manufacturing overhead 68, 000 96, 800 103,200 76, 000 344,000
Selling & Administrative 93, 000 130, 900 184,750 129, 150 537,800
Equipment purchases 50, 000 40, 000 20,000 20,000 130,000
Dividend 8, 000 8, 000 8, 000 8, 000 32,000
Total disbursements 352, 500 540,000 632,000 426,500 1,951,000
Minimum cash balance 40, 000 40, 000 40, 000 40, 000 40, 000
Total need 392, 500 580, 000 672, 000 466, 500 1, 991,000
Excess (deficiency) of cash (120, 000) (60, 000) 108, 000 94, 000 21, 500
available over total need
Financing:
Borrowing(at beginning) 120,000 60, 000 - - 180, 000
Repayments( at ending) - - (100, 000) (80,000) (180,000)
Interest(at 10% per annum) - - (7,500) (6,500) (14,000)
Total financing 120, 000 60, 000 (107,500) (86,500) (14,000)
Cash balance, ending Br.40,000 Br.40, Br.40, Br.47, Br.47, 500
000 500 500

b) Budgeted Income Statement

Great Company
Budgeted Income Statement
For the Year Ended December31, 20x4

Sales [100, 000units at Br.20 Schedule 1(a)] Br.2, 000, 000

Cost of Goods Sold [100, 000 units at Br.13 Schedule1 (h)] 1, 300, 000
Gross Margin 700, 000
Selling & Administrative Expenses [Schedule 1 (i)] 577, 800
Net Operating Income 122, 200
Interest Expense [Schedule 2(a)] 14, 000

Page 49 of 65
Net Income Br. 108, 200
c) Budgeted Balance Sheet
Great Company
Budgeted Balance Sheet
December31, 20x4
ASSETS
Current assets:
Cash [Schedule 2(a)] Br. 47, 500
Accounts Receivable 120, 000
Raw Materials Inventory 4, 500
Finished Goods Inventory 39, 000
Total current assets Br.211, 000
Plant and Equipment:
Land Br.80, 000
Building and Equipment 830, 000
Accumulated Depreciation (392, 000)
Plant and Equipment, net 518, 000
Total assets Br.729, 000
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable (raw materials) Br.27, 900
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 526, 100
Total stockholders’ equity 701, 100
Total liabilities and stockholders’ equity Br.729, 000

Chapter IV:- Standard Costing, Flexible Budgeting and Variance Analysis

4.1 The uses and limitations of standard costing methods
Standard costing is typically used in manufacturing to determine the cost of products based on standard
rates for materials, labor, and overhead. Companies use standard costing to set target costs for
production and then compare actual production costs to the target costs. Standard cost is a predetermined

Page 50 of 65
cost. It is based on past experience and is referred to as a common sense cost, reflecting the best
judgment of management. It relates to a product, service, process or an operation. It is also determined
for a normal level of efficiency of operation. Standard cost is used to measure the efficiency of future
production or future operations. For this reason, it provides a useful basis for cost control. Also, standard
cost may be expressed in terms of money or other exact quantities.

The technique of using standard costs for the purposes of cost control is known as standard costing. It is
a system of cost accounting which is designed to find out how much should be the cost of a product
under the existing conditions. The actual cost can be ascertained only when production is undertaken.
The predetermined cost is compared to the actual cost and a variance between the two enables the
management to take necessary corrective measures.

Advantage

Standard costing is a management control technique for every activity. It is not only useful for cost
control purposes but is also helpful in production planning and policy formulation. It allows
management by exception. In the light of various objectives of this system, some of the advantages of
this tool are given below:

1. Efficiency measurement-- The comparison of actual costs with standard costs enables the
management to evaluate performance of various cost centers. In the absence of standard
costing system, actual costs of different period may be compared to measure efficiency. It is
not proper to compare costs of different period because circumstance of both the periods may
be different. Still, a decision about base period can be made with which actual performance
can be compared.
2. Finding of variance-- The performance variances are determined by comparing actual costs
with standard costs. Management is able to spot out the place of inefficiencies. It can fix
responsibility for deviation in performance. It is possible to take corrective measures at the
earliest. A regular check on various expenditures is also ensured by standard cost system.
3. Management by exception-- The targets of different individuals are fixed if the performance
is according to predetermined standards. In this case, there is nothing to worry. The attention
of the management is drawn only when actual performance is less than the budgeted
performance. Management by exception means that everybody is given a target to be
achieved and management need not supervise each and everything. The responsibilities are
fixed and everybody tries to achieve his/her targets.
4. Cost control-- Every costing system aims at cost control and cost reduction. The standards
are being constantly analyzed and an effort is made to improve efficiency. Whenever a
variance occurs, the reasons are studied and immediate corrective measures are undertaken.
The action taken in spotting weak points enables cost control system.

Page 51 of 65
 5. Right decisions-- It enables and provides useful information to the management in taking
important decisions. For example, the problem created by inflating, rising prices. It can also
be used to provide incentive plans for employees etc.
6. Eliminating inefficiencies-- The setting of standards for different elements of cost requires a
detailed study of different aspects. The standards are set differently for manufacturing,
administrative and selling expenses. Improved methods are used for setting these standards.
The determination of manufacturing expenses will require time and motion study for labor
and effective material control devices for materials. Similar studies will be needed for finding
other expenses. All these studies will make it possible to eliminate inefficiencies at different
steps.

Limitation
Although standard costing is a useful technique for a company's management team, it suffers from
limitations. Therefore, when using standard costing, management should remember these. The following
are the important limitation of standard costing.
 Difficulties determining standards
 Expensive
 Need for revised standards
 Not suitable for all producers
 Depends upon budgetary costing
 Needs experts

4.2 The determination of standards costing

How should the ideal standards for better controlling be determined?

1. Determination of Cost Center

According to J. Betty, “A cost center is a department or part of a department or an item of equipment or

machinery or a person or a group of persons in respect of which costs are accumulated, and one where
control can be exercised.” Cost centers are necessary for determining the costs. If the whole factory is
engaged in manufacturing a product, the factory will be a cost center. In fact, a cost center describes the
product while cost is accumulated. Cost centers enable the determination of costs and fixation of
responsibility. A cost center relating to a person is called personnel cost center, and a cost center relating
to products and equipment is called impersonal cost center.

2. Current Standards

A current standard is a standard which is established for use over a short period of time and is related to
current condition. It reflects the performance that should be attained during the current period. The
period for current standard is normally one year. It is presumed that conditions of production will remain

Page 52 of 65
unchanged. In case there is any change in price or manufacturing condition, the standards are also
revised. Current standard may be ideal standard and expected standard.

3. Ideal Standard

This is the standard which represents a high level of efficiency. Ideal standard is fixed on the assumption
that favorable conditions will prevail and management will be at its best. The price paid for materials
will be lowest and wastes etc. will be minimum possible. The labor time for making the production will
be minimum and rates of wages will also be low. The overheads expenses are also set with maximum
efficiency in mind. All the conditions, both internal and external, should be favorable and only then
ideal standard will be achieved.

Ideal standard is fixed on the assumption of those conditions which may rarely exist. This standard is not
practicable and may not be achieved. Though this standard may not be achieved, even then an effort is
made. The deviation between targets and actual performance is ignorable. In practice, ideal standard has
an adverse effect on the employees. They do not try to reach the standard because the standards are not
considered realistic.

4. Basic Standards

A basic standard may be defined as a standard which is established for use for an indefinite period which
may a long period. Basic standard is established for a long period and is not adjusted to the preset
conations. The same standard remains in force for a long period. These standards are revised only on the
changes in specification of material and technology productions. It is indeed just like a number against
which subsequent process changes can be measured. Basic standard enables the measurement of changes
in costs. For example, if the basic cost for material is Rs. 20 per unit and the current price is Rs. 25 per
unit, it will show an increase of 25% in the cost of materials. The changes in manufacturing costs can be
measured by taking basic standard, as a base standard cannot serve as a tool for cost control purpose
because the standard is not revised for a long time. The deviation between standard cost and actual cost
cannot be used as a yardstick for measuring efficiency.

5. Normal Standards

As per terminology, normal standard has been defined as a standard which, it is anticipated, can be
attained over a future period of time, preferably long enough to cover one trade cycle. This standard is
based on the conditions which will cover a future period of five years, concerning one trade cycle. If a
normal cycle of ups and downs in sales and production is 10 years, then standard will be set on average
sales and production which will cover all the years. The standard attempts to cover variance in the
production from one time to another time. An average is taken from the periods of recession and
depression. The normal standard concept is theoretical and cannot be used for cost control purpose.
Normal standard can be properly applied for absorption of overhead cost over a long period of time.

Page 53 of 65
6. Organization for Standard Costing

The success of standard costing system will depend upon the setting up of proper standards. For the
purpose of setting standards, a person or a committee should be given this job. In a big concern, a
standard costing committee is formed for this purpose. The committee includes production manager,
purchase manager, sales manager, personnel manager, chief engineer and cost accountant. The cost
accountant acts as a co-coordinator of this committee.

7. Accounting System

Classification of accounts is necessary to meet the required purpose, i.e. function, asset or revenue item.
Codes can be used to have a speedy collection of accounts. A standard is a pre-determined measure of
material, labor and overheads. It may be expressed in quality and its monetary measurements in standard
costs.
4.3 Flexible budgets and variances
Flexible Budget Variances:
Any variances between the flexible budget and actual results cannot be due to activity levels. These
variances between the flexible budget and actual results are called flexible budget variances and must be
due to departure of actual costs or revenues from flexible-budget formula amounts. Activity level
variances: Any differences or variances between the master budget and the flexible budget are due to
activity levels. These differences are called activity-level variances. The sum of the activity level
variances and the flexible budget variances equal the total of the master budget variances.

Example (3): Refer the data given in example (1) and (2). Prepare a condensed table showing the static
(master) budget variance, the sales activity variance, and the flexible-budget variance.
Exhibit 2.3 Evergreen Co. Summary of Performance
Actual Results Flexible Master Budget Flexible Sales Activity
Budget Budget Variances
Variance
Units 7,000 7,000 9,000 - 2,000U
Sales Br. 17,000 Br. 17,000 Br.279,000 - Br62,000 U
Variable costs 158,270 152,600 196,200 Br 5,670 U 43,600 F
Contribution Br. 58,730 Br. 64,400 Br. 82,800 Br.5,670 U Br18,400 U
margin
Fixed Costs 70,300 70,000 70,000 300 U -
Operating Br. (11,570) Br. (5,600) Br. 12,800 Br. 5,970 U Br. 18,400 U
Income (loss)

*U or F indicates whether the variances are unfavorable or favorable, respectively.

Total master budget variance (TMBV) = ALF + FBV
Where TMBV = Total Master Budget Variance

Page 54 of 65
 ALF = Activity Level Variance
FBV = Flexible Budget Variance
Thus, the total master budget variance for Evergreen Co. amounts to Br. 24,370 unfavorable (Br. 5970 U
+ Br. 18400 U). The sum of the activity-level variances here equals sales-activity variances because
sales are the only activity used as a cost driver. Managers use comparisons between actual results,
master budgets, and flexible budgets to evaluate organizational performance. When evaluating
performance, it is useful to distinguish between effectiveness-the degrees to which a goal, objective, or
target is met- and efficiency-the degree to which inputs are used in relation to a given level of outputs.
Performance may be effective, efficient, both, or neither.

For example, Evergreen Co. set a master budget objective of manufacturing and selling 9,000 units.
Only 7,000 units were actually made and sold, however. Performance, as measured by sales-activity
variances, was ineffective because the sales objective was not met. Was Evergreen’s performance
efficient? Managers judge the degree of efficiency by comparing actual outputs achieved (7,000 units)
with actual inputs (such as the cost of direct materials and direct labor). The less input used to produce a
given output, the more efficient the operation. Evergreen was in efficient in its use of a number of
inputs. Later in this Chapter, direct material, direct labor and variable and fixed overhead flexible-
budget variances will be discussed in detail.

Flexible budget variances measure the efficiency of operations at the actual level of activity. The
flexible-budget variances are shown in column (4) of Exhibit 2.3 total Br. 5,970 unfavorable. The total
flexible-budget variance arises from sales prices received and the variable and fixed costs incurred.
Evergreen Co. had no difference between actual sales price and the flexible-budgeted sales price, so the
focus is on the differences between actual costs and flexible-budgeted costs at actual 7,000-unit level of
activity. Salesactivity variances measure how effective managers have been in meeting the planned sales
objective. In Evergreen Co., sales activity fell 2,000 units short of the planned level. The sales-activity
variances (totaling Br. 18,400 U) are unaffected by any changes in unit prices or variable costs. Why?
Because the same budgeted unit prices and variable costs are used in constructing both the flexible and
master budgets. Therefore, all unit prices and variable costs are held constant in columns (2) and (3) of
Exhibit 2.3

4.4 Identification and calculation of variances: sales variances (including quantity and mix); cost
variances (including mix and yield); absorption and marginal approaches
Mix and Yield Variances

There are a variety of possible extensions to the basic variance analysis presented in previous chapter.
Although it is not practical to include all possible variations of variance analysis, one or two additional
types of analysis will provide you with a feel for the variations of variance analysis found in practice.
Material mix and yield variances provide a variance analysis extension that some firms have found
useful. Most products are a combination of different materials and several types of labor. For such

Page 55 of 65
products, particularly those that require precise recipes the mix of materials and labor should not vary.
Bottling plant managers at MOHA are not allowed to tamper with the formula used to make Pepsi.
Dairies mix precise amounts of chocolate and milk to produce chocolate flavored milk. Some production
environments, however, offer some flexibility. Different types of materials or classes of labor may be
substituted in a product. For example, orange juice manufacturers can mix Jimma and Harar oranges in
slightly different proportions. A fried chicken franchise may mix experienced higher paid cooks with
low paid helpers in their breading operation.
A mix variance is the cost that results from the difference between an actual mix and a standard mix.
Often mix changes can also impact the total output that is produced from a given amount of input. For
example, substituting cooks for helpers may result in higher quantity of breaded chicken pieces because
the cooks are faster and more experienced. A yield variance is the extra cost from the loss in quantity
that results when there is a change in the mix material or labor.

Material Mix and Yield Variance

When different types of materials may be used as substitutes for each other, a standard mix is usually
determined to insure a quality product at the lowest possible cost. If the actual material mix varies from
the standard mix, both quality and cost may be affected. The effect on cost can be determined by
separating the material quantity variance into two variances referred to as material mix and material
yield variances. In addition to the substitutability requirement, the unit of measure for the various
materials needs to be the same. Materials may be measured in gallons or pounds or board feet, or some
other measure, but the unit of measure must be the same for each ingredient. If these two prerequisites
are satisfied, material mix and yield variances can be calculated.
As said earlier, mix and yield variances for materials may be used when the materials are substitutable
for each other. When inputs are substitutable, direct materials efficiency improvement relative to
budgeted costs can come from two sources:
(1) Using less input to achieve a given output, and

(2) Using a cheaper mix to produce a given output.

The total material variance is the sum of material price variance and material quantity variance. The
material quantity variance is the difference between a flexible budget based on the actual quantity used
and a flexible budget based on the standard quantity allowed. The material quantity variance is further
separated into mix and yield variances. Material mix and yield variances are computed as follows.
Direct Material Actual DM Budgeted Actual Qty Budgeted
Mix Variance = Mix - DM mix x of All DM x Price of
Percentage Percentage used DM input

Direct Actual Qty Budgeted Qty of Budgeted Budgeted

Material = of All DM - All DM Allowed x DM mix x Price of
Yield Used for Actual Output Percentage DM input
Variance

Page 56 of 65
 Total Material
Variance

Material Price Material Quantity

Variance Variance

Material Mix Material Yield

Variance Variance

EXAMPLE

Assume Bole Burger combines three ingredients in the production of the firm's popular hamburger. The
standard quantities and input prices of these materials are provided below for a normal production batch
of 2,000 pounds of hamburger.

Material Standard Mix Standard Inputs Standard Price

per pound
A 10% 200 Br1.00
C 50% 1,000 2.00
B 40% 800 3.00
2,000 lbs
The following data are provided for a recent production period in which 20,500 pounds of materials
were used to produce 20,000 pounds of hamburger.
Material Actual Quantities Used
A
2,460
B
9,225
C
8,815
20,500
The requirements are simply to calculate the materials quantity, mix and yield variances for this
situation. The standard quantities of inputs allowed for actual output are:
A = (200/2,000) x 20,000 = 2,000
B = (1,000/2,000) x 20,000 = 10,000

Page 57 of 65
 C = (800/2,000) x 20,000 = 8,000
The variances are calculated in the following manner:
Material Quantity Variance = (AQ - SQ)(SP)
A (2,460 -2,000) (1.00) = Br 460 U
B (10,000 – 9,225) (2.00) = 1,550 F
C (8,000 - 8,815) (3.00) = 2,445 U
Br 1,355U
Material Mix Variance = (AM- SM) (ATM)(SP)
A (0.12-0.10) x 20,500x 1.00 Br 410 U
B (0.45– 0.50) x20,500 x 2.00 2,050 F
C (0.43 -0.40) x 20,500 x 3.00 1,845U
Br 205U
Material Yield Variance = (ATM - STM) (SM)(SP)
A (20,500-20,000)x 0.10x 1.00 Br 50 U
B (20,500-20,000)x 0.50x 2.00 500 U
C (20,500-20,000)x 0.40x 3.00 600 U
Br 1150 U

The sum of the mix and yield variances must be equal to the material quantity variance. The status of the
material quantity variance is determined in the usual way, i.e., it is unfavorable if the actual quantity
used exceeds the standard quantity allowed. The mix variance is unfavorable if Actual Mix > Standard
Mix, i.e., the actual quantity exceeds the quantity called for by the standard mix. This is unfavorable
because it increases the cost of the product. The material yield variances represent a measure of what the
material quantity variances would have been if the actual mix proportions were equal to the standard
mix proportions. The yield variances are unfavorable when Actual Total Material Used >Standard Total
Materials allowed for Actual Output.
Labor Mix and Yield Variances
The idea of labor mix and yield variance is the same as material mix and yield variance. To illustrate
mix and yield variances, consider Birhanu Electric Works – an electrical contractor who does new
construction wiring. The typical crew consists of one experienced electrician and two apprentice
electricians. An experienced electrician can wire 10 fixtures per hour while an apprentice can wire only
5 fixtures per hour. The standard and actual data is summarized as follows. Birhanu Electric: Standard
Cost Sheet for Ginbot

Labor Standard Standard Standard Standard Standard

Rate per Crew Hours Labor Output in
Hour Mix Cost Fixtures

Page 58 of 65
 Apprentice Electricians Br 15 2 (67%) 320 Br 4,800 1,600

Master Electricians Br 40 1 (33%) 160 6,400 1,600

Total 480 Br 11,200 3,200

During Ginbot, Birhanu Electric wired 3,600 fixtures at a total labor cost of Br 15,000. The detailed
breakdown of the actual hours is shown as follows:

Labor Standard Rate Actual Actual Output

per Hour Hours in Fixtures
Apprentice Electricians Br 15 240 1,440
Master Electricians Br 40 240 2,160
Total 480 3,600

Labor Quantity Variance

To understand labor mix and yield variances, we will begin by computing the quantity variance for the
two types of labor, apprentice and master. The first table shows the standard wage rates and the
budgeted hours (480) for a budgeted output of 3,200 fixtures. Since the actual output is 3,600 fixtures
(see the second table), the standard total hours for the actual output is 540 hours [(3,600/3,200) x 480)].
Ignoring the mix, we can compute a quantity variance as simply the difference between actual hours and
the flexible budget for the standard hours earned on the basis of the output of 3,600 fixtures. The labor
quantity variance for Ginbot is:
LQV (Apprentices) = (AQ – SQ) x SP
= (240 – 360) x Br 15
= Br 1,800 F
LQV (Master) = (AQ – SQ) x SP
= (240 – 180) x Br 40
= Br 2,400 U
LQV (Combined) = Br 1,800 F + Br 2,400 U
= Br 600U
Labor Mix Variance
Let us now consider the impact of a crew mix. For Ginbot, there is a mix variance because the actual
labor mix used differed from the standard labor mix. The third column of the second table above shows
that the actual apprentice labor was 50 percent rather than the expected 67 percent and that the master
electrician was 50 percent rather than 33 percent. The mix variance measures the monetary effect of
using a different mix. In our example, it is the higher than expected percentage of master electrician

Page 59 of 65
hours. The mix variance uses the actual hours, but assumes that they are distributed in the budgeted mix.
This is because we want to isolate the effect of a change in mix without adding the effect of a change in
output as well. The formula for computing the mix variance is as follows:

Direct Labor Actual DL Budgeted DL Actual Qty Standard

Mix Variance = Mix - Mix x of All DL x Rate per
Percentage Percentage Hours Used Hour

The electrician crew mix variance for Ginbot is computed as follows:

DLMV (Apprentice) = (.50 – .67) x 480 x Br15 = Br 1,200 F
DLMV (Master) = (.50 – .33) x 480x Br 40 = Br 3,200 U
Total Labor Mix Variance Br 2,000 U
The decrease in the percentage of apprentice labor used results in a favorable variance while the increase
in the use of master labor results in an unfavorable mix variance. The net effect of the mix change is an
unfavorable crew mix variance of Br 2,000. Because the total mix must equal 100 percent, there is
always at least one favorable and one unfavorable mix variance if there is any change in mix.
Labor Yield Variance
The change in mix required more of the expensive master electricians. While this increased the total
wages paid, master electricians work faster and the yield from the same 480 labor hours has gone up.
Instead of the budgeted 3,200 fixtures we have 3,600 fixtures. In effect, the 480 hours at the new mix
has yielded 540 labor hours worth of output. This impact can be captured in the yield variance, which
shows us the productivity impact of the new mix. Again, to isolate the effect of a change in the yield, we
will hold the mix constant and assume that the earned hours and the actual hours were both at the
standard mix. The formula for computing the mix variance is as follows:
Direct Actual Budgeted Total Budgeted Standard
Labor Yield = Total - Labor Hours x DL mix x Rate per
Variance Labor Allowed for Percentage Hour
Hours Used Actual Output
The crew yield variance for Ginbot is computed as follows:
DLYV (Apprentice) = (480 – 540) x 0.67 x Br 15 = Br 600 F
DLYV (Master) = (480 – 540) x 0.33 x Br 40 = Br 800 F
Total Labor Yield Variance = Br 1,400 F
Note that the mix and yield variances together give additional information about the causes of a quantity
variance. When mix and yield variances are combined, they equal the quantity variance. In our example,
the mix and yield equal the combined quantity variance of Br 600 Unfavorable.
Total mix variance = Br 2,000 U
Total yield variance = Br1,400 F

Page 60 of 65
 Total Quantity variance = Br 600 U
We can see that despite the increased productivity of the master electricians, the decision to substitute
the higher paid labor has resulted in an overall unfavorable variance of Br 600. This was because
unfavorable mix variance was larger than the favorable yield variance. Birhanu is better off sticking to
its standard crew mix and avoiding the type of tradeoff between using cheaper labor it did in Ginbot.

SALES VARIANCES
The idea of variance analysis can be extended to areas other than production. For example, an analysis
can be made on why actual revenue differed from budgeted revenue. If, for example, a company
budgeted to sell 10,000 units at Br 50 each but because of market forces had to reduce the price to Br 48
and even so they were only able to sell 9,000 at this price, a variance occurs. Then:

Actual Sales Revenue = 9,000 x Br 48 = Br 432,000

Budgeted Sales Revenue = 10,000 x Br 50 = Br 500,000
Sales Variance = Br 432,000 – Br 500,000 = -Br 68,000 = Br 68,000 U
This variance is negative which means that less revenue was obtained than expected and is therefore
unfavorable and marked with U. This variance is made up of two elements: the reduction in volume of
1,000 units and the reduction in selling price of Br 2 per unit. From the above example it can be seen
that two items will contribute to sales variance: the sales-price variance (SPV) and the sales-volume
variance (SVV). The sales-price variance arises because a company increased or decreased its sales
price when compared with the budgeted sales price. The sales-volume variance arises from an increase
or decrease in units sold. Generally speaking, sales variances can be analyzed by splitting the total
variance into six variance as shown below.

Static-Budget
Variance

Flexible-Budget Sales-Volume
Variance Variance

Sales-Mix Sales-Quantity
Variance Variance

Market-Size Market-Share
Variance Variance

Example

Page 61 of 65
Agere ltd sales three products in the Dembel City centre. The Company Budgeted to sell 10,000 units.
The budgeted 10,000 units represent 50% market share. The details for the budgeted and actual data for
the year 1996 fiscal year are as follows:

Budgeted Data Actual Data

Product Selling Quantity Sales Total Selling Unit Sales Total
t Price per Mix Revenue Price per Volume Mix Revenue
Unit Unit

A 12 1,000 10% 12,000 10 1,800 15% 18,000

B 20 3,000 30 60,000 25 4,800 40 120,000
C 15 6,000 60 90,000 15 5,400 45 81,000
10,000 162,000 12,000 219,000

Static-budget variance: is the difference between an actual result and a budgeted amount in the static
budget.

Static-Budget Variance= Actual Result- budgeted Amount

The Static-budget variance for Agere Ltd is computed as follows:
A= 18,000-12,000 = 6,000F
B= 120,000-60,000 =60,000F
C= 81,000-90,000 = 9,000U
Total SBV =57,000F
A. Static-Budget variance can be further split into Flexible-Budget and Sales-Volume variance.
1. Flexible-budget variance: Is the difference between the actual revenues and the flexible-
budget amount for the actual unit volume of sales. It is computed as: -
FBV=Actual Result- Flexible-budget Amount
The Static-budget variance for Agere Ltd is computed as follows:
FBV A=18,000- (12x 1,800) = 3,600U
B=120,000-(20x 4,800) =24,000F
C=81,000-(15 x 5,400) = 0 Total..............................20,400F
2. Sales-volume variance: shows the effect of the difference between the actual and budgeted
quantity of variable used to flex the flexible budget. The sales-volume variance, which arises
from an increase or decrease in units sold, is calculated as:
SVV = (Actual Sales Quantity - Budgeted Sales Quantity) x Budgeted Selling Price per Unit
The Sales-volume variance for Agere Ltd is computed as follows:

Page 62 of 65
 SVV-A= (1,800-1,000) x 12= $9,600F
B= (4,800-3,000) x 20=$36,000F
C= (5,400-6,000) x 15= $9,000U
Total SVV=$36,600F
B. Subdivisions of sales-volume variance
1. Sales-mix variance: difference between (1) budgeted amount for the actual sales mix, and (2)
the budgeted amount if the budgeted sales mix had been changed. The formula for computing the
salesmix variance in terms of revenue and the amount for Agere Ltd is:-

Actual Budgeted Actual Units Budgeted

SMV = Sales Mix - Sales Mix x of All x Selling Price
Percentage percentage Products Sold Per Unit

SMV-A= (0.15-0.10) x 12,000 x 12=$7,200F

B= (0.40-0.30) x 12,000 x 20=$2,400F
C= (0.45-0.60) x 12,000 x 15=$27,000U
TSMV= $17,400U
2. Sales-quantity variance: is the difference between two amounts: (1) the budgeted amount based
on actual quantities sold of all products and the budgeted mix, and (2) the amount in the static
budget (which is based on the budgeted quantities to be sold of all products and the budgeted
mix). The formula for computing the sales-quantity variance in terms of revenue and the amount
for Agere Ltd is:-
Actual Units Budgeted Budgeted Sales Budgeted
SQV= Of All - Units Of All x Mix X Selling Price
Products Sold Products Sold percentage Per Unit

SQV-A = (12,000 -10,000) x 0.10x 12=

B = (12,000 -10,000) x 0.30x 20=
C = (12,000 -10,000) x 0.60x 15=
Market Share and Market Size Variance
Sales depend on overall market demand as well as the firm’s ability to maintain its share of the market.
The following table summarizes the budgeted and actual sales units for the industry.
Budgeted Industry Actual Industry
Quantity Quantity
Product A 1,800 2,200
Product B 6,200 8,000

Page 63 of 65
 Product C 12,000 14,800
Total 20,000 25,000

Agere Ltd can use the industry information to get further insight into the sales quantity variance by
dividing this variance into a market-size and market-share variance.
Market- size variance is the difference between two amounts (1) the budgeted amount based on the
actual market size in units and the budgeted market share, and (2) the static budget amount based on the
budgeted market-size in units and the budgeted market share. The formula and the amount for Agere Ltd
are: -
MSV= (Actual MSZ - Budgeted MSZ) x Budgeted MSR x Budgeted ASP
Where, MSV= Market Share Variance MSR= Market Share in Units
MSZ= Market Size in Units ASP= Average Selling Price per Unit
MSV for Agere Ltd is computed as follows:-
MSV= (25,000-20,000) x 0.50x 16.20
= Br 40,500F
Market –share variance is the difference between two amounts: (1) the budgeted amount at budgeted
mix based on actual market size in units and the actual market share, and (2) the budgeted amount at
budgeted mix based on actual market size in units and the budgeted market share. The formula and the
amount for Agere Ltd are: -
Mkt-share Variance= (Actual MSR- Budgeted MSR)x Actual MSZ x Budgeted ASP
MSV for Agere Ltd is computed as follows:-
Mkt-share Variance= (0.48- 0.50) x 25,000x 16.20
=Br 8,100 U
4.5 Uncertainty and variance analysis
Uncertainty is the error in estimating a parameter, such as the mean of a sample, or the difference in
means between two experimental treatments, or the predicted response given a certain change in
conditions. Uncertainty is measured with a variance or its square root, which is a standard deviation.
4.6 Identification of relevance and variance analysis for performance and control
Variance analysis provides organizations with a lot of benefits, including:
i. Planning: Helps managers to budget smarter and more accurately.
ii. Control: Assists in more significant control management of departments and budgeting.
iii. Responsibility: Helps with the assignment of trust within an organization.
Every business owner must have a budget which lays out the company’s future course of activities. A
budget helps to showcase from where the sales would come and how the funds would be spent to
achieve those sales, with the key objective of generating a profit. While budgeting is a great planning
tool, it is also a useful management tool for keeping the business on track for meeting its objectives. For
accomplishing this goal, budgeting and variance analysis provides key insights to help the management
in taking prompt and feasible decisions. The core reason for using standard costs is that there are a

Page 64 of 65
number of applications where it is too time-consuming to collect actual costs, so standard costs are used
as a close approximation to actual costs. This results in significant accounting efficiencies.
The advantage of variance
The advantage of variance is that it treats all deviations from the mean as the same regardless of their
direction. The squared deviations cannot sum to zero and give the appearance of no variability at all in
the data. One drawback to variance, though, is that it gives added weight to outliers.
Disadvantages of Variance analysis
Disadvantages of Variance analysis has a major drawback in that it takes a long time to examine the
effect of the variance and therefore corrective actions are delayed. The monitoring tool results in large
lag time and therefore application of control measures will be significantly delayed.
Variance analysis performance
This chapter discusses the use of variance analysis in performance evaluation. Variance analysis
compares standard to actual performance. It can be done by division, department, program, product,
territory, or any other responsibility unit. By questioning the variances and trying to find answers, the
manager can make the operation more efficient and less costly. When more than one department is used
in a production process, individual standards should be developed for each department in order to assign
accountability to department managers. Standards may be set by engineers, production managers,
purchasing managers, and personnel administrators. Depending on the nature of the cost item,
computerized models can be used to corroborate what the standard costs should be. Standards and
variance analyses resulting from them are essential in financial analysis and decision making. These can
aid in inventory costing and assist in decision making.

Page 65 of 65