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Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 4
Relevant Information for Decision Making
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Q1: Nonroutine Operating Decisions
• Routine operating decisions are those made on a
regular schedule. Examples include:
• annual budgets and resource allocation decisions
• monthly production planning
• weekly work scheduling issues
• Nonroutine operating decisions are not made on a
regular schedule. Examples include:
• accept or reject a customer’s special order
• keep or drop business segments
• insource or outsource a business activity
• constrained (scarce) resource allocation issues
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Process for Making Nonroutine
Operating Decisions
1. Identify the type of decision to be made.
2. Identify the relevant quantitative analysis
technique(s).
3. Identify and analyze the qualitative factors.
4. Perform quantitative and/or qualitative analyses
5. Prioritize issues and arrive at a decision.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q1: Identify the Type of Decision
•
•
Special order decisions
•
determine the pricing
•
accept or reject a customer’s proposal for order quantity
and pricing
•
identify if there is sufficient available capacity
Keep or drop business segment decisions
•
•
examples of business segments include product lines,
divisions, services, geographic regions, or other distinct
segments of the business
eliminating segments with operating losses will not
always improve profits
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q1: Identify the Type of Decision
•
•
•
Outsourcing decisions
•
make or buy production components
•
perform business activities “in-house” or pay another
business to perform the activity
Constrained resource allocation decisions
•
determine which products (or business segments)
should receive allocations of scarce resources
•
examples include allocating scarce machine hours or
limited supplies of materials to products
Other decisions may use similar analyses
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q2-Q5 : Identify and Analyze Qualitative Factors
•
Qualitative information cannot easily be valued in
dollars.
•
•
•
can be difficult to identify
can be every bit as important as the quantitative
information
Examples of qualitative information that may be
relevant in some nonroutine decisions include:
•
quality of inputs available from a supplier
•
effects of decision on regular customers
•
effects of decision on employee morale
•
effects of production on the environment or the
community
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q1: Consider All Information and Make a Decision
•
Before making a decision:
•
Consider all quantitative and qualitative information.
• Judgment is required when interpreting the effects of
qualitative information.
•
Consider the quality of the information.
• Judgment is also required when user lower-quality
information.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q2: Special Order Decisions
•
•
A new customer (or an existing customer) may
sometimes request a special order with a lower
selling price per unit.
The general rule for special order decisions is:
•
•
accept the order if incremental revenues exceed
incremental costs,
subject to qualitative considerations.
Price >=
•
Relevant
Variable Costs +
Relevant
Fixed Costs +
Opportunity
Cost
If the special order replaces a portion of normal
operations, then the opportunity cost of accepting
the order must be included in incremental costs.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q2: Special Order Decisions
RobotBits, Inc. makes sensory input devices for robot manufacturers.
The normal selling price is $38.00 per unit. RobotBits was approached
by a large robot manufacturer, U.S. Robots, Inc. USR wants to buy
8,000 units at $24, and USR will pay the shipping costs. The per-unit
costs traceable to the product (based on normal capacity of 94,000
units) are listed below. Which costs are relevant to this decision?
yes$6.20 Relevant?
Direct materials
yes 8.00 Relevant?
Direct labor
Variable mfg. overhead yes 5.80 Relevant?
no 3.50 Relevant?
Fixed mfg. overhead
yes
Shipping/handling
no 2.50 Relevant?
Fixed administrative costs no 0.88 Relevant?
no 0.36 Relevant?
Fixed selling costs
$27.24
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
$20.00
Slide # 12
Q2: Special Order Decisions
Suppose that the capacity of RobotBits is 107,000 units and projected
sales to regular customers this year total 94,000 units. Does the
quantitative analysis suggest that the company should accept the
special order?
First determine if there is sufficient idle capacity to accept this
order without disrupting normal operations:
Projected sales to regular customers
Special order
94,000 units
8,000 units
102,000 units
RobotBits still has 5,000 units of idle capacity if the order is
accepted. Compare incremental revenue to incremental cost:
Incremental profit if accept special order =
($24 selling price – $20 relevant costs) x 8,000 units = $32,000
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q2: Qualitative Factors in
Special Order Decisions
What qualitative issues, in general, might RobotBits consider before
finalizing its decision?
• Will USR expect the same selling price per unit on future
orders?
• Will other regular customers be upset if they discover the
lower selling price to one of their competitors?
• Will employee productivity change with the increase in
production?
• Given the increase in production, will the incremental costs
remain as predicted for this special order?
• Are materials available from its supplier to meet the increase
in production?
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q2: Special Order Decisions and Capacity Issues
Suppose instead that the capacity of RobotBits is 100,000 units and
projected sales to regular customers this year totals 94,000 units.
Should the company accept the special order?
Here the company does not have enough idle
capacity to accept the order:
Projected sales to regular customers
Special order
94,000 units
8,000 units
102,000 units
If USR will not agree to a reduction of the order to 6,000
units, then the offer can only be accepted by denying sales
of 2,000 units to regular customers.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q2: Special Order Decisions and Capacity Issues
Suppose instead that the capacity of RobotBits is 100,000 units and
projected sales to regular customers this year total 94,000 units. Does
the quantitative analysis suggest that the company should accept the
special order?
Direct materials
Direct labor
Variable mfg. overhead
Fixed mfg. overhead
Shipping/handling
Fixed administrative costs
Fixed selling costs
$6.20
8.00
5.80
3.50
2.50
0.88
0.36
$27.24
Variable cost/unit for
regular sales = $22.50.
CM/unit on regular sales
= $38.00 – $22.50 = $15.50.
The opportunity cost of accepting this
order is the lost contribution margin
on 2,000 units of regular sales.
Incremental profit if accept special order =
$32,000 incremental profit under idle capacity – opportunity cost =
$32,000 – $15.50 x 2,000 = $1,000
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q3: Keep or Drop Decisions
•
Managers must determine whether to keep or
eliminate business segments that appear to be
unprofitable.
•
The general rule for keep or drop decisions is:
•
•
keep the business segment if its contribution margin
covers its avoidable fixed costs,
subject to qualitative considerations.
Drop if: Contribution < Relevant
Margin
Fixed Costs
•
+
Opportunity
Cost
If the business segment’s elimination will affect
continuing operations, the opportunity costs of its
discontinuation must be included in the analysis.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q3: Keep or Drop Decisions
Starz, Inc. has 3 divisions. The Gibson and Quaid Divisions have recently
been operating at a loss. Management is considering the elimination of these
divisions. Divisional income statements (in 1000s of dollars) are given below.
According to the quantitative analysis, should Starz eliminate Gibson or
Quaid or both?
Revenues
Variable costs
Contribution margin
Traceable fixed costs
Division operating income
Unallocated fixed costs
Operating income
Gibson Quaid Russell
$390 $433
$837
247
335
472
143
98
365
166
114
175
($23) ($16)
$190
Breakdown of traceable fixed costs:
Avoidable
$154
Unavoidable
12
$166
© John Wiley & Sons, 2011
$96
18
$114
Total
$1,660
1,054
606
455
151
81
$70
$139
36
$175
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q3: Keep or Drop Decisions
Revenues
Variable costs
Contribution margin
Traceable fixed costs
Division operating income
Unallocated fixed costs
Operating income
Gibson Quaid Russell
$390 $433
$837
247
335
472
143
98
365
166
114
175
($23) ($16)
$190
Breakdown of traceable fixed costs:
Avoidable
$154
Unavoidable
12
$166
$96
18
$114
Total
$1,660
1,054
606
455
151
81
$70
$139
36
$175
Contribution margin
Avoidable fixed costs
Effect on profit if keep
Use the general rule
to determine if Gibson
and/or Quaid should
be eliminated.
Gibson Quaid
$143
$98
154
96
($11)
$2
The general rule shows that we should keep Quaid and drop Gibson.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q3: Keep or Drop Decisions
Revenues
Variable costs
Contribution margin
Traceable fixed costs
Division operating income
Unallocated fixed costs
Operating income
Gibson Quaid Russell
$390 $433
$837
247
335
472
143
98
365
166
114
175
($23) ($16)
$190
Breakdown of traceable fixed costs:
Avoidable
$154
Unavoidable
12
$166
$96
18
$114
Total
$1,660
1,054
606
455
151
81
$70
$139
36
$175
Using the general rule is easier
than recasting the income
statements:
Gibson Quaid Russell
Total
Revenues
$390
$433
$837
$1,270
Variable costs
247
335
472
807
Contribution margin
143
98
365
$463
Traceable fixed costs
166
114
175
289
Division operating income
($23)
($16)
$190
$174
Unallocated fixed costs
81
Gibson's unavoidable fixed costs
12
Operating income
$81
Quaid &
Russell
only
Profits increase by $11 when Gibson is eliminated.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q3: Keep or Drop Decisions
Suppose that the Gibson & Quaid Divisions use the same supplier for a
particular production input. If the Gibson Division is dropped, the decrease in
purchases from this supplier means that Quaid will no longer receive volume
discounts on this input. This will increase the costs of production for Quaid by
$14,000 per year. In this scenario, should Starz still eliminate the Gibson
Division?
Effect on profit if drop Gibson before considering
impact on Quaid's production costs
Opportunity cost of eliminating Gibson
Revised effect on profit if drop Gibson
$11
(14)
($3)
Profits decrease by $3 when Gibson is eliminated.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
•
Q4: Insource or Outsource
(Make or Buy) Decisions
Managers often must determine whether to
•
•
•
make or buy a production input
keep a business activity in house or outsource the activity
The general rule for make or buy decisions is:
•
•
choose the alternative with the lowest relevant
(incremental cost), subject to qualitative considerations
If the decision will affect other aspects of
operations, these costs (or lost revenues) must be
included in the analysis.
Outsource if: Cost to Outsource < Cost to Insource
Where:
© John Wiley & Sons, 2011
Cost to
Relevant Relevant Opportunity
Insource =
FC
+
VC
+
Cost
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 24
Q4: Make or Buy Decisions
Graham Co. currently of our main product manufactures a part called a
gasker used in the manufacture of its main product. Graham makes and
uses 60,000 gaskers per year. The production costs are detailed below.
An outside supplier has offered to supply Graham 60,000 gaskers per
year at $1.55 each. Fixed production costs of $30,000 associated with
the gaskers are unavoidable. Should Graham make or buy the gaskers?
The production costs per unit for manufacturing a gasker are:
yes $0.65 Relevant?
Direct materials
yes 0.45 Relevant?
Direct labor
Variable manufacturing overhead yes 0.40 Relevant?
no 0.50 Relevant?
Fixed manufacturing overhead*
$2.00
*$30,000/60,000 units = $0.50/unit
$1.50
Advantage of “make” over “buy” = [$1.55 - $1.50] x 60,000 = $3,000
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 25
Q3: Make or Buy Decisions
Suppose the potential supplier of the gasker offers Graham a discount for a
different sub-unit required to manufacture Graham’s main product if Graham
purchases 60,000 gaskers annually. This discount is expected to save
Graham $15,000 per year. Should Graham consider purchasing the
gaskers?
Advantage of “make” over “buy”
before considering discount (slide 23)
$3,000
Discount
Advantage of “buy” over “make”
15,000
$12,000
Profits increase by $12,000 when the gasker is
purchased instead of manufactured.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 27
Q5: Constrained Resource
(Product Emphasis) Decisions
•
Managers often face constraints such as
•
•
production capacity constraints such as machine hours
or limits on availability of material inputs
limits on the quantities of outputs that customers
demand
•
Managers need to determine which products
should first be allocated the scarce resources.
•
The general rule for constrained resource
allocation decisions with only one constraint is:
•
allocate scarce resources to products with the highest
contribution margin per unit of the constrained resource,
•
subject to qualitative considerations.
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 28
Q5: Constrained Resource Decisions
(Two Products; One Scarce Resource)
Urban’s Umbrellas makes two types of patio umbrellas, regular and deluxe.
Suppose there is unlimited customer demand for each product. The selling
prices and variable costs of each product are listed below.
Selling price per unit
Variable cost per unit
Contribution margin per unit
Regular
$40
20
$20
Deluxe
$110
44
$ 66
Contribution margin ratio
50%
60%
Required machine hours/unit
0.4
2.0
Urban has only 160,000 machine hours available per year.
Write Urban’s machine hour constraint as an inequality.
0.4R + 2D 160,000 machine hours
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 29
Q5: Constrained Resource Decisions
(Two Products; One Scarce Resource)
Suppose that Urban decides to make all Regular umbrellas. What is the total
contribution margin? Recall that the CM/unit for R is $20.
The machine hour constraint is: 0.4R + 2D 160,000 machine hours
If D=0, this constraint becomes 0.4R 160,000 machine hours,
or R 400,000 units
Total contribution margin = $20*400,000 = $8 million
Suppose that Urban decides to make all Deluxe umbrellas. What is the total
contribution margin? Recall that the CM/unit for D is $66.
If R=0, this constraint becomes 2D 160,000 machine hours, or
D 80,000 units
Total contribution margin = $66*80,000 = $5.28 million
© John Wiley & Sons, 2011
Chapter 4: Relevant Costs for Nonroutine Operating Decisions
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 30
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 7
Activity-Based Costing and
Management
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Q1: Activity-Based Costing (ABC)
• ABC is a method of cost system refinement.
• Indirect costs are divided into “sub-pools” of
costs of activities.
• Activity costs are then allocated to the final cost
objects using a cost allocation base (more
commonly called cost drivers in ABC).
• Activities are measurable, making it more likely
that cost drivers can be found so that a final cost
object will absorb indirect costs in proportion to
its use of the activity.
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Traditional Costing vs. ABC
Traditional costing systems:
Indirect
Costs
Indirect costs are
grouped into one (or a
small number) of cost
pools; a cost allocation
base assigns costs to
the individual products
© John Wiley & Sons, 2011
Product A
Direct Costs
Product B
Direct Costs
Product C
Direct Costs
The individual
products are
the final cost
objects.
Direct costs are
traced to the
individual
products.
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Traditional Costing Systems
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q1: Traditional Costing vs. ABC
Activity-based costing systems:
Activity 1
Indirect
Costs
Activity 2
Product A
Direct Costs
Product B
Direct Costs
Product C
Direct Costs
Activity 3
Indirect costs are
assigned (traced &
allocated) to various
pools of activity costs.
© John Wiley & Sons, 2011
Activity costs are
allocated to
products
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
The individual products
are the final cost objects
& direct costs are traced
to the individual products.
Slide # 6
Q1: ABC Costing Systems
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q2: What are Activities and How are They
Identified?
The ABC cost hierarchy includes the following activities:
• organization-sustaining – associated with overall
organization
• facility-sustaining – associated with single manufacturing
plant or service facility
• customer-sustaining – associated with a single customer
• product-sustaining – associated with product lien or
single product
• batch-level – associated with each batch of product
• unit-level – associated with each unit produced
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q2: ABC Cost Hierarchy Example
Some of the costs incurred by the Dewey Chargem law firm are listed
below. This firm specializes in immigration issues and family law. For each
cost, identify whether the cost most likely relates to a(n) (1) organiz-ationsustaining, (2) facility-sustaining, (3) customer-sustaining, (4) productsustaining, (5) batch-level, or (6) unit-level activity and explain your choice.
Cost
Cost Hierarchy Level
Bookkeeping software
Salary for partner in charge of family law
Office supplies
Subscription to family law update journal
Telephone charges for local calls
Long distance telephone charges
Window washing service
Salary of receptionist
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q3: What Process is Used to Assign Costs in an
ABC system?
1. Identify the relevant cost object.
2. Identify activities and group homogeneous
activities.
3. Assign costs to the activity cost pools.
4. Choose a cost driver for each activity cost
pool.
5. Calculate an allocation rate for each
activity cost pool.
6. Allocate activity costs to the final cost
object.
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q3: How Are Cost Drivers Selected for
Activities?
• For each activity, determine its place
in the ABC cost hierarchy.
• Look for drivers that have a good
cause-and-effect relationship with the
activities’ costs.
• Use a reasonable driver when there is
no cause-and-effect relationship.
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q3: ABC in Manufacturing Example
Alphabet Co. makes products A & B. Product A is a low-volume
specialty item and B is a high-volume item. Estimated factory- wide
overhead is $800,000, and the number of DL hours for the year is
estimated to be 50,000 hours. DL costs are $10/hour. Each product
uses 2 DL hours. Compute the traditional cost of each product if
Products A & B use $25 and $10 in direct materials, respectively.
First, compute the estimated overhead rate:
Estimated overhead rate = $800,000/50,000 hours = $16/hour.
Direct materials
Direct labor (2hrs @ $10)
Overhead (2 hrs @ $16)
© John Wiley & Sons, 2011
Product A
$25
20
32
$77
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Product B
$10
20
32
$62
Slide # 12
Q3: ABC in Manufacturing Example
Alphabet Co. is implementing an ABC system. It estimated the costs
and activity levels for the upcoming year shown below.
Estimated Estimated Activity Levels
Costs
Prod. A Prod. B
Total
Machine set-ups
$200,000 3,000 2,000 5,000
Inspections
140,000
500
300
800
Materials handling
80,000
400
400
800
Machining dep't
320,000 12,000 28,000 40,000
Quality control dep't
60,000
600
150
750
$800,000
Cost Driver
# set-ups
# inspections
# mat'l requistions
# machine hours
# tests
First, compute the estimated overhead rate for each activity:
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q3: ABC in Manufacturing Example
Estimated
Costs
Estimated Activity
Overhead Rate
$40
Machine set-ups
$200,000 5,000 set-ups
$40/setup
/setup
$175
Inspections
140,000
800 inspections
$175/inspection
/inspection
Materials handling
80,000
800 mat'l requistions $100
$100/requisition
/requisition
$8
Machining dep't
320,000 40,000 machine hours
$8/mach
/machhrhr
$80
Quality control dep't
60,000
750 tests
$80/test
/test
$800,000
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q3: ABC in Manufacturing Example
Alphabet recently completed a batch of 100 As and a batch of 100 Bs.
Direct material and labor costs were as budgeted. Information about each
batch’s use of the cost drivers is given below. Compute the overhead
allocated to each unit of A and B.
100 As 100 Bs
Machine set-ups
60
10
Inspections
10
2
Overhead allocated: 100 As 100 Bs
Materials handling
4
2
Machine set-ups
$2,400 $400
Machining dep't
240
120
Inspections
1,750
350
Quality control dep't
3
1
Materials handling
400
200
Machining dep't
1,920
960
Quality control dep't
240
80
Overhead for batch $6,710 $1,990
Overhead per unit
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
$67.10 $19.90
Slide # 15
Q3: ABC in Manufacturing Example
Compute the total cost of each product and compare it to the costs
computed under traditional costing.
Prod A Prod B
Direct material $25.00 $10.00
Direct labor
20.00 20.00
Overhead
67.10 19.90
$112.10 $49.90
Total
Traditional costing
assigned $77 to a unit of
Product A and $62 to a
unit of Product B.
•
The only difference between the two costing systems is that
Product A is assigned more overhead costs under ABC.
•
The additional overhead assigned to Product A reflects Product
A’s consumption of resources.
© John Wiley & Sons, 2011
Chapter 7: Activity-Based Costing and Management
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 8
Measuring and Assigning Support
Department Costs
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Q1: Support versus Operating Departments
• The operating departments of an organization
produce products or services that generate
revenue.
• The support departments of an organization
produce products or provide services to the
operating and other support departments.
• The support department costs are common
costs that are shared between two or more
other departments.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Reasons for Allocating Support
Department Costs
• External reporting
• Motivation
• appropriate consumption of support
department resources
• efficiency of support department
• monitor consumption of support
department services
• Decision making
• product pricing
• make or buy decisions
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q2: Process for Allocating Support
Department Costs
1. Clarify allocation purpose
2. Identify cost pools
3. Assign costs to cost pools
4. Choose allocation bases for each cost pool
5. Choose allocation method; allocate support
department costs
6. Allocate updated operating department costs to
units of goods or services, if relevant
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q3: The Direct Method of Allocating
Support Department Costs
• The direct method ignores the fact that
support departments use each others’
services.
• Each support department’s costs are
allocated only to operating departments.
• This method is the easiest
computationally and the easiest to
explain.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q3: The Direct Method Example
Philco Toys makes metal and plastic toys in separate departments. It has
two support departments, Accounting and Information Systems. Philco has
decided to allocate Accounting department costs based on the number of
employees in each department and Information Systems costs based on
the number of computers in each department. Given the information below,
use the direct method to allocate support department costs.
Support Dep'ts
Total department costs
Number of employees
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
(48,000)
Information Systems
Totals
© John Wiley & Sons, 2011
$0
27,789
20,211
$0
(72,000)
36,000
36,000
$0
$0
$449,789
$238,211
$688,000
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q3: The Direct Method Example
Plastic Products is allocated
Plastic and Metal Product share
22/(22+16) of Accounting
Info Systems costs equally
department costs, and Metal
because they have the same
Products is allocated
number of computers in each
16/(22+16). Notice that the
department. Notice that the
number of employees in the
number of computers in the
support departments is ignored
departments
is ignored
Support Dep'ts support
Operating
Departments
under the direct method.
under the direct method.
Total department costs
Number of employees
Number of computers
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
(48,000)
Information Systems
Totals
© John Wiley & Sons, 2011
$0
27,789
20,211
$0
(72,000)
36,000
36,000
$0
$0
$449,789
$238,211
$688,000
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q4: The Step-Down Method of Allocating
Support Department Costs
• The step-down method allocates some (but not all)
support department costs to other support
departments.
• The first support department’s costs are allocated
to all operating and support departments that use
its services.
• Each subsequent support department’s costs are
allocated to all operating and support departments
that use its services, except any support
department whose costs were already allocated.
• Allocation order must be determined.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q4: The Step-Down Method Example
Given the information for Philco, use the step-down method to allocate
support department costs. Allocate the costs of the support department that
provides the largest percentage of its services to the other support
department first.
First determine
allocation order:
Accounting provided 4/(4+22+16) = 4/42
= 9.5% of its services to Info Systems.
Information Systems provided 4/(4+3+3) = 4/10 = 40% of its
services to Accounting, so Information Systems goes first.
Support Dep'ts
Total department costs
Number of employees
Number of computers
© John Wiley & Sons, 2011
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q4: The Step-Down Method Example
Given the information for Philco, use the step-down method to allocate
support department costs.
Now perform the allocation:
Support Dep'ts
Total department costs
Number of employees
Number of computers
Operating Departments
Metal
Plastic
Info
AccTotal
Products
ounting Systems Products
$48,000 $72,000 $386,000 $182,000 $688,000
45
16
22
4
3
16
3
3
6
4
Allocate costs:
Accounting
(76,800)
(48,000)
Information Systems
28,800
$0
Totals
© John Wiley & Sons, 2011
44,463
27,789
32,337
20,211
$0
$0
(72,000)
21,600
21,600
21,600
$0
$0
$0
$435,389
$452,063
$223,811
$235,937
$659,200
$688,000
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q4: The Step-Down Method Example
Info Systems costs are allocated
to Accounting, Plastic, & Metal
based on each department’s
number of computers compared
to total non-Info Systems
Support Dep'ts
computers: 4+3+3=10.
Total department costs
Number of employees
Number of computers
Accounting costs are allocated
only to Plastic & Metal based on
each department’s number of
employees compared to total
non-Accounting and non-Info
Operatingemployees:
Departments
Systems
22+16=38
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
(76,800)
Information Systems
28,800
$0
Totals
44,463
32,337
$0
(72,000)
21,600
21,600
$0
$0
$452,063
$235,937
$688,000
Total costs allocated out of Accounting are now higher because of
the Info Systems costs allocated to Accounting.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q4: The Step-Down Method Example
(22/38) x $76,800
(4/10) x $72,000
(16/38) x $76,800
(3/10) x $72,000
Support Dep'ts
Total department costs
Number of employees
Number of computers
(3/10) x $72,000
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
(76,800)
Information Systems
28,800
$0
Totals
© John Wiley & Sons, 2011
44,463
32,337
$0
(72,000)
21,600
21,600
$0
$0
$452,063
$235,937
$688,000
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q5: The Reciprocal Method of Allocating
Support Department Costs
• The reciprocal method allocates all support
department costs to other support
departments.
• The first step is to compute the total costs of
each support department when its usage of
other support department services is taken
into consideration.
• Support department costs are then allocated
to all other operating and support
departments that consume its services.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q5: The Reciprocal Method Example
Given the information for Philco, use the reciprocal method to allocate
support department costs.
First determine total costs for each support department by writing an equation for its
costs (use A and IS as abbreviations).
A = $48,000 + [4/(4+3+3)] x IS; IS = $72,000 + [4/(4+22+16)] x A
Then solve: A = $48,000 + (4/10) x [$72,000 + (4/42) x A]
A = $48,000 + $28,800 + (16/420) x A]
(404/420) x A = $76,800
A = $76,800 x (420/404) = $79,842
IS = $72,000 + (4/42) x $79,842 = $79,604
Support Dep'ts
Total department costs
Number of employees
Number of computers
© John Wiley & Sons, 2011
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
Q5: The Reciprocal Method Example
Given the information for Philco, use the reciprocal method to allocate
support department costs.
Now perform the allocation:
Support Dep'ts
Total department costs
Number of employees
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
Information Systems
Totals
© John Wiley & Sons, 2011
(79,842)
7,604
41,822
(79,842)
7,604
41,822
31,842 (79,604)
(79,604)
23,881
31,842
23,881
$0
$0 $451,703
$451,703
$0
$0
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
30,416
30,416
23,881
23,881
$0
$0
$236,297
$236,297
$688,000
Slide # 23
Q5: The Reciprocal Method Example
These numbers are the
solutions to the
simultaneous equations.
(4/42) x $79,842
(22/42) x $79,842
(16/42) x $79,842
Support Dep'ts
Total department costs
Number of employees
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
Information Systems
Totals
© John Wiley & Sons, 2011
(79,842)
7,604
41,822
(79,842)
7,604
41,822
31,842 (79,604)
(79,604)
23,881
31,842
23,881
$0
$0 $451,703
$451,703
$0
$0
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
30,416
30,416
23,881
23,881
$0
$0
$236,297
$236,297
$688,000
Slide # 24
Q5: The Reciprocal Method Example
(4/10) x $79,604
(3/10) x $79,604
(3/10) x $79,604
Support Dep'ts
Total department costs
Number of employees
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
Information Systems
Totals
© John Wiley & Sons, 2011
(79,842)
7,604
41,822
(79,842)
7,604
41,822
31,842 (79,604)
(79,604)
23,881
31,842
23,881
$0
$0 $451,703
$451,703
$0
$0
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
30,416
30,416
23,881
23,881
$0
$0
$236,297
$236,297
$688,000
Slide # 25
Q6: Single- versus Dual-Rate Allocation
• In single-rate allocation, each cost pool
includes fixed and variable costs.
• In dual-rate allocation, fixed and variable
costs are in separate cost pools.
• Both methods can be employed with the
direct, step-down, or reciprocal methods.
• The prior three examples used the singlerate allocation method.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 26
Q6: Single- versus Dual-Rate Example
Philco has decided to use the direct method and allocate variable
Accounting costs based on the number of transactions and fixed
Accounting costs based on the number of employees. The Info Systems
variable costs will be allocated based on the number of service requests
and fixed costs will be allocated based on the number of computers. The
required information is presented below.
Support Dep'ts
Total department variable costs
Total department fixed costs
Number of transactions
Number of employees
Number of service requests
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
$20,000 $22,000 $186,000 $100,000
$28,000 $50,000 $200,000
$82,000
20
32
140
86
3
4
22
16
18
5
12
8
4
6
3
3
Now perform the allocation…
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 27
Q6: Single- versus Dual-Rate Example
Total department variable costs
Total department fixed costs
Number of transactions
Number of employees
Number of service requests
Number of computers
Support Dep'ts
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
$20,000 $22,000 $186,000 $100,000
$28,000 $50,000 $200,000
$82,000
20
32
140
86
3
4
22
16
18
5
12
8
4
6
3
3
Allocate variable costs:
Accounting
(20,000)
12,389
7,611
(22,000)
13,200
8,800
$0
$211,589
$116,411
$0
(50,000)
$0
16,211
25,000
$241,211
11,789
25,000
$118,789
$0
$0
$452,800
$235,200
Information Systems
Total variable costs
Allocate fixed costs:
Accounting
Information Systems
Total fixed costs
Total fixed and variable costs
© John Wiley & Sons, 2011
$0
(28,000)
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 28
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 9
JOINT PRODUCT AND BY-PRODUCT COSTING
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Q1: Joint Processes and Costs
• A process that yields one or more products is
called a joint process.
• The products are called joint products.
• The costs of the process are called joint costs.
• The split-off point is the stage in the joint process
where the separate products become
identifiable.
• Joints costs are incurred prior to the split-off point.
• Costs incurred past split-off are separable costs.
• Joint products that have minimal sales value
compared to the main product are called byproducts.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Joint Processes and Costs
Sawdust
Bark
Joint costs
include DM,
DL &
Overhead.
© John Wiley & Sons, 2011
Planks
If sawdust sells for a
relatively minimal amount,
it is a byproduct.
The costs of
processing
planks further
are separable
costs.
Wall
paneling
Joint products
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q2: Methods of Allocating Joint Costs
• Physical output methods
• Can be used only when joint products are
measured the same way (e.g. pounds or feet).
• Market-based methods
• Sales value at split-off method
• Often used when all products sold at split-off.
• Net realizable value (NRV) method
• NRV = Final selling price – Separable costs.
• Constant gross margin (GM) NRV method
• The two NRV methods can be used when
some products are processed past split-off.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q2: Physical Volume Method Example
Pleasing Peaches grows peaches and processes three different peach
products that are sold to a canning company. The pounds produced for
each product, and the selling price per pound, is given below. The joint
costs of processing the 280,000 pounds of products were $70,000.
Allocate the joint costs to each product using the physical volume method.
Pounds
Product
Produced
Peach halves 160,000
Peach slices
80,000
Peach purée
40,000
280,000
© John Wiley & Sons, 2011
Selling Total Sales
Price per
Value at
Pound
Split-Off
$0.50
$80,000
$0.40
$32,000
$0.30
$12,000
$124,000
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Relative
Allocated
Weight Joint Costs
57.1%
$40,000
28.6%
$20,000
14.3%
$10,000
100.0%
$70,000
Slide # 6
Q2: Sales Value at Split-Off Method Example
Allocate the joint costs of $70,000 to each of Pleasing Peaches products
using the sales value at split-off method.
Product
Peach halves
Peach slices
Peach purée
© John Wiley & Sons, 2011
Pounds
Produced
160,000
80,000
40,000
280,000
Selling Total Sales
Price per
Value at
Pound
Split-Off
$0.50
$0.40
$0.30
$80,000
$32,000
$12,000
$124,000
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Relative
Sales
Allocated
Value Joint Costs
64.5%
25.8%
9.7%
100.0%
$45,161
$18,065
$6,774
$70,000
Slide # 7
Q2, 6: Compare the Physical Volume and
Sales Value at Split-Off Methods
Compute the gross margin for each product for each of the two allocation
methods. Discuss the differences between the two methods.
Allocated Joint
Costs
Total
Sales
Sales
Physical Value at
Value at Volume Split-Off
Product
Split-Off Method
Method
Peach halves $80,000 $40,000 $45,161
Peach slices
$32,000 $20,000 $18,065
Peach purée
$12,000 $10,000 $6,774
$124,000 $70,000 $70,000
© John Wiley & Sons, 2011
Gross Margin
Sales
Physical Value at
Volume Split-Off
Method
Method
$40,000 $34,839
$12,000 $13,935
$2,000 $5,226
$54,000 $54,000
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q2, 6: Compare the Physical Volume and
Sales Value at Split-Off Methods
Compute the gross margin ratio (GM/Sales) for each product under both of
the methods and discuss.
Product
Peach halves
Peach slices
Peach purée
© John Wiley & Sons, 2011
Total
Sales
Value at
Split-Off
$80,000
$32,000
$12,000
$124,000
Gross Margin
Sales
Physical Value at
Volume
Split-Off
Method
Method
$40,000 $34,839
$12,000 $13,935
$2,000 $5,226
$54,000 $54,000
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Gross Margin Ratio
Sales
Physical Value at
Volume Split-Off
Method
Method
50.0%
43.5%
37.5%
43.5%
16.7%
43.5%
43.5%
43.5%
Slide # 9
Q2: Net Realizable Value (NRV) Method Example
Pleasing Peaches could process each of its three products beyond split off.
It could can the peach halves itself, make the peach slices into frozen
peach pie, and make juice out of the peach purée. The retail value of the
new products and the separable costs for the additional processing are
given below. Compute the joint costs allocated to each of the products
using the NRV method.
Final
Allocated
Sales Separable
Relative
Joint
Product
Value
Costs
NRV NRV
Costs
Canned peaches $180,000 $60,000 $120,000
64.2% $44,920
Peach pie
$120,000 $70,000
$50,000
26.7% $18,717
Peach juice
$50,000 $33,000
$17,000
9.1% $6,364
$350,000 $163,000 $187,000 100.0% $70,000
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 10
Static and Flexible Budgets
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Q1: Budgets & Strategic Management Process
• A budget is
• A formalized financial plan.
• A translation of an organization’s strategies.
• A method of communicating.
• A way to define areas of responsibility and
decision rights.
• The budget cycle is the series of
sequential steps followed to create and
use budgets.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Budgets & Strategic Management Process
• Budgeting process begins with the organizational
vision, core competencies, and risk appetite
• Organizational strategies designed to achieve the
vision will drive the capital expenditures and long
term financing plans
• Operating plans are then created in line with the
organizational strategies
• Actual results must be monitored, measured, and
analyzed compared to budgeted plans
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Budgets & Levers of Control
Belief Systems
• Communicates
organizational
strategies and
goals
• Motivates
managers to
plan in
advance and
coordinate
activities
© John Wiley & Sons, 2011
Boundary
Systems
Interactive
Control Systems
Diagnostic
Control Systems
• Authorizes
employees to
engage in
planned
activities and
spend within
budget limits
• Ensures
sufficient cash
flow for
financial
viability
• Utilize
variances to
identify
opportunities
and threats to
the business
• Revaluate
strategies and
operating plans
as conditions
changes
• Assign
responsibility
and reward
employees for
achieving
budget targets
• Motivate
managers to
provide good
estimates and
use resources
appropriately
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q2: Master Budgets
• A master budget is
• A comprehensive plan for the upcoming
accounting period.
• Usually prepared for a one-year period.
• Is based on a series of budget assumptions.
• The master budget consists of several
subsidiary budgets, in two categories:
• Operating budgets.
• Financial budgets.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q2: Operating Budgets
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q2: Operating Budget Example
Stanley J, Inc., makes a tool used by auto mechanics that sells for
$68/unit. It expects to sell 6,000 units in April and 7,000 units in May.
Stanley J prefers to end each period with a finished goods inventory
equal to 10% of the next period’s sales in units and a direct materials
inventory equal to 20% of the direct materials required for the next
period’s production. The company never has any beginning or ending
work-in-process inventories. There were 400 units in finished goods
inventory on April 1. Prepare the revenue and production budgets for
April.
Production budget
Revenue budget
Budgeted sales in units in April
6,000 Budgeted sales in units in April
Budgeted selling price per unit
$68.00 Desired ending FG inventory
Budgeted revenues
$408,000 Total units required
Less: beginning FG inventory
Required production in units
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
6,000
700
6,700
(400)
6,300
Slide # 10
Q2: Operating Budget Example
Stanley J’s product uses 0.3 pounds of direct material per unit, at a cost
of $4/lb. There were 220 lbs. of direct material on hand on April 1.
Assume that budgeted production for May is 6,500 units. Prepare the
direct materials purchases and usage budget for April.
Direct materials budget
Required production in units
DM required per unit, in pounds
Total DM required, in pounds
Less: Beginning DM inventory
Plus: Desired ending DM inventory
Required DM purchases in pounds
Budgeted DM cost per pound
Budgeted cost of DM
6,300
0.3
1,890
(220)
390
2,060
$4.00
$8,240
Usage Budget = 1,890 pounds * $4 per pound = $7,560
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q2: Operating Budget Example
Stanley J’s product uses 0.2 hours of direct labor at a cost of $12/hr.
Prepare the direct labor budget for April.
Direct labor budget
Required production in units
DL required per unit, in hours
Total DL hours required
Budgeted cost per DL hour
Budgeted cost of DL
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
6,300
0.2
1,260
$12.00
$15,120
Slide # 12
Q2: Operating Budget Example
Stanley J’s budgeted fixed manufacturing overhead for April is $167,000,
and variable manufacturing overhead is budgeted at $6 per direct labor
hour. Prepare the manufacturing overhead budget for April.
Manufacturing overhead budget
Total DL hours required
Budgeted variable overhead per DL hour
Total budgeted variable overhead
Budgeted fixed overhead
Total budgeted overhead
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
1,260
$6.00
$7,560
$167,000
$174,560
Slide # 13
Q2: Operating Budget Example
Assume that Stanley J’s April 1 direct materials inventory had a cost of
$1,560. Prepare the April ending inventories budget for direct materials.
Ending inventories budgets
Budgeted cost of DM purchases
$8,240
Beginning DM inventory
$854
DM available for use
$9,094
Budgeted cost of desired ending DM inventory:
[6,500 units x 0.3 lbs/unit] x 20% x $4/lb
$1,560
Budgeted cost of DM to be used
$7,534
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q2: Operating Budget Example
Prepare the April ending inventories budget for finished goods.
Budgeted cost of DM to be used
Budgeted cost of DL
Total budgeted overhead
Total budgeted manufacturing costs
Required production in units
Budgeted manufacturing cost per unit
Budgeted ending FG inventory in units
Budgeted cost of ending FG inventory
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
$7,534
$15,120
$174,560
$197,214
6,300
$31.3037
700
$21,913
Slide # 15
Q2: Operating Budget Example
Assume that Stanley J’s April 1 finished goods inventory had a cost of
$12,146. Prepare the cost of goods sold budget for April.
Cost of goods sold budget
Beginning FG inventory
Total budgeted manufacturing costs
Cost of goods available for sale
Less: budgeted ending FG inventory
Budgeted cost of goods sold
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
$12,146
$197,214
$209,359
$21,913
$187,447
Slide # 16
Q2: Operating Budget Example
Stanley J’s budget for April includes $22,000 for administrative costs,
$34,000 for fixed distribution costs, $18,000 for research and
development, and $13,000 for fixed marketing costs. Additionally, the
budgeted variable costs for distribution are $0.75/unit sold and the
budgeted variable costs for marketing are 4% of sales revenue. Prepare
the support department budget for April.
Support department budget
Administration
$22,000
Distribution: Fixed costs
$34,000
Variable costs
$4,500 $38,500
Research & development
$18,000
Marketing: Fixed costs
$13,000
Variable costs
$16,320 $29,320
Total budgeted support department costs
$107,820
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q2: Operating Budget Example
Suppose that Stanley J’s income tax rate is 28%. Prepare the budgeted
income statement for April.
Budgeted income statement
Sales revenue
Cost of goods sold
Gross margin
Operating costs:
Administration
Distribution
Research & development
Marketing
Net income before taxes
Income taxes
Net income
© John Wiley & Sons, 2011
$408,000
$187,447
$220,553
$22,000
$38,500
$18,000
$29,320 $107,820
$112,733
$31,565
$81,168
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q4: Budget Variances
• Managers compare actual results to
budgeted results in order to
• Monitor operations, and
• Motivate appropriate performance.
• Differences between budgeted and
actual results are called budget
variances.
• Variances are stated in absolute value
terms, and labeled as Favorable or
Unfavorable.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q4: Budget Variances
• Reasons for budget variances are
investigated.
• The investigation may find:
• Inefficiencies in actual operations that can
be corrected.
• Efficiencies in actual operations that can be
replicated in other areas of the
organization.
• Uncontrollable outside factors that require
changes to the budgeting process.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q3: Static Budgets
• A budget prepared for a single level of
sales volume is called a static budget.
• Static budgets are prepared at the
beginning of the year.
• Differences between actual results and
the static budget are called static budget
variances.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q3, Q4: Flexible Budget Example
Tina’s Trinkets is preparing a budget for 2006. The budgeted selling price
per unit is $10, and total fixed costs for 2006 are estimated to be $5,000.
Variable costs are budgeted at $3/unit. Prepare a flexible budget for the
volume levels 1,000, 1,100, and 1,200 units.
Sales in units
Revenues
Variable costs
Contribution margin
Fixed costs
Operating income
© John Wiley & Sons, 2011
Volume Levels
1,000
1,100
1,200
$10,000 $11,000 $12,000
$3,000 $3,300 $3,600
$7,000 $7,700 $8,400
$5,000 $5,000 $5,000
$2,000 $2,700 $3,400
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 23
Q3, Q4: Static Budget Variances Example
Suppose that Tina’s 2006 static budget was for 1,100 units of sales. The
actual results are given below. Compute the static budget variances for
each row and discuss.
Static
Budget
Sales in units
1,100
Revenues
$11,000
$3,300
Variable costs
Contribution margin $7,700
Fixed costs
$5,000
$2,700
Operating income
© John Wiley & Sons, 2011
Static
Actual Budget
Results Variance
980
$9,604 $1,396 Unfavorable
$311 Favorable
$2,989
$6,615 $1,085 Unfavorable
$4,520
$480 Favorable
$605 Unfavorable
$2,095
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 24
Q3, Q4: Flexible Budget Variances Example
Compute the flexible budget variances for Tina and discuss the results.
Compare the flexible budget variances to the static budget variances on the
prior page.
Year-end
Flexible
Flexible Actual Budget
Budget Results Variance
Sales in units
980
980
Revenues
$9,800 $9,604
$196 Unfavorable
Variable costs
$2,940 $2,989
$49 Unfavorable
Contribution margin $6,860 $6,615
$245 Unfavorable
Fixed costs
$5,000 $4,520
$480 Favorable
Operating income
$1,860 $2,095
$235 Unfavorable
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 25
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 11
Standard Costs and Variance Analysis
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Q2: Standard Costs
• Organizations set standards to help plan
operations.
• A standard cost is the expected cost of
providing a good or service.
• In manufacturing, the standard cost of a
unit of output is comprised of:
• the standard price (SP) of the input, and
• the standard quantity of the input expected
to be consumed in the production of one
output unit.
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q2: Standard Costs
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q2: Standard Costing Systems
Advantages
Disadvantages
• Information can be used
to quickly estimate job or
project costs
• Monitor resources to
measure efficiency
• Communicates targets
(goals) to employeess
• Provides information to
analyze operations
• May reduce employee
motivation if the standards
are too high or low
• Time involved in setting
standards and analyzing
variances
• Incorrect standards could
result in inappropriate
employee rewards or
penalties
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q1: Variance Analysis
• The difference between an actual cost and
the standard cost of producing goods or
services at the actual volume level is
called a standard cost variance.
• Managers investigate the reasons for
standard cost variances so that:
• efficiencies can be rewarded and replicated,
• inefficiencies can be minimized, and
• the validity of the standards can be assessed.
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q3: Direct Cost Variances
• A price variance is the difference between
the standard cost of resources purchased
(or that should have been consumed) and
the actual cost.
• An efficiency variance measures whether
inputs were used efficiently.
• It is the difference between the inputs used
and the inputs that should have been used,
times the standard price of the input
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q3: Direct Cost Variances
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q3: Direct Labor Cost Variances
• The direct labor price and efficiency variances are
a decomposition of the direct labor flexible budget
variance.
• The year-end flexible budget direct labor cost is
based on the standard direct labor hours for the
actual output, or standard quantity allowed (SQA).
• Other abbreviations used:
• SP = standard price of the input
• AP = actual price of the input
• AQ = actual quantity of the input used
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q3: Direct Labor Cost Variances Example
Matthews Manufacturing makes a product that is expected to use ¼ hour
of direct labor to produce. At the beginning of the year Matthews expected
to produce 10,000 units. Actual production, however, was 9,800 units.
The standard price of direct labor is $10/hour. Actual direct labor costs
were $24,696 for the 2,520 labor hours used. Compute the direct labor
cost variances.
First compute SQA for direct labor:
SQA = 9,800 units x ¼ hour/unit = 2,450 hours
Then compute AP for direct labor:
AP = $24,696/2,520 hours = $9.80/hour
DLPV = [SP – AP] x AQ = [$10/hour - $9.80/hour] x 2,520 hours = $504F
DLEV = [SQA – AQ] x SP = [2,450 hours - 2,520 hours] x $10/hour = $700U
Note that the DL FBV = $504F + $700U = $196U
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q3: Direct Material Cost Variances Example
Matthews Manufacturing makes a product that is expected to use 2
pounds of direct material to produce. At the beginning of the year
Matthews expected to produce 10,000 units. Actual production, however,
was 9,800 units. The standard price of direct materials is $3/pound.
Matthews purchased 20,500 pounds of direct material at $3.10/pound, and
used 19,400 pounds. Compute the direct material cost variances.
First compute SQA for direct materials:
SQA = 9,800 units x 2 pounds/unit = 19,600 pounds
DMPV = [SP – AP] x Actual Quantity Purchased =
[$3/pound - $3.10/pound] x 20,500 pounds = $2,050U
DMEV = [SQA – AQ] x SP =
[19,600 pounds - 19,400 pounds] x $3/pound = $600F
© John Wiley & Sons, 2011
Chapter 11: Standard Costs and Variance Analysis
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 15
Performance Evaluation and Compensation
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Q1: Agency Theory
• In agency theory, a principal contracts with
an agent to act on his or her behalf.
• The principal can observe the outcome of
the agent’s actions, but cannot observe the
agent’s behavior or effort level.
• The costs or lost benefits the principal
suffers when the agent does not act in the
best interests of the principal are called
agency costs.
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Agency Costs
• Agency Costs include:
• Losses from poor decisions
• Losses from incongruent goals
• Monitoring costs
• Goal alignment costs
• Contracting costs
• The principal must design plan to minimize
agency costs.
• Utilize well designed compensation schemes
• Assign responsibility for decision making
• Establish appropriate transfer prices
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q2: Decision Making Responsibility
• In a centralized organization, decision
making authority and responsibility resides
with top management.
• In a decentralized organization, decision
making authority and responsibility is given
to lower levels of management.
• Usually, top management has general
knowledge about the operations of business
segments and the business segment
managers have specific knowledge.
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q4: Performance Evaluation of
Investment Centers
• Return on investment (ROI) shows the
percentage return the center made on the
investment level chosen.
• Residual income (RI) shows the dollar
amount the center earned above the
minimum required for the center’s investment
level.
• Economic value added (EVA®) is a specific
type of residual income calculation.
• ROI can be used to compare the
performance of different-sized business
segments, but RI and EVA® can not.
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
® Stern Stewart & Co.
Slide # 13
Q4: Return on Investment (ROI)
• ROI is simply calculated as “earnings” over
“investment”.
• “Earnings” and “investment” must be
defined; often, earnings is defined as
operating income and investment is defined
as average operating assets, so that
Operating income
ROI =
Average operating assets
• Operating assets include cash, A/R,
inventory, and the property and equipment
used in producing the revenue.
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q4: ROI Example
Altus Industries has two divisions, North and South. Given the information
below, compute the ROI for each division.
Operating income
After-tax operating income
Average operating assets
Average current liabilities
Net sales
North
South
$180,000 $40,000
120,000 24,000
2,000,000 200,000
400,000 36,000
2,600,000 100,000
North ROI = $180,000/$2,000,000 = 9%
South ROI = $40,000/$200,000 = 20%
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q4: ROI and DuPont Analysis Example
Altus Industries has two divisions, North and South. Use DuPont analysis
to decompose the ROI for each divisions and discuss.
Operating income
After-tax operating income
Average operating assets
Average current liabilities
Net sales
Return on sales (ROS)
Investment turnover (ITO)
ROI (ROS x ITO)
North
South
$180,000 $40,000
120,000 24,000
2,000,000 200,000
400,000 36,000
2,600,000 100,000
North
6.92%
1.30
9.0%
South
40.00%
0.50
20.0%
North does a better job of using its asset base to generate sales than
does South. However, South does a better job of turning sales dollars
into operating income than does North.
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q4: ROI and New Projects Example
Suppose that Altus has a minimum required rate of return for all
investments of 10%. Each division is considering a new project. The
expected return and initial investment of each project is shown below. If
ROI is used to evaluate division performance, will each division accept or
reject the new project? Are these decisions in line with the best interests
of Altus?
Project income
Project investment
Project ROI
North
South
$7,500 $2,250
$80,000 $15,000
9.38% 15.00%
North will decide to accept the project because it will increase division
ROI. However, this is not in line with the organization’s best interests
because investments with an ROI less than 10% should not be accepted.
South will decide to reject the project because it will decrease division
ROI. However, this is not in line with the organization’s best interests
because investments with an ROI exceeding 10% should be accepted.
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q4: Residual Income (RI)
• RI is operating income less the minimum
required operating income given the
segment’s investment in assets.
RI = Operating income -
Required
rate of
return
X
Average
operating
assets
• RI removes the incentive for business
segment managers to make project
investment decisions based on a
comparison of segment ROI and project
ROI.
© John Wiley & Sons, 2011
Chapter 15: Performance Evaluation and Compensation
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
