Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management

Accounting II

Chapter One

Cost-Volume-Profit Relationship

1.1. Introduction

Without any doubt profit is a backbone of any business operation. Regardless of the types of
business operations or types of business organizations, all business aims to get profit or to
maximize wealth. Thus it is a question of all managers to search a ways to quickly answer a
number of important questions about profitability of a company’s products (involve businesses
that produce products, since they are often more complex situations, we may focus on this part)
or services (health care, accounting, barbers & beauty shops, auto repair, etc.). For such analysis
managers uses a tool known as Cost Volume Profit (CVP) analysis.

Cost Volume-Profit analysis studies the behavior and relationship among total revenues, total
costs and income as changes occur in the units sold, the selling price, the variable cost per unit,
or the fixed cost a product. (Charles T. Horngren, 2012)

(Garrison, 2012) Also defines CVP as a powerful tool that helps managers to understand the
relation among cost, volume and profit. It focuses on how profits are effected by selling price,
sales volume, unit variable costs, total fixed costs and mix of products sold.

Generally Cost-volume-profit (CVP) analysis is a technique that examines changes in profits in

response to changes in sales volumes, costs, and prices. Accountants often perform CVP analysis
to plan future levels of operating activity and provide information about managerial decisions.

For our specific understanding we may focus on variable product costing (Direct costing) as this
method classify costs based on cost behavior and uses for managerial decisions. Unlike variable
costing full costing approach, absorption costing, is not essential for management decision. Full
costing approach use for financial reporting than routine management accounting works. On the
other hand managers focus on income statement accounts than balance sheet accounts. The
income statement accounts basically consists of revenue and expense accounts that leads to
operating income or net income.

1|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

The following items shows the basic difference between absorption costing and variable costing
(Dr. M. P. Gupta, 2013)

No. Areas of difference Absorption Variable

1) MOH rate calculation: Include both fixed and Only variable MOH
variable MOH
2) Classification of MOH Based on category of Based on behavior
activity
3) Valuation of Inventory Prime cost, applied Prime cost and applied
fixed and Variable variable MOH
MOH
4) Operating Profit = NS – CGS (Fixed = NS – CGS – Operating
moh) – operating expense (Fixed Moh)
expense

** Dear Students: Please it advisable to refer part III of Chapter 4 from Cost and Management Accounting I**

The Cost Volume Profit Analysis involves three basic elements

1. Cost: the cost of making the product or providing a service.

2. Volume: the number of units or products produced or hours/units of service delivered.
3. Profit: Selling price of product/services minus cost to make product/provide service

A successful business can be built around a single profitable product. It can also be built around
hundreds or thousands of profitable products. Many businesses start small and grow over time,
adding products as they gain experience and are able to identify and/or develop new markets and
products. No matter the size of the business or the number of products, the same rules apply.
Each product must "carry its own weight" for the business to be profitable.

Using CVP Analysis we can analyze a single product, a group of products, or evaluate the entire
business as a whole. The ability to work across the entire product line in this way gives us a
powerful tool to analyze financial information. It provides us with day-to-day techniques that are
easy to understand and easy to use. The concepts parallel the real world, so they are easy to
visualize and use. The math is very simple - no complex formulae or techniques. Just simple
formulae that can be easily modified to analyze a large variety of situations.

2|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

There are three methods of expressing cost volume relationships

i. The equation method

ii. The contribution margin method
iii. The graph method

The equation and the contribution margin method are most useful when managers want to
determine operating income at few specific levels of sales. The graph method helps managers
visualize the relationship between units sold and operating income over a wide range of
quantities of units sold.

We may see each method in all the topics of the chapter:

Equation method Contribution margin The graph method

method
OI = TR-VC-FC OI=(SP*Q) – (UVc * Q) –
FC
TR = SP * Q
UCM = SP – UVc
VC = UVc * Q
OPI= (UVc * Q) - FC
OPI(SP*Q) – (UVc * Q) – FC

(Dr. M. P. Gupta, 2013)*** States variable costing as marginal costing approach.

Cost volume profit assumptions
A. Effect of product or service: Changes in total revenue or costs arise only because of
changes in number of units (services) sold.
B. Cost built based on cost behavior: Total cost composes of variable cost which varies with
respect to unit sold and fixed cost which remains the same as the units sold varies.
C. When represented graphically, the behaviors 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).

3|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

D. Selling price, variable cost per unit, and total fixed costs (within a relevant range and
time period) are known and constant.

1.2. Variable and fixed cost behavior and patterns

No Particu Fixed costs Variable costs

lars
1 Type Remain constant irrespective of the volume of Tends to vary directly with output
of cost output or activity. They accrue with the passage or activity. They are called activity
of time, they are known as period cost, time cost cost and they are called cost of
and they are cost of being in business. doing business
2
Relatio They result from capacity to produce, they are They are result of output and
n to not result of performance, not affected by output. directly related without put.
activity Thus making fixed cost per unit does not make Variable cost in relation to time
any sense. does not make any sense.
Releva Fixed remain constant with a given output or The pattern of variable costs also
nt activity range. There are a few, if any, costs that remains constant within normal or
activity would remain constant over the wide range or relevant range of operations;
range output or activity, say, from zero to full capacity. beyond that, these costs may well
change.
Releva Other things remaining constant, a change in a All other factors given constant,
nt period may lead to a change in fixed cost variable costs cannot be affected
period structure. (e.g due to annual increment, salary due to change in period alone.
bills in two periods will not be identical)
Control All fixed costs are controllable over the lifespan They are subject to short term
lability of an enterprise. Many fixed costs are dependent management control, may also be
on management decision of firms. affected by discretionary policy
decision of management.
As it is tried to mention in table above costs are classified in to fixed cost and variable cost
according to how they behave, in relation to units of production. Cost behavior can be viewed in
terms of total cost or unit cost.

Total fixed costs: stay essentially the same month to month, regardless of the number of units
produced. Unit fixed cost or sometimes called average fixed cost goes down as production goes
up.

Total Variable costs: Are costs those fluctuates with the number of production. The unit
variable cost is the same regardless of how many units are produced.

In some case mixed costs change somewhat in relation to production, but proportionately like
variable costs do. Mixed costs generally have a fixed portion and a variable portion.

4|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Illustration case selection

Student named Lemlem is one of the outstanding students from our few self-sponsored students.
As she is a good example for other similar type of students, we have visited her and found as she
has a business called Lemlem Enjera that operates in Wolkite town. In her good permission, we
TC
have chosen her business for our illustration to complete the module of Cost and management
Accounting
VC

Fixed Cost

Example:
Lemlem Enjera incur a total fixed cost of 36000 for house rent and salaries of employees for one
month and a total of 12000 Enjera produced each month. Lemlem Enjera incur an additional cost
of birr 1.25 per Enjera for purchase of teff, birr 0.55 per Enjera for payment of ingredients and
birr 1 Enjera for labor fee. If she sold one Enjera for birr 5 birr:

- What is fixed cost?

- What is variable cost?
- What is profit amount?
- How much the business earn on each Enjera?
Contribution Margin
The contribution margin (CM) is one of the most essential parts of variable costing and
managerial accounting. It can be calculated as either unit CM or total CM. CM is the profit
available to cover fixed costs and provide net income to the owners. The contribution margin is
total revenue minus total variable costs. Similarly, the contribution margin per unit is the selling
price per unit minus the variable cost per unit. Both contribution margin and contribution margin
per unit are valuable tools when considering the effects of volume on profit.

Example:

Lemlem Enjera has monthly fixed costs of birr 36,000. Lemlem Enjera incur an additional cost
of birr 1.25 per Enjera for purchase of teff, birr 0.55 per Enjera for payment of ingredients and
birr 1 Enjera for labor fee. They sell about 12000 units per month at birr 5 each. Compute CM

5|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

1.3. Break-even analysis uses and techniques

The breakeven point is the where total revenues equals total cost (i.e: point of zero profit).
Managers often want to know the level of activity required to break even. A CVP analysis can be
used to determine the breakeven point, or level of operating activity at which revenues cover all
fixed and variable costs, resulting in zero profit.

Break even chart, regardless of multi product or single product, may be prepared to suit different
purposes.

Detailed break-even chart: detail of variable costs chart appears on break even chart. In
addition profit appropriations (income tax, preference dividend, equity dividend and retentions)
of profit are shown in the chart.

Cash break even chart: In such charts fixed cost is divided in to two; fixed cost requires cash
outlay and fixed cost that not requires cash out lays. The fixed cost not require cash outlay is
considered as part of variable cost and sketched below variable cost. This type of breakeven
point sketched when there is necessity of cash flow analysis.

Control breakeven Chart: when the budgetary control and variable costing is mixed, breakeven
chart necessary shows actual costs and the budgeted one.

Factors which can affect BEP

- Change in fixed cost
- Change in variable cost
- Change in selling price
- Change in production quantity

…… an equation we use to compute quantity at breakeven point. Or

6|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

… an equation we use to compute sales at breakeven point

Contribution margin ratio: Is the ratio that we can get by dividing contribution margin divided by
price. Assume if we get 75% of contribution margin means that 75% of the revenue from each
units sold contributes first to fixed costs and then to profit after fixed costs are covered.

Example:

Lemlem Enjera has monthly fixed costs of birr 36,000. Lemlem Enjera incur an additional cost
of birr 1.25 per Enjera for purchase of teff, birr 0.55 per Enjera for payment of ingredients and
birr 1 Enjera for labor fee. How much they earn and need to sell at birr 5 each to be at BEP

Evaluate the effect of change on fixed cost, variable cost, selling price and production quantity.

Case on break-even analysis

Lemlem Enjera considering the sitting of a new Restaurant beside a city bypass. It has made the
following calculation

Cost of operations per annum: Birr

Salaries of staff ------------------------------------------ 30000

Depreciation of equipment ------------------------------- 5000

Rental of site-------------------------------------------------5000

Cost of one Enjera ----------------------------------------------0.48

Selling price of one Enjera ------------------------------------------------5 birr

a) How many Enjera must be sold to break even?

b) If an investment in promotional advertising would produce an increase in Enjera sold of
250000 Enjera, how much could the company afford to spend on this exercise to break
even?
c) Were the company to sell quality Enjera, retailing at birr 5.2 per Enjera and costing birr
0.49 per Enjera, the more expensive equipment’s would require a further depreciation of

7|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

birr 3000. What effect would such a scenario have on the break-even point calculated in
requirement 1?

1.4. Planning with cost-volume-profit Data

Managers sometimes plan the level of profit so as to project the amount of production or sales.
We begin with the preceding profit equation. Assuming that fixed costs remain constant, we
solve for the expected quantity of goods or services that must be sold to achieve a target level of
profit.

…… an equation we use to compute quantity at TOI. Or

… an equation we use to compute sales at TOI

Example:

Lemlem Enjera has monthly fixed costs of birr 36,000 and projected to earn an operating income
of 45000 in coming month. Lemlem Enjera incur an additional cost of birr 1.25 per Enjera for
purchase of teff, birr 0.55 per Enjera for payment of ingredients and birr 1 Enjera for labor fee.
How much they earn and need to sell at birr 5 each to achieve their plan?

Evaluate the effect of change of each items on the level of production/sale.

Case on Target Operating Income
Imagine Lemlem Enjera have the following data, given to calculate the given requirements
 Sales price Birr 20 per unit
 Fixed factory overheads Birr 5,40,000 per year
 Fixed selling costs Birr 2,52,000 per year
 Variable manufacturing costs Birr 11 per unit
 Variable selling cost Birr 3 per unit
Compute for 1. Breakeven point expressed in unit and sales

2. Number of units that must be sold to earn a profit of birr 60,000 per year
3. How many units must be sold to earn a net profit of 10% of sales.

Profit-Volume Ratio (P/V Ratio)

It determines relation between cost volume and profit based on ratio between variable
contribution and sales. It is rate (normally percentage) at which contribution or profit increase
with volume.

8|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

P/V ratio = Contribution *100 /Sales or (1-(VC/P))*100 then Thus BEP = Fixed cost / P/V ratio

Sometimes P/V ratio can also be calculated by determining the amount of changes in profit ad
change in the total sales between two periods

Margin of Safety (M/S)

Any sales in excess of break-even volume represents margin of safety. It is also sales beyond
break even volume which brings in profit

Margin Safety (M/S) = Actual Sales – Sales at BEP

Example:

Assume Lemlem Enjera incurred a fixed of 12000 with a selling price per Enjera of 10 and
variable cost per Enjera is 7. What can be the margin of safety if the business sold 6000 units?
1.5. Limitation of CVP analysis
CVP is a '''short run''', '''marginal''' analysis: it assumes that unit variable costs and unit revenues
are constant, which is appropriate for small deviations from current production and sales, and
assumes a neat division between fixed costs and variable costs, though in the long run all costs
are variable. For longer-term analysis that considers the entire life-cycle of a product, one
therefore often prefers [[activity-based costing]] or [[throughput accounting]].

When we analyze CVP is where we demonstrate the point at which in a firm there will be no
profit nor loss means that firm works in breakeven situation

1. Segregation of total costs into its fixed and variable components is always a daunting task to
do.
2. Fixed costs are unlikely to stay constant as output increases beyond a certain range of
activity.
3. The analysis is restricted to the relevant range specified and beyond that the results can
become unreliable.
4. Aside from volume, other elements like inflation, efficiency, capacity and technology
impact on costs
5. Impractical to assume sales mix remain constant since this depends on the changing demand
levels.

9|Page @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

6. The assumption of linear property of total cost and total revenue relies on the assumption
that unit variable cost and selling price are always constant. In real life it is valid within
relevant range or period and likely to change.

Chapter Two

2. Master Budget
2.1. Overall plan and its characteristics
Planning is deciding in advance what is to be done, when, where, how and by whom it is to be
done. Planning bridges the gap from where we are to where we can go, includes the selection of
objectives, policies, procedures and programs among alternatives. It is an intellectual process
characterized by thinking before doing. It is an attempt on the part of manager to anticipate the
future in order to achieve better performance. Planning is the primary function of management.

The main characteristics or nature of planning is given below:

1) Planning is an Intellectual Process
Planning is an intellectual process of thinking in advance. It is a process of deciding the future on
the series of events to follow. Planning is a process where a number of steps are to be taken to
decide the future course of action. Managers or executives have to consider various courses of
action, achieve the desired goals, go in details of the pros and cons of every course of action and
then finally decide what course of action may suit them best.

2) Planning Contributes to the Objectives

Planning contributes positively in attaining the objectives of the business enterprise. Since plans
are there from the very first stage of operation, the management is able to handle every problem
successfully. Plans try to set everything right. A purposeful, sound and effective planning
process knows how and when to tackle a problem. This leads to success. Objectives thus are
easily achieved.

3) Planning is a Primary Function of Management

Planning precedes other functions in the management process. Certainly, setting of goals to be
achieved and lines of action to be followed precedes the organization, direction, supervision and

10 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

control. No doubt, planning precedes other functions of management. It is primary requisite

before other managerial functions step in. But all functions are inter-connected. It is mixed in all
managerial functions but there too it gets precedence. It thus gets primary everywhere.

4) A continuous Process
Planning is a continuous process and a never ending activity of a manager in an enterprise based
upon some assumptions which may or may not come true in the future. Therefore, the manager
has to go on modifying, revising and adjusting plans in the light of changing circumstances.
Planning is a continuous process and there is no end to it. It involves continuous collection,
evaluation and selection of data, and scientific investigation and analysis of the possible
alternative courses of action and the selection of the best alternative.

5) Planning Pervades(encompass) Managerial Activities

From primary of planning follows pervasiveness of planning. It is the function of every
managerial personnel. The character, nature and scope of planning may change from personnel
to personnel but the planning as an action remains intact over every managerial personnel. Plans
cannot make an enterprise successful. Action is required, the enterprise must operate managerial
planning seeks to achieve a consistent, coordinated structure of operations focused on desired
trends. Without plans, action must become merely activity producing nothing but chaos."
Meaning and Definition of Budget
A budget is (a) the quantitative expression of a proposed plan of action by management for a
specified period and (b) an aid to coordinate what needs to be done to implement that plan. A
budget generally includes both financial and nonfinancial aspects of the plan, and it serves as a
blueprint for the company to follow in an upcoming period. A financial budget quantifies
management’s expectations regarding income, cash flows, and financial position. Just as
financial statements are prepared for past periods, financial statements can be prepared for future
periods—for example, a budgeted income statement, a budgeted statement of cash flows, and a
budgeted balance sheet. Underlying these financial budgets are nonfinancial budgets for, say,

11 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

units manufactured or sold, number of employees, and number of new products being introduced
to the marketplace.
2.2. Advantages of budgeting

Budgets’ main objective is resources allocation. In the agency theory vision, budgets are seen as
a negotiation between principal and agent. Budget negotiation and employee participation in its
development are a necessary step. The entity resources are limited. So, their allocation should be
done efficiently. Subordinates know better than their superiors the activities that they perform,
their implications and what resources they need in order to achieve the stated objectives (they are
holding information with a high degree of accuracy). Information they can provide through
participation in the budgeting process allows an efficient resource allocation.
Participatory budgets take into account in resource allocation the needs of subordinates, and by
doing so it reduces the risk of inefficient allocations. Participatory budgeting, by transparency
and communication, ensures a fair allocation of resources. This helps to improve the decision-
making process and individual performances.
There are a number of advantages to budgeting:
 Compels management to think about the future, which is probably the most important
feature of a budgetary planning and control system. Forces management to look ahead, to
set out detailed plans for achieving the targets for each department, operation and
(ideally) each manager, to anticipate and give the organization purpose and direction.
 Promotes coordination and communication.
 Clearly defines areas of responsibility. Requires managers of budget centers to be made
responsible for the achievement of budget targets for the operations under their personal
control.
 Provides a basis for performance appraisal (variance analysis). A budget is basically a
yardstick against which actual performance is measured and assessed. Control is provided
by comparisons of actual results against budget plan. Departures from budget can then be
investigated and the reasons for the differences can be divided into controllable and non-
controllable factors.
 Enables remedial action to be taken as variances emerge.
 Motivates employees by participating in the setting of budgets.
 Improves the allocation of scarce resources.

12 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

 Economies management time by using the management by exception principle.

Problems in budgeting
Whilst budgets may be an essential part of any marketing activity, they do have a number of
disadvantages, particularly in perception terms.
 Budgets can be seen as pressure devices imposed by management, thus resulting in:
a) Bad labor relations
b) Inaccurate record-keeping.
 Departmental conflict arises due to:
a) Disputes over resource allocation
b) Departments blaming each other if targets are not attained.
 It is difficult to reconcile personal/individual and corporate goals.
Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This is
often coupled with "empire building" in order to enhance the prestige of a department.
Responsibility versus controlling, i.e. some costs are under the influence of more than one
person, e.g. power costs.
 Managers may overestimate costs so that they will not be blamed in the future should
they overspend.
2.3. Types of budgets

Managerial accounting approaches a company's financial situation in an operational way, giving

information in a manner that supports managers in planning and control procedures. Various
budget formats in managerial accounting influence how a manager forecasts department activity
and how he addresses progress or shortfall to meet goals. Companies may use several types of
managerial budgets concurrently.

1. Capital Budgets

A capital budget estimates all capital asset acquisitions and summarizes all expenses and costs of
major purchases for the next year. Capital assets include items that have useful lives of more
than 12 months, such as buildings, building improvements, land, furniture, fixtures, equipment,
computers, musical instruments, works of art and books, writes David C. Maddox, the author of

13 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

the book ―Budgeting for Not-for-Profit Organizations.‖ The main purpose of a capital budget is
to forecast costs of major capital purchases.

2. Operating Budgets

Operating budgets indicate the products and services a firm expects to use in a budget period. It
describes all the income-generating activities of a firm, including production, sales and
inventories of finished goods. An operating budget typically has two distinct parts: the expense
budget and the revenue budget. The expense budget indicates all expected expenses of a firm for
the coming year, while the revenue budget shows all projected revenues for the coming year.

3. Cash Budgets

A cash budget projects all cash inflows and outflows for the next year. Cash budgets have four
distinct elements: cash disbursements, cash receipts, net change in cash and new financing. A
cash budget is important, because it allows administrators to timely identify periods with cash
overages and shortages so they can take necessary remedial action.

4. Sales Budgets

Sales budgets indicate the sales a firm expects to make in units and dollars for a budget year.
They detail the quantities of products or services a firm expect to sell, revenues earned from
those sales and all expenses accrued during selling. Sales budget forecasts determine sales
potential, or the maximum number of sales a firm can make. This information is then used to
plan resource allocations to achieve those sales levels. Sales budgets serve as benchmarks or
yardsticks against which actual sales performance is measured and variables such as sales
volume, profitability and selling expenses are controlled.

5. Personnel Budgets

Personnel budgets, or salary and wage budgets, are cost estimations related to labor. They
forecast the costs of recruitment, hiring, training, assignment, salaries, overtime costs, additional
benefits and discharge. Calculating personnel budgets includes estimating the number of staff,
staffing ratios and overheads.

14 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Sometimes budget may be classified in different ways

A. Budget based on capacity

Based on the capacity, budgets are classified as fixed and flexible budgets.

i. Fixed Budgets: A fixed budget is one which will remain unchanged (immaterial) of the
level of activity. These budgets are prepared for fixed expenses and their aim is to control
cost.
ii. Flexible Budgets: A flexible budget is designed so as to change with the fluctuations in
output, turnover and other factors, which are variable. These budgets will change with the
change in activity. These budgets are prepared for various level of activity. While
preparing flexible budgets the expenses are broadly classified as fixed and variable.
A fixed budget is rigid and does not change with the volume of activity achieved,
whereas a flexible budget can be changed to suit the level of activity to be achieved.
Flexible budget is not rigid. A fixed budget is prepared for a particular level of activity
and for a particular set of conditions.
B. Budget Based on Time

Though budgets may cover long periods (called long-range budgets), the most frequently
used budget period is one year (short-range budgets) and master budget is one of these
budgets. The annual budget is often subdivided by months for the first quarter and by
quarters for the remainder of the year.

Companies are increasingly using rolling budgets. A rolling budget is always available for a
specified future period by adding a period (month, quarter, or year) in the future as the period
just ended is dropped. Rolling budgets are sometimes called revolving budgets or continuous
budgets.

2.4. Techniques of Budgeting

Different organizations prepare budget using different techniques that may be grouped as
follows:

15 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

(1) Incremental budgeting: is a budget set based on past year’s actual performance. In this
technique a budget for the coming year is simply this year budgeted or actual results plus
or minus some amount for expected change on planned operation or change in the market
price. This budgeting technique is easy and widely used, however it has its own draw
back. As the base is the current year performance or budget any anomaly in the current
year performance or budget may be incorporated in the budget.
(2) Zero based budgeting: In a dynamic business it often makes sense to 'start afresh' when
developing a budget, rather than basing ideas too much on past performance. In this
technique each budget is therefore constructed without much reference to previous
budgets. Preparing a budget afresh is usually required in most business organizations,
where the business environment is volatile that require continues effort of incorporating
changes in budget thinking.
(3) Rolling budgets: Given the speed of change and general uncertainty in the external
environment, shareholders seek quick results. US companies typically report to
shareholders every three months, compared with six months in the UK. Rolling budgets
involve evaluating the previous twelve months' performance on an ongoing basis, and
forecasting the next three months' performance.
(4) Strategic budgeting: This involves identifying new, emerging opportunities, and then
building plans to take full advantage of them. This is closely related to zero based
budgeting and helps to concentrate on gaining competitive advantage.
(5) Activity based budgeting: This examines individual activities and assesses the strength
of their contribution to company success. They can then be ranked and prioritized, and be
assigned appropriate budgets.

2.5. Developing the Master Budget

A Master Budget is a consolidated summary of the various functional budgets. It coordinates all the
financial projections in the organization’s individual budgets in a single organization wide set of budgets
for a set time period

A master budget consists two major parts, namely: operating budget and financial budget.

i Operating budget refers to the budgeted income statement and the supporting
budget schedules for various business functions in the value chain. The operating

16 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

budget basically shows the expected operating result of the organization in the
upcoming operational period.
ii The financial budget is part of the master budget made up of the capital
expenditures budget, the cash budget, the budgeted balance sheet, and the budgeted
statement of cash flow.

An overview of a Master Budget

Sales Budget

Ending Inventory Production Budget

Budget

Direct Material Direct Labor Budget Manufacturing

Overhead Budget
Budget

Cost of Goods Sold Budget

Operating Expense/none manufacturing

overhead/ Budget

Budgeted Income statement

Capital Cash Budget Budgeted Balance Sheet Budgeted Cash

Expenditure
Flow statement
Budget

Basic Steps in preparation of Master Budget

Goro business produces and sells a product whose peak sales occur in the third quarter.
Management is now preparing detailed budgets for 2009- the coming year and has assembled the
following information to assist in the budget preparation:

17 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

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.

2009 Quarters 2010 Quarters

Q1 Q2 Q3 Q4 Q1 Q2
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, 2004, 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.
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, 2008, 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, 20008 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.
6. Each unit of Gore’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:

18 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

2009 Quarters
1 2 3 4
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, 2003 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:

19 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

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 wishes to use any excess cash to pay loans off as rapidly as possible.

Required: Prepare a master budget for the four-quarter period ending December 31. Include the
following detailed budget and schedules:

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
j) A cash budget, by quarter and in total
k) A budgeted income statement for the four- quarter ending December 31, 2009
l) A budgeted balance sheet as of December 31, 2009.

a) Sales Budget
This budget is baseline budget for other budgets, and prepared at the beginning of the period.
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

20 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

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. The projected level of sales is then combined with estimated
of selling prices to form the sales budget. Sales forecasts are usually prepared under the direction
of the top sales executive. Important factors considered by sales forecasters include:

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.
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.
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.
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.
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.
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.
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.
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.
Sales Budget of Goro Business is presented below
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
A. Cash Collection budget

This budget shows the total cash that a company will collect from various sources during the
accounting period or the budget period.

21 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Quarter
1 2 3 4 Total
30% of the previous quarter sales Br. 90, 000 Br.60, 000 Br.180, 000 Br.240, 000 Br.570, 000

70% of the current quarter sales 140, 000 420, 000 560, 000 280, 000 1, 400, 000
Total collections Br.230, 000 Br.480, 000 Br.740, 000 Br. 520, 000 Br.1, 970, 000

B. Production Budget
This budgeted is prepared after sales budget to fix production requirements for the forth-coming
budget period can be determined and organized in the form of a production budget. The total
number of budgeted production requirement, is therefore, the sum of budgeted sales in unit and
target ending inventory. However, if the firm is not new in operation, usually some of its
production requirement can be satisfied using the inventory kept of the beginning of the period.
Therefore, the banging inventory should be deducted from the total production requirement to
determine the exact units in the production budget. Therefore, production needs can be
determined as follows:

Budgeted sales in units ……………………***

Plus Desired ending inventory …………… ***
Total needs ……………………………….. ***
Less Beginning inventory ………………… ***
Required Production, ……………………… ***
Quarter Total
1 2 3 4
Expected sales(units) 10, 000 30, 000 40, 000 20, 000 100, 000
Add: Desired Ending Inventory 6, 000 8, 000 4, 000 3, 000 3, 000
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
NB: Ending production is equals 20% of sales of next quarter.
C. Direct Material Budget
This budget is done after production requirement have been identified to identify how much unit
to buy to meet future direct material needs. The direct materials budget ties the production to the
direct materials that will need to be purchased in order to produce the estimated units. The
required purchases of raw materials are computed as follows:
Raw Material required for production ……………….. ***

22 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Plus desired ending raw material inventory …………. ***

Total raw material needs …………………….. ***
Less Beginning raw material ………………... ***
Raw Material to be purchase ………………………... ***

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 material purchase cost (in Birr)
1 2 3 4 Total
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516, 500
purchased
Raw materials cost per x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20
pound
Total Br.47, 400 Br.97, 200 Br.102, 900 Br.55, 800 Br.303, 300
D. Budgeted cash disbursement for direct material purchase
Businesses make cash payments for various purposes. This budget shows cash payments that will
be made only for purchase of direct materials.
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
E. Direct labor Budget
Direct labor budget is developed after production budget to fix the required level laborers
necessary to complete sufficient time for each production. To compute direct labor requirements,
the number of units of finished product to be produced each period (month, quarter, and so on) is
multiplied by the number of direct labor-hours required to produce 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.

23 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

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
F. 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.

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
Cash disbursements Br.68, 000 Br.96, 800 Br.103, 200 Br.76, 000 Br.344, 000
for MOH
G. 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 as follows:
Budgeted Finished Goods Inventory 3, 000
Unit product cost Br.13
Ending Finished Goods Inventory in birr 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/Direct labor hours = 404, 000/80,800 = Br.5.00

24 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Budgeted cost of goods sold for Lemlem Enjera for the budget period is computed as follows:
Cost of goods sold=100,000*13=1,300,000

H. Operating Expense Budget (selling and Administrative Expenses)

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. Selling and Administrative Expenses Budget for Gore Company for the
budget period is given below:

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 can also be prepared from the above facts
as follows for Gore Company:
Quarter Total
1 2 3 4
Budgeted Selling & Br.103, 000 Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
Administrative

25 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

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

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.

Budgeted Income Statement for Gore Company can be prepared as follows:

Gore Company
Budgeted Income Statement
For the Year Ended December31, 2004
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 profit 700, 000
Selling & Administrative Expenses [Schedule 1 (i)] 577, 800
Net Operating Income 122, 200
Interest Expense [Schedule 2(a)] 14, 000
Net Income Br. 108, 200
Preparing 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.

26 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

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:

1. 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.

2. 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.

3. 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 previous periods can be repaid or
the idle funds can be placed in short-term or other investments.

27 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

4. 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.

Cash Budget for Gore Company for the budget period is prepared as follows:

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 customers 230, 000 480, 000 740, 000 520, 000 1, 970, 000

Total cash available before financing 272, 500 520, 000 780, 000 560, 500 2, 012, 500

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 available (120, 000) (6 0, 000) 108, 000 94, 000 21, 500

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, 000 Br.40, 500 Br.47, 500 47, 500

28 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

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.

Gore Company
Budgeted Balance Sheet
December31, 2004
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

29 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Total liabilities and stockholders’ equity Br.729, 000

Chapter Three

Flexible budgets and Standards

1.6. Introduction

Static Budget

The static budget is the budget that is based on the projected level of output that is done prior to
the start of the period. In other words, the static budget is the ―original‖ budget. The static budget
variance is the difference between any line-item in this original budget and the corresponding
line-item from the statement of actual results. Often, the line-item of most interest is the ―bottom
line‖: total cost of production for the factory and other cost centers; net income for profit centers.

A static budget is a budget prepared for only one level of activity. It is based on the level of
output planned at the start of the budget period. The master budget is an example of a static
budget.

Flexible Budget

A flexible budget is developed using budgeted revenues or cost amounts based on the level of
output actually achieved in the budget period. Flexible budget is developed at the end of the
period. The flexible budget variance is the difference between any line-item in the flexible
budget and the corresponding line-item from the statement of actual results.

A key difference between a flexible budget and a static budget is the use of the actual output
level in the flexible budget. Static budget variance does not give much information about the

30 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

variances between actual results and budgeted amounts for each line item. Hence one has to
prepare flexible budget.

To have a better understanding of causes for variance managers usually require variance
calculated at different level. Variance according to the degree of detailed feedback on
performance can be classified as:
 Level 0 variance analysis
 Level 1 variance analysis
 Level 2 variance analysis
 Level 3 variance analysis
 Level 4 variance analysis
The difference between budget and actual result can be favorable or unfavorable based upon the
impact of the discrepancy on the overall profitability of the firm. If the variance has an
increasing effect on the operating income as compared to the budgeted amount, it is said to be
favorable variance. On the other hand unfavorable or adverse variance occurs when the
variance has a decreasing effect on the operating income relative to the budgeted amount.

Variances assist managers in their planning and control decisions. It enables to exercise
Management by Exception (MBE), which is the practice of concentrating attention on areas not
operating as expected and giving less attention to areas operating as expected. Managers
regularly pay attention to areas with large variances. Variances are also used in performance
evaluation. For example Production line managers in a manufacturing company may have
quarterly efficiency incentives linked to achieving a budgeted amount of operating costs.

For example we can take example from Gore. Assume Gore manufactures and sells different
project.

Budgeted variable cost per product are as follows

- Direct material cost Birr 65

- Direct manufacturing labor 26
- Variable manufacturing overhead 24
Total variable costs 115

31 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

If budgeted selling price is Birr 155 per product and expected fixed cost is to be Birr 286000
within a relevant range between 9000 and 13500 products. What is the static budget operating
profit if static budget is based on selling of 13000 product for 2011?

Revenue ………….…………. 2,015,000

Less Variable costs ----------- (1,495,000)

Fixed costs ------------ (286,000)

Budgeted operating profit …….. 234,000

What is the actual operating profit if Goro business produced and sold 10,000 products at 160
each with actual variable costs of 120 per product and fixed manufacturing costs of Birr
300,000?

Revenue …………… 1,600,000

Variable cost --------------- (1,200,000)

Fixed cost -------------- (300,000)

Actual operating profit ……. 100,000

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

- Level 0 analysis compares actual operating profit with budgeted operating profit.
- Level 1 analysis provides more detailed information on the operating profit static budget
variance

If we compute the static-budget variance of operating profit

Actual operating profit Birr 100,000

Budgeted operating profit 234,000

32 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Static-Budget Variance of OP 134,000 (Unfavorable) (This is a level 0 variance

Static Budget Based Variance Analysis (Level 1) in thousands

Static Budget Actual Result Variance

Product 13 10 3 U
Revenue 2,015 1,600 415 U
Variable cost 1,495 1,200 295 F
Contribution margin 520 400 120 U
Fixed costs 286 300 14 U
Operating profit 234 100 134 U

A favorable variance is a variance that increases operating profit relative to the budgeted amount.
An unfavorable variance is a variance that decreases operating profit relative to the budgeted
amount. A favorable variance for revenue items means that actual revenues exceeded budgeted
revenues. A favorable variance for cost items means that actual costs were less than budgeted
costs.

When we come to preparation of flexible budget needs some necessary steps. For preparation of
flexible budget, it is necessary to follow some necessary steps.

Step 1: Determine budgeted selling price, budgeted variable cost per unit and budgeted fixed
cost.

Step 2: Determine the actual quantity of out output

Step 3: Determine the flexible budget for revenues based on budgeted selling price and actual
quantity of output.

Step 4: Determine the flexible budget for costs based on budgeted variable costs per output unit,
actual quantity of output and the budgeted fixed costs.

Revenue ……………………… 1,550,000

Variable costs …………….. (1,150,000)

33 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Fixed costs ……………. (286,000)

Flexible operating profit ……. 114000

Level 2 analysis provides information on the two components of the variance

A. Flexible budget variance

B. Sales volume variance (Chapter 4 Concept)

Flexible Budget Variance (Level 2) in thousands

Flexible Budget Actual Result Variance

Product 10 10 0 U
Revenue 1,550 1,600 50 F
Variable cost 1,150 1,200 50 U
Contribution margin 400 400 0 U
Fixed costs 286 300 14 U
Operating profit 114 100 14 U

Dear students please analyze why the flexible budget is unfavorable by 14000!

Sales Volume Variance

The sales-volume variance is the difference between the static budget for the number of units
expected to be sold and the flexible budget for the number of units that were actually sold. The
only difference between the static budget and the flexible budget is the output level upon which
the budget is based.

Flexible Budget Static Budget Sales- Volume Variance

Product 10 13 3 U

Revenue 1,550 2,015 465 U

34 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Variable cost 1,150 1,495 295 F

Contribution margin 400 520 120 U

Fixed costs 286 286 0 U

Operating profit 114 234 120 U

Why is the sales-budget variance of Birr 120,000 unfavorable?

Static budget units ……………….. 13000

Actual units sold ……………….. 10000

Variance ……………….. 3000 U

Budgeted contribution margin per unit (155 – 115) = 40

3000 * 40 = 120,000 unfavorable variance

Static-budget variance 134,000 U (14,000 U flexible-budget variance and 120,000 U Sales-Volume Variance)

1.7. Standards for material and labor

1.7.1. Standard for material
Usually two standards are set for direct materials costs. These are:
A. A materials price standard.
B. A materials quantity (or usage) standard.
Direct materials price standards permit:

1. Checking the performance of the purchasing department and the influence of various
internal and external factors.
2. Measuring the effect of price increase or decrease on the company's profits.

Determining the price or cost to be used as the standard cost is often difficult, because the price
used are controlled more by external factors than by a company's management. Prices selected
should reflect current market prices and are generally used throughout the forthcoming fiscal
period. The standard price for direct materials should reflect the final, delivered cost of the
materials, net of any discounts taken.

35 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Example:

Assume a purchase price of product is 3.6 birr. The product requires freight of 0.44 birr,
receiving and storing cost of 0.05 birr for each products. The business got 0.09 birr for purchase
of each product. What is the standard cost of the product?

Direct material quantity standard

The normal or expected quantity of direct materials required to manufacture a unit of finished
product is called standard quantity per unit. It also includes allowances for normal wastage and
rejection.

Example:

Assume production of one product requires 3.85 kg of material and out of this 0.01kg spoiled
under normal business operation. What is the standard quantity of direct material for each
product if allowance of 0.05 kg is given per product for rejection?

1.7.2. Standard for Direct labor

Direct labor standards are established to control labor costs. Two commonly used direct labor
standards are direct labor rate standard and direct labor time standards. The direct labor rate
standard is also known as direct labor price standard

Direct labor rate standard:

Setting direct labor rate standard means calculating an expected hourly rate for labor costs. It
includes not only wages per hour but also other costs associated with labor such as fringe
benefits, employment taxes etc. The necessary information to calculate standard labor rate per
hour is taken from the production department and previous year’s data.

Example

Assume Gore company’s basic wage rate is birr 15 and other costs associated with labor are
employment taxes 5% of basic wage rate and fringe benefits 15% of basic wage rate. The hourly
wage rate is:

Direct labor time standard

36 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Direct labor time standard is the standard time required to manufacture a unit of product under
normal working conditions. This time is normally expressed in hours.

Example:

Assume Gore company manufacture a unit of product which requires basic time of 2.5 hour,
breaks and unrecognized time 0.2 hour, allowance for down time 0.3 hours and allowance for
rejected materials 0.25 hours. The time spend on one product is:

1.8. Controllability and variance analysis

1.8.1. Direct material
The direct material variance is the difference between the standard cost of materials resulting
from production activities and the actual costs incurred. The direct material variance is
comprised of two other variances, which are:

 Purchase price variance. This is the difference between the standard and actual cost per
unit of the direct materials purchased, multiplied by the standard number of units expected
to be used in the production process. This variance is the responsibility of the purchasing
department.
P. variance = (S. Cost – Actual cost) * Standard Units
 Material yield variance. This is the difference between the standard and actual number of
units used in the production process, multiplied by the standard cost per unit. This variance
is the responsibility of the production department.
Yield Variance = (S. unit – Actual units) * Standard Cost

Example

Assume Gore Company plans to produces 1000 products and records an unfavorable direct
material variance of Birr 700. Further investigation reveals that the cost purchase was 3.5 per
unit which was budgeted at birr 4.00 per unit. What is price variance and yield variance if actual
number of output is 1300?

P. Variance = (S. cost – Actual cost) * Standard units Y. variance = (S. Units – A. Units) * S. cost

= (4.00 – 3.50) * 1000 = (1300 – 1000) * 4.00

= 0.5 * 1000 = 300 * 4.00

37 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

= Birr 500 = Birr 1200

1.8.2. Direct labor

The direct labor (DL) variance is the difference between the total actual direct labor cost and the
total standard cost.

Direct labor variance = Total actual DL cost - Total standard DL cost

The total actual direct labor cost and total standard direct labor cost may be computed as follows:

Total actual DL cost = Actual hours used x Actual rate per hour

Total standard DL cost = Standard hours for actual production x Standard rate per hour

If the total actual cost incurred is less than the total standard cost, the variance is favorable and if
the total actual cost is higher than the total standard cost, the variance is unfavorable since the
company paid more than what it expected to pay.

For further analysis, the direct labor variance may be split into: direct labor rate variance and
direct labor efficiency variance. The rate variance is due to the difference between the actual and
standard labor rate, while the labor efficiency variance arises from the difference in the actual
number of hours worked and number of hours that should have been used.

Example:

Assume Gore Company as an annual production budget of 120,000 units and an annual DL
budget of $3,840,000. Four hours are needed to complete a finished product and the company
has established a standard rate of $8 per hour. Last month, the company produced 10,000 units.
The company used 39,500 direct labor hours and paid a total of $325,875.

Compute for 1. Direct labor variance

2. Direct labor rate variance

3. Efficiency variance

Direct labor variance = Total actual cost – total standard cost

= (325,875) – ((4*10000) * 8))

= 5875 …….. Unfavorable

38 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Direct labor variance = (Actual rate – Standard rate) * Actual hours

= (8.25 – 8.00) * 39500 = 9875 …..Unfavorable

Direct Labor efficiency variance = (Actual hour – Standard hour) * Standard rate

= (39500 – 40000) * 8 = 4000 ….. Favorable

1.8.3. Overheads
Factory overhead is most commonly defined as "manufacturing costs that are not classifiable as
direct material or direct labor."

Factory overhead costs include indirect materials, indirect labor, and factory expenses. In
standard costing, predetermined amounts are used to facilitate better control and faster recording
of costs. Standard costing allows management to determine areas that deviate from established
standards, to be able to investigate and take corrective actions.

Factory overhead costs are better analyzed when they are segregated into variable and fixed.

Variable Factory Overhead Variance

The computation and analysis of variable factory overhead (VFOH) is pretty much similar to that
of direct labor. The only difference is the rate applied. Also, variable overhead rates may use
direct labor hours or machine hours as its base.

VFOH variance = Total actual VFOH cost - Total standard VFOH cost
***** Actual VFOH cost = Actual hours used * Actual rate per hour
***** Standard VFOH cost = Standard hours for actual production * standard VFOH rate per
hour
Variable factory overhead may be split into: VFOH spending variance and VFOH efficiency variance.

VFOH spending variance = (Actual rate - Standard rate) x Actual hours

VFOH efficiency variance = (Actual hours - Standard hours) x Standard rate

Fixed Factory Overhead Variance

The computation for fixed factory overhead (FFOH) variance is similar to that of variable factory
overhead. Note, however, that fixed factory overhead amounts are almost always given in total
figures (thus, it may or may not require additional computations).

FFOH variance = Total actual FFOH cost - Total standard FFOH cost

39 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

The total actual fixed overhead cost is almost always given in total amount; hence no additional
computation is needed. The total standard fixed overhead cost (or applied fixed factory
overhead) may be computed as follows:

Total standard FFOH cost = Standard hours for actual production x Standard FFOH rate per hour

In generally fixed manufacturing overhead can be split in to; FFOH spending variance and
FFOH volume variance.
FFOH spending variance = Actual FFOH - Budgeted FFOH
FFOH volume variance = Budgeted FFOH - Standard FFOH

Chapter Four

Measuring Mix and Yield Variances

1.9. 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. This variance is
known as sales variance.

The sales variance is the difference between the budgeted revenue and actual revenue. We will
take example from Goro Company to illustrate. Goro Manufacturing Company produces and
sales three different products, X, Y and Z. The Company Budgeted to sell 20,000 units of its
products. The company’s budgeted sales of 20,000 units represent 40% of the market share. The
details for the budgeted and actual data for a given year are as follows:

Budgeted Data Actual Data

Product Selling Price Quantity Sales Total Selling Price Unit Sales Total
per Unit Mix Revenue per Unit Volume Mix Revenue
X 252,000 10% 50,000 20 4,000 0.1818 80,000
Y 408,000 0.40 320,000 45 10,000 0. 4545 450,000
Z 30
10,000 0.50 300,000 30 8,000 0.3637 240,000
20,000 670,000 22,000 770,000
1.9.1. Sales Volume Variance

The sales volume variance is the difference between the static budget and the flexible budget.
*Refer chapter three*

40 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Sales volume variance sometimes called variance due to change on number output level. For
example sales volume variance in above Goro Company’s example is change on output with
budgeted price.

Sales Volume Variance = (Actual Unit – Budgeted Unit) * Budgeted Price

= (22,000 – 20,000) * 100

= 2000 * 100 = 200,000 Favorable.

Sales Mix Variance

Sales mix variance is the difference between a companies’ budgeted sales mix and the actual
sales mix that the firm sells to customers. Sales mix is defined as the proportion of each product
a business sells, relative to total sales. Sales mix affects total company profit, because some
products generate higher profit margins than others. Sales mix variance includes each product
line sold by the firm.

Sales mix variance = (Actual all units sold * (Actual sales mix % - budgeted sales mix %) * B. price)

Thus sales mix variance of Goro Company is:

X = (22000 *(0.1818 – 0.10) * 25) = 44,990 F

Y = (22000 *(0.4545 – 0.40) * 40) = 47,960 F

Z = (22000 *(0.3637 – 0.50) * 30) = 89,958 .. U… 2992 F

Sales Quantity Variance

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).

SQV = (A. all units sold – B. all units sold) * B. sales mix % * B. sales price

SQV for X = (22,000 -20,000) x 0.10x 25= 5,000F

Y = (22,000 -20,000) x 0.40x 40= 32,000F
Z = (22,000 -20,000) x 0.50x 30= 30,000F

41 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

1.9.2. Market-size and Market-Share Variance

The market-size variance is the difference in budgeted contribution margin at budgeted market
share caused solely by actual market size in units being different from budgeted market size in
units. The formula for computing the market size variance is as follows:
MSV = (AMS – BMS)* BMSh * BCM
= (20,000 – 22,000) * 0.4 * 30 birr
= 24000
The market-share variance is the difference in budgeted contribution margin for actual market
size in units caused solely by actual market share being different from budgeted market share.
The formula for computing the market share variance is as follows:

MShV = AMS * (AMSh – BMSh) * BCM

= 60,000 * 30 * (0.367 – 0.4)

= Br 67000

Dear student’s market size and market share variance analysis focus on the following example:

Goro company have a budgeted sales level of 12000 units at a budgeted contribution margin of
birr 32 per unit. The company in this year loses its market share from budgeted percentage of
20% to 16% from total market size of 12,000 units and 10,000 units respectively. The market
share and market size variance are:

MShV = AMS * (AMSh – BMSh) * BCM

= 62500 * (0.16 – 0.20) * 32

= 80,000 …… Unfavorable

MSV = (AMS – BMS)* BMSh * BCM

= (62500 – 60000) * 0.2 * 32

= 2500 * 0.2 * 32

= 16000….. Favorable

What is the percentage of increase in market size?

42 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

1.10. Input Variances

1.10.1. Direct materials Mix and Yield Variances
A material price variance shows the Birr effect of paying prices that differ from the raw material
standard. The material mix variance (MMV) measures the effect of substituting a nonstandard
mix of materials during the production process. The material yield variance (MYV) is the
difference between the actual total quantity of input and the standard total quantity allowed based
on output; this difference reflects standard mix and standard prices. The sum of the material mix
and yield variances equals a material quantity variance; the difference between these two
variances is that the sum of the mix and yield variances is attributable to multiple ingredients
rather than to a single one. A company can have a mix variance without experiencing a yield
variance.

Material Yield Variance = Selling price * (Standard Quantity – R. Standard Quantity)

Material Mix Variance = Selling Price * (Revised Standard Quantity – Actual Quantity)
Material Quantity Variance: Is the result of material yield variance and material mix variance
Material Price Variance = (Standard Selling Price – Actual Selling Price) * Actual Quantity

FBV for is the sum of Material quantity variance and material price variance

Example: The Scent Makers Company produces perfume. To make this perfume, Scent makers
uses three different types of fluids: Dycone, Cycone, & Bycone are used in standard proportions
of 4/10, 3/10, & 3/10 and their standard costs are Br. 6.00, Br. 3.50 & Br. 2.50 per unit,
respectively. The chief engineer reported that for the past few months the standard yield has been
80% on 100 pints of mix. The Company maintains a policy of not carrying any direct material, as
inventory storage space is costly.
Last week the company produced 75,000 pints of perfume at a total direct material cost of Br.
449,500. The actual number of pints used and costs per unit for the three fluids are as follows:
Material Actual Pints Cost/Pint
Dycone 45,000 Br. 5.50
Cycone 35,000 4.20
Bycone 20,000 2.75
100,000
Required

43 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

1) Compute the total direct material yield & mix variances for the last week..
2) Compute the total direct material price & usage variances for perfume made in the
last week.
Solution

SQ = Standard quantity for actual output

Change the suggestion of Engineer on standard yield (80% on 100 Pints) to actual one.

80 Points required = 100 Pints

Actual 75000 points required = ?

75000 * = 93750

Standard quantity for: Dycone : 0.4 * 93,750 = 37,500

Cycone : 0.3 * 93,750 = 28, 125
Bycone : 0.3 * 93,750 = 28, 125

Revised standard quantity

Standard Mix Actual quantity Proportion RSQ

Dycone : 0.4 45,000 0.4 x 100,000 40,000
Cycone : 0.3 35,000 0.3 x 100,000 30,000
Bycone : 0.3 20,000 0.3 x 100,000 30,000
Total 100,000
Material Yield Variance = Selling price * (Standard Quantity – R. Standard Quantity)

Standard Mix Revised Standard Quantity Standard Quantity Selling Price Variance
Dycone : 40,000 37,500 6 15000 U
Cycone : 30,000 28,125 3.5 6562.5 U
Bycone : 30,000 28,125 2.5 4687.5 U
Total 100,000 93,750 26,250 U

Material Mix Variance = Selling Price * (Revised Standard Quantity – Actual Quantity)

Standard Mix Revised Standard Quantity Actual Quantity Selling Price Variance

44 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Dycone : 40,000 45,000 6 30,000 U

Cycone : 30,000 35,000 3.5 17,500 U
Bycone : 30,000 20,000 2.5 25,000 F
Total 100,000 100,000 22,500 U

Material Quantity Variance: Is the result of material yield variance and material mix variance
Standard Mix Material Mix Variance Material Yield Variance . Variance
Dycone : 30,000 U 15,000 U 45,000 U
Cycone : 17,500 U 6562.5 U 24062.5 U
Bycone : 25,000 F 4687.5 U 20,312.5 F
Total 22,500 U 26,250 U 48,750 U

Material Price Variance = (Standard Selling Price – Actual Selling Price) * Actual Quantity

Standard Mix Standard Price Actual Price Actual Quantity Variance

Dycone : 6 5.5 45,000 22,500 F
Cycone : 3.5 4.2 35,000 24500 U
Bycone : 2.5 2.75 20,000 5000 U
Total 7000 U
FBV for is the sum of Material quantity variance and material price variance

Standard Mix Material Price Variance Material Yield Variance . Variance

Dycone : 22,500 U 15,000 U 45,000 U
Cycone : 24500 U 6562.5 U 24062.5 U
Bycone : 5000 F 4687.5 U 20,312.5 F
Total 7000 U 26,250 U 48,750 U
Direct Labor Mix and Yield variances

The labor rate variance is a measure of the cost of paying workers at other than standard rates.
The labor mix variance is the financial effect associated with changing the proportionate amount
of higher or lower paid workers in production. The labor yield variance reflects the monetary
impact of using more or fewer total hours than the standard allowed. The sum of the labor mix
and yield variances equals the labor efficiency variance. The diagram for computing labor rate,
mix, and yield variances is as follows

Labor mix Variance = (Revised Standard hour RSH – Actual Hour AH) * Standard Rate
Labor Yield Variance = (Standard Hour (SH) – Actual Hour (AH)) * Standard Rate (SR)

45 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

(Revision needed)

Example: Buffon Legal Services has three labor classes: secretaries, paralegals, and attorneys.
The standard wage rates are shown in the standard cost system as follows: secretaries, Br 25 per
hour; paralegals, Br 40 per hour; and attorneys, Br 85 per hour. The firm has established a
standard of 0.5 hours of secretarial time and 2 hours of paralegal time for each hour of attorney
time in probate cases. The actual direct labor hours worked on probate cases and the standard
hours allowed for the work accomplished for one month in 2001 were as follows:

Standard Hours
Actual Labor Hrs for Output Achieved
Secretarial 500 500
Paralegal 1,800 2,000
Attorney 1,100 1,000
Total: 3, 400hrs 3,500hrs
Required: Calculate the amount of the direct labor efficiency variance for the month and
decompose the total into the following components:
1. Direct labor mix variance
2. Direct labor yield variance
Solution

Step I: computing for revised standard hour

Standard Rate = 25 Br for Secretarial, 40 Br for Paralegal and 85 Br for Attorney

Revised Standard hour =

Standard hour for Secretory = = 486 hours

Standard hour for Paralegal = = 1943 hours

Standard hour for Attorney = = 971hours

Step II: Labor mix Variance = (Revised Standard hour RSH – Actual Hour AH) * Standard Rate

For Secretarial: (486hrs - 500 hrs) * Br. 25 = Br. 350 (U)

46 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

For Paralegal: (1,943hrs - 1, 800 hrs) Br 40 = 5,720(F)

For Attorney: (971hrs - 1, 100 hrs) Br 85 = 10,965(U)
Total Br.5, 595(U)
Step III: Labor Yield Variance = (Standard Hour (SH) – Actual Hour (AH)) * Standard Rate
(SR)
For Secretarial: (500 hrs - 486hrs) *Br. 25 = Br. 350 (F)
For Paralegal: (2,000 hrs- 1,943hrs) Br 40 = 2,280(F)
For Attorney: (1,000 hrs - 971hrs) Br 85 = 2,465(F)
Total Br. 5, 095(F)

1.11. Productivity Measurement

From economists perspective productivity is the efficiency with which firms, organizations,
industry, and the economy as a whole, convert inputs (labor, capital and raw materials) in to
output. Productivity grows when output grows faster than inputs, which makes the existing
inputs more productively efficient. Productivity does not reflect how much we value the outputs,
it only measures how efficiently we use our resources to produce them.

In firm level productive efficiency can be improved in three ways:

- Improvements in technical efficiency: increases in output can be achieved, at a given level of

input, from more efficient use of the existing technologies.
- Technological progress and organizational change: as firms adopt technologies or
organizational structures that are new to the firm, or develop and apply new technologies or
approaches, they can expand output by more than any additional inputs that might be
required
- Increasing returns to scale: as the size of the firm expands, its unit cost of production can fall
as it becomes financially advantageous to adopt existing technologies.

To improve productive in national level:

- Expanding the firm level efficiencies of productivity to all similar firms. Which may need
availing fair competition among the individual firms.
- There is also potential for 'spillovers' between firms that mean productivity improvements
can be contagious. That is, the things that firms do to benefit themselves benefits other firms

47 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

as well. Proponents of proactive industry policies (such as government support for innovation
hubs and clusters) often cite the importance of spillovers as a source of productivity growth.

Measuring productivity growth:

There are a number of ways to measure productivity. The most common ways are:

A. Multifactor productivity (MFP), which measures the growth in value added output (real gross
output less intermediate inputs) per unit of labor and capital input used
The calculation of MFP using the traditional accounting methods requires independent
measures of inputs and outputs. MFP is a measure closer to the concept of productive
efficiency than LP as it removes the contribution of capital deepening from the residual. Two
potential sources of change in measured productivity warrant special attention: unmeasured
inputs that affect real costs, and capacity utilization.
B. Labor productivity (LP), which measures the growth in value added output per unit of labor
used.
LP can be measured for both the market and non-market sectors of the economy. This is
because labor input can be measured in real volume terms as hours worked.

Measurement problems:

Problems in both the accuracy of the raw data and in the methodologies applied generate
measurement errors. Two problems in measuring inputs that can introduce errors into the
estimates of productivity are difficulties in measuring the volume of capital services, and lags
between investment (when it is counted as adding to the productive capital stock) and when it is
actually utilized in production. These issues arise mainly where there are large infrastructure
projects and when major new technology is introduced, such as ICT.

Measured productivity growth (MFP and LP) reflects a number of influences:

- Changes in the productive efficiency of the economy

- Changes in unmeasured inputs (such as natural resources), which affect the real costs of
production
- Lags between investment (when an input is measured) and when it is utilized in production
- Variations in utilization of inputs due to economic cycles

48 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

- Errors and discrepancies in the underlying estimates of inputs, outputs and prices.

Chapter Four

Measuring Mix and Yield Variances

1.12. 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. This variance is
known as sales variance.

The sales variance is the difference between the budgeted revenue and actual revenue. We will
take example from Goro Company to illustrate. Goro Manufacturing Company produces and
sales three different products, X, Y and Z. The Company Budgeted to sell 20,000 units of its
products. The company’s budgeted sales of 20,000 units represent 40% of the market share. The
details for the budgeted and actual data for a given year are as follows:

Budgeted Data Actual Data

Product Selling Price Quantity Sales Total Selling Price Unit Sales Total
per Unit Mix Revenue per Unit Volume Mix Revenue
X 25 2,000 10% 50,000 20 4,000 0.1818 80,000

49 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Y 408,000 0.40 320,000 45 10,000 0. 4545 450,000

Z 30
10,000 0.50 300,000 30 8,000 0.3637 240,000
20,000 670,000 22,000 770,000
1.12.1. Sales Volume Variance

The sales volume variance is the difference between the static budget and the flexible budget.
*Refer chapter three*

Sales volume variance sometimes called variance due to change on number output level. For
example sales volume variance in above Goro Company’s example is change on output with
budgeted price.

Sales Volume Variance = (Actual Unit – Budgeted Unit) * Budgeted Price

= (22,000 – 20,000) * 100

= 2000 * 100 = 200,000 Favorable.

Sales Mix Variance

Sales mix variance is the difference between a companies’ budgeted sales mix and the actual
sales mix that the firm sells to customers. Sales mix is defined as the proportion of each product
a business sells, relative to total sales. Sales mix affects total company profit, because some
products generate higher profit margins than others. Sales mix variance includes each product
line sold by the firm.

Sales mix variance = (Actual all units sold * (Actual sales mix % - budgeted sales mix %) * B. price)

Thus sales mix variance of Goro Company is:

X = (22000 *(0.1818 – 0.10) * 25) = 44,990 F

Y = (22000 *(0.4545 – 0.40) * 40) = 47,960 F

Z = (22000 *(0.3637 – 0.50) * 30) = 89,958 .. U… 2992 F

Sales Quantity Variance

50 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

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).

SQV = (A. all units sold – B. all units sold) * B. sales mix % * B. sales price

SQV for X = (22,000 -20,000) x 0.10x 25= 5,000F

Y = (22,000 -20,000) x 0.40x 40= 32,000F
Z = (22,000 -20,000) x 0.50x 30= 30,000F
1.12.2. Market-size and Market-Share Variance
The market-size variance is the difference in budgeted contribution margin at budgeted market
share caused solely by actual market size in units being different from budgeted market size in
units. The formula for computing the market size variance is as follows:
MSV = (AMS – BMS)* BMSh * BCM
= (20,000 – 22,000) * 0.4 * 30 birr
= 24000
The market-share variance is the difference in budgeted contribution margin for actual market
size in units caused solely by actual market share being different from budgeted market share.
The formula for computing the market share variance is as follows:

MShV = AMS * (AMSh – BMSh) * BCM

= 60,000 * 30 * (0.367 – 0.4)

= Br 67000

Dear student’s market size and market share variance analysis focus on the following example:

Goro company have a budgeted sales level of 12000 units at a budgeted contribution margin of
birr 32 per unit. The company in this year loses its market share from budgeted percentage of
20% to 16% from total market size of 12,000 units and 10,000 units respectively. The market
share and market size variance are:

MShV = AMS * (AMSh – BMSh) * BCM

= 62500 * (0.16 – 0.20) * 32

= 80,000 …… Unfavorable

51 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

MSV = (AMS – BMS)* BMSh * BCM

= (62500 – 60000) * 0.2 * 32

= 2500 * 0.2 * 32

= 16000….. Favorable

What is the percentage of increase in market size?

1.13. Input Variances

1.13.1. Direct materials Mix and Yield Variances
A material price variance shows the Birr effect of paying prices that differ from the raw material
standard. The material mix variance (MMV) measures the effect of substituting a nonstandard
mix of materials during the production process. The material yield variance (MYV) is the
difference between the actual total quantity of input and the standard total quantity allowed based
on output; this difference reflects standard mix and standard prices. The sum of the material mix
and yield variances equals a material quantity variance; the difference between these two
variances is that the sum of the mix and yield variances is attributable to multiple ingredients
rather than to a single one. A company can have a mix variance without experiencing a yield
variance.

Material Yield Variance = Selling price * (Standard Quantity – R. Standard Quantity)

Material Mix Variance = Selling Price * (Revised Standard Quantity – Actual Quantity)
Material Quantity Variance: Is the result of material yield variance and material mix variance
Material Price Variance = (Standard Selling Price – Actual Selling Price) * Actual Quantity

FBV for is the sum of Material quantity variance and material price variance

Example: The Scent Makers Company produces perfume. To make this perfume, Scent makers
uses three different types of fluids: Dycone, Cycone, & Bycone are used in standard proportions
of 4/10, 3/10, & 3/10 and their standard costs are Br. 6.00, Br. 3.50 & Br. 2.50 per unit,
respectively. The chief engineer reported that for the past few months the standard yield has been
80% on 100 pints of mix. The Company maintains a policy of not carrying any direct material, as
inventory storage space is costly.

52 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Last week the company produced 75,000 pints of perfume at a total direct material cost of Br.
449,500. The actual number of pints used and costs per unit for the three fluids are as follows:
Material Actual Pints Cost/Pint
Dycone 45,000 Br. 5.50
Cycone 35,000 4.20
Bycone 20,000 2.75
100,000
Required
3) Compute the total direct material yield & mix variances for the last week..
4) Compute the total direct material price & usage variances for perfume made in the
last week.
Solution

SQ = Standard quantity for actual output

Change the suggestion of Engineer on standard yield (80% on 100 Pints) to actual one.

80 Points required = 100 Pints

Actual 75000 points required = ?

75000 * = 93750

Standard quantity for: Dycone : 0.4 * 93,750 = 37,500

Cycone : 0.3 * 93,750 = 28, 125
Bycone : 0.3 * 93,750 = 28, 125

Revised standard quantity

Standard Mix Actual quantity Proportion RSQ

Dycone : 0.4 45,000 0.4 x 100,000 40,000
Cycone : 0.3 35,000 0.3 x 100,000 30,000
Bycone : 0.3 20,000 0.3 x 100,000 30,000
Total 100,000
Material Yield Variance = Selling price * (Standard Quantity – R. Standard Quantity)

53 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Standard Mix Revised Standard Quantity Standard Quantity Selling Price Variance
Dycone : 40,000 37,500 6 15000 U
Cycone : 30,000 28,125 3.5 6562.5 U
Bycone : 30,000 28,125 2.5 4687.5 U
Total 100,000 93,750 26,250 U

Material Mix Variance = Selling Price * (Revised Standard Quantity – Actual Quantity)

Standard Mix Revised Standard Quantity Actual Quantity Selling Price Variance
Dycone : 40,000 45,000 6 30,000 U
Cycone : 30,000 35,000 3.5 17,500 U
Bycone : 30,000 20,000 2.5 25,000 F
Total 100,000 100,000 22,500 U

Material Quantity Variance: Is the result of material yield variance and material mix variance
Standard Mix Material Mix Variance Material Yield Variance . Variance
Dycone : 30,000 U 15,000 U 45,000 U
Cycone : 17,500 U 6562.5 U 24062.5 U
Bycone : 25,000 F 4687.5 U 20,312.5 F
Total 22,500 U 26,250 U 48,750 U

Material Price Variance = (Standard Selling Price – Actual Selling Price) * Actual Quantity

Standard Mix Standard Price Actual Price Actual Quantity Variance

Dycone : 6 5.5 45,000 22,500 F
Cycone : 3.5 4.2 35,000 24500 U
Bycone : 2.5 2.75 20,000 5000 U
Total 7000 U
FBV for is the sum of Material quantity variance and material price variance

Standard Mix Material Price Variance Material Yield Variance . Variance

Dycone : 22,500 U 15,000 U 45,000 U
Cycone : 24500 U 6562.5 U 24062.5 U
Bycone : 5000 F 4687.5 U 20,312.5 F
Total 7000 U 26,250 U 48,750 U
Direct Labor Mix and Yield variances

54 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

The labor rate variance is a measure of the cost of paying workers at other than standard rates.
The labor mix variance is the financial effect associated with changing the proportionate amount
of higher or lower paid workers in production. The labor yield variance reflects the monetary
impact of using more or fewer total hours than the standard allowed. The sum of the labor mix
and yield variances equals the labor efficiency variance. The diagram for computing labor rate,
mix, and yield variances is as follows

Labor mix Variance = (Revised Standard hour RSH – Actual Hour AH) * Standard Rate
Labor Yield Variance = (Standard Hour (SH) – Actual Hour (AH)) * Standard Rate (SR)
(Revision needed)

Example: Buffon Legal Services has three labor classes: secretaries, paralegals, and attorneys.
The standard wage rates are shown in the standard cost system as follows: secretaries, Br 25 per
hour; paralegals, Br 40 per hour; and attorneys, Br 85 per hour. The firm has established a
standard of 0.5 hours of secretarial time and 2 hours of paralegal time for each hour of attorney
time in probate cases. The actual direct labor hours worked on probate cases and the standard
hours allowed for the work accomplished for one month in 2001 were as follows:

Standard Hours
Actual Labor Hrs for Output Achieved
Secretarial 500 500
Paralegal 1,800 2,000
Attorney 1,100 1,000
Total: 3, 400hrs 3,500hrs
Required: Calculate the amount of the direct labor efficiency variance for the month and
decompose the total into the following components:
1. Direct labor mix variance
2. Direct labor yield variance
Solution

Step I: computing for revised standard hour

Standard Rate = 25 Br for Secretarial, 40 Br for Paralegal and 85 Br for Attorney

55 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Revised Standard hour =

Standard hour for Secretory = = 486 hours

Standard hour for Paralegal = = 1943 hours

Standard hour for Attorney = = 971hours

Step II: Labor mix Variance = (Revised Standard hour RSH – Actual Hour AH) * Standard Rate

For Secretarial: (486hrs - 500 hrs) * Br. 25 = Br. 350 (U)

For Paralegal: (1,943hrs - 1, 800 hrs) Br 40 = 5,720(F)
For Attorney: (971hrs - 1, 100 hrs) Br 85 = 10,965(U)
Total Br.5, 595(U)
Step III: Labor Yield Variance = (Standard Hour (SH) – Actual Hour (AH)) * Standard Rate
(SR)
For Secretarial: (500 hrs - 486hrs) *Br. 25 = Br. 350 (F)
For Paralegal: (2,000 hrs- 1,943hrs) Br 40 = 2,280(F)
For Attorney: (1,000 hrs - 971hrs) Br 85 = 2,465(F)
Total Br. 5, 095(F)

1.14. Productivity Measurement

From economists perspective productivity is the efficiency with which firms, organizations,
industry, and the economy as a whole, convert inputs (labor, capital and raw materials) in to
output. Productivity grows when output grows faster than inputs, which makes the existing
inputs more productively efficient. Productivity does not reflect how much we value the outputs,
it only measures how efficiently we use our resources to produce them.

In firm level productive efficiency can be improved in three ways:

- Improvements in technical efficiency: increases in output can be achieved, at a given level of

input, from more efficient use of the existing technologies.
- Technological progress and organizational change: as firms adopt technologies or
organizational structures that are new to the firm, or develop and apply new technologies or

56 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

approaches, they can expand output by more than any additional inputs that might be
required
- Increasing returns to scale: as the size of the firm expands, its unit cost of production can fall
as it becomes financially advantageous to adopt existing technologies.

To improve productive in national level:

- Expanding the firm level efficiencies of productivity to all similar firms. Which may need
availing fair competition among the individual firms.
- There is also potential for 'spillovers' between firms that mean productivity improvements
can be contagious. That is, the things that firms do to benefit themselves benefits other firms
as well. Proponents of proactive industry policies (such as government support for innovation
hubs and clusters) often cite the importance of spillovers as a source of productivity growth.

Measuring productivity growth:

There are a number of ways to measure productivity. The most common ways are:

C. Multifactor productivity (MFP), which measures the growth in value added output (real gross
output less intermediate inputs) per unit of labor and capital input used
The calculation of MFP using the traditional accounting methods requires independent
measures of inputs and outputs. MFP is a measure closer to the concept of productive
efficiency than LP as it removes the contribution of capital deepening from the residual. Two
potential sources of change in measured productivity warrant special attention: unmeasured
inputs that affect real costs, and capacity utilization.
D. Labor productivity (LP), which measures the growth in value added output per unit of labor
used.
LP can be measured for both the market and non-market sectors of the economy. This is
because labor input can be measured in real volume terms as hours worked.

Measurement problems:

Problems in both the accuracy of the raw data and in the methodologies applied generate
measurement errors. Two problems in measuring inputs that can introduce errors into the
estimates of productivity are difficulties in measuring the volume of capital services, and lags

57 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

between investment (when it is counted as adding to the productive capital stock) and when it is
actually utilized in production. These issues arise mainly where there are large infrastructure
projects and when major new technology is introduced, such as ICT.

Measured productivity growth (MFP and LP) reflects a number of influences:

- Changes in the productive efficiency of the economy

- Changes in unmeasured inputs (such as natural resources), which affect the real costs of
production
- Lags between investment (when an input is measured) and when it is utilized in production
- Variations in utilization of inputs due to economic cycles
- Errors and discrepancies in the underlying estimates of inputs, outputs and prices.

Chapter Five

Decision-Making and Relevant Information

Introduction

- Business should fix strategy in order to fight from aggressors; since business chance is to win
or to lose. This needs decision in order to focus on core competency by identifying
competitive advantages

58 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

- Using strategies to fulfil responsibility of organization requires decision making

- Accounting information can reduce management’s uncertainty about economic facts,
outcomes, and relationships involved in various courses of action, such information is
valuable for decision-making purposes.
- Relevant costing techniques are applied in virtually all business decisions in both short-term
and long-term contexts

Decision Making Process

Decision making is the process of choosing the best course of action from alternatives available.
Decision model is a method used by managers for deciding among courses of action. Accounting
information (revenue and cost information) are basic inputs in to decision model. However, other
quantitative as well as qualitative information can also be used. In general information is divided
in to relevant and irrelevant information.

Decision making process involves basically the following activities.

I. Identify and Define the Problem. The most important phase of decision making process
because all other activities in the process depend on this phase. Incorrectly defined
problems waste time and resources. That is why it is usually said that defining a problem
is solving half of the problem.
II. Specify the Criterion. The phase in which the purpose of decision is to be made. Is the
objective to maximize profit, increase market share, minimize cost, or improve public
service? For example, cost minimization, increase the quality of product, maximize
profit, etc.
III. Identify Possible Alternatives: Determining the possible alternatives is a critical step in
the decision process.
IV. Gathering Relevant Information. Information could be subjective or objective, internal or
external to the organization, historical (past) data, or future (expected) ones.
V. Making the Decision: Select the best alternative (course of action).

5.1. The Role of Accounting in Special Decisions

Though accountants are not decision makers, the decision makers need accounting information
for decision making. Financial information is needed before any economic decision is made.

59 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Financial accounting information focuses on actual events. For the purpose of decision
making, the past is used as a guide to future estimates of the consequences of different
alternatives. The accountant can help significantly in the areas of budgeting, investigating,
interpreting and communicating results for use by both internal and external decision
makers.

Management accounting is that area of accounting concerned with providing financial and
other information to management in an organization to enable them to carry out their planning,
controlling and decision-making responsibilities. Financial accounting is concerned with
reporting general-purpose information to users external to an entity in order to help them make
sound economic decisions about the entity’s performance and financial position. The
distinction between management and financial accounting can be identified by reference to
(1) the main users of the reports, (2) the types of reports produced, (3) the frequency of
reports, (4) the content and format of reports, and (5) external verification.

Accountants generally work in one of three main areas: public accounting, commerce and
industry, or not-for-profit entities, which include government departments at all levels,
churches, hospitals, clubs and charities. Public accountants tend to specialize in one of
four general services: auditing and assurance, taxation, advisory, and insolvency and
administration. Accountants in commerce and industry may be involved in six areas:
general accounting, cost accounting, accounting information systems, budgeting, taxation
and internal auditing. Not-for-profit accounting involves many of the problems and
decisions encountered in private industry, but may require a different approach in some
respects owing to the absence of a profit motive

5.2. The Meaning of Relevance

For information to be relevant, it must possess three characteristics. It must (1) be associated
with the decision under consideration, (2) be important to the decision maker, and (3) have a
connection to or bearing on some future endeavor.

Association with Decision

60 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Costs or revenues are relevant when they are logically related to a decision and vary from one
decision alternative to another.
An incremental revenue is the amount of revenue that differs across decision choices and
incremental cost (differential cost) is the amount of cost that varies across the decision choices.
Although incremental costs can be variable or fixed, a general guideline is that most variable
costs are relevant and most fixed costs are not. The logic of this guideline is that as sales or
production volume changes, within the relevant range, variable costs change, but fixed costs do
not change. As with most generalizations, some exceptions can occur in the decision-making
process. Management can compare the incremental benefits of alternatives to decide on the most
profitable (or least costly) alternative or set of alternatives.

Some relevant costs may be quantifiable and identifiable but those are not part of accounting
system like opportunity costs. Opportunity costs represents the benefits foregone because one
course of action is chosen over another.

Importance to Decision maker

The need for specific information depends on how important that information is relative to the
objectives that a manager wants to achieve. Moreover, if all other factors are equal, more precise
information is given greater weight in the decision making process. However, if the information
is extremely important, but less precise, the manager must weigh importance against precision.

Bearing on the Future

Information can be based on past or present data, but is relevant only if it pertains to a future
decision choice. All managerial decisions are made to affect future events, so the information on
which decisions are based should reflect future conditions. The future may be the short run (two
hours from now or next month) or the long run (three years from now). Future costs are the only
costs that can be avoided, and a longer time horizon equates to more costs that are controllable,
avoidable, and relevant. Only information that has a bearing on future events is relevant in
decision making.

Costs incurred in the past for the acquisition of an asset or resources are called sunk costs. They
cannot be changed, no matter what future course of action is taken because past expenditures are

61 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

not recoverable, regardless of current circumstances. Thus, the historical cost is not relevant to
the decision.

5.3. Special Decision Areas

5.3.1. Make or Buy Decision

A concern of production requires an appropriate decision in order to determine whether to

produce internally or outsource. This outsourcing decision (make-or-buy decision) is made only
after an analysis that compares internal production and opportunity costs with purchase cost and
assesses the best uses of available facilities. Consideration of an in source (make) option implies
that the company has available capacity for that purpose or has considered the cost of obtaining
the necessary capacity. The make versus buy decision should be based on which alternative is
less costly on a relevant cost basis; that is, taking into account only future, incremental cash
flows. In other words, in a make or buy situation with no limiting factors, the relevant costs for
the decision are the differential costs between the two options.

Such analysis requires identification of both qualitative and quantitative factors, the following
items may be the basic ones:

Quantitative Factors
Buy Make
 the amount paid to supplier  variable costs incurred to produce the
component
 transportation costs  special equipment to produce the
product
 costs incurred to process  hire additional supervisory personnel
the part upon receipt to assist with making the product

Qualitative Factors
 Advantage of long term  The quality of the product is decided
relationship with suppliers to be controlled
 Possibility of shortage of  If the purchase price is likely to rise
material or labor for making due to increased demand in the
the component market, it becomes uneconomical to
buy
 Uninterrupted supply of  Where the technical know-how is to
requisite quality from reliable be kept secret and not to be passed
supplies on to the suppliers

62 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Assume Selam Company became in dilemma weather to produce internally or outsource Enjera
from outside. For outsourcing one Enjera it costs 4.5 birr each and the detail of business cost data
is presented below for decision of availing an output level 175,000 Enjera.

Direct material ……………………………… 1.25

Direct labor ………………………………… 1.25

Variable manufacturing overhead …………. 0.75

Fixed manufacturing overhead ……………. 43750

Variable selling and administrative expense .. 0.75

Fixed Selling and Administrative expense ….. 125,000

5.3.2. Special Order Decisions

One type of decision that affects output level is accepting or rejecting a special order. A special
order is a one-time order that is not considered part of the company’s normal ongoing business.
In general, a special order is profitable as long as the incremental revenue from the special order
exceeds the incremental costs of the order. Thus, conditions to consider in a special order
decisions are: (i) Customers must be from markets not ordinarily served by the company, and (ii)
the company must operate below it maximum productive capacity.

For example: Assume Selam Company have the following detail income statement for year
ended December 31, 20XX

Sales ...…………………………………..……... 1,000,000

Selling price ………………………………..…... 20

Variable Cost of goods sold ……..……………... 3

Variable Selling and Administrative expense …. 1.5

Fixed manufacturing over head ……………….. 3,000,000

Fixed selling and Administrative expense ……… 2,900,000

Identify whether Selam should accept or reject the special order and whether the special order
affect Selam’s regular business.

63 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

5.3.3. Add or Drop Decisions

When there is multiple product lines, business may became in dilemma in order to decide which
product they need to add and which one is needed to be dropped from product line. During such
times business focus on costs those have a direct affect the product that is needed to be dropped
or needed to be added or needed to be substituted. The cost of new product should be less than
the former one to decide.
For example: Selam company focus on production of white Enjera with red Enjera in production
line. The related costs and revenue indicators of both product is listed below for decision making
Variables White Enjera Red Enjera
Sales Unit 125000 143000
Selling Price 5 4.5
Direct material 1.25 1.35
Direct labor 1.75 1.85
Variable MOH 0.5 0.75
Variable Selling and administrative expense 0.675 0.70
Fixed Selling and administrative expense 255,000 255,000
Other operational expense 14000 14000
5.3.4. Product Mix Decisions
Managers are frequently confronted with the short-run problem of making the best use of scarce
resources that are essential to production activity, but are available only in limited quantity.
Scarce resources create constraints on producing goods or providing services and can include
machine hours, skilled labor hours, raw materials, and production capacity and other inputs.
Management may, in the long run, obtain a greater quantity of a scarce resource. For instance,
additional machines could be purchased to increase availability of machine hours. However, in
the short run, management must make the most efficient use of the scarce resources it has
currently.

Determining the best use of a scarce resource requires managerial recognition of company
objectives. If the objective is to maximize company profits, a scarce resource is best used to
produce and sell the product having the highest contribution margin per unit of the scarce
resource. This strategy assumes that the company is faced with only one scarce resource. A

64 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

scarce resource or a limiting factor refers to any factor that restrict or constraint the production or
sale of a product or service.

Example6.5 Jimma Computers manufactured two products, desktop computer and notebook
computer. The Company’s scarce resource is a data chip that it purchases from a supplier. Each
desktop computer requires one chip and each notebook computer requires three chips. Currently,
the firm has access to only 5,100 chips per month to make either desktop or notebook computers
or some combination of both. Demand is above 5,100 units per month for both products and
there is no variable selling or administrative costs related to either product. The desktop’s Br.
650 selling price less its Br. 545 variable cost provides a contribution margin of Br. 105 per unit.
The notebook’s contribution margin per unit is Br.180 (Br.900 selling price minus Br.720
variable cost). Fixed annual overhead related to these two product lines totals Br. 6,570,000 and
is allocated to products for purposes of inventory valuation. Fixed overhead, however, does not
change with production levels within the relevant range

5.3.5. Keep or Replace Equipment Decisions

The usefulness of plant assets may be impaired long before they are considered to be worn out.
Equipment may be no longer being efficient for the purpose for which it is used. On the other
hand, the equipment may not have reached the point of complete inadequacy. Decisions to
replace usable plants assets should be based on studies of relevant costs. The relevant costs are
the future costs of continuing to use the equipment versus replacement. The book values of the
plant assets being replaced are sunk costs and are irrelevant.

Additional factors are often involved in equipment replacement decisions. For example,
differences between the remaining useful life of the old equipment and the estimated life of the
new equipment could exist. In addition, the new equipment might improve the overall quality of
the product, resulting in an increase in sales volume. Other factors that could be significant
include the time value of money and other uses for the cash needed to purchase the new
equipment.

In general, in deciding whether to replace or keep existing equipment, four commonly

encountered items considered in relevance:

65 | P a g e @ 2022
 Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

i. Book value of old equipment: irrelevant, because it is a past (historical) cost. Therefore,
depreciation on old equipment irrelevant.
ii. Disposal value of old equipment: relevant, because it is an expected future inflow that
usually differs among alternatives.
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.
As for example, assume that a business is considered disposing of several identical machines
having a total book value of Birr 1,000,000 and an estimated remaining life of five years. The old
machines can be sold for Birr 25,000. They can be replaced by a single high-speed machine at a
cost of Birr 250,000. The new machine has an estimated useful life of five years and no residual
value. Analyses indicate an estimated annual reduction in variable manufacturing costs from
Birr 225,000, with the old machine to Birr 150,000 with the new machine. No other changes in
the manufacturing costs or the operating expenses are expected.

CHAPTER SIX

6.1.PRICING DECISIONS

66 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Companies are constantly making product and service pricing decision. These are strategic
decision that affects the quantity produced and sold, and therefore cost and revenues. To make
these decisions, managers need to understand cost behavior pattern and cost drivers. They can
then evaluate demand at different prices and manage costs across the value chain and over a
products life cycle to achieve profitability.

Major influences on pricing decision

How companies prices a product or a service ultimately depends on the demand and supply of it.
Three influences on demand and supply are:-

i. Customers: - customer influences price through their effect on the demand for a
product or services, based on factors such as the features of a product and its quality.
ii. Competitors: when there are competitors, knowledge of rivals’ technology, plant
capacity, and operating policies enables a company to estimate its competitors’ costs-
valuable information in setting its own prices.
iii. Costs – costs influence prices because they affect supply. As companies supply more
product the cost of producing each additional unit initially declines but then
eventually increase managers who understand the cost of producing their companies
product set polices that make the products attractive to customers. In computing the
relevant costs for a pricing decision, the manager must consider relevant costs in all
business functions of the value chain.
Costing and pricing for the short run

Short-run pricing decisions typically have a time horizon of less than a year and include decision
such as (a) pricing one time only special order with no long run implications and (b) adjusting
product mix and output volume in a competitive market.

Company’s short run pricing decisions need identify a sufficiently low price at which company
would still make a profit and assumed that (a) company has access to extra capacity and (b) a
competitor with an efficient plant and idle capacity was likely to make a low bid. However, short
run pricing does not always work this way. Companies may experience strong demand for their
products in the short-run, but they may have limited capacity. In these cases, companies
strategically increase prices in the short run to as much as the market will bear.

67 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

In general, short run pricing decisions are responses to short-run demand and supply condition,
and the relevant costs are only those costs that will change in the short run.

Costing and pricing for the long run

Long run pricing decisions have a time horizon of a year or longer and include pricing a product
in a major market in which there is some see way in setting price. Two key differences affect
pricing for the long run versus the short run:-

1. Costs that are often irrelevant for short run pricing decisions, such as fixed costs that
cannot be changed, are generally relevant in the long run because cost can be altered in
the long run.
2. Profit margins in the long run pricing decision are often set to earn a reasonable return on
investment. Short run is opportunistic, prices are decreased when demand is weak and
increased when demand is strong.
Long run pricing is a strategic decision desired to build long run relationship with customers
based on stable and predictable prices. But to change a stable price and earn the target long run
return, a company must, over the long run, know and manage its costs of supplying product to
customers. Thus, relevant costs for long run pricing decision include all future fixed and variable
costs.

Long run pricing approaches

Two different approaches for pricing decision using product cost information are:-

1. Market based approach

2. Cost based/cost plus approach
1. Market based pricing

Market based pricing approach starts by management asking, given that our customers want and
how our competitors will react to what we do, what price should we charge?

Companies operating in a very competitive market, for example, commodities such as steel, oil,
and natural gas, use the market based pricing. An important form of market based pricing is
target pricing. Target price is the estimated price for a product or service that potential customers

68 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

will be willing to pay. This estimate is based on an understanding of customer’s perceived value
for a product or service and how competitors will price competing product or service.

Hence, target operating income is the operating income that a company wants to earn on each
unit of a product or service sold and target price leads to a target cost, target cost per unit is the
estimated long run cost per unit of a product or service that, when sold at the target price, enables
the company to achieve the target operating income.

Thus, Target price - Target operating income = Target cost

Implementing target pricing and target costing

In developing target prices and target cost companies may require to follow the following five
steps:

 Develop a product that satisfy the needs of potential customers

 Choose a target price based on customer’s perceived value for the product and the price
competitors charge, and target operating income per unit.
 Drive a target cost per unit by subtracting the target operating income per unit from the
target price
 Perform cost analysis to analyze which aspects of a product or service to target for cost
reduction.
 Perform value engineering to achieve target cost. Value engineering is a systematic
evaluation of all aspect of the value chain business function with the objective of
reducing cost while satisfying customers’ needs. Value engineering can result in
improvement in product design, change in material specification, and modification in
process method. In this case, Costs can be value adding or non value adding. Value
adding costs are costs that costumers perceive as adding utility or value while non value
adding cost that do not add value to the product and to customers. Value engineering will
focuses on eliminating non value adding cost and reduce as much as possible value
adding cost without affecting quality of the product and customers satisfaction.

Example : Astel Company is a manufacturer of personal computer .Astel expects its competitors
to lower prices of PC. Astels management believes that it must respond by reducing price by

69 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

20% from Br. 1000 per unit to Br.800 per unit. At this low price, Astels marketing manager
forecast an increase in annual sales from 150,000 to 200,000 units. Astel management wants a
10% target operating income on sales revenue. The total production cost at the moment for
150,000 units is Br. 135 million.

Required compute

a) The total target revenue

b) Total target operating income
c) Target operating income per unit
d) Current target cost per unit
Solution

a) Total target revenue ═ target price per unit x target annual unit sold
═ Br.800 per unit x 200,000 units ═ Br.160, 000,000

b) Total target operating income═ target rate x Total target revenue

═ 10% x Br.160, 000,000═ Br.16, 000,000

c) Target operating income per unit═ Total target operating income/ annual unit sold
═ Br.16, 000,000/200,000 units ═ Br.80

d) Current cost per unit═ target price per unit less target operating income per unit
═ Br.800 per unit - Br.80 ═ Br.720

2. Cost-plus pricing

Accounting information may be used in pricing decisions, particularly where the firm is a market
leader or price-maker. In these cases, firms may adopt cost-plus pricing, in which a margin is
added to the total product/service cost in order to determine the selling price. In many
organizations, however, prices are set by market leaders and competition requires that prices
follow the market (i.e. the firms are price-takers). Nevertheless, even in those cases an
understanding of cost helps in making management decisions about what product/services to
produce, how many units to make and whether the price that exists in the market warrants the
business risk involved in any decision to sell in that market. An understanding of the firm’s
marketing strategy is therefore, essential in using cost information for pricing decisions.

70 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

In the long term, the prices that businesses charge must cover all of its costs. If it is unable to do
so, it will make losses and may not survive. For every product/service, the full cost must be
calculated, to which the desired profit margin is added. Full cost includes an allocation to each
product/service of all the costs of the business, including producing and delivering a good or
service, and all its marketing, selling, finance and administration costs.

The general formula for setting a cost based price adds a markup component to the cost base to
determine the prospective selling price. One way to determine the markup percentage is to
choose a markup to earn a target rate of return on investment.

The target rate of return on investment is the target annul operating income that an organization
aims to achieve divided by invested capital (asset)

i.e. TRR = Target operating income

Invested capital
Therefore, Target operating income=TRR*Invested capital

Let illustrate a cost – plus pricing formula on top company. Assume top’s engineers have
redesigned product CD into 2CD and that top uses a 12% markup on the full unit cost of the
product in developing the prospective selling price. The target product 2CD profitability for
2000 is as follows:

Estimated total amounts Estimated total amount

for 200,000 units (1) per unit (2) = (1) 
200,000

Revenues Bir 160,000,000 Bir 800

Cost of goods sold 108,000,000 540

Operating costs 36,000,000 180

Total cost of product Bir 144,000,000 720

71 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

Operating income 16,000,000 Bir 80

Suppose that top’s target rate of return on investment is 18% and 2CD’s capital investment is Bir
96 million. The target annual operating income for 2CD is:

Invested capital ……………………………….. Bir 96,000,000

Target rate of return on investment……………. 18%

Target Annual Operating income [0.18  Bir 96mln]…Bir17,280,000

Target operating income per unit of 2A

[Bir17,280,000  200,000 units] …………. Bir 86.40

This calculation indicates that top needs to earn a target operating income of Bir86.40 on each
unit of 2A. The mark up of Bir 86.40 expressed as a percentage of the full production cost per
unit of Bir720 equals 12% (Bir 86.40  Bir 720]

Thus the prospective selling price of product 2A is Bir806.40 (Full unit cost of 2A, Bir 720 plus
the markup component of 12% (0.12  Bir 720= Bir 86.40).

72 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

CHAPTER -7

DECENTRALIZATION AND TRANSFER PRICING

7.1. INTRODUCTION

A management control system is a means of gathering and using information to aid and
coordinate the planning and control decisions throughout an organization and to guide the
behavior of its managers and other employees.

In a small business, virtually all plans and decisions can be made by one individual. As a
business grows or its operation become more diverse, it becomes difficult, if not impossible for
one individual to perform these functions.

Management accounts, therefore, must have the interpersonal and analytical skills necessary to
evaluate and implement management control system, as well as the ability to interpret out puts of
these systems, and to be effective, management control systems should be closely aligned to the
company’s strategies and goals and also must fit an organizations structure.

7.2.DECENTRALIZATION
 Have you made any decision for any department before?

As a business grows, it is difficult for one manager to manage the whole activity. Hence, they
need to delegate responsibility for portions of operation. This separation of a business in to more
manageable units is termed as Decentralization, the freedom of manager at lower levels of the
organization to make decision. The process of measuring and reporting operating activity by area

Benefit of Decentralization Limitation of Decentralization

Create greater response to local needs Suboptimal decision
Quicker decision making Duplication of asset & activity
Increase motivation Decrease loyalty to the organization as a whole
Increase creativity and productivity Increase cost of gathering information
Aids management development
Sharpens the focuses of manager

73 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

of responsibility is called responsibility accounting.

7.3.TRANSFER PRICING

In decentralized organizations, much of the decision, making power resides in its individual
submits. In these cases, the management control system often uses transfer prices to coordinate
the actions of the subunit and to evaluate their performance.

A transfer price is the price one subunit (department or division) charges for a product or service
supplied to another subunit of the same organization. If, for example, a car manufacturer has a
separate division that manufactures engines, the transfer price is the price the engine division
charges when it transfers engine to the assembly division. The transfer price creates revenues for
the selling subunit (the engine division in our example) and purchase cost for the buying subunits
(the assembly division), affecting each subunit operating income. These operating incomes can
be used to evaluate subunits performance and to motivate their manager. The products or
services transferred between sub-units of the organization are called intermediate products.
These products may either be further worked on by the receiving subunit or, if transferred from
production to marketing, sold to an external customer.

The three methods for determining transfer pricing are

1. Market-based transfer prices

In this case, top management may choose to use the price of a similar product or service
publicly listed, say, a trade association web site. Also top management may select, for the
internal price, the external price that subunit charges to outsider customers. This method is
preferred, (a) when the intermediate market is perfectly competitive, (b) Interdependence of
sub units is minimal, and (c) There are no other additional costs of using market price.

2. Cost-based transfer price:

Top management may choose a transfer price based on the cost of producing the product in
question. The cost used in the cost based transfer price can be the actual cost or the budgeted
cost. Sometimes, the cost based transfer price includes the mark up or profit margin that

74 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

represents a return on subunit investment. This method is used when market price is
unavailable, inappropriate or too costly to obtain. In this case, variable of full cost can be
used as a base

3. Negotiated transfer price

In some cases, the subunit of the company are free to negotiate the transfer price between
themselves and then to decide whether to buy and sell internally or dealing with external
prices. Subunit may use information about costs and market price in these negotiations, but
there is no requirement that the chosen transfer price bear any specific relationship to either
cost or market price data. Thus, negotiated transfer price is the outcome of a bargaining
process between the selling and buying divisions.

Example7.1:

Horizon Petroleum Company has two divisions. Each division operates as a profit center. The
transportation division manages the operation of pipeline that transfers crude oil from Mexico to
Texas. The refining division manages a refining at Texas that process crude oil in to gasoline.
Gasoline is the only salable product the refinery makes and that it takes two barrels of crude oil
to yield one barrel of gasoline

Variable cost in each division is assumed to be variable with respect to single cost driver in each
division: Barrels of crude oil transported by the transportation division, barrel of gasoline
produced by the refining division. The fixed cost per unit is based on the budgeted annual output
of crude oil to be produced and transferred and the amount of gasoline to be produced. Horizon
petroleum reports all costs and revenues of its non US operation in US dollars using the
prevailing exchange rate.

Transport Refining
Division Division
VC per unit Bir 1 Bir 8
FC per unit 3 6
Total Bir 4 Bir 14
Additional information’s

75 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

 The production division can sell crude oil to transport division in Mexico at Bir12 per
barrel
 The transport division buys crude oil from the production division in Mexico and sells it
to the refining division
 The refining division can buy crude oil in Texas from external supplier at Bir21 per
barrel and can sell the gasoline it produces at Bir58per barrel.
 The three divisions have sufficient capacity
Assume that 100 barrel of crude oil produced by production division is transported to the
refining division and assuming the following transfer pricing methods

Method A: Market based transfer price of Bir21 per barrel of crude oil based on the competitive
market price

Method B:Cost based transfer price at 110% of full cost where full cost are the cost of
transferred in product plus the divisions own variable and fixed cost.

Method C: Negotiated transfer price of Bir19.75 per barrel crude oil

Required

Compute the operating income for Horizon Petroleum Company and for each division under
each transfer pricing method.

Solution

i) Horizon Petroleum total operating income from purchasing, transporting and refining the
100 barrels of crude oil and selling of the 50 barrels of gasoline is the same, Bir600,
regardless of the internal transfer price used.
Thus, Operating income would be:
Revenues: (Bir58x50 barrels of gasoline)…………………………………Bir 2, 900
Less: cost of crude oil purchases (Bir12x100) barrels of crude oil)……… Bir 1,200
Transportation cost (Bir4(1+3) x100 barrels of crude oil)…... 400
Refining costs (Bir14(6+8) x50 barrels of gasoline)…………. 700 2,300
Operating income……………………………………. Bir600

76 | P a g e @ 2022
Principals Health and Business College, Business Faculty, Teaching Material of Cost and Management
Accounting II

ii) Division operating income of horizon petroleum for 100 barrels of crude oil under alternative transfer
pricing methods would be:
Internal transfers at Internal transfer at Internal transfer at
market price of 110% of full cost negotiated price
Bir21/barrel = Bir17.60 Bir19.25

Transportation division
Revenues, (a) Bir21x100 = Bir17.60x100 = Bir19.25x100=Bir1
Bir2,100 Bir1760 ,925
Costs:
Crude oil purchase
costs Bir1200 Bir1200 Bir1200
(Bir12x100)
Division VC (Bir1x100) 100 100 100
Division FC(Bir3x100) 300 300 300
Total division costs (b) Bir1600
1600 Bir1600
Division operating income(a-b) Bir500 Bir325
Bir160
Refining Division
Revenues (Bir58x50 barrels of gas Bir2900 Bir2900
oil) Bir2900
Costs:
Transportation in cost Bir21x100 = 1,760 1,925
Bir2,100
Division VC (Bir8x50) 400 400 400
Division FC(Bir6x50) 300 300 300
Total division costs (b) Bir2800 Bir2460 Bir2625

Division operating income (a-b) Bir100 Bir440 Bir275

Operating income of both division Bir600 Bir600 Bir600

77 | P a g e @ 2022