Differential Analysis The Key to Decision MakingChapter 12.docx

Differential Analysis: The Key to Decision Making
Chapter 12
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Learning Objective 1
Identify relevant and irrelevant costs and benefits in a decision.
Relevant Costs and Benefits

A relevant cost is a cost that differs between alternatives.
A relevant benefit is a benefit that differs between
alternatives.
Identifying Relevant Costs
An avoidable cost is a cost that can be eliminated, in whole or
in part, by choosing one alternative over another. Avoidable
costs are relevant costs. Unavoidable costs are irrelevant costs.
Two broad categories of costs are never relevant in any
decision. They include:
Sunk costs.
A future cost that does not differ between the alternatives.
Decision Making: A Two-Step Process
Eliminate costs and benefits that do not differ between
alternatives.
Use the remaining costs and benefits that differ between
alternatives in making the decision. The costs that remain are
the differential, or avoidable, costs.
Step 1
Step 2

Different Costs for Different Purposes
Costs that are relevant in one decision situation may not be
relevant in another context. Thus, in each decision situation, the
manager must examine the data at hand and isolate the relevant
costs.
Cynthia, a Boston student, is considering visiting her friend in
New York. She can drive or take the train. By car, it is 230
miles to her friend’s apartment. She is trying to decide which
alternative is less expensive and has gathered the following
information.
$45 per month × 8 months
$2.70 per gallon ÷ 27 MPG
$24,000 cost – $10,000 salvage value ÷ 5 years

Which costs and benefits are relevant in Cynthia’s decision?
The cost of the car is a sunk cost and is not relevant to the
current decision.
However, the cost of gasoline is clearly relevant if she decides
to drive. If she takes the train, the cost would not be incurred,
so it varies depending on the decision.
The annual cost of insurance is not relevant. It will remain the
same if she drives or takes the train.
The cost of maintenance and repairs is relevant. In the long-run
these costs depend upon miles driven.
The monthly school parking fee is not relevant because it must
be paid if Cynthia drives or takes the train.
At this point, we can see that some of the average cost of
$0.619 per mile are relevant and others are not.

The decline in resale value due to additional miles is a relevant
cost.
The round-trip train fare is clearly relevant. If she drives the
cost can be avoided.
Relaxing on the train is relevant even though it is difficult to
assign a dollar value to the benefit.
The kennel cost is not relevant because Cynthia will incur the
cost if she drives or takes the train.
The cost of parking in New York is relevant because it can be
avoided if she takes the train.
The benefits of having a car in New York and the problems of
finding a parking space are both relevant but are difficult to
assign a dollar amount.
From a financial standpoint, Cynthia would be better off taking
the train to visit her friend. Some of the non-financial factors
may influence her final decision.

Total and Differential Cost Approaches
The management of a company is considering a new labor
saving machine that rents for $3,000 per year. Data about the
company’s annual sales and costs with and without the new
machine are:
As you can see, the only costs that differ between the
alternatives are the direct labor costs savings and the increase in
fixed rental costs.
We can efficiently analyze the decision by
looking at the different costs and revenues
and arrive at the same solution.

Using the differential approach is desirable for two reasons:
Only rarely will enough information be available to prepare
detailed income statements for both alternatives.
Mingling irrelevant costs with relevant costs may cause
confusion and distract attention away from the information that
is really critical.
Prepare an analysis showing whether a product line or other
business segment should be added or dropped.
Adding/Dropping Segments
One of the most important decisions managers make is whether
to add or drop a business segment. Ultimately, a decision to
drop an old segment or add a new one is going to hinge
primarily on the impact the decision will have on net operating
income.
To assess this impact, it is necessary to carefully analyze the
costs.

Due to the declining popularity of digital watches, Lovell
Company’s digital watch line has not reported a profit for
several years. Lovell is considering discontinuing this product
line.
A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch segment only if its profit
would increase.
Lovell will compare the contribution margin that would be lost
to the costs that would be avoided if the line was to be
dropped.

An investigation has revealed that the fixed general factory
overhead and fixed general
administrative expenses will not be affected by dropping the
digital watch line. The fixed general factory overhead and
general administrative expenses assigned to this product would
be reallocated to other product lines.
The equipment used to manufacture
digital watches has no resale
value or alternative use.
Should Lovell retain or drop
the digital watch segment?
A Contribution Margin Approach

Retain
Comparative Income Approach
The Lovell solution can also be obtained by preparing
comparative income statements showing results with and
without the digital watch segment.
Let’s look at this second approach.
If the digital watch line is dropped, the company loses $300,000
in contribution margin.
On the other hand, the general factory overhead would be the

same under both alternatives, so it is irrelevant.
The salary of the product line manager would disappear, so it is
relevant to the decision.
The depreciation is a sunk cost. Also, remember that the
equipment has no resale value or alternative use, so the
equipment and the depreciation expense associated with it are
irrelevant to the decision.
The complete comparative income statements reveal that Lovell
would earn $40,000 of additional profit by retaining the digital
watch line.

Beware of Allocated Fixed Costs
Why should we keep the digital watch segment when it’s
showing a $100,000 loss?

The answer lies in the way we allocate common fixed costs to
our products.

Our allocations can make a segment look less profitable than it
really is.
Including unavoidable common fixed costs makes the product
line appear to be unprofitable.

Prepare a make or buy analysis.
The Make or Buy Decision
When a company is involved in more than one activity in the
entire value chain, it is vertically integrated. A decision to
carry out one of the activities in the value chain internally,
rather than to buy externally from a supplier is called a “make
or buy” decision.

Vertical Integration- Advantages
Smoother flow of parts and materials
Better quality control
Realize profits
Vertical Integration- Disadvantage
Companies may fail to take advantage of suppliers who can
create economies of scale advantage by pooling demand from
numerous companies.
While the economics of scale factor can be appealing, a
company must be careful to retain control over activities that
are essential to maintaining its competitive position.

The Make or Buy Decision: An Example
Essex Company manufactures part 4A that is used in one of its
products. The unit product cost of this part is:
The special equipment used to manufacture part 4A has no
resale value.
The total amount of general factory overhead, which is
allocated on the basis of direct labor hours, would be unaffected
by this decision.
The $30 unit product cost is based on 20,000 parts produced
each year.
An outside supplier has offered to provide the 20,000 parts at a
cost of $25 per part.
Should we accept the supplier’s offer?
The avoidable costs associated with making part 4A include
direct materials, direct labor, variable overhead, and the
supervisor’s salary.

The depreciation of the special equipment represents a sunk
cost. The equipment has no resale value, thus its cost and
associated depreciation are irrelevant to the decision.
Not avoidable; irrelevant. If the product is dropped, it will be
reallocated to other products.
Should we make or buy part 4A?
Given that the total avoidable costs are less than the cost of
buying the part, Essex should continue to make the part.

Opportunity Cost
An opportunity cost is the benefit that is foregone as a result of
pursuing some course of action.
Opportunity costs are not actual cash outlays and are not
recorded in the formal accounts of an organization.
Prepare an analysis showing whether a special order should be
accepted.
Key Terms and Concepts
A special order is a one-time order that is not considered part of
the company’s normal ongoing business.
When analyzing a special order, only the incremental costs and
benefits are relevant.
Since the existing fixed manufacturing overhead costs would
not be affected by the order, they are not relevant.

Special Orders
Jet Inc. makes a single product whose normal selling price is
$20 per unit.
A foreign distributor offers to purchase 3,000 units for $10 per
unit.
This is a one-time order that would not affect the company’s
regular business.
Annual capacity is 10,000 units, but Jet Inc. is currently
producing and selling only 5,000 units.
Should Jet accept the offer?
Special Orders
$8 variable cost

Special Orders
If Jet accepts the special order, the incremental revenue will
exceed the incremental costs. In other words, net operating
income will increase by $6,000. This suggests that Jet should
accept the order.
Note: This answer assumes that the fixed costs are unavoidable
and that variable marketing costs must be incurred on the
special order.
Quick Check ✓
Northern Optical ordinarily sells the X-lens for $50. The
variable production cost is $10, the fixed production cost is $18
per unit, and the variable selling cost is $1. A customer has
requested a special order for 10,000 units of the X-lens to be
imprinted with the customer’s logo. This special order would
not involve any selling costs, but Northern Optical would have
to purchase an imprinting machine for $50,000.
(see the next page)
Quick Check ✓
What is the rock bottom minimum price below which
Northern Optical should not go in its negotiations with the
customer? In other words, below what price would Northern
Optical actually be losing money on the sale? There is ample

idle capacity to fulfill the order and the imprinting machine has
no further use after this order.
a. $50
b. $10
c. $15
d. $29
Quick Check ✓
What is the rock bottom minimum price below which
Northern Optical should not go in its negotiations with the
customer? In other words, below what price would Northern
Optical actually be losing money on the sale? There is ample
idle capacity to fulfill the order and the imprinting machine has
no further use after this order.
a. $50
b. $10
c. $15
d. $29
Variable production cost $100,000
Additional fixed cost + 50,000
Total relevant cost $150,000
Number of units 10,000
Average cost per unit = $15

Determine the most profitable use of a constrained resource.
Key Terms and Concepts
When a limited resource of some type restricts the company’s
ability to satisfy demand, the company is said to have a
constraint.
The machine or process that is limiting overall output is called
the bottleneck – it is the constraint.
Utilization of a Constrained Resource
Fixed costs are usually unaffected in these situations, so the
product mix that maximizes the company’s total contribution
margin should ordinarily be selected.
A company should not necessarily promote those products that
have the highest unit contribution margins.
Rather, total contribution margin will be maximized by
promoting those products or accepting those orders that provide
the highest contribution margin in relation to the constraining
resource.

Utilization of a Constrained Resource: An Example
Ensign Company produces two products and selected data are
shown below:
Utilization of a Constrained Resource: An Example
Machine A1 is the constrained resource and is being used at
100% of its capacity.
There is excess capacity on all other machines.
Machine A1 has a capacity of 2,400 minutes per week.
Should Ensign focus its efforts on Product 1 or Product 2?
Quick Check ✓
How many units of each product can be processed through
Machine A1 in one minute?
Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit

How many units of each product can be processed through
Machine A1 in one minute?
Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit
Quick Check ✓
Quick Check ✓
What generates more profit for the company, using one
minute of machine A1 to process Product 1 or using one minute
of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
Quick Check ✓

What generates more profit for the company, using one
minute of machine A1 to process Product 1 or using one minute
of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
With one minute of machine A1, Ensign could make 1 unit of
Product 1, with a contribution margin of $24, or 2 units of
Product 2, each with a contribution margin of $15 per unit.
2 × $15 = $30 > $24
The key is the contribution margin per unit of the constrained
resource.
Ensign should emphasize Product 2 because it generates a
contribution margin of $30 per minute of the constrained
resource relative to $24 per minute for Product 1.
The key is the contribution margin per unit of the constrained
resource.
Ensign can maximize its contribution margin by first producing
Product 2 to meet customer demand and then using any

remaining capacity to produce Product 1. The calculations
would be performed as follows.
Let’s see how this plan would work.

According to the plan, we will produce 2,200 units of Product 2
and 1,300 of Product 1. Our contribution margin looks like
this.
The total contribution margin for Ensign is $64,200.
Determine the value of obtaining more of the constrained
resource.
Value of a Constrained Resource
Increasing the capacity of a constrained resource should lead to
increased production and sales.
How much should Ensign be willing to pay for an additional
minute of A1 machine time?

The additional machine time would be used to make more units
of Product 1, which had a contribution margin per minute of
$24.
Ensign should be willing to pay up to $24 per minute. This
amount equals the contribution margin per minute of machine
time that would be eared producing more units of Product 1.
Value of a Constrained Resource
Quick Check ✓
Colonial Heritage makes reproduction colonial furniture
from select hardwoods.
The company’s supplier of hardwood will only be able to
supply 2,000 board feet this month. Is this enough hardwood to
satisfy demand?
a. Yes
b. No

Quick Check ✓
Colonial Heritage makes reproduction colonial furniture
from select hardwoods.
The company’s supplier of hardwood will only be able to
supply 2,000 board feet this month. Is this enough hardwood to
satisfy demand?
a. Yes
b. No
(2 × 600) + (10 × 100 ) = 2,200 > 2,000
Quick Check ✓
The company’s supplier of hardwood will only be able to supply
2,000 board feet this month. What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables

c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
Quick Check ✓
The company’s supplier of hardwood will only be able to supply
2,000 board feet this month. What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
Quick Check ✓
As before, Colonial Heritage’s supplier of hardwood will
only be able to supply 2,000 board feet this month. Assume the

company follows the plan we have proposed. Up to how much
should Colonial Heritage be willing to pay above the usual price
to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
Quick Check ✓
As before, Colonial Heritage’s supplier of hardwood will
only be able to supply 2,000 board feet this month. Assume the
company follows the plan we have proposed. Up to how much
should Colonial Heritage be willing to pay above the usual price
to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
The additional wood would be used to make tables. In this use,
each board foot of additional wood will allow the company to
earn an additional $20 of contribution margin and profit.
Managing Constraints
It is often possible for a manager to increase the capacity of a
bottleneck, which is called relaxing (or elevating) the

constraint, in numerous ways such as:
Working overtime on the bottleneck.
Subcontracting some of the processing that would be done at
the bottleneck.
Investing in additional machines at the bottleneck.
Shifting workers from non-bottleneck processes to the
bottleneck.
Focusing business process improvement efforts on the
bottleneck.
Reducing defective units processed through the bottleneck.
Prepare an analysis showing whether joint products should be
sold at the split-off point or processed further.
Joint Costs
In some industries, a number of end products are produced from
a single raw material input.
Two or more products produced from a common input are called
joint products.
The point in the manufacturing process where each joint product
can be recognized as a separate product is called the split-off
point.

Joint Products
Joint
Input
Common
Production
Process
Split-Off
Point

Oil
Gasoline
Chemicals
For example, in the petroleum refining industry, a large
number of products are extracted from crude oil, including
gasoline, jet fuel, home heating oil, lubricants, asphalt, and

various organic chemicals.
Joint Products
Separate
Processing
Separate
Processing
Final
Sale
Final
Sale
Final
Sale
Separate
Product
Costs
Joint
Input
Common
Production
Process

Split-Off
Point
Oil
Gasoline
Chemicals

Joint costs
are incurred
up to the
split-off point
The Pitfalls of Allocation

Joint costs are traditionally allocated among different products
at the split-off point. A typical approach is to allocate joint
costs according to the relative sales value of the end products.
Although allocation is needed for some purposes such as
balance sheet inventory valuation, allocations of this kind are
very dangerous for decision making.
Sell or Process Further
Joint costs are irrelevant in decisions regarding what to do with
a product from the split-off point forward. Therefore, these
costs should not be allocated to end products for decision-
making purposes.
With respect to sell or process further decisions, it is profitable
to continue processing a joint product after the split-off point so
long as the incremental revenue from such processing exceeds
the incremental processing costs incurred after the split-off
point.

Sell or Process Further: An Example
Sawmill, Inc. cuts logs from which unfinished lumber and
sawdust are the immediate joint products.
Unfinished lumber is sold “as is” or processed further into
finished lumber.
Sawdust can also be sold “as is” to gardening wholesalers or
processed further into “presto-logs.”
Data about Sawmill’s joint products includes:

The lumber should be processed further and the sawdust should
be sold at the split-off point.
Activity-Based Costing and Relevant Costs
ABC can be used to help identify potentially relevant costs for
decision-making purposes.

However, managers should exercise caution against reading
more into this “traceability” than really exists.
People have a tendency to assume that if a cost is traceable to a
segment, then the cost is automatically avoidable, which is
untrue. Before making a decision, managers must decide which
of the potentially relevant costs are actually avoidable.
Questions
Page 564
12-1 12-2
12-3 12-5
12-6
Pages 567-569
12-1 12-2
12-3 12-4
Exercises
End of Chapter 12

Master Budgeting
Chapter 8
PowerPoint Authors:
Understand why organizations budget and the processes they
use to create budgets.

The Basic Framework of Budgeting
A budget is a detailed quantitative plan for acquiring and using
financial and other resources over a specified forthcoming time
period.
The act of preparing a budget is called budgeting.
The use of budgets to control an organization’s activities is
known as budgetary control.
Difference Between Planning and Control
Planning –
involves developing objectives and preparing various budgets to
achieve those objectives.
Control –
involves the steps taken by management to increase the
likelihood that the objectives set down while planning are
attained and that all parts of the organization are working
together toward that goal.
Advantages of Budgeting
Advantages

Define goals
and objectives
Uncover potential
bottlenecks
Coordinate
activities
Communicate
plans
Means of allocating
resources
Responsibility Accounting
Managers should be held responsible for those items - and
only those items - that they can actually control
to a significant extent. Responsibility accounting enables
organizations to react quickly to deviations from their plans and
to learn from feedback.
Choosing the Budget Period

Operating Budget
2014
2015
2016
2017
Operating budgets ordinarily
cover a one-year period
corresponding to a company’s fiscal year. Many companies
divide their annual budget
into four quarters.
A continuous budget is a
12-month budget that rolls
forward one month (or quarter)
as the current month (or quarter)
is completed.
Self-Imposed Budget
A self-imposed budget or participative budget is a budget that is
prepared with the full cooperation and participation of managers
at all levels.

Advantages of Self-Imposed Budgets
Individuals at all levels of the organization are viewed as
members of the team whose judgments are valued by top
management.
Budget estimates prepared by front-line managers are often
more accurate than estimates prepared by top managers.
Motivation is generally higher when individuals participate in
setting their own goals than when the goals are imposed from
above.
A manager who is not able to meet a budget imposed from
above can claim that it was unrealistic. Self-imposed budgets
eliminate this excuse.
Self-Imposed Budgets
Self-imposed budgets should be reviewed by higher levels of
management to prevent “budgetary slack.”
Most companies issue broad guidelines in terms of overall
profits or sales. Lower level managers are directed to prepare
budgets that meet those targets.

Human Factors in Budgeting
The success of a budget program depends on three important
factors:
Top management must be enthusiastic and
committed to the budget process.
Top management must not use the budget to
pressure employees or blame them when
something goes wrong.
Highly achievable budget targets are usually
preferred when managers are rewarded based on
meeting budget targets.
The Master Budget: An Overview
Production budget
Selling and
administrative
budget
Direct materials
budget
Manufacturing
overhead budget
Direct labor
budget
Cash Budget

Sales budget
Ending inventory
budget
Budgeted
balance sheet
Budgeted
income
statement
Seeing the Big Picture
To help you see the “big picture” keep in mind that the 10
schedules in the master budget are designed to answer the 10

questions shown on the next screen.
Seeing the Big Picture
How much sales revenue will we earn?
How much cash will we collect from customers?
How much raw material will we need to purchase?
How much manufacturing costs will we incur?
How much cash will we pay to our suppliers and our direct
laborers, and how much cash will we pay for manufacturing
overhead resources?
What is the total cost that will be transferred from finished
goods inventory to cost of good sold?
How much selling and administrative expense will we incur and
how much cash will be pay related to those expenses?
How much money will we borrow from or repay to lenders –
including interest?
How much operating income will we earn?
What will our balance sheet look like at the end of the budget
period?
A master budget is based on various estimates and assumptions.
For example, the sales budget requires three

estimates/assumptions as follows:
What are the budgeted unit sales?
What is the budgeted selling price per unit?
What percentage of accounts receivable will be collected in the
current and subsequent periods.
When Microsoft Excel© is used to create a master budget, these
types of assumptions can be depicted in a Budget Assumptions
tab, thereby enabling Excel-based budget to answer “what-if”
questions.
Prepare a sales budget, including a schedule of expected cash
collections.
Budgeting Example
Royal Company is preparing budgets for the
quarter ending June 30th.

Budgeted sales for the next five months are:
April 20,000 units
May 50,000 units
June 30,000 units
July 25,000 units
August 15,000 units
The selling price is $10 per unit.
The Sales Budget
The individual months of April, May, and June are summed to
obtain the total budgeted sales in units and dollars for the
quarter ended June 30th
Expected Cash Collections
All sales are on account.
Royal’s collection pattern is:
70% collected in the month of sale,
25% collected in the month following sale,
5% uncollectible.
In April, the March 31st accounts receivable balance of $30,000
will be collected in full.

From the Sales Budget for April.
From the Sales Budget for May.
Quick Check ✓
What will be the total cash collections for the quarter?
a. $700,000

b. $220,000
c. $190,000
d. $905,000
What will be the total cash collections for the quarter?
a. $700,000
b. $220,000
c. $190,000
d. $905,000
Quick Check ✓
Prepare a production budget.

The Production Budget
Production
Budget
Sales
Budget
and
Expected
Cash
Collections
Completed
The production budget must be adequate to
meet budgeted sales and to provide for
the desired ending inventory.
The management at Royal Company wants ending inventory to
be equal to 20% of the following month’s budgeted sales in
units.
On March 31st, 4,000 units were on hand.
Let’s prepare the production budget.

If Royal was a merchandising company it would prepare a
merchandise purchase budget instead of a production budget.
March 31
ending inventory.
Quick Check ✓
What is the required production for May?
a. 56,000 units
b. 46,000 units

c. 62,000 units
d. 52,000 units
What is the required production for May?
a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units
Quick Check ✓

Assumed ending inventory.
Prepare a direct materials budget, including a schedule of
expected cash disbursements for purchases of materials.
The Direct Materials Budget
At Royal Company, five pounds of material are required per
unit of product.
Management wants materials on hand at the end of each month
equal to 10% of the following month’s production.
On March 31, 13,000 pounds of material are on hand. Material
cost is $0.40 per pound.
Let’s prepare the direct materials budget.

From production budget.
Calculate the materials to
be purchased in May.
March 31 inventory.
10% of following month’s production needs.

Quick Check ✓
How much materials should be purchased in May?
a. 221,500 pounds
b. 240,000 pounds
c. 230,000 pounds
d. 211,500 pounds
How much materials should be purchased in May?
a. 221,500 pounds
b. 240,000 pounds
c. 230,000 pounds
d. 211,500 pounds
Quick Check ✓

Assumed ending inventory.
Expected Cash Disbursement for Materials
Royal pays $0.40 per pound for its materials.
One-half of a month’s purchases is paid for in the month of
purchase; the other half is paid in the following month.
The March 31 accounts payable balance is $12,000.
Let’s calculate expected cash disbursements.

140,000 lbs. × $0.40/lb. = $56,000
Compute the expected cash
disbursements for materials
for the quarter.
Quick Check ✓
What are the total cash disbursements for the quarter?
a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400
What are the total cash disbursements for the quarter?
a. $185,000
b. $ 68,000

c. $ 56,000
d. $201,400
Quick Check ✓
Prepare a direct labor budget.
The Direct Labor Budget
At Royal, each unit of product requires 0.05 hours (3 minutes)
of direct labor.
The Company has a “no layoff” policy so all employees will be
paid for 40 hours of work each week.
For purposes of our illustration assume that Royal has a “no
layoff” policy, workers are paid at the rate of $10 per hour
regardless of the hours worked.

For the next three months, the direct labor workforce will be
paid for a minimum of 1,500 hours per month.
Let’s prepare the direct labor budget.
From production budget.
Greater of labor hours required

or labor hours guaranteed.
Quick Check ✓
What would be the total direct labor cost for the quarter if
the company follows its no lay-off policy, but pays $15 (time-
and-a-half) for every hour worked in excess of 1,500 hours in a
month?
a. $79,500
b. $64,500
c. $61,000
d. $57,000
What would be the total direct labor cost for the quarter if
the company follows its no lay-off policy, but pays $15 (time-
and-a-half) for every hour worked in excess of 1,500 hours in a
month?

a. $79,500
b. $64,500
c. $61,000
d. $57,000
Quick Check ✓
Prepare a manufacturing overhead budget.
Manufacturing Overhead Budget
At Royal, manufacturing overhead is applied to units of product
on the basis of direct labor hours.
The variable manufacturing overhead rate is $20 per direct labor
hour.
Fixed manufacturing overhead is $50,000 per month, which
includes $20,000 of noncash costs (primarily depreciation of
plant assets).
Let’s prepare the manufacturing overhead budget.

Direct Labor Budget.
Total mfg. OH for quarter $251,000
Total labor hours required 5,050
= $49.70 per hour *
* rounded
Depreciation is a noncash charge.

Ending Finished Goods Inventory Budget
Direct materials
budget and information.
Direct labor budget.
Total mfg. OH for quarter $251,000
Total labor hours required 5,050
= $49.70 per hour

Production Budget.
Prepare a selling and administrative expense budget.
Selling and Administrative Expense Budget
At Royal, the selling and administrative expense budget is
divided into variable and fixed components.
The variable selling and administrative expenses are $0.50 per
unit sold.
Fixed selling and administrative expenses are $70,000 per
month.
The fixed selling and administrative expenses include $10,000
in costs – primarily depreciation – that are not cash outflows of
the current month.
Let’s prepare the company’s selling and administrative expense
budget.

Selling and Administrative Expense Budget
Calculate the selling and administrative
cash expenses for the quarter.
Quick Check ✓
What are the total cash disbursements for selling and
administrative expenses for the quarter?
a. $180,000
b. $230,000
c. $110,000
d. $ 70,000
What are the total cash disbursements for selling and
administrative expenses for the quarter?
a. $180,000
b. $230,000
c. $110,000

d. $ 70,000
Quick Check ✓
Selling Administrative Expense Budget
Prepare a cash budget.
Format of the Cash Budget
The cash budget is divided into four sections:
Cash receipts section lists all cash inflows excluding cash
received from financing;
Cash disbursements section consists of all cash payments
excluding repayments of principal and interest;
Cash excess or deficiency section determines if the company
will need to borrow money or if it will be able to repay funds
previously borrowed; and

Financing section details the borrowings and repayments
projected to take place during the budget period.
The Cash Budget
Assume the following information for Royal:
Maintains a 16% open line of credit for $75,000.
Maintains a minimum cash balance of $30,000.
Borrows on the first day of the month and repays loans on the
last day of the month.
Pays a cash dividend of $49,000 in April.
Purchases $143,700 of equipment in May and $48,300 in June
(both purchases paid in cash).
Has an April 1 cash balance of $40,000.
The Cash Budget
Schedule of Expected
Cash Collections.

The Cash Budget
Direct Labor
Budget.
Manufacturing
Overhead Budget.
Selling and Administrative
Expense Budget.
Schedule of Expected
Cash Disbursements.
The Cash Budget
Because Royal maintains
a cash balance of $30,000,
the company must borrow $50,000 on its line-of-credit.
The Cash Budget

Ending cash balance for April
is the beginning May balance.
Because Royal maintains
a cash balance of $30,000,
the company must borrow $50,000 on its line-of-credit.
The Cash Budget
Quick Check ✓
What is the excess (deficiency) of cash available over
disbursements for June?
a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000
What is the excess (deficiency) of cash available over

disbursements for June?
a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000
Quick Check ✓
The Cash Budget
$50,000 × 16% × 3/12 = $2,000
Borrowings on April 1 and
repayment on June 30.
The Budgeted Income Statement
Cash
Budget
Budgeted
Income
Statement
Completed

With interest expense from the cash budget, Royal can prepare
the budgeted income statement.
Prepare a budgeted income statement.
The Budgeted Income Statement
Sales Budget.
Ending Finished
Goods Inventory.
Selling and
Administrative
Expense Budget.
Cash Budget.

Prepare a budgeted balance sheet.
The Budgeted Balance Sheet
Royal reported the following account balances prior to
preparing its budgeted financial statements:
Land - $50,000
Common stock - $200,000
Retained earnings - $146,150 (April 1)
Equipment - $175,000

Questions
Page 372
8-1 8-2
8-3 8-4
8-6
Pages 374-379
8-1 8-2
8-3 8-4
8-5 8-6
8-7 8-12(1-3 )
8-13 (1-3 )
Exercises
End of Chapter 8
Performance Measurement in Decentralized Organizations

Chapter 11
PowerPoint Authors:
Decentralization in Organizations
Benefits of
Decentralization
Top management
freed to concentrate
on strategy.
Lower-level decisions
often based on
better information.

Lower level managers can respond quickly to customers.
Lower-level managers
gain experience in
decision-making.
Decision-making
authority leads to
job satisfaction.
Decentralization in Organizations
Disadvantages of
Decentralization
Lower-level managers
may make decisions
without seeing the
“big picture.”
May be a lack of
coordination among
autonomous
managers.
Lower-level manager’s
objectives may not
be those of the
organization.
May be difficult to

spread innovative ideas
in the organization.
Responsibility Accounting
Responsibility
Center
Cost
Center
Profit
Center
Investment
Center
Cost, profit,
and investment
centers are all
known as
responsibility
centers.

Cost Center
A segment whose manager has control over costs, but not over
revenues or investment funds.
Profit Center
A segment whose manager has control over both costs and
revenues,
but no control over investment funds.
Revenues
Sales
Interest
Other
Costs
Mfg. costs
Commissions
Salaries
Other
Investment Center
A segment whose manager has control over costs, revenues,
and investments in operating assets.

Compute return on investment (ROI) and show how changes in
sales, expenses, and assets affect ROI.
Return on Investment (ROI) Formula
ROI =
Net operating income
Average operating assets
Cash, accounts receivable, inventory,
plant and equipment, and other
productive assets.
Income before interest
and taxes (EBIT)
Net Book Value versus Gross Cost
Most companies use the net book value of depreciable assets to

calculate average operating assets.
Understanding ROI
Margin =
Sales
Turnover =
Sales
ROI =
Margin × Turnover
Increasing ROI – An Example
Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 470,000

ROI =
Margin × Turnover
Sales
Sales
×
ROI =
What is Regal Company’s ROI?
Increasing ROI – An Example
$30,000
$500,000
×
$500,000
$200,000
ROI =
6% × 2.5 = 15%
ROI =
ROI =
Margin × Turnover
Sales
Sales
×
ROI =

Investing in Operating Assets to Increase Sales
Assume that Regal's manager invests in a $30,000 piece of
equipment that increases sales by $35,000, while increasing
operating expenses by $15,000.
Let’s calculate the new ROI.
Regal Company reports the following:
Net operating income $ 50,000
Average operating assets $ 230,000
Sales $ 535,000
Operating expenses $ 485,000
Investing in Operating Assets to Increase Sales
$50,000
$535,000
×
$535,000
$230,000
ROI =
9.35% × 2.33 = 21.8%
ROI =
ROI increased from 15% to 21.8%.
ROI =
Margin × Turnover

Sales
Sales
×
ROI =
Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.
Managers often inherit many
committed costs over which
they have no control.
Managers evaluated on ROI
may reject profitable
investment opportunities.
Compute residual income and understand its strengths and

weaknesses.
Residual Income - Another Measure of Performance
above some minimum
return on operating
assets
Calculating Residual Income
(
)
This computation differs from ROI.
ROI measures net operating income earned relative to the
investment in average operating assets.
Residual income measures net operating income earned less the
minimum required return on average operating assets.
Residual Income – An Example
The Retail Division of Zephyr, Inc. has average operating assets

of $100,000 and is required to earn a return of 20% on these
assets.
In the current period, the division earns $30,000.
Let’s calculate residual income.
Residual Income – An Example
Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
Quick Check ✓
Redmond Awnings, a division of Wrap-up Corp., has a net
operating income of $60,000 and average operating assets of
$300,000. The required rate of return for the company is 15%.
What is the division’s ROI?

a. 25%
b. 5%
c. 15%
d. 20%
Quick Check ✓
What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20%
ROI = NOI/Average operating assets
= $60,000/$300,000 = 20%
Quick Check ✓
$300,000. If the manager of the division is evaluated based on
ROI, will she want to make an investment of $100,000 that
would generate additional net operating income of $18,000 per
year?
a. Yes

b. No
Quick Check ✓
$300,000. If the manager of the division is evaluated based on
ROI, will she want to make an investment of $100,000 that
would generate additional net operating income of $18,000 per
year?
a. Yes
b. No
ROI = $78,000/$400,000 = 19.5%
This lowers the division’s ROI from 20.0% down to 19.5%.
Quick Check ✓
The company’s required rate of return is 15%. Would the
company want the manager of the Redmond Awnings division to
make an investment of $100,000 that would generate additional
net operating income of $18,000 per year?
a. Yes
b. No

Quick Check ✓
The company’s required rate of return is 15%. Would the
company want the manager of the Redmond Awnings division to
make an investment of $100,000 that would generate additional
net operating income of $18,000 per year?
a. Yes
b. No
ROI = $18,000/$100,000 = 18%
The return on the investment exceeds the minimum required rate
of return.
Quick Check ✓
What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000
Quick Check ✓

What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000
Net operating income $60,000
Required return (15% of $300,000) (45,000)
Residual income $15,000
Quick Check ✓
If the manager of the Redmond Awnings division is
evaluated based on residual income, will she want to make an
investment of $100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No
Quick Check ✓
If the manager of the Redmond Awnings division is
evaluated based on residual income, will she want to make an
investment of $100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes

b. No
Net operating income $78,000
Required return (15% of $400,000) (60,000)
Residual income $18,000
Yields an increase of $3,000 in the residual income.
Divisional Comparisons and Residual Income
The residual income approach has one major disadvantage.
It cannot be used to compare the performance of divisions of
different sizes.
Zephyr, Inc. - Continued
Recall the following information for the Retail Division of
Zephyr, Inc.
Assume the following information for the Wholesale Division of
Zephyr, Inc.

Zephyr, Inc. - Continued
The residual income numbers suggest that the Wholesale
Division outperformed the Retail Division because its residual
income is $10,000 higher. However, the Retail Division earned
an ROI of 30% compared to an ROI of 22% for the Wholesale
Division. The Wholesale Division’s residual income is larger
than the Retail Division simply because it is a bigger division.
Compute delivery cycle time, throughput time, and
manufacturing cycle efficiency (MCE).
Process time is the only value-added time.
Delivery Performance Measures
Wait Time
Process Time + Inspection Time
+ Move Time + Queue Time
Delivery Cycle Time

Order Received
Production
Started
Goods Shipped
Throughput Time
Manufacturing
Cycle
Efficiency
Value-added time
Manufacturing cycle time
=
Delivery Performance Measures
Wait Time
Process Time + Inspection Time
+ Move Time + Queue Time
Delivery Cycle Time

Order Received
Production
Started
Goods Shipped
Throughput Time
Quick Check ✓
A TQM team at Narton Corp has recorded the following average
times for production:
Wait 3.0 days Move 0.5 days
Inspection 0.4 days Queue 9.3 days
Process 0.2 days
What is the throughput time?
a. 10.4 days.
b. 0.2 days.
c. 4.1 days.
d. 13.4 days.

Process 0.2 days
What is the throughput time?
a. 10.4 days.
b. 0.2 days.
c. 4.1 days.
d. 13.4 days.
Quick Check ✓
Throughput time = Process + Inspection + Move + Queue
= 0.2 days + 0.4 days + 0.5 days + 9.3 days
= 10.4 days
Quick Check ✓
Process 0.2 days
What is the Manufacturing Cycle Efficiency (MCE)?
a. 50.0%.
b. 1.9%.
c. 52.0%.
d. 5.1%.

Process 0.2 days
What is the Manufacturing Cycle Efficiency (MCE)?
a. 50.0%.
b. 1.9%.
c. 52.0%.
d. 5.1%.
Quick Check ✓
MCE= Value-added time ÷ Throughput time
= Process time ÷ Throughput time
= 0.2 days ÷ 10.4 days
= 1.9%
Quick Check ✓
Process 0.2 days
What is the delivery cycle time (DCT)?
a. 0.5 days.

b. 0.7 days.
c. 13.4 days.
d. 10.4 days.
Process 0.2 days
What is the delivery cycle time (DCT)?
a. 0.5 days.
b. 0.7 days.
c. 13.4 days.
d. 10.4 days.
Quick Check ✓
DCT = Wait time + Throughput time
= 3.0 days + 10.4 days
= 13.4 days
Understand how to construct and use a balanced scorecard.

The Balanced Scorecard
Management translates its strategy into performance measures
that employees understand and influence.
Customer
Learning
and growth
Internal
business
processes
Financial
Performance
measures
The Balanced Scorecard: From
Strategy to Performance Measures
Financial
Has our financial
performance improved?
Customer
Do customers recognize that

we are delivering more value?
Internal Business Processes
Have we improved key business processes so that we can
deliver more value to customers?
Learning and Growth
Are we maintaining our ability
to change and improve?
Performance Measures
What are our
financial goals?
What customers do
we want to serve and
how are we going to
win and retain them?
What internal busi-
ness processes are
critical to providing
value to customers?
Vision and Strategy
The Balanced Scorecard:

Non-financial Measures
The balanced scorecard relies on non-financial measures in
addition to financial measures for two reasons:
Financial measures are lag indicators that summarize
the results of past actions. Non-financial measures are
leading indicators of future financial performance.
Top managers are ordinarily responsible for financial
performance measures – not lower level managers.
Non-financial measures are more likely to be
understood and controlled by lower level managers.
The Balanced Scorecard for Individuals
A personal scorecard should contain measures that can be
influenced by the individual being evaluated and that
support the measures in the overall balanced scorecard.
The entire organization should have an overall balanced
scorecard.
Each individual should have a personal balanced scorecard.
The balanced scorecard lays out concrete actions to attain
desired outcomes.

A balanced scorecard should have measures
that are linked together on a cause-and-effect basis.
If we improve
one performance
measure . . .
Another desired
performance measure
will improve.
The Balanced Scorecard
Then
The Balanced Scorecard and Compensation
Incentive compensation should be linked to
balanced scorecard performance measures.
Employee skills in installing options
Number of
options available
Time to
install option

Customer satisfaction
with options
Number of cars sold
Contribution per car
Profit
Learning
and Growth
Internal Business Processes
Customer
Financial
The Balanced Scorecard ─ Jaguar Example
Increase Options
Time
Decreases

Strategies
Increase
Skills
Results
Number of
options available
Time to
install option
with options
Number of cars sold
Profit
Satisfaction Increases
Number of

options available
Time to
install option
with options
Number of cars sold
Profit
Results
Cars sold Increase
Number of
options available
Time to
install option
with options

Number of cars sold
Profit
Results
Time
Decreases
Contribution
Increases
Number of
options available
Time to
install option
with options
Number of cars sold

Profit
Results
Contribution
Increases
Profits
Increase
If number
of cars sold
and contribution
per car increase,
profit should
increase.
Cars Sold Increases
Questions
Page 503

11-1 11-9
11-4
11-5
Pages 505-506
11-1
11-2
11-3
Exercises
End of Chapter 11
!
Group Assignment
ACC252 T Managerial Accounting for Decision Making
2018
!
!
!

!
!
!
!
!
!
!
Due Date: Thursday 5th April 2018 ( 10 am )
Group Project: 15%
!
!
!
!
!
!
!
!
Adi
Adi
Adi
Adi

Adi
Company Information
Technovate Ltd manufacture a range of technology products and
accessories and sell to
outlets all over the Middle East. The company was established
one year ago and has had a
challenging first year in business. Technovate Ltd have three
main product lines; laptops,
tablets and accessories. The following financial information has
been provided.
!
!
Financial Information
Laptop Tablet
Accessories
Selling Price per unit SAR9,100.00
SAR1,000.00 SAR600.00
Direct Materials SAR 230 SAR 20
SAR 50
Number of direct materials per unit (Units) 23 3
n/a
Direct Labour hour cost per hour SAR 100 SAR 40
SAR 70
Sales commission per item sold SAR 1020 SAR 100
SAR 15

Variable manufacturing overhead per unit SAR 234 SAR
27 SAR 23
Number of labour hours per unit (Hours) 25 7
3
Budgeted sales per month (Units) 100 350
500 !
Additional Information:
a) The company bought specialised equipment 1 year ago which
cost SAR90,000.
The useful life of this equipment is 10 years. Depreciation is
allocated to
manufacturing overhead expenses and is absorbed equally by
the laptop and
tablet division.
b) Other costs:
Production manager annual salary SAR 234,000, annual selling
costs SAR
120,000
general expenses per month SAR 32,000, annual fixed
manufacturing overhead
(excluding depreciation) SAR15,000 per month. These costs are
apportioned as
follows; 60% relates to laptops, 30% relates to tablets and 10%
relates to
accessories.
c) Company policy is to maintain closing inventory for finished
goods and closing
inventory of direct materials for laptops at a % of following
months production/
materials requirements as outlined below. All other months is
maintained at 20%
for finished goods and 15% for direct materials. The finished
goods inventory in

December 2015 was 30 units and direct materials was 300 units.
!
January February March
Finished Goods 20% 25% 30%
Direct Materials 15% 20% 25% !
d) Cash collections on sales are as follows:
50% in the month of sale and 50% in the month following sale
Receivables at the end of December 2015 were SAR 30,000 !
e) Cash payments on purchases are as follows:
60% in the month of purchase and 40% in the following month
Payables at the end of December 2015 were SAR 60,000
All other expenses are paid in the month incurred. !
f) The closing cash balance in December 2015 was SAR
1,500,000. It is company
policy to maintain cash at SAR100,000 or above at the end of
each month. The
company are due to receive SAR1,050,000 from an investor in
March. !
g) The company have access to a 5% bank loan of SAR 800,000.
Interest will be paid
at the end of each quarter. The loan will be repayable at the end
of the year. !
h) The company paid a dividend of SAR 5,000 in February
2016.
!
Requirement:

Your group has been employed as the management accountants
for Technovate Ltd and
have been asked to prepare a report to the board of directors
outlining the following:
a) Using the information above, advise the company on the
following:
• Which product line is performing the best?
• Calculate the the break-even point in sales value for each
product line.
• If the selling price of laptops is increased to SAR 10,900 per
unit, what will be the
increase in overall profit for the company.
• What level of sales (value) and units must the company
achieve to make an annual
profit on laptops of SAR 40,000 (using the current selling
price).
• Using the original information presented, draw a CVP graph
outlining the costs, break-
even point and profit and loss area for Technovate Ltd and
comment on the overall
performance of the company.
!
b) Using the information above, prepare the master budget for
the laptop division only
for the quarter ending March 2016. Show the total for each
month and the quarter
total.

!
c) The company are considering dropping any loss making
divisions. Advise the
company whether this strategy makes sense and if yes, which
division they should
consider dropping. Include in your answer, any other factors
they should consider,
before making a final decision.
!
d) The company are considering implementing a balanced
scorecard system. Outline
how this could be implemented in this company giving at least
five performance
measures for each perspective. Include in your answer the
advantages and
disadvantages of traditional budgeting and advise the company
on whether you
believe it is a good decision to implement ‘the balanced
scorecard’ system in this
company.
!

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