Tai lieu ve cac loai chi phi trong doanh nghiep

Data Collected By: Hamed Ali Mohamed
Costing Fundamentals
‫التكاليف‬ ‫ادارة‬
–
‫الثالث‬ ‫الجزء‬
M 7
P 3
7/23/2022 Hamed Ali
@Hamed.Ali.Mohamed2@gmail.com 1-1

Cost Control and
Cost Reduction
7/23/2022 Hamed Ali
@Hamed.Ali.Mohamed2@gmail.com 2
Part One

Cost control
• Ability to earn sustained profits
• Profit depends upon the selling price and cost of
production
• Minimum cost
• Necessary for successful operation of the
business
• Search for better and economical ways of
completing each operation.
7/23/2022 Hamed Ali

Cost control
• Means a reduction in the percentage of costs and
an increase in the percentage of profits
• Reduction in specific expenses
• More efficient use of every Reyal spent.
• It is easier to keep costs down than it is to bring
down
• The amount of effort put into cost control tends to
increase when business is bad and decrease when
business is good
• There is more profit in cost control when business
is good than when business is bad.
7/23/2022 Hamed Ali

Tools for cost control
• Standard costs and budgets
• Ratio analysis
• Value analysis
7/23/2022 Hamed Ali

Standard costs and budgets
• Establish standards of performance for producing
goods and services
• Analysis of variance between actual and standard
costs
• Help fix responsibility for non-standard
performance
• Focus attention on areas in which cost
improvement should be sought by pinpointing the
source of loss and inefficiency
• Flexible budgets effective cost control technique
7/23/2022 Hamed Ali

Standard costs and budgets
• Budgets control factory overheads
• Flexible budgets also known as variable
budgets
• Provide a basis for determining costs
anticipated at various levels of activity
• The variances then can be analyzed and
necessary action can be taken in the matter
7/23/2022 Hamed Ali

Ratio analysis
• Statistical yardstick that provides a measure
of the relationship between two figures
• Relationship- expressed as rate, as per
cent or as a quotient
• Used in analysis of operations because the
use of absolute figures might be misleading
• Provide standards of comparison for
appraising the performance of a business
firm.
7/23/2022 Hamed Ali

Ratio analysis
• A businessman may compare his firm’s ratio’s for
the period under scrutiny with similar ratios of the
previous periods-will help him to focus on areas
which need his attention
• The businessman may compare his ratios with the
standard ratios in his industry. Standard ratios are
averages of results achieved by thousands of
firms in the same line business
7/23/2022 Hamed Ali

Comparisons
• Net profits/ sales
• Gross profits / sales
• Net profits / total assets
• Sales / total assets
• Production costs / cost of sales
• Administration costs / cost of sales
• Sales / inventory
7/23/2022 Hamed Ali

Value analysis
• It is an approach to cost saving that deals
with the product design
• Before buying any equipment or materials a
study is made as to what purpose these
things serve
• Identification of costs in a product that do
not in any manner contribute to its
specification or functional value.
7/23/2022 Hamed Ali

Value analysis
• Discarding tailored products where
standard components can do
• Dispensing with facilities not specified or
not required by the customer e.g. doing
away with the headphone in a radio set
• Use of newly developed better and cheaper
materials in place of traditional materials.
7/23/2022 Hamed Ali

Areas of cost control
• Materials
• Labor
• Overheads
7/23/2022 Hamed Ali

Cost reduction
• “ the achievement of real and permanent
reductions in the unit costs of goods
manufactured or services rendered without
impairing their suitability for the use
intended”
• Confined to savings in the cost of
manufacture, administration, distribution
and selling, brought about by the
elimination of wasteful and inessential
elements from the product design.
7/23/2022
Hamed Ali
@Hamed.Ali.Mohamed2@gmail.com
1-14

Essentials for the success of a cost
reduction program
• Every individual within the factory should
recognize his responsibility
• Employee resistance to change should be
minimized
• Efforts should be concentrated in the areas
where the savings are likely to be maximum
• Cost reduction efforts should be
continuously maintained
7/23/2022 Hamed Ali

Factors affecting cost control
• Cost of raw materials and other intermediate
products is high
• Inventory control is also not possible
• Shortages of raw materials are usual phenomenon
• Overheads are also high
• Indirect taxes tend to raise the overall costs of
production in India.
7/23/2022 Hamed Ali

Factors affecting cost control
• Underutilization of capacities due to lack of
raw materials and power shortage.
• Machinery and equipments are generally
obtained under tied credits usually cost 30
to 40 per cent more than what it would cost
if purchased in open market
• Delays in issue of licenses and by the time
licenses are issued cost of the equipment
goes up
7/23/2022 Hamed Ali

Break-even analysis
7/23/2022 Hamed Ali
Part Two

Break-even analysis
• break-even analysis provides a simple
means of measuring profits and losses at
different levels of output.
• sales revenues and total costs are analysed
for each different level of production.
• analysis is normally done graphically using a
break-even chart.
7/23/2022 Hamed Ali

Drawing a break-even chart
£
Quantity
Fixed costs
Total costs
Sales revenue
Break-even
output
Break-even
sales
break-
even
point
at the break-even point, total sales =
total cost (i.e. no profit or loss is made)
7/23/2022 Hamed Ali

Break-even point
• the point at which total costs are covered and no
profit or loss is made is called the break-even
point
• the break-even point is where the total revenue
and total cost lines intersect on the chart
• this can also be calculated using the formula:
BEP = fixed costs
contribution per unit
(Price-variable cost per unit)
7/23/2022
Hamed Ali
1-21

Uses of break-even analysis
• Provides useful information about the overall
performance of a firm.
• to see how changes in output, selling price or
costs will affect profit levels
• to calculate the level of output required to reach
a certain level of profit
• Provides useful information for decision making
• to aid forecasting and planning
7/23/2022 Hamed Ali

Limitations of break-even analysis
• its accuracy depends upon the accuracy of the
data used
• forecasting the future is difficult, especially long
term
• it assumes there is a simple relationship between
variable costs and sales
• sales income does not necessarily rise in a
constant relationship to sales volume
• external constraints have to be recognised
7/23/2022 Hamed Ali

Markup on Cost
• Selling Price: price for product offered to public
• Markup, margin, or gross profit: difference
between the cost and the selling price
• Basic formula: Cost + Markup = Selling Price
(in this section markup is based on cost)
S
M
C 

7/23/2022 Hamed Ali

Markup on Cost
• Example: A coffee maker is purchased for $15
and sold for $18.75. Find the percent of markup
based on cost.
Markup = M = $18.75 - $15 = $3.75
Percent equation:
P = part
B = base
R = rate = percent %
25
25
.
0
15
$
75
.
3
$
15
$
75
.
3
$







R
R
B
R
P
7/23/2022 Hamed Ali

Markup on Cost
• Example: A baseball glove is sold for $42,
which is 140% of cost. How much is the
store’s cost?
Selling price= 140% of cost so the markup
is 40% of cost (cost is 100% of itself)
30
$
4
.
1
42
$
42
$
4
.
1
4
.
0







C
C
C
C
S
M
C
7/23/2022 Hamed Ali

Markup on Cost
• Example: North American Coins priced a proof
coin at $868, which was 112% of cost. Find (a) the
cost, (b) the markup as a percent of cost, and (c)
the markup.
Selling price= 112% of cost so the markup is 12%
of cost
93
$
775
$
868
$
775
$
12
.
1
868
$
868
$
12
.
1
12
.
0










M
C
C
C
C
S
M
C
7/23/2022 Hamed Ali

Markup on Selling Price
• Sometimes markup is based on the selling
price rather than cost. The same basic
formula applies:
• The difference is that markup is now
considered a percent of the selling price
rather than cost
S
M
C 

7/23/2022 Hamed Ali

• Example: An auto parts dealer pays $7.14 per 12
gallons of windshield washer fluid and the
markup is 50% on selling price. Find the selling
price.
Markup = 50% of the selling price
gallon
per
S
C
S
S
S
C
S
S
C
S
of
M
and
S
M
C
19
.
1
$
5
.
595
.
0
$
595
.
0
$
12
14
.
7
$
5
.
0
5
.
0
5
.
0
%
50













7/23/2022 Hamed Ali
1-29

• Example: A retailer purchases silk flowers for
$31.56 per dozen and sells them for $4.78 each.
Find the percent markup on selling price and the
equivalent percent markup on cost.
%
7
.
81
817
.
%
45
450
.
15
.
2
$
63
.
2
$
78
.
4
$
63
.
2
$
12
56
.
31
$
63
.
2
15
.
2
78
.
4
15
.
2
















C
M
S
M
M
C
C
S
M
S
M
C
7/23/2022 Hamed Ali

• Converting percent markup on cost to
percent markup on selling price:
• Converting percent markup on selling price
to percent markup on cost:
S
S
C
M
M
M


%
100
C
C
S
M
M
M


%
100
7/23/2022 Hamed Ali

• Example: Convert a markup of 20% on
selling price to its equivalent markup on cost.
%
25
25
.
0
8
.
0
2
.
0
%
80
%
20
%
20
%
100
%
20
%
100








S
S
C
M
M
M
7/23/2022 Hamed Ali

Markup with Spoilage
• Markup with spoilage: Some items may
not be fit for sale or will go bad. Sometimes
they can be sold for a reduced price.
Sometimes they are a total loss. The
selling price has to be higher to make up
for this loss.
7/23/2022 Hamed Ali

• Example: The cost for 36 items is $540. If 6 items
cannot be sold, what is the selling price per item
for a % markup of 25% on selling price?
item
per
S
S
S
S
S
S
C
S
M
C
24
$
30
720
$
6
36
720
$
720
$
75
.
540
$
75
.
540
$
25
.
540
$
%
25














7/23/2022 Hamed Ali

• The cost for 120 items is $360. If 10% are sold at
a reduced price of $2, what is the selling price per
item for a markup of 20% on cost?
108
12
120
#
12
120
1
.
%)
10
(
#
432
$
)
360
($
2
.
1
%
20













price
regular
at
price
reduced
at
sold
S
S
C
C
S
M
C
78
.
3
$
108
408
408
$
24
$
432
$
24
$
2
$
12








item
per
price
sales
price
regular
sales
price
reduced
7/23/2022 Hamed Ali

Markdown
• When merchandise does not sell at the original
price the price must be reduced. The basic
formula for markdown is:
• Example: What is the reduced price if the original
price was $960 and the markdown is 25%?
720
$
240
$
960
$
240
$
960
$
25
.
0






price
reduced
markdown
markdown
price
original
price
reduced 

7/23/2022 Hamed Ali

Markdown
• Example: Given an original price of $240 and a
markdown of $96, what is the percent markdown
and the reduced price?
144
$
96
$
240
$
%
40
4
.
0
240
96
96
$
240
$











price
reduced
R
R
P
B
R
7/23/2022
Hamed Ali
1-37

Markdown
•Markdown equations:
Break-even point = Cost + Operating expenses.
Operating Loss = Break-even point – Reduced selling price.
Absolute loss = Cost – Reduced selling price.
7/23/2022
Hamed Ali

Markdown
• Given a cost of $25, operating expense of $8,
and reduced price of $22, what is the break-even
point, the operating loss, and the absolute loss?
3
$
22
$
25
$
11
$
22
$
33
$
33
$
8
$
25
$









loss
absolute
loss
operating
pt
even
break
7/23/2022 Hamed Ali

Basics of Simple Interest
• Simple Interest Formula:
I = interest, P = principal, R = rate of interest per
year, T = time in years
• Example: Given an investment of $9500 invested
at 12% interest for 1½ years, find the simple
interest.
PRT
I 
1710
$
5
.
1
12
.
0
9500
$





I
PRT
I
7/23/2022 Hamed Ali

• Example: If money invested at 10% interest for 7
months yields $84, find the principal.
1440
$
0583
.
84
$
0583
.
12
7
10
.
0
84
$







P
P
P
PRT
I
7/23/2022 Hamed Ali

• Example: If $2600 is invested for 7 months and
yields simple interest of $144.08, what is the
interest rate?
%
5
.
9
095
.
67
.
1516
08
.
144
67
.
1516
12
7
2600
$
08
.
144
$








R
R
R
PRT
I
7/23/2022 Hamed Ali

Simple Interest for a Given
Number of Days
• To find the exact number of days between two
dates (2 methods):
1. Get the number corresponding to each date (Julian
date) from table 11.1 and subtract
2. Add the number of days in between the two dates
going month by month using the number of days in
each month
7/23/2022 Hamed Ali

Number of Days
• Find the number of days from April 24 to July 7:
(1) Using table 11.1, April 24 = day 114
July 7 = day 188,
# days = 188 – 114 = 74
(2) # days left in April = 6
# days in May = 31
# days in June = 30
# days in July = 7
Total days = 6 + 31 + 30 + 7 = 74
7/23/2022 Hamed Ali

Number of Days
• Exact interest:
• Ordinary or banker’s interest:
• Example: Given an investment of $2600
invested at 10.5% interest for 180 days,
find the ordinary interest.
365
# days
exact
T 
360
# days
exact
T 
50
.
136
$
360
180
105
.
0
2600
$





I
PRT
I
7/23/2022 Hamed Ali

Number of Days
• Example: Bella missed an income tax
payment. The payment was due on June 15
and was paid September 7. The penalty was
14% simple interest on the unpaid tax of
$4600. Find the penalty using exact interest.
#days = 15 + 31 + 31 + 7 = 84 days
21
.
148
$
365
84
14
.
0
4600
$





I
PRT
I
7/23/2022 Hamed Ali

Maturity Value
• Maturity Value = amount loaned + interest
• Maturity Date = date the loan is paid off
• Example: A $12,200 loan is borrowed at 9.5% for 10
months. Find the interest and maturity value.
)
1
( RT
P
M
PRT
P
I
P
M






83
.
165
,
13
$
83
.
965
$
200
,
12
$
83
.
965
$
12
10
095
.
200
,
12
$








M
I
PRT
I
7/23/2022 Hamed Ali

Maturity Value
• Find the Time: If a loan of $7400 is borrowed at
9.5% has interest of $292.92, find the time in
days and the maturity value
92
.
7692
$
92
.
292
$
7400
$
150
360
4167
.
0
4167
.
0
095
.
7400
$
92
.
292
$
095
.
7400
$
92
.
292
$














M
days
T
years
T
T
PRT
I
7/23/2022 Hamed Ali

Maturity Value
• Find the Principal and Rate: If a loan is borrowed
with interest of $300 for 120 days with a maturity
value of $7800, find the principal and interest rate.
%
12
12
.
0
2500
$
300
$
2500
$
360
120
7500
$
300
$
7500
$
300
$
7800
$















R
R
R
PRT
I
P
P
I
P
M
7/23/2022 Hamed Ali

Inflation and the Time Value of Money
• Inflation: continuing rise in the general price
level of goods and services
• Consumer Price Index (CPI): one way to
measure inflation. The CPI reflects the
average change in prices from one year to the
next.
• Time Value of Money: the idea that loaning
money has value and that value is repaid by
returning interest in addition to principal.
7/23/2022 Hamed Ali

• Present value: principal amount that must be
invested today to produce a given future value.
• Future value: amount that a present value
grows to; also called the maturity amount.
RT
M
P
or
RT
P
M




1
)
1
(
7/23/2022 Hamed Ali

• Time Value of Money – with simple interest
of 5% per year.
2000 2010 2020
)
10
)
05
(.
1
(
1000
$
)
1
(
1000
$


 RT
10
)
05
(.
1
1000
$
1
1000
$


 RT
1000
$
7/23/2022 Hamed Ali

• Example: If the present value = $8000 at 8.5%
for 140 days, what is the future value?
44
.
8264
$
)
18
7
085
.
0
1
(
8000
$
)
1
(
18
7
360
140








M
RT
P
M
T
7/23/2022 Hamed Ali

• Example: If the future value = $1985.50 at 9%
for 180 days, what is the present value?
1900
$
5
.
0
09
.
0
1
50
.
1985
$
1
5
.
0
360
180








P
RT
M
P
T
7/23/2022 Hamed Ali
@Hamed.Ali.Mohamed2@gmail.c 1-54

Simple Interest Notes
• Promissory note: Legal note in which a person
agrees to pay a certain amount of money at a
stated time and interest rate to another person
• Face value of note: principal (P)
• Maturity value: M = P + I = P + PRT = P(1 + RT)
• Term of the note: T – often given in days (convert
to years for formulas)
7/23/2022 Hamed Ali

• Example: For a promissory note with face value
of $9500, term of 200 days, rate of 10%, and date
made of March 18, find the due date and the
maturity value.
Using table 11.1, March 18 = day 77
77 + 200 = day 277 = October 4 (due date)
78
.
027
,
10
$
)
9
5
10
.
0
1
(
9500
$
)
1
(
9
5
360
200








M
RT
P
M
T
7/23/2022 Hamed Ali

• Example: For a simple interest note with maturity
value of $7632, term of 240 days, and rate of 9%,
find the principal.
7200
$
3
2
09
.
0
1
7632
$
1
3
2
360
240








P
RT
M
P
T
7/23/2022 Hamed Ali

Simple Discount Notes
• Simple discount note: interest is deducted in
advance from the face value written on the note.
• M = face value = maturity value (not the
principal)
• B = bank discount (similar to interest)
• D = discount rate (similar to rate of interest)
• T = time in years
PRT
I
to
similar
MDT
B 


7/23/2022 Hamed Ali

• Maturity for simple interest:
• Maturity for discount notes:
(similar but you subtract the discount from the
maturity)
)
1
( RT
P
M
PRT
P
I
P
M






)
1
( DT
M
P
MDT
M
B
M
P






7/23/2022 Hamed Ali

• Example: For a simple discount note with a
maturity value of $6800, discount rate of 10%,
and time of 180 days, find the discount and the
proceeds.
6460
340
$
6800
$
340
$
5
.
0
10
.
0
6800
$
5
.
0
360
180












B
M
P
MDT
B
T
7/23/2022 Hamed Ali

• Example: For a simple discount note with a
maturity value of $8200, discount of $205, and
date made of 2/9, due date of 5/10, find the
discount rate, time in days, and the proceeds.
7995
$
205
$
8200
$
%
10
10
.
0
25
.
0
8200
$
205
$
205
$
25
.
0
8200
$
25
.
0
)
(
90
10
30
31
19
)
(
360
90





















B
M
P
D
D
MDT
B
years
T
days
T
7/23/2022 Hamed Ali

Comparing Simple Interest and
Simple Discount
Similarities between simple interest notes
and simple discount notes:-
1. Borrower receives money at the beginning of
each note.
2. Both notes are repaid with a single payment at
the end of the period.
3. Length of time is generally less than 1 year.
7/23/2022 Hamed Ali

Simple Discount
• Differences between simple interest notes and simple
discount notes:
1. Formulas
• Discount notes:
• Interest notes:
2. A simple interest rate 12% (relative to present value) is
not the same as a simple discount rate of 12% (relative
to maturity value.
)
1
( RT
P
M
PRT
P
I
P
M






)
1
( DT
M
P
MDT
M
B
M
P






7/23/2022 Hamed Ali

Simple Discount
1. Converting interest rate to discount rate
2. Converting discount rate to interest rate
DT
D
R


1
RT
R
D


1
7/23/2022 Hamed Ali

Simple Discount
• Example: Given an interest rate of 8% and a
time period of 240 days, find the corresponding
simple discount rate:
%
59
.
7
0759
.
0
08
.
0
1
08
.
0
1
3
2
360
240
)
(
3
2









D
RT
R
D
years
T
7/23/2022 Hamed Ali

Standard Costing
– Define standard costs and describe how
managers use standard costs in the management
cycle.
7/23/2022 Hamed Ali

Hamed Ali
Standard Costing
… is a method of cost control that includes a
measure of actual performance and a
measure of the difference, or variance,
between standard and actual performance.
7/23/2022 1-67

Hamed Ali
Standard Costs
• Realistic estimates of costs
– Based on analysis of both past and projected
operating costs and conditions
• Provide a predetermined performance
level for the standard costing method
• Usually stated in terms of cost per unit
7/23/2022
1-68

Hamed Ali
Standard Costs (cont’d)
• Based on
– Past costs
– Engineering estimates
– Forecasted demand
– Worker input
– Time and motion studies
– Type and quality of direct materials
7/23/2022 1-69

Hamed Ali
Standard Costing
• How the standard costing method differs
from the normal and actual costing
methods
Product Cost
Elements
Standard
Costing
Normal
Costing
Actual
Costing
Direct Materials Estimated costs Actual costs Actual costs
Direct Labor Estimated costs Actual costs Actual costs
Manufacturing Overhead Estimated costs Estimated costs Actual costs
7/23/2022 1-70

Hamed Ali
Standard Costs and the Management Cycle
• Planning
– Managers use standard costs to
• Develop budgets
– Direct materials
– Direct labor
– Variable manufacturing overhead
• Establish goals for product costing
7/23/2022
1-71

Hamed Ali
(cont’d)
• Executing
– Managers use standard costs to
• Apply dollar, time, and quality standards to
work
• Collect actual cost data
7/23/2022 1-72

Hamed Ali
(cont’d)
• Reviewing
– Managers compare standard and actual costs
• Compute variances
– Provide measures of performance that can be used to
control costs and evaluate managers
– Analyze significant variances to determine cause
» Unfavorable variances may reveal operating
problems that require correcting
» Favorable variances may indicate favorable
practices that should be implemented elsewhere
7/23/2022
1-73

Hamed Ali
(cont’d)
• Reporting
– Managers use standard costs to report on
• Operations
• Managers’ performance
7/23/2022
1-74

Standard
Costing,
Variance
Analysis,
and the
Management
Cycle
7/23/2022 Hamed Ali

Hamed Ali
The Relevance of Standard Costing in
Today's Business Environment
• Manufacturing companies
– Increased automation
• Significant decrease in direct labor cost
– Corresponding decline in importance of labor-related standard
costs and variances
• Many companies now apply standard costing only to direct
materials and manufacturing overhead
• Service organizations
– Use standard costing for direct labor and service
overhead costs
7/23/2022 1-76

Hamed Ali
Discussion
Q. What is the main difference between
the standard costing and normal
costing methods?
A. The standard costing method uses
estimated costs for direct materials and
direct labor, whereas the normal costing
method uses actual costs for these items
The methods are similar in that both use
estimated costs for manufacturing
overhead
7/23/2022 1-77

Hamed Ali
Computing Standard Costs
– Explain how standard costs are developed
and compute a standard unit cost
7/23/2022
1-78

Hamed Ali
Computing Standard Costs
• Fully integrated standard costing system
– Uses standard costing for all elements of product
cost
• Direct materials
• Direct labor
• Manufacturing overhead
– Inventory accounts and Cost of Goods Sold
account
• Maintained and reported in terms of standard costs
• Standard unit costs used to compute account balances
• Actual costs recorded separately
– Actual and standard costs can then be compared
7/23/2022
1-79

Hamed Ali
Computing Standard Costs (cont’d)
• Six elements of a standard unit cost for a
manufactured product
1. Price standard for direct materials
2. Quantity standard for direct materials
3. Standard for direct labor rate
4. Standard for direct labor time
5. Standard for variable overhead rate
6. Standard for fixed overhead rate
7/23/2022 1-80

Hamed Ali
Standard Direct Materials Cost
… is found by multiplying the price standard
for direct materials by the quantity standard
for direct materials
Standard Direct
Materials Cost
=
Direct Materials
Price Standard
x
Direct Materials
Quantity Standard
7/23/2022 1-81

Hamed Ali
(cont’d)
• Direct materials price standard
– Careful estimate of the cost of a specific direct
material in the next accounting period
– Developed by purchasing agent or purchasing
department
• Takes into account
– All possible price increases
– Changes in available quantities
– New sources of supply
7/23/2022 1-82

Hamed Ali
(cont’d)
• Direct materials quantity standard
– Estimate of the amount of direct materials that will be
used in the accounting period
• Includes scrap and waste
– Influenced by
• Product engineering specifications
• Quality of direct materials
• Age and productivity of machinery
• Quality and experience of work force
– Established and monitored by
• Production managers
• Management accountants
• Others
– Engineers, purchasing agents, machine operators
7/23/2022
1-83

Hamed Ali
Standard Direct Labor Cost
… for a product, task, or job is calculated by
multiplying the standard wage for direct
labor by the standard hours of direct labor
Standard Direct
Labor Cost
=
Direct Labor
Rate Standard
x
Direct Labor
Time Standard
7/23/2022
1-84

Hamed Ali
Standard Direct Labor Cost (cont’d)
• Direct labor rate standard
– Hourly direct labor rate expected to prevail
during the next accounting period
• For each function or job classification
– Average standard rate is developed for each
task
• Standard rate is used even if worker is paid
more or less than the standard rate
– Easy to establish
• Rates are set by labor unions or defined by
the company
7/23/2022
1-85

Hamed Ali
Standard Direct Labor Cost (cont’d)
• Direct labor time standard
– Expected time required for each department,
machine, or process to complete the production of
one unit or one batch of output
– Developed using
• Current time and motion studies of workers and
machines
• Records of past performance
– Should be revised when
• Machinery is replaced
• Quality of work force changes
7/23/2022
1-86

Hamed Ali
Standard Manufacturing Overhead Cost
• is the sum of the estimates of variable and
fixed overhead costs in the next accounting
period
• Two parts
– Variable costs and fixed costs
• Compute separately because their cost
behavior differs
7/23/2022 1-87

Hamed Ali
(cont’d)
• Standard variable overhead rate
– Computed by dividing the total budgeted
variable overhead costs by an expression of
capacity, such as number of standard direct
labor hours or standard machine hours
Total Budgeted Variable Overhead Costs
Standard Variable
Overhead Rate
=
Expected Number of Standard Machine Hours
7/23/2022 1-88

Hamed Ali
(cont’d)
• Standard fixed overhead rate
– Computed by dividing the total budgeted fixed
overhead costs by an expression of capacity,
usually normal capacity in terms of standard
hours or units
• Denominator expressed in same terms as
the variable overhead rate
Total Budgeted Fixed Overhead Costs
Standard Fixed
Overhead Rate
=
Normal Capacity in Terms of Standard Machine Hours
Normal capacity is the level of
operating capacity needed to
meet expected sales demand
Its use ensures that all fixed OH* costs
have been applied to units produced by
the time normal capacity is reached
*Overhead
7/23/2022 1-89

Hamed Ali
Total Standard Unit Cost
Direct materials price standards
Casing materials $9.20 per square foot
Movement mechanism $2.17 each
Direct materials quantity standards
Casing materials .025 square foot per watch
Movement mechanism 1 per watch
Direct labor time standards
Case Stamping Department .01 hour per watch
Watch Assembly Department .05 hour per watch
Direct labor rate standards
Case Stamping Department $8.00 per hour
Watch Assembly Department $10.20 per hour
Standard manufacturing overhead rates
Standard variable overhead rate $12.00 per direct labor hour
Standard fixed overhead rate $9.00 per direct labor hour
Compute the total
standard cost of
one watch Direct materials costs
Casing ($9.20 per sq.ft. x .025 sq.ft.) $ .23
One movement mechanism 2.17
Direct labor costs
Case Stamping Dept. ($8.00 per hour x .01 hour per watch) .08
Watch Assembly Dept. (10.20 per hour x .05 hour per watch) .51
Variable overhead ($12.00 per hour x .06 hour per watch) .72
Total standard variable cost of one watch $3.71
Fixed overhead ($9.00 per hour x .06 hour per watch) .54
Total standard cost of one watch $4.25
7/23/2022
1-90

Hamed Ali
Discussion
Q. Why are the variable and fixed
components for the standard
manufacturing overhead cost computed
separately?
A. Variable costs and fixed costs are
computed separately because their cost
behavior differs
7/23/2022
1-91

Hamed Ali
Variance Analysis
– Prepare a flexible budget and describe how variance
analysis is used to control costs.
7/23/2022
1-92

Hamed Ali
Variance Analysis
… is the process of computing the differences
between standard costs and actual costs
and identifying the causes of those
differences
• Managers use
– Flexible budgets to improve variance analysis
– Variance analysis to control costs
7/23/2022
1-93

Hamed Ali
The Role of Flexible Budgets in Variance Analysis
• Accuracy of variance analysis depends
greatly on the type of budget managers
use when comparing variances
– Static budget
– Flexible budget
7/23/2022
1-94

Hamed Ali
The Role of Flexible Budgets in Variance
Analysis (cont’d)
• Static budget
– Also called fixed budget
– Forecasts revenues and expenses for just one
level of sales and just one level of output
• Does not allow for changes in output level
– If actual output differs from budgeted output, a
variance between actual and budgeted amounts
will occur
» Cannot judge performance accurately
7/23/2022
1-95

Hamed
Ali
Performance Report Using Data from a Static Budget
7/23/2022
1-96

Hamed Ali
Analysis (cont’d)
• Flexible budget
– Also called variable budget
– Summary of expected costs for a range of
activity levels
• Provides forecasted data that can be
adjusted for changes in output level
– Used primarily as a cost control tool in
evaluating performance
7/23/2022
1-97

Hamed Ali
Analysis (cont’d)
• Flexible budget formula
– An equation that determines the expected, or
budgeted, cost for any level of output
• Includes
– Per unit amount for variable costs
– Total amount for fixed costs
Costs
Fixed
Budgeted
Produced)
Units
of
No.
per Unit
Cost
(Variable
Costs
Budgeted
Total 


7/23/2022
1-98

Hamed
Ali
Flexible Budget for Evaluation of Overall Performance
7/23/2022
1-99

Hamed Ali
Analysis (cont’d)
• The flexible budget formula for Remember When,
Inc. is
• The company produced 19,100 units during 20x5
$9,450
Produced)
Units
of
No.
($3.71
Costs
Budgeted
Total 


$9,450
19,100)
($3.71
Costs
Budgeted
Total 


$9,450
$70,861

$80,311

7/23/2022
1-100

Hamed
Ali
Performance Report Using Data from a
Flexible Budget
7/23/2022
1-101

Hamed Ali
Using Variance Analysis to Control Costs
Compute variance
Is the variance
significant?
No corrective
action needed
No
Yes
Analyze variance to
determine its cause
Select performance
measures to correct
the problem
Take corrective action
Step 1
Step 2
Step 3
Step 4
7/23/2022
1-102

Hamed Ali
Using Variance Analysis to Control Costs
(cont’d)
• Computing the amount of a variance is
important
– But, this does not prevent the variance from
reoccurring
– Must determine its cause
• Select performance measures that will help
track the problem
• Must then find the best solution
7/23/2022
1-103

Hamed Ali
Discussion
Q. What is the flexible budget formula?
A. It is an equation used to determine
expected, or budgeted cost for any level of
output

 per Unit
Cost
(Variable
Costs
Budgeted
Total

Produced)
Units
of
No.
Costs
Fixed
Budgeted
7/23/2022
1-104

Hamed Ali
Computing and Analyzing Direct Materials
Variances
– Compute and analyze direct materials variances
7/23/2022
1-105

Hamed Ali
Computing and Analyzing Direct Materials
Variances
• To control operations, managers compute
and analyze variances for
– Whole cost categories
• Such as total direct materials costs
– Elements of those categories
• Such as the price and quantity of each direct
material
The more detailed the analysis of a variance is, the
more effective managers will be in controlling costs
7/23/2022
1-106

Hamed Ali
Computing Direct Materials Variances
• Total direct materials cost variance
– Difference between the standard cost and
actual cost of direct materials
7/23/2022 1-107

Hamed Ali
Computing Direct Materials Variances
Cambria Company makes leather bags. Each bag should use 4 feet of
leather (standard quantity), and the standard price of leather is $6.00
per foot. During August, the company purchased 760 feet of leather
costing $5.90 per foot and used the leather to produce 180 bags
cost
Standard


 bag)
per
feet
4
bags
(180
foot
per
$6.00
$4,320
720
foot
per
$6.00 

cost
actual
Less
4,484
760
foot
per
$5.90 


 quantity
standard
price
Standard

 quantity
actual
price
Actual
nce
cost varia
materials
direct
Total (U)
164
$
Actual cost > standard cost
This is an
unfavorable (U)
situation
7/23/2022 1-108

Hamed Ali
Computing Direct Materials Variances (cont’d)
• Total direct materials cost variance must be
broken into two parts to find the cause of
the variance
– Direct materials price variance
– Direct materials quantity variance
7/23/2022 1-109

Hamed Ali
• Direct materials price variance
– Difference between the standard price and the actual
price per unit multiplied by the actual quantity
purchased
– Also called the direct materials spending or rate
variance
Price)
Actual
Price
(Standard
Variance
Price
Materials
Direct 

Quantity
Actual

feet
760
$5.90)
($6.00 


Because the company paid less for direct materials than it expected,
the variance is favorable (F)
(F)
$76

7/23/2022 1-110

Hamed Ali
• Direct materials quantity variance
– Difference between the standard quantity and the
actual quantity used multiplied by the standard
price
– Also called the direct materials efficiency or usage
variance
Quantity
(Standard
Price
Standard
Variance
Quantity
Materials
Direct 

Quantity)
Actual
Allowed 
feet)
760
feet
(720
foot
per
$6.00 


Because the company used more for direct materials
than it expected, the variance is unfavorable (U)
(U)
$240

7/23/2022
1-111

Hamed Ali
• Test calculations of variances
– If correct, the net of the direct materials price
variance and direct materials quantity variance
will equal the total direct materials cost
variance
Direct materials price variance $ 76 (F)
Direct materials quantity variance 240 (U)
Total direct materials cost variance $164 (U)
7/23/2022
1-112

Hamed
Ali
Diagram of Direct Materials Variance Analysis
7/23/2022
1-113

Hamed Ali
Analyzing and Correcting Direct Materials
Variances
• Company had been experiencing direct materials
price variances and quantity variances for some
time
• For three months, managers tracked
– Purchasing activities
• Discovered that the purchasing agent had purchased, without
authorization, a lower grade of leather at a reduced price
– After analysis, engineers determined the lower grade of leather
was not appropriate
– Scrap and rework
• Discovered that inferior leather was causing the unfavorable
quantity variance
7/23/2022
1-114

Hamed Ali
Discussion
Q. What is the direct materials price
variance?
A. It is the difference between the standard
price and the actual price per unit
multiplied by the actual quantity
purchased. It is also called the direct
materials spending or rate variance
Price)
Actual
Price
(Standard
Variance
Price
Materials
Direct 

Quantity
Actual

7/23/2022 1-115

Hamed Ali
Computing and Analyzing Direct Labor
Variances
– Compute and analyze direct labor variances.
7/23/2022
1-116

Hamed Ali
Computing Direct Labor Variances
• Total direct labor cost variance
– Difference between the standard direct labor
cost for good units produced and actual direct
labor costs
• Good units are the total units produced less
units that are scrapped or need to be
reworked
7/23/2022
1-117

Hamed Ali
Computing Direct Labor Variances (cont’d)
At Cambria Company, each leather bag requires 2.4 standard direct
labor hours, and the standard direct labor rate is $8.50 per hour.
During August, 450 direct labor hours were used to make 180 bags at
an average pay rate of $9.20 per hour
cost
Standard


 bag)
per
hours
2.4
bags
(180
foot
per
$8.50
$3,672
hours
432
hour
per
$8.50 

cost
actual
Less
4,140
hours
450
hour
per
$9.20 


 allowed
hours
standard
rate
Standard

 hours
actual
rate
Actual
nce
cost varia
labor
direct
Total (U)
468
$
7/23/2022 1-118

Hamed Ali
• Total direct labor cost variance must be
broken onto two parts to find the cause of
the variance
– Direct labor rate variance
– Direct labor efficiency variance
7/23/2022
1-119

Hamed Ali
• Direct labor rate variance
– Difference between the standard direct labor rate and
the actual direct labor rate multiplied by the actual
direct labor hours worked
– Also called the direct labor spending variance
Rate)
Actual
Rate
(Standard
Variance
Rate
Labor
Direct 

Hours
Actual

hours
450
$9.20)
($8.50 


(U)
$315

Because the company paid more per hour for direct labor than it
expected, the variance is unfavorable
7/23/2022 1-120

Hamed Ali
• Direct labor efficiency variance
– Difference between the standard direct labor hours
allowed for good units produced and the actual
direct labor hours worked multiplied by the
standard direct labor rate
– Also called the direct labor quantity or usage
variance
Allowed
Hours
(Standard
Rate
Standard
Variance
Efficiency
Labor
Direct 

Hours)
Actual

hours)
450
hours
(432
hour
per
$8.50 


(U)
$153

Because the company used more direct labor hours than it expected,
the variance is unfavorable (U)
7/23/2022 1-121

Hamed Ali
– If correct, the net of the direct labor rate
variance and direct labor efficiency variance
will equal the total direct labor cost variance
Direct labor rate variance $ 315 (U)
Direct labor efficiency variance 153 (U)
Total direct labor cost variance $468 (U)
7/23/2022
1-122

Diagram
of Direct
Labor
Variance
Analysis
7/23/2022
Hamed Ali

Hamed Ali
Analyzing and Correcting Direct Labor
Variances
• Managers analyzed
– Employee time cards
• An assembly worker who had fallen ill was replaced with a
machinery operator from another department
– Assembly worker is paid $8.50 per hour and the machine
operator is paid $9.20 per hour
– Machine operator not as skilled as the assembly worker
» Temporary situation so no corrective action taken
– Materials handling
• Parts delivered late on five occasions
– Will track delivery time and number of delays for next three
months
7/23/2022
1-124

Hamed Ali
Discussion
Q. What is the direct labor efficiency
variance?
A. The direct labor efficiency variance is the
difference between the standard direct
labor hours allowed for good units
produced and the actual direct labor
hours worked multiplied by the standard
direct labor rate. It is also called the
direct labor quantity or usage variance
Hours
(Standard
Rate
Standard
Variance
Efficiency
Labor
Direct 

Hours)
Actual
Allowed 
7/23/2022
1-125

Hamed Ali
Computing and Analyzing Manufacturing
Overhead Variances
– Compute and analyze manufacturing overhead
variances
7/23/2022
1-126

Hamed Ali
Computing and Analyzing Manufacturing
Overhead Variances
• Controlling variable and fixed overhead costs is
more difficult for managers than controlling direct
materials and direct labor costs
– Responsibility for manufacturing overhead costs is hard
to assign
• Fixed overhead costs
– Unavoidable past costs
– Not under the control of any department manager
• Variable overhead costs
– Some control possible if they can be related to departments or
activities
7/23/2022
1-127

Hamed Ali
Using a Flexible Budget to Analyze
Manufacturing Overhead Variances
• Fuchsia Company’s managers use a
flexible budget to evaluate performance
– For manufacturing overhead costs only
– Evaluate activity level using direct labor hours
• Variable costs vary with the number of
direct labor hours worked
• Total fixed overhead costs remain constant
7/23/2022
1-128

Flexible
Budget for
Evaluation of
Manufacturing
Overhead
Costs
7/23/2022
Hamed Ali
1-129

Hamed Ali
Using a Flexible Budget to Analyze
Manufacturing Overhead Variances
• Flexible budget formula
• Flexible budget formula when applied to
Cambria’s data

 Hour
Labor
Direct
per
Costs
(Variable
Costs
OH
Budgeted
Total

Hours)
Labor
Direct
of
Number
Costs
OH
Fixed
Budgeted
Hours)
Labor
Direct
of
No.
($5.75
Costs
OH
Budgeted
Total 

$1,300

To find the total monthly budgeted overhead costs, insert direct labor
hours into the flexible budget
7/23/2022 1-130

Hamed Ali
Computing Manufacturing Overhead Variances
• Total manufacturing overhead variance
– Difference between actual overhead costs and
standard overhead costs
• Standard overhead costs are applied to
production using a standard overhead rate
– Standard overhead rate has two parts
» Variable
» Fixed
7/23/2022 1-131

Hamed Ali
Computing Manufacturing Overhead
Variances (cont’d)
For Cambria Company, the standard variable overhead rate is $5.75
per direct labor hour (from the flexible budget). Total budgeted
overhead is $1,300 by normal capacity, which is 400 direct labor
hours.
rate
overhead
Fixed
$3.25
hours
labor
direct
400
$1,300 

rate
overhead
standard
Total
$9.00
$3.25
$5.75 


 capacity
normal
overhead
fixed
Budgeted

 rate
overhead
fixed
standard
rate
overhead
variable
Standard
7/23/2022
1-132

Hamed Ali
Computing Manufacturing Overhead
Variances (cont’d)
For Fuchsia Company, the standard variable overhead rate is $5.75 per
direct labor hour (from the flexible budget). Total budgeted overhead is
$1,300 by normal capacity, which is 400 direct labor hours.
888
,
3
$
bag)
per
hours
2.4
bags
(180
hour
labor
direct
per
$9.00 


costs
overhead
actual
Less
produced
units
good
to
applied
costs
OH
Standard
variance
overhead
ing
manufactur
Total (U)
212
$
This amount can be divided into variable overhead
variances and fixed overhead variances
produced
units
good
No.
(
rate
OH
standard
Total 

 allowed)
hours
standard
4,100
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Variable Overhead Variance
• Total variable overhead variance
– Difference between actual variable overhead
costs and the standard variable overhead costs
that are applied to good units produced using
the standard variable rate
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Variable Overhead Variances (cont’d)
At Fuchsia Company, each leather bag requires 2.4 standard labor
hours and the variable overhead rate is $5.75 per direct labor hour.
During August, the company incurred $2,500 of variable overhead
costs


 bag)
per
hours
2.4
bags
(180
hour
per
$5.75
cost
actual
Less
produced
units
good
to
applied
Overhead
nce
cost varia
overhead
variable
Total (U)
16
$

 allowed
hours
labor
direct
standard
rate
variable
Standard
2,500
$2,484
hours
432
hour
per
$5.75 

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Diagram of
Variable
Overhead
Variance
Analysis
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Hamed Ali
• Total variable overhead cost variance must
be broken into two parts to find the cause
of the variance
– Variable overhead spending variance
– Variable overhead efficiency variance
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• Variable overhead spending variance
– Difference between the budgeted variable
overhead costs at actual hours and actual
variable overhead
Hours
Actual
at
Costs
Variable
Budgeted
Variance
Spending
OH
Variable 

Overhead
Variable
Actual
Actual
Rate
Variable
(Standard 

OH
Variable
Actual
Worked)
Hours 
$2,500
hours)
450
($5.75 


(F)
$87.50

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• Variable overhead efficiency variance
– Difference between the standard direct labor
hours allowed for good units produced and the
actual hours worked multiplied by the standard
variable overhead rate
(Standard
Rate
Variable
Standard
Variance
Efficiency
OH
Variable 

Hours)
Actual
Allowed
Hours 
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• Compute standard hours allowed
• Compute variable overhead efficiency variance
hours)
450
hours
(432
$5.75 


Bag
per
Hours
Standard
Produced
Units
Good
Allowed
Hours
Standard 

bag
per
hours
2.4
bags
180 

hours
432

(U)
50
.
103
$

(Standard
Rate
Variable
Standard
Variance
Efficiency
OH
Variable 

Hours)
Actual
Allowed
Hours 
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– If correct, the net of the variable overhead
spending variance and variable overhead
efficiency variance will equal the total variable
overhead cost variance
Variable overhead spending variance $ 87.50 (F)
Variable overhead efficiency variance 103.50 (U)
Total variable overhead cost variance $ 16.00 (U)
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Fixed Overhead Variances
• Total fixed overhead variance
– Difference between actual fixed overhead
costs and the standard fixed overhead costs
that are applied to good units produced using
the standard fixed overhead rate
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Diagram
of Fixed
Overhead
Variance
Analysis
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Hamed Ali
Fixed Overhead Variances (cont’d)
At Fuchsia Company, each leather bag requires 2.4 standard direct labor
hours and the standard fixed overhead rate is $3.25 per direct labor hour.
During August, the company incurred $1,600 of actual fixed overhead costs


 bag)
per
hours
2.4
bags
(180
hour
per
$3.25
produced
units
good
to
applied
Overhead
nce
cost varia
overhead
fixed
Total (U)
196
$

 allowed
hours
labor
direct
standard
rate
fixed
Standard
cost
actual
Less 1,600
$1,404
hours
432
hour
per
$3.25 

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• Total fixed overhead cost variance must be
broken into two parts to find the cause of the
variance
– Fixed overhead budget variance
– Fixed overhead volume variance
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• Fixed overhead budget variance
– Difference between the budgeted and actual
fixed overhead costs
– Also called budgeted fixed overhead variance
Overhead
Fixed
Budgeted
Variance
Budget
OH
Fixed 

Overhead
Fixed
Actual
$1,600
$1,300

(U)
$300

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• Fixed overhead volume variance
– Difference between budgeted fixed overhead
costs and manufacturing overhead costs
applied to production using the standard fixed
overhead rate
hours
labor
direct
432
for
applied
OH
fixed
Standard
bag)
per
hours
2.4
bags
(180
hour
labor
direct
per
$3.25 
 $1,404
overhead
fixed
budgeted
total
Less 1,300
nce
cost varia
overhead
variable
Total (F)
104
$
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• A volume variance will occur if more or less than
normal capacity is used
– Fixed overhead volume variance measures the use of
existing facilities and capacity
– Favorable overhead volume variance
• Capacity exceeds the expected amount
– Unfavorable overhead volume variance
• Company operates at a level below normal capacity
– May be in best interest of company during periods of slow sales
– Means company is not building up excess inventory
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Summary of Manufacturing Overhead
Variances
Variable overhead spending variance $ 87.50 (F)
Variable overhead efficiency variance 103.50 (U)
Fixed overhead budget variance 300.00 (U)
Fixed overhead volume variance 104.00 (F)
Total manufacturing overhead variance $212.00 (U)
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Analyzing and Correcting Manufacturing
Overhead Variances
Variance Amount Cause Corrective Action
Variable overhead
spending variance
$87.50 (F) Savings on purchases No action
Variable overhead
efficiency variance
103.50 (U)
Inefficiency of machine
operator who substituted for ill
assembly worker
Consider feasibility of
implementing a program for
cross-training employees
Fixed overhead
budget variance
300.00 (U)
Higher than expected factory
insurance premiums due to
increased claims filed by
employees
Study insurance claims filed
over a three-month period
Fixed overhead
volume variance
104.00 (F)
Overutilization of capacity
traced to high seasonal demand
No action necessary because
variance fell within anticipated
range
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Discussion
Q. What four variances are used to analyze
the total manufacturing overhead
variance?
A. Variable overhead spending variance
Variable overhead efficiency variance
Fixed overhead budget variance
Fixed overhead volume variance
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Using Cost Variances to Evaluate Managers’
Performance
– Explain how variances are used to evaluate
managers’ performance
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Performance
• The effectiveness and fairness of a
manager's performance evaluation
depends on
– Human factors
– Company policies
• Should be based on input from managers
and employees
• Should specify procedures that managers
are to use
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Performance (cont’d)
• Procedures that should be specified for
managers
– Preparing operational plans
– Assigning responsibility for carrying out the
operational plans
– Communicating operational plans to key personnel
– Evaluating performance in each area of responsibility
– Identifying causes of significant variances from the
operational plan
– Taking corrective action to eliminate problems
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• Variance analysis
– Provides detailed data about differences
between standard and actual costs
• Effective at pinpointing efficient and
inefficient operating areas
– Basic comparison of budgeted and actual data
not as effective
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• Effective managerial performance reports based
on standard costs and related variances should
– Identify
• Causes of the differences
• Personnel involved
• Corrective actions taken
– Be tailored to the manager’s specific areas of
responsibility
• Explain clearly and accurately in what way the manager’s
department did or did not meet operating expectations
Managers should only be held accountable for cost areas under their control
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• Managerial performance reports should
– Summarize all cost data
– Include variances for direct materials, direct
labor, and manufacturing overhead
– Identify
• Causes of variances
• Corrective actions taken
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• The occurrence of a variance does not
indicate poor performance
• If a variance consistently occurs, its cause
is not identified, and no corrective action is
taken, it may indicate poor performance on
the part of the manager
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Discussion
Q. What items should be included in an
effective managerial performance report?
A. Summarization of all cost data
Variances for direct materials, direct labor,
and manufacturing overhead
Identification of the causes of the variances,
personnel involved, and any corrective
actions taken
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Part Three
Pricing
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Pricing and Business
• How companies price a product or service
ultimately depends on the demand and
supply for it
• Three influences on demand & supply:
1. Customers
2. Competitors
3. Costs
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Influences on Demand & Supply
1. Customers – influence price through their effect
on the demand for a product or service, based on
factors such as quality and product features
2. Competitors – influence price through their
pricing schemes, product features, and production
volume
3. Costs – influence prices because they affect
supply (the lower the cost, the greater the quantity
a firm is willing to supply)
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Time Horizons and Pricing
• Short-run pricing decisions have a time horizon of
less than one year and include decisions such as:
– Pricing a one-time-only special order with no long-run
implications
– Adjusting product mix and output volume in a competitive
market
• Long-run pricing decisions have a time horizon of
one year or longer and include decisions such as:
– Pricing a product in a major market where there is some
leeway in setting price
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Differences Affecting Pricing:
Long Run vs. Short Run
1.Costs that are often irrelevant for short-run policy
decisions, such as fixed costs that cannot be
changed, are generally relevant in the long run
because costs can be altered in the long run.
2.Profit margins in long-run pricing decisions are often
set to earn a reasonable return on investment –
prices are decreased when demand is weak and
increased when demand is strong.
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Alternative Long-Run Pricing
Approaches
• Market-Based: price charged is based on
what customers want and how competitors
react
• Cost-Based: price charged is based on
what it cost to produce, coupled with the
ability to recoup the costs and still achieve
a required rate of return
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ABC Manufacturing Cost Illustration
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Product Profitability Using ABC
Costing: Illustration
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Markets and Pricing
• Competitive Markets - use the market-
based approach
• Less-Competitive Markets – can use
either the market-based or cost-based
approach
• Non-Competitive Markets – use cost-
based approaches
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Market-Based Approach
• Starts with a target price
• Target Price – estimated price for a
product or service that potential customers
will pay.
• Estimated on customers perceived value
for a product or service and how
competitors will price competing products
or services
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Understanding the
Market Environment
• Understanding customers and competitors
is important because:
1. Competition from lower cost producers has
meant that prices cannot be increased
2. Products are on the market for shorter periods
of time, leaving less time and opportunity to
recover from pricing mistakes
3. Customers have become more knowledgeable
and demand quality products at reasonable
prices
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Five Steps in Developing
Target Prices and Target Costs
1. Develop a product that satisfies the needs of
potential customers
2. Choose a target price
3. Derive a target cost per unit:
– Target Price per unit minus Target Operating Income per
unit
4. Perform cost analysis
5. Perform value engineering to achieve target cost
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Value Engineering
• Value Engineering is a systematic
evaluation of all aspects of the value-chain,
with the objective of reducing costs while
improving quality and satisfying customer
needs
• Managers must distinguish value-added
activities and costs from non-value-added
activities and costs
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Value Engineering Terminology
• Value-Added Costs – a cost that, if eliminated,
would reduce the actual or perceived value or
utility (usefulness) customers obtain from using
the product or service
• Non-Value-Added Costs – a cost that, if
eliminated, would not reduce the actual or
perceived value or utility customers obtain from
using the product or service. It is a cost the
customer is unwilling to pay for
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Value Engineering Terminology
• Cost Incurrence – describes when a
resource is consumed (or benefit
foregone) to meet a specific objective
• Locked-in Costs (Designed-in Costs) –
are costs that have not yet been incurred
but, based on decisions that have already
been made, will be incurred in the future
– Are a key to managing costs well
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Cost Incurrence
and Locked-In Costs Graph
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Problems with Value Engineering
and Target Costing
1. Employees may feel frustrated if they fail to attain
targets
2. A cross-functional team may add too many feature
just to accommodate the wishes of team members
3. A product may be in development for along time
as alternative designs are repeatedly evaluated
4. Organizational conflicts may develop as the
burden of cutting costs falls unequally on different
business functions in the firm’s value chain
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Target Costing Illustration
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Target Costing Illustration, Continued
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Cost-Based (Cost-Plus) Pricing
• The general formula adds a markup
component to the cost base to determine a
prospective selling price
• Usually only a starting point in the price-
setting process
• Markup is somewhat flexible, based
partially on customers and competitors
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Forms of Cost-Plus Pricing
• Setting a Target Rate of Return on Investment: the
Target Annual Operating Return that an
organization aims to achieve, divided by Invested
Capital
• Selecting different cost bases for the “cost-plus”
calculation:
– Variable Manufacturing Cost
– Variable Cost
– Manufacturing Cost
– Full Cost
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Common Business Practice
• Most firms use full cost for their cost-based
pricing decisions, because:
– Allows for full recovery of all costs of the product
– Allows for price stability
– It is a simple approach
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Life-Cycle Product
Budgeting and Costing
• Product Life-Cycle spans the time from initial R&D on
a product to when customer service and support are
no long offered on that product (orphaned)
• Life-Cycle Budgeting involves estimating the revenues
and individual value-chain costs attributable to each
product from its initial R&D to its final customer service
and support
• Life-Cycle Costing tracks and accumulates individual
value-chain costs attributable to each product from its
initial R&D to its final customer service and support
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Important Considerations for
Life-Cycle Budgeting
• Nonproduction costs are large
• Development period for R&D and design is
long and costly
• Many costs are locked in at the R&D and
design stages, even if R&D and design
costs are themselves small
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Life Cycle Budgeting, Illustrated
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Other Important Considerations
in Pricing Decisions
• Price Discrimination – the practice of
charging different customers different prices
for the same product or service
– Legal Implications
• Peak-Load Pricing – the practice of
charging a higher price for the same
product or service when the demand for it
approaches the physical limit of the
capacity to product that product or service
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The Legal Dimension of
Price Setting
• Price Discrimination is illegal if the intent is
to lessen or prevent competition for
customers
• Predatory Pricing – deliberately lowering
prices below costs in an effort to drive
competitors out of the market and restrict
supply, and then raising prices
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Job-Costing and Process Costing:
Opposite Ends of a Continuum
Job-Costing Systems
Distinct, identifiable
units of a product
or service
Examples:
Custom-made
machines,
Houses
Process-Costing
Systems
Masses of identical
or similar units of a
product or service
Examples:
Food,
Chemical processing
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Process-Costing
• Process-costing is a system where the unit cost of a
product or service is obtained by assigning total
costs to many identical or similar units
• Each unit receives the same or similar amounts of
direct materials costs, direct labor costs, and
manufacturing overhead
• Unit costs are computed by dividing total costs
incurred by the number of units of output from the
production process
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Process-Costing Assumptions
• Direct Materials are added at the
beginning of the production process, or at
the start of work in a subsequent
department down the assembly line
• Conversion Costs are added equally along
the production process
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Five-Step Process-Costing Allocation
1. Summarize the flow of physical units of
output
2. Compute output in terms of equivalent
units
3. Compute cost per equivalent unit
4. Summarize total costs to account for
5. Assign total costs to units completed and
to units in ending Work-in-Process
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Equivalent Units
• A derived amount of output units that:
1. Takes the quantity of each input in units
completed and in unfinished units of work in
process and
2. converts the quantity of input into the amount
of completed output units that could be
produced with that quantity of input
• Are calculated separately for each input
(direct materials and conversion cost)
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Steps 1 & 2 Illustrated
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Steps 3, 4 & 5, Illustrated
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General Ledger Cost Flows
Illustrated
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Weighted-Average
Process-Costing Method
• Calculates cost per equivalent unit of all
work done to date (regardless of the
accounting period in which it was done)
• Assigns this cost to equivalent units
completed & transferred out of the process,
and to incomplete units in still in-process
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Weighted-Average
• Weighted-average costs is the total of all
costs in the Work-in-Process Account
divided by the total equivalent units of work
done to date
• The beginning balance of the Work-in-
Process account (work done in a prior
period) is blended in with current period
costs
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Steps 1 & 2 Illustrated
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Steps 3, 4 & 5 Illustrated
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Result of the Process
• Two critical figures arise out of Step Five
of the cost allocation process:
1. The amount of the Journal Entry transferring
the allocated cost of units completed and sent
from Work-in-Process Inventory to Finished
Goods Inventory
2. The ending balance of the Work-in-Process
Inventory account that will appear on the
Balance Sheet
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First-in, First-Out
• Assigns the cost of the previous accounting
period’s equivalent units in beginning work-in-
process inventory to the first units completed and
transferred out of the process
• Assigns the cost of equivalent units worked on
during the current period first to complete
beginning inventory, next to stat and complete new
units, and lastly to units in ending work-in-process
inventory
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First-in, First-Out
• The beginning balance of the Work-in-
Process account (work done in a prior
period) is kept separate from current
period costs
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Steps 1 & 2, Illustrated
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Result of the Process (as before)
• Two critical figures arise out of Step Five
of the cost allocation process:
1. The amount of the Journal Entry transferring
the allocated cost of units completed and
sent from Work-in-Process Inventory to
Finished Goods Inventory
2. The ending balance of the Work-in-Process
Inventory account that will appear on the
Balance Sheet
7/23/2022 Hamed Ali

Standard Costing and
Process Costing
• Teams of design and process engineers,
operations personnel, and management
accountants work together to determine
separate standard costs per equivalent
unit on the basis of different technical
processing specifications for each product
• Standard costs replace actual costs in
equivalent unit calculations
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General Ledger Cost Flows
Illustrated
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Transferred-in Costs
• Are costs incurred in previous departments that are
carried forward as the products cost when it moves
to a subsequent process in the production cycle
• Also called Previous Department Costs
• Journal entries are made to mirror the progress in
production from department to department
• Transferred-in costs are treated as if they are a
separate type of direct material added at the
beginning of the process
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The Costs of Production
• The Market Forces of Supply and Demand
– Supply and demand are the two words that
economists use most often.
– Supply and demand are the forces that make
market economies work.
– Modern microeconomics is about supply,
demand, and market equilibrium.
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WHAT ARE COSTS?
• According to the Law of Supply:
– Firms are willing to produce and sell a greater
quantity of a good when the price of the good
is high.
– This results in a supply curve that slopes
upward.
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Total Revenue, Total Cost, and Profit
• Total Revenue
– The amount a firm receives for the sale of
its output.
• Total Cost
– The market value of the inputs a firm uses
in production.
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Total Revenue, Total Cost, and Profit
• Profit is the firm’s total revenue minus its
total cost.
• Profit = Total revenue - Total cost
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Costs as Opportunity Costs
• A firm’s cost of production includes all the
opportunity costs of making its output of
goods and services.
• Explicit and Implicit Costs
– A firm’s cost of production include explicit costs
and implicit costs.
• Explicit costs are input costs that require a
direct outlay of money by the firm.
• Implicit costs are input costs that do not
require an outlay of money by the firm.
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Economic Profit versus Accounting Profit
• Economists measure a firm’s economic
profit as total revenue minus total cost,
including both explicit and implicit costs.
• Accountants measure the accounting profit
as the firm’s total revenue minus only the
firm’s explicit costs.
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Economic Profit versus Accounting Profit
• When total revenue exceeds both explicit
and implicit costs, the firm earns economic
profit.
• Economic profit is smaller than accounting
profit.
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Figure 1 Economists versus
Accountants
Revenue
Total
opportunity
costs
How an Economist
Views a Firm
How an Accountant
Views a Firm
Revenue
Economic
profit
Implicit
costs
Explicit
costs
Explicit
costs
Accounting
profit
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PRODUCTION AND COSTS
• The Production Function (Productivity)
– The production function shows the relationship
between quantity of inputs used to make a good
and the quantity of output of that good.
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The Production Function
• Marginal Product
– The marginal product of any input in the
production process is the increase in output
that arises from an additional unit of that input.
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Table 1 A Production Function and Total
Cost: Hungry Helen’s Cookie Factory
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• Diminishing marginal product is the
property whereby the marginal product of
an input declines as the quantity of the
input increases.
– Example: As more and more workers are hired
at a firm, each additional worker contributes
less and less to production because the firm
has a limited amount of equipment.
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Figure 2 Hungry Helen’s Production
Function
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
0 1 2 3 4 5 6 7
Number of Workers Hired
Quantity of output
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• Diminishing Marginal Product
– The slope of the production function measures
the marginal product of an input, such as a
worker.
– When the marginal product declines, the
production function becomes flatter.
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From the Production Function to the
Total-Cost Curve
• The relationship between the quantity a firm
can produce and its costs determines
pricing decisions.
• The total-cost curve shows this relationship
graphically.
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Table 1 A Production Function and Total
Cost: Hungry Helen’s Cookie Factory
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Figure 2 Hungry Helen’s Total-Cost
Curve
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160
Total
Cost
Quantity
of Output
(cookies per hour)
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THE VARIOUS MEASURES OF COST
• Costs of production may be divided into
fixed costs and variable costs.
– Fixed costs are those costs that do not vary
with the quantity of output produced.
– Variable costs are those costs that do vary
with the quantity of output produced.
7/23/2022 Hamed Ali

Fixed and Variable Costs
• Total Costs
– Total Fixed Costs (TFC)
– Total Variable Costs (TVC)
– Total Costs (TC)
– TC = TFC + TVC
7/23/2022 Hamed Ali

Table 2 The Various Measures of Cost:
Thirsty Thelma’s Lemonade Stand
7/23/2022
Hamed Ali
1-232

• Average Costs
– Average costs can be determined by dividing
the firm’s costs by the quantity of output it
produces.
– The average cost is the cost of each typical
unit of product.
7/23/2022 Hamed Ali

• Average Costs
– Average Fixed Costs (AFC)
– Average Variable Costs (AVC)
– Average Total Costs (ATC)
– ATC = AFC + AVC
7/23/2022 Hamed Ali

Average and Marginal Costs
Fixed cost
Quantity
FC
AFC
Q
 
Variable cost
Quantity
VC
AVC
Q
 
Total cost
Quantity
TC
ATC
Q
 
7/23/2022 Hamed Ali

Average and Marginal Costs
• Marginal Cost
– Marginal cost (MC) measures the increase in
total cost that arises from an extra unit of
production.
– Marginal cost helps answer the following
question:
• How much does it cost to produce an
additional unit of output?
7/23/2022 Hamed Ali

Average and Marginal Cost
(change in total cost)
(change in quantity)
TC
MC
Q

 

7/23/2022 Hamed Ali

Thirsty Thelma’s Lemonade Stand
Quantity Total
Cost
Marginal
Cost
Quantity Total
Cost
Marginal
Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
5 6.50 1.10 10 15.00 2.10
Note how Marginal Cost changes with each change in Quantity.
7/23/2022 Hamed Ali

Figure 4 Thirsty Thelma’s Average-
Cost and Marginal-Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantity
of Output
(glasses of lemonade per hour)
0 1 4
3
2 7
6
5 9
8 10
MC
ATC
AVC
AFC
7/23/2022
Hamed Ali
1-239

Cost Curves and Their Shapes
• Marginal cost rises with the amount of
output produced.
– This reflects the property of diminishing
marginal product.
7/23/2022 Hamed Ali

• The average total-cost curve is U-shaped.
• At very low levels of output average total
cost is high because fixed cost is spread
over only a few units.
• Average total cost declines as output
increases.
• Average total cost starts rising because
average variable cost rises substantially.
7/23/2022 Hamed Ali

• The bottom of the U-shaped ATC curve
occurs at the quantity that minimizes
average total cost. This quantity is
sometimes called the efficient scale of
the firm.
7/23/2022 Hamed Ali

• Relationship between Marginal Cost and
Average Total Cost
– Whenever marginal cost is less than average
total cost, average total cost is falling.
– Whenever marginal cost is greater than
average total cost, average total cost is rising.
7/23/2022 Hamed Ali

• Relationship between Marginal Cost and
Average Total Cost
– The marginal-cost curve crosses the average-
total-cost curve at the efficient scale.
• Efficient scale is the quantity that minimizes
average total cost.
7/23/2022 Hamed Ali

Typical Cost Curves
• It is now time to examine the relationships
that exist between the different measures
of cost.
7/23/2022 Hamed Ali

Typical Cost Curves
•Three Important Properties of Cost Curves
– Marginal cost eventually rises with the quantity
of output.
– The average-total-cost curve is U-shaped.
– The marginal-cost curve crosses the average-
total-cost curve at the minimum of average total
cost.
7/23/2022 Hamed Ali

Economies and Diseconomies of Scale
• Economies of scale refer to the property
whereby long-run average total cost falls as the
quantity of output increases.
• Diseconomies of scale refer to the property
whereby long-run average total cost rises as
the quantity of output increases.
• Constant returns to scale refers to the
property whereby long-run average total cost
stays the same as the quantity of output
increases.
7/23/2022
Hamed Ali
1-247

Figure 6 Average Total Cost in the
Short and Long Run
Quantity of
Cars per Day
0
Average
Total
Cost
1,200
$12,000
1,000
10,000
Economies
of
scale
ATC in short
run with
small factory
ATC in short
run with
medium factory
ATC in short
run with
large factory ATC in long run
Diseconomies
of
scale
Constant
returns to
scale
7/23/2022 Hamed Ali
@Hamed.Ali.Mohamed2@gmail.c 1-248

• The goal of firms is to maximize profit, which
equals total revenue minus total cost.
• When analyzing a firm’s behavior, it is
important to include all the opportunity costs
of production.
• Some opportunity costs are explicit while
other opportunity costs are implicit.
7/23/2022 Hamed Ali
OCR – Operation Cost Reduction

• A firm’s costs reflect its production
process.
– A typical firm’s production function gets flatter
as the quantity of input increases, displaying the
property of diminishing marginal product.
– A firm’s total costs are divided between fixed
and variable costs. Fixed costs do not change
when the firm alters the quantity of output
produced; variable costs do change as the firm
alters quantity of output produced.
7/23/2022 Hamed Ali
Continue

• Average total cost is total cost divided by
the quantity of output.
• Marginal cost is the amount by which total
cost would rise if output were increased by
one unit.
• The marginal cost always rises with the
quantity of output.
• Average cost first falls as output increases
and then rises.
7/23/2022 Hamed Ali
Continue

• The average-total-cost curve is U-shaped.
• The marginal-cost curve always crosses the
average-total-cost curve at the minimum of
ATC.
• A firm’s costs often depend on the time
horizon being considered.
• In particular, many costs are fixed in the
short run but variable in the long run.
7/23/2022 Hamed Ali
Continue

Using Activity-Based Costing to Implement
Supply Chain Improvements
7/23/2022 Hamed Ali
Part Four

•Critical link exists between corporate profitability
and logistics costs and performance
•Many logistics costs and effects of logistics
decisions buried in overhead costs
•Logistics particularly requires accurate costing
– Diversity in resource consumption
– Products and resource consumption not
correlated with unit based allocation measures
•Identifying and costing activities may reveal
opportunities to improve operating efficiencies
Transportation and logistics managers
need more accurate cost information
7/23/2022 Hamed Ali

Problems typically encountered in transportation
and logistics accounting systems
• Visibility frequently lost--included as part of SG&A
• Allocated using cases shipped, miles, or sales
• Costs not available by product, customer, or
supply channel
• Affect of logistics decisions/improvements not
readily apparent
• Output measures frequently not captured
7/23/2022 Hamed Ali

Activity
DIRECT
MATERIALS
Direct
Labor
Activity
DIRECT
MATERIALS
Activity
DIRECT
MATERIALS
Activity
DIRECT
MATERIALS
OUTPUT $$
Traditional Cost Accounting
Direct
Labor
Direct
Labor
Direct
Labor
Overhead
7/23/2022 Hamed Ali

Problems with Traditional
Costing of Transportation & Logistics
• Unit based allocation suggests costs will vary with volume--
cannot accurately determine how changes in customer service
effect total costs
• No reward for reducing indirect cost categories--benefits
diffused across all products
• Costs “reduced” by eliminating direct labor
• Overhead costs appear “fixed” and not affected by management
action
• Rewards based on cost center performance and not on total
product/customer/channel profitability
7/23/2022 Hamed Ali

Supervision
Office
Support Utilities Supplies Equipment
Receiving Put-Away Set-Ups
Resources
Activities
Cost
Objects
Packing &
Shipping
Product
Division A
Product
Division B
Product
Division C
Product
Division D
a technique to assign
more accurately direct
and indirect costs to
the activities,
customers or products
which consume an
organization’s
resources
Activity-Based Costing
7/23/2022 Hamed Ali
258

Activity-Based Costing
IS:
An overhead
allocation
technique which
generates the
cost of activities
IS NOT:
A bookkeeping
system
A consolidation
system
7/23/2022 Hamed Ali

General
Ledger
(account
balances)
ABC
Model
Data
Decision
Makers
Activity-based
information
Cost data
translated
by ABC
ABC translates traditional costing
into actionable information for decision-makers
7/23/2022 Hamed Ali

Supervision
Office
Support
Utilities Supplies Equipment
Receiving Put-Away Set-Ups
Resources
Activities
Cost
Objects
Packing &
Shipping
Product
Division A
Product
Division B
Product
Division C
Product
Division D
How Does ABC Assign Costs?
ABC uses a two-stage
process to assign costs
– Resource costs are
assigned to activities
based on use
– Activity costs are
assigned to the products
or customers consuming
the activity
7/23/2022 Hamed Ali
261

Activity
DIRECT
MATERIALS
Direct
Labor
Activity
DIRECT
MATERIALS
Activity
DIRECT
MATERIALS
Activity
DIRECT
MATERIALS
OUTPUT $$
Activity-based costing approach
Overhead
Direct
Labor
Overhead
Direct
Labor
Overhead
Direct
Labor
Overhead
7/23/2022 Hamed Ali

Profitability and
Productivity Analysis
Part Five
7/23/2022 Hamed Ali

Profitability and Productivity Analysis
 Productivity Analysis
is the assessment of
the sales or market
share consequences
of a marketing
strategy
 Profitability Analysis
is the assessment of the
impact of various
marketing strategies on
the profit contribution
that can be expected
from a product or
product line
7/23/2022 Hamed Ali

Factors to Consider in Making Marketing Expenditures
Impact on
Profitability Structure
Expected Productivity
in Terms of Sales
Product Objective
Industry Sales
Forecast
Decision
7/23/2022 Hamed Ali

Profit and Loss Statement
Sales ................................................................................................... $4640
Less cost of goods sold ................................. ...................... 2300
Gross Profit Margin .............................................................. $2340
Operating Expenses:
Advertising ......................................................... $600
Sales Salaries ...................................................... 500
Sales Commissions ............................................. 220
Designer’s Salaries ............................................. 400
Other (general and admin. costs )........................ 600
Total operating expense .......................................... 2320
Net operating profit (loss) before taxes .............................................. $20
7/23/2022 Hamed Ali

Measuring Product Profitability
Need to Distinguish Between:
Variable costs
Fixed Costs
– direct or tracable
– indirect or nontracable
7/23/2022 Hamed Ali

Contribution Margin Statement
Sales ............................................................................................................ $4640
Less variable cost of goods sold (Labor, materials, etc.) ............. 1620
Gross Profit Margin ...................................................................... $3020
Less other variable selling costs (sales commissions) ................. 220
Variable contribution margin ...................................................................... $2800
Fixed costs:
Advertising ................................................................. $600
Sales salaries .............................................................. 500
Fixed production costs ............................................... 680
Designer’s salaries ..................................................... 400
General and administrative overhead ......................... 600
Total operating expense ................................................. 2780
Net operating profit before taxes ................................................................. $ 20
7/23/2022 Hamed Ali

Company
Total Umbrellas Sweaters Jackets Cap
Sales $4640 $840 $2400 $1200 $200
Variable cost of goods sold 1620 400 800 380 40
Gross Profit Margin $3020 $440 $1600 $ 820 $160
Other variable costs 220 40 120 60 0
Variable contribution margin $2800 $400 $1480 $ 760 $160
Direct, traceable fixed costs:
Sales salaries $ 500 $ 20 $ 360 $ 120 $ 0
Designer’s salaries 400 0 300 100 0
Fixed production costs 680 100 340 230 10
Advertising of product lines 300 40 200 60 0
Total $1880 $160 $1200 $ 510 $ 10
Total Contribution $ 920 $240 $ 280 $ 250 $150
Indirect, nontraceable fixed costs:
Institutional advertising$ 300
General and admin. overhead 900
Total $1200
Net Operating Profit $ 20
Contribution by Product Line
7/23/2022 Hamed Ali

Percentage Variable Contribution Margins
Umbrellas Sweaters Jackets Caps
Number of customers 28,000 40,000 20,000 50,000
Average price paid $30 $60 $60 $4
Variable Cost per Unit $15.71 $23.00 $22.00 $0.80
Variable Contribution Margin
per Unit
(Average price - Variable cost) $14.29 $37.00 $38.00 $3.20
PVCM = (Price - VC) 47.6% 61.6% 63.3% 80%
Price
7/23/2022 Hamed Ali

Cost-Volume-Profit Relationships
Economies of Scale
Experience Curve Effect
7/23/2022 Hamed Ali

Economies of Scale for Sweaters
Annual sales volume
40,000 units 80,000 units
Unit variable cost $ 23 $ 23
Multiplied by volume 40,000 80,000
Total variable cost $ 920,000 $1,840,000
Plus: Total direct fixed cost $1,200,000 $1,200.000
Total Direct Cost $2,120,000 $3,014,000
Divided by Volume 40,000 80,000
Average Unit Cost $ 53 $ 38
7/23/2022 Hamed Ali

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