Managerial Accounting

Class 2

Fundamental Concepts

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There is little doubt that costs are a concern for all organizations. To generate profit,
costs should naturally be less than the revenues brought in from sales. Costs have
different behaviors depending on enterprise activities undertaken. Activities can include
production, selling, distance travelled, orders processed and so on. Both a concern for
costs and attention to revenues are essential for running a profitable enterprise. The
relationship between costs and activities is the first concern of this class. Our focus
will then be on revenue concepts.

The Costing Side

An increased use by enterprises of a variety of cost management techniques has

taken place as markets have become more competitive – there is always pressure on
prices and so costs have to be contained to generate profit. Examples of cost
management tools are activity-based costing, target costing, quality costing and life
cycle costing. These techniques are primarily concerned with costs and are discussed
in later classes. This class considers established management accounting approaches
focusing on cost behavior issues and standard costing systems which continue to find
usage in many organizations today. The starting point for us is to develop an
understanding of how costs change alongside organizational activities.

Costs and Expenses

Managers understand well that to ask, “what does it cost?” may require complex
calculations and many assumptions. For this reason, there are “Different costs for
different purposes” to recognise that judgment must be exercised in choosing how a
cost is determined depending on what managerial needs are to be served. As a
starting point, it is useful to consider what a cost is by definition. A cost may be defined
as the monetary measure given up to acquire a product. Managers refer to a wide
range of cost types. Many of these will be discussed here. In looking at financial
statements, one often identifies the timing of cost incursion in terms of the past, the
present and the future by referring to historical, current and budgeted costs. Some
costs may be expired and appear as expenses in a profit and loss statement (e.g.:
electricity, lighting and heating expenses). Other costs may result from expenditures
whereby assets are acquired with a view to generating income and remain unexpired
as they await expensing (e.g. the cost of a building or machine). Such unexpired costs
are typically referred to as assets in the balance sheet of a company. The immediate
purpose here is to describe how costs behave as changes in activities take place.
Sometimes this entails describing how an expense arises as an unexpired cost
becomes expired, such as for example, when a machine loses part of its value and
usefulness in producing items that are sold to customers.

Accountants typically recognise two main types of cost behavior patterns: Fixed and
Variable. A cost that varies directly in a one-to-one manner with changes in activity is
referred to as a variable cost. The variable cost per unit does not ordinarily change as
activity levels change. Examples of variable costs include material costs as production

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takes place, electricity costs to power a machine and sales commissions based on
revenues as sales take place. If a product A requires €5 of direct materials per unit.
The total direct materials cost of manufacturing 10,000 units is €50,000; 20,000 units
require direct materials of €100,000, and so on. The unit cost of the direct materials
(€5) remains constant with changes in volume, but total variable costs increase with
increased activity. By contrast, a fixed cost is one which remains constant in total terms
but which diminishes at the unit level as activity levels increase. Examples of fixed
costs include a machine’s monthly depreciation charge, a supervisor’s annual salary or
a quarterly insurance bill. Suppose straight-line depreciation of €200,000 on factory
buildings and equipment will not change, regardless of whether 10,000 units or 20,000
units of product are manufactured. Outside the relevant range of activities, further fixed
costs may have to be incurred. Although fixed costs do not vary in total with changes in
volume of activity, the unit cost will change with changes in activity. If volume
increases, the unit cost will decrease, and if volume decreases, the unit cost will
increase. Thus, the unit cost of straight-line depreciation of €200,000 for 10,000 units
is €20, and for 20,000 units of product, the unit cost is €10.

It is well to note that both variable and fixed costs exhibit the particular cost behavior
they describe only over defined relevant ranges. Thus, the variable cost per unit stays
the same only over a relevant range of activities over which changes in the marginal
cost per unit arising from economies of scale, increased productivity or operating
inefficiencies are considered negligible. The supply price of packaging material may fall
once a certain volume purchase triggers a set discount. Likewise, fixed costs will likely
remain fixed only until the capacity of the resource giving rise to the cost is attained.
Thus if a supermarket manager can only supervise ten customers, a second
supervisor will have to be hired if, between eleven and twenty cashiers, are to be
supervised. In this instance, the relevant range of the supervisor is for ten cashiers.
Such a situation can give rise to stepwise cost increases (sometimes referred to as
semi-fixed costs). Of course, if the relevant range for a fixed cost category diminishes,
at some point, the cost behavior may be more appropriately considered a variable cost
– again with its own relevant range.

There are costs which cannot be treated as purely fixed or variable, but which combine
an element of both forms of cost behavior. Mixed (or semi-variable) costs do not stay
constant as activity levels change, nor do they vary proportionately with such changes.
Rather, they may increase, but only in part, with increased activity. Consider, for
example, a mobile cell phone for which a periodic standing charge is payable in
addition to a talk-time related charge. The total cost of the phone per period would
reflect both a fixed and variable cost component. The same would be true of a
commissioned salesperson earning a base salary whereby the base salary would be a
fixed cost to the employer and the variable cost component would stem from, say, a
commission on total sales over a period. What is clear is that cost behavior
classification relies in large part, on approximations as to costs, relevant ranges and
activity levels. Nevertheless, ascribing behavior to costs can lead to useful cost
management applications.

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The Components of Product Costs

All products can be broken down into different cost components. Sometimes managers
are interested in attaching costs to departments or processes or hierarchical levels via
their organizations. The target of any cost attachment is referred to as a cost object. If
it is possible to clearly trace costs to a cost object then such costs are viewed as being
direct. Conversely, if costs can only be allocated by more or less arbitrary methods of
assignment then such costs are viewed as being indirect to the cost object.

Very often, costs associated with different cost objects in service organizations are
indirect. A service cannot be inventoried or stored and therefore the product cost must
represent the accumulation of many indirect costs. Manufacturing organizations
engage in the active production of products to be sold such that many costs
accumulate at the level of chosen cost objects in a more immediate and demonstrable
manner. Thus cost objects in manufacturing organizations often comprise many direct
costs.

For a manufactured product, much of the raw material can be expected to be

demonstrably traceable to the product. If it is convenient and economic to do so, then
such material input represents direct material costs. There may of course be material
costs which could be traced to the product only with difficulty of measurement and
which would not yield information that could be viewed as economically viable to
collect or material to management decisions (a €2,000 exercise to trace €100 more
accurately). Such theoretically traceable direct costs are often treated as if they were
indirect costs and regarded as part of overhead costs.

Direct labor costs consist of wages paid to employees in production or service

environments. These costs are referred to as direct because they are directly traceable
to the service or the product in an economically feasible way. They may be assumed
to be variable with activity levels if, over relatively small time frames, direct labor costs
can be increased or reduced. There are many situations of course where such a
perspective on direct labor costs would be difficult to uphold. For instance, if direct
labor is really seen to be near-permanent because of difficulties in recruiting once
workers are let go then it may be preferable to regard the labor resource as a fixed
cost.

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 Direct Material
+ calculate
Direct Labor  product
+ costs
Indirect Overhead

Figure 2.1 Components of Product costs

Although it may be possible to directly trace most labor cost categories to a product or
service, the question of whether it is desirable to do so must be posed. The production
of an item may require post-production labor costs to be incurred for clean-up. In
theory, it may be possible to ascribe the cleaning costs to the product but the company
may simply prefer to treat this cost genre as indirect labor (see figure 2.1). Moreover,
many companies making use of automated technologies now have a very small
proportion of direct labor costs which they prefer to treat as fixed. Across many
industries, the proportion of direct labor costs as part of the total costs of products or
services is declining. This is probably due to the generally inverse relationship that
exists between capital intensiveness and labor intensiveness. Investments into flexible
organizational technologies such as computer assisted design and computer aided
manufacturing systems as well as flexible manufacturing systems and industrial robots
mean that production processes and many operational activities can take place using
lower and lower levels of labor input.

Factory overhead costs refer to those which cannot directly be traced to the provision
of a service or the manufacture of a product because this would be too difficult or too
expensive to do (or both). Effectively, factory overhead costs include all production
costs except direct material and labor costs. Part of the overhead costs for a
department or for a process may vary with activity levels and therefore be viewed as
variable, whereas others may be fixed over defined activity levels. Such costs which
combine fixed and variable resource elements may be regarded as mixed and require
extricating one type of cost from the other to make managerially useful decisions.

The Revenue Side

Many managerial accounting practices have been in use for decades and continue to
serve important roles in the management of modern enterprises. One which directly
addresses profit issues is referred to as cost-volume-profit (CVP) analysis.

Once costs have been classified into their fixed and variable categories, their effects
on profit, along with revenues and volume, can be understood via cost-volume-profit
analysis. Cost-volume-profit analysis can be used to indicate the revenues necessary
to just match the total costs in carrying out operations or to indicate the revenues or
sales unit level necessary to achieve a desired or target profit.

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The point in the operations of an enterprise at which revenues and expired costs are
exactly equal is called the break-even point. At this level of operations, an enterprise
will neither realise an operating income nor incur an operating loss. Break-even
analysis can be applied to past periods but is most useful when visualising future
performance scenarios as a guide to business planning. When concerned with future
prospects and future operations, the approach relies upon estimates. The reliability of
the analysis is thus greatly influenced by the accuracy of the estimates.

The break-even point can be computed by means of a mathematical formula which

indicates the relationship between revenue, costs and capacity. The data required are:

(i) total estimated fixed costs for a future period, such as a year;

(ii) the total estimated variable costs for the same period, stated as a percentage of net
sales.

The starting point is the profit equation:

Profit = Sales – Costs

= (Selling Price per Unit x Quantity) – (Variable costs + Fixed Costs)

Naturally, if Sales = Costs, the entity does not generate profits. Knowing the point of
activity where this occurs is useful to managers.

Examples of CVP in action

Assume that an organization’s fixed costs are estimated at €90,000 and that the
expected variable costs are 60 per cent of sales. The maximum sales at 100 per cent
capacity are €400,000. The break-even point is €225,000 of sales, computed as
follows:

Break-even ( €) = Fixed costs ( €) + Variable costs

sales (as % break-even sales)
S = €90,000 = 60%S
40%S = €90,000
S = €225,000

The Profit and Loss statement would look like this:

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 Sales €225,000
Expenses:
Variable costs ( €225,000 x 60%) €135,000
Fixed costs €90,000 €225,000
Operating profit 0

This is also shown in the graph in Figure 2.2

The break-even point can be expressed either in terms of total sales or in terms of
units of sales. For example, if the unit selling price is €25, the break-even point can be
expressed as either €225,000 of sales or 9,000 units ( €225,000/ €25). The break-
even point can be affected by changes in the fixed costs, unit variable costs and unit
selling price.

Figure 2.2 Cost-Volume-Profit graphs

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At the break-even point, sales and costs are exactly equal. By modifying the break-
even equation, the sales volume required to earn a desired amount of profit may be
estimated. For this purpose, a factor for desired profit is added to the standard break-
even formula.

Consider a situation in which fixed costs are estimated at €200,000, variable costs are
estimated at 60 per cent of sales, and the desired profit is €100,000. The sales
volume is €750,000, computed as follows:

Sales ( €) = Fixed costs ( €) + Variable costs (as %

sales) + Desired profit
S = €200,000 + 60%S + €100,000
40% S = €300,000
S = €750,000

The validity of the computation is shown as follows:

Sales €750,000
Expenses:
Variable costs ( €750,000 x 60%) €450,000
Fixed costs €200,000 €650,000
Operating profit €100,000

The break-even point for an enterprise selling two or more products can be calculated
on the basis of a specified sales mix. If the sales mix is assumed to be constant, the
break-even point and the sales necessary to achieve desired levels of operating profit
can be readily calculated.

Consider the following data for the CVP Company:

Product Selling price Variable cost Sales

per unit per unit mix
A €90 €70 80%
B €140 €95 20%
Fixed costs = €200,000

To compute the break-even point when several products are sold, it is useful to think of
the individual products as contributing to a weighted average product W. These
computations are as follows:

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Unit selling price of W: ( €90 x 0. 8) + ( €140 x 0. 2) = €100
Unit variable cost of W: ( €70 x 0. 8) + ( €95 x 0. 2) = €75

The variable costs for product W are therefore expected to be 75 per cent of sales
(€75/ €100). The break-even point can be determined in the normal manner using the
equation as follows:

Break-even sales ( €) = Fixed costs ( €) + Variable costs (as %

of break-even sales)
Break-even sales S = €200,000 + 75% S
Break-even sales 25% S = €200,000
Break-even sales S = €800,000

The break-even point of €800,000 of sales of enterprise product W is equivalent to

8,000 total sales units ( €800,000/ €100). Since the sales mix for products A and B is
80 per cent and 20 per cent respectively, the break-even quantity of A is 6400 units
(8000 x 80%) and for B it is 1,600 units (8,000 x 20%) units. A verification of the
analysis is given in Table 2.1.

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 Table 2.1 CVP Company Income Statement for Year Ended 31 December

Product A Product B Total

Sales
6,400 units x €90 €576,000 €576,000

1,600 units x €140 €224,000 €224,000

Total sales €576,000 €224,000 €800,000

Variable costs
6,400 units x €70 €448,000 €448,000

1,600 units x €95 €152,000 €152,000

Total variable costs €448,000 €152,000 €600,000

Fixed costs €200,000

Total costs €800,000

Operating profit € 0

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The reliability of cost-volume-profit analysis depends upon the validity of several
assumptions. One major assumption is that there is no change in stock quantities
during the year – that is, the quantity of units in the beginning stock equals the quantity
of units in the ending stock. When changes in stock quantities occur, the computations
for cost-volume-profit analysis become more complex.

For cost-volume-profit analysis, a relevant range of activity is assumed within which all
costs can be classified as either fixed or variable. Within the relevant range, which is
usually a range of activity over which the company is likely to operate, the unit variable
costs and the total fixed costs will not change. Moreover, the sales mix remains
constant for a multi-product environment.

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Contribution Margin Analysis

The classification of costs according to the way in which they behave enables
particular types of short run decision to be made (i.e., one year or less). Contribution
margin analysis relies on an appreciation of fixed versus variable cost components.
Contribution margin represents sales net of variable costs. In other words, the
contribution margin represents the amount available to cover fixed costs for a period
and ultimately to produce a profit. The application of a contribution margin
computation for a special order decision is provided by The Gondola Company.

The Gondola Company manufactures a specialty electronic toy. It has developed the
following predetermined unit cost estimates at a production and sales volume of
25,000 units:

Direct materials €20

Direct labor €15
Variable factory overhead €5
Fixed factory overhead €10
Variable selling and administrative €5
Fixed selling and administrative €2
Total €57

A special order has been received from a foreign distributor to purchase 2000 units at
€47 each. The company has sufficient excess capacity and does not currently
compete in any foreign market. Accepting the special order will result in special selling
and administrative expenses of €500. There will be no additional variable-selling and
administrative expenses. Should the order be accepted?

The relevant unit costs are direct materials, direct labor and variable factory overhead.
They total €40 per unit. Hence, the unit contribution margin if the order is accepted is
€7. The total contribution margin of €14,000 (€7 x 2000) far exceeds the contract’s
fixed costs of €500. Accordingly, the contract contributes €13,500 to common fixed
costs and profits. The relevant costs to include in the analysis are the incremental
costs of the contract, and not the allocated fixed costs.

Suppose now that Gondola can reduce the direct materials cost by €2 per unit and
direct labor costs by €3 per unit if it purchases component GZ99 from a domestic
supplier at a cost of €5.50 per unit. Accepting the order will permit Gondola to rent
one of its buildings to a local firm for €20,000 per year. Should Gondola make or buy
component GZ99?

The incremental unit cost of buying is €0.50 per unit. However, buying will result in
incremental revenues of €20,000 per year. At a volume of 25,000 units, the
incremental profit from buying is €20,000 - €0.50(25,000) = €7,500. It appears
desirable to buy. Given the focus on incremental costs, this approach to short run
decision-making is sometimes referred to as incremental cost analysis. What is

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important to ask in relation to incremental costs is whether costs differ between the
alternative courses of action being considered and whether they relate to the future.
Only such costs are deemed ‘relevant’ in incremental cost analysis.

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Maintaining Standards

Standard costs provide a useful means for costing products. For a manufacturing
company, labor and material costs can often be predetermined to coincide with actual
cost incursion. Overhead costs, however, may pose costing problems in that not all
overhead costs per unit will be known at any one stage of the financial period. For
costing a contract, it is thus useful to determine a volume-based method of allocating
overhead costs. The link between overhead cost incursion and a volume variable such
as units produced, or labor cost or machine hours worked, can be statistically tested
using regression analysis.

Consider the Contract Co., which uses a budgeted overhead rate in applying overhead
to production orders on a labor cost basis for Department A and on a machine-hour
basis for Department B. At the beginning of Year 1, the company made the following
estimations:

Department A Department B
Direct labor €128,000
Machine-hours 20,000
Factory €144,000 €150,000
overhead
Overhead rates 112.5% of direct labor €7.50 per machine-hour

During January, the cost record for job order number 500 which consisted of 20 units
of product shows the following:

Department A Department B
Materials €20 €40
requisitioned
Direct labor cost €32 €21
Machine-hours 13

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The total departmental costs are then determined to obtain the unit
product costs:

Department A Department B
Raw materials €20.00 Raw materials € 40.00
Direct labor €32.00 Direct labor € 21.00
Factory department Factory department
overhead applied overhead applied
(32 x 112.5%) €36.00 (13 x €7.50) € 97.50
Total €88.00 €158.50

Total costs: €88.00 + €158.50 = €246.50

€246.50 x 20 = €12.325 per unit

An adjustment will likely be made for deviations between budgeted overhead rates and
the actual costs incurred. Thus, suppose that at the end of Year 1 it is found that
actual factory overhead cost amounts to €160,000 in Department A and €138,000 in
Department B and that the actual direct labor cost is €148,000 in Department A and
the actual machine-hours are 18,000 in Department B. The over-applied or under-
applied overhead amount for each department and for the factory as a whole can be
readily calculated:

Department A: Applied overhead

(112.5% of €148,000) € 166,500
Actual overhead € 160,000
Over-applied overhead € 6,500

Department B: Applied overhead

(18,000 x €7.50) € 135,000
Actual overhead € 138,000
Under-applied overhead (3,000)
Total over-applied factory overhead € 3,500

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It is to be noted that the extent of the variances and therefore cost misallocations is
dependent principally on the choice of overhead allocation base and the accuracy of
the rate at which it is allocated. If the difference is significant in relation to the year-end
accounts, an adjustment to the overhead value of stock at the year-end can be
calculated.

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Standard Costing and Variance Analysis

A standard cost may be defined as the budgeted cost for one unit of a particular
resource. One objective of using standard costs is to provide a tool for investigating
deviations between expectations and outcomes. The actual profit for a year may differ
from plan depending on how far sales and costs have deviated from expected values.
The variance between volume expectations and actual activity is also an essential
component of the investigation. This requires a consideration of ‘flexible’ rather than
‘static’ activity volumes. A useful illustration of the use of standard costs to investigate
differences between expectations and outcomes follows.

Suppose that for October, the Macron Co. budgeted sales at 30,000 units at a selling
price of €10 each and a variable cost of €6 each. Actual sales were 28,000 units.
Table 2.2 shows that net income was €17,000 less than budgeted.

One could conclude that the reduced sales caused net income to be reduced by
€20,000. It would appear that variable costs were €5,000 less than expected, helping
to offset the reduced sales. However, this is misleading. The €5,000 favorable
variance was derived by comparison of the actual costs for 28,000 units with the
budgeted costs for 30,000 units. Such a comparison is inappropriate. Costs are
expected to be lower if sales are lower. In fact, the firm can reduce variable costs to
zero by selling nothing.

It is useful to prepare a flexible budget that shows total variable costs for 28,000 units
rather than 30,000 units, at a variable cost per unit of €6. This is illustrated in Table 2.3
which shows that variable costs are not €5,000 favorable but €7,000 unfavorable. In
other words, since the company sold only 28,000 units, variable costs should have
been only €168,000 ( €6 x 28,000 units). Instead, they were €175,000.

Fixed cost variances total €2,000 unfavorable. Notice that the budget for fixed costs is
€50,000 in both the ‘static’ budget (for 30,000 units) and the ‘flexible’ budget (for
28,000 units). By definition, fixed costs do not change within a relevant range.
Assuming a relevant range of 0–50,000 units for Macron Co.’s fixed costs, these costs
would be the same for both 28,000 units and 30,000 units of sales. Thus, within the
relevant range the flexible budget shows the same amount of fixed costs. However,
outside the relevant range, the flexible budget would also show different levels of fixed
costs. A detailed analysis of specific items of fixed cost would reveal those costs that
resulted in the €2,000 unfavorable variance.

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 Table 2.2 Macron Co. Income Statement for the Month ended 31 October

Budget Actual Variance

(30,000 units) (28,000 units)
Sales €300,000 €280,000 €20,000 U
Variable costs €180,000 €175,000 € 5,000 F
Contribution €120,000 €105,000 €15,000 U
margin
Fixed costs € 50,000 € 52,000 € 2,000 U
Net income € 70,000 € 53,000 €17,000 U

F = favorable
U = unfavorable.

Table 2.3 Macron Co. Income Statement for the Month ended 31 October

Budget Actual Variance

(28,000 units) (28,000 units)
Sales €280,000 €280,000 –-
Variable costs €168,000 €175,000 €7,000 U
Contribution €112,000 €105,000 €7,000 U
margin
Fixed costs € 50,000 € 52,000 €2,000 U
Net income € 62,000 € 53,000 €9,000 U

Actual net income was €17,000 less than budgeted net income; €9,000 of that
€17,000 was caused by variances in costs. Specifically, variable costs were €7,000
more than they should have been for the achieved level of activity, 28,000 units, and
fixed costs were €2,000 more than they should have been. The fact that actual sales
in units were less than budgeted also caused net income to be less than expected.
This difference is referred to as the sales variance. The sales variance shows how
much contribution margin was lost because budgeted sales were not achieved. Thus:

Sales variance = (Actual unit sales - Budgeted unit sales) x Contribution margin
per unit
Sales variance = (28,000 units - 30,000 units) x €4 per unit
= - 2,000 units x €4 per unit
= €8,000 U
The calculation above shows that because sales were 2,000 units less than expected,
net income was €8,000 less than expected, resulting in an unfavorable sales variance.
The €17,000 unfavorable variance in net income is as follows:

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Sales variance €8,000 U
Variable cost variances €7,000 U
Fixed cost variances €2,000 U
Net income variance €17,000 U

In summary, the company failed to achieve its budgeted net income of €70,000
because lost sales resulted in an €8,000 decrease in expected net income, variable
cost variances resulted in a €7,000 decrease in expected net income, and fixed cost
variances resulted in a €2,000 decrease in expected net income. The details of these
variances can be further analysed to determine more specific reasons why they
occurred.

We can view a standard cost system as an accounting system under which all
manufacturing costs are charged to production at standard costs. This practice is in
contrast to an actual cost system, which charges actual costs to production as they are
incurred, or to an actual/normal cost system, which charges actual direct material and
direct labor costs to production but charges variable and fixed factory overhead at a
predetermined, or standard rate. Consider the following standards for Macron:

Unit Cost
Direct material (2.5 kgs per unit at €0.70 per kg) €1.75
Direct labor (0.25 hrs per unit at €8 per hr) €2.00
Factory overhead (0.25 hrs per unit at €3 per DLH) €1.00
Total standard variable cost per unit €4.75

For November Macron Co. budgeted production for 12,000 units. However, only
10,000 units were produced. A performance report based on a flexible budget of
10,000 units may be prepared as shown in Table 2.4. The budgeted amounts in the
performance report are based on the standard variable costs per unit multiplied by
10,000 units. The performance report shows that the total variable cost variance for
November was unfavorable by €2,335.

Table 2.4 Macron Co. Performance Report for the Month ended 30 November

Budget Actual Variance

Direct material €17,500 €16,900 € 600 F

Direct labor €20,000 €21,735 €1,735 U
Variable factory €10,000 €11,200 €1,200 U
overhead
Totals €47,500 €49,835 €2,335 U

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To illustrate how standard costs are used in analysing variances, suppose that Macron
Co. is applying variable factory overhead on the basis of direct labor hours rather than
the units produced. Table 2.5 indicates the calculations that must be performed in
order to obtain variance values for each variable cost category. The actual material
and labor costs and quantities used are obtained from the company’s records.

Table 2.5 Macron Co. Calculations to Obtain Variance Values

Material price variance

(Actual quantity x Actual price) - (Actual quantity x Standard price)

(AQ x AP) - (AQ x SP)
(26,000 kg x €0.25) - (26,000 x €0.70) = €1,300 F

Material usage variance

(Actual quantity x Standard price) - (Standard quantity allowed for flexible budget x
Standard price)
(AQ x SP) - (SQA x SP)
(26,000 x €0.70) - (25,000 kg x €0.70) = €700 U

Labor rate variance

(Actual hours x Actual rate) - (Actual hours x Standard rate)
(AH x AR) - (AH x SR)
(2,700 hr x €8.05) - (2,700 hr x €8.00) = €135 U

Labor efficiency variance

(Actual hours x Standard rate) - (Standard hours allowed for flexible budget x
Standard rate)
(AH x SR) x (SAH x SR)
(2,700 hr x €8.00) - (2,500 hr x €8.00) = €1,600 U

Overhead spending variance

Actual cost incurred - (Actual hours x Standard rate)
€11,200 - (2,700 hr x €4.00) = €400 U

Overhead efficiency variance

(Actual hours x Standard rate) - (Standard hours allowed for flexible budget x
Standard rate)

(AH x SR) – (SHA x SR)

(2,700 hr x €4.00) – (2,500 hr x €4.00) = €800 U

Individual variances will provide information on the efficiency and effectiveness with
which organizational resources are used. The use of standard costing is appropriate
for organizations with activities that consist of a series of repetitive operations. This
would include many manufacturing organizations. Standard costing cannot be readily

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applied to activities of a non-repetitive nature as there is little basis for observing
recurring actions and processes with continuity.

Whilst it is possible to extend standard cost-based variance analysis to achieve greater

degrees of refinement, an increased focus on the technical complexities of deviations
of actual performance from expectations can detract managers’ attention on what is
driving the deviations. Advocates of change in management accounting think it is
better to train managers to assess strategic issues rather than to train them to
undertake complex calculations. An understanding of external business forces and
their impact on internal organizational activities can be valuable. Companies should
not crowd out assessing external factors and pay excessive attention to complex
calculations of internal issues because such analysis may lead to enterprise paralysis.

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 Class 2 Questions

1. Which of the following statement is true?

(1) Operating costs can be subdivided into fixed costs and variable costs.
(2) Variable costs are costs that change in total as the volume of activity changes.
(3) Fixed costs remain constant in total as the volume of activity changes over a
defined relevant range.
(4) Fixed costs do not vary in total, but the unit cost will change with change in volume
of activity.
a. (1) (2) are correct
b. (1) (3) are correct
c. (2) (3) (4) are correct
d. (1) (2) (3) (4) are correct
e. (3) (4) are correct
Answer: d

2. Which of the following are examples of variable costs?

(1) Direct labor and direct materials

(2) Factory rent and electricity
(3) Indirect materials and salaries
(4) Straight-line depreciation on equipment
(5) Property insurance and tax
(6) Packaging and office salaries
a. (1) (2) (3)
b. (4) (5) (6)
c. (1) (4) (6)
d. (2) (3) (4) (5)
e. (1) (2) (3) (4) (5) (6)
Answer: a

3. Assume that your company produces bicycles. You calculate the variable unit
cost to be €200. The number of units produced is 5000, and the fixed cost is
€10,000. What is the estimated total cost?

a. 1,010,000
b. 1,100,000
c. 1,000,000
d. 1,111,000
e. 100,000
Answer: a
= (€200 x 5000) + €10,000= 1,010,000

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4. Which one of the following statement is wrong for the break-even point?

a. It is most useful when visualising future performance scenarios

b. To compute the break-even point you need the total estimated fixed costs for a
future period
c. To compute the break-even point you need the total estimated variable costs for a
future period
d. It can be applied to past periods
e. An enterprise will make positive operating income at this point
Answer: e

5. Assume that Company A’s fixed costs are €100,000, and the expected variable
costs are 50 per cent of sales. Compute the break-even sales.

a. 200,000
b. 220,000
c. 100,000
d. 300,000
e. 150,000
Answer: a
Break-even sales = Fixed costs + Variable costs
S = €100, 000 + 50% S

6. Assume that Company A’s fixed costs are €100,000, and the expected variable
costs are 50 per cent of sales, and the desired profit is €50,000. Compute the
sales.

a. 300,000
b. 350,000
c. 400,000
d. 150,000
e. 100,000
Answer: a
Sales = Fixed costs + Variable costs + desired profit
S = €100, 000 + 50% S + €50, 000

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7. Assume that Company C produces two products A & B

Product Selling price per unit Variable costs per unit Sales mix
A €80 €60 40%
B €120 €80 60%
Fixed costs = €200,000

Compute the break-even sales.

a. 645,161
b. 714,388
c. 760,000
d. 767,000
e. 750,000
Answer: a
Unit selling price of W = €80 x 40% + €120 x 60% = €104
Unit variable costs of W = €60 x 40% + €80 x 60% = €72
Thus the variable costs for product W are 69% of sales (€72/€104)
Break-even sales= Fixed costs + Variable Costs
S = €200,000 + 69% S

8. Company A produces chairs. The unit costs are as follows:-

Direct materials €30

Direct labor €20
Variable factory overhead €10
Fixed factory overhead €5
Fixed selling and administrative €5

A special order has been received from Company B to purchase 3000 units at €65.
Accepting the order will result in special selling and administrative expense of €500.
Which of the following statement is true?

(1) The relevant unit costs are Direct materials, Direct labor and Variable factory
overhead totalling €60 per unit.
(2) The Unit contribution margin if the order is accepted is €5.
(3) The Total contribution margin is €15,000.
(4) There is €14,500 in profits before tax.
(5) The order should be accepted.
a. (2) (3) (4) (5)
b. (1) (2) (3) (4) (5)
c. (2) (4) (5)
d. (3) (4) (5)
e. (2) (3) (5)
Answer: b

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9. Company A uses a budget overhead rate in applying overhead to production
order on a machine-hours basis.

At the beginning of the year the following estimates are made:

Machine-hours 10,000
Factory overhead €100,000
Compute the overhead rate.
a. €10 per machine-hour
b. €5 per machine-hour
c. €8 per machine-hour
d. €7 per machine-hour
e. €15 per machine-hour
Answer: a
Overhead rate= €100,000 / 10,000 = €10 per machine-hour

10. During January the costs record for Company A (from question 9) is:

Materials requisitioned 450

Direct labor cost 420
Machine-hours 10

Compute the total cost for January:

a. 170
b. 150
c. 180
d. 190
e. 970
Answer: e
Overhead costs = 10 x €10 = €100
Total cost = €450 + €420 + €100 = €970

11. Refer to question 10 - At the end of the year, it is found that actual factory
overhead costs are €150,000 and the actual machine-hours are 1,200.
Compute the over-applied or under-applied overhead amount.

a. Over-applied overhead is 30,000

b. Over-applied overhead is 20,000
c. Under-applied overhead is 30,000
d. Under-applied overhead is 20,000
e. None is correct
Answer: c
Applied overhead = €10 x 1200= €120,000
Under-applied overhead = €150,000 - €120,000 = €30,000

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12. Company B uses a budget overhead rate in applying overhead to production
orders on a labor cost basis.

At the beginning of the year:

Direct labor €100,000

Factory overhead €120,000
Compute the overhead rate.
a. 150% of direct labor
b. 120% of direct labor
c. 110% of direct labor
d. 140% of direct labor
e. 105% of direct labor
Answer: b
Overhead rate = €120,000 / €100,000 = 120% of direct labor

13. During January for Company B: -

Materials requisitioned €50

Direct labor cost €60
Compute the total costs.
a. 182
b. 152
c. 172
d. 168
e. 170
Answer: a
Overhead applied = €60 x 120% = €72
Total costs = €50 + €60+ €72

14. At the end of the year, it is found that the actual overhead cost is €120,000,
the actual direct labor cost is €80,000. Compute the over-applied or under-
applied overhead amount for Company B.

a. Over-applied overhead 24,000

b. Under-applied overhead 24,000
c. Over-applied overhead 22,000
d. Under-applied overhead 22,000
e. None is correct
Answer: b
Overhead applied = 120% x €80,000= €96,000
Under–applied overhead = €96,000 - €120,000

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15. Below is the income calculation for the month ended 30 September for
Company C. The selling price is €10 and the variable cost is €5 for each unit.

Budget (50,000 units) Actual (40,000 units) Variance

Sales €500,000 €400,000 €100,000 U
Variable costs € 300,000 €280,000 €20,000 F
Contribution margin € 200,000 €120,000 €80,000 U
Fixed costs €50,000 €55,000 €5,000 U
Income €150,000 €65,000 €85,000 U

A flexible budget showing total variable costs for 40,000 units would be:
Budget (40,000 units) Actual (40,000 units) Variance
Sales €400,000 €400,000 --------------
Variable costs €240,000 €280,000 €40,000 U
Contribution margin €160,000 €120,000 € 40,000 U
Fixed costs €50,000 €55,000 € 5.000 U
Income €110,000 €65,000 €45,000

The €85,000 U static budget figure is the more useful variance to look at.

True or False?

Answer: False

16. Which of the following statement is true?

(1) Material price variance

= (Actual quantity x Actual price) – (Actual quantity x Standard price)
(2) Material usage variance
= (Actual quantity x Standard price) – (Standard quantity allowed for flexible
budget x Standard price)
a. (1) (2)
b. (1)
c. (2)
d. None
e. Cannot tell.
Answer: a

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17. Company C’s actual hours in the year is 2400 hours, the actual labor rate is
€8 and the standard labor rate is €7. The standard hours allowed for the
flexible budget is 2200 hours. Calculate the labor rate variance and the labor
efficiency variance.

(1) Labor rate variance is 2400 U

(2) Labor rate variance is 2400 F
(3) Labor efficiency variance is 1400 U
(4) Labor efficiency variance is 1400 F
a. (1) (3)
b. (2) (4)
c. (1) (4)
d. (2) (3)
e. only (1) is correct
Answer: a
Labor rate variance= (2400 x €8) – (2400 x €7) = €2400 U
Labor efficiency variance= (2400 x €7) – (2200 x €7)= €1400 U

18. Company C’s actual overhead spending cost is €12,000, the actual hours is
2400 hours, the standard overhead spending rate is €4 and the standard
hours allowed for flexible budget is 2200 hours. Calculate the overhead
spending variance and overhead efficiency variance.

(1) Overhead spending variance is 2400 U

(2) Overhead spending variance is 2400 F
(3) Overhead efficiency variance is 800 U
(4) Overhead efficiency variance is 800 F
a. (1) (3) are correct
b. (2) (4) are correct
c. (1) (4) are correct
d. (2) (3) are correct
e. Only (2) is correct
Answer: a
Overhead spending variance = €12,000 – (2400hr x €4) = € 2400 U
Overhead efficiency variance = (2400hr x €4) – (2200 hr x €4)= €800 U

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19. Which of the following statement is true?

(1) The use of standard costing is appropriate for the organisations with activities that
consist of a series of repetitive operations.
(2) Many critics of standard costing system focus on price and efficiency to the
exclusion of quality.
(3) The use of the volume variance to measure utilisation of capacity while ignoring
over-production can lead to unnecessary build-ups of stock levels.
a. (1) (2) are correct
b. (1) (2) (3) are correct
c. (1) (3) are correct
d. (2) (3) are correct
e. (1) is correct
Answer: b
Answer: The use of standard costing is appropriate for the organisations with activities
that consist of a series of repetitive operations. Many critics of standard costing system
focus on price and efficiency to the exclusion of quality. In addition, the use of the
volume variance to measure utilisation of capacity while ignoring over-production can
lead to unnecessary build-ups of stock levels.

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