Techno Star College

Department of Accounting and Finance

Module Name: Cost and Management Accounting II

Course Code: AcFn322
Credit Hour: 3

Aksum, Ethiopia

Techno Star College 1

Contents
Chapter One....................................................................................................................................................2
Cost-Volume-Profit (CVP) Analysis..............................................................................................................2
1.1 CVP – Underlying Assumptions..........................................................................................................2
1.2 The Basics Of Cost-Volume-Profit (CVP) Analysis............................................................................2
1.3 Break-Even Analysis............................................................................................................................5
1.4 Applying CVP Analysis.......................................................................................................................8
1.5 CVP Considerations In Choosing A Cost Structure...........................................................................13
Review Questions.....................................................................................................................................17
Chapter Two Master Budget........................................................................................................................17
2.1 Benefits of Budgets...........................................................................................................................17
2.2 Types of Budget.................................................................................................................................17
2.3 The Master Budget.............................................................................................................................18
2.4 Understand The Difficulties of Sales Forecasting..............................................................................19
Chapter –Three And Four.............................................................................................................................25
Flexible Budgets And Standard Costing......................................................................................................25
3.1 Static Budgets Vs Flexible Budget.....................................................................................................25
3.2 Flexible Budget (Dynamic Budget)....................................................................................................27
3.3 Standards For Control.........................................................................................................................29
Chapter Five.................................................................................................................................................36
Relevant Information & Decision Making: Production Decision................................................................36
5.1 Introduction.........................................................................................................................................36
5.2 Alternative Choice Decisions.............................................................................................................37

Techno Star College 2

 CHAPTER ONE
Cost-Volume-Profit (CVP) Analysis
1. Introduction
Cost-volume-profit (CVP) analysis is a powerful tool that helps managers to
understand the relationships among cost, volume, and profit. CVP analysis focuses
on how profits are affected by the following five factors:
1) Selling prices. 4) Total fixed costs.
2) Sales volume. 5) Mix of products sold.
3) Unit variable costs.
Because CVP analysis helps managers understand how profits are affected by
these key factors, it is a vital tool in many business decisions. These decisions
include what products and services to offer, what prices to charge, what marketing
strategy to use, and what cost structure to implement.
1.1. CVP – Underlying Assumptions
Cost-Volume-Profit Assumptions and
Terminology
1) Changes in the level of revenues and costs arise only because of changes
in the number of product (or service) units produced and sold.
2) Total costs can be divided into a fixed component and a component that
is variable with respect to the level of output.
3) When graphed, the behavior of total revenues and total costs is linear
(straight-line) in relation to output units within the relevant range (and time
period).
4) The unit selling price, unit variable costs, and fixed costs are known and
constant.
5) The analysis either covers a single product or assumes that the
sales mix when multiple products are sold will remain constant as the level
of total units sold changes.
6) All revenues and costs can be added and compared without taking into
account the time value of money.
1.2. The Basics of Cost-Volume-Profit (CVP) Analysis

1.2.1. Contribution Margin Vs Gross Margin Concept

The contribution income statement emphasizes the behavior of costs and
therefore is extremely helpful to managers in judging the impact on profits of
changes in selling price, cost, or volume.
The form of income statement used in CVP analysis is shown in Exhibit 1.1, i.e.,
the projected income statement of Sample Merchandising Company for the month
ended January 31, 2006. This income statement is called contribution approach
to income statement.

Techno Star College 3

Exhibit 1.1
Sample Merchandising
Company
Projected Income
Statement Total Per
Sales (10, 000 units) Br. 150, Unit
Br.15.0
Variable Expenses 000120, 0 12.0
Contribution Margin Br.000
30, Br0.3.0
Fixed Expenses 00024, 0
Net Income Br. 000
6,
0000
Note that: In the income statement here above, sales, variable expenses, and
contribution margin are expressed on a per unit basis as well as in total. This is
commonly done on income statements prepared for management‘s own use since it
facilitates profitability analysis.
Contribution
Margin
 It represents the amount remaining from sales revenue after variable
expenses have been deducted i.e., CM = Sales Revenue – Variable
Costs
 Thus, it is the amount available to cover fixed expenses and then to provide
profit for the period.
 Notice the sequence here- contribution margin is used first to cover the fixed
expenses, and then whatever remains goes toward profit.
 In the Sample Merchandising Company income statement shown above,
the company has a contribution margin of Br. 30, 000. In this case, the first
Br.24, 000 covers fixed expenses; the remaining Br. 6, 000 represents
profit.
Per unit contribution
margin
 I t indicates by how much Birrs the contribution margin is increased for each
unit sold.
 Sample Merchandising Company‘s contribution margin of Br.3.00 per unit indicates
that each unit sold contributes Br.3.00 to covering fixed expenses and
providing for a profit.
To illustrate with an extreme example, assume that the company sells only 5000
units during a particular month. The company‘s income statement would appear as follows:

Sample Merchandising
Company
Projected Income
Statement Total Per
Sales (5, 000 units) Br. 75, Unit
Br.15.0
Variable Expenses 00060, 0 12.0
Contribution Margin Br. 000
15, Br0.3.0
Fixed Expenses 00024, 0
Net Loss 000
Br. (9,
0000)
i.e., If the firm had sold 5, 000 units, this would cover only Br.15, 000 of their fixed
expenses
(5, 000 units x Br.3.00 per unit). Therefore, the firm would have a net loss of Br.9,
000.

Sample Merchandising
Company
Projected Income
Statement Total Per
Sales (8, 000 units) Br. 120, Unit
Br.15.0
Variable Expenses 000 96, 0 12.0
Contribution Margin Br. 000
24, Br0.3.0
Fixed Expenses 00024, 0
Net Loss 000
Br. 0
If enough units can be sold to generate Br.24, 000 in contribution margin, then all
of the fixed costs will be covered and the company will have managed to show
neither profit nor loss but just cover all of its cost. To reach this point (called
breakeven point), the company will have to sell 8, 000 units in a month, since each
unit sold yield Br. 3.00 in contribution margin.
Computations of the break-even point are discussed in detail later in this
unit. For the moment, note that the break-even point can be defined as
the point where total sales revenue equals total expenses (variable plus fixed) or
as the point where total contribution equals total fixed expenses.
 Too often people confuse the terms contribution margin and gross margin.
Gross margin (which is also called gross profit) is the excess of sales over the
cost of goods sold (that is, the cost of the merchandise that is acquired or
manufactured and then sold). It is a widely used concept, particularly in the
retailing industry.
Contribution Margin Ratio (Cm-
Ratio)
In addition to being expressed on a per unit basis, revenue, variable expenses,
and contribution margin for Sample Merchandising Company can also be
expressed on a
Percentage basis:
Sample Merchandising
Company
Projected Income
Statement Total Per Percenta
Sales (10, 000 units) Br. 150, Unit
Br.15.0 ge 100
Variable Expenses 000120, 0 12.0 %
80%
Contribution Margin Br.000
30, Br0.3.0 20%
Fixed Expenses 00024, 0
Net Income Br. 000
6,
0000
The percentage of the contribution margin to total sales is referred to as the
contribution margin ratio (CM-ratio). This ratio is computed as follows:
CM-ratio = Contribution Margin
Sales
 Contribution margin ratio = 1 – variable cost ratio. The variable-cost ratio or
variable- cost percentage is defined as all variable costs divided by sales. Thus, a
contribution margin of 20% means that the variable-cost ratio is 80%.
In the example here below, the contribution margin percent or contribution margin
ratio, also called profit/volume ratio (p/v ratio) is 20%. This means that for each birr
increase in sales, total contribution margin will increase by 20 cents (Br.1 sales x
CM ratio of 20%). Net income will also increase by 20 cents, assuming that there
are no changes in fixed costs. At this illustration suggests, the impact on net
income of any given birr change in total sales & be computed in seconds by simply
applying the contribution margin ratio to birr change.
Once the break-even point has been reached, net income will increase by the unit
contribution margin for each additional unit sales. If 8,001 units are sold in a
month, for example, then we can expect that the Sample Merchandising Company‘s net
income for the month will be Br. 3, since the company will have sold 1 unit more than
the number needed to break even:

Sample Merchandising
Company
Projected Income
Statement
Total Per
Sales (8, 001 units) Br. 120, Unit
Br.15.0
Variable Expenses 015 96, 0 12.0
Contribution Margin Br. 012
24, Br0.3.0
Fixed Expenses 00324, 0
Net Loss 000
Br .
 If 8002 units are sold (2 units above the break-even3.00point). Then we can expect
that the net income for the month will be Br.9, and so forth.
1.3. Break-Even Analysis
The study of cost-volume-profit analysis is usually referred as break-even analysis.
This term is misleading, because finding break-even point is often just the
first step in planning decision. CVP analysis can be used to examine how various
alternatives that a decision maker is considering affect operating income. The
break-even point is frequently one point of interest in this analysis
Break-even point can be defined as the point where total sales revenue equals
total expenses (i.e., total variable cost plus total fixed costs). It is a point where
contribution margin total equals total fixed expenses. Stated differently, it is a
point where the operating income is zero.
 there are three alternative approaches to determine break-even point:
(A) Equation technique,
(B) Contribution margin technique and
(C) Graphical method.
A) Equation
Method
It is the most general form of break-even analysis that may be adapted to any
conceivable cost-volume-profit situation. This approach is based on the profit
equation. Income (or profit) is equal to sales revenue minus expenses. If expenses
are separated into variable and fixed expenses, the essence of the income
statement is captured by the following equation:
 Operating profit = Total Revenue – Total Costs
TR – TC, where TR = Average SP/unit (sp) x units of output (Q)
TC = (Variable costs/unit (VC) x units of output (Q))+Fixed costs (FC)

 Profit (net income) is the operating income plus non-operating revenues

(such as interest revenue) minus non-operating costs (such as interest cost)
minus income taxes. For simplicity, throughout this unit non-operating revenues
and non-operating cost are assumed to be zero. Thus, the above formula can be
restated as follows
 = (SPxQ) – ((VCxQ) +FC) ………… expanding original equation for profits!
 = (SP - VC) Q - FC
 At break-even point, net income=0 because total revenue equal total expenses.
That is, NI=SPQ-VCQ-FC
0= SPQ-VCQ-FC ……………………………………equation
(1)
B) Contribution Margin
Technique
The contribution margin technique is merely a short version of the equation
technique. The approach centers on the idea that each unit sold provides a
certain amount of fixed costs. When enough units have been sold to generate a
total contribution margin equal to the total fixed expenses, break-even point (BEP)
will be reached. Thus, one must divide the total fixed costs by the contribution
margin being generated by each unit sold to find units sold to break- even.
BEPQ= Fixed expenses
Unit contribution margin
B PEP (in sales Birrs) = Fixed expenses = FC CM ratio SP-VC
 given the equation for net income, you can arrive at the above short cut formula
for computing break-even sales in units as follows:
NI= SPQ-VCQ-FC
0=Q (SP-VC)-FC ………………………… because at BEP net income equals
zero. Q (SP-VC) =FC …………………………… divide both sides by (p-v)
Q = FC ………………….……………….. Equation (2)
SP-VC
 This approach to break-even analysis is particularly useful in those situations
where a company has multiple product lines and wishes to compute a single
break-even point for the company as a whole. More is said on this point in later
section titled Sales Mix and CVP Analysis.
 The contribution- margin and equation approaches are two equivalent
techniques for finding the break-even point. Both methods reach the same
conclusion, and so personal preference dictates which approach should be used.
C) Graphical Method
In the graphical method we plot the total costs and revenue lines to
obtain their point of intersection, which is the breakeven point.
 Total costs line. This line is the sum of the fixed costs and the variable costs. To
plot fixed costs, draw a line parallel to the volume axis. To plot the total cost
line, choose some volume of sale and plot the point representing total expenses
(fixed and variable) at the activity level you have selected. After the point has
been plotted, draw a line through it back to the point where the fixed expense
line intersects the birrs axis (the vertical axis).
 Total Revenue Line. Again choose some volume of sales to construct the
revenue line and plot the point representing total sales birrs at the activity you
have selected. Then draw a line through this point back to the origin.
The break-even point is where the total revenues line and the total costs line
intersect. This is where total revenues just equal total costs.
Example (1) Zoom Company manufactures and sells a telephone answering
machine.
Total Per Unit Percen
Sales (20,000 units) Br. Br. 60 t 100
Variable expenses 1,200,000
900,00 45 ?
Contribution Margin Br. 0 Br. 15 ?
Fixed Expenses 300,000
240,00
Net Income 060,00
The company‘s income statement for0the most recent year is given below:
Based on the above data, answer the following questions.
Instructions:
a) Compute the company‘s CM ratio and variable expense ratio.
b) Compute the company‘s break-even point in both units and sales birrs. Use the
above three approaches to compute the break-even.
c) Assume that sales increase by Br. 400,000 next year. If cost behavior
patterns remain
unchanged, by how much will the company‘s net income increase?
Solution:
a) CM – ratio = 60-45 = 0.25 (25%)
60
Variable expense ratio = 1 – CM-ratio = SP-VC= 1-0.25 = 60 –15
= 0.75 (75%) SP
60
b) Method 1: Equation Method
i) Net Income (NI) = SPQ – VCQ – FC
0 = Q (60-45) – 240,000
15Q = 240,000
BEPQ = 240,000 = 16,000 units, at Br. 60 per unit, Br. 960,000 ( BEP
sales in Birr)
15
ii) Let ―X‖ be sales volume in birrs to breakeven
CM- ratio = 0.25; Variable expense ratio = 0.75
Net Income = Total revenue – Total variable expense – total
fixed cost
0 = X – 0.75X-240, 000
0.25X = 240,000
X = 240,000 = Br. 960,000
0.2
5
Method 2: Contribution Margin Method
i) BEP (in units) = Fixed expenses = Br. 240,000 = 16,000 units
CM per unit Br. 60 – Br. 45

ii) BEP (in birrs) = Fixed expenses = Br. 240,000 = Br. 960,000
 CM – ratio
0.25
Method 3: Graphical Method: To plot fixed costs, measure Br. 240,000 on the
vertical axis and extend a line horizontally. Select a point (say, 20,000 units) and
determine the total costs (the total of fixed and variable) at the selected activity
level. The total costs at this output level are Br. 1,140,000= Br. 240,000 + (20,000
X Br. 45). Then, starting from the selected point draw a line back to the origin
where the fixed cost line touches the vertical axis. The break-even point (BEP)
is where the total revenues line and the total costs line intersect. At this point,
total revenues equal total costs. Refer Exhibit 1.2.

Exhibit 1.2 Cost-Volume-Profit Chart

TR
TC
Sales in birr
Br.1, 500,000
Profit area
(TR>TC)
units
Br. 750,000
Br. 500,000
Los area BEP: 16,000 units or
(TR<TC) Br.960, 000 sales
TVCs @ Br. 45 per
000 c)
TFC @ Br. 240,
0
10,000 20,000 30,000 Volume in units sold

Increase in sales Br. 400,000

Multiply by the CM ratio X 25%
Expected increase in contribution margin Br. 100.000
 Since the fixed expenses are not expected to change, net income will
increase by the entire Br. 100,000 increase in contribution margin.
1.4. Applying CVP Analysis
1.4.1. Sensitivity “What If” Analysis
Sensitivity analysis is a ―what if‖ technique that examine how a result will change if the
original predicted data are not achieved or if an underlying assumption
changes. In the context of CVP, sensitivity analysis answers such questions as,
 What will operating income be if the output level decreases by a given
percentage from the original reduction? And
 What will be operating income if variable costs per unit increase?
The sensitivity analysis to various possible outcomes broadens managers’ perspectives as to
What might actually occur despite their well-laid
plans?
Example (1) Zebib Concepts, Inc., was founded by Zenebe Aderajew, a graduate
student in engineering, to market a radical new speaker he had designed for
automobiles sound system. The company‘s income statement for the most recent month is
given below:
Sample Projected Income Statement
Total Per
Sales (400 speakers) Br. 100, Unit
Br.250.0
Variable Expenses 000 60, 0 150.0
Contribution Margin Br. 000
40, 0 .10
Br
Fixed Expenses 00035, 0
Net Income Br000
.
5,000
 Yohannes Tilahun, the senior accountant at Zebibib Concepts, wants to
demonstrate the company‘s president how the concepts developed on the preceding
pages can be used in planning and decision-making. To this end, Yohannes will
use the above data to show the effects of changes in variable costs, fixed costs,
sales, and sales volume on the company‘s profitability.
(i) Changes in Fixed Costs and Sales Volume:
 Zebib Concepts is currently selling 400 speakers per month (monthly sales
of Br.100,
000). the sales manager feels that a Br.10, 000 increases in the monthly
advertising budget would increase monthly sales by Br.30, 000.
 Should the advertising budget be increased?
Expected contribution margin ( Br.130, 000 x 40% CM ratio)………..… Br.52, 000
Present contribution margin (Br.100, 000 x 40% CM ratio)………….… 40,
000
Incremental contribution margin…………………………….……………. 12, 000
 Change in fixed costs (incremental advertising expense)……..………… 10, 000
Increased net income……………………………………..…………….... Br. 2,
000
 Answer is: Yes, based on the information above and assuming that other
factors in the company don‘t change, the advertising budget should be increased.
(ii) Changes in Variable Costs and Sales Volume
 Refer to the original data. Management is contemplating the use of high-
quality components, which would increase variable costs by Br.10 per speaker.
However, the sales manager predicts that the higher overall quality would
increase sales to 480 speakers per month.
 Should the higher quality component be used?

The Br10 increase in variable costs will cause the unit contribution margin to
decrease from
Br.100 to Br90.
Expected total contribution margin (480 speakers xBr.90)…………… Br.43, 200
Present total contribution margin (400 speakers xBr.100)……………. 40, 000
Increase in total contribution margin………………………………….. Br.3, 200
 Answer is: Yes, based on the information above, the high-quality component
should be used. Since the fixed expenses will not change, net income will
increase by the Br3, 200 increase in contribution margin shown above.

(iii) Change in Fixed Cost, Sales Price, and Sales Volume:

 Refer to the original data and recall that the company is currently selling 400
speakers per month. To increase sales, the sales manager would like to cut
selling price by Br 20 per speaker and increase the advertising budget by Br 15,
000 per month. The sales manager argues that if these two steps are taken, unit
sales will increase by 50%.
 Should the change be made?
A decrease of Br 20 per speaker in the selling price will cause the unit
contribution margin to decrease from Br100 to Br 80.
Expected total contribution margin :( 400-speakersx150%xBr80)………………… Br.80, 000
Present total contribution margin (400 speakers x Br 100)……….…………………… 40,000
Incremental contribution margin……………………………….……………………………
8,000 Change in fixed costs:
Incremental advertising expenses…………………………...……………………………….
15, 000
Reduction in
net
Income………………………………………………………………………………… Br. (7, 000)
 Answer is: NO, based on the information above, the changes should not be
made.
(iv) Changes in Variable Cost, Fixed Cost, and Sales Volume:
 Refer to the original data. The sales manager would like to replace the sales
staff on a commission basis of Br 15 per speaker sold, rather than on flat salaries
that now total Br 6, 000 per month. The sales manager is confident that the
change will increase monthly sales by 15%.
 Should the change be made?
Changing the sales staff from a salaried basis to a commission basis will affect
both fixed and variable costs. Fixed costs will decrease by Br 6,000, from Br 35,
000 to Br 29, 000. Variable costs will increase by Br 15, from Br 150 to Br 165,
and the unit contribution margin will decrease from Br 100 to Br 85.
Expected total contribution margin (400speakers x 115% x Br85)………………. Br.39, 100
Present total contribution margin (400 speakers x Br. 100)………….…………… 40,
000
Decrease in total contribution margin……………………………………………….. (900)
Change in fixed
costs:
Salaries avoided if a commission is paid [to be added on Br. (900)]……………… 6,
000
Increase in net income…………………………………………………………………… Br.5,
10 0

Present 400 Expected

460*
Sp eakers Per
Total perunit
month speakers
Total
Sales Per unit 000
Br100, Br.250 Br 115,
000 Br 250
Variable costs 60, 000 150 75, 900
165
Contribution margin 40, 000 Br.100 39, 100
Br 85 expenses
Fixed 35, 000 29, 000
Net income Br 5, 000 Br 10, 100
*400 speakers x 115%= 460 speakers
 Answer is: Yes, based on the information above, the changes should be
made. Again, the same answer can be obtained by preparing comparative
income statements:
(v) Changes in Regular Sales Price:
 Refer the original data. The company has an opportunity to make a bulk sales
of 150 speakers to wholesalers if an acceptable price can be worked out. This
sale would not disturb the company‘s regular sales .
 What price per speaker should be quoted to the wholesaler if Zena Concepts
wants to increase its monthly profits by Br 3, 000?
Variable cost per speaker…………………………..…………………. Br 150
Desired profit per speaker (Br3, 000÷150 speakers)……… 20
Quoted price per speaker…………………………………………..… Br 170
Notice that no element of fixed cost is included in the computation. This is because
fixed costs are not affected by the bulk sale, so all of the additional revenue that
is in excess of variable costs goes to increasing the profits of the company.
1.4.2. Target Net Profit Analysis
 Managers can also use CVP analysis to determine the total sales in units and
birrs needed to reach a target profit.
 The method used for computing desired or targeted sales volume in units to
meet the desired or targeted net income is the same as was used in our
earlier breakeven computation.
Example (1): Tre Company manufactures and sales a single product. During the
year just ended the company produced and sold 60,000 units at an average price
of Br.20 per unit. Variable manufacturing costs were Br 8 per unit, and variable
marketing costs were Br 4 per unit sold. Fixed costs amounted to Br. 180,000 for
manufacturing and Br.72, 000 for marketing. There was no year-end work-in-
 progress inventory. Ignore income taxes.
Instructio
ns:
a. Compute Tre‘s breakeven point (BEP) in sales Birrs for the year.
b. Compute the number of sales units required to earn a net income of Br
180,000 during the year
c. Tre‘s variable manufacturing costs are expected to increase 10 % in the
coming year. Compute the firm‘s breakeven point in sales birrs for the coming
year.
d. If Tre‘s variable manufacturing costs do increase 10%, compute the selling
price that would yield the same CM-ratio in the coming year.

Solutions:
a. The BEP using contribution margin technique can be calculated as:
BEP (in birrs) = Fixed Expenses = Br. 180,000 + 72,000 =
Br. 630,000
Cost –ratio
0.4
b. Target – net profit analysis can be approached using either of these two
methods
I. Equation method II. Contribution margin
method
I. Equation Method.
 Managers use a targeted income as the starting point in decision which
marketing and pricing strategies to use.
 The formula to determine a specific targeted income is an extension of the
break-even formula. Here, instead of solving sales volume where profits are zero,
you instead solve sales where profit equals some targeted amount. The equation
for target income is:
TI = Total sales – Variable expenses – Fixed expenses
TI = SPQ – VCQ – FC
Where SP = sales price
Q = sales unit to achieve the targeted income
VC= unit variable costs
FC = fixed costs
For Tre Company, the targeted sales volume in units would be determined as given below:
TI = SPQ – VCQ – FC 180, 000 = 20Q – 12Q – 252, 000 8Q= 180, 000
+ 252, 000
Thus, Q= Br.432, 000 = 54, 000 units
8
 Target sales (in birrs) = Br.20 x 54,000=Br. 1, 080, 000
Alternatively computed,
 Target income=SPQ –VCQ – FC = Total CM* - FC = CM-ratio x S – FC where
S= Birr sales to achieve the target income
Target income= 0.4S – Br.252, 000 Br. 180, 000=0.4S- Br.252, 000
= Br.1, 080, 000
II. Contribution Margin Approach.
 A second approach would be expanding the contribution margin formula to
include the target income requirements. Thus, we can modify the formula given
earlier for BEP
Computations as follows:
 Target sales (in units) = Fixed expenses + Target Profit
Unit CM
 This approach is simpler and more direct than using the CVP
equation. In addition, it shows clearly that once the fixed costs are
covered, the unit contribution is fully available for meeting profit
requirements.

 Target sales (in units) = Fixed expenses + Target Profit = Br.252, 000+180, 000 =54, 000 units
Unit CM) Br. 8
Target sales in birrs ( = Br.20 x 54, 000 = Br.1,

For Tantu
080, 00
 The total birr sales required to earn a target net profit is found by: Target sales (in birrs) =
Fixed expenses + Target Profit
CM-ratio
 Target sales in birrs (for Tre) = Br.252, 000 + Br. 180, 000 = Br. 1, 080, 000
0.4
I.4.3 The Margin of Safety
 The margin of safety is the excess of budgeted (or actual) sales over the
breakeven volume of sales.
 It states the amount by which sales can drop before losses begin to be
incurred. In other words , it is the amount of sales revenue that could be lost before the
company‘s profit would be reduced to zero.
 The formula for its calculations follows:
Margin of safety = Total sales - Break even Sales
The margin of safety can also be expressed in percentage form. This percentage is
obtained by dividing the margin of safety in birr terms by total sales:
Margin of safety (in %age) = Margin of safety in birrs
Total sales
Example (1): Consider the cost structure for ABC Company and XYZ in Exhibit 1-3
ABC Co. and XYZ
Co.
Comparative
ABC Co. Cost XYZ Co.
Amount Percent Amount Percen
Sales Br. 500,000 100 t
Br. 500,000 100
Variable costs 20 300,000 60
Contribution Margin 100,000
400,000 80 200,000 40
Fixed costs 300,000 100,000
Net income Br. Br. 100,000
100,000
The breakeven sales for each company may be computed as
follows:
 BEP (in birrs) = Fixed Costs
CM ratio
 BEP (ABC Co.) = Br.300, 000 = Br.375, 000
0.8
 BEP (XYZ Co.) = Br.100, 000 = Br.250, 000
0.4
 The margin of safety for each company may be computed as:
 Total sales - Break even Sales = Margin of safety
 ABC Co.’s: Br.500, 000- Br.375, 000 = Br.125, 000
 XYZ Co.’s: Br.500, 000- 250,000 = Br. 250,000
 Note t h a t the companies’ sales revenues are the same (Br. 500,000) and their net
incomes are the same (Br. 100,000) their individual margins of safety are different.
 T h i s is because they have different cost structures, and
consequently different breakeven.
 A higher breakeven sales amount for ABC Co. produces a lower margin of safety.
For ABC Co., the Br.125, 000 margin of safety means that sales
would have to diminish by more than this amount before the
company suffers a loss. In effect the
Margin of safety is a buffer before losses are incurred.

The same analysis applies to XYZ Co., except its buffer is Br.
250,000. At this point, neither company is experiencing losses;
 Thus it is difficult to say which company is better off. Because they are in
different businesses the amounts computed as b u f f e r s may m e a n the
c o m p a n i e s ‘ operating results are fine. A comparison within each company on a year-
by-year basis may shed light on the possibility of impending difficulties.
The margin of safety may also be expressed as a percentage. The calculation is
done by dividing the margin of safety (in birrs) by the total sales (in birrs). This,
the calculation of the margins of safety percentage is:
Margin of safety percentage = Margin of safety in birrs
Total sales in birrs
ABC Co.’s: Br. 125,000 = 25 %
Br.500, 000
XYZ Co.’s: Br. 250,000 = 50 %
Br.500, 000

1.5 CVP CONSIDERATIONS IN CHOOSING A COST STRUCTURE

Cost structure refers to the relative proportion of fixed and variable costs in an
organization. Managers often have some latitude in trading off between these
two types of costs. For example, fixed investments in automated equipment can
reduce variable labor costs. In this section, we discuss the choice of a cost
structure. We introduce the concept of operating leverage, which plays a key role
in determining the impact of cost structure on profit stability.
1.5.1 Cost Structure and Profit Stability
Which cost structure is better — high variable cost and low fixed costs, or the
opposite? No
Single answer to this question is possible; each approach has its advantages. To
show what we mean, refer to the income statements given below for two farms.
Example (1) Revenue and cost behavior relationships at two firms, A
and B, follow:
 Firm A
Amount Percent Amount
Firm B Percent
Sales …………………………………….… Br.100, 000 100 Br.100, 000 10
Less variable expenses ……………. 60,000 60 30,000 03
Contribution margin ……………..… 40,000 40 70,000 0
7
Less fixed expenses ………………… 30,000 60,00 0
Net income ……………………………. Br. 10,000 0
Br .
 Firm A has higher variable costs because it is labor-intensive while Firm B
has higher fixed costs as a result of its investment in machines.
 The question as to which firm has the better cost structure depends on
many factors, including the long run trend in sales, year-to-year fluctuations in
the level of sales and the attitude of the owners toward risk.
 If sales are expected to trend above Br. 100, 000 in the future, then Firm
B has the better-cost structure. The reason is that its CM ratio is higher,
and its profits will therefore increase more rapidly as sales increase.
To illustrate, assume that each firm experiences a 10% increase in sales. The
new income statement will be as follows:
Firm A Firm
B Amount Percent
Amount Percent

Sales ……………………..…… Br.110, 100 Br.110, 000 10

000
Less variable expenses ……... 66,000 60 33,000 03
Contribution margin ………… 44,000 40 77,000 0
7
Less fixed expenses ………….. 30,000 60,000 0
Net income …………….... Br. 14,000 Br. 17,000
 As we would expect, for the same birr increase in sales, Firm B has
experienced a greater increase in net income due to its higher CM ratio.
What if sales can be expected to drop below Br.100, 000 from time to time?
What are the break-even points of the two firms? What are their margins of
safety? The computations needed to answer these questions are carried out
below using the contribution margin method.
Firm A Firm B
 Fixed expenses ……………………………….. Contribution margin ratio ………………
Br.30, 000
  40%
Br.60, 000
Breakeven in total sales birrs. ……………. Br.75, 000
Br.85, 714
Total current sales (a) ……………………… Br.100, 000
Br.100, 000
Break-even sales ………………………………. 75,000
85,714
Margin of safety in sales birrs (b) ……………. Br. 25,000 Br .
14,286
Margin of safety as a %age of sales (b)  (a) 25.0%
14.3%
 This analysis makes it clear that Firm A is less vulnerable to downturns than
Firm B.
 We can identify two reasons why it is less vulnerable.
 First, due to its lower fixed expenses, Firm A has a lower break-even point and
a higher margin of safety, as shown by the computations above. Therefore, it
will not incur losses as quickly as Firm B in periods of sharply declining sales.
 Second, due to its lower CM ratio, Firm A will not lose contribution margin as
rapidly as Firm B when s a l e s fall off. Thus, Firm A‘s income will be less volatile.
We saw earlier that this is a drawback when sales increase, but it provides more
protection when sales drop.
 To summarize, without knowing the future, it is not obvious which cost
structure is better. Both have advantages and disadvantages. Firm B, with
its higher fixed costs and lower variable costs, will experience wider swing
in net income as changes take place in sales, with greater profits in good
years and greater losses in bad years. Firm A, with its lower fixed costs and
higher variable costs, will enjoy greater stability in net income and will be
more protected from losses during bad years, but at the cost of lower net
income in good years.
1.5.2 Operating Leverage
To the scientist, leverage explains how one is able to move a large object with a
small force. To the manager, leverage explains how one is able to achieve a
large increase in profits with only a small increase in sales and/or assets. One
type of leverage that the manager uses to do this is known as operating
leverage.
Operating leverage –is a measure of how sensitive net operating income
is to a given percentage change in dollar sales. Operating leverage acts as a
multiplier. If operating leverage is high, a small percentage increase in sales
can produce a much larger percentage increase in net operating income.
Operating
leverage
 It is a measure of the extent to which fixed costs are being used in an
organization.
 It is greatest in companies that have a high proportion of fixed cost in
relation to variable costs.
 Conversely, operating leverage is lowest in companies that have a low
proportion of fixed costs in relation to variable costs.
 If a company has high operating leverage (that is, a high proportion of fixed
costs in relation to variable costs), then profits will be very sensitive to
changes in sales. Just a small percentage increase (or decrease) in sales can
yield a large percentage increase (or decrease) in profits.
Operating leverage can be illustrated by returning to the data given above for
the two firms, A and B. Firm B has a higher proportion of fixed costs in
relation to its variable costs than does Firm A, although total costs are the
same in the two firms at a $100,000 sales level. We previously showed that with
a 10% increase in sales (from $100,000 to $ 110,000 in each firm), the net
income of Firm B increases by 70% (from $10,000 to $17,000), whereas the
net income of Firm A increases by only 40% (from $10,000 to $14,000). Thus,
for a 10% increase in sales, Firm B experiences a much greater percentage
increase in profits than does Firm A. The reason is that Firm B has greater
operating leverage as a result of the greater amount of fixed cost in its cost
structure.
The DOL at a given level of sales is computed by the
following formula:
Degree of operating leverage (DOL) = Contribution margin
Net income
The degree of operating leverage is a measure, at a given level of sales, of
how a percentage change in sales volume will affect profits. To illustrate, the
degree of operating leverage for the two firms at a Br. 100, 000 sales would be
as follows:
Firm A: Br.40, 000 = 4 Firm B: Br.70, 000 =7
Br.10, 000
Br.10, 000
 These figures tell us that for a given percentage change in sales we can
expect a change four times as great in the net income of Firm A and a change
seven times as great in the net income of Firm B.
 Thus, if sales increase by 10% then we can expect the net income of Firm A to
increase by four times this amount, or by 40%, and the net income of Firm B
to increase by seven times this amount, or by 70%.
The degree of operating leverage is greater at sales levels near the break-
even point and decreases as sales and profits rise. This can be seen from the
tabulation below, which shows the degree of operating leverage for Firm A at
various sales levels. [Data used earlier for Firm A are shown under column (3)]
Sales ……… Br.75, 000 Br.80, 000 Br.100, 000 Br.150,
000 Br.225, 000

Less: VCs 48, 000 60, 000 90, 000 135,

45, 000
Contribution margin (a) 30, 32, 000 40, 000 60, 000 000
90,
000 fixed expenses … 30,000
Less 30, 000 30, 000 30, 000 000
30,
Net income (b) … 000
Br. –0- Br.2, 000 Br. 10, 000 Br.30, 000
Br.60, 000
DOL (a) ÷ (b) ∞ 16 4 2
1.5
Thus, a 10% increase in sales would increase profits by only 15%(10% x 1.5)
if the company were operating at a Br. 225, 000 sales level, as computed
to the 40% increase we computed earlier at the Br.100, 000 sales level. The
degree of operating leverage will continue to decrease the farther the
 company moves from its break-even point. At the break-even point, the
degree of operating leverage will be infinitely large (Br.30, 000 contribution
margin÷Br.0 net income=∞)
A manager can use the degree of operating leverage to quickly estimate
what impact various percentage changes in sales will have on profits,
without the necessity of preparing detailed income statements. As shown by
our examples, the effect of operating leverage can be dramatic. If a
company is fairly near its break-even point, then even small increase in
sales can yield large increase in profits. This explains why management
often works very hard for only a small increase in sales volume. If the
degree of operating leverage is 5, then a 6% increase in sales would
translate into a 30% increase in profits.

Review Questions
1. Define what cost volume analysis is
2. What are the basis for CVP analysis?
3. Define break even analysis, cost structure, margin
of safety and operating leverage

Chapter Two
Master Budget
Budget: A budget is a quantitative expression of a plan of action that imposes the formal
structure of an organization.
 Managers use budgeting as an effective cost-management tool
 Budgets facilitate planning and coordination.

2.1 Benefits of Budgets

 Compel managers to think ahead
 Provide an opportunity to reevaluate existing activities and evaluate new ones.
 Aid managers in communicating objectives and coordinating actions across the
organization.
 Provide benchmarks to evaluate subsequent performance.
 Problems in implementing budgets:
 Low level of participation in the budget process,
 Lack of acceptance of responsibility for the final budget,
 Incentives to lie and cheat in the budget process,
 Difficulties in obtaining accurate sales forecasts
2.2 Types of Budget
Budgets are classified in different ways:
A) Based on capacity
i) Fixed budget –is a budget that remains unchanged with level of activity.
ii) Flexible budget –it is the budget that will fluctuate with the level of output.
B) Based on time
i) Long-rang budget –a budget that may cover long periods.
ii) Short-rang budget –a budget that covers less than one
year.
C) Based on coverage
i) Functional budget –budgets related to the various functions of a business.
 F u n c t i o n a l budget includes:
 a) Physical budget –budgets of quantity of sales & productions.
b) Profit budget –budgets that ascertains the profit; like sales budget, profit & sales
budget, etc.
c) Cost budget –these provide information on costs like manufacturing cost, selling &
administration costs etc.
d) Financial budgets –these provide information on the financial position of the firm.
e.g.; cash budget, capital expenditure budget etc.
ii) Master budget – is a consolidated summary of the various operation & financial
budgets. Or - It is a set of budgets prepared collectively for all activities of a
company.

2.3 The Master Budget

A comprehensive set of budgets, budgetary schedules, and pro forma organizational
financial statements
 For a specific period of time
 Static—based on a single level of output demand
 Interactive—departments generate and consume information
 The master budget is a detailed and comprehensive analysis of the first year of the
long- range plan. It summarizes the planned activities of all subunits of an
organization.
2.3.1 Components of Master Budget
The two major components of master budget are the:
1) Operating budget and
2) The financial budget.
1) Operating budget
 It focuses on income statement and its supporting schedules.
 It is also called profit plan. However, such budget may show a budgeted loss, or can
be used to budget expenses in an organization or agency with no sales revenues.
2) Financial budget
 It focuses on the effects that the operating budget and other plans will have on cash.
 The usual master budget for a non-manufacturing company has the following
components.
Exhibit 2.1: Components of master budget
Operating budget includes:
Financial budget includes:
a. Sales budget d. Capital budget
b. Purchase budget e. Cash budget
c. Cost of goods sold budget f. Budgeted balance sheet
Exhibit 2-1: above show graphically the follow of process in development of the master budget
1. Operating Budget
A. Sales budget:
 First budget prepared.
 Derived from the sales forecast.
 Management‘s best estimate of sales revenue for the budget period.
 Every other budget depends on the sales budget.
 Prepared by multiplying expected unit sales volume for each product times
anticipated unit selling price.
B. Cash Collections
 It is easiest to prepare budgeted cash collections at the same time as the sales
budget.
 Cash collections include the current month‘s cash sales plus the previous
month‘s credit sales.
C. Production Budget
 Production manager combines
 Sales estimates
 Beginning inventory targets
 Ending inventory targets
 Determines the types, quantities, and timing of products to be manufactured
D. Operating Expense Disbursements: Disbursements for operating expenses are based
on the operating expense budget
2. Financial budget:
The second major part of the master budget is the financial budget, which consists of the capital
budget, cash budget, and ending balance sheet.
A. Cash budget
The cash budget is a statement of planned cash receipts and disbursements that contains these
major sections: available cash balance, net cash receipts, and disbursement financing.
The cash budget has the following major sections:
 total cash available before financing
 cash disbursements
 minimum cash balance desired
 financing requirements
 ending cash balance
Total cash available before financing = Beginning cash balance + Cash receipts
 Cash receipts depend on collections from customers‘accounts receivable and cash
sales and on other operating income sources.
 Management determines the minimum cash balance desired depending on the nature
of the business and credit arrangements
 Financing requirements depend on how the total cash available compares with the
total cash needed
B. Capital Budget
 Long-term fixed asset needs
 Plant
 Equipment
 Payment points
C. Budgeted Balance sheet
 The final step in preparing the master budge is to construct the budgeted balance
sheet that projects each balance sheet item in accordance with the business plan an
 expressed in the previous schedules
 Beginning balances would be increased or decreased in light of the expected cash
receipts and disbursements and the effects of noncash items on the income statement.

2.4 Understand the difficulties of sales forecasting

A sales forecast is a prediction of sales under a given set of conditions.
Sales forecasts are usually prepared under the direction of the top sales executive
The sales budget is the result of decisions to create conditions that will generate a desired level
of sales.
Factors to Consider When Forecasting Sales
 Past patterns of sales
 Estimates made by the sales force
 General economic conditions
 Competitors‘ actions
Illustration: Elias Magnet Co. is preparing budgets for the quarter ending June 30. The sales
price is Br.10 per magnet. Budgeted sales for the next four months are: 20,000, 50,000 &
30,000 units 25,000 in July. The sales price is Br.10 per magnet
 The company wants ending inventory to be 20% of the next month‘s budgeted sales in
units. 4,000 units were on hand on March 31. Five pounds of material are needed for each
unit produced.
 The company wants to have materials on hand at the end of each month equal to
10 percent of the following month‘s production needs.
 The materials inventory on March31 is 13,000 pounds. July production is budgeted
for 23,000 units. Materials used in production cost Br.40 per pound. One-half of a
month‘s purchases are paid for in the month of purchase; the other half is paid for in the
following month. No discount terms are available. The accounts payable balance on
March 31 is Br.12,000
 Each unit produced requires 3 minutes (.05 hours) of direct labor. The company employs
30 persons for 40 hours each week at a rate of Br.10 per hour. Any extra hours needed are
obtained by hiring temporary workers also at Br.10 per hour.
 Variable manufacturing overhead is Br.1 per unit produced and fixed
manufacturing overhead is Br.50, 000 per month.
 Fixed manufacturing overhead includes Br.20, 000 in depreciation which does not require a
cash outflow.
 Variable selling and administrative expenses are Br.50 per unit sold and fixed selling and
administrative expenses are Br.70,000 per month.
 Fixed selling and administrative expenses include Br.10,000 in depreciation which
does not require a cash outflow
 All sales are on account.
 The company‘s collection pattern is: 70 percent collected in month of sale and the
remaining was collected in month after sale. Ignore uncollectible. Accounts receivable on
March 31 is Br.30,000, all of which is collectible
 The Company:
 Has a Br.100, 000 line of credit at its bank, with a zero balance on April 1.
 Maintains a Br.30, 000 minimum cash balance.
 Borrows at the beginning of a month and repays at the end of a month.
 Pays interest at 16 percent when a principal payment is made.
 Pays a Br.51, 000 cash dividend in April.
 Purchases equipment costing Br.143, 700 in May and Br.48, 800 in June.
 Has a Br.40, 000 cash balance on April 1.
The company reports the following account balances on June 30, prior to preparing its budgeted
financial statements:
Land - Br.50, 000
Building (net) - Br.174, 500
Common stock - Br.200, 000
Equipment (net) - Br.192, 500
Retained earnings - Br.148, 150
Required:
1. using the data given above, prepare the following detailed schedules for the first quarter of the
year:
A. Sales budget
B. Cash collection budget
C. Purchase budget
D. Disbursement for material purchases
E. Disbursement for direct labor
F. Disbursement for manufacturing overhead
G. Disbursement for selling and administrative expense
H. Comprehensive cash budget
I. The budgeted income statement
2. Using the budget data given above and the schedules you have prepared, construct the
following pro forma financial statements
A. Income statement for the first quarter of the year.
B. Cash budget including receipts, payments, and effect of financing
Solution for preparing master budget
A. Sales budget
Month Unit sales Selling price Total sales
April 20,000 Br.10 Br.200,000
May 50,000 Br.10 Br.500,000
June 30,000 Br.10 Br.300,000
July 25,000 Br.10 Br.250,000*

*July is needed for June ending inventory computations

B. Production Budget
 production budget= Budgeted product sales in units + Desired product units in
ending inventory = Total product units needed – Product units in beginning inventory =
Product units to produce
April May June Total
Budgeted unit sales 20,000 50,000 30,000
Desired ending inventory ** 10,000 6,000 5,000
Total units needed 30,000 56,000 35,000
Less beginning inventory 4,000 10,000 6,000
Units to produce 26,000 46,000 29,000

** Ending inventory = 20% of next month's production needs. June ending inventory = .20 ×
25,000 July units = 5,000 units. Beginning inventory is last month's ending inventory
 C. The material purchases budget
The material purchases budget is based on production quantity and desired material inventory
levels
 The material purchases budget= Units to produce × Material needed per unit =
Material needed for units to produce + Desired units of material in ending inventory =
Total units of material needed – Units of material in beginning inventory= Units
of material to purchase
April May June Total
Units to produce 26,000 46,000 29,000
Pounds per unit 5 5 5
Material needs (lbs.) 130,000 230,000 145,000
Desired ending inventory* 23,000 14,500 11,500
Total material needs (lbs.) 153,000 244,500 156,500
Less beginning inventory** 13,000 23,000 14,500
Material purchases (lbs.) Br140,000 Br221,500 Br142,000

*Ending inventory = 10% of next month's material needs. June ending inventory = .10 ×
(23,000 units × 5 lbs. per unit). June ending inventory = 11,500 lbs.
**Beginning inventory is last month's ending inventory.
D. Cash Payments for Material Purchases

April May June Total

Material purchases (lbs.) 140,000 221,500 142,000

Cost per pound Br.0.40 Br. 0.40 Br.0.40
Total cost Br.56,000 Br.88,600 Br.56,800
Payables from March 12,000
April purchase Br.28,000* Br.28,000
May purchases 44,300** 44,300
June purchases 28,400***
Total payments in month Br.40,000 Br.72,300 Br.72,700

* ½ × Br.56,000 = Br.28,000
**½ × Br.88,600 = Br.44,300
***½ × Br.56,800 = Br.28,400
E. Cash Payments for Direct Labor
April May June Total
Units to produce 26,000 46,000 29,000
Hours per unit 0.05 0.05 0.05
Total hours required 1,300 2,300 4500
Wage rate per hour Br.10 Br.10 10
Direct labor cost Br.13,000 Br.23,000 Br.14,500
 F. Cash Payments for Manufacturing Overhead
April May June Total

Units to produce 26,000 46,000 29,000

Variable overhead rate Br.1.00 Br.1.00 Br.1.00
Variable overhead cost 26,000 46,000 29,000
Fixed overhead 50,000 50,000 50,000
Total mfg. Overhead cost Br.76,000 Br.96,000 Br.79,000
Deduct depreciation 20,000 20,000 20,000
Manufacturing overhead - cash Br.56,000 Br.76,000 Br.59,000

G. Cash Payments for (S&A) Expenses

April May June Total

Budgeted unit sales 20,000 50,000 30,000

Variable S&A per unit Br.0.50 Br.0.50 Br.0.50
Variable S&A expense Br.10,000 Br.25,000 Br.15,000
Fixed S&A expense 70,000 70,000 70, 000
Total S&A expense 80,000 95,000 85,000
Deduct depreciation 10,000 10,000 10,000
S&A expense - cash Br.70,000 Br.85,000 Br.75,000

H. Cash Receipts Budget

April May June Total

Budgeted unit sales 20,000 50,000 30,000
Price per unit 10 10 10
Budgeted sales revenue 200,000 500,000 300,000
Receipts from March sales 30,000
Receipts from April sales * 140,000 50,000
Receipts from May sales 350,000 125,000
Receipts from June sales 210,000
Total cash receipts Br.170,000 Br400,000 Br335,000

*April: .70 × Br 200,000 = Br 140,000 and .25 × Br 200,000 = Br 50,000 May: .70 × Br 500,000
= Br 350,000 and .25 × Br 500,000 = Br 125,000
**June: .70 × Br 300,000 = Br 210,000
I. Comprehensive Cash Budget

April May June

Beginning cash balance 40,000 30,000 30,000
Cash receipts 170,000 400,000 335,000
Cash available 210,000 430,000 365,000
Cash payments: Materials budget 40,000 72,300 72,700
Labor budget 13,000 23,000 14,500
Manufacturing OH budget 56,000 76,000 59,000
S&A expense budget 70,000 85,000 75,000
 Equipment purchases 143,700 48,800
Dividends 51,000
Total cash payments Br Br400,000 Br 270,000
230,000
Balance before financing (20,000) 30,000 95,000
Borrowing 50,000 (50,000)
Principal repayment (2,000)
Interest **
Ending cash balance Br 30,000 Br 30,000 Br 43,000

** Br 50,000 × .16 × 3/12 = Br 2,000

J. The Budgeted Income Statement
ELIAS MAGNET COMPANY
Budgeted Income Statement
For the Three Months Ended June 30
Sales (100,000 units @ Br 10) 1,000,000
Cost of goods sold (100,000 @ Br 4.99) 499,000
Gross margin 501,000

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. Br 0.40 Br 2.00
Direct labor 0.05 hrs. Br 10.00 0.50
Manufacturing overhead 0.05 hrs. Br 49.70 2.49
Total unit cost Br 4.99

Total manufacturing overhead for quarter 251,000 = Br 49.70 per hour

Total labor hour required 5050

From labor and Mfg. OH budgets

Labor Hours Mfg. OH

April 1,300 Br.76,000
May 2,300 96,000
June 1,450 79,000
Total 5,050 $251,000

Manufacturing overhead is applied based on direct labor hours

 Elias Magnet Company
Budgeted Income Statement
For the Three Months Ended June 30

Sales (100,000 units @ Br 10) 1,000,000

Cost of goods sold (100,000 @ Br 4.99) 499,000
Gross margin 501,000
Selling and administrative expenses 260,000
Operating income 241,000
From S&A Expense Budget
April Br 80,000
May 95,000.
June 85,000

Elias Magnet Company

Budgeted Income Statement
For the Three Months Ended June 30
Sales (100,000 units @ Br 10) 1,000,000
Cost of goods sold (100,000 @ Br 4.99) 499,000
Gross margin 501,000
Selling and administrative expenses 260,000
Operating income 241,000
Interest expense 2,000
Net income 239,000
 Chapter –Three and Four
Flexible Budgets and Standard Costing
3.1 Static Budgets Vs Flexible Budget
All mastester budg
budgets disc
discusse
ussed in the previous
revious uniunit are
are static or inflexible because the
they assume fix
fixed level
evel of
activity
ity. A mastester bud
budget or static bud
budget is pre
prepar
pared for only one activ tivity
ity level
evel (for
for example one volume of
sales activi
activitty). The static budget is based on the level of output planned at the start of the budget period. The
master budget is called a static budget because the budget for the period is developed around a single (static)
planned output level. It is static in the sense that the budget is developed for a single planned output level.
When variances are computed from a static budget at the end of the period, adjustments are not made to the
budgeted amounts for the actual output level for the budget period.
A variance is the difference between actual results and expected performance. The expected performance is
also called budgeted performance, which is a point of reference for making comparisons.
The static-budget variance is the difference between the actual result and the corresponding budgeted
amount in the static budget.
A favorable variance—denoted F —has the effect, when considered in isolation, of increasing operating
income relative to the budgeted amount. For revenue items, F means actual revenues exceed budgeted
revenues. For cost items, F means actual costs are less than budgeted costs. An unfavorable variance—
denoted U—has the effect, when viewed in isolation, of decreasing operating income relative to the budgeted
amount. Unfavorable variances are also called adverse variances.

N.B
N.B. Maste
aster budge
budget vari
arianc
ance (static budge
budget varianc
ariance) is the varianc
ariance of actual result from the mast
master budge
budget.
Tot
Total maste
ster bud
budget vari
ariance (TMB
TMBV) = ALF + FBV
Where
ere TMB
TMBV = Tota
Total Maste
ster Budget Vari
ariance
ALF = Activit
tivity Level Variance
FBV = Flexible Budget Vari ariance
Consider ABC Company produce product X. Budgeted data for the company is as follows:
Budgeted selling price Br. 31
Budgeted Variable cost per unit Br. 21.8
Budgeted production and sales 9,000 units
Budgeted Fixed costs Br. 70,000
The actual result income statement is as follows:
 ABC Company
Income Statement
For the year ended Dec 31
Units 7,000
Revenues Br. 217,000
Variable costs 158,270
Contribution margin 58,730
Fixed costs 70,300
Operating income (11,570)
Compute the static budget variance.
ABC Company
Income Statement
For the year ended December 31

Units
Actual Result
7,000
Static Budget Variance
2,000 U
Static Budget
9,000
Revenues Br. 217,000 Br. 62,000 U Br. 279,000
Variable costs 158,270 37,930 F 196,200
Contribution margin 58,730 24,070 U 82,800
Fixed costs 70,300 300 U 70,000
Operating income (11,570) 24,370 U 12,800
Static Budget variance =Br. 24,370 U
The unfavorable static-budget variance for operating income of Br. 24,370 in the above table is calculated by
subtracting static-budget operating income of Br. 12,800 from actual operating loss of Br. 11,570:
The analysis in table provides managers with additional information on the static budget variance for
operating income of Br. 24,370 U. The more detailed breakdown indicates how the line items that comprise
operating income—revenues, variable costs, and fixed costs—add up to the static-budget variance of Br.
24,370 U.
Remember, ABC Company produced and sold only 7,000 units, although managers anticipated an output of
9,000 units in the static budget. Managers want to know how much of the static-budget variance is because of
inaccurate forecasting of output units sold and how much is due to company’s performance in
manufacturing and selling 7,000 units. Managers, therefore, create a flexible budget, which enables a more in-
depth understanding of deviations from the static budget.
It is usua
usual to label vari ariances
ces favora vorable
ble (F)(F) or unfavo
favora
rabble (U). The label indica indicattes whe
whethe
ther the target or the
actu
actuaal figure is larger. er. The wa y in whic which labels are are applie
pplied depends on the ite item for whic
which a variariance is
Computed.
Computed. If the ite item for which the vari ariance is compute
mputed is a revenu evenuee or prof
profit ite
item, favo
favora
rable
ble vari
ariances
ces
ar e
Those for whic hich act actual is greateater tha than the target; unfa unfavor
voraable vari ariances
ces are
are those for whicwhich actu
actuaal is less
tha
tha n the t arg
arg e t ( or the bud
bud g e t ) . I f t h e ite
ite m f or whic
whi c h t he v ari
ari a n c e is c ompute
omput e d is a c ost o r e xpe
xpense ite
item,
favo
favorarable
ble varia
riances
ces is those for whi which actual is less tha than the target. Therefo erefore,
re, if actua
tual cost is great
eater tha
than
target cost, the vari ariance will be labeled unfavo favorrable
ble.

3.2 Flexible budget (dynamic budget)

Actual activi
activitty ma y dif differ
fer signif nificantcantlly from from budg udgeted activi
activitty becau
cause of an une unexpect ected labor str strike
ike,
cann
ca cecell
lla
a tion of a n o r d er,
er, a n u n e x p ect
ec t e d l a r g e n e w p r oduc
oduc tion c ontrac
ont ract,
t, a nd othe
othe r f a c tor
to r s. W h e n actu
actuaa l resul
re ts
sult
dif
differ consid
onsiderab
erabl y from plans,, a fixed or sta static budg
budget may not be particularly effective effective in suppor
supporting
managers.ers. In such cascases several eral bud
budgets prep repared
ared for a variet y of activi
activitty levels may be mor more usef
useful.
ul.
In contr
contrast to the performance repo reporrt based onl onl y on compari aring the master budgbudget to the actu actuaal res
results, a mormore
usef
useful benchmarhmark k for anal ysis is the flexible budg budget. A flexible budgbudget (sometime times calle lled a variariable bud
budget) is
budg
budget thathat can
can easi
easilly be adju djuste
sted for differen fferencesces in the level of activi
activitty. It provi
ovides managers ers more usef useful
ul
inf
information for pla plannin
nning and bette tter basis for compar ompariing perfoerformance tha than, a static or fixed budg budget. In
performance evalua luation, a maste ster bud budget is kept fixed or static to serve as a benchmark for evalua luatin
ting
performance. ce. It shows revenues and costs at only the origina inall y pla
planned levels of activi activitty. Howe owever, er,
a flexible budg
budget will be prepared ared at the actu actuaal activi
activitty level.
 The flex flexible
ible budge
budget is identic ntical to the mastemaster budgedget in format, but managers may pre prepare it
for any leveleve l of a c tiv
tiv i t y .
A flexible budget calculates budgeted revenues and budgeted costs based on the actual output in the budget
period. The flexible budget is prepared at the end of the period after the actual output is known. The flexible
budget is the hypothetical budget that would have prepared at the start of the budget period if it had correctly
forecast the actual output. In other words, the flexible budget is not the plan initially had in mind. Rather, it is
the budget that would have put together for the year if we knew in advance that the output for the year would
be different. In preparing the flexible budget, note that:
 The budgeted selling price is the same used in preparing the static budget.
 The budgeted unit variable cost is the same used in the static budget.
 The budgeted total fixed costs are the same static-budget.
The only difference between the static budget and the flexible budget is that the static budget is prepared for
the planned output, whereas the flexible budget is based on the actual output. The static budget is being
―flexed, ‖ or adjusted for actual output. The flexible budget for actual output assumes that all costs are
either completely variable or completely fixed with respect to the number of output produced.
Flexible budget can be prepared in three steps
1. Identify the Actual Quantity of Output
2. Calculate the Flexible Budget for Revenues Based on Budgeted Selling Price and Actual Quantity
of
Output.
3. Calculate the Flexible Budget for Costs Based on Budgeted Variable Cost per Output Unit, Actual
Quantity of Output, and Budgeted Fixed Costs.
3.2.1 Dist
istinguishing Features res of Flexib
xible Budg
Budget
Flex
lexible budg
budgets have severaleral desir
sirable charact
aracteri
eristic
stics. The
They:
a) Cove
over a ran
range of activ
activiity
b) Are dynamic
c) Facilit
Facilitaate perfo
erformance
measu
easure
remm e nt.
a) Flexible Budg
Budgeet Cover a Range of Activ tivity
ity: Accuccurat
rate predi
redicctions of activit
tivity levels are
are some
sometime
times hard
ard
to make, and many managers find the they make mor more eff
effective
ective decisions
ecisions with the aid of flexible budge
budgets. In
developing a flexible budgbudget one activi
activitty level at each
each extreme
reme of the relevant range is select ected, with one
or mor
more in betwee
tween.n.
b) Flexible Budg
Budgeet Are Dynamic: Flexible bud budgets allow managers ers to adjust pla
plans easi
easilly whe
when activit
tivity
level differ
differss fro
from the expected level. Such budg budgets addre
ddress
ss ―wha
―what is ‖ rather
rather tha
than ―wha
―what was‖ or
―wh
―what was expect ected‖. This dynamic natur ture of flexible budg
budget makes them a very usef useful
ul decision
ecision making
 tool for management.
c) Flexible Budg Budgeet Facilitate Perform ormance Measu asurement: Measu easurring eff
efficienc y is an impor
important role
of
Performance repor port. Fix
Fixed budge
budgets are use useful for measuring effe ffective
tiven
ness, i.e., achieve
hievemment of goal.
In some cas cases, howe
however,
er, fixed budgbudgets do not ide identif
tify the que
question, ―what should the result result be,
give
iven the actu
actuaal level of activ
activiit y‖. In oth
other words, the flexible-
ible-bud
budg get approach sa ys, ―Give me an y
activi
activitty level you choose
hoose, and I ll provide a bud budget customiz
ustomized to thathat part
articula
ular level.‖
l.‖ To summar
summariize,
whenever actuactuaal and budg
budgeted act activity are
are sig
signif
nificant
cantlly differen
erent, a flexible bud budget var
variance rep
report
provide
ovides a bettetter measu
easurre of effi
efficienc y than a repo
reporrt based on a fix
fixed budg
budget.
3.2.2 Flexible-Budget Variances
The flexible-budget-based variance analysis for ABC Company, which subdivides the Br. 24,370 unfavorable
static-budget variance for operating income into two parts: a flexible-budget variance of 5,970 U and a sales-
volume variance of 18,400 U. The flexible-budget variance is the difference between an actual result and the
corresponding flexible-budget amount.
 ABC Company
Income Statement
For the year ended …
Actual Flexible Flexible Sales Volume Static
Budget Budget Variance Budget
Variance
Units 7,000 0 7,000 2,000 U 9,000
Revenues Br. 217,000 0 Br. 217,000 Br. 62,000 U Br. 279,000
Variable costs 158,270 5,670 U 152,600 43,600 F 196,200
Contribution margin 58,730 5,670 U 64,400 18,400 U 82,800
Fixed costs 70,300 300 U 70,000 0 70,000
Operating income (11,570) 5,970 U (5,600) 18,400 U 12,800
Flexible Budget variance =Br. 5,970 Sales volume variance =Br.
*U or F indica
indicattes whethe ther the vari ariancesces areare unf
unfavorable
rable or favor vorableble, res
respectiv
ectiveely.
 Managers ers use comparompariisons betwee tween n act
actual resresults, maste ster budg
budgets, and flexible budg budgets to evalua luate
organiz
nizationa
tional perfoerformanceance.. When evalua luating perfo erformance, ce, it is useful eful to disting
distinguish betwee tween n
effectiv
effectiveeness- ss-the degrees
rees to whicwhich a goal, objec objecttive, or targ arget is met- and effici efficieency-the degree to whic which
inputs areare use
used in rel
relation to a give iven level of outp outputs.
 Perfoerformance ma y be eff effective
tive, effi efficient, both, or neither ither.. For example ple, ABC Co. set a maste ster
budg
budget objec
objective
tive of manufacnufactu turring and selling 9,000 units.. Onl Only 7,000 units were act actually made and
sold,, howe
however. er. Performance, ce, as measu easure
red d by sales-act activit
vity vari ariances,
ces, was inef inefffective
ective becau ecause the
sales objec
objective
tive was not met.
 Was ABC‗s perfo erformance effi efficient? Managers ers judg
judge the degree of efficiency b y comp ompariaring actactual
outputs achi
achieeved (7,000 units) with actu actuaal inputs (suc such as the cost of direc directt materials and direc directt labor
bor).
The less input used to prod produce a given ven outpu tput, the more effi fficient the ope operation
ration. ABC was in effi efficient in
its use of a numbe
number of inputs. Later in the second econd sect ection, direc
directt materi erial, direct
rect labor and vari ariable and
fixed over
overh head
ead flexible-
ible-bud
budg get vari ariances ces will be discdiscusse
ussed in detail.
 Flexible-
xible-b budge
dget variariances measu asure the effi efficiency of ope operation
rations at the actual level evel of activ tivity
ity. The
flexible-
ible-bud
budg get variariances shown in column (2) of Exhibi hibit above tota total Br. 5,975,970 unfa
unfavo vorarabl
blee. The
total flex
flexibl
ible-
e-budg
budge e t v arianc
arian c e a r ise
ise s from salee s
sal pri priceces s recei i
ece vevedd and the v ariable and f i xed
xed c osts inc
in urred.
c urre
ABC Co. had no dif difference betwee tween n actu
actuaal sales price and the flexible- ible-bud
budggeted sales price, ce, so the focus
is on the diffe
differrences
ces betwee
tween n actua
ctual costs and flexible ible-budg
budgeted costs at actu actuaal 7,000-
000-unit level of activiactivitty.
 Sale
ales-activtivity variance
ariancess measu asure how effec ffectiv
tive manage agers have been een in meeti eetin
ng the pla planne
nned salesales
objec
objectitive
ve.. In ABC Co., sales act activit
ivity fell
fell 2,00
2,000 units shor short of the planne nned level. The sales--activi activitty
vari
ariances
ces (tota
totaling Br. 18,400 U) are unaf unafffect
ected by an y changes in unit prices or vari ariable costs. Why?
Because
cause the s a me bud
bud g e ted unit p r i ces
ce s a nd v ari
ar i a ble c osts are
ar e u s e d in c onstr
onst r ucting both the flexible and
 Master budg
budgets. Theref
Therefor
ore,
e, all unit prices
ces and variable costs are
are held cons
onstant in columns (2) and (4) of
the above illustr
illustr a tion.

3.3 Standards for control

A standard is a benchmark or ―norm‖ for measuring performance. Standard Costs Defined: Standard costs
are carefully predetermined costs created by management and used as a basis for comparison with actual
costs. Like all standards, standard costs are measure of achievement. Consequently, managers must use care
to ensure that the standards are appropriate measures of performance that encourage attainment of
organizational goals.
 T y p e s of standards: Different firms may fix different standards and the same firm may adopt different
standards at different points of time. This difference in standards arises due to the variation in
circumstances or conditions under which standards are fixed. On the basis of circumstances, the
standards may be classified as under:
 Ideal standard: A standard is said to be an ideal if it is based on ideal conditions of work. It reflects
the most optimistic expectations of management. Ideal standards (also called perfection standards) can
be achieved only with perfect operating conditions. It pre-supposes most favorable conditions of
work and rules out any possibility of loss arising out of abnormal conditions such as break-down
of machines, failure of power, employee error, labor strikes, changes in government policy,
defective raw material, inventory shortage, etc. In brief, it assumes no production problems of any
sort. Some managers believe that perfection (or ideal) standards motivate employees to achieve the
lowest cost possible. They claim that since the standard is theoretically attainable, employees will have
an incentive to come as close as possible to achieving it. Other managers and many behavioral scientists
disagree. They feel that ideal standards discourage employees, since they are so unlikely to be attained.
Moreover, setting unrealistically difficult standards may encourage employees to sacrifice product quality
to achieve lower cost.
 Basic standard: It is a fixed standard that provide a framework for comparing performance over a period
of years. They are sometimes called long-range standards because once created, they are used for
several years or longer. Since a basic standard remains unchanged, it does not suggest,
―What the cost for the year ought to be?‖ Therefore, it cannot be used for valid comparisons as rapidly rising
resource costs and charging production technology often make basic standards difficult to use. As a result, not
many firms use basic standards.
 N o r m a l standard: Normal standards can also be termed as historical standards as it is based on the
average performance in the past years. It can be fairly a satisfactory standard if the performance
in the past has been fairly stable. In case of constantly improving efficiency or erratic performance,
the normal standards will fail to serve the purpose. It suffers from all the defects of an arithmetic average
based on a series of items that include few extreme items.
 Attainable standard: It is one that can be attained under the conditions and circumstances
prevailing within the organization. Currently attainable standards are the most commonly used standards.
They represent benchmarks for efficient production in the current environment. Currently attainable
standards are not as stringent as ideal standards because they allow for normal production
problems, such as equipment maintenance, downtime, random employee errors, and occasional
inventory shortages. Still, currently attainable standards represent desirable information. Currently
attainable standards are also called practical standards.
ARE STANDARDS THE SAME AS BUDGETS?
 Standards and budgets are very similar. The major distinction between the two terms is that a standard is
a unit amount, whereas a budget is a total amount. Suppose that the standard cost for materials is Br.
12 per unit and 1,000 units are to be manufactured during a budget period, then the budgeted cost of
materials would be Br. 12,000 (Br. 12 x 1,000). In effect, a standard can be viewed as the budgeted cost
for one unit of product.
3.3.1 PURPOSES OF STANDARD COSTS
Cost information may be used for many different purposes. It should be noted that cost information that
serves one purpose might not be appropriate for another. Therefore, the purpose for which cost information is
to be used should be clearly defined before procedures are developed to accumulate cost data. Standard costs
may be used for the following purposes:
a) Cost control: Monitoring and controlling the cost of production, marketing, and administrative activities
are among the primary functions of managers. Cost control is not merely the minimization of costs; it is
identifying costs with their benefits and ensuring that the costs are justified, given the benefits derived.
Standard costs provide a useful framework for cost control.
 Typically, standards are expressed in terms of one unit of output. When standards are expressed
in terms of a single unit of output, they can be used to measure cost with standard costs as
frequently as desired – monthly, weekly, daily, or for each work shift. As long as production
output can be measured and actual cost accumulated, cost performance can be measured.
b) Product pricing: The selling price of a unit and the cost per unit are usually closely related. The cost
data are readily available under standard costing system and the price can be quoted on the basis of
standard costs without fear of under or over pricing. Standard cost is the predetermined normal cost of
Normal output and as such forms basis for price fixation.
c) Estimating budgets: Standard costs and budgets are similar, because they both represent planned costs
for a specific period. Standard costs are very useful when developing a budget, since they form the
building blocks of a total cost goal (or budget). Budgets, in effect, are standard costs multiplied by the
volume or activity level expected.
d) Performance appraisal: Employee performance evaluation is a difficult task involving many different
variables, some of which are subjective and therefore difficult to use in comparing employees. When
standards are established for performance evaluation, they provide tangible measures that can be
applied uniformly to all personnel.
 For example, the standard labor time for performing various production activities may be used to
evaluate the efficiency of employees. Similarly, production department supervisors may be
evaluated on how close their department came to achieving standards. Standards can be
effective in performance evaluation if employees have a clear understanding of the standards and
the way they are used. In addition, employees must be given timely reports evaluating their
performance. The timely reports are possible because the standards are readily available for
quick comparison and reporting.
e) Simplify performance reports: The performance reports presented in the form of variance analysis are
simple to understand as they clearly distinguish between favorable and unfavorable variances. The busy
top management can concentrate on significance variances and take appropriate action in the matter.
f) Record Keeping: Detailed record keeping may be reduced when standard costs are used in conjunction
with actual costs. For example, when materials are kept at standard cost, the materials ledgers need only
keep track of quantities.
g) Cost awareness: Accountants and financial managers are aware of the costs associated with the
activities of the business, because they deal with them daily. Many other employees, however, have little
or no awareness of costs. They may be concerned with increasing daily production, improving
employee morale, and improving production efficiency, all of which have an impact on costs, but many
employees do not understand the cost consequences of these activities. Standard costs and standard
cost performance reports inform employees about the cost implications of their actions. Such cost
awareness may result in better employee efforts at cost control.
3.3.2 The standard cost system
Three fundamental activities in a standard cost system are:
1) Standard setting.
2) Accumulation of actual costs.
3) Variance analysis.
1) Standard setting: The first step in a standard cost system is the creation of the standards to be used as a
basis for measuring performance. Standard setting is an important activity because poorly conceived
standards result in inappropriate measures of performance. Standard setting is not a one – time activity.
 As resource costs and production methods change, revision of the standard is necessary. In many firms
standards are evaluated on a regular basis, such as annually or every 6 months.
 Management accountants typically use two methods for setting standards: analysis of historical
data and task analysis.
a) Historical data: Often the immediate past is the best indicator of the near future. Firms that have been
producing the same product using the same production technology for a number of years may base their
standards on their historical experience. The past relationships and prices are then used as standards. However,
the management accountant often will need to adjust these predictions to reflect movements in price levels or
technological changes in the production process.
b) Task analysis: Another way to set cost standards is to analyze the process of manufacturing a product to
determine what it should cost. The emphasis shifts from what the product did cost in the past to what it
should cost in the future. In using task analysis, the management accountant typically works with engineers
who are intimately familiar with the production process. Together they conduct studies to determine how much
direct material should be required and how machinery should be used in the production process. Time and
motion studies are conducted to determine how long each step performed by direct laborers should take.
2) Accumulation of actual costs: A standard cost system does not eliminate the need for accumulating actual
production costs. Actual costs are compared with standard costs to determine variances. In
manufacturing, actual costs are accumulated in a job order or a process costing system. With
nonmanufacturing activities, actual costs are also accumulated and compared with standards established
for nonmanufacturing activities.
3) Variance analysis: A variance occurs when actual costs differ from standard costs. Variances are
expressed in total birr amounts and separated into specific classifications to facilitate cost analysis and
control. Variance analysis is a systematic process of identifying variances and reporting them to
Management.
 3.3.3 Setting the Standards
The first step in the development of a standard costing system is to set standard cost, i.e., to predetermine the
standards in respect of each element of cost - direct material, direct labor and overheads. Extreme care is
essential in the fixation of standards as the success of a standard costing system depends largely upon the
accuracy of the standard costs used. Establishment of standards for direct materials and direct labor will be
presented here under, along with variance analysis to these two basic cost elements of manufacturing. While
setting production cost standards, the following factors should be considered:
 Technical and operational aspects of the concern.
 The type of standard to be used.
 Proper classification of the accounts so that variance may be determined properly.
 Responsibility for setting standards. As definite responsibility for variances from standards is
ultimately to be laid on individuals or departments, it is obvious that all those individuals
or departments should be associated with setting of standards.
1. Direct materials standards
Direct materials cost standards may be divided into:
a) Quantity (usage) standards.
b) Price standards.
 Quantity (usage) standards: It refers to predetermined specifications of the quantity of direct materials
that should go into the production of one finished unit under normal conditions. If more than one direct
material is required to complete a unit, individual standards must be computed for each direct material.
The number of direct materials required to complete one unit can be developed from engineering
studies, analyses of past experiences, and /or tests runs under controlled conditions.
 The engineering department is normally responsible for setting quantity standards because it is
generally responsible for designing production processes for making a product. Many
manufacturing companies have separated departments that are assigned the responsibility for setting
standards.
 Price standards: It refers to prices at which direct materials should be purchased. The cost accounting
department and /or the purchasing department are normally responsible for setting materials price
standards because they have ready access to price data and should have knowledge of market
conditions. If more than one direct material is used in a production process, a standard unit
price must be computed for each one.
 2. Direct labor standards
Direct labor cost standards may be divided into:
a) Efficiency (time or usage) standards.
b) Rate (wage) standards.
 Efficiency standards: These are predetermined performance standards of the cost of direct labor that
should go into production, under normal conditions, of one finished unit. Time – and – motion studies
is very helpful in developing direct labor efficiency standards. In these studies, an analysis is made of
procedures to be followed by workers, and the conditions (space, temperature, equipment, tools,
lighting, etc.) under which the worker must perform assigned tasks. Procedures and conditions
are closely related; and therefore, a change in one is usually accompanied by a change in the other.
For example, the introduction of an additional piece of equipment to an assembly line would
require a change in the procedures followed by workers. When either the situations or procedures
are changed, a new standard should be developed. Time – and – motion studies must be performed
for all steps in the production process.
 Staff specialists are usually given the responsibility for setting direct labor efficiency
standards. Staff specialists should have a thorough knowledge of the production process used by
the factory in addition to knowledge of the techniques of time – and – motion studies. Many
companies have departments devoted solely to the establishment of direct labor efficiency
standards.
 Rate standards: These are predetermined wage rates for a period. The cost accounting, engineering, or
personnel departments are normally responsible for setting direct labor rate standards, because they
usually have access to the data required to set standards.
Variance Analysis
The primary object of standard costing is to reveal the difference between actual cost and standard cost. A
variance‗ in standard costing refers to the divergence of actual cost from standard cost. Variances of different
cost items provide the key to cost control. They indicate whether and to what extent standards set have been
achieved. This enables management to correct adverse tendencies.
After standard costs have been established, the next step is to ascertain the actual cost under each element and
compare them with the standard cost. The difference between these two is termed as cost variance.
Cost variance is the difference between a standard cost and the comparable actual cost incurred during a given
period.
Variances arise when actual results do not equal the standard because of either external or internal factors.
Management has little control over internal factors. Therefore, external factors (uncontrollable variances)
should be separated from internal factors (controllable variances). Variance analysis is a valuable technique
for separating the two. It is defined as the systematic evaluations of variances to provide managers with
useful
Information for measuring efficiency and improving performance.
Controllable and Uncontrollable Variance: When the variance with respect to any cost item reflects the
degree of efficiency of an individual or department, i.e., a particular individual or departmental head is
responsible for the variance, the variance is known as a controllable variance. Obviously, such a variance is
amenable to control by suitable action. An uncontrollable variance is one which is not amenable to control by
individual or departmental action. Such a variance is caused by external factors like change in market
conditions, fluctuations in demand and supply, etc. No particular individual within the organization can be
held responsible for it.
When variances are reported, attention of the management is particularly drawn towards controllable
variances. If a variance has been caused by multiple factors, the part of cost variance relevant to each factor
should be determined.
 Variances can be computed for all three of the basic cost elements – direct materials, direct labor, and
manufacturing overhead. The computation for materials and labor is quite similar. Manufacturing
overhead variances require different and somewhat more complex situations
A. Direct material variances
Direct materials variances may be divided into:
1) Quantity (usage) variance.
2) Price variance.
Material Quantity Variance: The material quantity variance measures the amount of variance caused by
using more or less materials than standard. Direct materials quantity variance is favorable when the
actual quantity used is less than the standard quantity allowed and is unfavorable when more materials
are used than standard.
The formula for the variance can be expressed as follows:

MQV = (AQ – SQ) x SP

Where MQV = Direct Materials Quantity variance
AQ = Actual Quantity used
SQ = Standard Quantity allowed
SP = Standard unit price
Standard quantity allowed is the amount of direct materials that should have been used to produce the
actual unit output of the period. And it is equal to the predetermined quantity of direct materials that should
go into one finished unit multiplied by the number of units produced.

Standard quantity of = Actual output x materials allowed

Materials allowed Achieved per unit of out put
Compiled by: course instructors Page
  Material quantity variance highlights deviations between the quantity of material actually used and the
standard quantity allowed. Thus, it makes sense to compute this variance at the time the material is
used in production.
 The production department or cost center that controls the input of direct materials into the production
process is usually assigned the responsibility for this variance.
MPV = (AP – SP) x AQ
Where MPV = direct materials price variance
AP = actual price or unit cost
SP = standard price
AQ = actual quantity purchase
1) Material Price Variance: The material price variance measures the amount of variances from standard
that occurs because the price paid for raw materials is different from the standard cost. If the actual
materials cost is greater than standard, the price variance is unfavorable. A favorable variance occurs if
the cost of materials is less than standard. The equation of the material price variance is:

 As stated above, the direct material price variance is based on the actual quantity purchased because
deviations between the actual and standard price relate to the purchasing function in the firm.

 Management has little control over price variances, especially when they result from rising
prices.
However, the purchasing department may have some control over prices by ordering in economical
quantities, and /or finding suppliers who offer the same quality of goods at lower prices.
Note that: The sum of the direct material usage and price variances equals the total direct material flexible
budget variance (MFBV).
MFBV = MQV + MPV
Example (1) National Company produces a single product. For the first quarter of the year, the following data
were collected:
Units produced (finished products) 10,000 units
Direct materials quantity standard 4 units of direct materials per unit of finished product
Direct materials used in production 39,000 units
Direct materials purchased 50,000 units
Direct materials standard cost Br. 2.00 each
Actual direct materials cost Br. 2.10 each.
Instruction: For materials used in the production, compute the following variances for the quarter:
a) Direct materials quantity and price variances.
b) Direct materials flexible budget variance.
c) And identify each variance as favorable (F) and unfavorable (U).
Solutions:
a) i) Direct materials quantity variance
Standard materials allowed (SQ) = Actual Output x Materials allowed per unit.
= 10,000 x 4 = 40,000 units
MQV = (AQ – SQ) x SP
= (39,000 – 40,000) x 2.00
= Br. (2,000) F
A favorable (F) variance indicates that direct materials quantity used was less than the standard quantity
allowed.
ii) Direct materials price variance
MPV = (AP – SP) x AQ
= (2.10 – 2.00) x 50,000
= Br. 5,000 U
An unfavorable (U) direct materials price variance resulted because the actual unit cost was greater than
the standard unit cost.
b) Direct materials flexible budget variance (MFBV)
MFBV = MQV + MPV
= Br. (2,000) F + Br. 5,000 U
= Br. 3,000 U
Manufacturing overhead variances
The flexible overhead budget is the management accountant‗s primary tool for the control of manufacturing
overhead costs. At the end of each accounting period, the management accountant uses the flexible overhead
budget to determine the level of overhead that should have been incurred, given the actual level of activity.
Then the accountant compares the overhead cost in the flexible budget with the actual overhead costs
incurred. The management accountant then computes separates overhead variances, each of which conveys
separate information useful in controlling overhead costs.
However, many organizations believe that it is not worthwhile to monitor individual overhead items.
Therefore, overhead variances often are not subdivided the flexible budget variances- the complexity of the
analysis may not be worth the effort.
The formula for the variance can be expressed as follows:
VOEV =(AH-SH) X VOHR
Where: AH =actual direct labor hours
SH = standard direct labor hours allowed
VOHR = standard variable overhead rate per hour
Compiled by: course instructors
 As its name implies, the variable overhead spending variance (VOHSV) measures deviations in
amounts spent for overhead inputs such as lubricants and utilities. The formula for the variance can be
expressed as follows:
VOHSV = AH (AR-SR)
Where: AH= actual direct labor hours used
AR= actual variable overhead rate
SR = standard variable overhead (VOH) rate
VOHSV = AH (AR-SR)
VOHSV = (AH x AR) – (AH x SR)
= Actual variable overhead – (actual direct labor hours used x standard VOH rate)
Example (4) Wale Company uses standard costs and a flexible budget to control its manufacture of fine
chocolates. Operating data for the past week are summarized as follows :(lb= pound)
a) Finished units produced: 5, 000 units of chocolates.
b) Direct materials: purchases, 8,000 lbs @ Br15 per lb; standard price is Br.16 per lb. Used 5, 400 lbs
allowed per case produced, 1lb.
c) Direct labor: actual hours, 8, 000 hours @ Br.30.50. standard allowed per good case produced, 11/2
hours. Standard price per direct labor, Br.30
d) Variable manufacturing overhead: actual costs Br. 88, 000. Budget formula is Br.10 per standard
direct labor hour.
Instructions:
 A. Material purchase price variance
B. Material usage variance
C. Direct labor rate variance
D. Direct labor usage variance
E. Variable overhead efficiency variance.
F. Variable overhead spending variance
Solutions:
a) MPV = (AR-SP) X AQ
= (15-16) X 8, 000 = Br. (8000) F
b) MUV = (AQ –SQ) X SP
= (5, 400-5, 000) X 16 = Br.6, 400 U
c) LRV = (AR –SR) X AH
= (30.5 –30) X 8, 000 = Br. 4, 000 U
d) LEV = (AH – SH) X SR
= (8000 –7500) X30 =Br.15, 000U
e) VOHEV = (AH –SH) X VOH rate
= (8, 000 - 7, 000)x 10 =
Br.5, 000 U
f) VOHSV = actual variable overhead-(SRX AH) = Br.88, 000 – (10 X8, 000)
= Br.8, 000 U
Learning Activity 1
1. What is a static budget?
2. What is a flexible budget? Identify its major features?
3. What are standards?
4. What are the basic types of standards?
5. What are the basic purposes of standard costs?
CHAPTER FIVE
Relevant Information & Decision Making: Production Decision
5.1 Introduction
This unit illustrates relevant costs for many types of decisions. Does this mean that each decision
requires a different approach to identifying relevant costs? No. The fundamental
principle in all decision situations is that relevant costs are future costs that differ among
alternatives. The principle is simple, but its application is not always straightforward.
Managers must have tools at their disposal to assist them in distinguishing relevant
and irrelevant costs so that the latter can be eliminated from the decisions
framework.
As a matter of fact, you may find it would be helpful to refresh your memory concerning
relevance. What costs are relevant in decision-making? The answer is easy. Any future cost that
makes a difference between decisions alternative is relevant for decision purpose. All costs are
considered relevant, except
a) Sunk costs –is a cost that has already been incurred and that cannot be avoided regardless
of which course of action a manager may decide to take. As such, sunk costs have no
relevance to future events and must be ignored in decision- making.
b) Future costs that do not differ between the alternatives at hand.
 Relevant costs are avoidable costs. An avoidable cost can be defined as cost that can be
eliminated as a result of choosing one alternative over another in a decision-making
In m a n a g e m e n t a c c o u n t i n g , the term avoidable is synonymous with differential cost.
These terms are frequently used interchangeably. To identify the costs that are avoidable
(differential) in a particular decision situation, the manager‘s approach to cost analysis should
include the following steps:
Assemble all of the costs associated with each alternative being considered. Eliminate
those costs that are sunk.
Eliminate those that do not differ between alternatives.
Make a decision based on the remaining costs. These costs will be the differential or
avoidable costs, and hence the costs relevant to the decision to be made.

5.2 Alternative Choice Decisions

5.2.1. Make or Buy Decision
Managers in manufacturing companies are often faced with the problem whether to manufacture a
component used in manufacturing a product or to purchase from the outside. Production of such basic
materials as screws, nails, washers, sheet metal and so on is not usually economical owing to
specialization and returns to scale. These materials can almost always be acquired more cheaply
from outside suppliers. But for many materials, such as subassemblies and special parts, it is not always
clear which is least costly means of acquisition. The cost and management accounting system assist
managers in arriving at a correct decision by presenting suitable analysis of the cost of production and
comparing it with the purchase price of the product.
 In make or buy decisions, the appropriate means of analysis is to compare the relevant cost of
buying the part with the relevant cots of making the part. Here relevant cost of buying the
component is typically the amount paid to supplier. It may also include transportation costs
incurred to get the component to the company‘s plant and costs incurred to process the part upon
receipt.
 The rel relevant cost of making the compone omponent is often the var variable cost osts inc
incurred
rred to
produce the compone
omponent. In some cas cases, howe however,er, the compa
ompany will need to acquire speci ecial
equipme
quipment to produ oduce the produc oduct or will hir hire additiona
dditional sup
superviso
ervisorry personn
ersonneel to assis sist wit
with
making the produc duc t. T h e se incre
increm
m e nta
nta l f i x e d c osts will be p art
art of the r e l e v a nt c ost of m a kin
king
the part. The alter
ltern
native chosen- make or buy is t ypical call y the one with the lowe lowest cost.
In the final deci
ecision regarding mak make or buy qualitativ
qualitative fac
factors, besidsides the
quantitativ
quantitative data, should be conside
onsidered as part of the decision.
ecision.
 In make or buy deciecision, the followin
ollowing qualitalitative facto
actorrs, beside
sides the quantita
quantitative
conside
onsiderations may favoavor the decision
ecision to ―buy‖:
 Adva
Advanta
ntage of lon
long-term relationship with sup supplier
pliers.
s.
 Possibili
ossibility of shor
hortage of materi erial or labor for making the compon
omponent.
 Uninterr
Uninterrupt
upteed suppl
suppl y of requisite qua
qualit
lity from
from reli
reliaable supplier
suppliers.
s.
On the contra
ontrarry, the following quaqualita
litative facto
actorrs may favor the decision
ecision ―to make‖ke‖:
 The quaqualit
lity of the produc
oduct is decid
ecideed to be contr
ontroll
olled.
 if the pur
purchase price is likelikely to rise due to increa
creased demand in the mark arket, it
becom
ecomees une
uneconomica
conomicall to buy.
 Where ere the tech
echnica
nicall kno
know-how is to be kept secre ecret and not to be passed on to the
supplier
suppli ers
s a nd so o n.
Exam
xample (1): Great eat Compa
mpany manufactfactures
res 60, 000 units of part
art XL-40 each year for use on
its produc
oduction line
line. The following are are the costs of makin
king part
art XL-40:
Tota
Total Costs of 60, 000 units Cost per unit
Direc
Directt materialerial Br. 480, 000 Br.8
Direc
Di rectt l a bor 360, 000 6
Vari
ariable factfactory overh
erhead
ead (FO
(FOH) 180, 000 3
Fixed FOH 360, 000 6
Tota
Total manufa nufactu
cturring costs Br. 1, 380, 000 Br.23
Anothe
Another manufacnufactu turrer has offered
ffered to sell the same part art to Great
reat for Br.21 each.
each. The fixed
over
overhhead
ead consi
onsists of depreci reciation, prope
operty taxes, insura
insurannce,
ce, and supe
supervisor
visory salari
aries. The entir
ntire
fixed over
overh
head
ead would cont ontinue if the Great
reat Compa
ompany bou
bought the compone
omponent excep cept that the cost of
Br. 120, 000 pert ertaining to some supervisoervisorry and custodia
ustodial personn
ersonneel could be avoide
voided.
a. Should the parts be made or boug bought? Assume that the cap capaci
acity now used to make parts arts
int
intern
ernally wil
will become
ecome idle if the pats are purc
purch
hased?
b. Assume tha that the cap capacit y now use
used to make parts will be eithe
ither (i) be rente
nted to near
earbyy
manuf
nufactu
acturrer for Br. 60, 000 for the year or (ii) be use make anothe
used to make nother produ
oduct tha
that will
yield a profit contr ontributio
ibution of Br. 250,000 per year. Should the company pur purchase the
them
from the outsi
outside de supplie
supplier?

Solu
olutio
tions:
a) To apprpproach
ach the decision
ecision from
from a fina
inancial point
oint of vie
view, the manager must focus on the relevant or
dif
differenti
erentiaal costs. The differenti
fferentiaal cost can
can be obta
obtaine
ined b y elimina
liminating from the cost data those costs
tha
that are
are not avoida
voidable –tha
–that is, by elimina
liminatin
ting the sunk cost
osts and the futur
uture cost
osts tha
that will continue
reg
regard
ardless of whe
whethe
ther the parts
arts XL-40 areare produ
oduced
ced inter
intern
nally or purch
rchased from
from outs
outside
ide.
Thus, the rel
relevant cost computa
omputation follows:
COST TO M AKE
Per Unit Tota
Total
Direc
Directt materi
erials Br.8.00 Br.480, 000
Direc
Directt labor 6.00 360, 000
Vari
ariable FOH 3.00 180, 000
Fixed FOH, avoida
voidable 2.00 120, 000
COST TO BUY
Per Unit Tota
Total
Total cost Br. 19.00 Birr 1, 140, 000 Br.21.
.21.00 Br.1, 260, 000
Here
ere above
bove, the anal ysis shows tha that the vari
ariable costs of produ oducing the part art XL-40
(materi
eri a ls, l a bor
bor , a nd v a r i a ble over
erh
h ead
ov ea ar d ) are
e d i f f e r e ntia
ntia l c osts. All the
the se v ari
ar ble costs,
i a
theref
therefo
ore,
re, can
can be avoivoided or eliminaliminated by buying the part art from
from the outside supplier
supplier..
Aga
Again, are
are onl
onl y the vari
ariable costs rel
relevant? No. Perh
Perhaps Br. 120, 000 of the totatotal fixed
facto
factorry overhead
ead cost is avoida
voidable by purch
rchasing the compone
omponent partart from outside
outside, the
then
it too will be a diffedifferrential cost and relrelevant to the decision.
ecision. Therefore fore, the
decision
ecision should be made by com comparing the total of all variable costs and the
avoidable fixe
fixed
d fac
factory overh
verheead agai
against the total purc
purchase price
price-- that is, cost to buy
buy.
Recom
ecommmendatio
dation: Grea
Greatt Compa
ompany should rej
reject
ect the outside supplier‘
supplier‘ss offer becau
ecause
it costs Br.2 less per uni
unit to continue to make the part XL-40. This is a tota
total of Br.120,
000 net adva
dvantages.
Relevanvant Costs Per Unit
Cost to buy Br.21
.21.00
Cost to make
(19.00) Adva
Advantage of making the
part
art inter
intern
nall y Br. 2.00
2.00
Tota
Total adva
dvanta
ntage = Br. 2.0 2.00 x 60,
000 units = Br. 120, 000
b) If the spa
space now is being use used to produc
oduce the part art would other
otherwise
wise be idle
idle, the
then
Great
rea t should c o ntinue to p r oduc
oduc e its own X L - 4 0 a nd the supplier‘
supplier‘s
s o f fer
fer sh ould be
rej
reject
ected, as stastated above
bove. Idle space
ace tha
that has no altern ernative use has an oppor portunit
tunity
cost of zero.
ero.
19 | P a g
But wha
what if the spaspace now being use used to produ oduce the part would not sit idle rath ratheer could be
used for some othe e r pur
oth pu pos r pose
e ? I n t h a t cas
cas e , the sp ace
ac e w o uld h a ve a n oppor
oppo tunit
r tunit y cost that
would have to be conside nsidered in asse ssessing the desir sirabilit
ability of the supplier‘
supplier‘ss offer.
fer. Wha
What would
this opp
opportunit
tunity cost be? It would be the segment margin tha that coul
ould be deriveived from
from the
best alter
ltern
native use of the space
space.. Therefo
erefore, re, the use of the idle facilities
facilities may change our previousrevious
decision
ecision in req
requir
uirement (a) above
bove.
Assuming the spac spacee now being used to produc oduce partart
XL-40 would be
A) Rente
nted to a nearb
earby manufactufacturre for Br. 60, 000 per annum or
B) Use
Used to produc
roduce othe
other produc
oduct tha that cont
ontribute
ibutes a profit of Br. 250, 000 per year, ar,
the rele
elevant cost computa
omputation follows:

Make Buy and Leav

eave Buy and Rent Buy
Buy and Produ
roduce
Facilit
Facility Idle
Idle out Oth
Other Produ
roduct
Cost to obta
obtaiin parts Br. 1, 140,00
40,000 Br. 1, 260, 000
000 Br.1,
r.1, 260,
260, 000 Br. 1, 260,
60, 0000
0000
Contribution fro m other products
products - - (250,
250, 000)
00)
Rent rev
revenue
nue - - (60, 000) -
Net relev
elevant costs Br. 1, 140,
140, 000 Br. 1, 260, 000
000 Br.1,
r.1, 200,
200, 000 Br.1,
r.1, 010,
010, 000

 Great
reat compa
ompan y would be bette tter off thr
through accepting the supplier‘
supplier‘ss offer
ffer and using
the availa
ilable facili
facilitty to produ
oduce the new produc
oduct line
line. This mov
move has the least
east net
relevant cost of Br. 1,010,000.
5.2.2 Joint Product Decisions: Sell or
Process Further
Often a firm manufactur tures several differe
different
nt produc
oducts from from a common input and a common
produc
oductiotion process.
cess. In some cas cases of such multiple produc oduct processin
cessing g, onl
onl y one produ oduct is of
major impor
mpo r t a n ce.
ce. The othee r producc ts are
oth produ ar in id nte inc
c ide
e ntaa l to p r o duc
duc tion. F or e x a m p l e , p r o cessing
cessing of
log in a wood ind industr
ustry produ
oduces
ces lumbe
mber and saw dust whe where the latte tter is produce
oduced d incide
cidenta
ntally.
In oth
other cas
cases, sevseveral produc
oducts of compa
omparable value or impor importance emerge from a sin single process.cess.
For example
mple, gasoline
soline, jet fuel, and lubr
lubrican
cants all result
result from
from petroleum refinin refining g. The accountaccountaant
classif
ssifies multip
ltiple produoducts acco
accordin
ding to their relative importance.. The principal p r o d u c t is
cal
called the main produ product. Incideidenta
ntal products of lesse sser value are usua usually calle lled by –
produ
products. Produc oducts of nearlearly equa
qual value are usually call calleed join
joint produ
products, or co-produ products. ts.
When two or mor more manufactu facturred produc
oducts have rel relative
tivel y signifnificant
cant sales value lues and are are not
separat
arately identif
identifiable as individua
individual produoducts until the
their spli
split off,
ff, they are call
called
ed join
joint produ
products.
 Split –of
–off poinpoint- is the junc junctur
ture in manufacnufactturing whe where the joi joint produc
oducts beco
ecome
individ
individually ide identif
ntifiable
ble.
 The costs of manuf nufactu
acturring joint produ oducts befor eforee the split – off are callcalleed join
joint costs.
osts.
The costs of furthe ther processi
cessinng beyond the split- split-off are
are separable costs.
osts.
Firms tha that produce several end produc oducts from common inputs are are faced with the proble oblem
of decid
ecidiing whethe ther it is mor
more adva dvantageous to sell the produc oducts at split- off point or process cess
the
th e m f u r ther
ther.
. W h e n suc
suc h a c h oic
oic e is a v a ila
a ble
il bl e , m a n a g ers
ers must be famili
familiaa r with the r e l e v ant
cost and rev revenue data to reach
reach a correct
rrect decis
ecisiion.

Here, the decision

ecision whether to sell or proce
process
ss furthe
rther will be take
takenn by comparing the additional
cost of pro
proces
cessing with the inc
incremental revenue
evenue obtainable fro
from the produc
product proprocess
cesseed furthe
further.
This decision
ecision wil
will not be influe
influenced
ced eithe
ither b y the siz
size of the joint cost or the portion of the
joint cost alloca
locatted to the product whic
which is to be process
cesseed further
ther.. Thus, joint prod
product costs
are
are irrelevant in decision
ecision reg
regardi
ardin
ng wha
what to do with a produc
oduct from
from the split
split-off point forward,
ard, the
joint produc
oduct cost
osts have alread
eady been incur
ncurred and therefore
fore are sunk costs.sts. Howe
However,
er, allocation
of joint product costs is need for some pur purpose
poses, suc
such as balance sheesheett inve
inventor
ntory valua
luation. In
cas
case joint producducts are
are on hand at the end of an accounting
accounting period,
eriod, some value must be
assig
ssigned to the
them. To do so, joint produc
oduct costs must be alloca
llocatted to spec
speciific units of inve
inventor
ntory.
  As a general rule, it will alw
always be prof
profitable to continu
tinuee proce
processi
ssinng a join
joint produ
product
–of
f f
after the split –o poin
point so lon
long as the incr
ncremental revenuenue from such proce
processi
ssin
ng
exceeds the incremental costs.
Exam
xample (1): GREAT Co. use uses a common dir direct
ect materi
erial R tha
that has a joint produc
oduct cost of
Br. 16,000 and yields 6,000 pounds of produc oduct X selling for Br. 3 per pound and 4,000
pounds of produ
oduct Y selling for Br.
3.50 Per pound. Produ
oduct X can
can be proces
cessed furthe
urther into XP at an addition
dditional cost of Br.
8,000, and produc
oduct Y can
can be process
cesseed further into YP at an additiona
dditional cost of Br. 6,000. The
new produc
oducts, XP and YP, cancan the
then be sold for Br. 4 and Br.. 6 per pound, res respectiv
ectiveel y.
Instruction: Which product (s) should be sold at split off and which should be sold
After process
cesseed further
ther? Why? Assume no loss of input in furthe
ther process
cessiing.

Soluti
olution:
Sales rev
revenue (6,000 x Br 4) Br. 24, 000
Less: Sales value at splitsplit- off (6,000 x Br. 3) 18, 000
Additiona
Additional sales rev revenue Br.6, 000
Less: separab
arable costs 8, 000
Disa
Disadva
dvanta
ntage (loss) of processingcessing furthe
ther Br.(2, 000)
Sales rev
revenue (4,000 x Br 6) Br. 24, 000
Less: Sales value at splitsplit- off (4,000 x Br. 3.50
3.50) 14, 000
Additiona
Addition a l sa les rev
rev e n u e Br. 10, 000
Less: separab
ara costs
b le 6, 000
Adva
Advantage of processi cessin
ng furthe
ther Br.4, 000
Commentent: From
From this anal ysis, a manager wou
would correctly conc onclude that produc oduct X should
be sold at the split – off and produc
oduc t Y should be p r o cess
cessee d into p r oduc
odu YP. The joint
c t
produ
oduct cost of Br. 16,000 should not be use used to reach
each this decision.
cision. Rather
ther,, the anal ysis
should be limite
mited to the differe
differen
nce betwee
tween
n the increm
crementa ntal rev
revenue and the incre increm
menta
ntal
(separable) cost.
5.2.3 Keep or Replace
Equipment Decisions
Care
are must be taken to select ect onl
onl y the data tha that are relevant for a decis ecisiion whe
whethe
ther to repreplace
ace or
keep
eep the old equipme quipment. In such kind of decision, ecision, the book value of the old equipme quipment is not a
rel
relevant conside
onsideration, for ins instance.ce.
In decidi
ecidin ng whethe ther to repl replacacee or keep eep exist isting equipme
quipment, four comm ommonl only
encounte
ountered ite items differffer in rel
relevance:ce:
(i) Book valu value of old equipment: nt: Irrel relevant, because
ecause it is a past
(Historical) Cost. Theref Therefo ore,
re, depreci
reciation on old equipme
quipment’s is irrelevant.
(ii) Disposal value of old equipment: Relevant, because ecause it is an expected futur uture infinflow
tha
that usua
usually deference among alternatives
(iii) . Gain or los loss on disposal
isposal: This is the algebraic raic dif
differen
ference between book value
and dispos
disposal value lue. It is theref
therefoore,
re, a meani eanin ngless combina
ombination of irrel rrelevant and
rel
relevant iteitems. Cons onsequequentl
ntly, it is best to thin think of each
each separately.
(iv) Cost of new equipm ipment: Relevant, becau ecause it is an expected future outf outflow tha that will
differ r
fe moa mon n g a lter
ltern
n a tive
e s.
tiv Th Theref
erefo
o re,
re , d e p reci
reci a tion on new e quip
qui p m e nt is rel
rel e v a nt.
 Exam
xample (1
(1): Consid
onsider t h e s e d a t a r e g a r d i n g S u c c e s s p h o t o c o p y i n g req
requirem
rements:
OLD
OLD P RO P O S E D
EQ UI P M E NT REPLA
PLACEMENT
EQUIP
UIPMENT
Usef
Useful
ul life
life,, in years
ears 5 3
Current
rrent age, in yearsars 2 0
Usef
Useful
ul lif
life remaining
ining, in years
ars 3 B r. 3
Origina
inal cost Br. 25,000 Not acqu
acqu 15,000
Accumul
ccumulaated depreci reciation 10,000 Not acqu
acqu 0
Book value 15,000 ired
red yet
ired
red yet
Disposa
Disposal value (in cas
cash) now 3,000 0
Disposa
Disposal value in 2 years 0
B
Annua
Annual cash
cash ope
operating costs for power,
mainte
intenance,
ce, tone
toner and supplie
upplies
Br. 14,000 r.7, 500
The administra
dministrator
tor is trying to decide
ecide whethe
ther to repl
replac
acee the old equipm
quipment. Because of
rapid changes in tech echnolog
nology, he expects
ects the replace
placemment equipme
quipment to have onl onl y a
three
three--year
ear useful
eful life
life.. Ignore the effects
fects of taxes.
Instru
structio
tion: Should SUCCESS keep or repl replac
acee the old equipme
quipment? Comp ompute the
diffe
differrence in tota
total cost ove over the next 3-years
ars under both alter
ltern
native
tives, i.e
i.e., keepi
eepin
ng the
origina
inal or repl
replac
aciing it with the new mach achine.
Solu
olutio
tion:
THR
THREE YEAR
YEARS TAKE
AKEN TOGETHER
OLD EQU
EQUIPMENT NEW EQU
EQUIPMENT
Cost of new equipme
uipment - Br. 15,000
Disposa
Disposal Value - (3,000)
Cash opera
operati
tin
ng costs Br. 42,000 22,500
Net rel
relevant costs Br. 42,000 Br. 34,500
 Recom
ecommmendatio
dation: Replac
placing
ing the old equipme
quipment has a net Br. 7,500 advanta
ntage (Br.42,
000 less Br.
34,500)
a) Comparat
parative income approac
approach.
AWASH COMPOMPANY
COMP
OMPARAT IVE INCOME STATEM TATEMENT
FOR THE NEXNEXT 4 YEAR
EARS TOGETHER
OLD MAC
MACHINE NEW MAC
MACHINE
S a le s Br. 600,000 Br. 600,000
Cash opera
operati
tin
ng costs (60,000) (36,000)
Othe
Other cashcash costs (440,000) (440,000)
Depreciation (20,000) (24,000)
23 | P a g
 Loss on disposa
disposal - (12,000)
Income Br. 80,000 Br. 88,000

Comment ent: The above analysis (whi which inc

include bot
both rel
relevant and irre
rrelevant
ite
items) shows Br. 8000 cumulative differe differennce in operati
eratin
ng income for the 4
years
ars taken togtogether
ther.. Ignoring income taxes and the time value of mone money, the
purch
rchase of the new machine
achine appears
ears to be a fav
favorabl
rablee.

Techno Star College

Department Of Accounting and Finance
Work sheet on the course of cost and management accounting II
PART I: choose the appropriate answer from the given alternatives and put your
answer on the separate answer sheet only
Balk Company manufactures and sales a single product. During the year just ended the
company produced and sold 80,000 units at an average price of Br.24 per unit. Variable
manufacturing costs were Br 10 per unit, and variable marketing costs were Br 8 per unit sold.
Fixed costs amounted to Br. 80,000 for manufacturing and Br.74, 000 for marketing. There was
no year-end work-in-progress inventory. Ignore income t
1) From the given above data Compute Blak‘s breakeven point (BEP) in sales birrs for the
year.
A) Br.154,000 B) Br.616,000 C) Br.254,000 D) Br.661,000
2) From the given above data Compute the number of sales units required to earn a net income
of Br
200,000 during the year.
A) 80,000 units B) 60,000 units C) 354,000 units D) 59,000 units
3) Which one of the following is
true?
A) The sales budget is usually prepared before the cash collection
budget. B) The cash budget is the starting point in preparing the
master budget.
C) The first budget a company prepares in a master budget is the production budget.
D) Budgeting is a trade-off between planning and control in that increased use of
budgeting will usually improve planning but will weaken control.
4) Which of the following is not a component of financing
budget?
A) Operating expense budget C) Capital budget

B) Cash Budget D) Budgeted Balance sheet

5) Which one is correct
statement?
A) If sales are increased both contribution margin and degree of operating leverage also
increased. B) If sales are increased both contribution margin and degree of operating
leverage decreased.
C) If sales are decreased, both contribution margin and degree of operating leverage
decreased. D) None of the above.
6) Given the following information in standard
costing.
Standard costing 16,000 hours @$4.00
 Actual 15,800hours @$4.20
What is the total direct labor cost variance?
A) $3,160 F C) $2,360 F B)
$3,160 U D) $2,360 U
7) Flexible budget is characterized by ;
A) Parallels a static budget with respect to format and advantages of use B)
It is preferred over a static budget in the evaluation of performance. C)
Gives management flexibility in terms of meeting budget goals
D. All
8) Which of the following is not a characteristic of flexible budget?
A. Cover a range of activity B. Are dynamic C. Facilitate performance measurement
D. None
9) From the following is not function in a standard cost system are:
a. Standard setting B. Accumulation of actual costs C. Variance analysis D. None
10) Standard cost system consists of the following except:
A. Establishing standard B. Accumulation of actual costs C. Variance analysis D.
None
11) In deciding whether to replace or keep existing equipment, which of the following
relevance:
a. Cost of old equipment
b. Accumulated depreciation of old equipment c.
Cost of new equipment
d. None
12) Cost that can be avoid when an action is taken
A. Avoidable costs B. Unavoidable costs C. Sunk costs D. None
13) In preparing the flexible budget:
A. The budgeted selling price is the same used in preparing the static budget. B.
The budgeted unit variable cost is the same used in the static budget.
C. The budgeted total fixed costs are the same static-budget. D.
All
14) The only difference between the static budget and the flexible budget is that:
a. In their output B. In their cost C. In selling price D. None
15) Which of the following type of standard does not allow for defective raw material,
inventory shortage?
A. Ideal standardB.Attainable standard C. Basic standard D. Historical standard
16) refers to determining the number of quantity of direct materials that should go into the
production of one finished unit under normal conditions
A. Quantity (usage) standards B. Price standards C. Labor variance D. None
Part II: WORK OUT
1. Assume Awash Factory‘s normal capacity to produce and sell is 10,000 bottles of Wine
annually. The company is reformulating its plans for the coming fiscal year. The following
data were used to project the current year‘s operating income of Br.150,000
Average selling price Birr 4.00 per unit
Average variable costs Birr 2.4 per unit
Annual fixed costs:
 Selling Birr160, 000
Advertising Birr 280,000
Total Birr 440,000
Expected annual sales (390,000 units) = Birr 1,560,000
Based on the above given data you are required to:
A. Compute the Company‘s breakeven point in unit and the break even sales for the current year.
(Use the contribution margin approach)
B. Determine what average selling price per bottle the Company must charge to cover the
15% increase in the variable cost and still maintain the current contribution margin ratio. C.
Refer to the original data, Assume that the company wants to use higher quality raw
materials, thus, results an increment in variable costs per unit by Birr 0.5 but fixed cost is
decreased by Birr 10,000 to generate an increase in unit sales by 25%, what will be the effect on
the operating profit? Should the company made the change? Justify your answer.
2. National Company produces a single product. For the first quarter of the year, the following data
were collected:
Units produced 20,000 units
Direct materials quantity standard 4 units of direct materials per unit of finished product
Direct materials used in production 40,000 units
Direct materials purchased 60,000 units Direct
materials standard cost Br. 4.00 each Actual direct
materials cost Br. 4.5 each.
Instruction: For materials used in the production, compute the following variances for the
quarter:
Direct materials quantity and price variances
3. Given the following data,
Normal selling price Br. 10/ unit Special
Order Selling price 8/unit Normal units sold
1,000 units Special order in units 100
Variable manufacturing cost 6/unit
Total Fixed costs 6,000
All of the total fixed cost is unaffected by variations in how much units is produced in any
given period. However, the special order requires an acquisition of a special machine costing
Br.1000 that would have no other use once the special order is completed. Based on the above
given data, should the company accept or reject the offer?
 Techno Star College
Cost and management accounting II
nd
Individual assignment for 2 year Semester II (Accounting and finance (students)
Maximum weight: 20%
Name _________________________________________________ ID no______________________

Writ e “ true” if the statement is correct and “ false” if the statement is incorrect

______1. Static-budget variance is the difference between the actual result and the corresponding budgeted amount
in the static budget.
______2. Favorable variance is a variance that increases operating income.
______3. The flexible budget uses budgeted selling price the same used in preparing the static budget
______4. The only difference between the static budget and the flexible budget is output.
______5. Flexible-budget variances measure the efficiency of operations at the actual level of activity.
______6. Standard setting is the first step in a standard cost system.
______7. Variance that is caused by external factors are controllable variance
PART II:choose the appropriate answer from the given alternatives

_____1. Which of the following is not a characteristic of flexible budget?

A. Cover a range of activity B. Are dynamic C . Facilitate performance measurement D. None
_____2. From the following is not function in a standard cost system are:
A. Standard setting B. Accumulation of actual costs C. Variance analysis D. None
_____3. In deciding whether to replace or keep existing equipment, which of the following relevance:
A. Cost of old equipment C. Cost of new equipment
B. Accumulated depreciation of old D. None
equipment
_____4. Standards are benchmarks or norms for measuring performance.
A. True B. False
_____5. Cost that can be avoid when an action is taken
A. Avoidable costs B. Unavoidable costs C. Sunk costs D. None
_____6. In preparing the flexible budget:
A. The budgeted selling price is the same used in preparing the static budget.
B. The budgeted unit variable cost is the same used in the static budget.
C. The budgeted total fixed costs are the same static-budget. D. All
_____7. The only difference between the static budget and the flexible budget is that:
A. In their output B. In their cost C. In selling price D . None
_____8. Which of the following t ype of standard does not allow for defective raw material,
 Inventory shortage?
A. Ideal standard B. Attainable standard C. Basic standard D. Historical standard
_____9. _____ refers to determining the number of quantity of direct materials that should go into
the production of one finished unit under normal conditions
A. Quantity (usage) standards B. Price standards C. Labor variance D. None
_____10. Fixed cost per unit decreases when
A. Variable cost per unit decreases C. Variable cost per unit increases
B. Production volume increases D. Production volume decreases
_____11. Difference between an actual and an expected (budgeted) amount
A. Variance B. Standard C. Budget D. None

_____12. Favorable Variance has the effect of increasing operating income relative to the budget
amount
A. True B. False
_____13. Sunk costs are:
A. Past costs that cannot be changed by a current decision. B.
Irrelevant for decision making
C. All D. None
_____14. A price variance is favorable if the actual price is less than the standard
A. True B. false
_____15. The differences between actual results and the static budget for the original planned level
of output is
A. static-budget variances B. Flexible budget variance C . sales volume variance D . none
Part III: Work Out Questions
1. National Company produces a single product. For the first quarter of the year, the following
data were collected:
Units produced 20,000 units
Direct materials quantity standard 4 units of direct materials per unit of finished product
Direct materials used in production 40,000 units
Direct materials purchased 60,000 units Direct
materials standard cost Br. 4.00 each Actual
direct materials cost Br. 4.5 each.
Instruction: For materials used in the production, compute the following variances for the
quarter:
A. Direct materials quantity and price variances
2. XY Company manufactures and sales a single product. During the year just ended the company
produced and sold 80,000 units at an average price of Br.24 per unit. Variable
manufacturing costs were Br 10 per unit, and variable marketing costs were Br 8 per unit sold.
Fixed costs amounted to Br. 80,000 for manufacturing and Br.74, 000 for marketing. There was
no year-end work-in-progress inventory. Ignore income taxes.
3. From the given above data Compute the number of sales units required to earn a net income of Br
200,000 during the year.
4. XY‘s variable manufacturing costs are expected to increase 10 % in the coming year.
What is the firm‘s breakeven point in sales birrs for the coming year?
5. If the company variable manufacturing costs do increase 10%, what is the selling price that would
yield the same CM-ratio in the coming year?
6. Mossobo cement factory manufactures PPC by mixing three raw materials. The standards and actual
for May 2016 was as follows:
Standard:
3750 tons of Material A at a standard cost of birr 20
2250 tons of Material B at a standard cost of birr 10
1500 tons of Material C at standard cost of birr 5
 Actual result:
4800 tones of Material A at a actual cost of birr 21
1500 tones of Material B at a actual cost of birr 8
1600 tones of Material C at a actual cost of birr 6
Required:
A. Direct material price variance
B. Direct material efficiency variance